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Answer: A sudden market crisis in an emerging market, which leads to losses in the equity positions in that country.
## Explanation Under the Basel framework for backtesting VaR models, penalties are applied when there are more than four exceptions (actual losses exceeding the VaR estimate) over 250 trading days for a 1-day 99% VaR model. Let's analyze each option: - **Option A**: A large move in interest rates with a small move in correlations - This represents normal market risk that should be captured by a well-specified VaR model. - **Option B**: Using median duration for interest rate risk calculation - This represents a model specification issue, but it's more about model methodology rather than an exception event. - **Option C**: A sudden market crisis in an emerging market causing equity losses - This represents a market risk event that a properly calibrated VaR model should capture. If this causes an exception, it suggests the model may be inadequate in capturing emerging market risks. - **Option D**: A sudden devastating earthquake - This is an operational risk event (natural disaster) rather than a market risk event. VaR models are designed to measure market risk, not operational risk, so such events would not typically count as exceptions for VaR backtesting purposes. **Option C is the correct answer** because it describes a market risk event that should be captured by the VaR model. If such an event causes an exception, it indicates potential model inadequacy in capturing emerging market risks, which could lead to penalties under the Basel framework.
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A regulatory analyst 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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