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Answer: 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
## Explanation In VaR model backtesting, the two most appropriate sets of returns data are: **1. Hypothetical Returns** - These represent the returns obtained from freezing the starting positions in the bank's trading portfolio. This isolates the model's predictive ability from trading activities. **2. Cleaned Returns** - These are the actual returns minus any profit and loss from intraday trades. This removes the impact of intraday trading activities that weren't captured in the VaR model. ### Why Option C is Correct: - **Hypothetical returns** test whether the VaR model would have been adequate if no trading occurred - **Cleaned returns** remove intraday trading effects to focus on the model's performance - This combination provides the most comprehensive validation of the VaR model's accuracy ### Why Other Options are Incorrect: - **Option A**: Uses actual returns instead of cleaned returns, which includes intraday trading effects - **Option B**: Compares cleaned returns with actual returns, which doesn't provide the proper comparison framework - **Option D**: Uses trading returns (minus fees/commissions) which doesn't properly isolate model performance from trading activities This approach allows for proper assessment of whether VaR exceptions are due to model inadequacy or trading activities.
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An analyst at bank LKS has been asked to validate the bank's VaR model through backtesting. The analyst uses two sets of returns data to generate results of predicted and actual losses that can be compared in the validation process. Which of the following correctly describes the two most appropriate sets of returns data to use in backtesting?
A
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
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
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