FRM Part II · FRM Exam Part II · Backtesting VaR
A risk manager reviews the Basel traffic light backtest for a 99% VaR model using 250 days. She notes that the green zone ends at 4 exceptions, which has cumulative probability of about 89.2% under a correct model, while the yellow zone begins at 5 exceptions. Which statement best describes the rationale behind the zone boundaries?
The zone boundaries balance the two types of backtesting error. A correct model should have a high chance of landing in the green zone, while an inaccurate model should have a reasonable chance of being flagged as yellow or red. Type II errors cannot be eliminated entirely, so the framework is a compromise.
- AThe boundaries are set so that a correct model has a high probability of being green, while an inaccurate model is not too likely to avoid yellow or redCorrect
- BThe boundaries are set so that Type II errors are eliminated entirely, so every inaccurate model is penalised
- CThe boundaries are chosen so that exactly 1% of correct models fall in the red zone
- DThe boundaries equal the expected number of exceptions plus two standard deviations of the binomial distribution
Explanation
The framework balances Type I errors (rejecting a correct model) and Type II errors (accepting an inaccurate model). It cannot eliminate Type II errors, so the claim of eliminating them is wrong. The boundaries come from the binomial distribution with chosen cumulative probability cutoffs, not from a fixed 1% red-zone share or a two-standard-deviation rule.
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