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FRM Part II · FRM Exam Part II · Backtesting VaR

A bank backtests its 99% one-day VaR over 500 days using hypothetical (clean) P&L, where positions are held fixed, and separately using actual P&L that includes intraday trading and fees. The clean backtest shows 4 exceptions and the actual P&L backtest shows 9. Which conclusion is most consistent with the purpose of backtesting the model itself?

Hypothetical P&L isolates model performance because it holds positions fixed, whereas actual P&L is contaminated by intraday trading, fees and reserves. The 4 exceptions are consistent with the expected 5, and the extra exceptions in actual P&L point to non-model effects needing investigation.

  1. AThe actual P&L result should be used alone because it reflects what the desk really earned, so the model is rejected
  2. BThe hypothetical P&L result is more relevant for isolating model quality, since actual P&L is contaminated by intraday trading, fees and reserves; the difference warrants investigation of those non-model effectsCorrect
  3. CBoth results are meaningless because exceptions cannot be counted over 500 days
  4. DThe difference proves the VaR model is correct because 4 is below 5

Explanation

Hypothetical P&L isolates the model's risk estimates for the static portfolio, which is what the VaR model forecasts. Actual P&L is affected by intraday trades, fees and reserves, so the gap points to non-model effects worth investigating. Expected exceptions are 5, so 4 is consistent, while 9 is high but explained by contamination.

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