8.2, when JPM developed its RiskMetrics Model it had 14 active trading locations
with 120 independent units trading fixed income securities, foreign exchange, com-
modities, derivatives, emerging-market securities, and proprietary assets, with a total
daily volume exceeding $50 billion. This scale and variety of activities is typical of
the major money center banks, large overseas banks (e.g., Deutsche Bank and Bar-
clays), and major insurance companies and investment banks.
Here, we will concentrate on measuring the market risk exposure of a major FI on
a daily basis using the RiskMetrics approach. As will be discussed later, measuring
the risk exposure for periods longer than a day (e.g., five days) is under certain as-
sumptions a simple transformation of the daily risk exposure number.
Essentially, the FI is concerned with how much it can potentially lose if market
conditions move adversely tomorrow; that is:
More specifically, the market risk in terms of the FI’s daily earnings at risk
(DEAR)has three measurable components:
(1)Since price sensitivity multiplied by adverse yield move measures the degree of
price volatility of an asset, we can also write Equation (1) as Equation (2):
(2)How price sensitivity and an “adverse yield move” will be measured depends on
the FI and its choice of a price-sensitivity model as well as its view of what exactly
is a potentially “adverse” price (yield) move.
We concentrate on how the RiskMetrics model calculates daily earnings at risk in
three trading areas—fixed income, foreign exchange (FX), and equities—and then
how it estimates the aggregate risk of the entire trading portfolio to meet Dennis
Weatherstone’s objective of a single aggregate dollar exposure measure across the
whole bank at 4:15 PMeach day.^6
(a) Market Risk of Fixed-Income Securities. Suppose an FI has a $1 million market
value position in zero-coupon bonds of seven years to maturity with a face value of
Daily earnings at risk 1 Dollar market value of the position 2 1 Price volatility 2 1 Potential adverse move in yield 2 1 Price sensitivity of the position 2Daily earnings at risk 1 Dollar market value of the position 2Market riskEstimated potential loss under adverse circumstances8.4 RISKMETRICS MODEL 8 • 5(^6) It is clear from the above discussion that interest rate risk (see Chapter 7) is part of market risk.
However, in market risk models we are concerned with the interest rate sensitivity of the fixed-income
securities held as part of an FI’s active trading portfolio. Many fixed-income securities are held as part
of an FI’s investment portfolio. While the latter are subject to interest rate risk, they will not be included
in a market risk calculation.