WHICH OF THE FOLLOWING STATEMENTS ABOUT THE RISK MANAGEMENT IMPLIC...

19.

Which of the following statements about the risk management implications of this replacement is correct?

a.

Delta-normal VaR is more appropriate than historical simulation VaR for assets with non-linear payoffs.

b.

Changing the look-back period and weighing scheme from three years, equally weighted, to four years,

exponentially weighted, will understate the risk in the portfolio.

c.

The desk increased its exposure to model risk due to the potential for incorrect calibration and program-

ming errors related to the new model.

d.

A 95% VaR model that generates no exceedances in four weeks is necessarily conservative.

Correct Answer: c

Rationale:

Given the quick implementation of the new VaR model and the insufficient amount of testing that was

done, the desk has increased its exposure to model risk due to the increased potential for incorrect calibration and

programming errors. This situation is similar to the JP Morgan London Whale case in 2012, where a new VaR model

was very quickly introduced for its Synthetic Credit portfolio without appropriate time to test the model in

response to increasing losses and multiple exceedances of the earlier VaR model limit in the portfolio.

Section: Operational and Integrated Risk Management

Reference:

Kevin Dowd, Measuring Market Risk, 2nd Edition, Chapter 16, “Model Risk.”

Learning Objective:

Define model risk; identify and describe sources of model risk.

Reference:

Allan Malz, Financial Risk Management: Models, History, and Institutions, Chapter 11, "Assessing the

Quality of Risk Measures," section 11.1.

Learning Objective:

Describe ways that errors can be introduced into models.

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2015 Financial Risk Manager (FRM®) Practice Exam

Section: Current Issues

Reference:

“JP Morgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses—Executive Summary,”

US Senate Subcommittee on Investigation, April 2013.

Learning Objective:

Summarize the deficiencies in risk management practices related to the SCP, including the VAR

model change.

Section:

Market Risk Measurement and Management

Reference:

Kevin Dowd, Measuring Market Risk, 2nd Edition, Chapter 3, “Estimating Market Risk Measures.”

Learning Objective:

Calculate VaR using a parametric estimation approach assuming that the return distribution is

either normal or lognormal.