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FRM Part II · FRM Exam Part II · Risk Capital Attribution and Risk-Adjusted Performance Measurement

A bank's risk team wants to allocate total economic capital of a portfolio to its business units so that the allocated amounts add up exactly to the portfolio capital and reflect each unit's contribution to the portfolio's overall risk. Which approach best meets this requirement?

Diversified covariance-based (Euler-type) contributions are best, because they sum exactly to total portfolio capital and capture each unit's correlation with the rest of the firm. Stand-alone and marginal measures do not add up to firm capital, and notional ignores risk.

  1. AStand-alone capital of each unit, computed as if it were a separate firm
  2. BMarginal capital, computed as the change in firm capital from removing each unit entirely
  3. CDiversified (Euler-type) capital contributions based on each unit's covariance with the portfolioCorrect
  4. DAllocation in proportion to each unit's notional exposure

Explanation

Covariance-based (Euler) contributions are additive: weighted contributions sum to total portfolio risk, and they reflect diversification. Stand-alone capital ignores diversification and sums to more than firm capital. Marginal capital from full removal generally does not sum to the total.

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