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

A bank's backtest uses actual P&L, which includes fees, commissions and intraday trading results, rather than hypothetical P&L based on frozen end-of-day positions. Which statement best describes the effect on the backtest?

Actual P&L includes fees, commissions and intraday trading that are not part of the static-portfolio VaR assumption. This contamination typically offsets losses and can mask model weaknesses, which is why hypothetical P&L is a cleaner basis for backtesting alongside actual P&L.

  1. AActual P&L is preferred because it isolates the model's market risk prediction cleanly
  2. BActual P&L contaminates the test with income unrelated to the static portfolio, which can mask model deficienciesCorrect
  3. CActual P&L always produces more exceptions than hypothetical P&L
  4. DActual P&L is irrelevant because supervisors require only stressed VaR backtests

Explanation

VaR assumes a static portfolio over the horizon, so hypothetical (clean) P&L is the cleaner comparison. Actual P&L includes fee income and intraday trading, which typically offsets losses and can hide model weaknesses by reducing exceptions. It does not always produce more exceptions; the effect is usually the opposite.

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