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Probability and Statistics Applied to the Practice of Financial Risk Management: The Case of JP Morgan's RiskMetrics™

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  • Michael Phelan

Abstract

RiskMetrics was unveiled by JP Morgan in October of 1994. RiskMetrics is JP Morgan's risk management product that is based on the bank's methodology for the management of financial risk. The methodology specifies an approach to quantifying market risk for the purpose of managing and controlling financial risk in trading, arbitrage, and investment activities. This paper describes the application of probability and statistics in RiskMetrics with the purpose of identifying problems for further research, attracting statisticians to this line of investigation, and establishing a framework for collaboration with financial economists and managers of financial risk. The discussion centers on the four applications of probability and statistics in RiskMetrics : 1) the statistical analysis of returns in the estimation of market risk, 2) the time series properties and statistical description of volatility, 3) the treatment of risk and optionality, and 4) a methodology for mapping financial instruments that relies on the CIR model for the term structure of interest rates. Included in the paper are suggestions for future research. Also included is a summary of the RiskMetrics product and a glossary of risk management terms.

Suggested Citation

  • Michael Phelan, 1995. "Probability and Statistics Applied to the Practice of Financial Risk Management: The Case of JP Morgan's RiskMetrics™," Center for Financial Institutions Working Papers 95-19, Wharton School Center for Financial Institutions, University of Pennsylvania.
    • Handle: RePEc:wop:pennin:95-19
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    File URL: http://fic.wharton.upenn.edu/fic/papers/95/9519.pdf
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    References listed on IDEAS

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    1. Cox, John C. & Ingersoll Junior, Jonathan E. & Ross, Stephen A., 2007. "A theory of the term structure of interest rates," RAE - Revista de Administração de Empresas, FGV-EAESP Escola de Administração de Empresas de São Paulo (Brazil), vol. 47(2), April.
    2. Robert A. Jarrow, 2009. "The Term Structure of Interest Rates," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 69-96, November.
    3. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
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    2. Dimson, Elroy & Marsh, Paul, 1997. "Stress tests of capital requirements," Journal of Banking & Finance, Elsevier, vol. 21(11-12), pages 1515-1546, December.
    3. Billio, Monica & Pelizzon, Loriana, 2000. "Value-at-Risk: a multivariate switching regime approach," Journal of Empirical Finance, Elsevier, vol. 7(5), pages 531-554, December.
    4. David Feldman & Xin Xu, 2018. "Equilibrium-based volatility models of the market portfolio rate of return (peacock tails or stotting gazelles)," Annals of Operations Research, Springer, vol. 262(2), pages 493-518, March.
    5. Ryohei Kawata & Masaaki Kijima, 2007. "Value-at-risk in a market subject to regime switching," Quantitative Finance, Taylor & Francis Journals, vol. 7(6), pages 609-619.

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