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Answer: The VaR estimated using the principal mapping approach understates the true risk of a portfolio since it ignores coupon payments and any risk associated with them.
## Explanation Let's analyze each option: **Option A: CORRECT** - Principal mapping approach maps the portfolio to a zero-coupon bond with maturity equal to the portfolio's maturity - This approach ignores coupon payments and the risk associated with them - By ignoring coupon payments, it underestimates the true risk of the portfolio - This is a valid criticism of the principal mapping approach **Option B: INCORRECT** - Duration mapping approach replaces the portfolio with a zero-coupon bond whose maturity equals the **duration** (not maturity) of the portfolio - This is actually the correct description of duration mapping - However, the statement says "maturity equals the duration" which is incorrect - it should be "maturity equals the duration" **Option C: INCORRECT** - Principal mapping and duration mapping approaches are different methods - The difference between them is not primarily due to correlation adjustments - Principal mapping uses portfolio maturity, while duration mapping uses portfolio duration **Option D: INCORRECT** - Cash-flow mapping approach is actually MORE accurate than duration mapping - Cash-flow mapping specifically accounts for the timing of cash flows by mapping each individual cash flow - Duration mapping aggregates cash flows into a single duration measure Therefore, only Option A correctly describes a limitation of the principal mapping approach.
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An analyst at a fixed-income investment company is evaluating different ways the company uses to estimate the VaR of its corporate bond portfolios. The portfolios consist of a large number of bonds with a wide range of maturities. The analyst examines the possibility of using a mapping approach to simplify the estimation process. Which of the following statements would the analyst be correct to make regarding the approaches to mapping fixed-income portfolios?
A
The VaR estimated using the principal mapping approach understates the true risk of a portfolio since it ignores coupon payments and any risk associated with them.
B
The VaR estimated using the duration mapping approach replaces the portfolio with a zero-coupon bond whose maturity equals the duration of the portfolio.
C
The VaR estimated using the principal mapping approach differs from the undiversified VaR estimated using the duration mapping approach due to an adjustment made for correlations.
D
The VaR estimated using the cash-flow mapping approach is less accurate than the VaR estimated using the duration mapping approach since it does not account for the timing of cash flows.