Overview

The concept of portfolio optimization is critical under the Basel II Accords. Below are several excerpts from the Basel Committee on Banking Supervision s June 2004 publication International Convergence of Capital Measurement and Capital Standards: A Revised Framework (Bank of International Settlements), which points to the need for analysis in terms of portfolios.

Section 232. The exposure must be one of a large pool of exposures, which are managed by the bank on a pooled basis. Furthermore, it must not be managed individually in a way comparable to corporate exposures, but rather as part of a portfolio segment or pool of exposures with similar risk characteristics for purposes of risk assessment and quantification.

Section 527 (a). The capital charge is equivalent to the potential loss on the institution s equity portfolio arising from an assumed instantaneous shock equivalent to the 99th percentile, one-tailed confidence interval of the difference between quarterly returns and an appropriate risk-free rate computed over a long-term sample period.

Section 527 (c). However, the model used must be able to adequately capture all of the material risks embodied in equity returns including both the general market risk and specific risk exposure of the institution s equity portfolio.

Section 528 (a). Internal models should be fully integrated into the institution s risk management infrastructure including use in: (i) establishing investment hurdle rates and evaluating alternative investments; (ii) measuring and assessing equity portfolio performance (including the risk-adjusted performance); and (iii) allocating economic capital to equity holdings and evaluating...