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

A bank's economic capital framework is being designed to support a target senior debt rating equivalent to an annual default probability of 0.03%. Which choice of confidence level for the economic capital loss distribution is most consistent with this objective?

A confidence level of about 99.97% over a one-year horizon fits, because economic capital is calibrated so the chance of losses exceeding capital equals the target annual default probability of 0.03%. Short horizons like one or ten days belong to trading VaR, not solvency-based capital.

  1. ARoughly 99.97% over a one-year horizonCorrect
  2. BRoughly 97% over a one-year horizon
  3. CRoughly 99.97% over a one-day horizon
  4. DRoughly 99% over a ten-day horizon

Explanation

Economic capital is typically calibrated so that the probability that losses exceed capital over one year equals the target default probability. A 0.03% default probability corresponds to a 99.97% confidence level at an annual horizon. Short horizons such as one or ten days are used for trading VaR, not for solvency-based capital.

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