Question

Q1. Discuss the JP Morgan RiskMetrics Model for measuring market risk and explain how it can be applied for FX, equity and bond portfolios.

Q2. John Orange, Vice President of operations of ABC Bank, is estimating the aggregate DEAR of the bank’s portfolio of assets consisting of loans (L), foreign currencies (FX), and common stock (EQ). The individual DEARs are £25,310, £23,155, and £67,328 respectively. If the correlation coefficients ρ_ij between L and FX, L and EQ, and FX and EQ are -0.2, 0.5, and 0.8, respectively, what is the DEAR of the aggregate portfolio?

Answer 1

During the late 1980s, J.P. Morgan developed a firm-wide value-at-risk system. This modeled several hundred key factors. A covariance matrix was updated quarterly from historical data. Each day, trading units would report by e-mail their positions’ deltas with respect to each of the key factors. These were aggregated to express the combined portfolio’s value as a linear polynomial of the risk factors. From this, the standard deviation of portfolio value was calculated. Various value-at-risk metrics were employed. One of these was 1-day 95% USDvalue-at-risk, which was calculated using an assumption that the portfolio’s value was normally distributed.

With thisvalue-at-risk measure, J.P. Morgan replaced a cumbersome system of notional market risk limits with a simple system ofvalue-at-risk limits. Starting in 1990, value-at-risk numbers were combined with P&L’s in a report for each day’s 4:15 PM Treasury meeting in New York. Those reports, with comments from the Treasury Group, were forwarded to Chairman Weatherstone.

One of the architects of the new value-at-risk measure was Till Guldimann. His career with J.P. Morgan had positioned him to help develop and then promote the value-at-risk measure within the firm. During the mid 1980s, he was responsible for the firm’s asset-liability analysis. Working with other professionals, he developed concepts that would be used in the value-at-risk measure. Later, as chairman of the firm’s market risk committee, he promoted the value-at-risk measure internally. As fate would have it, Guldimann’s next position placed him in a role to promote the value-at-risk measure outside the firm.

In 1990 Guldimann took responsibility for Global Research, overseeing research activities to support marketing to institutional clients. In that capacity he managed an annual research conference for clients. In 1993, risk management was the conference theme. Guldimann gave the keynote address and arranged for a demonstration of J.P. Morgan’s value-at-risk system. The demonstration generated considerable interest. Clients asked if they might purchase or lease the system. Since J.P. Morgan was not a software vendor, they were disinclined to comply. Guldimann proposed an alternative. The firm would provide clients with the means to implement their own systems. J.P. Morgan would publish a methodology, distribute the necessary covariance matrix, and encourage software vendors to develop compatible software.

Guldimann formed a small team to develop something for the next year’s research conference. The service they developed was called RiskMetrics. It comprised a detailed technical document as well as a covariance matrix for several hundred key factors, which was updated daily. Both were distributed without charge over the Internet. The service was rolled out to the public with considerable fanfare in October 1994. A public relations firm placed ads and articles in the financial press. Representatives of J.P. Morgan went on a multi-city tour to promote the service. Software vendors, who had received advance notice, started promoting compatible software.14