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Answer: The decision to accept or reject a VaR model based on backtesting results at the two-tailed 95% confidence level is less reliable using a 99% VaR model than using a 95% VaR model.
The correct statement concerning the switch from a 95% to a 99% VaR confidence level is A. The decision to accept or reject a VaR model based on backtesting results at the two-tailed 95% confidence level is less reliable using a 99% VaR model than using 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 concept being tested here is the understanding of the difference between the VaR parameter for confidence (95% vs. 99%) and the validation procedure confidence level (95%), and how they interact with one another.
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A newly employed risk analyst is performing a back-testing exercise on the company’s current Value at Risk (VaR) model. Historically, the company has been calculating the 1-day VaR at a 95% confidence level. The risk analyst, adhering to Basel guidelines, proposes that the company should adjust its VaR calculations to a 99% confidence level. Which of the following statements accurately reflects the implications of this proposed change?
A
The decision to accept or reject a VaR model based on backtesting results at the two-tailed 95% confidence level is less reliable using a 99% VaR model than using a 95% VaR model.
B
The 95% VaR model is less likely to be rejected using backtesting than the 99% VaR model.
C
When backtesting using a two-tailed 90% confidence level test, 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 1 and type 2 errors.
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