Financial Risk Manager Part 1

Explanation

Economic capital is designed to absorb unexpected losses. These are losses that are not anticipated and can occur due to various unforeseen circumstances. The concept of economic capital is based on the premise that a bank or financial institution should have enough capital to absorb such losses and continue its operations without any significant disruption. This is why economic capital is often calculated based on a certain level of confidence, which represents the probability that the capital will be sufficient to cover the unexpected losses.

It's important to note that economic capital is not a fixed amount. It varies depending on the risk profile of the bank or financial institution. The higher the risk, the more economic capital is needed.

Why other options are incorrect:

• Choice A is incorrect: Economic capital does not serve the purpose of economic losses. Economic losses are a result of poor financial decisions or market downturns, which are not directly related to the concept of economic capital.

• Choice B is incorrect: Economic capital does not cover expected loss. Expected loss is typically covered by provisions and reserves set aside as part of normal business operations, and it's not the primary purpose of economic capital.

• Choice D is incorrect: While tail loss refers to extreme events with low probability but high impact, it's too specific to be the main purpose of economic capital. Economic capital serves a broader role in covering unexpected losses that may arise from various sources, not just extreme events.