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The limits of diversification when losses may be large

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Title: The limits of diversification when losses may be large
Authors: Ibragimov, R
Walden, J
Item Type: Journal Article
Abstract: Recent results in value at risk analysis show that, for extremely heavy-tailed risks with unbounded distribution support, diversification may increase value at risk, and that generally it is difficult to construct an appropriate risk measure for such distributions. We further analyze the limitations of diversification for heavy-tailed risks. We provide additional insight in two ways. First, we show that similar non-diversification results are valid for a large class of risks with bounded support, as long as the risks are concentrated on a sufficiently large interval. The required length of the support depends on the number of risks available and on the degree of heavy-tailedness. Second, we relate the value at risk approach to more general risk frameworks. We argue that in markets for risky assets where the number of assets is limited compared with the (bounded) distribution support of the risks, unbounded heavy-tailed risks may provide a reasonable approximation. We suggest that this type of analysis may have a role in explaining various types of market failures in markets for assets with possibly large negative outcomes.
Issue Date: 1-Aug-2007
Date of Acceptance: 7-Nov-2006
URI: http://hdl.handle.net/10044/1/67784
DOI: https://dx.doi.org/10.1016/j.jbankfin.2006.11.014
ISSN: 1872-6372
Publisher: Elsevier
Start Page: 2551
End Page: 2569
Journal / Book Title: Journal of Banking and Finance
Volume: 31
Issue: 8
Copyright Statement: © 2007 Elsevier Ltd. All rights reserved. This manuscript is licensed under the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International Licence http://creativecommons.org/licenses/by-nc-nd/4.0/
Keywords: Social Sciences
Business, Finance
Business & Economics
value at risk
coherent measures of risk
heavy-tailed risks
catastrophe insurance
risk bounds
0102 Applied Mathematics
1502 Banking, Finance And Investment
Publication Status: Published
Online Publication Date: 2007-01-25
Appears in Collections:Imperial College Business School