Possible causes

There may be risk factors that are not included when risk is measured. For instance,
a government bond position hedged by a swap may be considered riskless, when
there is actually swap spread risk. Some positions in foreign currency-denominated
bonds may be assumed to be FX hedged. If this is not so, FX fluctuations are an
extra source of risk.
Especially if the problem only shows up on a recent part of the backtesting graph,
the reason may be that volatilities have increased. Extreme moves used to calculate
risk are estimates of the maximum moves at the 99% confidence level of the
underlying market prices or rates. Regulatory requirements specify a long observation
period for extreme move calculation (at least one year). This means that a sharp
increase in volatility may not affect the size of extreme moves used for risk measurement
much even if these are recalculated. A few weeks of high volatility may have a
relatively small effect on extreme moves calculated from a two-year observation
period. Figure 9.5 shows the risk and return on a position in the S&P 500 index. The
risk figure is calculated using two years of historical data, and is updated quarterly.
The period shown is October 1997 to October 1998. Volatility in the equity markets
increased dramatically in September and October 1998. The right-hand side of the
graph shows several exceptions as a result of this increase in volatility.
The mapping of business units for P&L reporting may be different from that used
for risk reporting. If extra positions are included in the P&L calculation that are
missing from the risk calculation, this could give a risk figure that is too low to
explain P&L fluctuations. This is much more likely to happen at a trading desk level
than at the whole bank level. This problem is most likely to occur for trading desks
that hold a mixture of trading book and banking book positions. Risk calculations
may be done only for the trading book, but P&L may be calculated for both trading
and banking book positions.