In the RiskMetrics methodology, a portfolio of
financial instruments is broken down into a number of cash flows,
each occurring at a particular time. This leads to an unmanageable
number of combinations of cashflow dates when many financial
instruments are considered.
To avoid an intractable number of correlations and volatilities in
the VaR calculation, the RiskMetrics methodology simplifies the
time structure by mapping each cash flow to a pre-specified set of
RiskMetrics vertices.
In the next section, we present the current RiskMetrics cash flow
mapping methodology which works well under most circumstances, but
was recently found to produce undesirable results under extreme
vertex volatility and correlation scenarios. Then, we present a
simple alternative that preserves most of its properties and
behaves well under extreme circumstances. The last section
summarizes our findings. |
