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FRM Part II · FRM Exam Part II · Case Study: Model Risk and Model Validation

A bank must quantify the model risk in its option pricing model for a book of exotic options. Which approach is most consistent with quantifying model risk as the potential loss from using an incorrect model?

Pricing the book under several plausible alternative models and using the dispersion or difference from a benchmark as a reserve or adjustment quantifies model risk. A single production-model VaR cannot reveal error in that same model, so comparison across models is needed.

  1. ACompute the VaR of the book using the production model only and report it as model risk
  2. BPrice the book under several plausible alternative models and treat the dispersion of values, such as the gap from a benchmark model, as a model reserve or adjustmentCorrect
  3. CReduce the number of risk factors in the production model to simplify it
  4. DAverage the P&L of the last 30 days and subtract it from the book value

Explanation

A common way to quantify model risk is to compare valuations from alternative reasonable models; the difference to a benchmark indicates potential mispricing and can support a reserve. Using only the production model cannot reveal model error, simplifying the model likely increases it, and averaging P&L is unrelated.

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