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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 trading desk has a 99% one-day VaR model. Over 250 days, it records only 0 exceptions. Which interpretation is best supported?

Zero exceptions against an expected 2.5 suggests the model overstates risk and is too conservative, tying up unnecessary capital. Backtesting is two-sided, so too few exceptions is also a calibration failure, though with 250 days the evidence is weak.

  1. AThe model is certainly accurate because no losses exceeded VaR
  2. BThe model is likely too conservative, overstating risk and tying up excess capitalCorrect
  3. CThe model has a Type II error problem that guarantees underestimated risk
  4. DThe test is invalid because zero exceptions cannot be evaluated

Explanation

Expected exceptions are 2.5, and zero is well below that. The probability of zero is 0.99^250, about 8%, so it is not conclusive, but it points to a conservative model. Backtesting is two-sided: too few exceptions signals overstated VaR, which is costly in capital terms.

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