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Answer: Mapping USD/EUR forward contracts to the USD/EUR spot exchange rate
The correct answer is A. Mapping several USD/EUR forward contracts to the USD/EUR spot exchange rate is an adequate process because all the forward positions are exposed to a single major risk factor, which is the USD/EUR spot exchange rate. This mapping simplifies the risk measurement by aggregating the exposure to this risk factor, even though it may not be a perfect mapping due to differences in sensitivity to specific risk factors like changes in interest rates. The mapping is acceptable for risk measurement purposes, but not for pricing the portfolio. Option B is incorrect because it is important to map bonds to yields that best represent their current profile, and the yield differences between corporate and government bonds make this option less suitable. Option C is also incorrect as it maps a single source of uncertainty (the payoff at maturity) to multiple sources of uncertainty (coupon payments and the payoff at maturity), which goes against the principle of simplifying the source of uncertainty. Option D is incorrect because it suggests mapping a diversified factor (stock market index) to a less diversified one (a single stock), which is typically the opposite of how mapping should be done for risk measurement purposes.
Author: LeetQuiz Editorial Team
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As a chief risk officer at a major financial institution, you are evaluating a proposal put forth by a senior risk analyst. The proposal aims to enhance the institution's risk assessment methodology. Specifically, the analyst suggests improving the calculation of the institution's portfolio Value at Risk (VaR). This improvement involves correlating the institution's numerous trading positions to a limited set of basic risk elements to streamline the process. Which of the following methods would be the most suitable for correlating the given 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 zero-coupon government bonds to government bonds paying regular coupons
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