Explanation:
The correct answer 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 explanation is based on 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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In the context of the firm's Value at Risk (VaR) model, which was initially calculated at a 95% confidence level, and considering the Basel framework guidelines, which of the following statements correctly reflects the impact of adjusting to a 99% VaR confidence level as recommended by the newly hired risk analyst?
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.