medium · FRM Part 2 Risk & Investment Management

Which explanation is correct, and what does it imply for hedging?

1. Component VaR depends on each strategy's marginal contribution — its correlation/covariance with the total portfolio — not its stand-alone VaR; relative-value can have lower component VaR if it is less correlated with the portfolio, so cutting macro reduces total VaR more per dollar.
2. Component VaR is simply the stand-alone VaR of each strategy scaled by the portfolio's overall diversification ratio, so the ranking must always match the stand-alone VaR ordering exactly; the report has transposed the two strategies here and needs correcting before any hedge.
3. Component VaR equals marginal VaR multiplied by the square root of the position weight, so a smaller relative-value position automatically yields a smaller component VaR regardless of correlation; reduce whichever strategy carries the larger notional exposure to cut risk fastest.
4. Because component VaRs must always sum to a total that exceeds portfolio VaR by the size of the diversification benefit realized, the relative-value figure reported here is understated; the correct remedial action is to gross up both components proportionally, then hedge the larger one first.

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