Continuing Education

Part 1 : Risk methodologies

Risk Trees
in the Woods
By Peter Davies
Sailfish Systems

With multiple risk methodologies to

choose from, treasurers should know
what each does and then apply that
most appropriate within the context of
their company's business objectives.

In going public with i ts RiskMetrics

methodology, JP Morgan has put a
very bright spotli ght on risk eva lu ation
methods. As attractive as Ri skMetri cs
is, particu larl y to corporate treasurers,
there are other m ethodolo g ies that
treasurers should be awa re of.
This overview of the three primary
types of risk meas urement- deterministic, probabilistic, and analyti ca lshould help treasury ri sk managers to
quickly identify th e trees (a ltern ate risk
measurement m et h odo lo g i es) and
keep their eyes o n the forest (managing the risks aris ing from their company's business objecti ves).

Deterministic methods
The deterministic m e thod o lo g i es
in c lud e scenarios, se nsitivi ty, th e
"Greeks" (de lta, ga mm a, etc .), and
stress testing. Th ese methods are those
most w id ely supported in traditional
trading systems as they are ofte n used
by fin anc ial traders.

Deterministic risk measurement methods require those employing them to

specify what they expect future market rates (scenarios) to be and value
their positions accordingly. The risk
measured, therefore, is that arising if
the expected rates indeed occur.
Traditionally, determini st ic methods
we re used by traders to measure the
risk of p roducts with t he sa m e ri sk
characte ri st ics - e.g., spot FX or US
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treasury notes . The sim p li city of th e

risk st ru cture in suc h instruments
makes it easy fo r traders to judge how
the relatively few risk factors affectin g
their positions may behave- these
op inion s are inh erent in their trad in g.
Th e p roblem w ith deterministic
methods is that they are highly tra nsaction o rie nted. They foc us on the
p ri ci ng and executio n of a stream of
individual dea ls, acco untin g for the
fact that eac h o ne may be misvalued
before it ca n be hedged or closed. The
"G reeks" gained popularity, fo r exa mple, because they alert trade rs to margin al se nsitivity to mispricing any price
variab le.
Deterministic methods are not as
we ll suited to assessi ng the risk of a
portfolio of d ive rse in st rum ents (e.g. ,
derivatives). Thi s is part icul arly true in
a cor porate treasury co ntext w here
t reas urers are not the direct expert
trader- i.e., where operati ng management creates the und erlyin g positions.
Even very good traders can not assess
the reaso nab leness of sce nario s that
cover many risk factors (market rates
as we ll as comp lex pos iti o ns)- let
alon e t he positions of ot hers. Thu s,
ad ditional risk measurement methodo logies sho uld be used to help manage ri sk beyond the tactical leve l.
Even w ith tactical risks, however,
"traders" should not be left to manage
their ow n positions. Stress-testing,
hi ghli ghted in the G-30 recommendations, is an important part of an overall risk measurem ent po li cy . It looks at
the extremes, the unthinkables, and
the intentionall y irrationa l. It balances
th e trader' s mentali ty that positions
can always be traded o ut of -even in
extreme stress. Management can take
so me comfort in knowing what kinds
of extreme markets w ill have the most
dire conseq uences for their positions .

Probabilistic methods
Th e probab ili stic methods includ e: JP
Morgan ' s RiskMetrics, Monte Ca rl o
simul atio n, and historical simul atio n.
Ge n era ll y speaki ng, probabilistic
methodologies forgo the ce rtainty of

determi ni stic methods and measure

risks resu lting from an uncertain range
of rates or prices.
The key to mo st probabi I i sti c
methodologies is the distribution function. It describes the range of uncerta inl y in the future rate or price "variab le" being dealt with . O nce a distributio n fu nctio n is chosen , a computer
can fi ll in the actual sa m p les w ithin
the distribution w ith as much detail as
demanded.

While probabilistic methods eliminate

the need for "traders" to make
assumptions about future rates/prices,
they do require "statisticians" to make
assumptions about how future rates/
prices are distributed.
The power of the distribution function is that a si n g l e function ca n
embody many details, e.g., any probab ility fo r any rate, thereby red uc in g
the number of c hoi ces or assumption s
needed. Un fortun ately, th e remainin g
c h o i ces a r e much mor e obscure.
Assumptions in probabilistic methodo logies require a familiarity with statist ica l descriptions of an in creas in gly
comp l ex a nd dynamic f i nanc i al
world-and their fa llibili ty.
There is a lso a second dimension
w hen probabi I is tic methods are used
to m eas ure the risk in a portfolio of
positions. Even if an appropri ate distribution funct io n for all the variables
affecting the a portfolio can be specified , eac h di stribution fun c tion i s
merely defining the range of expected
future "variab les" affecting eac h pos ition. To accu rate ly m eas ure the risk in
the portfolio, "statistic ians" must also
desc ri be the re l atio n ship between
these "variab les."
Th e relationship between rate/p ri ce
mov e m ents i s usu all y described in
terms of cova ri ance. Th e covar iance
approach quantifies these re lationshi ps by taking hi storica l data samp les
and ca lcu latin g the distributions and
re latio nshi ps from past obse rvations .
Covar i ance models are att ract i ve
beca use they enab le risk measurers to
red uce a lot of sa mpl e data into a few
Inte rn ational Treasurer/November 28, 1994

Financial Risk Measurement

numbers. If the historical samp l e is
bel ieved to be a good indi cator of
expected future rates, they can generate who le ran ges of expected future
rates based on the calcu lated probabilities of a single distribution function .
RiskMetrics is a specific implementation of a covar i ance mod e l. JP
Mor ga n has in vested its r esea rch
efforts into developing a set of fi nelynoned variance ~volatility) and covariance data that treasury can use w itho ut the effort of gather in g numbers
and pay ing for ana lysts.
The weakness in covar iance methods co m es from th e ve ry thing that
makes tnem powerfu I: tlie reduction
of a lot of data into a few descriptors.

To use a covariance risk model is to

accept that rates have one distribution
and that combinations of rates have
one relationship between them. Even
elementary experience suggests that
these assumptions are not true in
many, or even most cases.
Monte Carlo simulations take the
same ingredients as a cova rianc e
model (d istribution functions and
covariances) but introduce a degree of
uncertainty in estim ating the expected
rates. Instead of a trader or a statistician defining a likely risk parameter, a
comp uter makes a l arge number of
ra ndom draws from the specified distributions. The pattern of resulting
rates approximates (but does not
---~:e-xaGtl'{-matcn) the underlyin g distributions). We can think of this as though
the d istribution and covariance data
describes some underlyin g process in
th e f in ancia l markets . The randomness
of the draws reflects the " noi se" level
tha t overlays the underlying process.
To use and understand a Monte Carlo
risk estimate treasurers must be comfortab le with the stat istics behind the
distribution and covar iance estimates
as well as have an opinion about how
dominant the underl y in g process is
vers us the random risk observed dayto-day. In most cases, Monte Carlo
techniques are restr icted to the handful
of " quants" who have the answers to
Internati onal Treasurer/November 28, 1994

enter into th e machine and ca n subsequently und erstand the results.

Historical simul atio n is qu ite different from the other probabilist ic methods and has almost oppos ite strengths
and weaknesses. The probabilities
us ed in a hi storical simul ation are
take n direc tly from the observed
events of the p as t. A covar i ance
mode l wou ld use the same hi stor ica l
data, but reduc e it from , say, 3 00
observa ti ons to 3 stat ist ica l descriptions . A histori ca l simu lation wou ld
use all 500 observatio ns and sid estep
the iss ue of how to describe them.This
gets around th e biggest drawback of
cova ri ance, and, to a lesser deg ree,
Mo nte Carlo mod els: the ass umption
that there is one description for the
distribution of market variab les and
one description for the re lations hips
between them.
The lack of abstraction all ows historic al simulations to discriminate, fo r
exa mpl e, between hi gh vo lati lity days
and low vo lati lity days, up markets
from down markets, if that is the way
it is in the observed data . This is most
important where treasurers have very
specific price relat ionships at risk, as
is the case with derivatives. The
downsid e to hi stor ical simulation is
that it does not give the knowledgeab le user the ab ility to descr ib e the
underlyin g processes and see their
effec ts independently from a samp le
time ser ies . Rather, they use c hanges
in past periods to show the effects in
today' s markets if they were repeated.

Analytic methods
Th e analytic methods include lin ea r
and non- I i near regression techniques .
The analytic approaches are extensio ns
of probabi l istic models in that they
attempt to describe the way market
rates behave. Unlike the simpler probabilistic methodologies, the ana lyti c
methodologies are predictive: their purpose is to estim ate actual future rates .
Th e lin ear approaches are all based
o n more powerful statistical methods
than covariance . The most popu l ar
approac h is to use var iation s of auto-

corre lation analysis (ARCH , GARCH,

etc. ). Auto-corre lation desc ribes how
rates w ithin a ser ies are related to each
other rather than between seri es. These
effects are often described by market
participants as trends, cyc les, etc.
GARCH has attracted a great dea l of
attention in academ ic ci rc les and is
we ll recognized for its validity when
app li ed to hi g he 1 order processes ,
especia ll y vo lati lity. Volatility is persistent- it jumps up, then stays up with
a gradual decay over time . While the
und e rlyin g pr i ces may be moving
a round at r andom, we can use
GARCH to m ake a good estimate of
what the vo lati lity leve l will be in the
future based on where it is now .
These stati sti ca I techniques suffer
from the same prob lem as Monte Carlo
simulation in that they demand a significant degree of understanding on the
part of the user. Furthermore, GARCHtype ana lysi s may be a good estimator
of volat i I ity levels, but is not effective
for estimating price directions . Most
treasurers are as co ncerned about the
direction of rates/prices as they are
abo ut the volatility. In fact, movement
in the right d irection may not even be
cons idered a risk!
Th e mor e obscure, non-lin ea r
app roaches are really predictive trading syste ms. These systems are developed to predict the future path of rates,
taking into account that the future is
not simpl y based on the present by
either corre lation or autocorrelation .
The basic technologies used include
neural networks and fuzzy matrices. As
their names imply, these are esoteric
tools and their predictive (i.e ., biased)
estimator rol e makes them questionab le for risk measurement purposes.
In co nsiderin g any risk measurement
methodo logy, it is important for treasurers to keep in mind th at risk measurement is not their main objectiverisk management is. In part 2, I shall
provide some exa mpl es showing
which risk measures are more appropriate in m eet in g specific business

objectives.
Mr. Davies is reached at (2 12) 587-0007.
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