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

Michael Phelan

Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania

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.

Date: 1995-08
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