FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks

An economic capital model aggregates risk types using a single correlation matrix with assumed correlations between credit, market and operational risk of 0.3, estimated from limited internal data. Which validation approach is most appropriate to address the uncertainty in these inter-risk correlations?

Validators should run sensitivity analysis on the correlation assumptions and benchmark against alternative aggregation approaches such as copulas or simple summation. Inter-risk correlations are hard to estimate from limited data, so the key is to understand how much capital depends on them, not to assume them away.

1. AReplace the matrix with zero correlations because they cannot be measured
2. BSet all correlations to one in the base case and never revisit them
3. CAccept the values because expert judgment needs no testing
4. DRun sensitivity analysis on the correlation assumptions and compare with alternative aggregation methods such as copulas or simple summationCorrect