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

A risk manager at a bank holding company reviews the bank's VaR model validation. Which of the following is a recognized limitation of relying only on backtesting to validate a 99% one-day VaR model?

Backtesting has low statistical power with limited data. At 99% confidence only a few exceptions are expected per year, so it is hard to tell an accurate model from an inaccurate one. Backtesting therefore must be supplemented by other validation tools such as stress tests and input checks.

  1. ABacktesting with a limited number of observations has low power to distinguish an inaccurate model from an accurate oneCorrect
  2. BBacktesting measures the model's input data quality directly
  3. CBacktesting eliminates the need for stress testing because it covers tail events
  4. DBacktesting can only be applied to portfolios with linear payoffs

Explanation

At 99% confidence, only about 2 to 3 exceptions are expected in 250 days, so the test has little statistical power to separate good and bad models. Backtesting does not test input data quality directly, does not replace stress testing, and is not limited to linear portfolios.

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