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Answer: The decision to accept or reject a VaR model based on the results of a backtest that uses a two-tailed 95% confidence level is less reliable when applied to a 99% VaR model than when applied to a 95% VaR model.
The correct answer is A. The decision to accept or reject a VaR model based on the results of a backtest that uses a two-tailed 95% confidence level is less reliable when applied to a 99% VaR model than when applied to a 95% VaR model. This is because using a 95% VaR confidence level creates a narrower nonrejection region than using a 99% VaR confidence level by allowing a greater number of exceptions to be generated. This increases the power of the backtesting process and makes for a more reliable test than using a 99% confidence level. The other options are incorrect because: B is incorrect as it suggests that the 95% VaR model is less likely to be rejected by a backtest than the 99% VaR model, which is the opposite of the correct reasoning. C is incorrect because it implies that using a two-tailed 90% confidence level test in a backtest results in a smaller probability of incorrectly rejecting a 95% VaR model than a 99% VaR model, which is not relevant to the question asked. D is incorrect as it suggests that using a 99% VaR model will lower the probability of committing both Type I and Type II errors, which is not supported by the information provided. In fact, a higher confidence level like 99% may increase the likelihood of Type II errors (failing to reject a false model) due to a wider nonrejection region.
Author: LeetQuiz Editorial Team
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A new risk analyst employed at a medium-sized bank is currently assisting in the evaluation of the bank’s Value at Risk (VaR) model. At present, the 1-day VaR is being calculated at a 95% confidence level. However, following the Basel Committee's recommendations, the bank is considering adjusting it to a 99% confidence level for the 1-day VaR calculation. Which of the following statements correctly reflects the implications of this proposed change?
A
The decision to accept or reject a VaR model based on the results of a backtest that uses a two-tailed 95% confidence level is less reliable when applied to a 99% VaR model than when applied to a 95% VaR model.
B
The 95% VaR model is less likely to be rejected by a backtest than the 99% VaR model.
C
When using a two-tailed 90% confidence level test in a backtest, there is a smaller probability of incorrectly rejecting a 95% VaR model than a 99% VaR model.
D
Using a 99% VaR model will lower the probability of committing both Type I error and Type II error.