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

A risk manager reviews a fund that, like LTCM, has equity of USD 4.7 billion and assets of USD 125 billion. Its leverage ratio (assets/equity) is closest to which value, and what is the loss in assets value that would wipe out equity?

Leverage is 125 divided by 4.7, about 26.6 times. Equity is eliminated when assets fall by equity divided by assets, 4.7/125, roughly 3.8%. A small adverse move therefore destroys the capital, showing why leverage magnifies model error.

  1. AAbout 26.6x; a fall of about 3.8% in asset valueCorrect
  2. BAbout 26.6x; a fall of about 26.6% in asset value
  3. CAbout 3.8x; a fall of about 26.6% in asset value
  4. DAbout 2.7x; a fall of about 37.6% in asset value

Explanation

Leverage = 125/4.7 = 26.6x. Equity is wiped out when the loss equals equity: 4.7/125 = 3.76%, about 3.8%. Option B inverts the percentage, and C and D use wrong ratios.

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