📊 VaR vs Economic Capital — Understanding the Difference

Both Value at Risk (VaR) and Economic Capital (EC) are key tools in Financial Risk Management (FRR), but they serve different purposes in assessing and managing risk.

🔹 Value at Risk (VaR)

Definition:
VaR estimates the maximum expected loss over a specific time horizon, at a given confidence level, under normal market conditions.

Example:
A 99% one-day VaR of ₹10 million means there’s only a 1% chance the firm will lose more than ₹10 million in a day.

Key Features:

  • Time horizon: Usually 1 day to 10 days

  • Confidence level: Typically 95% or 99%

  • Purpose: Market risk measurement and daily risk limit setting

  • Usage: Regulatory capital under Basel II/III for trading book

Limitations:
VaR doesn’t capture extreme tail losses beyond the chosen confidence level — hence not always sufficient for capital adequacy.

🔹 Economic Capital (EC)

Definition:
Economic Capital represents the amount of capital a firm needs to remain solvent over a longer horizon (typically 1 year), considering unexpected losses from all risk types — market, credit, operational, and liquidity risks.

Key Features:

  • Time horizon: 1 year

  • Confidence level: Often 99.9% (tail-focused)

  • Purpose: Internal risk appetite, capital planning, and stress testing

  • Usage: Economic value-based view, aligning with shareholders’ risk tolerance

Limitations:
Depends on complex internal models and assumptions; difficult to compare across firms.

⚖️ VaR vs EC — At a Glance

FeatureValue at Risk (VaR)Economic Capital (EC)
ObjectiveMeasure potential market lossMeasure required capital for all risks
Time Horizon1–10 days1 year
Confidence Level95–99%99.9%
ScopeMainly Market RiskCredit, Market, Operational, Liquidity
Use CaseDaily risk control, regulatory capitalInternal capital adequacy, ICAAP
OutputLoss estimateCapital buffer

🧭 In FRR / GARP FRM Context

VaR focuses on short-term potential loss, while Economic Capital focuses on long-term solvency and resilience.
Regulators use VaR for capital calculation, but banks use EC to determine how much capital they should hold beyond regulatory minimums — for real economic safety.

#FRR #GARPFRM #RiskManagement #ValueAtRisk #EconomicCapital #MarketRisk #CreditRisk #OperationalRisk #BaselFramework #FRRPrep#financialRisk&Regulation

Comments

Post a Comment

Popular posts from this blog

  Hi everyone, today I want to share my journey of preparing for the GARP FRR exam—that’s Financial Risk and Regulation. I began my preparation in February 2025, and honestly, I was surprised to see how little dedicated material was available. Unlike FRM, which has plenty of resources, FRR mostly relies on official GARP content. Even AI tools and question banks are usually built on FRM data, which makes preparing for FRR more challenging. Here’s what I noticed: FRM questions are more logical and concept-driven, while FRR questions focus heavily on facts, figures, and numbers. The exam often gives options that look very similar, which can be tricky. In my exam, I saw about 8–9 numerical questions. If you’re not strong in math, don’t worry—you can still manage by focusing on formulas and practicing straightforward to medium-level problems. During my preparation, I solved around 4,000 MCQs. Later, I realized most of them were FRM-based, but they still helped me strengthen my concept. ...
Read more
Understanding Duration Gap Analysis from the FRR Perspective In the world of banking and financial management, managing interest rate risk is crucial. One of the most important tools used by banks for this purpose is the Duration Gap (DG) Analysis . This analysis helps banks understand how sensitive their assets and liabilities are to changes in market interest rates and how those changes impact both their Net Interest Income (NII) and the Economic Value of Equity (EVE) . ✅ What Is Duration Gap Analysis? Duration Gap measures the difference between the average duration of a bank’s assets and liabilities. Duration of Assets (DA) refers to how long it takes for the bank to recover its invested funds through interest payments and principal repayments. Duration of Liabilities (DL) refers to the time period over which the bank pays interest and repays its borrowed funds. The formula is simple:    Duration Gap (DG) = Duration of Assets (DA) − Duration of Liabilities (DL) A p...
Read more

Three Lines of Defence in Financial Risk Management

🧱 Three Lines of Defence in Financial Risk Management (FRR Concept Explained) In the world of Financial Risk Management (FRR) , one of the most essential frameworks every GARP FRM aspirant must understand is the Three Lines of Defence Model . It forms the backbone of how financial institutions like banks, asset managers, and insurance companies manage and control risk effectively. Let’s decode this concept in simple, exam-ready language 👇 🔹 First Line of Defence — Business & Frontline Management The first line of defence represents the business units that take and manage risk on a day-to-day basis. These are the teams directly involved in revenue-generating activities , such as trading desks, lending departments, and investment teams. They are responsible for: Identifying and managing risks in their processes Implementing internal controls Ensuring compliance with the Risk Appetite Framework (RAF) 💡 Example: A trading desk ensuring position limits are not breached...
Read more