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

A risk manager notes that incremental capital allocation, measured as total firm capital minus firm capital without a unit, is used for a bank's three units. What is the main implementation issue with this approach?

Incremental allocations typically do not add up to total firm capital, because each unit is removed one at a time while diversification interacts across units. This leaves an unallocated residual that must be distributed by some additional rule.

  1. AThe incremental amounts generally do not sum to total firm capital, leaving an unallocated residualCorrect
  2. BThe approach ignores correlation between the unit and the rest of the firm
  3. CThe approach always allocates more capital than stand-alone
  4. DThe approach requires that all units be uncorrelated

Explanation

Incremental capital captures the effect of each unit on the firm given correlations, but because it is evaluated one unit at a time, the sum of the incremental amounts typically falls short of total capital under diversification. Hence a residual remains. It does consider correlation and is generally no larger than stand-alone.

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