2. Suppose that the economic capital estimates for two business units are as follows:

Business unit

1 2

Market risk 10 50

Credit risk 30 30

Operational risk 50 10

Market Risk- Unit 1- 10, Unit 2- 50

Credit Risk-Unit 1- 30, Unit 2- 30

Operational Risk- Unit 1- 50, Unit 2-10

The correlation between market risk and credit risk in the same business unit is 0.3. The correlation between credit risk in one business unit and credit risk in another is 0.7. The correlation between market risk in one business unit and market risk in the other is 0.2. All other correlations are zero. Using three methods to calculate the total economic capital. How much should be allocated to each business unit?

NOTE: these are the three methods

Method 1: Allocate economic capital in proportion to the stand alone economic capitals

Method 2: Allocate economic capital in proportion to marginal contribution of business units to total economic capital

Method 3: Set economic capital for business unit i equal to where xi is the size of business unit i