FRM Part II · FRM Exam Part II · Backtesting VaR
A bank backtests its 99% one-day VaR over 250 days. To reduce the chance of wrongly rejecting a sound model, the validation team raises the exception cutoff for rejection from 5 to 7. Holding everything else constant, what is the most likely effect?
Raising the rejection cutoff lowers Type I error because fewer sound models are rejected, but it raises Type II error because more flawed models slip through. For a fixed sample, the two error types trade off against each other.
- AType I error probability falls and Type II error probability risesCorrect
- BBoth Type I and Type II error probabilities fall
- CType I error probability rises and Type II error probability falls
- DBoth error probabilities are unchanged because the VaR confidence level is unchanged
Explanation
A higher cutoff makes rejection harder. Correct models are rejected less often (lower Type I), but inaccurate models, which produce excess exceptions, are more likely to pass (higher Type II). The two errors trade off for a fixed sample size.
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