Early Detection Techniques for Market Risk Failure

Jose Olmo and William Pouliot

No 08/09, City University Economics Discussion Papers from Department of Economics, City University, London

Abstract: The implementation of appropriate statistical techniques for monitoring conditional VaR models, i.e, backtesting, reported by institutions is fundamental to determine their exposure to market risk. Backtesting techniques are important since the severity of the departures of the VaR model from market results determine the penalties imposed for inadequate VaR models. In this paper we make six contributions to backtesting techniques. In particular, we show that the Kupiec test can be viewed as a combination of CUSUM change point tests; we detail the lack of power of CUSUM methods in detecting violations of VaR as soon as these occur; we develop an alternative technique based on weighted U-statistic type processes that have power against wrong specifications of the risk measure and early detection; we show these new backtesting techniques are robust to the presence of estimation risk; we construct a new class of weight functions that can be used to weight our processes; and our methods are applicable both under conditional and unconditional VaR settings.

Keywords: Asymmetries, crises; Extreme values; Hypothesis testing; Leverage effect; Nonlinearities; Threshold models (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ecm and nep-rmg
Date: 2008-05

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Persistent link: http://EconPapers.repec.org/RePEc:cty:dpaper:0809

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