AIM 1: Define model risk and identify and discuss sources of model risk.

1、One would generally expect model risk to be least for a model that prices:

A) put options.
 
B) callable corporate bonds.
 
C) Treasury bonds.
 
D) barrier options.

The correct answer is C

Less model risk is expected when pricing less complex securities.

2、Model risk is least affected by which of the following:

A) the predictive ability of the model.
 
B) the inclusion of all critical inputs.
 
C) the accurate estimation of model parameters.
 
D) the accuracy of the assumptions underlying the model.

The correct answer is D

In many cases, accurate model assumptions are not critical.

3、Which of the following sources of model risk suggest a poor match of the model to the risk?

Incorrect model specification.
Incorrect model application.
Implementation risk.
Programming errors.
A) I and III only.
 
B) I and II only.
 
C) I, II, and III only.
 
D) II and IV only.
 

The correct answer is B

Incorrect model specification is driven by:

misspecification of the underlying stochastic process,
omission of important risk factors, or
the relationship between variables is misspecified.

4、Which of the following sources of model risk results from making a mistake in implementing the model?

Implementation risk.
Calibration error.
Programming errors.
Data problems.
A) I, II, and III only.
 
B) II and III only.
 
C) I, III, and IV only.
 
D) III and IV only.

The correct answer is B

The correct answer is BCalibration and programming errors are mistakes. Implementation risk and Data problems may represent mistakes, but also may represent a choice between several acceptable alternatives.

5、Which of the following is NOT a source of model risk?

A) Widespread implementation of models across business units.
 
B) Minimal rounding errors from algorithms.
 
C) Failure to recalibrate models.
 
D) Non-synchronous data.

The correct answer is B

Minimal rounding errors from algorithms is an attractive feature of a good model.

AIM 2: Discuss the challenges involved with quantifying model risk.

1、Which of the following methods for estimating model risk must make assumptions about the related underlying distribution?

Single unknown parameter.
Two unknown parameters.
Unknown correlations.
Mixing parameter and distribution risk.
A) I, II, III, and IV.
 
B) I, II, and IV only.
 
C) I, II, and III only.
 
D) I and II only.

The correct answer is A

All of the above make assumptions about the related underlying distribution.

AIM 3: Identify approaches risk managers can select to protect against model risk, and discuss the role of senior managers in managing model risk.

1、In managing model risk, risk managers should do all of the following EXCEPT:

A) avoid adding complexity to a model unless there is a strong need.
 
B) backtest and stress test models. 
 
C) check the sensitivity of a model’s performance to changes in key assumptions. 
 
D) try to eliminate model risk. 

The correct answer is D

Model risk cannot be eliminated. A risk manager can protect against some of the adverse consequences of model risk by becoming aware of the limitations of a model and applying it only to situations for which it is appropriate.

A) accurate prices for financial instruments were observable at all times.
 
B) assets were traded infrequently.
 
C) all financial assets were simple in design.
 
D) all financial assets were complex.

The correct answer is A

Model risk is a result of incorrect estimates of market prices. If accurate prices were always observable, there would be no need to estimate market prices and no need to manage model risk. Infrequent trading exacerbates model risk, because it makes asset values difficult to determine based on recent transactions. Model risk exists for both simple and complex instruments when assets are infrequently traded.

2、Under the efficient market hypothesis, which of the following statements is FALSE?

A) The most effective way to manage model risk is to either improve the model being used, or find a more sophisticated model.
 
B) Deviations from an asset’s true fundamental value will be temporary. 
 
C) With respect to managing model risk, traders and risk managers will have different goals.
 
D) The source of model risk is that the model being used is not advanced or realistic enough to obtain the correct value.

The correct answer is C

An implication of the efficient market hypothesis is that traders and risk managers will both seek to find the fundamentally correct price for the security. Thus, both will have the same goal: find the most advanced and sophisticated model available.

3、The management team at Global Bank believes in the efficient market hypothesis and assumes that the EMH is valid as part of its approach to risk management. The management team at J.T. Molson Securities takes a different approach to risk management, and assumes that the EMH is invalid and that markets for certain assets may be inefficient. Which of the following statements regarding the firms is most likely CORRECT?

A) Traders and risk managers at J.T. Molson will both seek to find the most sophisticated model available. 
 
B) The management team at Global Bank can leverage its resources by combining the model research efforts of its risk management and trading departments. 
 
C) Model risk management efforts at Global Bank focus on researching how today’s pricing relationships may change in the future. 
 
D) A trader at Global Bank is more likely to violate firm imposed VAR limits than a trader at J.T. Molson. 

The correct answer is B

Since Global Bank operates under the EMH-framework, traders and risk managers will both seek to find the most sophisticated model available and could therefore leverage their resources by combining their efforts to find the best possible model. J.T. Molson does not believe in the EMH, which implies that risk managers and traders have different goals and that traders may be more likely to violate the VAR-limits determined by the firm’s risk management department. Model risk management efforts in a non-EMH framework (such as at J.T. Molson) focus on researching how pricing relationships may change in the future.

4、If a risk manager assumes that the EMH is valid and that markets are efficient, the best way to manage model risk is to:

A) use models that are specific to each type of asset being valued. 
 
B) find a more sophisticated model. 
 
C) backtest models to ensure they work effectively using historical data.
 
D) use more than one model to value each asset to ensure that models come up with the same estimate of value. 

The correct answer is B

Since the EMH assumes that the price of security will ultimately reflect the security’s true fundamental value, the risk that a model will not price a security correctly must mean that the model is not advanced or realistic enough to obtain the correct value. It follows that the best way to manage model risk under an EMH framework is to find a better or more sophisticated model.

5、Which of the following is most likely a belief held by a risk manager that operates in a non-EMH framework for assessing model risk?

A) Simplistic pricing models will be less effective than complex models for estimating asset prices.
 
B) Model risk management is an exercise in determining how pricing methodologies may change in the future. 
 
C) Losses by a trader mean that a security’s price is moving away from its fundamental value, and the trader should be encouraged to add to the position. 
 
D) Pricing methodologies will change in an evolutionary way toward more sophisticated models. 

The correct answer is B

A non-EMH framework means that the process for managing model risk becomes an exercise not in finding a model that will lead to a correct price, but in estimating how ways of deriving security prices in the future may differ from today’s commonly accepted wisdom.

6、If an institution believes that the efficient market hypothesis does not hold, which of the following statements is TRUE?

A) The focus of traders is on identifying the model that produces true fundamental values.
 
B) The focus of traders is on identifying the model that produces today’s prices.
 
C) Deviations from an asset’s true fundamental value will be temporary.
 
D) The institution should seek a single model that serves both its trading and risk management functions.

The correct answer is B

If the efficient market hypothesis does not hold, prices may not revert to a certain fundamental value. Thus, the focus is on finding a model that produces today’s prices rather than fundamental value. It is when the efficient market hypothesis does hold that traders and risk managers will seek a single model, because both will seek the same fundamentally correct price.

7、When managing model risk, predicting how pricing methodologies may change in the future is:

A) important if one believes that the efficient market hypothesis does hold.
 
B) important whether or not one believes that the efficient market hypothesis holds.
 
C) never relevant in managing model risk.
 
D) important if one believes that the efficient market hypothesis does not hold.

The correct answer is D

In a non-EMH framework the source of model risk shifts from finding the best model to how today’s pricing methodologies may change in the future.