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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

A firm reports a daily 99% VaR of $4 million and has had no VaR exceedance in 500 trading days. A later review finds the positions held large illiquid, complex instruments marked using a model chosen by the desk. Which conclusion is most appropriate?

Zero exceedances in 500 days is suspicious because about five would be expected at 99% confidence. With illiquid, model-valued positions chosen by the desk, returns may be smoothed and risk understated, so reported VaR may be unreliable. VaR also never guarantees a maximum loss.

  1. AThe absence of exceedances may reflect unreliable valuations and smoothed returns, so VaR may understate riskCorrect
  2. BZero exceedances proves the VaR model is perfectly calibrated
  3. CThe result confirms that illiquid assets have lower risk than liquid ones
  4. DVaR at 99% guarantees losses cannot exceed $4 million

Explanation

At 99% about 5 exceedances would be expected in 500 days, so zero is itself suspicious. Desk-chosen models for illiquid assets can smooth marks and understate volatility, making VaR unreliable. VaR is never a maximum loss guarantee.

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