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Explanation:
Market risk VaR typically relies on short time horizons (e.g., one to ten days) because market prices fluctuate continuously and positions can be liquidated or hedged quickly. Credit VaR uses a longer horizon (usually one year) because credit events like downgrades or defaults are infrequent and take longer to materialize.
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Q.4 When preparing a comparison report for the board of a financial institution, a risk manager is asked to explain the differing use of time horizons for market risk VaR versus credit VaR. Recognizing that the frequency of the risk events each VaR measures impacts the appropriate time horizon, what distinction should the risk manager clarify regarding the time horizons used for market risk VaR and credit VaR?
A
Credit VaR and market risk VaR both typically use a one-day time horizon due to the high-frequency nature of their respective risk events.
B
Market risk VaR often uses a longer time horizon than credit VaR because market prices fluctuate less frequently than credit events.
C
Market risk VaR uses a typically short time horizon, such as one day, while credit VaR uses a longer time horizon, often one year, due to the differing frequency of the risk events they measure.
D
The time horizon for credit VaR is generally shorter than market risk VaR, as credit events such as defaults and downgrades occur more frequently than market price changes.