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

A treasurer sets a single-level threshold on the 3-month unsecured funding spread. During back-testing, the indicator breached the threshold 14 times in 3 years, but only 1 breach preceded an actual liquidity event. Which conclusion and response is most appropriate?

The threshold produces too many false alarms, with 13 of 14 breaches not followed by stress. A better design uses amber and red tiers or corroborating indicators to raise precision while keeping sensitivity. Lowering the threshold would add noise, and dropping the indicator would discard a useful signal.

  1. AThe threshold generates many false positives; consider a tiered threshold (amber/red) or combine with other indicators to improve signal qualityCorrect
  2. BThe threshold is optimal because it captured the one real event
  3. CThe threshold should be lowered so that it triggers even more frequently
  4. DThe indicator should be dropped because any indicator with false signals is useless

Explanation

13 of 14 breaches were false alarms, which risks alert fatigue. Tiering thresholds or requiring confirmation from other indicators improves precision while preserving sensitivity. Lowering the threshold would worsen false positives, and discarding the indicator ignores its usefulness in the real event.

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