Financial Risk Manager Part 1
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At a 95% confidence interval, the value at risk (VaR) of a portfolio is approximately $10 million. During 100 days, the VaR was exceeded on 9 different occasions. Based on this information:
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A
This model is overestimating risk.
B
This model is underestimating risk.
C
This model is appropriate for estimating the risk.
D
The model is accurate.
Explanation:
Explanation
At a 95% confidence interval, we expect VaR exceedances to occur only 5% of the time. Over 100 days, this translates to:
- Expected exceedances: 100 days × 5% = 5 exceedances
- Actual exceedances: 9 exceedances
Since the actual number of exceedances (9) is significantly higher than the expected number (5), this indicates that:
- The model is underestimating risk because losses exceeding the VaR threshold are occurring more frequently than predicted
- The VaR of $10 million is too low for the actual risk level
- The model is not accurately capturing the portfolio's true risk exposure
Key Insight: When actual exceedances exceed expected exceedances, the VaR model is underestimating risk, suggesting the need for model recalibration or a more conservative risk assessment approach.
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