FRM Part II · FRM Exam Part II · Backtesting VaR
A bank's risk committee asks why the market risk team compares daily trading P&L with the previous day's 99% one-day VaR over a long period. Which statement best describes the primary purpose of this backtesting exercise?
Backtesting aims to verify that the proportion of days on which losses exceed VaR matches the model's confidence level. At 99%, roughly 1% of days should show exceptions. Too many or too few both signal model problems, so the goal is consistency rather than eliminating exceptions.
- ATo verify that the frequency of losses exceeding VaR is consistent with the stated confidence levelCorrect
- BTo maximize the number of days on which actual losses stay below VaR
- CTo determine the regulatory capital multiplier directly from the average loss size
- DTo confirm that the VaR model never underestimates losses on any single day
Explanation
Backtesting checks whether observed exceptions are statistically consistent with the confidence level (about 1% of days at 99%). Zero exceptions or minimizing exceptions is not the goal, since too few suggests an overly conservative model. No model can guarantee no underestimation on any day.
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