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Answer: Due to imperfect correlations between pairwise risk factors.
**Explanation:** Cash flow mapping provides more accurate risk measurement because: - **Cash flow mapping:** Maps each individual cash flow to its corresponding maturity point on the yield curve - **Duration mapping:** Maps the entire bond to a single maturity point (duration) - **Principal mapping:** Maps only the principal payment With a flat yield curve and constant volatility, the diversification benefit comes from **imperfect correlations between different maturity points**. Cash flow mapping captures these diversification benefits more accurately because: - It recognizes that cash flows at different maturities have less than perfect correlation - This diversification reduces the overall portfolio VaR - Duration and principal mapping oversimplify by aggregating cash flows, losing this diversification benefit Therefore, the lower diversified VaR is due to imperfect correlations between pairwise risk factors.
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Q-50. Under these assumptions - in particular: a flat yield curve and constant yield volatility of 1.0% - why can we expect cash flow mapping to produce a lower diversified VaR than either duration and principal mapping?
A
The risk measures are non-linear.
B
Due to imperfect correlations between pairwise risk factors.
C
Fewer total cash flows will be mapped.
D
We cannot expect a lower diversified VaR.
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