What is Back Testing?

Back testing is a useful technique adopted by financial institutions to reconcile predicted losses from Value at Risk (VaR) with actual losses, typically at 1 day, 1 or 2 weeks, 1 month or a year. VaR is best known for quantifying the risk of loss on a portfolio. For a given probability, VaR is defined as the loss that a portfolio may make by the end of a given time horizon under normal market conditions.

The framework was developed by the Basel Committee and is the central format for judging the performance of a VaR model. Back testing helps a company test the accuracy of a VaR model. Employing this technique can enable a comparison of the losses that were forecast with the actual losses at the end of the defined time horizon.

How to Enhance Back Testing

To minimise any problems or limitations that might arise from back testing, it is recommended to follow the steps below:

  1. Refer to the Basel Committee’s three-zone approach. The green zone means that the possibility of incorrectly accepting a model that is inaccurate is low. The yellow zone displays an alert that the model should be checked (most likely by the risk manager) before any action is taken. Finally, the red zone represents the probability of incorrectly rejecting a model that is accurate so the performance of a model can then be [removed/ replaced/ amended].
  2. Keep up to date with new approaches to back testing, as they are constantly being developed, and any updates may be useful.
  3. Carry out back testing by using daily profit and losses as it will give a broader insight into cases where risk measures have not been accurately catching stock trading volatility.
  4. Data sets should be updated at least once every 3 months

With these in mind, an operative back testing framework can be put into effect in order to measure risk and performance.

This post was written by UnaVista from the London Stock Exchange Group. UnaVista is a hosted matching and reconciliation platform built by London Stock Exchange, aiming to provide a range of regulatory solutions. The platform is the UK’s leading approved reporting mechanism (ARM) for MiFID transaction reporting, and can provide solutions across a number of other regulations including the potential to connect to ACER for REMIT reporting. For more information on how regulations such as CRD IV will affect you please visit the UnaVista website.