Can someone please explain this sentence, ” if the total risk budget is equal to each sub-portfolio’s individual VAR, there is a risk that this approach may cause underutilization of capital.”
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A portfolio is made up of sub-portfolios.
The risk of each sub-portfolio may be measured by its VAR.
To find the risk of the entire portfolio, if we use the sum of VAR of each sub-portfolio then that would be wrong.
Why?
There may be two or more sub-portfolios that are affected by the same risk factor. So, if we add up the VAR for all these sub-portfolios, we would be counting the same risk factor’s impact multiple times at a Portfolio level. This means that we would believe there’s higher risk than there actually is, and would invest our capital more conservatively than required thereby underutilising it.