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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 backtests a 99% one-day VaR model over 500 days and observes 11 exceptions. Using the unconditional coverage (Kupiec proof-of-failure) approach, which statement is most accurate?

Expected exceptions are 500 × 1% = 5. Observing 11 is more than twice that, so the evidence suggests the VaR model understates risk. A Kupiec unconditional coverage test would likely reject the model at common significance levels.

  1. AThe expected number of exceptions is 5, and 11 is well above it, suggesting the model may understate riskCorrect
  2. BThe expected number of exceptions is 11, so the model is accurate
  3. CThe expected number of exceptions is 5, and 11 is below it, suggesting the model overstates risk
  4. DThe expected number of exceptions is 50, so the model is highly conservative

Explanation

Expected exceptions = 500 × 0.01 = 5. Observing 11 is more than double the expected count, which points to VaR understating risk and would likely lead to rejection in a Kupiec test. Counts below expectation would indicate overstatement, not this case.

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