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

A portfolio has an expected credit loss of USD 30 million. The 99.9% quantile of the one-year loss distribution is USD 210 million. Under the credit VaR convention where economic capital is measured relative to the mean loss, what is the economic capital, and what does it represent?

Economic capital is USD 180 million, the 99.9% loss quantile of USD 210 million minus the USD 30 million expected loss. Expected loss is covered by provisions and pricing, so capital only needs to absorb unexpected losses beyond the mean up to the confidence level.

  1. AUSD 210 million; the maximum possible loss on the portfolio
  2. BUSD 240 million; the worst-case loss plus provisions
  3. CUSD 180 million; the loss at the 99.9% level in excess of expected loss, which should be covered by capitalCorrect
  4. DUSD 30 million; the amount to be covered by loan pricing

Explanation

Credit VaR at 99.9% is 210m. Economic capital = quantile minus EL = 210 - 30 = 180m. The EL of 30m is covered by pricing and provisions, so adding it (240m) double counts.

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