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

A pension fund with a USD 500 million portfolio is managed against a benchmark. The risk team reports two figures: the 95% one-month VaR of the total portfolio's dollar loss, and the 95% one-month VaR of the portfolio's return in excess of the benchmark. Which description of these measures is correct?

The first figure is absolute VaR, which measures the potential loss in the portfolio's total value, and the second is relative VaR, which measures the potential underperformance versus the benchmark and is driven by tracking error, the volatility of active returns.

  1. AThe first is absolute VaR and the second is relative VaR, which is based on tracking errorCorrect
  2. BThe first is relative VaR and the second is absolute VaR, which is based on tracking error
  3. CBoth are absolute VaR because both are measured in one month at 95%
  4. DBoth are relative VaR because the fund is managed against a benchmark

Explanation

Absolute VaR measures the potential loss in total portfolio value, ignoring any benchmark. Relative VaR (tracking error VaR) measures the potential shortfall of the portfolio versus its benchmark, so it rests on the volatility of active returns. The other options swap or conflate the two definitions.

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