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FRM Part II · FRM Exam Part II · VaR Mapping

A risk officer notes that mapping a large bond portfolio onto a handful of vertices has made the VaR calculation much faster. Which is the most important limitation she should keep in mind?

The key limitation is that mapping can understate risk because specific or basis risk not captured by the chosen risk factors is left out. The simplification speeds computation but loses residual risk. It does not ignore diversification and it is commonly applied to bonds.

  1. AMapping always overstates VaR because it ignores diversification
  2. BMapping removes interest rate risk but leaves credit risk unchanged
  3. CMapping can understate risk by ignoring specific or basis risk not captured by the chosen risk factorsCorrect
  4. DMapping requires that all positions be linear in the underlying factors, so it cannot be used for bonds

Explanation

Mapping represents positions through selected factors, so risk unexplained by those factors (specific or basis risk) is omitted, potentially understating VaR. It does not systematically ignore diversification, and it is routinely applied to bonds.

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