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

In the London Whale case, the CIO's trading positions grew while VaR limits were exceeded, and the 10-Q VaR was temporarily reported using the older model after the new model was found to produce a lower figure. Which conclusion about this episode is most accurate?

The episode shows model risk from outcome-driven model selection: the VaR model was changed or reverted depending on which figure eased limit breaches or reporting, instead of on validated methodology. That undermines governance, and limit breaches should be escalated and not managed away by switching models.

  1. AReverting to the previous, higher VaR number was evidence that the model governance process worked fully as designed
  2. BSwitching between models in response to limit breaches and results illustrates the risk of model selection driven by outcomes rather than by validated methodologyCorrect
  3. CVaR limit breaches are not relevant to model risk and need no escalation
  4. DUsing two models simultaneously always reduces model risk

Explanation

Model choice was influenced by the effect on reported VaR and limit breaches, rather than by a validated methodology and sound approval. This outcome-driven selection is a governance weakness, not evidence of a working process. Breaches should be escalated, and running two models does not by itself reduce risk.

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