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# In range of practices and issues in economic capital framework,

#### christylee

##### New Member
Subscriber
I bought the garp book for part 2 and found out that the part "in range of practices and issues in economic capital framework" is quite deep and vast I mean there are so many pages in the garp book to study for that topic while the study notes bionicturtle has provided has only 20 pages. Is it enough to only study the study notes for this topic? I am worried because some parts of that topic in the book are not found in the study notes.

#### Nicole Seaman

Staff member
Subscriber
I bought the garp book for part 2 and found out that the part "in range of practices and issues in economic capital framework" is quite deep and vast I mean there are so many pages in the garp book to study for that topic while the study notes bionicturtle has provided has only 20 pages. Is it enough to only study the study notes for this topic? I am worried because some parts of that topic in the book are not found in the study notes.
Hello @christylee

Generally, our study notes are enough because we make sure to cover all of the learning objectives that GARP provides. We make sure to summarize all of the important content within those learning objectives. We have not yet updated this specific set of notes for 2019 but it is on our list to update soon. If this is a reading that you can skip for now, our updated notes will cover all of the concepts in the learning objectives. I hope this helps!

Nicole

##### Member
Subscriber
hi @David Harper CFA FRM

Under this topic in your notes, subtopic "Interest rate risk in the banking book" you have mentioned below line

Trade-offs between using an earnings-based or economic value-based approach to measuring interest rate risk in the banking book need to be recognized. The use of an earnings-based measure creates aggregation challenges when other risks are measured on the basis of economic value. Conversely, the use of an economic value based approach may create inconsistencies with business practices

Can you help me understand this? I didn't get what its meant to convey.

Thanks

#### David Harper CFA FRM

##### David Harper CFA FRM (test)
Staff member
Hi @Jaskarn it would be helpful if you can reference the reading because it took me time just to find the reference. Okay so this refers to the accounting versus economic (value) trade off that is generally introduced in Crouhy and which is discussed at length here https://www.bionicturtle.com/forum/threads/economic-earning-accounting-earning.10625/

BIS has a specific instance of this as they are referring to the interest rate risk in the banking book, but I illustrated a very general concept of the difference using an FX hedge at the end of the thread:
@umerkhan The difficultly is not the distinction between accounting and economic profit: that should be easily understood by any accounting student (accounting profits refers to reported earnings per accounting conventions, which any analyst knows does not equate to cash flow or economic balance sheet changes. Among the primary reasons for this are the matching principle. I don't want to spend current time on illustrating accounting basics). Accounting profits are the result of period (quarterly, annual) reports according to accounting rules; economic profits refer to cash-flows and value-based (even if unrecognized) changes which are the economic "truth." The challenge here is Crouhy (the author) is imprecise with respect to the specific example.

If you want me to further color my interpretation, it has already been nicely summarized by @terrence, but I will illustrate below. Let me say that I think Crouhy's abstract concept is straightforward and fine: he is saying that if the balance sheet is already naturally, economically hedged, then the addition of a futures contract (albeit for accounting motivations; again, this refers to reported earnings) will "unbalance" the natural hedge. If we can understand that concept, then we can imagine other permutations, in addition to mine below.

I have three steps, they correspond to the above descriptions (I am using modifications of my learning XLS for the Saunders FX reading; Saunders is precise.)

1. The initial state is short GPB (the loan liability) matched with the GPB Asset; below illustrates the GPB 1,000 loan funds the GPB asset, but there is a GBP depreciation (USD appreciation) from $1.30 to 1.15. The loss on the asset is offset by the negative COF. 2. My mere interpretation of Crouhy's imprecise language is that the company, for unstated reasons (this gets into accounting and hedge accounting ) must "realize" the loss on the asset due to FX translation; by "realize" I mean "report on the quarterly/annual accrual-based income statement." But if the company only realized the asset loss, it suffers on its accounting profit. So, to hedge the accounting problem, the company adds a FX forward contract position. In my example, the strike price is a 5% discount to the$1.30 and so the company gains on the futures contract. The company's "accounting profit" exposure is represented on the left hand side only; its economic reality includes all three positions (liabilities, assets + FX forward contract). But in this situation, the company's economics are better than before due to the additional +6.88%. Yay for good news!!!

3. Except ooops forward contracts go both ways, uh oh. If the GBP instead appreciates (as below, to \$1.45), the accounting is still fine (left hand side only), but the economic (total) situation is worse. I think that's what he means. Here is my XLS: https://www.dropbox.com/s/2s54iy6s4rfawhh/082118-crouhy-hedge-accounting.xlsx?dl=0 if you want to explore this with yet more precision