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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.

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The correct answer is A

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

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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. 

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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.

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AIM 5: Discuss the implications of the efficient markets assumption and the assumption that financial instrument prices deviate from their fundamental values have as sources of model risk and its management, respectively.

 

1、For a financial institution, model risk would NOT exist if:

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.

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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.

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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.

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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.

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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. 

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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.