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Chapter 13 - Economic Capital

B

BhatiaI

Member
Hi All,

Just a quick question, I was re-reading chapter 13 and it says
"However, if the mix of businesses is changed, there will be a change in the
correlation of each business with the total. For example, if changes occur in the
businesses of Divisions 1 and 2 then the correlation factor for Division 3 would alter
despite there being no changes within that division. This might lead to a change in the
amount of risk capital allocated to Division 3 and hence the derived performance of that
division.
In order to prevent this, we focus on the marginal risk capital required by each
business. This is done by repeating the calculations looking at the correlation of
each business in turn to the remaining businesses of the institution, and then
using the results to determine the marginal EAR of each business."

What I understand is that Marginal EAR was introduced to deal with the problem of diversified EAR i.e. Capital for division 3 will be dependent on business mix and if division 2 or 1 changes then capital for division 3 also changes.

However, this problem exists in Marginal EAR too if I am not wrong, since capital for division 3 will still change if there is a change in division 2 or 1.

Am I missing anything?

Any help will be highly appreciated.

Thanks and kind regards
Ishita
 
Yes, I agree with you - the problem will still be there (with my simply way of thinking about it). I suspect that using marginal capital may be slightly more stable though. If you have 5 business units, and units one and two double in size, what will be the effect on the marginal capital required to add business 3 to the pot? Probably not a lot. Whereas if business unit three has a fifth of the total capital for the business and units one and two double in size, and the total capital is then re-distributed according to the total risk that each unit represents, it may make quite a change to the capital that unit 3 is awarded. I have no mathematical proof, but just a gut feeling.
 
Ya, I kind of understand, but ya the problem will be there.

Thanks you Colin.
 
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