Module: | MODULE B: RISK MANAGEMENT
Q362: Consider the following statements regarding the Backtesting of VaR models under the Basel market risk framework:
1. Backtesting involves comparing the daily VaR estimates against the actual daily mark-to-market trading outcomes over the past 250 trading days.
2. Under the Basel Traffic Light approach, a model generating 7 exceptions over a year falls into the Green Zone, requiring no additional regulatory capital add-on.
3. If a model generates 10 or more exceptions, it enters the Red Zone, and the regulator will likely mandate an immediate review, penalty, or rejection of the internal VaR model.
2. Under the Basel Traffic Light approach, a model generating 7 exceptions over a year falls into the Green Zone, requiring no additional regulatory capital add-on.
3. If a model generates 10 or more exceptions, it enters the Red Zone, and the regulator will likely mandate an immediate review, penalty, or rejection of the internal VaR model.
✅ Correct Answer: B
The correct answer is B. Statement 1 is correct: Backtesting is the ex-post comparison of the risk measure generated by the VaR model against the actual daily changes in portfolio value over a fixed 250-trading-day lookback period.
Statement 3 is correct: Generating 10 or more exceptions (where actual loss exceeded VaR) places the bank in the Red Zone.
This triggers severe regulatory action, including a +1.0 multiplier penalty and potential disqualification of the internal model.
Statement 2 is incorrect: A model with 7 exceptions does not fall into the Green Zone; it falls directly into the Yellow Zone (5 to 9 exceptions). In the Yellow Zone, the regulator imposes an automatic capital penalty by increasing the VaR multiplier.
Statement 3 is correct: Generating 10 or more exceptions (where actual loss exceeded VaR) places the bank in the Red Zone.
This triggers severe regulatory action, including a +1.0 multiplier penalty and potential disqualification of the internal model.
Statement 2 is incorrect: A model with 7 exceptions does not fall into the Green Zone; it falls directly into the Yellow Zone (5 to 9 exceptions). In the Yellow Zone, the regulator imposes an automatic capital penalty by increasing the VaR multiplier.