Volatility Analysis and Economic Capital

Joseph Breeden

Any scenario-based forecasting model can be used to measure volatility or economic capital. Rather than testing a few economic scenarios, as is done in stress testing, we need to create the full range of possible scenarios. When those scenarios are fed through the forecasting model, the distribution of possible futures is created.

This assumes that a functioning, well-validated forecast model is in place before beginning the next step of building a model to generate environmental scenarios. What we cannot do is take a poor forecasting model and attempt to build an economic capital model on top of it. If the capital model does not produce good forecasts for common scenarios, it cannot be considered reliable under extreme scenarios.

GENERAL CONCEPTS

Under the Basel II framework (BCBS 2005), risk and capital are thought of as being split into four distinct categories:

  • credit risk;

  • market risk;

  • operational risk;

  • liquidity risk.

For retail loan portfolios, credit risk refers to loan defaults due to a failure to repay on the part of consumers. Market risk is only an issue in securitised pools where mark-to-market assessments can show trading book losses.

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