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

A risk budgeting committee finds that an equity sleeve has a component VaR equal to 55% of total fund VaR but holds only 30% of fund capital. Which action is most consistent with using component VaR for risk budgeting?

The committee should review whether the sleeve's 55% risk contribution is justified by its expected excess return relative to other sleeves. Component VaR measures actual risk contribution, which differs from capital weight, so risk budgets should be compared with return per unit of risk.

  1. AReview whether the sleeve's risk contribution is justified by its expected excess return relative to other sleevesCorrect
  2. BCut the sleeve's stand-alone VaR to zero
  3. CAllocate risk equally across sleeves regardless of return
  4. DIgnore the finding because capital weights define risk

Explanation

Component VaR shows each sleeve's contribution to total risk, so it can be compared with expected return contribution when budgeting risk. A sleeve using 55% of risk with 30% of capital warrants scrutiny of its return per unit of risk. Capital weights do not measure risk contribution, and equal risk allocation ignores return.

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