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

A risk manager values an exotic option using three internally approved models. The valuations are USD 4.10 million, USD 4.30 million and USD 4.80 million. The bank decides to quantify model risk as the difference between the highest and the lowest valuation produced by the alternative models, and to hold a reserve equal to half of that range. What is the reserve?

The reserve is USD 0.35 million. The valuation range across the models is 4.80 minus 4.10, or USD 0.70 million, and the policy holds half of it. Using the full range or only adjacent model pairs would give other figures that do not match the stated policy.

  1. AUSD 0.35 millionCorrect
  2. BUSD 0.70 million
  3. CUSD 0.25 million
  4. DUSD 0.20 million

Explanation

Range = 4.80 - 4.10 = 0.70 million. Half of the range = 0.35 million. The USD 0.70 million option forgets to halve the range; 0.25 is half of 4.80-4.30 (wrong pair of models); 0.20 is half of 4.30-4.10 (wrong pair).

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