Suppose there are two investments A and B. Either investment A or B has a 4.5%...

 

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Suppose there are two investments A and B. Either investment A or B has a 4.5% chance of a loss of $15 million, a 2% chance of a loss of $2 million, and a 93.5% change of a profit of $2 million. The outcomes of these two investments are independent of each other. (a) What is the 95% VaR of investment A? How about investment B? (b) What is the 95% for a portfolio consisting of both investments A and B? (Hint: write out the probabilities of all possible portfolio outcomes.) (c) Is the summation of the 95% VaRs of the individual investments greater or smaller than the 95% VaR of the portfolio? If we measure the risk of an investment or portfolio using VaR, does this suggest that diversification must decrease risk? (Intuitively, putting A and B in a portfolio is a form of diversification.) Suppose there are two investments A and B. Either investment A or B has a 4.5% chance of a loss of $15 million, a 2% chance of a loss of $2 million, and a 93.5% change of a profit of $2 million. The outcomes of these two investments are independent of each other. (a) What is the 95% VaR of investment A? How about investment B? (b) What is the 95% for a portfolio consisting of both investments A and B? (Hint: write out the probabilities of all possible portfolio outcomes.) (c) Is the summation of the 95% VaRs of the individual investments greater or smaller than the 95% VaR of the portfolio? If we measure the risk of an investment or portfolio using VaR, does this suggest that diversification must decrease risk? (Intuitively, putting A and B in a portfolio is a form of diversification.)

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aThe 95 VaR of investment A is 2 million and the 95 VaR of investment B is also 2 million The 95 VaR of investment A is the amount of loss that is exp... View the full answer