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

After a pricing model fails, a review notes that the model assumed constant volatility, although observed market volatility changes strongly over time. Programmers coded the model exactly as specified and the inputs were accurate. Which classification is most appropriate?

It is conceptual or specification risk. The model faithfully implements an unrealistic constant-volatility assumption with accurate inputs, so the weakness is in the model's design rather than in coding, data entry or user behavior.

  1. AConceptual or specification risk from an unrealistic assumptionCorrect
  2. BImplementation risk from a programming bug
  3. COperational risk from a data-entry mistake
  4. DMisuse risk from an unauthorized user

Explanation

Because the code matches the specification and the inputs are right, the flaw lies in the design assumption of constant volatility. That is conceptual soundness or specification risk. Implementation risk would require a gap between specification and code.

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