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FRM Part II · FRM Exam Part II · Beyond Exceedance-Based Backtesting of Value-at-Risk Models

A risk manager backtests a 99% one-day VaR model over 250 trading days and finds 2 exceedances, a result that passes the standard traffic-light test. Which limitation of exceedance-based backtesting does this example best illustrate?

Exceedance-based backtesting counts only whether losses exceed VaR, not how large they are. A model can therefore pass with few exceedances while badly understating the severity of tail losses, which is a key limitation of the approach.

  1. AExceedance counts ignore the size of losses beyond VaR, so a model may pass while understating tail severityCorrect
  2. BExceedance counts cannot be computed for 99% confidence levels
  3. CExceedance counts always reject correct models too often
  4. DExceedance counts require knowledge of the full return distribution to compute

Explanation

Exceedance-based tests only record whether a loss exceeded VaR, not by how much. A model with few exceedances could still have very large losses on those days. The other options misstate how the test works.

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