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

A bank's one-year economic capital at 99.9% is 800 million using a model with estimated standard error of 10% on the tail loss estimate due to limited data. A senior manager wants a conservative buffer for this parameter uncertainty equal to one standard error added to the estimate. What economic capital figure results, and what is the principal reason for such an add-on?

The adjusted figure is 880 million: 10% of 800 million is 80 million, added to the base estimate. The add-on is a conservative model-risk buffer for estimation uncertainty in the tail, since limited data make the 99.9% loss estimate imprecise.

  1. A720 million, because estimation error always overstates capital
  2. B880 million, because the add-on reflects estimation uncertainty in the tail, a form of model riskCorrect
  3. C900 million, because the buffer is two standard errors
  4. D800 million, because model risk cannot be quantified

Explanation

Standard error is 10% of 800 = 80 million; adding one gives 880 million. The buffer is a model-risk adjustment for sampling uncertainty in tail estimates. 720 subtracts the error (wrong sign); 900 uses an incorrect multiple.

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