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

Under supervisory guidance on model risk management, model risk arises primarily from two sources. Which pair correctly describes them?

Model risk stems from fundamental errors in the model's design, assumptions, or inputs that lead to inaccurate outputs, and from incorrect or inappropriate use of the model, such as applying it beyond its intended purpose. Other options describe unrelated market, credit, or liquidity risks.

  1. AFundamental errors in model design or inputs that produce inaccurate outputs, and incorrect or inappropriate use of a modelCorrect
  2. BMarket volatility exceeding forecasts, and counterparty default exceeding expectations
  3. CRegulatory capital shortfalls, and inadequate liquidity buffers
  4. DStaff turnover in the quant team, and vendor pricing disputes

Explanation

Supervisory guidance identifies model risk as arising from the model possibly having fundamental errors that give inaccurate outputs relative to its design objective, and from the model being used incorrectly or inappropriately. The other options describe market, credit, liquidity or people risks, not the two defined sources.

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