Earnings-at-Risk as a Capital Allocation Tool

Nothing is more soothing or more persuasive than the computer screen, with its imposing array of numbers, glowing colours, and elegantly structured graphs. As we stare at the passing show, we become so absorbed that we tend to forget that the computer only answers questions; it does not ask them.1

In Parts Three and Four of this book, I have described models for allocating capital which are essentially bottom-up methodologies. In both the regulatory and internal risk-model approaches, individual assets or exposures were assigned a level of capital, based on assumptions as to their potential loss in value over a given time horizon. These were called “asset volatility” approaches to allocating capital. We saw how these types of model can be very precise if applied properly, but have some shortcomings. The regulatory model is too crude, and ignores diversification effects. The internal risk models are more sophisticated, and take diversification into account, but tend to lose value at higher levels of aggregation. This is because they are good tools for managing individual risks, but it is difficult to aggregate the results across different risk classes. It is also possible for individual risks to be misrepresented or even omitted altogether, especially in the case of operational risks.

In this section of the book, I will address the issue of capital allocation from a completely different angle, looking at the volatility of earnings ...

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