Concentration Risk

Understand the point at which risk begins to magnify

Concentration risk is the potential for a loss in value of an investment portfolio or a financial institution when an individual or group of exposures move together in an unfavorable direction. The implication of concentration risk is that it generates such a significant loss that recovery is unlikely. The portfolio will be liquidated or the institution will face bankruptcy.

In addition, concentration risk can be found in various types of risk exposure such as:

  • Market liquidity risk: The difficulties in liquidating, purchasing, or switching investment assets quickly are common problems for a large investment portfolio. Concentration risk is usually calculated by comparing the liquidity of assets to their risk exposure.
  • Credit risk: The default of an individual debtor or a group of debtors in the same sector can be ruinous without sufficient diversification.

Generally, concentration risk is managed by concentration risk limits. There are many techniques for quantifying the concentration risk.

  • Use transaction cost analysis to estimate market impact
  • Incorporate turnover constraints into portfolio analysis
  • Determine the impact from “what-if” scenarios
  • Stress test the extreme events

For more on tools for concentration risk, see MATLAB®, Financial Toolbox™, and Trading Toolbox™.

See also: Financial Instruments Toolbox, Spreadsheet Link, Statistics and Machine Learning Toolbox, Financial Toolbox, Datafeed Toolbox, Econometrics Toolbox, MATLAB, Database Toolbox, Trading Toolbox, credit trading, liquidity risk, transaction cost analysis, basel III