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FRM Part II · FRM Exam Part II · Credit Value at Risk

A validation analyst notes that credit VaR models generally cannot be backtested as easily as market VaR models. What is the main reason?

Credit VaR is hard to backtest because it uses a long horizon, typically one year, and a very high confidence level. A bank therefore has very few independent observations and expects almost no exceedances, which leaves backtests with little statistical power to distinguish good models from bad.

  1. ACredit VaR uses a long holding period, typically one year, and a very high confidence level, so few independent observations existCorrect
  2. BCredit losses are always normally distributed, so backtesting is meaningless
  3. CMarket VaR is calculated using only default probabilities
  4. DRegulators prohibit backtesting of credit models

Explanation

With a one-year horizon and a 99.9% confidence level, a bank has few non-overlapping observations and expects almost no exceedances. This gives backtests very low statistical power. Credit losses are skewed rather than normal, and backtesting is not prohibited.

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