P2.T5.

Market Risk Measurement & Management

Bionic Turtle FRM Practice Questions Sample

Jorion, Value-at-Risk: The New Benchmark for

Managing Financial Risk

By David Harper, CFA FRM CIPM

www.bionicturtle.com
Jorion, Chapter 6: Backtesting VaR
P2.T5.712. BACKTESTING VALUE AT RISK (VAR) EXCEPTIONS .................................................... 3

2
Jorion, Chapter 6: Backtesting VaR
P2.T5.712. Backtesting value at risk (VaR) exceptions
P2.T5.713. Backtesting in the Basel rules
P2.T5.57. Value at Risk (VaR) Backtest
P2.T5.58. Value at Risk (VaR) Backtest Significance
P2.T5.59. Backtest Framework
P2.T5.60. Basel IMA Backtest

P2.T5.712. Backtesting value at risk (VaR) exceptions

Learning objectives: Define backtesting and exceptions and explain the importance of
backtesting VaR models. Explain the significant difficulties in backtesting a VaR model.
Verify a model based on exceptions or failure rates.

712.1. Sally the risk manager is backtesting her company's one-day 97.0% value at risk (VaR)
model over a two-year horizon. Because there are 250 trading days in a year, the horizon is 500
days. For her two-tailed backtest, the desired confidence is 95.0% If she uses a normal
distribution to approximate the binomial, then what is the maximum number of daily losses that
can be observed (aka, the "cutoff") in order to conclude the model is calibrated correctly? (note:
inspired by GARP's 2017 Part 2 Practice Exam, Question 12).

a) 15 exceptions
b) 19 exceptions
c) 22 exceptions
d) 25 exceptions

712.2. Peter the risk manager conducts a backtest of his company's 97.0% value at risk (VaR)
model over a one-year horizon that includes 250 days. He observes only one exception; i.e., for
the year the loss exceeded the VaR only once. If his backtest requires a one-tailed confidence
level of 99.0%, should he conclude the model is correctly calibrated (note: because there are
two "yes" and two "no" choices, please select the best answer)?

a) No, the model is probably bad because the cutoff (inclusive of the acceptance region) is
two or more exceptions
b) No, the model is probably bad because the cutoff (inclusive of the acceptance region) is
four or more exceptions
c) Yes, the model is probably good (ie, cannot be rejected) because the z-based cutoff
extends to 0.55 exceptions and this straddles zero and one exception
d) Yes, the model is probably good (ie, cannot be rejected) because the the asymmetry of
the binomial precludes left-tail rejection for this combination of probability and sample
size

3
712.3. Charlie the risk manager has a small sample of only 60 days (three months each of 20
trading days) for which he wants to conduct a backtest. He observes zero exceptions over this
short horizon. His VaR model is calibrated at 95.0% which, conditional on an accurate VaR
model, occurs with a probability of only 0.95^60 = 4.61%. Assuming a one-tailed 95.0%
confidence level, he considers the model bad, if barely. He really wished he could accept the
model. Under each of the following alternative scenarios, ceteris paribus, he could accept the
model EXCEPT which statement is false?

a) If zero exceptions had occurred for a 97.0% VaR model, then he could have accepted
the model as good
b) If he had lowered his backtest confidence to 90.0%, then he could have accepted the
model as good
c) If zero exceptions had occurred for a smaller sample of n = 50 days, then he could have
accepted the model as good
d) If he switched to a two-tailed 95.0% backtest and used the normal approximation, then
he could have accepted the model as good (even as his reliance on the normal
approximation is dubious for this sample/probability scenario)

4
Answers:

712.1. C. 22 exceptions

Because this is a two-tailed test, the normal deviate at 95.0% is 1.96. The maximum cutoff is
given by z = 1.96*σ(binomial) + (expected exceptions) = 1.96*sqrt(0.970*0.030*500) +
(0.030*500) = 22.476. This binomial distribution is illustrated below.

712.2. A. No, the model is probably bad because the cutoff (inclusive of the acceptance
region) is two or more exceptions

Per the binomial, the probability of zero or one exceptions is equal to BINOM.DIST(1, 250,
0.030, TRUE) = 0.431% which is less than 1.0% one-tailed significance (note this would barely
fail 99.0% two-tail significance test also).

5
712.3. B. False. Decreasing confidence DECREASES the acceptance region and
increases the rejection region.

In regard to (A), (C) and (D), each is true.

 In regard to true (A), zero exceptions for a 97.0% VaR model is possible with fully
16.08% probability, although please note that we cannot expect the same pattern of
exceptions as this is a lower VaR threshold; e.g., a $120,000 daily loss is an exception
against a $100,000 VaR, but if that is the 97.0% VaR then maybe the 99.0% VaR is
$150,000 and the same $120,000 loss will not be an exception to this VaR. Given the
same loss pattern, there will more exceptions for a lower VaR confidence level!
 In regard to true (C), the probability of zero exceptions when n = 50 is fully 0.950^50 =
7.69%
 In regard to true (D), the two-tailed normal implied cutoff is given by (60*5%) -
1.96*sqrt(0.950*0.050*60) = -0.3088 which implies acceptance, and this is consistent
with the 4.61% probability exceeding 2.50% rather than 5.0%. However, please not per
the parenthetical expression, the normal approximation is not really justified here
because we do not have the condition met that p*n ≥ 10 and (1-p)*n ≥ 10; or even that
p*n ≥ 5 and (1-p)*n ≥ 5 which is sometimes used.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p2-t5-712-backtesting-

value-at-risk-var-exceptions-jorion-ch-6.12326/