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FRM Part II · FRM Exam Part II · Validating Bank Holding Companies' Value-at-Risk Models for Market Risk

A bank backtests its 99% one-day VaR using actual P&L that includes fees, commissions and intraday trading gains. A validator argues this contaminates the test. What is the best recommendation?

The validator should supplement actual P&L with hypothetical P&L that holds end-of-day positions constant. Actual P&L includes fees and intraday trading not modeled by VaR, which can mask model errors, whereas hypothetical P&L isolates the model's market risk prediction.

  1. AAlso backtest using hypothetical P&L that holds end-of-day positions fixed, so results reflect only the model's market riskCorrect
  2. BDrop backtesting and rely on stress tests only
  3. CUse only actual P&L because hypothetical P&L is irrelevant
  4. DReplace the 99% confidence level with 50% to increase exceptions

Explanation

Actual P&L includes intraday trading and fees not captured by a static-position VaR, so it can mask model errors. Hypothetical (clean) P&L isolates the effect of market moves on fixed positions and is a better test of the model, ideally alongside actual P&L.

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