Framework for the use of back-testingFramework for the use of back-testing

Framework for the use of back-testing

An ADI’s back-testing program must consist of a periodic comparison of its daily VaR measure (based on a one-day holding period) with the realised daily profit or loss (‘trading outcome’). The program must include a formal evaluation of instances where trading outcomes are not covered by the risk measures (termed ‘exceptions’) on at least a quarterly basis, using the most recent twelve months of VaR and profit data. The ADI must document all of the exceptions generated from its ongoing back-testing program, including an explanation for the exceptions. An ADI must have the capacity to perform back-testing analysis both at the level of the whole portfolio and at the level of sub-portfolios or books or that contain material risk.
An ADI must perform back-tests using both actual trading outcomes and hypothetical trading outcomes. Hypothetical trading outcomes are calculated by applying the day’s price movements to the previous day’s end-of-day portfolio. When performing back-tests using actual trading outcomes, an ADI must use clean trading outcomes, i.e. actual trading outcomes adjusted to remove the impact of income arising from factors other than market movements alone, such as fees and commissions, brokerage, additions to and releases from reserves which are not directly related to [market risk](http://fsahandbook.info/FSA/glossary-html/handbook/Glossary/M?definition=G1564) (e.g. administration reserves).
An ADI must calculate the number of exceptions for use by APRA in developing its supervisory response. For this purpose, the ADI must use either the hypothetical trading outcomes or clean trading outcomes as determined, in writing, by APRA. The plus factor to be added to the multiplication factor will be based on the number of exceptions out of the most recent 250 trading days. These plus factors are outlined in Table 11.

Table 11: Plus factors

<table cellspacing="0" cellpadding="0" style="margin-right:auto; margin-left:auto; border:0.75pt solid #000000; border-collapse:collapse"><tbody><tr style="height:4.5pt"><td style="width:68.6pt; border-right:0.75pt solid #000000; border-bottom:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span style="font-weight:bold">Zone</span></p></td><td style="width:145.1pt; border-right:0.75pt solid #000000; border-left:0.75pt solid #000000; border-bottom:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span style="font-weight:bold">Number of exceptions</span></p></td><td style="width:107.55pt; border-left:0.75pt solid #000000; border-bottom:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span style="font-weight:bold">Plus factor</span></p></td></tr><tr style="height:7.05pt"><td style="width:68.6pt; border-top:0.75pt solid #000000; border-right:0.75pt solid #000000; border-bottom:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>Green Zone</span></p></td><td style="width:145.1pt; border:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>4 or less</span></p></td><td style="width:107.55pt; border-top:0.75pt solid #000000; border-left:0.75pt solid #000000; border-bottom:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>0.00</span></p></td></tr><tr style="height:3.25pt"><td rowspan="5" style="width:68.6pt; border-top:0.75pt solid #000000; border-right:0.75pt solid #000000; border-bottom:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>Yellow Zone</span></p></td><td style="width:145.1pt; border:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>5</span></p></td><td style="width:107.55pt; border-top:0.75pt solid #000000; border-left:0.75pt solid #000000; border-bottom:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>0.40</span></p></td></tr><tr style="height:4pt"><td style="width:145.1pt; border:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>6</span></p></td><td style="width:107.55pt; border-top:0.75pt solid #000000; border-left:0.75pt solid #000000; border-bottom:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>0.50</span></p></td></tr><tr style="height:4pt"><td style="width:145.1pt; border:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>7</span></p></td><td style="width:107.55pt; border-top:0.75pt solid #000000; border-left:0.75pt solid #000000; border-bottom:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>0.65</span></p></td></tr><tr style="height:4pt"><td style="width:145.1pt; border:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>8</span></p></td><td style="width:107.55pt; border-top:0.75pt solid #000000; border-left:0.75pt solid #000000; border-bottom:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>0.75</span></p></td></tr><tr style="height:4pt"><td style="width:145.1pt; border:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>9</span></p></td><td style="width:107.55pt; border-top:0.75pt solid #000000; border-left:0.75pt solid #000000; border-bottom:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>0.85</span></p></td></tr><tr style="height:3.25pt"><td style="width:68.6pt; border-top:0.75pt solid #000000; border-right:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>Red Zone</span></p></td><td style="width:145.1pt; border-top:0.75pt solid #000000; border-right:0.75pt solid #000000; border-left:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>10 or more</span></p></td><td style="width:107.55pt; border-top:0.75pt solid #000000; border-left:0.75pt solid #000000; padding-right:5.03pt; padding-left:5.03pt; vertical-align:middle"><p style="margin-top:3pt; margin-left:28.35pt; margin-bottom:3pt; text-align:center; page-break-inside:avoid; page-break-after:avoid"><span>1.00</span></p></td></tr></tbody></table>