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

Which of the following is a recognized approach that goes beyond simple exception counting to address the fact that exceedance-based backtests ignore the magnitude of tail losses?

A loss function that penalizes each exceedance by the size of the shortfall beyond VaR captures tail severity, which simple exception counts ignore. Quantile loss and expected shortfall based backtests are examples of this approach.

  1. AIncreasing the confidence level from 99% to 99.9% without changing the sample
  2. BEvaluating the model with a loss function that penalizes exceptions according to the size of the shortfall beyond VaRCorrect
  3. CCounting only exceptions that occur on Mondays
  4. DReplacing the VaR with the average of the previous year's daily P&L

Explanation

Loss-function approaches, such as quantile or tick loss measures and expected shortfall based tests, weight each exceedance by how far the loss exceeds VaR, thus capturing severity. A higher confidence level makes exceptions even rarer and reduces power, and the other options have no valid statistical basis.

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