Hi David,

I was going through the flash quiz and I see that for economic capital we use top-down approach . The way I reasoned was EC=VaR-EL , basically EC has to take care of unexpected loss . If that is the case UL occurs more at the tail it is LFHS event, hence to determine this we need a bottom-up approach as a top-down does not diffrentiate between LFHS and HFLS . Is there a flaw in my reasoning?

Ravi

Hi Ravi,

Nothing wrong with that reasoning...Very nicely put!

It’s funny b/c in re-writing this question I struggled with your point for twenty minutes checking the source, etc, and i decided to leave it but i didn’t feel totally comfortable, so I am glad you noticed this (I should have known!)- it is the weakest part of the question. I was just trying to quiz the Linda Allen reading (Chapter 5) where her exhibit 5.2 has Top-Down as the *primary* model for Economic Capital. That is my reluctant source. She has some supporting text but likely it refers to Basel II OpRisk BIA and SA approaches which indeed are TOP-DOWN (Risk indicator = gross income) models of economic captial, but on the other hand, AMA is bottom-up...so, EC has no exclusive claim here, and I like your answer better...

David