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FRM Part II · FRM Exam Part II · Risk Measurement and Assessment

A bank's operational risk team builds a loss distribution approach (LDA) model using only internal loss data collected over the past five years. The data contain very few losses above USD 5 million, yet the bank's risk profile suggests that rare severe events are plausible. Which is the most significant measurement weakness of relying only on this dataset?

The main weakness is that a short internal loss history under-represents rare, severe events, so the tail of the severity distribution is poorly estimated and capital may be understated. External data and scenario analysis are normally added to fill this gap.

  1. AInternal data are always biased upward because losses are recorded at replacement cost
  2. BInternal data tend to under-represent low-frequency, high-severity tail events, so capital may be understatedCorrect
  3. CInternal data cannot be used to estimate loss frequency
  4. DInternal data are by definition forward-looking and therefore too subjective

Explanation

A short internal history rarely captures the tail events that drive operational risk capital. Supplementing with external data and scenario analysis is the standard remedy. Frequency can be estimated from internal data, and internal data are historical, not forward-looking.

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