Which of the following best describes economic capital?

Which of the following best describes economic capital?
A . Economic capital is the amount of regulatory capital mandated for financial institutions in the OECD countries
B . Economic capital is the amount of regulatory capital that minimizes the cost of capital for firm
C . Economic capital reflects the amount of capital required to maintain a firm’s target credit rating
D . Economic capital is a form of provision for market risk losses should adverse conditions arise

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Answer: C

Explanation:

Economic capital is often calculated with a view to maintaining the credit ratings for a firm. It is the capital available to absorb unexpected losses, and credit ratings are also based upon a certain probability of default. Economic capital is often calculated at a level equal to the confidence required for the desired credit rating. For example, if the probability of default for a AA rating is 0.02%, and the firm desires to hold an AA rating, then economic capital maintained at a confidence level of 99.98% would allow for such a rating. In this case, economic capital set at a 99.8% level can be thought of as the level of losses that would not be exceeded with a 99.8% probability, and would help get the firm its desired credit rating.

Choice ‘c’ is the correct answer. Economic capital does not target minimizing the cost of capital, nor is it a provision for losses arising from market risk. The concept of economic capital is unrelated to where an institution or firm is based, therefore Choice ‘a’ is incorrect as well.