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

A risk manager reviews a 99% one-day VaR model over 250 trading days and finds 2 exceedances, so the model passes the standard binomial (Kupiec-type) test. Which limitation of exceedance-based backtesting does this result best illustrate?

Exceedance-based tests count only whether a loss breached VaR, not by how much. Two small breaches and two catastrophic breaches look identical, so the test cannot reveal the severity of tail losses. This is a core limitation that motivates backtests using the full loss distribution or expected shortfall.

  1. AThe test ignores the size of losses on the exceedance days, so it cannot show whether the tail losses were mild or severeCorrect
  2. BThe test requires the VaR confidence level to be 95% to be valid
  3. CThe test can only be applied to portfolios holding linear instruments
  4. DThe test measures the whole forecast distribution rather than only the tail

Explanation

Exceedance counting converts each day into a hit or no-hit indicator. It discards the magnitude of the loss beyond VaR, so a model with 2 small breaches and one with 2 catastrophic breaches look identical. The other options misstate the test's scope.

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