RiskMetrics is a methodology that an investor can use to calculate the value at risk (VaR) of a portfolio of investments.
Launched in 1994 by J.P. Morgan, RiskMetrics was upgraded by the company in partnership with Reuters in 1996. The companies teamed up to make the data used in RiskMetrics widely available to individual investors. RiskMetrics is now owned by MSCI.
VaR is, at its core, focuses on the potential downside risk of an investment.
- RiskMetrics is a method for calculating the potential downside risk of a single investment or an investment portfolio.
- The method assumes that an investment's returns follow a normal distribution over time.
- It provides an estimate of the probability of a loss in an investment's value during a given period of time.
The RiskMetrics methodology for calculating VaR assumes that a portfolio or any asset's returns follow a normal distribution over time. Following J.P. Morgan's and Reuters' release of its volatility and correlation data sets, the variance-covariance method used to calculate the VaR became an industry standard, as RiskMetrics intended.
For example, the profit and loss distribution of an investment portfolio is assumed to be normally distributed. Using the RiskMetrics methodology to calculate the VaR, the portfolio manager must first select a confidence level and a lookback period.
Suppose the lookback period selected is one trading year, or 252 days. The confidence level selected is 95%, and the corresponding z-score value must be multiplied by the standard deviation of the portfolio.
VaR is essentially a measurement of the potential downside risk of an investment.
The actual daily standard deviation of the portfolio over one trading year is 3.67%. The z-score for 95% is 1.645.
The VaR for the portfolio, under the 95% confidence level, is -6.04% (-1.645 * 3.67%). Therefore, there is a 5% probability that the loss of the portfolio, over the given time horizon, will exceed 6.04%.
Another method to calculate the VaR of a portfolio is to use the correlations and standard deviations of stock returns provided by RiskMetrics. This method also assumes that stock returns follow a normal distribution.
The first step to calculating VaR is taking the square of the allocated funds for the first asset, multiplied by the square of its standard deviation, and adding that value to the square of the allocated funds for the second asset multiplied by the square of the second asset's standard deviation.
That value is then added to two multiplied by the allocated funds for the first asset multiplied by the allocated funds for the second asset multiplied by the first and second asset's volatility and the correlation between the two assets.
For example, suppose a portfolio has two assets with $5 million allocated to stock ABC and $8 million allocated to stock DEF. Respectively, the price volatility of stock ABC and stock DEF is 2.98% and 1.67% for a one-day period.
The correlation between the two stocks is 0.67. The value at risk is $258,310.93 (sqrt(($5 million)^2 * (0.0298)^2 + ($8 million)^2 * (0.0167)^2 + (2 * $5 million * $8 million * 0.0298 * 0.0167 * 0.067)).