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Answer: The 99% VaRs of the bonds are equal, which fails to reflect the fact that the bonds have different levels of risk.
## Explanation **D is correct** because: - Both bonds have a 1% chance of suffering a loss of at least GBP 10 million, meaning the 99% VaR for both bonds is GBP 10 million - However, Bond F is clearly riskier than Bond G because: - Bond F has a 0.8% chance of losing the entire GBP 20 million investment - Bond G cannot lose more than GBP 17.5 million and has a 0.9% chance of losing between GBP 10-17.5 million - The 99% VaR measure fails to capture this difference in tail risk beyond the VaR threshold **Why other options are incorrect:** - **A is incorrect**: VaR is not the most effective measure here because it doesn't capture the severity of losses beyond the VaR level. Expected Shortfall (ES) would be more appropriate. - **B is incorrect**: VaR can be calculated for any distribution, not just normal distributions. The assumption of normality is not required. - **C is incorrect**: The 99% VaRs are actually equal (GBP 10 million for both bonds), not different. This demonstrates a key limitation of VaR - it only tells you the minimum loss at a given confidence level, but not how bad losses could be beyond that point.
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A risk manager at a distressed debt hedge fund is comparing the credit risk of the fund's investments of GBP 20 million each in two corporate bonds, Bond F and Bond G. The manager models credit losses on the bonds as discrete random variables and makes the following assumptions about their probability distributions:
Assuming the loss distributions for the two bonds are the same for all losses below the 99 percentile point, which of the following would the manager be correct to conclude?
A
The 99% VaR measure is the most effective risk measure for comparing the relative riskiness of the bonds.
B
The 99% VaR measure cannot be used in this case, as losses must be assumed to follow a normal distribution to estimate VaR.
C
The 99% VaRs of the bonds differ, which accurately represents the bonds as having different levels of risk.
D
The 99% VaRs of the bonds are equal, which fails to reflect the fact that the bonds have different levels of risk.