Backtesting Parametric Value-at-Risk with Estimation Risk

Juan Carlos Escanciano and Jose Olmo

No 2007-005, CAEPR Working Papers from Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington

Abstract: One of the implications of the creation of Basel Committee on Banking Supervision was the implementation of Value-at-Risk (VaR) as the standard tool for measuring market risk. Since then, the capital requirements of commercial banks with trading activities are based on VaR estimates. Therefore, appropriately constructed tests for assessing the out-of-sample forecast accuracy of the VaR model (backtesting procedures) have become of crucial practical importance. In this paper we show that the use of the standard unconditional and independence backtesting procedures to assess VaR models in out-of-sample composite environments can be misleading. These tests do not consider the impact of estimation risk and therefore may use wrong critical values to assess market risk. The purpose of this paper is to quantify such estimation risk in a very general class of dynamic parametric VaR models and to correct standard backtesting procedures to provide valid inference in out-of-sample analyses. A Monte Carlo study illustrates our theoretical findings in finite-samples and shows that our corrected unconditional test can provide more accurately sized and more powerful tests than the uncorrected one. Finally, an application to S and P500 Index shows the importance of this correction and its impact on capital requirements as imposed by Basel Accord.

Keywords: Backtesting; Basel Accord; Conditional Quantile; Estimation Risk; Forecast evaluation; Fixed, rolling and recursive forecasting scheme; Risk management; Value at Risk (search for similar items in EconPapers)
JEL-codes: C22 C52 G21 G32 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2007-03, Revised 2008-09
New Economics Papers: this item is included in nep-ban, nep-cfn, nep-ecm and nep-rmg
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Journal Article: Backtesting Parametric Value-at-Risk With Estimation Risk (2010)
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