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FRM Part II · FRM Exam Part II · Credit Value at Risk

A bank's risk team compares its credit VaR output with the portfolio's realised loss history. Over many years, the annual losses have exceeded the 99.9% credit VaR estimate in several years, far more than the roughly one-in-a-thousand frequency implied. Which conclusion is most appropriate?

Frequent breaches of a 99.9% credit VaR far exceed the expected one-in-a-thousand frequency, so the model is probably understating tail risk. Typical causes are understated default correlations, unrepresentative PD inputs or ignored systematic factors. It is not conservative or evidence of diversification.

  1. AThe model is probably underestimating tail risk, for example through understated correlations or unrepresentative inputsCorrect
  2. BThe model is conservative because the confidence level is very high
  3. CThe exceedances show the portfolio is well diversified
  4. DThe result is expected because credit VaR is measured over a one-day horizon

Explanation

At 99.9% confidence, exceedances should occur about once in a thousand years. Several breaches in a modest history indicate the model understates tail losses, commonly because of understated default correlation, stale PDs or ignored systematic factors. The other options misread what frequent breaches imply.

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