1-1. Definition: http://www.investopedia.com/terms/e/economic-capital.asp
The amount of capital that a firm needs to ensure that the company stays solvent (Economic capital is a useful yardstick both internally and externally).
Required economic capital for a firm as a whole is the notional amount capital to withstand an extreme but rare loss event after taking into account all the interactions of the risks in the portfolio. Once the required economic capital of a firm is estimated, it should be compared with the total capital of the firm (market capitalization). If firm's equity capital less than the economic capital then firm is in a risk position that cannot be sustained because the available capital is negative.
**Video lecture(Michael Ong): http://www.youtube.com/watch?v=6Ddn3oKIOu8
2. Use of the Pricing Mechanism
2-1. Marginal Cost Pricing
The price of asset should compensate the institution for its marginal cost pricing as measured on a risk-adjusted basis. The more a product increases a lender's porftolion concentration, the higher its marginal costs to that lender.
2-2. Cost-Plus-Profit Pricing
A credit pricing mechanism that adds a credit spread to the base capital cost for the lending institution.
Credit spread based on:
- Borrower Rating
- Tenor (Loan Term)
- Collateral
- Guarantees
- Covenants
- Various other relevant costs
* Historic Loss Rate by Internal Risk Rating (historic 5 years rost rate)
- Aaa: 0.034%
- Aa: 0.106%
- A: 0.264%
- Baa: 1.166%
- Ba: 6.371%
- B: 15.737%
*Term Structure of Rates: Maturity vs. Cost of Funds(%)
- 1 year: 5%
- 2 years: 5.5%
- 3 years: 6%
- 4 years: 8%
- 5 years: 10%
- 10 years: 12%
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