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FRM Part II · FRM Exam Part II · Validating Bank Holding Companies' Value-at-Risk Models for Market Risk

A risk manager at a bank holding company reviews a validation report on the bank's trading VaR model. The report relies solely on comparing daily trading P&L to the 99% one-day VaR. Which limitation of this approach is most relevant to the reading's findings on VaR validation?

The key limitation is low statistical power. With only about 250 daily observations and 1% expected exceptions, a small number of breaches cannot reliably separate an accurate model from a moderately flawed one, so backtesting alone is insufficient validation.

  1. ABacktesting with limited exceptions has low statistical power, so it cannot reliably distinguish an accurate model from a moderately inaccurate oneCorrect
  2. BBacktesting cannot be performed on portfolios that contain options
  3. CBacktesting requires that VaR be computed using historical simulation only
  4. DBacktesting results are only meaningful if the exceptions occur on consecutive days

Explanation

With a 99% VaR and about 250 observations, only around 2.5 exceptions are expected, so tests have little power to separate good from poor models. Backtesting can be applied to option portfolios and to any VaR method, and clustering of exceptions signals a problem rather than being required.

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