Query - LVAR

[Avishek]

Hi David,

Could really make sense out of the below solution. I couldn't solve it but luckily got the correct answer. Can you please explain why the LVAR formula (considering absolute LVAR since mean is not provided) is not being applied?

Question - A $10 MM portfolio has a daily volatility of 0.50 percent and a bid-ask spread of 0.05 percent. What is the daily liquidity-adjusted VAR (LVAR) for the portfolio at the 99 percent confidence level?

A) $116,300.

B) $2,576.

C) $112,576.

D) $118,800.

Your answer: D was correct!

Solution:
VARP = (0.005)(2.326)($10 MM) = $116,300

LVARP = $116,300 + ($10 MM)(0.0005 / 2) = $118,800

Thanks, Avi

 

[David Harper CFA FRM]

Avi,

You have some point. It will be a bad/imprecise question if they do not insert "assume the mean is zero" or "assume the daily mean is 0.x%" (This was included in my list of observations to GARP regarding the test, specifically this sort of thing about the LVAR since they assigned a reading that uses the mean in the LVAR)...but that said...

When you see "daily volatility" and no mean (expected return) is specified, just assume zero for the expected mean. And the mean term will drop out. This was Jyothi's point in another thread: she was saying that in regard to daily VaR, when we can assume zero return, there is no difference between absolute and relative.

So, we can still apply the LVAR formula:

http://learn.bionicturtle.com/images/forum/lvar_dowd.jpg

(10 MM)[-0 + (.05%)(2.33) + (0.5)(0.0005)] = 119,000

David