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

A bank targets an AA rating with a one-year default probability of 0.03%. It calibrates economic capital to the 99.97% confidence level of its one-year loss distribution. The expected loss is 40 million and the 99.97th percentile loss is 310 million. What is the economic capital under the unexpected-loss definition?

Economic capital is 270 million. It equals the 99.97th percentile loss of 310 million less the expected loss of 40 million, because expected losses are covered by pricing and provisions, and capital is held for unexpected losses beyond that.

  1. A270 millionCorrect
  2. B310 million
  3. C350 million
  4. D40 million

Explanation

Economic capital covers unexpected loss: the percentile loss minus expected loss = 310 - 40 = 270 million. Using 310 million ignores that expected loss is covered by provisions and pricing. Adding 40 gives 350, the wrong sign.

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