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Model Risk in Backtesting Risk Measures

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  • Evers, Corinna
  • Rohde, Johannes

Abstract

Under the Basel II regulatory framework non-negligible statistical problems arise when backtesting risk measures. In this setting backtests often become infeasible due to a low number of violations leading to heavy size distortions. According to Escanciano and Olmo (2010, 2011) these problems persist when incorporating estimation and model risk by adjusting the asymptotic variance of the test statistics. In this paper, we analyze backtests based on hit and duration sequences in a univariate framework by running a simulation study in order to identify the problems of backtests that examine the adequacy of Value at Risk measures. One main finding indicates that backtests of all classes show heavy size distortions. These problems for the relevant Basel II set-up, however, cannot be alleviated by modifying backtests in a way that accounts for estimation risk or misspecification risk.

Suggested Citation

  • Evers, Corinna & Rohde, Johannes, 2014. "Model Risk in Backtesting Risk Measures," Hannover Economic Papers (HEP) dp-529, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    • Handle: RePEc:han:dpaper:dp-529
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    References listed on IDEAS

    as
    1. Bertrand Candelon & Gilbert Colletaz & Christophe Hurlin & Sessi Tokpavi, 2011. "Backtesting Value-at-Risk: A GMM Duration-Based Test," Journal of Financial Econometrics, Oxford University Press, vol. 9(2), pages 314-343, Spring.
    2. Jeffrey R. Russell & Robert F. Engle, 1998. "Econometric Analysis of Discrete-valued Irregularly-spaced Financial Transactions Data Using a New Autoregressive Conditional Multinomial Model," CRSP working papers 470, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    3. Escanciano, J. Carlos & Olmo, Jose, 2010. "Backtesting Parametric Value-at-Risk With Estimation Risk," Journal of Business & Economic Statistics, American Statistical Association, vol. 28(1), pages 36-51.
    4. Cristina Danciulescu, 2010. "Backtesting Value-at-Risk Models: A Multivariate Approach," Caepr Working Papers 2010-004, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
    5. Sean D. Campbell, 2005. "A review of backtesting and backtesting procedures," Finance and Economics Discussion Series 2005-21, Board of Governors of the Federal Reserve System (U.S.).
    6. Paul H. Kupiec, 1995. "Techniques for verifying the accuracy of risk measurement models," Finance and Economics Discussion Series 95-24, Board of Governors of the Federal Reserve System (U.S.).
    7. Escanciano, J. C. & Olmo, J., 2007. "Estimation risk effects on backtesting for parametric value-at-risk models," Working Papers 07/11, Department of Economics, City University London.
    8. Cristina Danciulescu, 2010. "Backtesting Value-at-Risk Models: A Multivariate Approach," CAEPR Working Papers 2010-004, Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington.
    9. J. Carlos Escanciano & Jose Olmo, 2011. "Robust Backtesting Tests for Value-at-risk Models," Journal of Financial Econometrics, Oxford University Press, vol. 9(1), pages 132-161, Winter.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Model risk; backtesting; Value at risk;
    All these keywords.

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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