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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 uses an equally weighted 500-day historical window. After a long calm period, market volatility rises sharply, and the bank records several VaR exceptions in a few weeks. Which model assumption is the most plausible cause, and what is a sensible remedy?

The most plausible cause is the slow reaction of an equally weighted window to rising volatility, and the remedy is to weight recent data more, for example exponential decay or volatility updating. Calm-period data dominate the window, so VaR lags and exceptions cluster after the shift.

  1. AAssumption of normality; the remedy is to lower the confidence level
  2. BAssumption that the horizon is one day; the remedy is to use a ten-day horizon only
  3. CSlow response of the equally weighted window to new volatility; the remedy is to add a weighting scheme such as exponential decay or a volatility-updating approachCorrect
  4. DExcessive number of risk factors; the remedy is to remove factors

Explanation

An equally weighted long window gives recent high-volatility observations only small weight, so VaR lags the regime change and exceptions cluster. Weighting recent data more heavily or rescaling for current volatility makes VaR react faster. Lowering confidence would worsen coverage, and the other options do not address the lag.

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