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

Which practice would most directly have mitigated the model risk that both the London Whale and LTCM cases revealed regarding reliance on a single risk metric?

Supplementing VaR with stress testing, scenario analysis and non-model limits, together with independent challenge of models, best addresses the lesson. Both cases showed a single model metric can understate risk, so complementary tools and independent oversight are needed rather than a tweak to VaR parameters.

  1. ASupplementing VaR with stress tests, scenario analysis and limits independent of the model, with challenge from an independent functionCorrect
  2. BIncreasing VaR confidence level to 99.9% and dropping all other metrics
  3. CAllowing business lines to own and validate their own models
  4. DUsing only longer historical windows without any judgment overlay

Explanation

Both cases showed that VaR alone can mislead. Stress and scenario analysis, non-VaR limits and effective independent challenge reveal risks the model misses. Self-validation weakens challenge, and a higher confidence level or longer window still relies on the same limited approach.

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