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

A risk analyst applies Kupiec's proportion-of-failures (unconditional coverage) test to a 99% VaR model. Which statement best describes what the test assesses?

Kupiec's test checks whether the observed share of VaR exceptions is statistically consistent with the frequency implied by the confidence level, such as 1% for 99% VaR. It does not examine clustering of exceptions or the size of losses beyond VaR.

  1. AWhether exceptions are clustered in consecutive days
  2. BWhether the observed exception frequency is consistent with the 1% expected frequencyCorrect
  3. CWhether the magnitude of losses beyond VaR is acceptable
  4. DWhether the VaR model uses the correct correlation matrix

Explanation

The Kupiec POF test compares the observed exception rate with the rate implied by the confidence level using a likelihood ratio, which is chi-square with 1 degree of freedom. It ignores timing, so clustering is not tested, and it ignores the size of exceedances.

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