FRM Part II · FRM Exam Part II · Backtesting VaR
A bank backtests its VaR using hypothetical P&L (static portfolio, price changes only) and also actual P&L (including intraday trading fees and new trades). The team wants to isolate whether the VaR model itself, rather than intraday activity, is misestimating market risk. Which approach best serves that objective?
Hypothetical (clean) P&L should be used, because it holds positions fixed and reflects only market price changes, exactly what VaR models. Actual P&L includes fees, commissions and intraday trading that VaR does not capture, so it contaminates the assessment of the model's accuracy.
- AUse hypothetical (clean) P&L, because it removes effects not captured by the VaR modelCorrect
- BUse actual P&L, because it includes fee income that offsets losses
- CUse whichever series yields fewer exceptions
- DUse only the weeks with the largest market moves
Explanation
Hypothetical P&L holds the portfolio fixed and reflects only market moves, matching what VaR measures, so it isolates model quality. Actual P&L mixes in fees and intraday trading, contaminating the test. Choosing a series for fewer exceptions or cherry-picking periods defeats the objective.
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