An Introduction to Economic Capital (Risk Books Introductory Series) by Mohan Bhatia

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Mohan Bhatia
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Book review

With the Basel II and Solvency II framework in place, all types of financial intermediaries are preparing to implement economic capital measurement at some level of granularity.

This new addition to the Risk Books Introductory Series identifies the basic building blocks for economic capital measurement. It familiarises and trains a newcomer to the economic capital building blocks, computation approaches and taxonomy, risk measures, risk aggregation, distribution, correlation and dependency structures, risk mitigation, simulation and basic modelling techniques necessary for an institution to invent their own techniques and parameters for modelling economic capital for various types of risks.

The primer format will enable new entrants to quickly grasp the fundamental concepts, and covers:

• Economic capital: the purpose and objectives
• Credit risk
• Insurance risk
• Market risk
• Operational risk
• Liquidity risk
• Correlations and approximations

Recommended for risk managers, compliance officers, information technology planners and implementers, front and middle office personnel and students of Financial Engineering and Financial Risk Management courses.

TABLE OF CONTENTS

1. Economic Capital
Economic capital distribution
Regulatory capital versus economic capital
Economic capital aggregation
Issues of model risk
Conclusion

2. Credit Risk
Revisiting the Basel II model
Challenges and approximations of the Basel II model
Extending the Basel II model
Extending the Basel II model for sector concentration
Stochastic process
Markovian process
Building transition matixes
Regime shifting
Dependency structures
Copulas
Credit spreads
Unbundling the shape of a credit spread curve
Modelling correlation
Counterparty risk
Building the counterparty exposure profile
Conclusion

3. Insurance Risk
Insurance risks
Solvency II
Internal models
Conclusion

4. Market Risk
Stylised facts about market risk
Pricing, returns and risk premiums
Common characteristics of financial time series
Risk premiums
A common approach to derive EWMA, ARMA, ARCH and GARCH
Stochastic volatility models
Challenge of EWMA, ARMA, ARCH and GARCH models
Volatility
Value-at-risk
Recommended best practices for VaR models
Evaluation VaR models
Conclusion

5. Operational Risk
Overview of advanced measurement approach
Issues and challenges concerning loss data
Extreme-value theory
Modelling insurance
Conclusion

6. Liquidity Risk
Market liquidity risk equals systemic liquidity risk
Measuring funding liquidity risk
Measuring market liquidity risk premium – internal models for liquidity risk
Market liquidity risk premium
Implementing contingency liquidity risk planning
Conclusion

7. Correlation
Covariance, correlation and co-movement
Extremes have strong co-movements
Approaches to measuring correlation
Modelling tail dependence
Conclusion


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