FRM Part II · FRM Exam Part II · Backtesting VaR
A regulator and a bank's internal model validation team both use backtesting but with different emphases. Which description most accurately reflects the difference in their typical concerns?
Regulators primarily worry that VaR understates risk, leading to inadequate capital. Internal users share that concern but also care about overestimation, since an overly conservative VaR wastes capital and restricts business. Backtesting therefore serves both safety and efficiency objectives.
- ARegulators care mainly about overestimation of VaR, while validators care only about underestimation
- BRegulators focus mainly on VaR underestimation because it implies insufficient capital, while internal users also care about overestimation because it implies inefficient use of capitalCorrect
- CBoth are concerned only with the average size of exceptions, not their number
- DRegulators ignore the number of exceptions and focus only on model inputs
Explanation
Regulators are mainly concerned with models that understate risk and thus leave capital too low. Bank management also cares about overstated VaR, which ties up capital and limits risk-taking. The other options reverse or distort these concerns.
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