medium · FRM Part 1 Valuation and Risk Models
During a backtest of a 99% 1-day VaR model over 250 days, a bank observes 8 exceptions (days where losses exceeded VaR).
How should the bank interpret this result using the Basel traffic light system?
- The model is correctly calibrated because 8 exceptions is within the normal statistical fluctuation for a 95% confidence interval.
- The model is likely understating risk and falls into the 'Red zone' (or high Yellow), as the expected number of exceptions was only 2.5.
- The model is in the 'Green zone' because the number of exceptions is less than the 5% significance level often used in hypothesis testing (12.5 days).
- The bank should decrease its capital requirement because the model proved to be conservative by identifying so many tail events.
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