You invest $100 in a corporate bond. You estimate that with probability 0.95, the corporation will pay back the promised amount of $110 at the end of one year; with probability 0.04, the corporation will default and the recovered amount will be $70; and with probability 0.01, the corporation will default and you will recover nothing. The 95%-VaR in this scenario is
A) $30
B) $40
C) $70
D) $100

Question

You invest $100 in a corporate bond. You estimate that with probability 0.95, the corporation will pay back the promised amount of $110 at the end of one year; with probability 0.04, the corporation will default and the recovered amount will be $70; and with probability 0.01, the corporation will default and you will recover nothing. The 95%-VaR in this scenario is 
A) $30
B) $40
C) $70
D) $100

Quizplus · Accepted Answer

The 95%-VaR is the maximum loss not exceeded with 95% confidence. In this scenario, with 95% probability, you will get $110, so the loss is $0. The worst 5% outcomes are $70 and $0, with losses of $30 and $100, respectively. The 95%-VaR is the smallest loss in the worst 5% of cases, which is $30.

You Invest $100 in a Corporate Bond