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FRM Part II · FRM Exam Part II · Risk Measurement and Assessment

An operational risk analyst combines internal loss data with external loss data from a consortium to estimate severity. Which is the most important adjustment before pooling the external data?

The external data should be scaled for differences in size and business mix and adjusted for the consortium's reporting threshold before pooling. Otherwise the severity estimates are biased because the losses come from dissimilar institutions and are truncated at different levels. Deleting losses or using medians distorts the distribution.

  1. ADelete all external losses below the internal mean to avoid double counting
  2. BScale the external losses for differences in bank size and business mix, and account for the consortium's reporting thresholdCorrect
  3. CMultiply every external loss by the ratio of internal to external event counts
  4. DReplace external loss amounts with the consortium's median loss

Explanation

External data come from institutions of different size and risk profiles and are reported above differing thresholds. Scaling and threshold adjustment are needed to avoid biased severity estimates. Deleting or replacing losses with a median distorts the distribution.

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