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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 model uses a single set of correlation parameters estimated during a calm period. Which model risk is most clearly present?

The risk is parameter instability. Correlations estimated in calm conditions tend to rise in stress, so using them understates tail dependence and overstates diversification benefits, which leads to economic capital that is too low when it is most needed.

  1. AParameter instability, since correlations tend to rise in stress and the calm-period estimates may understate tail dependence and capitalCorrect
  2. BSpecification certainty, since calm-period correlations are always the most conservative
  3. CDouble counting, since correlations cannot be used with economic capital
  4. DLiquidity risk, since correlations measure funding costs

Explanation

Correlations estimated in calm periods often understate dependence in stress, when they tend to increase. This leads to understated diversification risk and capital. Calm-period estimates are not conservative, so option B is wrong.

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