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

In the 2012 JPMorgan 'London Whale' episode, a change to the Value-at-Risk model for the Chief Investment Office synthetic credit portfolio was implemented in early 2012. Which feature of this episode best illustrates model risk?

The London Whale case shows model risk because the revised VaR model was run through error-prone spreadsheets with manual steps and weak independent validation, which understated risk and lowered reported VaR. Flawed implementation and inadequate validation, not an overly conservative or correct model, masked the true exposure.

  1. AThe new model was built and operated using spreadsheets with manual copy-paste steps and was not adequately validated, understating VaRCorrect
  2. BThe model was too conservative and forced the desk to close positions prematurely
  3. CThe model was developed by an external vendor and was never used internally
  4. DThe model correctly estimated risk but traders ignored the limits set by the board

Explanation

The new VaR model was implemented through spreadsheets with manual data entry and formula errors, and lacked independent validation. It understated volatility, which reduced reported VaR and masked risk. The model was not conservative, and the issue was flawed model implementation rather than correct estimates being ignored.

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