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

A bank uses a vendor-supplied option pricing model as a black box. The vendor refuses to disclose the code and documentation is minimal. Which statement best reflects how model risk should be handled?

The bank remains responsible for vendor models and should validate them as far as possible through benchmarking, outcomes analysis, and sensitivity testing, plus compensating controls and monitoring. Lack of code access does not remove the model from the inventory or shift model risk to the vendor.

  1. AThe bank should still validate the model, using benchmarking, outcomes analysis and sensitivity testing, and set controls around its useCorrect
  2. BValidation is unnecessary because the vendor bears the model risk
  3. CValidation is impossible, so the model should be exempt from the inventory
  4. DOnly the vendor's own audit report needs to be filed

Explanation

Vendor models remain the bank's responsibility. Even without code access, the bank can run benchmarking against alternatives, back-test outcomes, test sensitivities, and put limits and monitoring in place. Exempting it or relying solely on the vendor leaves model risk unmanaged.

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