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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% VaR model shows 3 exceptions in 250 days, all in a single week during a market shock. A validator concludes the model passes the Basel traffic-light test. Which critique is most appropriate?

The count passes, but clustering of all exceptions in one week breaches the independence property of a good VaR model. It suggests the model reacts slowly to volatility changes, so an independence or conditional coverage test is needed beyond simple exception counting.

  1. AThree exceptions is below the expected number and signals an overly conservative model
  2. BThe count test ignores the independence of exceptions; clustering suggests VaR failed to respond to changing volatilityCorrect
  3. CThe model should be moved to the red zone because exceptions occurred in one week
  4. DException counts are invalid unless hypothetical P&L is used exclusively

Explanation

Three exceptions is in the green zone and close to the expected 2.5, so the count looks fine. But clustered exceptions violate independence and indicate VaR is slow to adapt to volatility, which a conditional coverage or independence test would reveal. Red zone requires 10 or more.

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