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

A validator at a bank holding company finds that the VaR model's backtests are satisfactory on the aggregate portfolio, but the model used hypothetical (clean) P&L for backtesting while actual P&L includes intraday trading and fees. The firm's trading book also recently added complex options with significant nonlinear risk, which the model treats with delta-normal approximations. Which conclusion is most defensible?

Validation is incomplete. Aggregate backtests can mask offsetting errors, and a delta-normal approach is conceptually weak for material option positions. The validator should test sub-portfolios and benchmark against full revaluation. Using hypothetical P&L is acceptable and not a reason for rejection by itself.

  1. AThe model is valid because aggregate backtests pass
  2. BThe model should be accepted since actual P&L contamination only biases results toward more exceptions
  3. CThe validation is incomplete: aggregate backtesting can mask offsetting errors, and the delta-normal treatment of options is a conceptual weakness that should be tested at sub-portfolio level and with alternatives such as full revaluationCorrect
  4. DThe model should be rejected solely because hypothetical P&L is used in backtesting

Explanation

Passing aggregate backtests can hide offsetting errors across desks or risk types. Delta-normal ignores gamma and convexity, so it is unsuitable for significant option positions; validation should test sub-portfolios and benchmark against full revaluation. Using hypothetical P&L is acceptable practice and not grounds for rejection alone.

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