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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

A trader marks an illiquid structured credit position using a model whose inputs are mostly unobservable and set by the trading desk itself. Which valuation control weakness does this most directly represent?

This is a lack of independent price verification. When traders control unobservable model inputs for illiquid positions, marks can be biased in their favor. A separate control function should verify prices and challenge assumptions to prevent overstated valuations.

  1. ALack of independent price verificationCorrect
  2. BExcessive use of market-observable inputs
  3. COverly frequent collateral calls
  4. DUse of a risk-neutral measure

Explanation

When the desk that benefits from the valuation also sets the model inputs, there is no independent check. Independent price verification by a control function reduces the risk of biased marks, as seen in several disasters including Barings and the subprime crisis. Observable inputs and collateral calls would improve, not weaken, control.

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