Economic Capital

[rahul.goyl]

Hi David,

Can you please brief on the below. The answer is A but I am not convinced somehow with II & III.
Which of the following statements about economic capital is (are) TRUE?
I.The economic capital system provides an appropriate level of capital to meet any potential disaster.
II.The economic capital system ensures that the firm is not overcapitalized.
III.The economic capital system properly manages the risk of the firm.
IV.The economic capital system makes sure capital is efficiently utilized.
A) I, II, III and IV.
B) I only.
C) II and IV.
D) I and III.

Regards,
Rahul

 

[David Harper CFA FRM]

Hi Rahul,

Answer (I) cannot be true: per Stulz and ERM, shareholders do now want the firm to--and the firm cannot (should not)--hold capital to meet *any* potential loss ... this implies capital for 100% of the loss potential.

There is another confusion in the question: it appears to confuse economic captial with a capital resource rather than the internal capital requirement (i.e., a risk measure) ... so if you want me to select the "most true," then I would select (IV) but with assumptions...then I do agree with you that (II) and (III) are debatable...the question expects (II) to be true because a "proper" EC system would support this but forgets that regulatory capital is may exceed EC .... the question I guess expects (III) to be true b/c it is refering to a "proper" EC system ... but frankly, i don't think this question is very useful to an 2009 FRM candidate (the FRM has advanced it's view of EC)

David

 

[rahul.goyl]

Hi David,
The Question is from Scheweser CD #71539

The Answer is (A), so all the 4 are correct according to Scheweser CD Q banks.
The Question test about the Economic capital for MR, CR, OR.
Even I got the same intution about I & III to be debatable, however I am just accepting it for exam point of view.


Thanks
Rahul

 

[David Harper CFA FRM]

Hi Rahul,

It's still wrong because it's important to understand why (I) is *definintely* wrong (nevermind the other answers mis-interpret EC as a capital resource): EC is for UL not for (any) all losses

David