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

A bank's VaR model was calibrated on five years of benign market data. During a stress period, losses exceed VaR far more often than the confidence level implies. A validator concludes the problem lies in the model's assumptions rather than in coding or data errors. Which finding most directly supports this conclusion?

Evidence of fat tails and correlation breakdown in the stress period, contradicting the model's normality and stable-correlation assumptions, shows the failure is conceptual assumption risk. Matching independent code results and reconciled inputs only show implementation and data are sound.

  1. AReturns in the stress period show fat tails and correlation breakdown inconsistent with the model's normality and stable-correlation assumptionsCorrect
  2. BThe VaR code reproduces independently written results exactly
  3. CInput prices reconcile to the market data vendor
  4. DReports were delivered on schedule to senior management

Explanation

Assumption risk arises when the model's structural assumptions fail in new conditions. Fat tails and unstable correlations contradict normality and constant-correlation assumptions. The other options show the code, data and reporting are fine, which rules out implementation and data errors but does not explain the failures.

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