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

A bank's VaR model has been backtested over 250 days at 99% confidence and produced 9 exceptions. Validators conclude the model is likely underestimating risk. Which is the most appropriate model-risk mitigation response?

The bank should investigate the causes, recalibrate or redevelop the model, and apply a conservative overlay or add-on meanwhile. Nine exceptions against about 2.5 expected indicates underestimation, and changing the confidence level or deleting exception days would merely mask the weakness.

  1. ADocument the exceptions and continue using the model unchanged since 9 is close to 2.5
  2. BInvestigate the causes of exceptions, recalibrate or redevelop the model, and apply a conservative overlay or capital add-on until it is fixedCorrect
  3. CChange the confidence level to 95% so exceptions fall
  4. DRemove the days with exceptions from the backtest sample

Explanation

At 99% over 250 days about 2.5 exceptions are expected; 9 is well above and signals inadequacy. Appropriate action is root-cause analysis, remediation and interim conservatism. Lowering the confidence level or deleting exception days only hides the problem.

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