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FRM Part II · FRM Exam Part II · Validating Bank Holding Companies' Value-at-Risk Models for Market Risk

Which feature is a recognized limitation of using historical-scenario stress tests as part of VaR model validation?

A key limitation is that historical scenarios only reflect events that have already occurred, so they may miss new or unprecedented combinations of risk factor moves. Hypothetical scenarios are used to fill this gap. Historical stress tests do apply to trading books and do not require normality.

  1. AThey cannot be applied to trading portfolios
  2. BThey require a normal distribution assumption
  3. CThey are limited to events that have already occurred and may miss new risk combinationsCorrect
  4. DThey produce results identical to backtesting

Explanation

Historical scenarios rely on past episodes, so they may not capture new vulnerabilities or novel combinations of shocks; hypothetical scenarios are used to address this. They can be applied to trading portfolios, do not need normality, and differ from backtesting.

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