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FRM Part II · FRM Exam Part II · Early Warning Indicators

A bank calibrates an EWI threshold for the daily change in its 5-year CDS spread. Over the past year, daily changes had a mean of 0 bp and a standard deviation of 4 bp. Management sets the amber trigger at 2 standard deviations and the red trigger at 3 standard deviations of daily change. Today the CDS spread rose by 10 bp. What is the correct classification?

The move is amber. With a standard deviation of 4 bp, the amber trigger is 8 bp and the red trigger is 12 bp. A 10 bp rise exceeds the amber level but does not reach the red level.

  1. AGreen, because 10 bp is below 3 standard deviations
  2. BAmber, because 10 bp exceeds 8 bp but is below 12 bpCorrect
  3. CRed, because 10 bp exceeds 8 bp
  4. DAmber, because 10 bp exceeds 4 bp but is below 12 bp, and red begins at 8 bp

Explanation

Amber trigger is 2 x 4 = 8 bp and red is 3 x 4 = 12 bp. A 10 bp move exceeds 8 bp but is below 12 bp, so it is amber. Treating 8 bp as red mixes up the two triggers.

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