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

Long-Term Capital Management (LTCM) relied on VaR estimates calibrated on a few years of historical data when it held highly leveraged convergence trades. In August-September 1998 losses far exceeded model estimates. Which model-risk issue best explains this?

LTCM's models assumed stable historical correlations and liquid markets. After the 1998 Russian default, correlations among its trades surged and positions could not be unwound, so losses far exceeded VaR. This is a failure of stress and liquidity assumptions combined with high leverage.

  1. AHistorical correlations and liquidity assumptions broke down in stress, as positions across markets became highly correlated and could not be unwoundCorrect
  2. BThe model used Monte Carlo simulation, which cannot be applied to bonds
  3. CVaR was calculated at a 99.99% confidence level, which is too conservative
  4. DThe firm hedged all interest rate exposure with futures, eliminating basis risk

Explanation

LTCM assumed diversification across trades and ability to liquidate positions, based on benign historical data. After the Russian default, correlations rose sharply and liquidity vanished, so losses were much larger than modeled. The other options are not supported by the case.

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