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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

In the 2012 JPMorgan 'London Whale' case, the Chief Investment Office changed the VaR model used for its synthetic credit portfolio. What was the main consequence of the new model?

The new model reported a materially lower VaR, aided by spreadsheet and operational errors in its implementation. That understated the synthetic credit portfolio's risk and kept it within limits, illustrating model risk and weak model validation and governance.

  1. AIt produced a lower VaR, partly through an error-prone spreadsheet implementation, which masked the portfolio's riskCorrect
  2. BIt produced a higher VaR that forced immediate position reductions
  3. CIt replaced VaR with full stress testing across all desks
  4. DIt had no effect on reported VaR because it used identical inputs

Explanation

The new model, implemented with manual spreadsheet steps and formula errors, cut reported VaR roughly in half. This helped keep the portfolio within limits and understated risk. Higher VaR would have constrained the positions, which did not happen.

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