2. Following the recent credit crisis of 2007 and 2008, regulators proposed the

calculation of stressed Value at Risk (VaR).

(a) Critically discuss the above argument highlighting the importance and the difference between stress testing and back testing.

(b) Consider a position consisting of a $250,000 investment in asset A and a $450,000 investment in asset B. Suppose that the daily volatilities of these two assets are 1.9% and 1.4% respectively, and that the coefficient of correlation between their returns is 0.4

i. What is the 10-day 99% VaR for the portfolio?

ii. By how much does diversification reduce the VaR?