How To Backtest A Model?

Explaining What Backtesting Is And How To Backtest a Real-Life Market Risk VaR Model

The models and the parameters are chosen based on the assumptions and intensive research that the analysts perform. Once the models have been implemented, the model validation teams backtest the model to ensure that the assumptions were valid and the model is adequate.

This article will explain the process of backtesting with a real usecase of VaR models. It will also explain how we need to backtest a VaR model.

If you want to get a basic understanding of VaR then please read this article:

Backtesting a model is extremely important to ensure that the assumptions which were taken to implement the model are valid.

Let’s assume we have implemented a VaR model. The model is based on a number of assumptions about the parameters and the functionality of the model.

As an instance, the model is usually implemented based on a portfolio that is static in nature. However, the risk of the portfolio is dependent on a number of risk factors that are changing all the time. Hence the risk of the portfolio is constantly changing too.

Additionally, the dynamics of the portfolio are also changing due to the commissions and fees. Once the model is implemented and calibrated, it needs to be backtested to ensure that it is accurate, unbiased and adequate.

There is always a chance that the chosen sample set does not represent the true picture of the market current economical situation.

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