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

A risk manager uses a delta-normal VaR model for a portfolio that contains a large short position in out-of-the-money equity put options. Which limitation of the analytical approach is MOST relevant to this portfolio?

The delta-normal model treats option payoffs as linear, so it ignores gamma. A short out-of-the-money put loses more than delta suggests in a large market fall, so analytical VaR can materially understate tail losses for this portfolio.

  1. AThe model ignores the nonlinear payoff of options, so it can understate tail lossesCorrect
  2. BThe model requires a full revaluation of each option in every simulated scenario
  3. CThe model cannot be used when the portfolio contains more than one risk factor
  4. DThe model assumes that returns are serially correlated over the holding period

Explanation

Delta-normal VaR approximates option payoffs linearly using delta. A short out-of-the-money put has negative gamma, so large market moves produce losses larger than the linear approximation implies. Full revaluation is a feature of simulation methods, not of the delta-normal approach, and the model handles many risk factors through a covariance matrix.

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