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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 VaR model values a portfolio of thinly traded corporate bonds by mapping each bond to a liquid government yield curve plus a single average credit spread index. During validation, the reviewer notes that daily P&L from these bonds is much more volatile than the model predicts. Which is the most likely model deficiency?

The likely deficiency is basis risk from proxy mapping. Mapping thinly traded bonds to a single spread index omits issuer-specific spread movements, so actual P&L is more volatile than modelled. Horizon or confidence level choices change VaR scale but do not create this missing-risk-factor gap.

  1. AExcessive use of a long historical window that smooths volatility
  2. BBasis risk from the proxy mapping, because issuer-specific spread movements are not captured by the risk factorsCorrect
  3. CUse of a one-day horizon rather than a ten-day horizon
  4. DUse of a 99% rather than a 95% confidence level

Explanation

Mapping bonds to a generic spread index leaves idiosyncratic spread risk outside the model, so actual P&L varies by more than the model implies. The horizon and confidence level affect the size of VaR but do not explain unexplained P&L volatility from missing risk factors.

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