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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 VaR model maps a portfolio of 40 individual single-name equity options onto a small set of broad equity index risk factors and implied volatility factors. Which risk does this mapping most directly introduce that validators should test?

Mapping single-name options to broad index and volatility factors omits idiosyncratic and basis risk specific to each name. This can understate VaR, so validators should test proxy quality and the materiality of the residual risk not captured.

  1. AIdiosyncratic or basis risk not captured by the chosen factors, which can understate VaRCorrect
  2. BOverestimation of VaR because mapping always adds extra volatility
  3. CExceedance clustering caused solely by the confidence level selected
  4. DDouble counting of the holding period in the scaling of daily VaR

Explanation

Mapping positions to broad factors removes security-specific movements, so residual (basis/idiosyncratic) risk is omitted. Validators should check proxy quality and whether the omitted risk is material. Mapping does not systematically add volatility.

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