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FRM Part II · FRM Exam Part II · VaR and Risk Budgeting in Investment Management

A fund's risk budget allocates VaR to desks. Desk X has a stand-alone VaR of USD 4 million but a component VaR of USD 0.5 million because it is negatively correlated with the rest of the portfolio. How should the risk manager interpret this when setting limits?

Component VaR shows Desk X contributes little to portfolio risk because of its negative correlation with the other desks, so it reflects diversification. Limits based on it are reasonable but must be revisited, since component VaR depends on the rest of the portfolio and shifts as positions change.

  1. ADesk X's contribution to portfolio risk is small, so a limit based on component VaR reflects its diversification benefit, though component VaR will change as the other positions changeCorrect
  2. BDesk X should be limited to USD 0.5 million stand-alone VaR because that is its true risk
  3. CDesk X adds USD 4 million to portfolio VaR whatever the other desks hold
  4. DComponent VaR is invalid for desk X because it is less than stand-alone VaR

Explanation

Component VaR captures a desk's contribution given the existing portfolio, including diversification. It is lower than stand-alone VaR when correlation with the rest is low or negative. It is context-dependent, so limits need review as positions change. Stand-alone VaR is not the contribution.

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