Explanation:
Decreasing the confidence level from 99% to 95% means the VaR threshold is lower, and therefore, the expected number of exceptions (violations) will increase. A larger expected number of exceptions provides a larger sample size for the statistical test (e.g., Kupiec's test), which increases the statistical power of the test. An increase in statistical power means the test is better able to correctly reject a false model (decreasing Type II error). Consequently, the decisions to accept or reject VaR models based on backtesting become more reliable.
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Q.45 A newly recruited intern has been tasked with backtesting a firm’s VaR model. Since inception, the firm has always calculated 1-day VaRs at the 99% level of confidence. In a marked departure from the recommendations set by the Basel Committee, the intern has proposed a shift to the 95% level of confidence. What will be the implication of making this switch?
A
Decisions on whether to accept or reject VaR models based on backtesting will be more reliable
B
The power of statistical tests will decrease
C
The probability of making both type I and type II errors will increase
D
The 95% VaR model is less likely to be rejected using backtesting than the 99% VaR model
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