Impact of High-Yield Bonds on Portfolio VaR

Very Hard Risk Management Applications Value At Risk

Aman Financial Services (AFS) manages a portfolio of diverse assets and is focused on calculating the Value at Risk (VaR) to understand potential losses under various market conditions. The portfolio has a current value of $10 million with a 1-day VaR at the 95% confidence interval calculated to be $600,000. AFS is examining the potential effects of a market downturn on its portfolio and seeks to adjust its risk management strategies based on this VaR assessment.

Recently, AFS has been experimenting with a new asset allocation strategy that includes a heavier weighting in high-yield bonds, which historically have higher returns but significantly higher volatility compared to government bonds. The risk manager at AFS has argued that this strategy may improve returns, but could also increase the overall VaR of the portfolio due to the attached risks from high-yield bond volatility.

Given this situation, which of the following statements is TRUE regarding the impact of the new asset allocation on the portfolio’s VaR?

The new strategy will decrease the portfolio's VaR due to higher expected returns from volatility.

The new strategy will increase the portfolio's VaR because high-yield bonds contribute more risk than government bonds.

The new strategy will have no effect on the portfolio's VaR as VaR is primarily driven by equity investments.

Hint

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