Marginal VAR

[notjusttp]

Pls consider the following question

In a two-position portfolio consisting of positions X and Y, it is found that the marginal VAR of X is greater than that of Y. Using this information, which of the following is most likely to be TRUE?
Answer is Increasing the allocation to: a. X and/or reducing the allocation to Y will move the portfolio toward the optimal portfolio

Doubt

How is this true? If marginal VAR of X is greater allocating a larger portion of investible asset would increase the risk and thus move away from an optimal portfolio.

Thanks & Rgds

 

[David Harper CFA FRM]

HI notjusttp:

I don't think the question can be answered.
Per Jorion Ch 7, portfolio optimization is achieved by increasing the allocation to the component (position) with the highest:
expected return/marginal VaR or expected return/beta
...until the portfolio reaches an "equilibrium" where all components have the same ratio of return/marginal VaR.

(note: this is analogous to maximizing the sharpe ratios, where are all return/return metrics, RAPMs). What each "portfolio optimization" approach has in common is the idea of optimizing a portfolio RAPM (risk-adjusted performance metric; i.e., Sharpe ratio under traditional Markowitz theory) by increasing allocation to the component(s) with the highest RAPM, until such "rebalancing" gets to an equilibrium where all RAPMs (e.g., expected return/marginal VaR) are the same.

such that, if position X has higher ratio of (expected return)/(marginal VaR) than position Y, then the allocation to position X should be increased until they "meet" at the optimal portfolio ratio....

...so I don't think it can be answered without expected returns...

David

 

[notjusttp]

David,

Thanks a lot for the amazing explanation. Your Clarity of thoughts is amazing. 1 more question. Is this kind of question expected for level 1 exam as i would be appearing for the same in this Nov.

Thanks & Best Rgds
Amit

 

[David Harper CFA FRM]

Amit, glad to help...

No, IMO this above L1 and squarely in Level 2: Jorion Ch7 is L2 and appropriately found in the "portfolio" aspects of investment management...David