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

Which approach to risk aggregation most directly allows a bank to capture non-linear interactions between risk types, such as credit losses rising when market prices fall, in a single framework?

Simulation with common risk factors driving both credit and market losses best captures non-linear interactions, because the joint loss distribution arises from shared drivers. Summation, fixed correlation matrices and haircuts cannot represent conditional dependence between risk types.

  1. ASimulation using common risk factors driving both credit and market lossesCorrect
  2. BSimple addition of stand-alone capital figures
  3. CVariance-covariance aggregation with a single constant correlation matrix
  4. DApplying a fixed percentage haircut to the sum of capital

Explanation

Common-factor simulation models both losses as functions of shared drivers, capturing non-linear and conditional interactions. Summation and a constant correlation matrix assume linear or fixed dependence, and a haircut is arbitrary.

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