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

A bank's 99% one-day VaR backtest over 500 days shows 5 exceptions, but 4 occurred on consecutive days during one market episode. Which conclusion is most appropriate?

The count of five matches the five expected from 500 days at 99%, so unconditional coverage is fine. But four consecutive exceptions point to clustering, which an independence or conditional coverage test would likely flag, indicating the VaR model adapts slowly to changing volatility.

  1. AThe model passes unconditional coverage and clearly passes independence, so no concern arises
  2. BThe exception count is consistent with 99% coverage, yet the clustering suggests the model may fail an independence testCorrect
  3. CThe model should be rejected because 5 exceptions exceed the expected 2.5
  4. DThe clustering is irrelevant because only the total count matters in any statistical test

Explanation

Expected exceptions are 500 x 1% = 5, so the count matches coverage exactly. However, four consecutive exceptions indicate dependence, which a conditional coverage or independence test would flag, suggesting the model reacts slowly to volatility changes. The expected count is 5, not 2.5.

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