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

A risk committee notes that a bank's credit portfolio loss distribution is highly right-skewed with a long fat tail. Which implication is most appropriate when using standard deviation of losses to set capital?

Because credit loss distributions are skewed with fat right tails, standard deviation understates extreme losses. Capital should therefore be set from a high quantile of the loss distribution, as in credit VaR, less expected loss, rather than from a normal-based multiple of standard deviation.

  1. AStandard deviation fully captures tail risk, so a multiple of it is always an accurate capital estimate
  2. BCapital should be set from a high quantile of the loss distribution, because standard deviation understates tail losses for skewed distributionsCorrect
  3. CExpected loss should be raised to equal the standard deviation to compensate for skew
  4. DCapital is unnecessary since the skew is already priced into the expected loss

Explanation

Credit losses are skewed with fat tails, so a multiple of standard deviation (as under a normal assumption) misstates the tail. Credit VaR uses a high quantile of the simulated or modeled loss distribution directly. The other options misstate how EL and capital work.

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