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

A bank estimates its one-year loss distribution. The 99.9% VaR is USD 480 million, the expected loss is USD 120 million, and the average loss in the worst 0.1% of outcomes is USD 640 million. The bank defines economic capital as unexpected loss at the 99.9% level, using VaR. What is the economic capital?

Economic capital is USD 360 million. Defined as unexpected loss, it equals the 99.9% VaR of USD 480 million minus the expected loss of USD 120 million, since expected losses are covered by pricing and provisions rather than capital.

  1. AUSD 360 millionCorrect
  2. BUSD 520 million
  3. CUSD 480 million
  4. DUSD 600 million

Explanation

Economic capital as unexpected loss equals VaR minus expected loss: 480 - 120 = 360. Using expected shortfall (640 - 120 = 520) would be a different measure. Using VaR alone ignores that expected loss is covered by provisions and pricing.

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