Asset Allocation - Babb Q5 on VAR

CFA Level III
#1

This is about Q5 of the Asset Allocation - Babb item set on the CFA web site.

We’re given a chart that shows probability distribution of fund returns.

It also provides the mean annual fund return and the fund return volatility.

The answer key uses the probabiliy distribution chart to solve, which I understand.

However, why can’t I also use the provided return and volatility to calculate the answer with:

[annual return - 1.65 (volatility)] x fund amount

Sure I’m missing something obvious but am traveling and don’t have books with me. Thanks.

#2

What kind of VaR is it asking for? Historical or analytical (variance-covariance)?

If it is analytical, then you would use the formula. If it is historical, then you would use the chart.

#3

Good point hei.so. Interestingly it doesn’t make the distinction in asking for either historical or analytical.

Re-reading the text, it does say that:

“Although Babb, Downing, and Lockwood believe that future expected fund returns can be based on the historical average (as shown in Exhibit 1), future annual volatility cannot.”

So I guess that should have been my prompt to not use the annual fund return volatility and instead look at the historical distribution.

#4

This one I had a trouble too.

I first computed the analytical VaR using given return, standard deviation, and z=1.65. The number was not in the multiple choices so I switched to the historical return distribution table to find out the return corresponding to cumulative bottom 5% probability. This led me to a number which was fortunately in the multiple choices.

Does anybody understand why we need to use historical return distribution table for this question?