Skip to content

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

Which statement best describes why model risk can increase when many institutions use the same popular model with similar assumptions?

Widespread use of the same model creates correlated errors and herding behavior. Firms misjudge risk in the same direction and react together under stress, which amplifies market moves instead of diversifying mistakes.

  1. ACommon reliance can create correlated errors and herding that amplify market stressCorrect
  2. BShared models guarantee diversification of errors
  3. CVendor models are always more accurate than internal ones
  4. DRegulators require identical models so no risk arises

Explanation

If many firms rely on identical models and assumptions, they tend to make the same mistakes and react alike, such as selling simultaneously, which amplifies stress. Errors are correlated rather than diversified. Accuracy does not depend on whether a model is vendor-built.

Did you get it right without looking?

One question tells you little. A timed set on Case Study: Model Risk and Model Validation shows your real accuracy, how long you take and where you lose marks.

Practise Case Study: Model Risk and Model ValidationFree diagnostic mock

More Case Study: Model Risk and Model Validation questions