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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.
**Explanation:** Option A is correct. This question tests the understanding of the interaction between the VaR confidence level parameter (95% vs. 99%) and the validation procedure confidence level (95%). **Key Points:** - A 95% VaR confidence level creates a narrower nonrejection region than a 99% VaR confidence level - The 95% VaR model allows more exceptions to be generated, which increases the power of the backtesting process - This makes the backtest more reliable when applied to a 95% VaR model compared to a 99% VaR model - The backtest using a two-tailed 95% confidence level is less reliable when validating a 99% VaR model because it has lower power to detect model inadequacies **Type I vs Type II Errors:** - **Type I Error**: Incorrectly rejecting a valid model (false positive) - **Type II Error**: Failing to reject an invalid model (false negative) The 95% VaR model's backtesting provides better power to detect model problems, making it more reliable for model validation decisions.
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A newly hired risk analyst at a mid-size bank is assisting in backtesting the bank's VaR model. Currently, the 1-day VaR is estimated at the 95% confidence level but the bank is considering a change to estimating 1-day VaR at the 99% confidence level, as recommended in the Basel framework. Which of the following statements concerning this change is correct?
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.