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FRM Part II · FRM Exam Part II · Portfolio Risk: Analytical Methods

A risk manager is deciding whether to add a new USD 20 million position to an existing portfolio. She wants the change in portfolio VaR from adding the whole position, recognizing that the position is large enough that the linear approximation is poor. Which measure is most appropriate?

Incremental VaR computed as portfolio VaR with the position minus VaR without it is best. It fully captures the effect of a large trade, whereas marginal or component VaR rely on a linear approximation suited only to small changes, and stand-alone VaR ignores diversification.

  1. AIncremental VaR computed as the difference between portfolio VaR with and without the positionCorrect
  2. BMarginal VaR multiplied by the position size
  3. CComponent VaR of the new position in the current portfolio
  4. DStand-alone VaR of the new position

Explanation

Incremental VaR is measured by fully revaluing VaR with and without the position, so it captures nonlinearity for large trades. Marginal VaR times size is only a first-order approximation valid for small changes. Component VaR is an allocation of existing risk, and stand-alone VaR ignores diversification.

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