The Risk Of Individual Investments

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To remedy for the latter, the risk of individual investments in the portfolio is mapped to more common market risks when we compute VaR. Before we proceed with an example involving bonds, two terms have to be defined: coupon bond and a zero coupon bond. A coupon bond is a debt investment in which an investor loans money to a company for a period of time. The company, the borrower, in return promises to make interest payments called coupons over a defined period of time and also pay the full amount of the loan at the end of the period. A zero coupon bond on the other does not pay coupon interest. Suppose that we want to determine the VaR of a 10-year coupon bond with annual coupons C in our portfolio. First, we break the 10-year coupon…show more content…
Finally, we compute the Value at Risk by using the weights on the standardized instruments that we previously computed. Again, before we proceed with an example involving this time forward contract, we should define what a forward contract is and how it is used in financial markets. Futures contracts are contractual agreement to buy or sell a particular commodity or financial asset at a predetermined price in the future. The contract usually details the quantity and quality of the underlying asset to be delivered in the future. Suppose now that we want to find the VaR of a six-month dollar to euro forward contract. We compute the VaR going through the following four steps: We first map the standardized market risks and instruments underlying this security. Second, we determine the position needed to be taken in the standardized instruments. We then estimate the variances and covariance of these instruments and we finally compute the VaR in the forward contract.
Step 1: Again, we are looking forward to map the standardized market risks and the instruments underlying this security. The market variables that affect the six-month forward contract are the six-month risk free rate in each currency (dollar and euro) and the spot exchange rate. We hence match up the previous market factors respectively to a six-month zero coupon dollar bond, a six-month zero coupon euro bond and the spot dollar to euro.
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