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FRM Part II · FRM Exam Part II · Validating Bank Holding Companies' Value-at-Risk Models for Market Risk

A bank holding company's model validation group is asked to describe the core purpose of validating the bank's trading VaR model. Which of the following best describes that purpose?

Validation exists to confirm that VaR estimates are reliable and suitable for their intended uses, such as regulatory capital and limit setting. It cannot remove exceptions, force peer-identical methods, or replace stress testing, because VaR does not describe losses beyond its confidence level.

  1. ATo confirm that the model's risk estimates are reliable and fit for their intended uses, including regulatory capital and risk limitsCorrect
  2. BTo guarantee that the model will never produce a backtesting exception
  3. CTo ensure the model uses the same methodology as every peer institution
  4. DTo replace the need for stress testing by showing that VaR captures all tail losses

Explanation

Validation assesses whether a model is conceptually sound and performs as intended for its uses. It cannot eliminate exceptions, since a 99% VaR is expected to be exceeded about 1% of the time. Methodology need not match peers, and VaR does not replace stress testing.

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