Defining and measuring business risk in an economic-capital framework
Purpose – The objectives of this paper are to: define business risk; identify whether economic capital could be used to mitigate this risk; and investigate business-risk measurement methodologies. Design/methodology/approach – The paper analyzes definitions used in theory and practice and derived a definition. It analyzes three measurement methodologies: analogue companies/peer group analysis, statistical methods, and scenario analysis. These methodologies are tested against the criteria of effective management control, because economic capital is increasingly used as a management control instrument. Findings – Economic capital can be used as business-risk mitigant albeit not the only one. The measurement methodology of scenario analysis satisfies most of the criteria for effective control. Practical implications – This paper opens a discussion to further develop the scenario approach in theory and practice. Originality/value – Despite the amount of economic capital that financial institutions hold to cover business risk, it has received little attention in literature. This paper opens a discussion on a relatively new field of research.
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