Skip to content

FRM Part II · FRM Exam Part II · VaR Mapping

A risk manager at an asset management firm has a portfolio of 400 individual equities and wants to estimate its VaR. Rather than modeling each stock separately, she maps each stock to its sensitivity to a broad market index (its beta) and models the index return. Which statement best describes the main trade-off of this beta-mapping approach?

Beta mapping reduces the problem to one risk factor, the market index, which simplifies computation. However, it ignores stock-specific risk, so VaR is understated when the portfolio is concentrated and not well diversified. The other options misstate what the mapping does.

  1. AIt reduces the number of risk factors to one, but ignores the stocks' specific (idiosyncratic) risk, so VaR is understated for an undiversified portfolioCorrect
  2. BIt captures every stock's specific risk exactly, but requires a full covariance matrix of all 400 stocks
  3. CIt eliminates both systematic and specific risk, so VaR equals zero
  4. DIt increases the number of risk factors to match the number of stocks, improving accuracy

Explanation

Mapping on a single index replaces hundreds of risk factors with one, greatly simplifying VaR. The cost is that residual (specific) risk is dropped. For a well-diversified portfolio this is small, but for a concentrated one VaR is understated.

Did you get it right without looking?

One question tells you little. A timed set on VaR Mapping shows your real accuracy, how long you take and where you lose marks.

Practise VaR MappingFree diagnostic mock

More VaR Mapping questions