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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 model is backtested over 250 trading days and produces 9 exceptions. The validator is deciding how to interpret this. Which conclusion is most appropriate?

Expected exceptions at 99% over 250 days are 2.5, so nine is far too many. It suggests the model underestimates risk, perhaps through poor volatility estimates, missing risk factors or mis-measured P&L, and the cause should be investigated rather than accepted.

  1. AThe result is consistent with a well-calibrated model because 9 is close to the expected count of 2.5
  2. BThe count is well above the 2.5 expected, suggesting the model may understate risk, and the cause should be investigatedCorrect
  3. CThe model overstates risk because exceptions are fewer than the 250 days observed
  4. DThe model should be accepted because exceptions are independent by assumption

Explanation

Expected exceptions are 250 x 1% = 2.5. Nine is far above this and in the Basel red zone (10 or more) it is nearly so, indicating likely underestimation of risk. Distractor A wrongly treats 9 as close to 2.5. Independence is something to test, not an excuse to accept.

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