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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 of the following best describes the primary source from which model risk arises?

Model risk arises from fundamental errors that cause a model to produce inaccurate outputs, and from incorrect or inappropriate use of a model, including applying it outside its intended purpose. Market volatility, capital shortfalls and regulatory changes are different risks, not the defined sources under SR 11-7.

  1. AFundamental errors in a model that produce inaccurate outputs, and incorrect or inappropriate use of a model's outputsCorrect
  2. BRegulatory changes that alter the capital treatment of a bank's trading positions
  3. CMarket volatility that causes realized losses to exceed expected losses
  4. DFailure of a bank to hold sufficient capital against operational loss events

Explanation

SR 11-7 defines model risk as the potential for adverse consequences from decisions based on incorrect or misused model outputs. It arises from two sources: fundamental errors in the model and incorrect or inappropriate use. Market volatility and capital shortfalls are separate risks, not the defining sources of model risk.

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