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

A portfolio has a 1-day 95% VaR of USD 10.00 million. A risk manager considers adding a new position. The post-trade portfolio VaR is USD 10.60 million, while the new position's stand-alone VaR is USD 3.00 million. Which conclusion is best supported?

Incremental VaR is USD 0.60 million, the difference between post-trade VaR of 10.60 and pre-trade VaR of 10.00. Being far below the USD 3.00 million stand-alone VaR, it shows substantial diversification. It is positive, so the position adds risk rather than hedging.

  1. AIncremental VaR is USD 0.60 million, showing substantial diversification benefit versus stand-alone VaRCorrect
  2. BIncremental VaR is USD 3.00 million because stand-alone VaR measures the change in risk
  3. CIncremental VaR is USD 10.60 million, the new total VaR
  4. DIncremental VaR is negative, so the position is a hedge

Explanation

Incremental VaR is the change in portfolio VaR from adding the position: 10.60 - 10.00 = USD 0.60 million. This is well below the stand-alone VaR of USD 3.00 million, indicating a large diversification benefit. Stand-alone VaR ignores interaction with the existing portfolio. A positive change means it is not a hedge.

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