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FRM Part II · FRM Exam Part II · Portfolio Credit Risk

A bank's credit portfolio has an expected loss of USD 40 million. The 99.9% quantile of the one-year portfolio loss distribution is USD 340 million. Which statement about economic capital under the common definition is correct?

Economic capital is the loss quantile at the chosen confidence level minus expected loss, so USD 340 million less USD 40 million equals USD 300 million. Expected loss is assumed to be covered by pricing and provisions, so it is not held as capital.

  1. AEconomic capital is USD 300 million, the 99.9% loss quantile less expected loss, because expected loss is covered by provisions and pricingCorrect
  2. BEconomic capital is USD 340 million, because capital must cover the full quantile
  3. CEconomic capital is USD 380 million, because expected loss is added to the quantile
  4. DEconomic capital is USD 40 million, because it equals expected loss

Explanation

Economic capital is commonly the unexpected loss at the chosen confidence level: quantile minus expected loss = 340 - 40 = USD 300 million. Expected loss is expected to be absorbed by pricing and provisions. Using 340 double counts expected loss; adding it overstates capital.

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