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

A validator wants to test whether a credit risk model's performance deteriorates when applied to a borrower segment not represented in the development sample. Which technique is most appropriate?

Out-of-sample and out-of-time testing is most appropriate, because it applies the model to data not used in development, such as the new borrower segment, showing whether performance generalizes. Refitting on development data, adding variables or reviewing documentation cannot reveal that weakness.

  1. AOut-of-time and out-of-sample testing on data from that segmentCorrect
  2. BRe-estimating parameters on the full development sample
  3. CIncreasing the number of explanatory variables
  4. DReviewing the model documentation for completeness

Explanation

Out-of-sample (and out-of-time) testing applies the model to data not used in development, revealing whether it generalizes to new segments. Re-estimating on the development sample or adding variables risks overfitting and does not test generalization. Documentation review does not measure performance.

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