Explanation:
The manager's approach is incorrect because it completely disregards the effects of diversification. In a portfolio, assets are usually correlated with each other. This correlation leads to a diversification effect when these assets are combined in a portfolio. Diversification effect refers to the reduction in risk that can be achieved by combining different kinds of investments within a portfolio. The risk reduction is possible because different investments will respond differently to the same event; while some investments might suffer, others might benefit. Therefore, the total portfolio VaR cannot be calculated by simply adding up the individual VaRs of the assets. Doing so would completely ignore the diversification effect, which is a crucial aspect of portfolio risk management. Therefore, the manager's proposed method is flawed and does not accurately reflect the true risk of the portfolio.
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Q.2470 A portfolio manager intends to decompose the portfolio risk in order to compute the contribution of each asset to the overall portfolio VaR. The manager argues that taking individual VaRs, adding them up, and computing their individual percentages will provide the component VaR of each asset. Which of the following statements is accurate?
A
The manager is correct.
B
The manager is incorrect as the method adopted completely ignores the diversification effects.
C
The manager is incorrect as the method adopted assumes a non-linear VaR.
D
The manager is incorrect as the method adopted assumes a linear VaR.
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