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FRM Part II · FRM Exam Part II · Integrated Risk Management

A bank allocates economic capital to business units using incremental (marginal) contributions to total portfolio capital. The risk team notices that the sum of the unit-level incremental capital amounts does not equal total bank economic capital. Which statement best explains this result?

Incremental capital is the change in total bank capital when a unit is removed, and because of diversification and non-linearity of risk measures these changes generally do not sum to total capital. The mismatch is expected and does not indicate a calibration error or differing confidence levels.

  1. AIncremental capital is computed at a different confidence level for each unit, so the amounts cannot be added
  2. BIncremental capital measures the change from removing a unit entirely, and these changes generally do not sum to the total because of diversification and non-linearityCorrect
  3. CIncremental capital excludes operational risk, so the sum is always smaller than the total
  4. DThe discrepancy shows that the correlation estimates are invalid and must be recalibrated

Explanation

Incremental capital is the difference in total capital with and without a unit. Because of diversification effects and non-linearity in risk measures such as VaR, these differences generally do not add up to the total. Euler-type (marginal contribution) allocations, by contrast, sum exactly to the total for homogeneous measures. The other options invent causes.

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