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FRM Part II · FRM Exam Part II · Credit Risk

A risk manager at a bank reviews a portfolio and notes that the bank sets loan loss provisions and loan pricing to cover expected loss, and holds economic capital against unexpected loss. Which statement about unexpected loss is most accurate?

Unexpected loss is the standard deviation of credit losses around expected loss. Expected loss is covered by pricing and provisions, while capital is held to absorb unexpected loss. The average loss is expected loss, not unexpected loss.

  1. AIt is the standard deviation of credit losses around the expected loss, and capital is held to absorb itCorrect
  2. BIt is the average loss over a full credit cycle and is covered by pricing
  3. CIt is the loss in excess of the 99.9% quantile, which capital does not cover
  4. DIt equals expected loss multiplied by a diversification factor of one minus correlation

Explanation

Unexpected loss is the volatility (standard deviation) of credit losses around the mean; capital buffers it. Average loss is expected loss, not unexpected. Losses beyond the confidence quantile are tail losses, but UL itself is the volatility measure.

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