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FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A risk manager estimates that a portfolio's one-year credit loss distribution has a mean of $12 million and a 99.9th percentile loss of $87 million. The bank holds economic capital to cover unexpected loss at this confidence level, while expected loss is covered by provisions and pricing. How much economic capital is required?

Economic capital is the percentile loss minus expected loss, because expected loss is covered by provisions and pricing. Here 87 million minus 12 million gives 75 million. Using the full 87 million would double count the expected loss already provided for.

  1. A$12 million
  2. B$75 millionCorrect
  3. C$87 million
  4. D$99 million

Explanation

Credit VaR at 99.9% is $87 million as a loss, and economic capital is the unexpected component: 87 - 12 = $75 million. $87 million ignores that expected loss is already provisioned; $99 million adds the mean wrongly; $12 million is only the expected loss.

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