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Answer: Mapping USD/EUR forward contracts to the USD/EUR spot exchange rate.
The most appropriate way of mapping the given position, as suggested by a senior risk analyst at a large investment bank, is option A: Mapping USD/EUR forward contracts to the USD/EUR spot exchange rate. This is because all forward positions are exposed to a single major risk factor, which is the USD/EUR spot exchange rate. Although the sensitivity of the forward and spot exchange rates to specific risk factors such as changes in interest rates may differ, mapping them to a single risk factor is acceptable for risk measurement purposes. However, it is not adequate for pricing the portfolio. The other options are incorrect for various reasons: B is incorrect because corporate bonds should be mapped to yields that best represent their current profile, not to government bonds with the closest maturity. Option C is incorrect because it maps a simple source of uncertainty to multiple sources, violating the principle of simplifying the source of uncertainty. Option D is incorrect because a stock market index is a more diversified factor than a single stock, and typically, a position in a stock within an index is mapped to a position in that index, not the other way around.
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A chief risk officer at a leading financial institution is evaluating a proposal from an experienced risk analyst aimed at improving the firm's risk assessment processes. The analyst suggests simplifying the Value at Risk (VaR) calculation for the firm's large portfolio by consolidating the numerous trading positions into a smaller, more manageable set of core risk components. Which of the following methods would be the most appropriate for mapping the current positions?
A
Mapping USD/EUR forward contracts to the USD/EUR spot exchange rate.
B
Mapping each position in a corporate bond portfolio to the bond with the closest maturity among a set of government bonds.
C
Mapping zero-coupon government bonds to government bonds paying regular coupons.
D
Mapping a position in a stock market index to a position in a stock within that index.