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

A risk manager reviewing the London Whale lessons notes that the CIO's VaR model relied on spreadsheets with manual copy-and-paste steps. Which model risk is MOST directly highlighted?

The spreadsheet issue highlights implementation and operational model risk. Manual copy-and-paste steps allowed calculation errors to pass unnoticed, understating risk. This is a control and process failure in model use rather than a problem of distributional assumptions, sample length, or hedge basis.

  1. AImplementation and operational risk in model use, where calculation errors went undetectedCorrect
  2. BPure estimation risk from using too short a sample window
  3. CRisk from using a normal distribution for returns
  4. DBasis risk between the hedge and the hedged asset

Explanation

Manual spreadsheet processes allowed formula errors, such as an incorrect division in a volatility calculation, to go undetected, which is an implementation and control weakness. The other options are valid model risks but are not what the spreadsheet issue demonstrates.

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