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

A bank's risk team computes standalone economic capital of 60 for market risk, 100 for credit risk and 80 for operational risk, a total of 240. The team then builds a single aggregate figure using a model that allows for imperfect dependence between the risk types. Which statement best describes the expected result and its main reason?

Aggregate capital will normally be below the 240 simple sum, because risk types rarely peak together. Summation assumes perfect dependence, whereas an integrated model with imperfect dependence recognises diversification benefits and so produces a lower total.

  1. AAggregate capital will be lower than 240 because the risks are unlikely to produce extreme losses at the same timeCorrect
  2. BAggregate capital will be higher than 240 because dependence between risk types always amplifies tail losses
  3. CAggregate capital will equal 240 because economic capital is additive by construction
  4. DAggregate capital will be lower than 240 only if all risk types are perfectly correlated

Explanation

Simple summation implicitly assumes perfect dependence in the tail. If correlation is below one, diversification reduces the aggregate figure below the sum of standalone amounts. Perfect correlation is the case where the total would equal 240, so the last option is reversed.

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