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

A validator wants to assess how sensitive a pricing model's output is to a key assumption, such as a volatility input, holding the model structure fixed. Which activity does this describe?

This is sensitivity analysis. It varies inputs or assumptions, such as volatility, while keeping the model structure unchanged, to see how outputs respond. It differs from benchmarking, backtesting and conceptual review, which compare models, outcomes or theory.

  1. ABenchmarking against a vendor model
  2. BSensitivity analysis of inputs and assumptionsCorrect
  3. CBacktesting against realised outcomes
  4. DConceptual soundness review of the literature

Explanation

Sensitivity analysis varies inputs or assumptions one at a time or jointly to see the effect on outputs. Benchmarking compares with another model, backtesting compares with realised outcomes, and conceptual review evaluates the theory and design.

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