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April 25, 2005

Modelling Economic Capital: Clever Strategy or Dead Alley?

mrleft.gifmrright.gifEconomic capital modelling is a controversial approach that some financial institutions use to estimate extremely high percentiles (typically 99.5%, 99.9% or higher) of overall loss distribution. But what is the true value of the this approach? Is it a flawed strategy crippled by insufficient data? Or is it a critical component of a larger framework for assessing risk and return? Is it virtually impossible to use high percentiles to make an investment decision? Or does the economic capital approach serve as a key ingredient in the investment decision-making process? Is it the way of the future for strategic allocation of resources or a dangerous dead alley? Riccardo Rebonato and Dr. Joe Pimbley offer strong opinions on these issues (and others) in a lively debate.

“Trying to estimate very high percentiles of the distribution of non-stationary processes where we collect data with relatively low frequency is a dead alley.” --Riccardo Rebonato

“Beyond serving as an intellectual bridge for investment decisions,
models are indispensable for helping us understand the nature of risk in our positions. Model development itself teaches risk managers what we need to know.” -- Joe Pimbley

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Posted by Tom Troceen