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FRM Part I · FRM Exam Part I · Measuring Credit Risk

A bank's credit portfolio has an expected loss of USD 30 million. The 99.9% quantile of the portfolio loss distribution is USD 210 million. The bank holds economic capital equal to the 99.9% credit VaR measured relative to expected loss, and its provisions already cover expected loss. Which statement is correct?

Economic capital is USD 180 million. It is the 99.9% loss quantile of USD 210 million minus the expected loss of USD 30 million, because expected loss is covered by pricing and provisions, leaving only unexpected loss for capital.

  1. AEconomic capital is USD 210 million, because it equals the 99.9% quantile
  2. BEconomic capital is USD 240 million, because expected loss is added to the quantile
  3. CEconomic capital is USD 180 million, because the quantile less expected loss represents unexpected loss to be covered by capitalCorrect
  4. DEconomic capital is USD 30 million, because capital should only cover expected loss

Explanation

Capital covers unexpected loss: 210 - 30 = 180 million, since expected losses are covered by pricing and provisions. Using 210 double counts expected loss. Adding 30 is the wrong sign.

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