Free Access GARP 2016-FRR New Release

Current VaR: The bank has an existing VaR estimate of $100 million.

Standalone VaR for New Transaction: The standalone VaR of the new transaction is $5 million.

Correlation with Current Portfolio: The correlation of the new transaction with the current portfolio is 0.35.

Formula for Combined VaR:

New VaR=(Current VaR2)+(Standalone VaR2)+2×Correlation×Current VaR×Standalone VaR\text{New VaR} = \sqrt{(\text{Current VaR}^2) + (\text{Standalone VaR}^2) + 2 \times \text{Correlation} \times \text{Current VaR} \times \text{Standalone VaR}}New VaR=(Current VaR2)+(Standalone VaR2)+2×Correlation×Current VaR×Standalone VaR​

Plugging in the values:

New VaR=(1002)+(52)+2×0.35×100×5=10000+25+350=10375≈101.86\text{New VaR} = \sqrt{(100^2) + (5^2) + 2 \times 0.35 \times 100 \times 5} = \sqrt{10000 + 25 + 350} = \sqrt{10375} \approx 101.86New VaR=(1002)+(52)+2×0.35×100×5​=10000+25+350​=10375​≈101.86

References

Source: How Finance Works​

An operational risk policy should include:

The firm's definition of risk: Clearly defining what constitutes operational risk for the organization.

The governance of operational risk including who owns it, what it owns, and how issues should be escalated: Establishing roles and responsibilities for managing operational risk.

The main activities and elements that are managed by the operational risk function: Outlining the key processes and controls that are in place to manage operational risks.

Comprehensive and Detailed In-Depth Explanation:

Under Basel II’s Foundation Internal Ratings-Based (FIRB) Approach for non-retail exposures (e.g., corporate loans), banks are required to estimate the Probability of Default (PD) internally, while the Basel framework provides supervisory estimates for Loss Given Default (LGD), Exposure at Default (EAD), and Maturity (M). PD represents the likelihood of an obligor defaulting within a year and is a key input into the risk-weighted asset (RWA) calculation. The FIRB approach balances bank-specific inputs with standardized parameters, distinguishing it from the Advanced IRB approach, where banks also estimate LGD and EAD.

In practice, financial institutions often sum the economic capital required for market, credit, and operational risks to arrive at an aggregate economic capital estimate. This is done because:

Difficulty in Estimating Correlations: Estimating the correlations between different types of risks is complex and data-intensive. These correlations can change over time and under different market conditions, making it challenging to arrive at accurate estimates.

Conservatism: To avoid underestimating the total risk, a conservative approach is often taken by adding up the individual risk capitals. This ensures that the institution holds sufficient capital to cover potential losses from all types of risks, even if they were to occur simultaneously.

Regulatory Guidance: Although regulations encourage a more integrated approach, the lack of precise data often leads banks to use simpler, more conservative methods in practice.

Thus, option B correctly reflects the practical approach taken due to the difficulty in estimating correlations between different risk categories.