LO 4.3: Differentiate am ong the three methods o f m apping portfolios o f fixed

LO 4.3: Differentiate am ong the three methods o f m apping portfolios o f fixed income securities.
After we have selected our general risk factors, we must map our portfolio onto these factors. The three methods of mapping for fixed-income securities are (1) principal mapping, (2) duration mapping, and (3) cash flow mapping.
Principal mapping. This method includes only the risk of repayment of principal amounts. For principal mapping, we consider the average maturity of the portfolio. VaR is calculated using the risk level from the zero-coupon bond that equals the average maturity of the portfolio. This method is the simplest of the three approaches.
Duration mapping. With this method, the risk of the bond is mapped to a zero-coupon bond of the same duration. For duration mapping, we calculate VaR by using the risk level of the zero-coupon bond that equals the duration of the portfolio. Note that it may be difficult to calculate the risk level that exactly matches the duration of the portfolio.
Cash flow mapping. With this method, the risk of the bond is decomposed into the risk of each of the bonds cash flows. Cash flow mapping is the most precise method because we map the present value of the cash flows (i.e., face amount discounted at the spot rate for a given maturity) onto the risk factors for zeros of the same maturities and include the inter- maturity correlations.

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