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

A trading desk uses a vendor-supplied option pricing model. A validator finds the model's mathematics are sound and the code matches the specification, but traders apply it to exotic products whose payoffs it was never designed to capture. Which type of model risk is most prominent?

This is model misuse. The model is mathematically correct and properly coded, but it is applied to exotic products outside its design scope, so its outputs are unreliable for those uses despite being sound for its intended purpose.

  1. AModel misuse, because the model is applied outside its intended scopeCorrect
  2. BModel error from a flawed mathematical derivation
  3. CImplementation error from incorrect coding
  4. DData error from stale market inputs

Explanation

The mathematics and code are verified as correct, which rules out derivation and implementation error. No data problem is mentioned. The problem is that a sound model is used for products beyond its intended purpose, which is misuse.

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