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FRM Part II · FRM Exam Part II

Fundamental Review of the Trading Book (FRTB) for FRM Part 2

The Fundamental Review of the Trading Book (FRTB) is the Basel framework that sets market risk capital for trading positions. It replaced Value at Risk with Expected Shortfall, tightened the trading book boundary, and offers a Standardized Approach and an Internal Models Approach. To solve questions, identify the approach, then apply the measure and its conditions.

What this chapter covers

This chapter covers how Basel revised market risk capital after the 2007-09 crisis. Basel 2.5 patched the old rules. FRTB then rebuilt them. You study why the old regime failed, how positions are assigned to the trading book or banking book, and the two ways to calculate capital: the Standardized Approach and the Internal Models Approach.

The core ideas are few but precise. Expected Shortfall replaces VaR to capture tail risk. Liquidity horizons replace a flat 10-day horizon. Non-modellable risk factors get a separate stress-based charge. Desks must pass P&L attribution and backtesting tests to keep using internal models. The chapter ends with credit valuation adjustment (CVA) and securitization treatment.

This chapter links to the rest of Part II. It builds on the Market Risk Measurement and Management topic, especially VaR, Expected Shortfall and backtesting. It touches credit risk through CVA and securitization, and it connects to liquidity through liquidity horizons. Treat it as the regulatory frame around the market risk tools you already know.

FRTB is a regulatory chapter, and the exam rewards precise recall of Basel concepts inside applied questions. You may be asked why a position sits in the trading book, which test a desk failed, or how a measure changes under stress. These are factual and structured, so careful study turns directly into correct answers. It also reinforces VaR, Expected Shortfall and backtesting, which appear elsewhere in the paper. Because the exam has 80 equally weighted questions, every precise point you secure here counts the same as any other.

Fundamental Review of the Trading Book: topics in the order to study them

  1. 1Basel 2.5 and Why FRTB Was IntroducedStart with the weaknesses of the old regime, because every FRTB feature answers one of them.
  2. 2Trading Book vs Banking Book BoundaryThe boundary decides which rules apply to a position, so learn it before any capital calculation.
  3. 3Standardized Approach (Sensitivities-Based Method)It applies to all banks and is the fallback for desks that lose internal model approval, so it is the base case.
  4. 4Internal Models Approach and Expected ShortfallOnce you know the standardized method, you can see what internal models change: Expected Shortfall and liquidity horizons.
  5. 5Modellability, P&L Attribution and BacktestingThese are the conditions for keeping internal model approval, so they only make sense after the model itself.
  6. 6Credit Valuation Adjustment and Securitization TreatmentThese are separate capital treatments with their own rules, best learned last and kept distinct.

How to prepare Fundamental Review of the Trading Book

Plan for rule-based learning with light calculation. Aim to explain each concept in one or two sentences, then practise applying it.

  1. Read the topics in the study order above. After each, write one line on the problem it solves.
  2. Build a comparison sheet of VaR versus Expected Shortfall: what each measures, the confidence level and how tail risk is treated.
  3. Learn the standardized and internal approaches side by side: who can use each, what the inputs are and what happens on failure.
  4. Memorise the desk-level tests and what each one checks: modellability, P&L attribution and backtesting. Note the consequence of failing.
  5. Practise short scenario questions: a position, a desk result or a risk factor. Decide which rule applies and why before looking at options.
  6. Review the CVA and securitization treatments last, and note how each differs from the main market risk charge.
  7. Revisit your errors in the last week and rewrite each as a one-line rule.

Common mistakes in Fundamental Review of the Trading Book

  • Treating Expected Shortfall as just a higher VaR.

    Fix: Remember ES is the average loss beyond the tail threshold, so it reflects the size of tail losses, not just where the tail begins.

  • Assuming internal models are approved for the whole bank.

    Fix: Link approval to the trading desk. Each desk must pass its own tests.

  • Mixing up the three desk-level tests.

    Fix: Tie each to one question: are the inputs observable, does the model P&L match front-office P&L, and do actual losses fit the model.

  • Using one flat holding period for every risk factor.

    Fix: Recall that FRTB assigns liquidity horizons by risk factor category, so less liquid factors are scaled longer.

  • Confusing Basel 2.5 additions with FRTB features.

    Fix: Keep a two-column list: Basel 2.5 as interim fixes, FRTB as the redesign that follows.

  • Ignoring the boundary rules and focusing only on calculations.

    Fix: Expect scenario questions on which book a position belongs to and what limits moving it, and learn those conditions precisely.

Last-day revision: Fundamental Review of the Trading Book

  • FRTB replaces VaR with Expected Shortfall to capture tail risk beyond a single quantile.
  • Basel 2.5 added stressed VaR, the incremental risk charge and the comprehensive risk measure as patches.
  • The trading book boundary is based on trading intent and tighter rules limit moving positions between books.
  • The Standardized Approach is sensitivities-based and applies to all banks.
  • The Internal Models Approach is approved desk by desk, not for the whole bank at once.
  • Liquidity horizons vary by risk factor, replacing a single flat horizon.
  • Risk factors that lack enough real price observations are non-modellable and get a separate stress-based charge.
  • Desks must pass P&L attribution and backtesting to keep using internal models.
  • A desk that fails the tests falls back to the Standardized Approach.
  • CVA risk has its own capital framework, separate from the market risk charge.
  • Securitization positions have separate treatment and are not simply handled with internal models.
  • Always state the approach first, then the measure, then the interpretation.

Fundamental Review of the Trading Book practice questions

Fundamental Review of the Trading Book in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Fundamental Review of the Trading Book: frequently asked questions

Is Fundamental Review of the Trading Book part of FRM Part II?

Yes. It sits within market risk and regulation in Part II, which is an 80-question, four-hour multiple-choice exam. Expect applied questions that use Basel terms precisely.

Do I need to calculate Expected Shortfall in the exam?

Be ready for simple calculations, such as averaging losses beyond a threshold. Equally important is explaining why Expected Shortfall replaced VaR and how it is used in capital.

What happens if a trading desk fails backtesting or P&L attribution?

The desk cannot keep using the Internal Models Approach and falls back to the Standardized Approach, which usually brings a different capital outcome. Learn this consequence along with each test.

Which topic should I study first in this chapter?

Start with Basel 2.5 and why FRTB was introduced. It explains the weaknesses that each later rule fixes, which makes the rest easier to remember.