Skip to content

FRM Part II · FRM Exam Part II · Risk Identification

A risk manager is combining internal loss data with scenario-based estimates to model severity for a rare event category. Internal data contain only a handful of losses, all modest, while scenarios describe a few extreme events. Which approach best uses the strengths of both sources while limiting the weakness of each?

The best approach is to fit the body of the distribution with internal loss data and use scenario assessments to shape the tail, while validating the scenarios against external data. Internal data are sparse in extremes, and scenarios are subjective, so combining them offsets each weakness.

  1. AUse only internal data because it is objective and therefore sufficient for tail estimation
  2. BUse only scenario estimates because they are forward-looking and need no validation
  3. CUse internal data to fit the body of the severity distribution and scenario assessments to inform the tail, with scenarios challenged against external dataCorrect
  4. DAverage the largest internal loss and the largest scenario loss to obtain the capital figure

Explanation

Internal data are reliable for frequent, small losses but sparse in the tail, whereas scenarios address low-frequency high-severity events but are subjective and need challenge. Combining them lets each cover the other's gap. Using either alone leaves a weakness, and a simple average has no statistical basis.

Did you get it right without looking?

One question tells you little. A timed set on Risk Identification shows your real accuracy, how long you take and where you lose marks.

Practise Risk IdentificationFree diagnostic mock

More Risk Identification questions