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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 passes an unconditional coverage test, with exceptions near the expected 1%. However, the exceptions all occurred within two consecutive weeks during a market sell-off. What does this indicate?

Clustered exceptions indicate a failure of independence even if the exception count is right. It suggests the VaR model adjusts too slowly to volatility changes. Conditional coverage or independence tests are needed in addition to unconditional coverage, which only checks the frequency of exceptions.

  1. AThe model is validated because the exception count is correct
  2. BThe exceptions are clustered, suggesting a failure of independence and that the model is slow to react to changing volatilityCorrect
  3. CThe confidence level should be raised to 99.9%
  4. DThe backtest is invalid because exceptions must be spread evenly by month

Explanation

Unconditional coverage tests only the frequency of exceptions. Clustering violates independence, which conditional coverage or independence tests detect. It signals that the model fails to adapt to volatility regimes. Raising the confidence level does not fix this, and exceptions need not be evenly spread, only independent.

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