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Regulatory Evaluation of Value-at-Risk Models

  • Jose A. Lopez

Value-at-risk (VaR) models have been accepted by banking regulators as tools for setting capital requirements for market risk exposure. Three statistical methodologies for evaluating the accuracy of such models are examined; specifically, evaluation based on the binomial distribution, interval forecast evaluation as proposed by Christoffersen (1995), and distribution forecast evaluation as proposed by Crnkovic and Drachman (1995). These methodologies test whether the VaR forecasts in question exhibit properties characteristic of accurate VaR forecasts. However, the statistical tests used often have low power against alternative models. A new evaluation methodology, based on the probability forecasting framework discussed by Lopez (1995), is proposed. This methodology gauges the accuracy of VaR models using forecast evaluation techniques. It is argued that this methodology provides users, such as regulatory agencies, with greater flexibility to tailor the evaluations to their particular interests by defining the appropriate loss function. Simulation results indicate that this methodology is clearly capable of differentiating among accurate and alternative VaR models. This paper was presented at the Financial Institutions Center's October 1996 conference on "

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Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 96-51.

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Date of creation: Sep 1996
Date of revision:
Handle: RePEc:wop:pennin:96-51
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  1. Francis X. Diebold & Todd A. Gunther & Anthony S. Tay, 1997. "Evaluating Density Forecasts," Center for Financial Institutions Working Papers 97-37, Wharton School Center for Financial Institutions, University of Pennsylvania.
  2. Granger, C.W.J. & Pesaran, H., 1996. "A Decision_Theoretic Approach to Forecast Evaluation," Cambridge Working Papers in Economics 9618, Faculty of Economics, University of Cambridge.
  3. Darryll Hendricks & Beverly Hirtle, 1997. "Bank capital requirements for market risk: the internal models approach," Economic Policy Review, Federal Reserve Bank of New York, issue Dec, pages 1-12.
  4. Granger, C. W. J. & White, Halbert & Kamstra, Mark, 1989. "Interval forecasting : An analysis based upon ARCH-quantile estimators," Journal of Econometrics, Elsevier, vol. 40(1), pages 87-96, January.
  5. J. S. Butler & Barry Schachter, 1996. "Improving Value-At-Risk Estimates By Combining Kernel Estimation With Historical Simulation," Finance 9605001, EconWPA.
  6. 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.).
  7. Paul H. Kupiec & James M. O'Brien, 1995. "A pre-commitment approach to capital requirements for market risk," Proceedings 475, Federal Reserve Bank of Chicago.
  8. Christoffersen, Peter F, 1998. "Evaluating Interval Forecasts," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 841-62, November.
  9. Dimson, Elroy & Marsh, Paul, 1995. " Capital Requirements for Securities Firms," Journal of Finance, American Finance Association, vol. 50(3), pages 821-51, July.
  10. Jose A. Lopez, 1995. "Evaluating the predictive accuracy of volatility models," Research Paper 9524, Federal Reserve Bank of New York.
  11. Arturo Estrella, 1995. "A prolegomenon to future capital requirements," Economic Policy Review, Federal Reserve Bank of New York, issue Jul, pages 1-12.
  12. Chatfield, Chris, 1993. "Calculating Interval Forecasts," Journal of Business & Economic Statistics, American Statistical Association, vol. 11(2), pages 121-35, April.
  13. Darryll Hendricks, 1996. "Evaluation of value-at-risk models using historical data," Economic Policy Review, Federal Reserve Bank of New York, issue Apr, pages 39-69.
  14. Francis X. Diebold & Jose A. Lopez, 1996. "Forecast Evaluation and Combination," NBER Technical Working Papers 0192, National Bureau of Economic Research, Inc.
  15. repec:att:wimass:9520 is not listed on IDEAS
  16. Paul H. Kupiec & James M. O'Brien, 1995. "The use of bank trading risk models for regulatory capital purposes," Finance and Economics Discussion Series 95-11, Board of Governors of the Federal Reserve System (U.S.).
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