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FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks

A risk manager notes that a copula-based aggregation of credit and operational risk gives much higher capital than a Gaussian-correlation approach with the same linear correlation. Which feature of the copula choice most plausibly explains this?

A copula with tail dependence, such as a t-copula, raises the likelihood of joint extreme losses at high confidence levels, so aggregate capital is higher than under a Gaussian approach even when the linear correlation is identical.

  1. AThe copula has tail dependence, so joint extreme losses are more likelyCorrect
  2. BThe copula lowers the marginal distribution volatility
  3. CThe copula forces risks to be independent in the body of the distribution
  4. DThe copula removes the need to specify marginal distributions

Explanation

Copulas such as the Student-t exhibit tail dependence, increasing the probability of simultaneous extreme losses at high confidence levels. This raises aggregate capital at the same linear correlation. The marginals are unchanged by the copula, and copulas still require marginals.

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