Answer-first summary for fast verification
Answer: The actual returns, which correspond to the total return on the bank's trading portfolio, and the hypothetical returns, which represent the returns obtained from freezing the starting positions in the bank's trading portfolio
B is correct. Ideally, the analyst will use both the actual and hypothetical returns for backtesting since both yield informative comparisons. If the model passes backtesting with hypothetical but not actual returns, the problem in the model lies with intraday trading. If the model does not pass backtesting with hypothetical returns, the modelling methodology should be re-examined.
Author: LeetQuiz Editorial Team
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A financial analyst at Bank LKs needs to authenticate the reliability of the bank's Value at Risk (VaR) model using a backtesting methodology. The analyst plans to use two separate datasets containing returns data to compare the predicted losses with the actual losses to complete this verification process. Among the given options, which two sets of return data would be most appropriate for executing this backtesting?
A
The cleaned returns, which are the actual returns minus any profit and loss from intraday trades, and the actual returns, which correspond to the total returns on the bank's trading portfolio
B
The actual returns, which correspond to the total return on the bank's trading portfolio, and the hypothetical returns, which represent the returns obtained from freezing the starting positions in the bank's trading portfolio
C
The hypothetical returns, which represent the returns obtained from freezing the starting positions in the bank's trading portfolio, and the cleaned returns, which are the actual returns minus any profit and loss from intraday trades
D
The trading returns, which are the actual returns minus any fees and commissions, and the hypothetical returns, which represent the actual returns obtained from freezing the starting positions in the bank's trading portfolio
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