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FRM Part II · FRM Exam Part II · Case Study: Model Risk and Model Validation

A bank's validation of a credit model shows strong performance, but the validator discovers the validation sample was drawn from the same benign economic period as the development sample. Which conclusion is most appropriate?

Validation is limited because both samples come from the same benign period, so the test does not show how the model behaves under stress or regime change. Agreement and sample size do not substitute for testing in varied conditions.

  1. AThe model is validated because both samples agree
  2. BValidation is limited because it did not test performance under different or stressed conditionsCorrect
  3. CThe model should be validated using only in-sample statistics
  4. DValidation is complete because the sample size is large

Explanation

Agreement between samples from the same regime does not show robustness. Effective validation should include stress periods or alternative regimes, so the validation is limited. A large sample from one benign period does not fix this, and in-sample statistics are weaker still.

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