Model Comparison and Backtesting Flashcards
What is an estimation window?
The data from a time period a model uses to base its risk forecasting on.
What is a testing window?
A time period in which a model forecasts risk.
What is a VaR violation?
A VaR violation is an event where the forecasted risk is less than the risk that actually occurred.
What is the violation ratio?
The number of observed violations divided by the number of expected violations. A good forecast is made when this number is between 0.8 and 1.2.
What is the coverage test? Explain how it works.
It tests if the probability at VaR violation of the model corresponds with reality. A likelihood ratio test can be used for this purpose. For this, the Bernoulli distribution is used.
What is the main advantage and disadvantage of the coverage test?
The main advantage is that it is nonparametric. This makes it a good benchmark for the accuracy of VaR models.
The main disadvantage is that these test rely on asymptotic distributions. This makes the tests less robust as the violations are rare events.
A second disadvantage is that the test focusses on unconditional coverage which ignores time variation in the data.
What defines the degrees of freedom of the X^2 test statistic?
The number of restrictions needed to convert the unrestricted model to the restricted model.
Discuss the usage of backtesting in evaluating the quality of volatility forecast models.
Using time varying volatility as is done in models such as MA, EWMA, and GARCH is beneficial to VaR forecasting. Backtesting tests which of these models is the best, and thus only the best model is used for the forecast.
