The RiskMetrics Group is best known for its leadership in the development of transparent risk estimation methodologies and easy-to-use software tools. The founders of the Group have long recognized, however, that there is much more to risk management that just risk measurement. Indeed, perhaps too much public focus has been placed on the sophistication and apparent precision of risk estimation models, and not enough on the more important managerial and judgmental elements of a strong risk management framework. These include the clarity of risk policies, the strength of internal control, the degree of management discipline, the level of internal risk transparency, and ultimately, the experience and market knowledge of risk management professionals. No technical document, however complete and rigorous, can impart that experience and knowledge.

To contribute to a better understanding of these broader elements of risk management, and in response to frequent client inquiries, the experienced professionals of the RiskMetrics Group have developed this practitioner's oriented guide to Risk Management. While the details of the subject matter can, at times, be technical and complex, the essence of the guide is helping practitioners to get the right information on the right issues to the right people at the right time. Not with a view to producing a single right answer, but with a confidence that the right questions will then be asked, leading to the best informed, experienced judgments.

As with all other elements of risk management, the state-of-the-art guide will itself need to be open to continuous improvement, as new techniques are developed in response to ongoing innovations in markets and risk products. This first edition of the guide focuses on market risk analysis and reporting, while also touching upon closely related issues of counterpart risk reporting and external risk disclosures.

Stephen G. Thieke
Chairman
RiskMetrics Group

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1.1 History of Value-at-Risk 3
1.2 VaR, relative VaR, marginal VaR, and incremental VaR 4
1.3 Overview of risk methodologies 8
1.4 Confidence level scaling factors 11
1.5 Time scaling of volatility 12
1.6 Components of market risk 13
1.7 Basic dimensions of market risk 15
1.8 Summary 20
Chapter 2. Stress testing 21
2.1 Why stress test 21
2.2 Two central questions for stress testing 22
2.3 How to use stress tests 23
2.4 What makes a good stress test 24
2.5 Forecasting time frame 26
2.6 How often to stress test 26
2.7 Steps for stress testing 26
2.8 Creating stress scenarios 27
2.9 Summary of stress tests 36
Chapter 3. Backtesting 39
3.1 Why backtest 39
3.2 Backtesting VaR vs. actual P&L 39
3.3 Accounting for non-position taking income 41
3.4 Backtesting VaR vs. hypothetical trading outcomes 41
3.5 Interpreting backtesting results 42
3.6 Other factors to consider in analyzing backtests 43
3.7 External disclosures of backtests 44
3.8 Backtesting summary 44
Part II Risk Management and Reporting
Chapter 4. Practical problems risk managers face 49
4.1 Risk reporting 49
4.2 How to use risk reports 50
4.3 What type of information is required 50
viii Table of contents

 
   
 

 

4.4 What risk solutions to choose 51
4.5 Summary of issues facing risk managers 53
Chapter 5. Generating a risk report 55
5.1 What makes a good risk report 55
5.2 What are the major types of risk reports 58
5.3 How to organize a risk report 60
5.4 Time dimensions in risk reporting 60
5.5 Global bank case study 61
5.6 Leveraged fund case study 68
5.7 Investment manager case study 71
5.8 Corporate case study 74
5.9 Summary of risk reporting issues 79
Chapter 6. External risk disclosures 81
6.1 Introduction 81
6.2 Emerging global standards for public disclosures 81
6.3 Voluntary risk disclosure for non-financial corporations 86
6.4 SEC disclosure requirements for derivatives 88
6.5 Summary 89
Chapter 7. Using risk information 91
7.1 Linking risk and return 91
7.2 Risk and performance 91
7.3 Risk and capital 93
7.4 Summary 95
Chapter 8. Market data for risk reporting 97
8.1 Type and quantity of market data 97
8.2 Deriving volatilities and correlations from raw historical data 98
8.3 Use of historical versus implied volatilities 99
8.4 Exponential weighting of time series 100
8.5 Log price change of GBP/DEM and 95% VaR estimates 100
8.6 What is good market data 100
8.7 The task of the risk data analyst 101
8.8 Where to get market risk data 102
8.9 Summary 102
Chapter 9. Position data for risk mapping 105
9.1 The data collection process 105
9.2 What type of position information is required 106
9.3 Principles of cashflow mapping for interest rate risk 107
9.4 Mapping commodities 108
9.5 Mapping equities 108
9.6 Choosing a methodology 109
9.7 Summary 110
Chapter 10. Evaluating a risk software vendor 111
10.1 How to choose a risk solution 111
10.2 Summary 113
10.3 Conclusion 114
Table of contents ix

Appendices
Appendix A. Risk-based limits 117
Appendix B. Credit exposure of market-driven instruments 119
Appendix C. The independent risk oversight function 125
Glossary of terms 127
Resources 137
Index 139

 

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