Estimating economic capital allocations for market and credit risk

ABSTRACT Value-at-Risk (VAR) measures often are used as a basis for setting so-called “economic capital” or buffer stock measures of equity capitalization requirements. VAR measures do not account for the time value of money or the equilibrium required return premium for credit risk on a firm’s funding debt, and consequently they produce biased estimates of economic capital. The bias in common VAR approaches increases with the horizon and consequently is most pronounced in the credit risk setting where capital allocations horizons typically coincide with extended holding periods, but the bias is also important in the market risk setting when capital allocations are set for similar tenors. Accurate capital estimates can be obtained using a VAR-like measure that is constructed relative to a portfolio’s initial market value and augmented by an estimate of the interest compensation required on funding debt.