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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A portfolio has a one-year expected loss of USD 12 million. The 99.9th percentile of the loss distribution is USD 95 million. The bank defines economic capital as the amount needed to cover losses beyond expected loss at that confidence level. What economic capital is required, and what does this represent?

Economic capital is the 99.9% loss quantile of USD 95 million minus the USD 12 million expected loss, giving USD 83 million. This is credit VaR measured relative to the mean, since expected loss is already covered by provisions and pricing.

  1. AUSD 95 million, the total credit VaR in absolute terms
  2. BUSD 83 million, the credit VaR measured relative to the expected lossCorrect
  3. CUSD 107 million, the credit VaR plus expected loss
  4. DUSD 12 million, the expected loss reserve

Explanation

Economic capital = percentile loss − expected loss = 95 − 12 = 83 million. Option A ignores that EL is already covered by provisions and pricing. Option C adds EL instead of subtracting it.

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