“Risk Capital: Theory and Applications,” by Brattle Principals Stewart Myers and James Read, with Isil Erel of Ohio State University, is the lead article in the latest issue of the Journal of Applied Corporate Finance. The article presents a theory of risk capital and principles for allocating capital to investments and contracts made by financial firms.

Risk capital ­– often referred to as “economic” capital – is not the same as cash capital, which is the primary focus of capital budgeting in nonfinancial firms. It also differs from regulatory capital, for example, bank capital requirements based on risk-weighted assets. Since risk capital is costly, it must be allocated to make efficient investment and risk management decisions, to price products and services, and to evaluate profitability and management performance.

Capital allocation and investment decisions based on the authors’ theory can differ importantly from those based on value at risk (VaR) and risk-adjusted return on capital (RAROC), concepts that are widely used in the banking and financial services industries. And while risk capital is primarily of interest to financial firms, nonfinancial companies can also put the theory to work to inform their risk management and financial decision making.

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