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

Long-Term Capital Management (LTCM) collapsed in 1998 after the Russian default. Which statement best describes the model risk lesson regarding its risk models?

LTCM's models relied on historical correlations and assumed liquid markets, so the supposed diversification across convergence trades disappeared when the Russian default drove correlations toward one and liquidity dried up. Losses on a highly leveraged book far exceeded model estimates.

  1. AModels calibrated to history assumed stable correlations and liquidity, so diversification failed when positions became highly correlated in a crisisCorrect
  2. BModels were too conservative and prevented profitable trades
  3. CModels ignored leverage entirely and used only unlevered returns
  4. DModels failed because regulators mandated incorrect parameters

Explanation

LTCM's VaR and stress tests relied on historical correlations among convergence trades and assumed positions could be liquidated. In the crisis, correlations rose and liquidity vanished, so losses were far larger than the models implied. The other options are not supported by the case.

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