FRM Part I · FRM Exam Part I · Operational Risk
In the Loss Distribution Approach (LDA) to operational risk capital, a bank models each business line and event type cell using two separate distributions. Which pair correctly describes these components?
The LDA uses a frequency distribution for how many loss events occur in a period and a severity distribution for the size of each loss. The two are combined into an aggregate annual loss distribution, from which a high percentile gives operational risk capital.
- AA severity distribution for the size of each loss and a frequency distribution for the number of losses in a periodCorrect
- BA frequency distribution for the size of each loss and a severity distribution for the number of losses in a period
- CA normal distribution for losses and a Poisson distribution for recoveries
- DA copula for losses and a binomial distribution for capital
Explanation
LDA separates the number of loss events in a horizon (frequency, often Poisson) from the dollar size of each event (severity, often lognormal or heavy-tailed). These are combined by simulation or convolution into an aggregate annual loss distribution. Reversing the roles in the second option is incorrect.
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