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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 despite using sophisticated VaR models. Which model-related weakness best explains why its risk estimates failed in the August-September 1998 crisis?

LTCM's models relied on historical correlations and volatilities from calm periods, so they missed that correlations among its supposedly diversified convergence trades would surge in stress and that liquidity would disappear. High leverage then turned these underestimated risks into losses that could not be absorbed.

  1. AIt calibrated on historical correlations and volatilities that held in normal markets, so it underestimated how correlations among diversified convergence trades would rise in stress and how liquidity would vanishCorrect
  2. BIt used a parametric model with a confidence level of 50%, which produced overly wide risk estimates
  3. CIt applied excessive stress tests that forced it to hold too much cash
  4. DIt relied on a single trade, so diversification was never assumed in the model

Explanation

LTCM's models assumed stable historical relationships and diversification across many convergence trades. In the crisis, correlations jumped, spreads widened together, and liquidity dried up, with high leverage amplifying the losses. The model's neglect of stress correlation and liquidity is the core flaw.

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