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

A fund's one-day 99% VaR is estimated at 10 million using a 10-year history that excludes any crisis. Management argues the fund is safe because leverage of 25x is 'covered' by this VaR. Applying LTCM lessons, which action best addresses the model weakness?

The best response is to add stress testing with crisis correlations and realistic liquidity horizons, and to examine funding risk from leverage. Changing the confidence level on the same benign history does not fix the blind spot that caused LTCM's failure.

  1. ASupplement VaR with stress tests using crisis correlations and liquidity horizons, and assess funding risk under leverageCorrect
  2. BIncrease the confidence level to 99.9% and keep the same data window
  3. CScale the one-day VaR by the square root of 250 and treat that as the worst loss
  4. DRely on the VaR because it is backward-looking and therefore objective

Explanation

The key LTCM lesson is that history-based VaR misses regime shifts, correlation breakdown and liquidity-driven funding stress. Stress tests with crisis correlations and longer liquidation periods address this. A higher confidence level on the same benign data still inherits the same blind spot, and scaling VaR gives no worst-case.

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