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

A risk manager wants to quantify the model risk in a derivatives valuation by comparing the production model with several alternative, reasonable models calibrated to the same market data. The production model values a position at USD 10.00 million and the alternatives give USD 9.70 million, 10.20 million and 9.50 million. If the bank sets a model reserve equal to the gap between the production value and the lowest alternative value, what is the reserve?

The reserve is USD 0.50 million. Production value of 10.00 million minus the lowest alternative model value of 9.50 million gives 0.50 million. Using the lowest value measures the downside exposure to model choice, while the other options use the wrong comparison model.

  1. AUSD 0.20 million
  2. BUSD 0.30 million
  3. CUSD 0.50 millionCorrect
  4. DUSD 0.70 million

Explanation

The lowest alternative value is 9.50 million. The gap to production is 10.00 - 9.50 = 0.50 million. The 0.30 figure uses the nearest lower alternative (9.70) instead of the lowest, and 0.20 is the gap to the highest alternative, which is in the opposite direction.

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