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Encyclopedia of Financial Models III
book

Encyclopedia of Financial Models III

by Frank J. Fabozzi
November 2012
Beginner content levelBeginner
733 pages
27h 41m
English
Wiley
Content preview from Encyclopedia of Financial Models III

Back-Testing Market Risk Models

KEVIN DOWD, PhD

Partner, Cobden Partners, London

Abstract: Back-testing is the quantitative evaluation of a model, and back-testing a risk or probability density forecasting model involves a comparison of the model's density forecasts against subsequently realized outcomes of the random variable whose density is forecast. One purpose of back-testing is to determine whether the forecasts are sufficiently close to realized outcomes to enable us to conclude that the forecasts are statistically compatible with those outcomes. Back-tests conducted for this purpose involve statistical hypothesis tests to determine if a model's forecasts are acceptable. Hypothesis tests can be applied to observations involving a loss that exceeds the value-at-risk at a given confidence interval, or they can be applied to forecasts of VaRs at multiple confidence intervals. A second purpose of back-testing is to assist risk managers to diagnose problems with their risk models and so help improve them. A third purpose of back-testing is to rank the performance of a set of alternative risk models to determine which model gives the “best” density forecast evaluation performance.

To back-test a model is to evaluate it in quantitative terms, and back-testing a risk (or probability density forecasting) model involves a comparison of the model's density forecasts against subsequently realized outcomes of the underlying random variable whose density is forecast. The importance ...

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Publisher Resources

ISBN: 9781118539835Purchase book