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Economic Capital by Idzard van Eeghen, Pieter Klaassen

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Chapter 4. Running the Numbers - Measuring Economic Capital

In Chapter 3 we arrived at the following definition of economic capital: Economic capital is an estimate of the maximum potential downward deviation of a firm's equity value from the expected equity value at a time horizon of one year, subject to a chosen confidence level.

An important feature of this definition is that economic capital is derived from the probability distribution of equity values at the chosen time horizon. Hence, it does not measure the change in equity value between the current date and the chosen time horizon, but rather how much lower the equity value at the time horizon can be compared to the expected equity value, given the chosen confidence level.

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