Explanation:
B is correct. In the case of bad luck, no penalty is given, as would be the case for a bank affected by unpredictable movements in rates or markets. However, when risk models are not precise enough, a penalty is typically given since model accuracy could have easily been improved.
Explanation:
The Basel framework distinguishes between exceptions due to bad luck (market movements) and exceptions due to model inadequacy. When models can be easily improved but aren't, penalties are applied.
A regulatory analyst at an investment bank is reviewing the Basel Committee rules for backtesting VaR models. The analyst notes that under the Basel framework, a penalty can be given to banks that have more than four exceptions to their 1-day 99% VaR over the last 250 trading days. Which of the following scenarios is most likely to result in a penalty?
A
A large move in interest rates occurs in conjunction with a small move in correlations.
B
The bank's model calculates interest rate risk based on the median duration of the bonds in the portfolio.
C
A sudden market crisis in an emerging market, which leads to losses in the equity positions in that country.
D
A sudden devastating earthquake that causes major losses in the bank's key area of operation.
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