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FRM Part II · FRM Exam Part II · Fundamental Review of the Trading Book

Under Basel 2.5, a bank's internal-models market risk capital charge included a stressed VaR component alongside ordinary VaR. What was the main purpose of adding stressed VaR?

Stressed VaR was added to make capital less procyclical. It calibrates the model to a twelve-month period of significant financial stress for the current portfolio, so capital does not shrink just because recent market conditions are calm, as happens with VaR calibrated only on recent history.

  1. ATo replace the 10-day holding period with a 1-day period during crises
  2. BTo remove the multiplier applied to VaR
  3. CTo reduce procyclicality by ensuring capital reflected a period of significant financial stress rather than only recent calm market dataCorrect
  4. DTo capture default risk of equity positions in the trading book

Explanation

Ordinary VaR calibrated on recent data falls in calm periods, lowering capital just before stress, which is procyclical. Stressed VaR is calibrated to a 12-month period of significant stress for the current portfolio, putting a floor under capital. It did not change the holding period or deal with equity default risk, which was the incremental risk charge's domain for credit products.

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