But first, we have to define the trading outcome.

One definition is the profit or

loss from the actual portfolio over the next day. This return, however, does not

exactly correspond to the previous day’s VAR. All VAR measures assume a frozen

portfolio from the close of a trading day to the next, and ignore fee income. In

practice,tradingportfoliosdochange.Intradaytradingwillgenerallyincreaserisk.

Feeincomeismorestableanddecreasesrisk.Althoughtheseeffectsmayoffseteach

other, the actual portfolio may have more or less volatility than predicted by VAR.

This is why it is recommended that hypothetical portfolios be constructed so as

tomatchtheVARmeasureexactly.Theirreturnsareobtainedfromfixedpositions

applied to the actual price changes on all securities, measured from close to close.

The Basel framework recommends using both hypothetical and actual trading

outcomes in backtests. The two approaches are likely to provide complementary

information on the quality of the risk management system. For instance, suppose

the backtest fails using the actual but not the hypothetical portfolio. This indicates

that the model is sound but that actual trading increases volatility. Conversely, if

the backtest fails using the hypothetical model, the conclusion should be that the

risk model is flawed.