1

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
RISKMETRICS
Dr Philip Symes
2

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
1. Introduction

RiskMetrics is JP Morgan's risk management

methodology.

It as released in 1!!"

This as to standardise risk analysis in the industry.

Scenarios are generated using#

$istorical simulation%

Theoretical modelling%

Stress testing scenarios.

Metholodolgies are discussed in the short term limit

Collateral is not modelled.

3

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
&. Contents
This 'resenation ill (ocus on these to'ics.

Risk )actors in the RiskMetrics a''roach.

Methodologies (or risk management.

Products and 'ricing (rameorks.

Risk analysis and re'orting.

4

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
*. Risk )actors

The main (actors a((ecting 'ort(olio +alue are modelled

in RiskMetrics.

E,uities#

Indi+idual 'rices -a.solute or relati+e to an inde/ -011%

Inde/ le+els2 e.g. )TSE 133%

4((ects e,uities and e,uity (utures5o'tions.

)6 rates#

4((ects cash 'ositions2 )6 (orards5o'tions and

currency sa's.

Commodity 'rices#

Construct constant maturity cur+es%

4((ects s'ot and (uture 'rices.

5

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
". Risk )actors (cont)

Interest rates are the (ourth ma7or (actor.

8ield cur+es are constructed (rom

9ero cou'on and cou'on .ond 'rices%

interest rate sa' 'rices.

Continuously com'ounded interest rate is used (or

sim'licity

other IR 'ayments must .e con+erted

6

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
:. Risk )actors -cont1

Cou'on .onds are 'riced in terms o( 9ero cou'on

.onds.

E/am'le#

;ond maturing in 1 year%

Semi<annual cou'on o( 13=#

Same 'rocess is a''lied to sa's.

IR are used (or 'ricing sa's2 o'tions and (i/ed income.

7

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
>. Risk )actors -cont1

RiskMetrics also deals ith less ma7or (actors that a((ect

'rice.

Credit s'read#

Construct yield cur+es ith similar ,uality instruments%

Cali.rate# add a s'read to each security.

Im'lied +olatility#

?sed (or 'ricing o'tions%

4ssume constant im'lied +olatility i( no historic data.

8

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
@. Em'irical Models

Aistri.ution o( returns is gi+en .y 'ast 'er(ormance

Bo theoretical models are used.

The historical simulation method#

?ses o.ser+ations o( actual changes in risk (actors%

E+ents are scaled ith their (re,uency o( occurrence%

Models these changes to generate scenarios.

Past o.ser+ations must .e scaled according to their

+olatility -Hull & White Model1.

Method includes e/treme returns that occurred during

the historical 'eriod.
9

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
C. Em'irical Models (cont.)

Changes in asset 'rices are con+erted to risk (actors.

)ormalise ideas in a matri/ R o( historical returns using

o( n risk (actors ith m daily returns#

So each ro o( R corres'onds to a s'eci(ic scenario r.

10

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
!. Em'irical Models -cont.1

D.tain a T<day PEF scenario (rom R#

Take ro5scenario r (rom R;

This gi+es a +ector o( 'rices P -(or each risk (actor1.

D.tain 'rice P o( risk (actor T days (rom no using

Price each instrument using P

0
and scenario 'rice P
T
.

The 'ort(olio PEF is gi+en .y

11

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
13. Theoretical Models

The multi+ariate normal model is used to 'redict returns#

This model assumes lognormal returns%

Geometric random alk%

This is standard < see Hull or Wilmott (or more details.

Ari(ts are assumed to .e 9ero -+olatility dominates1#

Bo accurate 'redictions a+aila.le (or time hori9ons

.elo * months%

Hero assum'tion as good as any 'rediction.

12

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
11. Theoretical Models -cont.1

The return on the risk (actor ith these assum'tions is#

Iolatility estimated (rom e/'onentially eighted mo+ing

a+erage#
13

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
1&. Theoretical Models -cont.1

4n e/'onentially eighting mo+ing a+erage scheme is

used to determine the decay (actors#

The o'timal +alue as (ound .y (inding the minimum

mean s,uare di((erence .eteen the +ariance
estimate and the actual s,uared return on each day.

Aecay (actors ere set at#

3.!" -1<day1 (rom 11& days o( data%

3.!@ -1<month1 (rom &&@ days o( data.

The num.er o( days included comes (rom the (act that

!!.!= o( in(ormation is contained in the last
days
ln 10 ln
3
14

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
1*. Theoretical Models -cont.1

This does not 'reclude a hea+y tailed unconditional

distri.ution

E.g. i( +olatilities de'endent on the day o( the eek2

then days could .e dealt ith se'arately.

Dne day returns are#

J
Conditioned on the current
le+el o( +olatility%
J
Inde'endent across time%
J
Bormally distri.uted.
K RiskMetrics
15

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
1". Theoretical Models -cont.1

Multi+ariate method can .e generalised to include

multi'le risk (actors#
L
these are correlated ith a co+ariance matri/.

In this case2 the return (or each asset i is no gi+en .y#

4nd the co+ariance .eteen i and j .y#

16

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
1:. Theoretical Models -cont.1

The co+ariance matri/ is most easily ritten as#

Mhere the m/n matri/ o( eighted returns is#

17

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
1>. Theoretical Models -cont.1

Monte Carlo -MC1 simulation#

Generates scenarios (rom o( random num.ers%

See MC in Finance presentation for more details.

Generating random scenarios#

?se Princi'le Com'onent 4nalysis to deri+e (ormula.

18

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
1@. Theoretical Models -cont.1

The c
ij
used in the (ormula are not uni,ue#

These coe((icients satis(y certain re,uirements.

They .uild u' a +ector C o( units Nc
ij
O.

The co+ariance matri/ can then .e ritten as#

4nd the +ector o( returns as#

19

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
1C. Theoretical Models -cont.1

Inde'endent standard normal +aria.les -ISBI1 are used

to generate random scenarios#

F'Ecuyer method ith &/13

1C
'eriod%

Mill take 13
13
years to re'eat scenarios.

Matri/ decom'osition .y Cholesky or Single Ialue

decom'osition methods#

See FI!" 'resentation (or details on matri/

decom'osition%

Bote that Cholesky decom'osition only orks (or

'ositi+e de(inite matrices%

;ut any negati+e terms are redundant anyay.

20

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
1!. Theoretical Models -cont.1
The scheme to generate the MC +aria.les is#
11 Generate a set # o( ISBI%
&1 Trans(orm ISBI to set o( returns r2 correlated to
each risk (actor using matri/ C (rom c
ij
so

*1 D.tain the 'rice o( each risk (actor -as (or historical
simulation1%
"1 Price each instrument at current 'rice and 1<day
'rice scenario%
:1 Get 'ort(olio PEF -as (or historical simulation1.
21

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
&3. Theoretical Models -cont.1

Parametric methods -PM1 are an alternati+e to MC.

The method uses a''ro/imate 'ricing (or e+ery

instrument to get analytic (ormulae#

4ssumes lognormality o( returns.

PM uses a PQ<methodR#

It models changes in asset +alues in a 'ort(olio%

This is .ased on a linear a''ro/imation.

This makes PM (aster than MC

MC is still o(ten 're(erred as it is more accurate.

22

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
&1. Theoretical Models -cont.1

The 'resent +alue $ is gi+en .y a 1

st
order Taylor
e/'ansion#

There is a sim'le e/'ression (or PEF here Q are Pdelta

e,ui+alentsR#
23

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
&&. Theoretical Models -cont.1

4ssume the lognormality o( returns2 .ecause#

Fognormal returns aggregate nicely across time

-tem'oral additi+e1%

Dne 'eriod returns are inde'endent%

This im'lies that the +olatility scales ith root o( time

consistent ith MC%

4+erage PEF (rom this method is 3 since instrument

'rices and risk le+els are linear.

The alternati+e is 'ercentage returns

These aggregate across assets.

24

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
&*. Stress Testing

Stress tests are needed to com'lement statistical

models#

Stress tests and models 'redict di((erent ty'es o(

scenarios%

Stress tests need certain ty'es o( credi.le

scenarios.

Selection o( stress e+ents is im'ortant2 and can .e#

$istorical e+ents

E.g. Te,uila crisis in 1!!:%

?ser de(ined sim'le scenarios

E.g. interest rate stee'eners%

?ser de(ined 'redicti+e models

These take account o( correlations2 etc.

25

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
&". Stress Testing -cont.1

?sing historical e+ents is a use(ul ay o( creating

meaning(ul scenarios

Mhat ould ha''en to my 'ort(olio i( the e+ents that

caused % crash ha''ened againS

In general2 .eteen times t and T2 the historical returns

are gi+en .y#

The PEF (or the 'ort(olio .ased on this is#

26

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
&:. Stress Testing -cont.1

The 'ort(olio must .e re+alued .ased on the e+ents in

the stress scenario.

The RiskMetrics (rameork#

Ae(ines changes (or a su.set o( PcoreR (actors%

?ses these to 'redict the e((ect on P'eri'heralR

(actors.

Co+ariance matrices are used (or multi'le core (actors

4''roach corres'onds to multi+ariate regression -as

.e(ore1.
27

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
&>. Stress Testing -cont.1

E/am'le ith 1 core (actor#

T12333 in Indonesian JSE e,uity inde/%

Scenario o( 13= currency de+aluation -IAR1#

Mith &U3.&2 JSE inde/ dro's .y an a+erage &=.

28

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
&@. Pricing )rameork# ;asic Conce'ts

Cash(los are the .uilding .locks (or descri.ing

'ositions in RiskMetrics.

Cash(los must alays .e ma''ed and discounted#

The BPI o( a cash(lo is the 'roduct o( cash(lo

amount and discount (actor%

Cash(lo ma''ing means that 'rinci'al and cou'on

'ayments are con+erted to their e,ui+alent 9ero
cou'on rates at the 'ayo(( date.

8ield cur+es are treated in RiskMetrics as 'ieceise

linear.

Points .eteen +ertices are 7oined ith straight lines.

RiskMetrics uses continuous com'ounding -see earlier1.

29

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
&C. Pricing )rameork E/am'les

The (irst e/am'le is a (i/ed cou'on .ond#

Auration & yr%

Par +alue T133%

Interest rate := '.a.%

semi<annual cou'ons%

(irst cou'on ".@:= at > m#

sum o( discounted
cash(los# T!C.3*
Inter'olation o( interest rates
(rom term structure
K RiskMetrics
30

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
&!. Pricing )rameork E/am'les -cont.1

E.g. a +anilla interest rate sa'#

)i/ed (or (loating2 'ith e/change o( notionals%

1.&: y to maturity.

)loating leg#

)irm recei+es ><mo FI;DR -ne/t +alue >.3=1%

?se cash(lo ma''ing (or *2 ! E 1: months#

)i/ed leg#

)irm 'ays := semi<annually on T133M notional#

Ialue o( sa'#
31

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
*3. Pricing )rameork E/am'les -cont.1

D'tions can also .e 'riced in this (rameork2 e.g. a

.ond o'tion.

;lack's Model is an e/tension o( ;lack<Scholes#

4ssumes lognormal distri.ution o( the +alue o( the

underlying at maturity%

Can .e used (or Eu o'tions2 IR deri+ati+es2 ca's E

(loors and sa'tions.
32

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
*1. Pricing )rameork E/am'les -cont.1

The .ond (orard 'rice2 F2 is gi+en .y#

Consider a 13<month Eu .ond o'tion on#

!.@:<year .ond2 T12333 'ar +alue2 rU13= semi<annual

cou'on%

Airty 'rice T!>3 and clean 'rice o( (UT12333%

*2 ! and 13 month risk (ree IR's are !=2 !.:= and 13=
'.a.%

VU!= annualised +olatility o( TU13 month .ond 'rice%

T:3 cou'ons in * months and ! months%

;ond (orard 'rice is#

D'tion 'rice is T!."!

33

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
*&. Risk Measures

Ialue 4t Risk is the industry standard methodology#

It states that2 at a certain con(idence limit -e.g. !!=1

no more that W% ill .e lost in a T day 'eriod%

The current +alue o( 'ort(olio is used (or 'redicting

losses%

I4R is the method s'eci(ied in ;asel &.

Marginal I4R -MI4R1 is an e/tension to the I4R

'rinci'le#

It shos the amount o( risk a 'articular 'osition is

adding to 'ort(olio%

It uses the 'arametric a''roach to se'arate out the

risks and (ind correlations.
34

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
**. Risk Measures -cont.1

Incremental I4R -II4R1is similar to MI4R#

II4R uses MI4R to ad7ust 'ort(olio risk%

It shos the sensiti+ity o( I4R to 'ort(olio changes.

$oe+er2 there are se+eral dra.acks ith I4R#

There is no estimate o( the si9e o( losses once the

I4R limit is e/ceeded%

I4R is not a coherent measure o( risk.

35

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
*". Risk Measures -cont.1

Coherent measures o( risk ha+e these 'ro'erties#

Translational in+ariance

4dding cash to a 'ort(olio decreases risk .y the

same amount%

Su.additi+ity

Risk o( the sum o( 'ort(olios is smaller than the

sum o( their indi+idual risks%

Positi+e homogeneity o( degree 1

I( the si9e o( the 'ositions dou.les2 the risk ill

dou.le%

Monotonicity

I( 'ort(olio 4 has higher losses than ; (or all risk

(actors2 then 4 is riskier than ;.
36

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
*:. Risk Measures -cont.1

E/'ected short(all -ES1 'ro+ides more in(ormation than

I4R on tail o( the PEF distri.ution#

It gi+es an a+erage measure o( ho hea+y the tail is%

It is a con+e/ (unction o( 'ort(olio eights

use(ul (or risk o'timisation%

The ES is alays higher than the I4R.

ES is a coherent risk measure.

Com.ined ith I4R2 ES gi+es a measure o( the cost o(

insuring 'ort(olio losses

These to methods are com'lementary.

37

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
*>. Risk Re'orting

4t the sim'lest le+el2 re'orting is 7ust a PEF histogram

Shos I4R and e/'ected short(all

MC shos loest
(igures
K RiskMetrics
$istorical simulation
shos most
conser+ati+e (igures
38

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
*@. Risk Re'orting -cont.1

D(ten need more detailed analysis to dissect risk and

identi(y risk sources in a 'ort(olio.

Arilldons slice<u' 'ort(olio risk to gi+e more details.

Arilldon dimensions are these su.<categories#

Position%

Port(olio%

4sset ty'e%

Counter'arty%

Currency%

Risk ty'e -)62 IR2 etc.1%

8ield cur+e maturity.

39

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
*C. Risk Re'orting -cont.1

Arilldon dimensions come in to main grou's.

PPro'er dimensionsR are grou's o( 'ositions#

Position assigned to one .ucket so easy to calculate%

E.g. PregionR could assign I4R to di((erent regions.

PIm'ro'er dimensionsR are grou's o( risk (actors#

Position might corres'ond to more than one .ucket%

E.g. an )6 sa' has IR risk2 )6 risk and to yield

cur+es.

Simulation or 'arametric methods must .e used.

40

P
h
i
l
i
p

S
y
m
e
s
,

2
0
0
6
*@. Summary

RiskMetrics is the industry standard risk analysis

methodology#

;ut does not include collateral.

Me ha+e dealt only ith non<collateralised trades in

the short<term limit.

RiskMetrics can handle trades in di((erent asset classes

Some e/am'les ha+e .een shon.

RiskMetrics handles risk .y de(ining core risk (actors2

analyses the risk using : di((erent methods and re'orts
the risk using & metrics.

RiskMetrics can .e e/'anded to include non<normal

distri.utions2 co'ulas2 etc.