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

A risk manager reviewing lessons from LTCM and the London Whale proposes controls. Which proposal best addresses the common model risk lesson from both cases, namely that a model's output was trusted while its assumptions and limits were not effectively challenged?

The best control is independent validation with real authority to challenge assumptions, supplemented by stress and liquidity analysis beyond VaR and escalation when the model conflicts with other risk indicators. Both LTCM and the London Whale involved unchallenged reliance on models that understated risk.

  1. ALet the business line that uses the model approve any change so that approvals are quick
  2. BEstablish independent validation with authority to challenge assumptions, require stress and liquidity-adjusted analysis beyond VaR, and escalate when the model understates risk compared with other indicatorsCorrect
  3. CReplace the VaR measure with a lower confidence level to reduce the frequency of breaches
  4. DLimit model documentation to the final output so that reviewers focus on results

Explanation

Both cases show a reliance on a single model output. Independent challenge, stress analysis beyond VaR, and escalation of discrepancies address this. Letting the business approve changes, loosening confidence levels or thinning documentation weakens control.

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