GARP FRM Part II Glossary
34 essential terms and definitions for GARP FRM Part II. Each definition is written for exam preparation, covering the concepts as they are tested on the 2026 syllabus.
A
- Active Risk
- Active risk is the volatility of returns that arise from deviating from a benchmark, equivalent to tracking error in most usages. It is the risk currency in which active managers are graded, paired with active return through the information ratio.
- Additional Tier 1
- Additional tier 1 (AT1) capital includes perpetual instruments such as contingent convertible bonds that absorb losses through write-down or equity conversion when CET1 falls below a trigger. AT1 sits below CET1 in the capital stack but above tier 2.
B
- Backtesting
- Backtesting compares a VaR model's predicted exceedances against realized losses to verify the model is properly calibrated. Kupiec's proportion-of-failures test checks the count of exceptions, while Christoffersen's test additionally checks that exceptions are independent over time.
C
- Coherent Risk Measures
- Coherent risk measures satisfy four axioms: monotonicity, subadditivity, positive homogeneity, and translation invariance. VaR fails subadditivity in general, while expected shortfall satisfies all four, which is the main reason Basel shifted to ES under FRTB.
- Credit VaR
- Credit VaR is the unexpected credit loss at a stated confidence level over a given horizon, typically one year for capital purposes. It is computed from a portfolio loss distribution that combines probabilities of default, recoveries, exposures, and correlations.
- Counterparty Credit Risk
- Counterparty credit risk is the risk that a derivatives counterparty defaults before settling future cash flows in your favor, leaving you to replace the trade at a worse market price. It is bilateral and depends on the trade's mark-to-market path.
- Credit Valuation Adjustment
- Credit valuation adjustment (CVA) is the market value of counterparty default risk on a derivatives portfolio, computed as the expected loss from counterparty default discounted to today. Banks hedge CVA with credit default swaps and contingent CDS where liquidity allows.
- Cross-Currency Basis
- Cross-currency basis is the deviation of observed FX-forward pricing from covered interest parity, reflecting balance-sheet costs and dollar funding scarcity. A negative basis means borrowing dollars synthetically through FX swaps is more expensive than the rate differential implies.
- CET1
- Common equity tier 1 (CET1) is the highest quality of regulatory capital, comprising common shares, retained earnings, and disclosed reserves net of goodwill and certain deductions. Basel III raised CET1 minimums and added buffers to absorb stress losses on a going-concern basis.
D
- Debt Valuation Adjustment
- Debt valuation adjustment (DVA) is the mirror of CVA from the bank's own credit perspective, capturing the gain in derivative liabilities when the bank's own credit spread widens. It is controversial because it implies booking accounting gains as your own creditworthiness deteriorates.
E
- Extreme Value Theory
- Extreme value theory (EVT) models the tails of a distribution directly using either block maxima or peaks-over-threshold methods. It produces more reliable estimates of rare losses than fitting a normal or Student-t to the full distribution and ignoring tail shape.
F
- FRTB
- Fundamental Review of the Trading Book (FRTB) is the Basel framework that overhauls market-risk capital, replacing VaR with expected shortfall, tightening the boundary between trading and banking books, and offering banks either the standardized sensitivities-based approach or an internal models approach.
- Funds Transfer Pricing
- Funds transfer pricing (FTP) is the internal pricing system that charges business lines for the funding they consume and credits them for the funding they provide. A well-designed FTP framework allocates liquidity and interest-rate risk to the units that originate it.
G
- Gaussian Copula
- Gaussian copula joins individual default-time distributions into a multivariate distribution using a normal dependence structure parameterized by a correlation matrix. It became infamous in the 2008 crisis after underestimating tail dependence in CDO tranches.
- G-SIB Surcharge
- Global systemically important bank (G-SIB) surcharge is an additional CET1 capital requirement applied to the largest, most interconnected banks based on size, interconnectedness, complexity, cross-jurisdictional activity, and substitutability. It ranges from 1.0% to 3.5% of risk-weighted assets.
H
- High-Quality Liquid Assets
- High-quality liquid assets (HQLA) are unencumbered assets that can be converted to cash quickly with little or no value loss in stressed markets, such as central bank reserves and high-grade sovereign bonds. They form the numerator of the LCR and define a bank's liquidity buffer.
I
- Internal Models Approach
- Internal models approach (IMA) is the FRTB method allowing banks to use their own expected shortfall models for trading-desk capital, subject to backtesting, P&L attribution, and supervisory approval. Desks that fail tests fall back to the standardized SBA charge.
K
- Key Risk Indicator
- Key risk indicator (KRI) is a forward-looking metric that signals rising operational risk before losses materialize, such as system downtime minutes or trade-break counts. KRIs complement loss event data by warning when control environments are weakening.
L
- Liquidity Coverage Ratio
- Liquidity coverage ratio (LCR) is a Basel III metric requiring banks to hold enough high-quality liquid assets to cover 30 days of stressed net cash outflows. The ratio must remain at or above 100% to ensure short-term liquidity resilience.
N
- Net Stable Funding Ratio
- Net stable funding ratio (NSFR) is a Basel III ratio requiring a bank's available stable funding to be at least equal to its required stable funding over a one-year horizon. It complements the LCR by addressing structural funding mismatches rather than acute liquidity stress.
O
- Output Floor
- Output floor caps the capital benefit a bank can derive from internal models at 72.5% of the standardized-approach calculation under the Basel III endgame. It prevents excessive variation in risk-weighted assets across banks and limits model-driven undercapitalization.
R
- Risk and Control Self-Assessment
- Risk and control self-assessment (RCSA) is a structured process in which business units identify their operational risks, evaluate the design and effectiveness of existing controls, and document residual risk. Findings feed risk reporting and shape remediation plans.
- Risk Budgeting
- Risk budgeting allocates portfolio risk, typically tracking error or volatility, across asset classes, strategies, or managers in line with conviction and information ratios. It shifts the allocation discussion from dollars invested to risk consumed, encouraging more efficient use of an active-risk budget.
S
- Sensitivities-Based Approach
- Sensitivities-based approach (SBA) is the FRTB standardized method that computes capital from delta, vega, and curvature sensitivities aggregated across risk classes using prescribed correlations and risk weights. It is the default for desks that cannot or do not seek IMA approval.
- Securitization
- Securitization pools financial assets such as mortgages or auto loans into a special-purpose vehicle that issues tranched securities of varying seniority. It transforms illiquid assets into tradable instruments and shifts credit risk from originators to capital-market investors.
- Swiss Cheese Model
- Swiss cheese model views operational losses as the alignment of holes across multiple defensive layers, where each control has weaknesses but layered defenses normally block the path. A loss event happens when latent holes line up, motivating overlapping rather than redundant controls.
- SR 11-7
- SR 11-7 is the Federal Reserve and OCC supervisory guidance on model risk management, requiring banks to maintain inventories, conduct independent validation, and govern the full life cycle of every model used for material decisions. It is the de facto US standard for model risk.
T
- Tranche
- Tranche is a slice of a securitization with a defined seniority that determines the order in which it absorbs losses or receives cash flows. Senior tranches absorb losses last and earn the lowest yield; equity tranches absorb first losses and command the highest expected return.
- Three Lines of Defense
- Three lines of defense is a governance model where the business owns and manages risk in the first line, independent risk and compliance functions oversee in the second, and internal audit provides assurance in the third. The model clarifies accountability across an organization.
- Tier 2
- Tier 2 capital is gone-concern regulatory capital, typically subordinated debt with at least five years of original maturity. It absorbs losses only in resolution or liquidation, ranking ahead of senior creditors but behind tier 1 instruments.
V
- Volatility Smile
- Volatility smile is the empirical pattern in which implied volatilities vary by strike and expiry, contradicting Black-Scholes-Merton's constant-volatility assumption. Equity index options usually show a skew with deep out-of-the-money puts trading at higher implied vols than calls.
- Vasicek Single-Factor Model
- Vasicek single-factor model derives portfolio credit loss distribution by assuming each obligor's asset return depends on a single systemic factor and an idiosyncratic shock. It underpins Basel's IRB risk-weight formulas, allowing a closed-form portfolio loss percentile.
W
- Wrong-Way Risk
- Wrong-way risk arises when exposure to a counterparty rises just as the counterparty's credit quality deteriorates. Specific wrong-way risk involves a structural link, such as buying CDS protection on the counterparty's parent; general wrong-way risk reflects macro correlation.
X
- xVA
- xVA is the family of valuation adjustments applied to derivatives, including CVA, DVA, funding (FVA), capital (KVA), margin (MVA), and collateral (ColVA). Each adjustment refines fair value to reflect a specific cost or benefit beyond the textbook risk-neutral price.