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

A validator examines a bank's parametric delta-normal VaR for a trading book with large short option positions. Which model assumption is most problematic for this book?

The linearity and normality assumption is the problem. Delta-normal ignores gamma and fat tails, so for large short option positions, where losses accelerate in big market moves, it understates VaR and fails to capture the nonlinear risk.

  1. ALinear sensitivity of portfolio value to risk factors, ignoring gamma and fat tailsCorrect
  2. BUse of a daily rather than annual horizon
  3. CUse of a covariance matrix rather than a single volatility
  4. DUse of a one-sided confidence level

Explanation

Delta-normal approximates value changes linearly and assumes normal factor returns. For short options, negative gamma means losses grow faster than linear in large moves, so VaR is understated. The other choices are standard, not problematic, features.

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