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FRM Part II · FRM Exam Part II · Validating Bank Holding Companies' Value-at-Risk Models for Market Risk

When backtesting a trading VaR model, a validator compares VaR with hypothetical P&L, which is generated from end-of-previous-day positions held fixed and revalued with the next day's price moves. What is the main advantage of this approach over using actual P&L?

Hypothetical P&L revalues fixed prior-day positions with the next day's price moves, removing contamination from intraday trading, fees, commissions and reserve adjustments. This isolates how well the VaR model estimates market risk, which gives a cleaner backtest than actual P&L.

  1. AIt includes intraday trading revenue and fees, giving a more realistic picture
  2. BIt removes the effects of intraday trading, fees and reserve changes, so the test isolates the model's market risk estimationCorrect
  3. CIt guarantees fewer exceptions at the stated confidence level
  4. DIt eliminates the need for any data on position holdings

Explanation

Hypothetical (clean) P&L holds positions static, so contamination from fees, commissions, intraday trades and reserve changes is excluded. This isolates the VaR model's performance. Option A describes actual P&L, and the approach still needs position data.

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