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

A validator backtests a 99% one-day VaR model over 250 days and finds 7 exceedances. Under a simple Basel-style traffic-light approach, the yellow zone covers 5 to 9 exceptions. The expected number of exceptions is 2.5. Which conclusion and next step is most appropriate?

Seven exceptions against an expected 2.5 puts the model in the yellow zone. That signals possible risk underestimation without proving the model is flawed, so the validator should investigate causes such as data quality, volatility estimation or fat tails before concluding, rather than accepting or rejecting it outright.

  1. AGreen zone; accept the model with no action because 7 is close to 2.5
  2. BRed zone; the model must be rejected immediately and replaced
  3. CYellow zone; the result suggests possible underestimation, so investigate causes (e.g., data, volatility estimation, fat tails) before concludingCorrect
  4. DYellow zone; ignore because exceedances only matter above 10

Explanation

Expected exceptions are 250 x 1% = 2.5. Seven falls in the 5-9 yellow zone, which signals possible but not conclusive deficiency, so investigation of root causes is warranted. Green is wrong since 7 exceeds 4; red begins at 10 so immediate rejection is not supported.

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