Back to backtesting: integrated backtesting for value-at-risk and expected shortfall in practice

Carsten Wehn

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Need to know

With expected shortfall, backtesting raises new challenges.
Within market risk, this can be systemized and solved.
New tools with helpful properties are shown.

Abstract

This paper aims to reflect the current state of the discussion on the validation of market risk forecasts by means of backtesting. Due to the upcoming Fundamental Review of the Trading Book (FRTB), the importance of expected shortfall (ES) as a risk measure will be significantly strengthened, which, in turn, should influence the discussion on appropriate approaches for its proper validation. While procedures based on forecast distribution and backtesting for value-at-risk have already been established and discussed intensively, the development of a standard for backtesting ES is still in full swing. In addition to a classification in this context, our paper offers a practical application for backtesting via an example portfolio with three comparative models and shows how to integrate the different backtesting methods in a holistic framework.

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