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FRM Part II · FRM Exam Part II · Risk Measurement and Assessment

During validation of an operational risk capital model, the validation team finds that the model's output changes sharply when a single extreme loss is added to or removed from the dataset. Which is the most appropriate interpretation and response?

The model is overly sensitive to outliers, which signals unstable parameter estimates and thus model risk. The bank should run sensitivity and stability tests, consider robust estimation techniques, and apply conservative overlays or documented limitations rather than treating the swing as a sign of robustness.

  1. AThe model is robust, because sensitivity shows it responds to new information
  2. BThe model has high sensitivity to outliers; the bank should perform sensitivity and stability analysis and consider robust estimation or conservative overlaysCorrect
  3. CThe model should be accepted since capital will fall when the loss is removed
  4. DThe result shows loss frequency is mis-specified and severity can be ignored

Explanation

Large sensitivity to one observation signals parameter instability, a core model risk. Validators should test stability, consider robust methods and document limitations, possibly applying a conservative add-on. Rapid capital swings are not evidence of robustness.

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