The Roles of Backtesting of Value-at-Risk Model

Applied Funds Management
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Question 1
Introduction
Within the finance field, Value-at-Risk (VaR) model is an increasingly popular portfolio management technique. It is important in forecasting an investment’s future risk. Nevertheless, to ensure VaR estimates’ accuracy, this framework should be backtested under specific means. That said, backtesting constitutes a framework for comparing the VaR outputs with the real financial institutions’ real losses or gains. The possible investment problems could be determined by through the backtests outcomes, including risk estimation with undermines investors’ decisions to put their resources into financial projects. As noted above, the backtesting process ascertain investors to appropriately delineate the inherent market risk and execute much prudent risk management technique. These functions and the VaR model limitations are delineated in the subsequent sections.
Roles of Backtesting of VaR Model
Apart from the credit risks, market risks have increasingly emerged as another critical risk element. The unfavorable market shifts could trigger huge and instantaneous financial loses. In responding to this risk type, the Basle accord Amendment was suggested by the Bank for International Settlements (BIS). Consequently, the financial intermediaries were empowered to compute the capital requirement anchored on their internal frameworks rather than adhering to the standard supervisory standards (Hendricks & Hirtle, 1997). Accordingly, the novel proposal culminated to the moral hazard problem which emanates from the banks tendency to use an aggressive internal framework in their efforts to pursue greater profitability. This challenge calls for an increasingly stringent way to effectively reflect and manage the banks’ capital requirements considerations, which provided an incentive to the model’s backtesting process. In this vein, the backtesting process is employed in collaboration with the framework centered the VaR concept, which describes the maximum losses that a financial intermediary’s portfolio is likely to incur provided the given timescale and inflation indicator is employed alongside the VaR framework to generate sufficient capital requirements.
Based on the procedure as well as the variable delineated above, as if the financial intermediary use improper internal frameworks for capital requirement computation, the monetary fines would be imposed on them accordingly. Furthermore, the backtesting framework would result in increasingly stricter capital requirement for the financial intermediaries producing an excessive level of inaccurate VaR predictions. Research indicates that the backtesting process enables investors to evaluate the investment bank’s internal frameworks as well as mitigate the potential for undermining the framework when that framework is correct (De la Pena, Rivera, & Ruiz-Mata, 2006). It is held that VaR model backtesting is useful in determining the market risk underreporting and also contributed to effective risk management approaches.
VaR Model Limitations
Like in other frameworks, the VaR approach encompasses drawbacks and limitations, the investors ar...