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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 team compares its internally estimated 99.97% one-year loss quantile with the capital figure used for business decisions. A reviewer notes that the quantile is estimated from only a few years of loss history for a portfolio with a fat-tailed loss distribution. Which concern about the economic capital estimate is most directly raised?

The main concern is high estimation uncertainty. A 99.97% quantile lies far in the tail, where a short loss history supplies almost no observations, so the estimate is very sensitive to sampling error and distributional assumptions, particularly for fat-tailed losses.

  1. AThe estimate has high sampling and tail-estimation uncertainty because few observations lie near the extreme quantileCorrect
  2. BThe estimate is biased downward because the confidence level is too low relative to regulatory capital
  3. CThe estimate is invalid because economic capital must always use a 95% confidence level
  4. DThe estimate cannot be validated because quantiles are not measurable from loss data

Explanation

Extreme quantiles such as 99.97% rely on very few or no observations, so estimates are highly uncertain, especially with fat tails. The confidence level is chosen by the bank, often tied to a target rating, so a fixed 95% is not required. Option B is wrong because 99.97% is a high level, not a low one.

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