When combining separate bottom up estimates of market, credit and operational risk measures, a most conservative economic capital estimate results from which of the following assumptions:

When combining separate bottom up estimates of market, credit and operational risk measures, a most conservative economic capital estimate results from which of the following assumptions:
A . Assuming that the resulting distributions have a correlation between 0 and 1
B . Assuming that market, credit and operational risk estimates are perfectly positively correlated
C . Assuming that market, credit and operational risk estimates are perfectly negatively correlated
D . Assuming that market, credit and operational risk estimates are uncorrelated

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Answer: B

Explanation:

Explanation

If the risks are considered perfectly positively correlated, ie assumed to have a correlation equal to 1, the standard deviations can simply be added together. This gives the most conservative estimate of combined risk forcapital calculation purposes. In practice, this is the assumption used most often.

If risks are uncorrelated, ie correlation is assumed to be zero, variances can be added or the standard deviation is the root of the sum of the squares of the individual standard deviations. This obviously gives a number lower than that given when correlation is assumed to be +1.

Similarly, assumptions of negative correlation, or any correlation other than +1 will give a standard deviation number that is smaller and thereforeless conservative. Choice ‘b’ is the correct answer.