In portfolio risk management, which calculation method includes correlation between assets?

The correct answer, concerning the inclusion of correlation between assets in portfolio risk management, is related to the specific way in which portfolio VaR (Value at Risk) is calculated. The Dollar Portfolio VaR calculation refers to a method that takes into account the various risk factors that can affect a portfolio, including the correlation between the assets in that portfolio.

When assets are combined in a portfolio, their individual risks do not simply add up because their price movements are often related. This correlation can either increase or decrease the overall risk profile of the portfolio. A proper Dollar Portfolio VaR calculation employs a covariance matrix which incorporates the correlation coefficients among the separate assets. This adjustment allows for a more accurate measure of potential loss, reflecting how diversification among assets impacts the total risk.

In contrast, the simple summation of individual VaRs does not account for this interaction between different asset classes, leading to an overstated risk estimation. Similarly, stating that no correlation adjustment is needed ignores the reality of how varied asset returns can be interrelated. The formula involving the squares of individual VaRs and the correlation could conceptually illustrate a scenario for calculating a combined VaR, but it is not a standard approach for calculating a Dollar Portfolio VaR.

Thus, the right method