Backtesting Value-at-Risk: A Generalized Markov Test

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DOI

  • Thor Pajhede, Københavns Universtitet

Testing the validity of value-at-risk (VaR) forecasts, or backtesting, is an integral part of modern market risk management and regulation. This is often done by applying independence and coverage tests developed by Christoffersen (International Economic Review, 1998; 39(4), 841-862) to so-called hit-sequences derived from VaR forecasts and realized losses. However, as pointed out in the literature, these aforementioned tests suffer from low rejection frequencies, or (empirical) power when applied to hit-sequences derived from simulations matching empirical stylized characteristics of return data. One key observation of the studies is that higher-order dependence in the hit-sequences may cause the observed lower power performance. We propose to generalize the backtest framework for VaR forecasts, by extending the original first-order dependence of Christoffersen to allow for a higher-or kth-order dependence. We provide closed-form expressions for the tests as well as asymptotic theory. Not only do the generalized tests have power against kth-order dependence by definition, but also included simulations indicate improved power performance when replicating the aforementioned studies. Further, included simulations show much improved size properties of one of the suggested tests. Copyright (C) 2017 John Wiley & Sons, Ltd.

Original languageEnglish
JournalJournal of Forecasting
Volume36
Issue5
Pages (from-to)597-613
Number of pages17
ISSN0277-6693
DOIs
Publication statusPublished - Aug 2017

    Research areas

  • value-at-risk, backtesting, Markov chain, duration, quantile, likelihood ratio, maximum likelihood, INFERENCE

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