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

A validator reviewing a historical simulation VaR model at a bank holding company finds that missing daily prices for an illiquid risk factor are filled by carrying forward the previous day's value (stale prices). What is the most likely effect on the VaR estimate?

Stale price filling most likely understates volatility and correlation with other factors, so VaR is biased too low. Carried-forward prices produce many zero returns and occasional large jumps, which reduces measured variation in the data and makes the risk of the illiquid positions look smaller than it is.

  1. AUnderstated volatility and correlations with other factors, leading to VaR that is too lowCorrect
  2. BOverstated volatility, leading to VaR that is too high
  3. CNo effect on volatility, only on the mean return
  4. DOverstated correlations with liquid factors, leading to VaR that is too high

Explanation

Carrying forward prices creates zero returns on many days and then large catch-up moves, which understates measured volatility and typically dampens measured correlation with liquid factors. The result is VaR that is biased downward, especially for diversified portfolios.

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