If E denotes the expected value of a loan portfolio at the end on one year and U the value of the portfolio in the worst case scenario at the 99% confidence level, which of the following expressions correctly describes economic capital required in respect of credit risk?

If E denotes the expected value of a loan portfolio at the end on one year and U the value of the portfolio in the worst case scenario at the 99% confidence level, which of the following expressions correctly describes economic capital required in respect of credit risk?
A . E – U
B . U/E
C . U
D . E

View Answer

Answer: A

Explanation:

Economic capital in respect of credit risk is intended to absorb unexpected losses. Unexpected losses are the losses above and beyond expected losses and up to the level of confidence that economic capital is being calculated for. The capital required to cover unexpected losses in this case is E – U, and therefore Choice ‘a’ is the correct answer. This question does raise an important point – are expected losses a part of economic capital, or are they not? Different text books say different things, and sometimes they say both the things. I have tried to take an approach that uses what I read in the PRMIA handbook.

This writeup – http://www.riskprep.com/all-tutorials/37-exam-3/111-credit-var-an-intuitive-understanding – may help clarify things further.