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FRM Part II · FRM Exam Part II · Performing Due Diligence on Specific Managers and Funds

During a risk review of a long/short equity fund, an allocator finds that the fund's risk reports use only a 1-day 99% historical VaR based on the past year of calm markets, with no stress tests. Which recommendation is most appropriate?

The allocator should require stress testing and scenario analysis, including liquidity considerations. A one-year calm-window VaR omits tail events and says nothing about losses beyond the threshold or the cost of exiting positions, so it understates risk. Changing the confidence level with the same data does not solve this.

  1. AAccept the VaR because historical simulation is model-free and therefore complete
  2. BReplace VaR with a measure of annual return volatility
  3. CRequire supplementary stress testing and scenario analysis, including liquidity-adjusted measures, because VaR from a calm window understates tail and liquidity riskCorrect
  4. DAsk the manager to increase the confidence level to 99.9% while keeping the same data window

Explanation

A calm one-year window misses tail events, and VaR says nothing about losses beyond the cutoff or about liquidity. Stress tests and scenarios fill these gaps. Raising confidence with the same calm data does not add information about unobserved stress, and volatility alone is weaker.

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