What is the level of economic capital required to cushion unexpected losses?

A loan portfolio’s full notional value is $100, and its value in a worst case scenario at the 99% level of confidence is $65. Expected losses on the portfolio are estimated at 10% .

What is the level of economic capital required to cushion unexpected losses?
A . 25
B . 65
C . 10
D . 35

View Answer

Answer: A

Explanation:

Expected value = $90 ($100 – 10%)

Value at 99% confidence level = $65

Therefore economic capital required at this level of confidence = $90 – $65 = $25.

Choice ‘a’ is the correct answer, the other choices are not.

(We can also look at it this way as explained in section III.B.6.2.2 of the handbook: Economic capital is designed to absorb unexpected losses, which areequal to total losses at a given confidence level minus expected losses. (Expected losses are to be covered by credit reserves). Total losses are $100-$65=$35, and expected losses are 10%*$100=$10, therefore economic capital should be $35-$10=$25.)