Backtesting
Backtesting is a term used in modeling to refer to testing a predictive model on historical data. Backtesting is a type of retrodiction, and a special type of cross-validation applied to previous time period(s).
Financial analysis
In the economic and financial field, backtesting seeks to estimate the performance of a strategy or model if it had been employed during a past period. This requires simulating past conditions with sufficient detail, making one limitation of backtesting the need for detailed historical data. A second limitation is the inability to model strategies that would affect historic prices. Finally, backtesting, like other modeling, is limited by potential overfitting. That is, it is often possible to find a strategy that would have worked well in the past, but will not work well in the future.[1] Despite these limitations, backtesting provides information not available when models and strategies are tested on synthetic data.
Backtesting has historically only been performed by large institutions and professional money managers due to the expense of obtaining and using detailed datasets. However, backtesting is increasingly used on a wider basis, and independent web-based backtesting platforms have emerged. Although the technique is widely used, it is prone to weaknesses.[2] Basel financial regulations require large financial institutions to backtest certain risk models.
For a Value at Risk 1-day at 99% backtested 250 days in a row, the test is considered green (0-95%), orange (95-99.99%) or red (99.99-100%) depending on the following table:[3]
Zone | Number exceptions | Probability | Cumul |
---|---|---|---|
Green | 0 | 8.11% | 8.11% |
1 | 20.47% | 28.58% | |
2 | 25.74% | 54.32% | |
3 | 21.49% | 75.81% | |
4 | 13.41% | 89.22% | |
Orange | 5 | 6.66% | 95.88% |
6 | 2.75% | 98.63% | |
7 | 0.97% | 99.60% | |
8 | 0.30% | 99.89% | |
9 | 0.08% | 99.97% | |
Red | 10 | 0.02% | 99.99% |
11 | 0.00% | 100.00% | |
... | ... | ... |
For a Value at Risk 10-day at 99% backtested 250 days in a row, the test is considered green (0-95%), orange (95-99.99%) or red (99.99-100%) depending on the following table:
Zone | Number exceptions | Probability | Cumul |
---|---|---|---|
Green | 0 | 36.02% | 36.02% |
1 | 15.99% | 52.01% | |
2 | 11.58% | 63.59% | |
3 | 8.90% | 72.49% | |
4 | 6.96% | 79.44% | |
5 | 5.33% | 84.78% | |
6 | 4.07% | 88.85% | |
7 | 3.05% | 79.44% | |
8 | 2.28% | 94.17% | |
Orange | 9 | 1.74% | 95.91% |
... | ... | ... | |
24 | 0.01% | 99.99% | |
Red | 25 | 0.00% | 99.99% |
... | ... | ... |
Hindcast
In oceanography[5] and meteorology,[6] backtesting is also known as hindcasting: a hindcast is a way of testing a mathematical model; researchers enter known or closely estimated inputs for past events into the model to see how well the output matches the known results.
Hindcasting usually refers to a
An example of hindcasting would be entering climate forcings (events that force change) into a climate model. If the hindcast showed reasonably-accurate climate response, the model would be considered successful.
The ECMWF re-analysis is an example of a combined atmospheric reanalysis coupled with a wave-model integration where no wave parameters were assimilated, making the wave part a hindcast run.
See also
- Applied research (customer foresight)
- Black box model
- Climate
- ECMWF re-analysis
- Forecasting
- NCEP re-analysis
- Economic forecast
- Retrodiction
- Statistical arbitrage
- Thought Experiment
- Value at risk
References
- ^ Bailey, Borwein, Lopez de Prado, Zhu (2014). "Pseudo-mathematics and financial charlatanism. Notices of the American Mathematical Society, Volume 61, Number 5, pp. 458-471" (PDF).
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: CS1 maint: multiple names: authors list (link) CS1 maint: numeric names: authors list (link) - ^ FinancialTrading (2013-04-27). "Issues related to back testing".
- ^ "Supervisory framework for the use of "backtesting" in conjunction with the internal models approach to market risk capital requirements" (PDF). Basle Committee on Banking Supervision. January 1996. p. 14.
- ^ Taken from p.145 of Yeates, L.B., Thought Experimentation: A Cognitive Approach, Graduate Diploma in Arts (By Research) dissertation, University of New South Wales, 2004.
- ^ "Hindcast approach". OceanWeather Inc. Retrieved 22 January 2013.
- . Retrieved 22 January 2013.
- ^ "Guidance on Conducting Streamflow Hindcasting in CHPS" (PDF). NOAA. Retrieved 22 January 2013.