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FRM Part I · FRM Exam Part I · Hypothesis Testing

A regulator applies a one-tailed test to a 99% VaR model, where too many exceptions indicate underestimated risk. Which statement about the test is correct?

A Type I error means rejecting an accurate model, wrongly penalizing the bank. The null hypothesis is that the model is correct, so rejecting it when true is Type I. Failing to reject only shows insufficient evidence against the model, not proof of accuracy.

  1. AThe null hypothesis is that the exception probability exceeds 1%
  2. BFailing to reject the null proves the model is accurate
  3. CA Type I error means rejecting an accurate model, which wrongly penalizes the bankCorrect
  4. DA Type II error means rejecting an accurate model

Explanation

The null is that the model is correct (exception probability of 1%). A Type I error is rejecting a true null, meaning an accurate model is wrongly rejected. A Type II error is failing to reject a flawed model. Failing to reject does not prove accuracy; it only shows insufficient evidence.

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