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

A derivatives desk uses a pricing model that is theoretically sound and correctly coded. A trader applies it to value an exotic product for which the model's key assumption, constant volatility, is clearly violated by the product's payoff. This is best classified as which type of model risk?

This is model misapplication risk. The model is theoretically sound and correctly coded, but it is used for a product whose payoff violates its constant-volatility assumption, so the problem lies in how the model is used rather than its construction or code.

  1. AModel misapplication riskCorrect
  2. BModel implementation risk
  3. CData quality risk
  4. DModel calibration frequency risk

Explanation

The model is sound and correctly implemented, but it is being used for a product it was not designed to value. That is misapplication (inappropriate use). Implementation risk would involve coding or numerical errors, which are not present here.

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