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

Which statement best explains why FRTB replaced VaR with expected shortfall as the internal model measure, in light of the shortcomings seen under Basel 2.5?

FRTB adopted expected shortfall because it measures the average loss in the tail beyond the cut-off, which VaR ignores. It is calibrated to a stress period at 97.5% confidence, replacing the patchwork of VaR, stressed VaR and IRC from Basel 2.5.

  1. AExpected shortfall captures the size of losses beyond the threshold, addressing VaR's blindness to tail severity, and is calibrated to stress with a 97.5% confidence levelCorrect
  2. BExpected shortfall is always lower than VaR at the same confidence level, reducing capital
  3. CExpected shortfall removes the need for stress calibration because it is inherently forward looking
  4. DExpected shortfall eliminates the need for backtesting and desk-level approval

Explanation

VaR ignores losses beyond its quantile, and Basel 2.5 patched this with stressed VaR and added charges. FRTB uses ES at 97.5% calibrated to stress, capturing tail severity. ES is not lower than VaR at the same level, still uses stress calibration, and desk-level approval and backtesting remain.

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