FRM Part II key terms

A statistical estimate of the maximum loss a portfolio is expected to suffer over a given holding period at a specified confidence level; it does not describe losses beyond that threshold.

The average of losses that exceed the VaR threshold, giving the expected loss conditional on being in the worst tail of the distribution; also called conditional VaR.

A validation process that compares a model's forecast losses (such as VaR) with realized profits and losses to count exceptions and judge whether the model is adequately calibrated.

A VaR method that revalues the current portfolio using many past market moves, so the loss distribution is built empirically without assuming a particular parametric shape.

A hybrid approach that scales historical standardized returns by a current volatility estimate (often GARCH), then resamples them to produce a VaR forecast that reacts to changing market conditions.

A branch of statistics that models the tail of a loss distribution, either block maxima or exceedances over a high threshold, to estimate extreme quantiles beyond observed data.

The empirical tendency for large price moves to be followed by large moves and small moves by small moves, implying that volatility is autocorrelated and changes over time.

The pattern in which Black-Scholes implied volatilities differ across strike prices for the same maturity, contradicting the constant-volatility assumption and reflecting fat tails and skew in the risk-neutral distribution.

A forward-looking exercise that evaluates portfolio losses under specified severe but plausible scenarios, including historical episodes or hypothetical shocks, rather than relying on statistical probabilities.

Basel's revised market risk framework that replaces internal-model VaR with expected shortfall, imposes stricter model approval and trading-desk rules, and recalibrates standardised charges.

The likelihood that a borrower will fail to meet a contractual obligation within a specified horizon, usually one year, expressed as a percentage or annual rate.

The share of exposure that is lost when a default occurs, after accounting for recoveries, collateral, and workout costs; equal to one minus the recovery rate.

The estimated amount outstanding at the time of default, including drawn balances plus a credit conversion factor applied to undrawn commitments.

The average credit loss predicted over a horizon, computed as probability of default times loss given default times exposure at default.

A table showing the historical probabilities that an obligor moves from one credit rating to another, including default, over a given period; used to model rating transitions and portfolio credit risk.

A structural credit model treating equity as a call option on the firm's assets, so default occurs when asset value falls below the debt's face value at maturity.

A Merton-model measure of how many standard deviations the firm's asset value lies above the default point, indicating how close the company is to insolvency.

The market value of counterparty credit risk in derivatives, equal to the expected loss from counterparty default over the life of the trade, adjusted for exposure and recovery.

A situation where exposure to a counterparty rises as the counterparty's probability of default increases, so credit losses are larger than a simple independent model predicts.

An operational risk capital method that combines frequency and severity distributions for loss events, often through simulation, to obtain an aggregate annual loss distribution.

A structured process in which business units identify operational risks, assess their likelihood and impact, and evaluate the effectiveness of the controls designed to mitigate them.

A measurable indicator tracked over time to provide early warning of rising operational risk exposure or weakening controls, with thresholds that trigger escalation and action.

Basel's standardised approach for operational risk capital, based on a business indicator and a marginal coefficient, replacing earlier advanced measurement approaches.

A governance model in which business units own risk (first line), independent risk and compliance functions oversee it (second line), and internal audit provides assurance (third line).

The ability of an organisation to prevent, withstand, recover from, and learn from operational disruptions so that critical business services continue at acceptable levels.

A Basel liquidity standard requiring banks to hold high-quality liquid assets sufficient to cover net cash outflows over a 30-day stress period, with a minimum ratio of 100%.

A Basel standard that requires available stable funding to exceed required stable funding over a one-year horizon, limiting reliance on short-term wholesale funding.

VaR adjusted for the cost or risk of liquidating a position, typically by adding an exogenous liquidity cost such as the bid-ask spread or by using a longer holding period.

The risk that a firm cannot meet its cash and collateral obligations as they come due without incurring unacceptable losses or funding costs.

A documented playbook specifying how a bank will manage a liquidity stress, including funding sources, collateral, early-warning triggers, and responsibilities.

A risk-adjusted performance measure equal to excess return over the risk-free rate divided by the standard deviation of returns; higher values indicate better return per unit of total risk.

Excess return of a portfolio over its benchmark divided by the standard deviation of that excess return (tracking error), measuring active management skill.

The process of allocating a portfolio's total risk among strategies, asset classes, or managers so that each contributes a desired amount to overall portfolio volatility.

The distortion in performance statistics that arises when failed or closed funds are excluded from a database, making average returns appear better than they really are.

A change in a fund's investment style away from its stated mandate, which can make its benchmark inappropriate and distort performance evaluation and risk comparisons.

A model that explains asset returns through exposures to common risk factors (such as market, size, value, or momentum) plus idiosyncratic noise.

The shift from LIBOR, an interbank offered rate based on expert judgment, to risk-free rates such as SOFR, requiring fallback language and repricing of legacy contracts.

The risk of loss from climate-related events such as floods, storms, droughts, and wildfires, including damage to assets and disruption to operations and supply chains.

The risk of financial loss arising from the shift to a low-carbon economy, including policy changes, technology shifts, and reputational or legal effects.

Risks from decentralised finance protocols, including smart-contract bugs, liquidity fragmentation, governance failures, collateral liquidation spirals, and weak investor protection.