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FRM Part II · FRM Exam Part II · Risk Measurement and Assessment

A bank uses scenario analysis to supplement an internal loss dataset with only 8 years of data. For a scenario, experts estimate a frequency of 0.05 events per year and a severity of USD 60 million per event. Internal data show an expected annual loss of USD 1 million for that risk category from small events. Assuming independence and that the scenario is not in the internal data, what is the combined expected annual loss?

The combined expected annual loss is USD 4 million. The scenario contributes 0.05 times USD 60 million, or USD 3 million, and the small internal losses add USD 1 million. Ignoring frequency or omitting either component gives wrong figures.

  1. AUSD 3 million
  2. BUSD 4 millionCorrect
  3. CUSD 61 million
  4. DUSD 1 million

Explanation

Scenario expected annual loss = 0.05 x 60 = USD 3 million. Adding the internal-data expected loss of USD 1 million gives USD 4 million. USD 3 million omits the internal losses, USD 61 million ignores frequency, and USD 1 million ignores the scenario.

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