Backtesting is a framework that uses historical data to validate financial models, including trading strategies and risk management models. Depending on the goals of validation, financial professional use more than one indicator or methodology to measure the effectiveness of financial models.
Backtesting is routinely performed in trading and risk management. As a result, there are a number of dedicated backtesting techniques specific to these two areas.
In trading, common backtesting techniques include:
In-sample vs. out-of-sample testing
Walk-forward analysis or walk-forward optimization
Instrument-level analysis vs. portfolio-level assessment
In risk management, backtesting is generally applied to value-at-risk (VaR) and is also known as VaR backtesting. There are various VaR backtesting techniques, such as:
Basel's traffic light test
Binomial test
Kupiec's proportion of failures test
Kupiec's time until first failure test
Christoffersen's conditional coverage mixed test
Christoffersen's conditional coverage independence test
Haas' time between failures or mixed Kupiec test
Haas' time between failures independence test
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