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

A plan sponsor's total portfolio has an annual VaR of 10 million. Manager X has a standalone VaR of 6 million and a component (marginal-based) VaR contribution of 4 million. If the sponsor removes Manager X's positions entirely, which is the best first-order estimate of the total VaR change using the component VaR?

The best estimate is a reduction of about 4 million. Component VaR is the manager's contribution to portfolio VaR after diversification, so it approximates the effect of removing the position. Standalone VaR of 6 million ignores diversification benefits and would overstate the reduction.

  1. AA reduction of about 6 million, the standalone VaR
  2. BA reduction of about 4 million, the component VaRCorrect
  3. CA reduction of about 10 million
  4. DNo change, since component VaR is only an accounting allocation

Explanation

Component VaR measures a position's contribution to total portfolio VaR so contributions sum to total VaR; it approximates the change from removing the position. Standalone VaR ignores diversification and overstates the reduction.

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