Question

Backtesting is usually conducted on a short horizon, such as daily frequency. Explain why?

Answer 1

Backtesting is the process of comparing losses which have been predicted by value at risk model to those actually experienced over the testing period. It is done to ensure that value-at-risk model are reasonably accurate.this is a technique for simulating a model or strategy on pass data to gauge its accuracy and effectiveness.

Backtesting in value at risk is used to compare predicted losses from the calculated value and actual losses realised at the end of the specific time horizon which are mostly short time horizon such as daily frequency, because the comparison identifies the period when the value of risk is underestimated.

It is done for the shorter time frame because the goal of the backtesting is to ensure that actual losses do not exceed the expected losses.when the Backtesting is done for the largest timeframes then too many exceptions are observed, and the model in world is not calibrated properly and actually it underestimates risk.So the Backtesting is done for shorter time frame to avoid too many exceptions and hence this model is calibrated properly and it actually studies risk in a shorter time frame which is efficient because it will help in reducing the number of observed exceptions as same as value at risk significance level.