FRM Part II · FRM Exam Part II · Backtesting VaR
A bank tightens its backtesting rule by lowering the number of exceptions at which a 99% VaR model is rejected, keeping the same 250-day sample. Holding everything else constant, the most likely effect is:
Lowering the rejection cutoff makes the test stricter. Correct models are more often rejected by chance, so the Type I error rate rises, while incorrect models are more often caught, so the Type II error rate falls. For a fixed sample these errors trade off.
- AHigher Type I error rate and lower Type II error rateCorrect
- BLower Type I error rate and higher Type II error rate
- CLower Type I and lower Type II error rates
- DHigher Type I and higher Type II error rates
Explanation
A lower cutoff means a correct model is more likely to be rejected by chance, raising Type I errors. It also means fewer bad models pass, reducing Type II errors. The trade-off for a fixed sample is unavoidable.
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