Financial Risk Manager Part 2
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An analyst working at a fixed-income investment firm is evaluating different approaches the firm uses to determine the Value at Risk (VaR) for its corporate bond portfolios, which are made up of a wide range of bonds with varying maturities. One method the analyst is contemplating is the use of a mapping technique to simplify the VaR estimation process. Which of the following statements would be correct for the analyst to assert regarding the mapping methods for fixed-income portfolios?
An analyst working at a fixed-income investment firm is evaluating different approaches the firm uses to determine the Value at Risk (VaR) for its corporate bond portfolios, which are made up of a wide range of bonds with varying maturities. One method the analyst is contemplating is the use of a mapping technique to simplify the VaR estimation process. Which of the following statements would be correct for the analyst to assert regarding the mapping methods for fixed-income portfolios?
Explanation:
B is correct. The process used in the duration mapping approach is to replace the portfolio of fixed-income investments with a single zero-coupon with a maturity equal to the duration of the portfolio.
A is incorrect because principal mapping overstates the true risk of the portfolio as it ignores coupon payments. Considering these payments decreases the duration of the portfolio, which in turn decreases portfolio VaR. Hence, principal mapping overstates the risk.
C is incorrect because undiversified VaR and the inclusion of correlations are associated with the cash-flow mapping approach rather than the duration mapping approach. The difference between the VaR estimated using the principal mapping approach and the diversified VaR estimated using the duration mapping approach is due to the intervening cash flows. The principal mapping approach ignores these cash flows, while they are implicitly accounted for in the duration mapping approach.
D is incorrect because the VaR estimated using the cash-flow mapping approach is more accurate than the VaR estimated using the duration mapping approach. This is because the cash-flow approach incorporates correlations into the estimation process, leading to a more precise calculation.