This year marks 25 years since the failure of Barings Bank. On Sunday 26 February 1995, the 200-year old merchant bank blew up thanks to derivatives trading, which it believed was both risk-free and highly profitable. It was neither of these things. The firm’s star trader was illicitly pursuing a strategy akin to ‘picking up pennies in front of a steam-roller‘. The steamroller arrived in the form the Kobe earthquake. The star trader’s losses ballooned and he doubled up on his bets, unsuccessfully. Barings went bankrupt. The episode captured the public imagination, and helped lead to the creation of a new regulator in the UK.
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.