Explanation:
The correct answer is C.
Sarah has correctly identified and applied the roles of VaR and tracking error within the context of risk planning, risk budgeting, and risk monitoring. VaR is used as the threshold for potential losses, guiding capital allocation among various asset classes according to their risk and return preferences. Meanwhile, tracking error serves as an indicator of the amount of active management discretion that can deviate from benchmark returns. However, Sarah's proposal does not mention the frequency of risk monitoring, which is a crucial aspect of an effective risk management process.
A is incorrect. VaR is indeed an appropriate tool for risk budgeting. It helps determine the threshold of acceptable losses and can guide the allocation of capital among various asset classes based on risk and return preferences.
B is incorrect. Tracking error can certainly be used as a guide for the amount of active management discretion. It helps determine how much a portfolio's performance can deviate from a benchmark, serving as a guide for active management.
D is incorrect. The uses of VaR and tracking error in Sarah's approach are appropriate. VaR should be used in risk budgeting and planning while tracking error is useful in determining the discretion in active management.
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Q.2525 Bridgewater Asset Management recently set up a new division and hired Sarah as the Risk Manager. Sarah has been tasked to align the company's risk management process with the firm's overall investment strategy. She begins by reviewing the firm's Value at Risk (VaR), Tracking Error, and the three dimensions of risk management: risk planning, risk budgeting, and risk monitoring. After some consideration, Sarah proposes the following approach: "Let's define VaR as our threshold for the maximum dollar value of losses we are willing to bear for a specific level of confidence over a specific time. We can then use this VaR as a guide to allocate capital among different asset classes based on their risk and return preferences. Additionally, we can use tracking error as a guide for the amount of discretion that can be taken away from benchmark returns for active management. With these measures in place, we can effectively plan, budget, and monitor our risks." Which of the following accurately critiques Sarah's approach?
A
Sarah's proposal is fundamentally flawed as VaR should never be used in risk budgeting.
B
Sarah's approach is incorrect as tracking error cannot be used as a guide for active management discretion.
C
Sarah has correctly applied VaR and tracking error to risk planning, budgeting, and monitoring, but the frequency of risk monitoring needs to be established.
D
Sarah's approach is incorrect as the use of VaR and tracking error should be reversed in risk planning and risk budgeting.