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Explanation:
Use of the internal models approach is conditioned on an experience of not more than 12 exceptions at 99% or not more than 30 exceptions at 97.5% in the most recent 12 month period. Otherwise, all positions must be capitalized using the standardized approach. Positions must continue to be capitalized using the standardized method until the desk no longer exceeds the above thresholds over the prior 12 months.
Further Explanation
The values of 12 and 30 represent the number of exceptions that a bank can tolerate in their Value at Risk (VaR) models before they’re required to switch to the standardized approach, according to the Fundamental Review of the Trading Book (FRTB) regulations. These exceptions represent instances where the actual losses exceed the VaR estimate.
The numbers are based on statistical expectations. When you calculate VaR at a 99% confidence level, you are essentially saying that you expect losses to exceed the VaR estimate 1% of the time. Similarly, a 97.5% VaR measure implies that you expect losses to exceed the VaR estimate 2.5% of the time.
Given that the backtest is over 1 year (or about 250 trading days), you would statistically expect:
For the 99% VaR: 1% * 250 days = 2.5 exceptions
For the 97.5% VaR: 2.5% * 250 days = 6.25 exceptions
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Q.4032 Richard Glen, FRM, is evaluating market capital requirements for Exim Bank. He starts by comparing the trading desk’s 1-day static value-at-risk measure (calibrated to the most recent 12 months’ data, equally weighted) at both the 97.5th percentile and the 99th percentile, using two years of current observations of the desk’s one-day P&L. The desk experiences 13 exceptions at the 99th percentile and 32 exceptions at the 97.5th percentile. Based on the results, which of the following models should Exim bank use to determine its capital needs going forward?
A
Internal models approach
B
Standardized approach
C
Advanced measurement approach
D
Revised internal models approach