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FRM Part II · FRM Exam Part II · Backtesting VaR

A risk manager reviews the Basel traffic light framework and asks why the green zone upper limit is set at 4 exceptions for a 99% VaR backtest over 250 days. Which statement best describes the rationale?

The green zone ends at 4 exceptions because, if the model is correct, the chance of observing 4 or fewer exceptions is high (about 89%). This keeps the chance of wrongly penalizing a sound model low, rather than matching the expected count of 2.5.

  1. AFour exceptions is the exact expected number of exceptions at 99% confidence over 250 days
  2. BUnder a correctly calibrated model, the probability of seeing 4 or fewer exceptions is high, so the green zone rarely penalizes accurate modelsCorrect
  3. CThe green zone is set so that the probability of a Type II error is zero
  4. DFour exceptions corresponds to a 1% probability of occurring under the correct model

Explanation

The expected count is 2.5, not 4. The green zone boundary is chosen so that cumulative probability of 4 or fewer exceptions under a correct model is about 89%, so accurate models are rarely misclassified. Type II error cannot be eliminated.

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