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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A bank's credit portfolio has a loss distribution that is highly right-skewed with a fat tail. A manager proposes setting capital as three times the portfolio standard deviation of loss, arguing it approximates the 99.9% quantile as under a normal distribution. What is the main weakness of this approach?

Credit loss distributions are skewed with fat right tails, so a normal-based multiple of the standard deviation usually understates the true high-percentile loss. Capital should instead be taken from the simulated or modeled loss quantile minus expected loss.

  1. AStandard deviation is undefined for credit losses
  2. BNormal-based multiples tend to understate the tail quantile for skewed credit loss distributionsCorrect
  3. CStandard deviation overstates risk because expected loss is subtracted twice
  4. DMultiples of standard deviation can only be used for market risk

Explanation

Credit losses are asymmetric with a long right tail, so the actual 99.9% quantile typically lies far above mean plus a normal-based multiple of sigma. Standard deviation is well defined, so A is wrong.

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