Explanation:
D is correct. The information given demonstrates that Bond F is riskier than Bond G. The average loss in the upper 1% tail of Bond F must be greater than that of Bond G. For both bonds, the 99% VaR is the loss that has a 1% chance of being exceeded, or GBP 10 million. Therefore, the 99% VaRs of the two bonds are equal, but this fails to reflect that Bond F is riskier than Bond G.
Learning Objective: Define the VaR measure of risk and describe assumptions about return distributions.
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Q-51. 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.