Hedge backtesting for model validation by lee jackson ssrn. One such a backtest would be to calculate how likely it is to find the actual number of defaults at or beyond the actual. Basics of hedge effectiveness testing and measurement. Model validation should include realistic backtesting hedging analysis. In a trading strategy, investment strategy, or risk. However, var models are useful only if they predict future risks accurately. Backtesting the hedged portfolio method seeking alpha. A regression analysis approach typically involves conducting a series of fair value simulations using. Even for modelbased valuations the fair value is a single number, not a range of. Banking supervision the committee for incorporating backtesting into the internal models approach to market risk capital requirements. In addition, the advancedapproaches riskbased capital rules 12 cfr 3, appendix c. The importance of validating a risk model originates from the fact that financial institutions are authorised by regulatory bodies to use inhouse models for the. If so, id agree whole heartedly and suggest that many of your readers reread jaffray woodriffs chapter in hedge fund market wizards where he discusses pitfalls similar to this and the solution he, i, and you have all seemed to converge upon. Backtesting is the process of testing a strategy, model or hypothesis against historical timeseries data.
Sti agrees that hypothetical backtesting should be used in model validation. Which models are used for estimating pd, lgd and ead and on what aspects should. Model validation and backtesting services from profitstars. Profitstar is a complex cashflow model with functions that many clients are not even aware of. Statistical overfitting and backtest performance david h. The backtesting suggests that, almost certainly, there is a fundamental problem with the model. Between 2000 and 2001, national australia bank took write downs totaling usd 1. Backtesting or crossvalidating when the modelbuilding.
Eurex clearing commits itself to a regular and thorough validation of all risk models and modelrelated processes along the model landscape. A pd model is supposed to calculate the probability that a client defaults on its obligations within a one year horizon. This presentation will cover only select components at a high level. The hedged portfolio method enables investors to precisely specify and strictly limit their risk. However, model risk is more and more prevalent in activities other than financial securities valuation, such as assigning consumer credit scores, realtime probability prediction of fraudulent credit card.
Quaternion approach to backtesting model validation. The cssf requires that the internal model is validated by a party independent of the models building process. As a result the models used for pd, lgd and ead estimation have been investigated and a full description of the model components and the aspects that require backtesting are included in this thesis. Hedging strategy, simulation and backtesting gtc 20. Simulating hedge fund strategies generalising fund. Quaternion approach to backtesting model validation the basel committee stated that banks using internal model method imm banks to calculate regulatory capital are required to carry out on. But what does this mean exactly, and how can it be used to reserve against model risk. Within this paper we shall research the validation methods of the risk model and. The model is in this band if the number of exceptions is 10 or greater. Generaltospecific model selection mapping hedge funds to indices gets in action paths searched. Backtesting is the process of testing a trading strategy on historical market data to see how it would have performed under those trading conditions.
Taking these objectives into account the first sub question is. This paper analyses the methods for validation of risk model and provides an overview of the present literature related to the validation and evaluation of var model success. Many banks that have adopted an internal modelbased approach to market risk. Here we shall address issues and present practical advice on how to proceed. In finance, model risk is the risk of loss resulting from using insufficiently accurate models to make decisions, originally and frequently in the context of valuing financial securities. Lee jackson introduces a general backtesting framework for marketcalibrated models, making the link with financial theory, and shows how it can inform recalibration and help. One of those five areas is model validation, and one method of model validation is backtesting as an aside, the other common method referenced in the policy statement is benchmarking. An illustrative example of a var backtesting exercise is shown in figure 1. The validation needs to ensure that the model is robust and reliable and captures adequately all material risks.
This is a key point and distinction that many miss, imo. Backtesting is a term used in modeling to refer to testing a predictive model on historical data. The backtesting component of the mra regulation specifies. Benchmarking and backtesting techniques in model validation. Also, key model stakeholders including the business units should be involved in the validation. To test whether a model is performing as expected socalled backtests are performed. The market risk capital multiplier gets adjusted to the maximum. So, for those of you that like pictures more than words. The probability of backtest overfitting request pdf.
Backtesting trading strategies for quantitative financial. Head of credit model validation focusedon validation of credit risk models where credit is defined as default, rather than market risk head of operational risk, capital, etc. Validation with outofsample tests fund of funds multi strategy. Backtesting is a type of retrodiction, and a special type of crossvalidation applied to previous time period s. Inherent risk model tier and residual risk of model a framework for model monitoring model risk aggregation framework model validation for stress test e.
From 122003 to 4302014, net of trading fees and hedging co. Back testing for model validation there are two approaches for model validation and selection. Lee jackson introduces a general backtesting framework for marketcalibrated models, making the link with financial theory, and shows how it can. Valueatrisk has become one of the most popular risk measurement techniques in finance. Hedging strategy simulation and backtesting with dsls, gpus and the cloud gpu technology conference 20 aon benfield securities, inc. Hedge backtesting for model validation derivatives pricing and expected exposure models must be backtested as a basic regulatory requirement. This model is used to produced a sequence of pseudo outof. A new approach to backtesting and risk model selection. The probability of backtest overfitting is the nonnull probability that a strategy with. Model risk management is a broad, evolving, and an expanding topic.
Derivative pricing models and riskneutral epe models can be assessed for their appropriateness using a nonparametric technique known as hedge backtesting, in which one looks at the quality of the hedging performance generated by the model. Pdf on jan 1, 2016, ivica terzic and others published risk model. Model validation focusedon validation of other models as determined, which may. Backtesting is the process of testing a trading strategy on relevant historical data to ensure its viability before the trader risks any actual. The federal reserves trading and capitalmarkets activities manual also discusses validation and model risk management. Our main field of application is in credit risk modelling but we are happy to consider any issues of risk model validation. While model owners are ultimately responsible for model development and associated model risk, model validation acts as a second line of defence. Given the intimate relationship between backtesting and validation, this document also lays out other sound practices that banks should consider in conjunction with backtesting. Derivatives pricing and expected exposure models must be backtested as a basic regulatory requirement.
Introduction backtesting principles testing strategies. Theoretical frameworkmodel validationmodel selection outline 1. In order to evaluate the quality of the var estimates, the models should always be backtested with appropriate methods. However, when hedge positions are excluded from the portfolio the models performance in accurately estimating var is questionable. An academic perspective on backtesting and stresstesting. You will, at a minimum, likely need functions for dataset selection i. Jackson, lee, hedge backtesting for model validation july 31, 2012. The validation process includes an exit interview where we discuss many of these features and train clients on their use. Model validation a key component to the implementation of modelbased risk management is model validation.
This paper presents a new method to validate risk models. When applying techniques such as aicbic and eacf, the entire dataset is used for both the estimation of model coefficients and for model comparison. The losses were attributed to a series of errors in how the firm modeled its portfolio of mortgage servicing rights. The backtesting problem 2 backtesting valueatrisk theory binomial and related tests 3 backtesting expected shortfall theory formulating tests acerbiszekely test 4 backtesting using elicitability theory model comparison model validation 5 concluding thoughts backtesting realized pvalues conclusions ajm hwu backtesting and elicitability qrm. Basics of hedge effectiveness testing and measurement 6 it is generally accepted that a slope parameter within a range of negative 0. Choice of validation groupings should be made for greatest clarity and efficiency. By setting the limit for the acceptable number of backtesting exceptions to four, the need for resilient internal models. Quantitative developers and analysts will use a market simulator like cloudquant to evaluate the trading strategy. Insample and outofsample testing alvarez quant trading. Hedge backtesting for model validation derivatives pricing and expected exposure models must be backtested as a basic regulatory.