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FRM Part II · FRM Exam Part II · Supervisory Guidance on Model Risk Management

Under the supervisory guidance on model risk management (SR 11-7), which description best captures how model risk is defined?

SR 11-7 defines model risk as the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports. It stems from errors in the model itself or from using it inappropriately, so it covers both design flaws and misuse.

  1. AThe potential for adverse consequences from decisions based on incorrect or misused model outputsCorrect
  2. BThe risk that a model's software fails to run during the production cycle
  3. CThe risk that a bank's trading book losses exceed its VaR estimate at a stated confidence level
  4. DThe risk that model developers leave the firm and documentation is lost

Explanation

SR 11-7 defines model risk as the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports. It arises from fundamental errors in the model and from incorrect or inappropriate use. The other options describe narrower operational, backtesting or key-person issues.

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