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Measuring Traded Market Risk: Value-at-risk and Backtesting Techniques

Author

Listed:
  • Colleen Cassidy

    (Reserve Bank of Australia)

  • Marianne Gizycki

    (Reserve Bank of Australia)

Abstract

The proposed market-risk capital-adequacy framework, to be implemented at the end of 1997, requires Australian banks to hold capital against market risk. A fundamental component of this framework is the opportunity for banks to use their value-at-risk (VaR) models as the basis of the market-risk capital charge. Value-at-risk measures the potential loss on a portfolio for a specified level of confidence if adverse movements in market prices were to occur. This paper examines the VaR measure and some of the techniques available for assessing the performance of a VaR model. The first section of the paper uses a simple portfolio of two spot foreign exchange positions to illustrate three of the approaches used in the calculation of a VaR measure: variance-covariance, historical simulation and Monte-Carlo simulation. It is concluded that, although VaR is a very useful tool, it is not without its shortcomings and so should be supplemented with other risk-management techniques. The second section of the paper focuses on the use of backtesting – the comparison of model-generated VaR numbers with actual profits and losses z– for assessing the accuracy of a VaR model. Several statistical tests are demonstrated by testing daily VaR and profit and loss data obtained from an Australian bank. The paper concludes that, although the tests are not sufficiently precise to form the basis of regulatory treatment of banks’ VaR results, the tests do provide useful diagnostic information for evaluating model performance.

Suggested Citation

  • Colleen Cassidy & Marianne Gizycki, 1997. "Measuring Traded Market Risk: Value-at-risk and Backtesting Techniques," RBA Research Discussion Papers rdp9708, Reserve Bank of Australia.
  • Handle: RePEc:rba:rbardp:rdp9708
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    File URL: https://www.rba.gov.au/publications/rdp/1997/pdf/rdp9708.pdf
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    References listed on IDEAS

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    1. Paul H. Kupiec, 1995. "Techniques for verifying the accuracy of risk measurement models," Finance and Economics Discussion Series 95-24, Board of Governors of the Federal Reserve System (U.S.).
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    Cited by:

    1. Luis Fernando Melo Velandia & Oscar reinaldo Becerra Camargo, 2005. "Medidas de Riesgo, Características y Técnicas de Medición: Una Aplicación del VAR y el ES a la Tasa Interbancaria de Colombia," Borradores de Economia 343, Banco de la Republica de Colombia.
    2. Pérignon, Christophe & Deng, Zi Yin & Wang, Zhi Jun, 2008. "Do banks overstate their Value-at-Risk?," Journal of Banking & Finance, Elsevier, vol. 32(5), pages 783-794, May.
    3. Sean D. Campbell, 2005. "A review of backtesting and backtesting procedures," Finance and Economics Discussion Series 2005-21, Board of Governors of the Federal Reserve System (U.S.), revised 2005.

    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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