15. You have a portfolio with a large investment in the Carpathia EUR 6% 07 bond. This bond rarely trades. Indicative bid prices for small size trades are posted for the bond, but they are mostly from dealers wanting to express a willingness to make negotiated trades. However, the Carpathia USD 9 3/8% 11 bond is liquid. Its dollar return is uncorrelated with the EUR/USD rate. Which of the following statements is correct?

A. The one-day USD VaR computed using the dollar return of the Carpathia USD 9 3/8% 11 bond is an unbiased estimate of the risk of the Carpathia EUR 6% 07 in dollars

B. The one-day VaR for the Carpathia EUR 6% 07 bond using daily indicative bid prices for the bond is an upward-biased estimate of the risk of the bond because the bid-ask spread on an illiquid bond is large

C. It is more appropriate to estimate the VaR of the Carpathia EUR bond using a mix of bonds to account for errors in the bond prices than just using the EUR bond

D. Unless a EUR futures position and a long position in the Carpathia USD bond replicate the Carpathia EUR bond, the VaR for the EUR bond should be computed over a multiple day horizon to account for illiquidity 

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The traditional VAR models are, by construction, static.  Increasing the risk horizon from one day to multiple days does not make the model static.  Additionally, traditional VAR models assume to use market data from liquid markets.  Liquidity risk cannot be factored into a traditional VAR model.  Thus, unless the EUR bond can be replicated by a liquid EUR futures position and a long position in the 9 3/8% 11 bond (both of which are liquid assets), dynamic VAR must be used.

Reference:  Understanding Market, Credit, and Operational Risk, Allen, Boudoukh and Saunders, 2004

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