International Finance and Accounting Handbook

8.3 CALCULATING MARKET RISK EXPOSURE. Large commercial banks, invest-
ment banks, insurance companies, and mutual funds have all developed market risk
models. In developing these models—so-called internal models—three major ap-
proaches have been followed:

1.RiskMetrics (or the variance/covariance approach)

2.Historic or back simulation

3.Monte Carlo simulation

We consider RiskMetrics^5 first and then compare it to other internal model ap-
proaches, such as historic or back simulation.

8.4 RISKMETRICS MODEL. The ultimate objective of market risk measurement
models can best be seen from the following quote by Dennis Weatherstone, former
chairman of J.P. Morgan (JPM), now J.P. Morgan Chase: “At close of business each
day tell me what the market risks are across all businesses and locations.” In a nut-
shell, the chairman of J.P. Morgan wants a single dollarnumber at 4:15 PMNew York
time that tells him J.P. Morgan’s market risk exposure the next day—especially if that
day turns out to be a “bad” day.
This is nontrivial, given the extent of JPM’s trading business. As shown in Exhibit

8 • 4 MARKET RISK

Foreign

Fixed Exchange Emergency

Income STIRT* Commodities Derivatives Equities Markets Proprietary Total

Number of active 14 12 5 11 8 7 11 14
locations
Number of 30 21 8 16 14 11 19 120
independent
risk-taking
units
Thousands of >5 >5 <1 <1 >5 <1 <1 >20
transactions
per day
Billions of dollars >10 >30 1 1 <1 1 8 >50
in daily trading
volume

*Short-term interest rate instruments.

Source:J.P. Morgan, Introduction to RiskMetrics(New York: October 1994). http://www.jpmorganchase.com.

Exhibit 8.2. JPM’s Trading Business.

(^5) J.P. Morgan (JPM) first developed RiskMetrics in 1994. In 1998 the development group formed a
separate company, partly owned by JPM. The material presented in this chapter is an overview of the
RiskMetrics model. The details, additional discussion and examples are found in “Return to RiskMetrics:
The Evolution of a Standard,” April 2001, available at the J.P. Morgan Chase website, http://www.jpmorgan-
chase.comorwww.riskmetrics.com.