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Answer: Loss severity and loss frequency are often modeled with lognormal and Poisson distributions, respectively.
B is correct. It is true that loss frequency is typically modeled using a Poisson distribution and loss severity tends to be modeled with a lognormal distribution. This is because the Poisson distribution is suitable for modeling the number of events (in this case, losses) occurring in a fixed interval of time, which is a common scenario for loss frequency. On the other hand, the lognormal distribution is often used for modeling loss severity due to its properties that allow for a range of positive values and can accommodate a wide variety of data shapes, which is useful for capturing the variability in the size of individual loss events.
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In a scenario where a candidate is being interviewed for an operational risk analyst position at a leading bank, the Chief Risk Officer (CRO) asks various questions concerning the evaluation of operational risks. Among the responses given by the applicant, which one is correct?
A
Economic capital of a bank should be sufficient to cover both the expected and the worst-case operational risk losses of the bank.
B
Loss severity and loss frequency are often modeled with lognormal and Poisson distributions, respectively.
C
Operational loss data available from data vendors tend to be biased toward small losses but are particularly useful in determining loss frequency.
D
The standardized approach used by banks in calculating operational risk capital requires the calculation of unexpected as well as expected losses.