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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 validation group finds that backtesting exceptions are clustered in a few consecutive weeks, although the total count of 4 over 250 days at 99% confidence is within the acceptable range. Which interpretation best reflects sound validation practice?

Clustered exceptions indicate dependence, meaning the model is slow to respond to changing volatility, even if the total count is acceptable. A sound validation checks both frequency and independence of exceptions, so the clustering warrants further analysis rather than comfort from the overall count.

  1. ANo concern exists because the total count is acceptable, so clustering is irrelevant
  2. BThe clustering suggests exceptions are not independent, indicating the model may be slow to adapt to changing volatility, so further analysis is warrantedCorrect
  3. CThe model is overly conservative because exceptions are rare overall
  4. DThe clustering proves that the confidence level should be raised to 99.9%

Explanation

A correct VaR model should produce exceptions that are independent over time as well as the right frequency. Clustering signals that the model fails to respond to volatility regimes, even if the count is acceptable. Count-only tests miss this, so the first option is wrong.

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