hard · 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 scaled by the portfolio diversification ratio, so the ranking must match stand-alone VaR; the report has transposed the two strategies and should be corrected before any hedging decision.
3. Component VaR equals marginal VaR times the square root of the position weight, so a smaller relative-value position automatically yields smaller component VaR regardless of correlation; reduce whichever strategy has the larger notional to cut risk fastest.
4. Because component VaRs must sum to a value exceeding portfolio VaR by the diversification benefit, the relative-value figure is understated; the correct action is to gross up both components proportionally and then hedge the larger one.

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