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FRM Part II · FRM Exam Part II · Supervisory Guidance on Model Risk Management

A treasury team uses a model designed to price plain-vanilla interest rate swaps to value a new structured note with embedded exotic options, because it is convenient and the output looks reasonable. Which statement most accurately classifies this under SR 11-7?

This is model risk from use outside the intended purpose. SR 11-7 says model risk arises not only from errors in a model but also from misuse, so a model validated for plain-vanilla swaps can still mislead when applied to exotic structured notes.

  1. AModel risk from use outside the model's intended purpose, even if the model is sound for its original designCorrect
  2. BNot model risk, because the model was already validated for swaps
  3. CModel risk only if the valuation differs from the market price by more than 10%
  4. DA data quality issue, not a model risk issue

Explanation

SR 11-7 identifies incorrect or inappropriate use as a source of model risk: a model valid for one purpose may produce misleading results when applied beyond its intended use. Prior validation covers only the intended scope. No fixed 10% threshold defines model risk.

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