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FRM Part II · FRM Exam Part II · Validating Bank Holding Companies' Value-at-Risk Models for Market Risk

A validation team at a bank holding company finds that its VaR model's 99% one-day VaR is consistently well below that of a benchmark model, yet backtesting shows few exceptions. Which is the most appropriate conclusion?

The gap should be investigated. Differences in assumptions, data windows or risk factor coverage may explain it, and neither few exceptions nor a higher benchmark proves which model is right. Benchmarking results are diagnostic inputs requiring analysis, not automatic grounds for accepting or replacing a model.

  1. AThe internal model must be correct because few exceptions prove accuracy
  2. BThe benchmark must be wrong because it is higher
  3. CThe difference should be investigated for causes such as differing assumptions, data or risk factor coverage, since neither result alone is conclusiveCorrect
  4. DThe model should be replaced by the benchmark immediately without analysis

Explanation

Benchmarking differences are signals to investigate, not automatic proof of error. Differences may arise from distributional assumptions, data windows, or risk factor coverage. Few exceptions can also reflect an overly conservative model or low-volatility periods, so the divergence needs analysis.

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