The investor should rank all marginal VaR numbers and select the asset with the largest marginal VaR because selecting that asset will have the largest hedging effect. Marginal VaR is the change in portfolio VaR resulting from taking an additional dollar of exposure to a given component. In this context, the asset with the largest VaR would contribute the most to the overall portfolio risk. Therefore, reducing the position in this asset would have the largest impact on reducing the portfolio's overall risk. This strategy is based on the principle that the assets that contribute the most to portfolio risk should be the first ones to be reduced when the goal is to lower portfolio risk.

Choice A is incorrect. Selecting the asset with the smallest VaR will not have the largest hedging effect. In fact, it would be less effective in reducing portfolio risk because assets with smaller VaR contribute less to overall portfolio risk.

Choice B is incorrect. While it's true that an asset with a larger VaR contributes more to overall portfolio risk, selecting such an asset will not have the smallest hedging effect. On contrary, reducing position in this asset would result in a larger reduction of portfolio risk.

Choice D is incorrect. As explained above, ranking all marginal VaR numbers and selecting the asset with the largest VaR for reduction will indeed have the largest hedging effect and thus effectively decrease portfolio's Value at Risk (VaR).

Things to Remember

• Value at Risk (VaR) is a measure used to assess the potential loss in value of a portfolio due to market risk over a specified time period and confidence level.
• Marginal VaR is the change in portfolio VaR resulting from taking an additional dollar of exposure to a given component.
• Hedging involves taking an offsetting position in a related security to reduce the risk of adverse price movements in an asset.
• Portfolio risk management involves analyzing the contribution of each asset to the