Explanation

When computing Value at Risk (VaR) for portfolios with numerous positions, risk factor mapping is used to simplify calculations by reducing the number of risk factors. Let's analyze each option:

Option A: USD/EUR forward contracts mapped to USD/JPY spot exchange rate

• Inadequate: This maps a USD/EUR position to a completely different currency pair (USD/JPY). The risk factors for USD/EUR and USD/JPY are different and not correlated in a way that would make this mapping valid. This would introduce significant basis risk.

Option B: Corporate bonds mapped to government bonds with closest maturity

• Inadequate: While maturity is one factor, corporate bonds have credit risk (default risk) that government bonds do not. Mapping corporate bonds to government bonds ignores the credit spread component, which is a significant risk factor for corporate bonds.

Option C: Government coupon bonds mapped to zero-coupon government bonds

• Adequate: This is a valid mapping technique known as cash flow mapping or duration mapping. A coupon-paying government bond can be decomposed into a portfolio of zero-coupon bonds with different maturities corresponding to each coupon payment date and the principal repayment. This:
  • Preserves the interest rate risk exposure
  • Maintains the duration characteristics
  • Uses government zero-coupon bonds as elementary risk factors
  • Is a standard practice in risk management

The correct mapping should preserve the key risk characteristics while reducing complexity. Option C achieves this by breaking down coupon bonds into their fundamental zero-coupon components, which are the basic building blocks for interest rate risk analysis.