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FRM Part II · FRM Exam Part II · Early Warning Indicators

A risk manager notes that several EWIs, such as deposit outflows, CDS spread widening and repo haircut increases, tend to breach simultaneously in market-wide stress. What is the most important design implication?

Because the indicators breach together in market-wide stress, they should not be treated as independent evidence. Designers should use composite scoring or multi-breach logic to calibrate escalation and distinguish idiosyncratic from systemic stress, rather than deleting indicators or raising thresholds until they stop warning.

  1. AAvoid treating the indicators as independent; consider combining them in a composite or requiring multiple breaches to calibrate escalationCorrect
  2. BRemove all but one indicator since the others add no information
  3. CRaise each threshold so that none breaches during market-wide stress
  4. DAssign identical thresholds to every indicator

Explanation

Correlated indicators overstate independent evidence if counted separately. A composite view or multi-indicator logic calibrates escalation and reflects whether stress is idiosyncratic or market-wide. Raising thresholds would defeat the warning purpose.

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