Answer: USD/EUR forward contracts are mapped 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 appropriate technique for simplifying the computation of Value-at-Risk (VaR) on a portfolio with a large number of positions. This is because all the forward positions are exposed to a single major risk factor, which is the USD/EUR spot exchange rate. Although this mapping is not perfect, as the sensitivity of both the forward and spot exchange rates to specific risk factors like changes in interest rates may differ, it is acceptable for risk measurement purposes. However, it is not adequate for pricing the portfolio. Option B is incorrect because mapping corporate bonds to government bonds with the closest maturity does not accurately reflect the yield differences between the two types of bonds, which are essential for an accurate representation of risk. Option C is also incorrect because mapping zero-coupon government bonds, which have a single source of uncertainty (the payoff at maturity), to bonds paying regular coupons introduces multiple sources of uncertainty (coupon payments and the payoff at maturity). This violates the principle of simplifying the source of uncertainty. Option D is incorrect as well because a stock market index is a more diversified factor than a single stock. Typically, a position in a stock within an index is mapped to a position in that index, not the other way around.

Author: LeetQuiz Editorial Team