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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 validation team reviews a trading desk's VaR model and finds that several illiquid corporate bonds are mapped to a broad investment-grade index rather than to their own issuer spreads. Which is the most important validation concern?

The main concern is that mapping illiquid bonds to a broad index drops issuer-specific spread risk and basis risk between the bond and the proxy, so VaR may understate the true risk of the positions held.

  1. AThe model may understate idiosyncratic and basis risk because the proxy omits issuer-specific spread movementsCorrect
  2. BThe model will overstate market risk because the index is always more volatile than single bonds
  3. CThe model cannot be backtested because index data is unavailable
  4. DThe model will violate the requirement to use a 10-day holding period

Explanation

Mapping to a broad index removes issuer-specific (idiosyncratic) and basis risk, so VaR can be understated for the actual positions. The index is not always more volatile, and proxying does not prevent backtesting or change the holding period.

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