Hiram Life (Hiram), a large multinational insurer located in Canada, has received permission to increase its ownership in an India- based life insurance company, LICIA, from 26% to 49%. Before completing this transaction, Hiram wants to complete a risk assessment of LICIAs investment portfolio. Judith Hamilton, Hirams chief financial officer, has been asked to brief the management committee on investment risk in its India- based insurance operations. LICIAs portfolio, which has a market value of CAD 260 million, is currently structured as shown in Exhibit 1. Despite its more than 1,000 individual holdings, the portfolio is invested predominantly in India. The Indian government bond market is highly liquid, but the countrys mortgage and infrastructure loan markets, as well as the corporate bond market, are relatively illiquid. Individual mortgage and corporate bond positions are large relative to the normal trading volumes in these securities. Given the elevated current and fiscal account deficits, Indian investments are also subject to above- average economic risk. Hamilton begins with a summary of the India- based portfolio. Exhibit 1 presents the current portfolio composition and the risk and return assumptions used to estimate value at risk (VaR). Exhibit 1 Selected Assumptions for LICIAs Investment Portfolio Allocation Average Daily Return Daily Standard Deviation India government securities 50% 0.015% 0.206% India mortgage/infrastructure loans 25% 0.045% 0.710% India corporate bonds 15% 0.025% 0.324% India equity 10% 0.035% 0.996% Infrastructure is a rapidly growing asset class with limited return history; the first infrastructure loans were issued just 10 years ago. Hamiltons report to the management committee must outline her assumptions and provide support for the methods she used in her risk assessment. If needed, she will also make recommendations for rebalancing the portfolio to ensure its risk profile is aligned with that of Hiram. Hamilton develops the assumptions shown in Exhibit 2, which will be used for estimating the portfolio VaR. Exhibit 2 VaR Input Assumptions for Proposed CAD 260 Million Portfolio Method Average Return Assumption Standard Deviation Assumption Monte Carlo simulation 0.026% 0.501% Parametric approach 0.026% 0.501% Historical simulation 0.023% 0.490%Hamilton elects to apply a one- day, 5% VaR limit of CAD 2 million in her risk assessment of LICIAs portfolio. This limit is consistent with the risk tolerance the committee has specified for the Hiram portfolio. The markets volatility during the last 12 months has been significantly higher than the historical norm, with increased frequency of large daily losses, and Hamilton expects the next 12 months to be equally volatile. She estimates the one- day 5% portfolio VaR for LICIAs portfolio using three different approaches: Exhibit 3 VaR Results over a One- Day Period for Proposed Portfolio Method 5% VaR Monte Carlo simulation CAD 2,095,565 Parametric approach CAD 2,083,610 Historic simulation CAD 1,938,874 The committee is likely to have questions in a number of key areasthe limitations of the VaR report, potential losses in an extreme adverse event, and the reliability of the VaR numbers if the market continues to exhibit higher- than- normal volatility. Hamilton wants to be certain that she has thoroughly evaluated the risks inherent in the LICIA portfolio and compares them with the risks in Hirams present portfolio. Hamilton believes the possibility of a ratings downgrade on Indian sovereign debt is high and not yet fully reflected in securities prices. If the rating is lowered, many of the portfolios holdings will no longer meet Hirams minimum ratings requirement. A downgrades effect is unlikely to be limited to the government bond portfolio. All asset classes can be expected to be affected to some degree. Hamilton plans to include a scenario analysis that reflects this possibility to ensure that management has the broadest possible view of the risk exposures in the India portfolio