Testing the test: How reliable are risk model backtesting results?

Emmanouil Karimalis, Paul Alexander & Fernando Cerezetti.

All models, including those which model financial risk, are in some sense “wrong” – they aim to “approximate” the real word but cannot possibly recreate it. Consequently, in a world in which risk models are used to calculate and exchange vast sums of capital and margin, the need for reliable tests is of paramount importance. The Kupiec-POF test represents the most widely-used test for assessing the reliability of these risk models (typically Value-at-Risk (VaR) models) – a process known as backtesting. As with all forms of testing, the Kupiec-POF test has a degree of error associated with its use and under certain circumstances these errors may be substantial.

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