Skip to content

FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks

A bank calculates credit economic capital using an internal model whose PD inputs are calibrated on only one benign economic cycle of five years. Which is the most significant model risk concern?

The main concern is that calibrating on a benign period understates default rates, correlations and tail losses, so economic capital may be too low through the cycle. The data lack stress observations, making the model unreliable exactly where capital matters most.

  1. ACapital will likely be overstated because defaults in benign periods are too frequent
  2. BTail losses and correlations may be understated, so capital may be too low through the cycleCorrect
  3. CDiversification benefits will be eliminated automatically
  4. DThe confidence level will become irrelevant

Explanation

Data from a benign period contain few defaults and understate default rates, volatility and correlations in stress. The model therefore likely underestimates tail loss and capital. The overstated option has the sign reversed.

Did you get it right without looking?

One question tells you little. A timed set on Range of Practices and Issues in Economic Capital Frameworks shows your real accuracy, how long you take and where you lose marks.

Practise Range of Practices and Issues in Economic Capital FrameworksFree diagnostic mock

More Range of Practices and Issues in Economic Capital Frameworks questions