Backtesting Risk Models

You built a VaR model. It says "You won't lose more than ₹1 Lakh with 99% confidence". How do you know if the model is right? Backtesting.

What is Backtesting?

Backtesting involves comparing the Model's Forecasts (VaR) against Actual Returns (P&L) over a historical period.

The Process

1. Take the last 250 days.
2. For each day, check: Did the Actual Loss exceed the VaR Calculation?
3. Exception: If Loss > VaR, it's called an "Exception" or "Breach".

Evaluating Results (Kupiec POV Test)

• If you calculate 95% VaR, you expect exceptions 5% of the time.
  • In 250 days, you expect 250 * 0.05 = 12.5 exceptions.
• Green Zone: If you get 10-15 exceptions, the model is Good.
• Red Zone: If you get 40 exceptions, the model is Underestimating Risk.
• Yellow Zone: If you get 0 exceptions, the model is Overestimating Risk (holding too much capital).

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