Economic Capital

Question 1

Purposes of an internal economic capital model (64)

Answer 1

1. To determine how much capital a firm should hold to protect it against adverse events
2. To price new products and decide how to allocate capital across business lines
3. To assess the amount of economic capital that should be held over time.
4. To assess the impact of changes in investment strategy and capital structure
5. To look at how an organization copes in the face of extreme events
6. To help measure performance
7. To carry out due diligence for corporate transactions
8. To provide info on the financial state of the organization to a regulator

Question 2

Considerations for designing an economic capital model (64)

Answer 2

1. Must agree on what the model will be used for
2. Must agree on what risks will be modeled
3. Must decide which approach to use
   a. Factor table - requires a certain amount of capital to be held for each unit of a particular activity
   b. Deterministic approach - stress test that considers the amount a firm would lose under different scenarios
   c. Stochastic approach - use a stochastic, parametric, or empirical model to produce a large number of simulated results
4. Decide whether the model will be run on an enterprise-wide basis, or whether individual models will be run for each business line with the results being combined later
5. Consider what output is required from the model

Question 3

Economic capital and risk optimization measures (65)

Answer 3

Definition of economic capital - the additional value of funds needed to cover potential outgoings, falls in asset values, and rises in liabilities at some given risk tolerance over a specified time horizon

1. Risk-adjusted return on capital (rA) = risk-adjusted return / economic capital. Is well suited for comparing different lines of business within a firm.
2. Economic income created (EIC) = (rA - rH) * EC, where rH is the hurdle rate of return and EC is the economic capital. Is the rate of return that each unit of a product sold must earn to cover the additional amount of risk it generates.
3. Shareholder value (SV) = EC * (rA - rG) / (rH - rG), where rG is the rate of growth of the cash flows. Represents the discounted present value of all future cash flows. Unlike the first 2 measures, which were single-period, SV reflects longer term based on present value.
4. Shareholder value added (SVA) = EC * [(rA - rG) / (rH - rG) - 1] = SV - EC

Question 4

Allocating an organization’s capital based on benefits of diversification (66)

Answer 4

1. Allocate full stand-alone capital requirement to each line and retain diversification benefit centrally. May make lines uncompetitive.
2. Give full benefit of diversification to new line triggering the benefit. This is arbitrary.
3. Allocate the benefit in proportion to the stand-alone capital requirements by line of business. This is unfair to smaller segments creating larger diversification benefits.
4. Euler capital allocation principal - considers marginal contribution of each additional unit of business to overall capital requirements. For example, if the required economic capital is proportional to the standard deviation of a loss, then allocate risk capital for a given line of business in proportion to the following ratio:
   a. the covariance between the loss in that line and the total loss
   b. divided by the standard deviation of the total loss