RDP 9708: Measuring Traded Market Risk: Value-at-risk and Backtesting Techniques 1. Introduction

At the beginning of 1998 the capital-adequacy standards applying to Australian banks will be amended and banks will be required to hold capital against market as well as credit risk. Market risk is the risk that changes in the market prices of financial assets will adversely affect the value of a bank's portfolios. An important component of the proposed capital-adequacy arrangements is the opportunity for banks to use their internal value-at-risk (VaR) models, as opposed to standard regulatory formulae, as a basis for the capital calculation.

VaR is a measure of potential loss, where the potential loss is linked directly to the probability of occurrence of large adverse movements in market prices. The first part of this paper outlines the VaR measure and three different methods that are used in calculating it: the variance-covariance, historical-simulation and Monte-Carlo simulation methods.

The practical implementation of VaR models differs widely across banks. If banks are permitted to use their internally developed methodologies as a basis for regulatory capital requirements, regulators need to be satisfied as to the level of risk coverage and accuracy of those models. Hence, the testing of VaR model performance is a fundamental part of the proposed capital standards.

The second part of the paper discusses a number of tests that can be used to evaluate the performance of a VaR model. Since these tests focus on the past performance of a VaR model such testing is commonly referred to as backtesting. Backtesting assesses the relationship between the estimates of potential loss provided by a VaR model and the actual profits and losses realised by a bank's traders. The backtests are illustrated by applying the tests to VaR and profit and loss data collected from an Australian bank.