Using Multidimensional Linear Interpolation to find Economic Capital Rates

In banking, Economic Capital (EC), is an internal measure of capital required to absorb unexpected losses while remaining solvent at a targeted solvency level. It provides a common basis for comparing risk-adjusted profitability and relative economic value of lines of business and asset classes with varying degrees and sources of risk.  EC has various applications that include performance measurement, risk-adjusted pricing, capital allocation, capital adequacy and risk concentration management. EC can be allocated at either a loan, facility or line of business level.

Economic Capital is statistically/quantitatively determined and designed to be sensitive to changes in loan characteristics (risk factors) as a result of both systematic and idiosyncratic factors. Very often EC is calculated through the use of Monte Carlo Simulation – An analytical technique that involves performing a large number of random iterations, called simulations, to generate a statistical distribution of possible outcomes.  In finance, Monte Carlo simulations are used to value and analyze complex instruments, portfolios and investments by simulating the various sources of uncertainty affecting their value.Read More »