8 • 1

CHAPTER

8

MARKET RISK

Anthony Saunders

New York University

Marcia M. Cornett

Southern Illinois University

CONTENTS

8.1 Introduction 1
8.2 Market Risk Measurement 3
8.3 Calculating Market Risk Exposure 4
8.4 RiskMetrics Model 4
(a) Market Risk of Fixed-Income
Securities 5
(b) Foreign Exchange 9
(c) Equities 10
(d) Portfolio Aggregation 10
8.5 Historic or Back Simulation
Approach 14
(a) Historic (Back Simulation)
Model versus RiskMetrics 17
(b) Monte Carlo Simulation
Approach 18

8.6 Regulatory Models: The BIS

Standardized Framework 18

(a) Fixed Income 19

(i) Specific Risk Charge 19

(ii) General Market Risk Charge 19

(iii) Vertical Offsets 21

(iv) Horizontal Offsets

within Time Zones 22

(v) Horizontal Offsets

between Time Zones 22

(b) Foreign Exchange 22

(c) Equities 22

8.7 BIS Regulations and Large Bank

Internal Models 23

8.8 Summary 26

8.1 INTRODUCTION. In recent years, the trading activities of financial institutions
have raised considerable concern among regulators and FI analysts alike. Major FIs
such as Merrill Lynch, Citigroup, and J.P. Morgan Chase have taken big hits to their
profits from losses in trading.^1 Moreover, in February 1995, Barings, the U.K. mer-
chant bank, was forced into insolvency as a result of losses on its trading in Japanese
stock index futures. In September 1995, a similar incident took place at the New York
branch of a leading Japanese bank, Daiwa Bank. The largest trading loss in recent
history involving a “rogue trader” occurred in June 1996 when Sumitomo Corp. (a
Japanese bank) lost $2.6 billion in commodity futures trading. 1997 was another rel-

*Reprinted with permission. Anthony Saunders and Marcia Millon Cornett, Financial Institutions
Management: A Risk Management Approach.New York: McGraw-Hill, 2002.

(^1) For example, one trader cost Merrill Lynch over $370 million in 1987 by taking a position in mort-
gage-backed security strips.