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FRM Part II · FRM Exam Part II · Risk Capital Attribution and Risk-Adjusted Performance Measurement

A bank measures the one-year loss distribution of its loan portfolio. The mean (expected) loss is USD 40 million. The 99.97th percentile loss is USD 340 million. The bank sets economic capital to support its target rating at that confidence level. What is the economic capital under the standard unexpected-loss definition?

Economic capital is USD 300 million: the 99.97th percentile loss of USD 340 million less the expected loss of USD 40 million. Expected loss is absorbed by pricing and provisions, so capital only needs to cover the unexpected portion of the loss.

  1. AUSD 40 million
  2. BUSD 300 millionCorrect
  3. CUSD 340 million
  4. DUSD 380 million

Explanation

Economic capital = percentile loss minus expected loss = 340 - 40 = USD 300 million. Expected loss is covered by pricing and reserves, so it is deducted. Using USD 340 million ignores that adjustment, and adding gives a wrong sign.

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