14.1 Motivation

The empiricist tradition in the philosophy of science tells us that a model should not be assessed based on the reasonableness of its assumptions or the sophistication of its analytics. It should be assessed based on the usefulness of its predictions. Backtesting is a process of assessing the usefulness of a value-at-risk measure’s predictions when applied to a particular portfolio over time. The value-at-risk measurements obtained for the portfolio from the value-at-risk measure are recorded, as are the realized P&L’s for the portfolio. Once sufficient data has been collected, statistical or other tests are applied to assess how well the value-at-risk measurements reflect the riskiness of the portfolio.