September 2008 Edition

LETTER FROM CRAIG HEATTER

Welcome to the latest issue of the J.P. Morgan Investment Analytics and Consulting
newsletter, which aims to provide informative and thought-provoking articles on
topics relating to portfolio optimization. In this issue, we analyze the historical
returns and future prospects of private equity investments, explore the potential
benefits and pitfalls of an active currency management strategy, and provide an
overview of Value-at-Risk modeling, with a particular focus on Analytical VaR.
We welcome your thoughts and suggestions, and hope that this issue provides you
with useful information.

CRAIG HEATTER
MANAGING DIRECTOR AND GLOBAL EXECUTIVE FOR INVESTMENT ANALYTICS AND CONSULTING
J.P. MORGAN WORLDWIDE SECURITIES SERVICES
CRAIG.HEATTER@JPMORGAN.COM

ABOUT J.P. MORGAN INVESTMENT TABLE OF CONTENTS

ANALYTICS AND CONSULTING
J.P. Morgan Investment Analytics and Consulting (IAC) helps institutional clients Private Equity For Institutional
make more informed investment decisions and optimize their portfolios through Investors 2
creating customized, innovative, and forward-looking solutions that address both
current and future needs. IAC services over 230 clients globally with over 7,000 Can You Make Cash With
institutional portfolios, representing approximately $2 trillion in assets. Its diverse Currency? 5
client list includes corporate and public DB/DC pensions, investment managers,
endowments and foundations, corporate treasuries, insurance companies, central
banks, and investment authorities. Value-at-Risk: An Overview of
Having the broadest and deepest product offering in the market, IAC offers
Analytical VaR 7
security-level, multi-currency performance measurement (monthly and daily) using
J.P. Morgan or third party accounting; analytics and attribution at the asset class, Global Capital Markets 10
sector, country, and individual security level; ex-ante risk management (including
Risk Budgeting and security-level VaR); investment manager analysis, universe Global Market Indices 12
comparison, and peer grouping; global consolidated reporting for multi-national
plans; and consultative services in the areas of liability and plan allocation strategy,
manager search, and liability-driven investments.
For further information, please visit www.jpmorgan.com/visit/iac or
Americas: Europe, Middle East, Africa:
Mark Huamani Romain Berry
Executive Director Vice President
mark.huamani@jpmorgan.com romain.p.berry@jpmorgan.com
212-552-0527 44-20-7325-8981
Asia Pacific: Alex Stimpson
Stuart Hoy Vice President
Vice President alex.stimpson@jpmorgan.com
stuart.d.hoy@jpmorgan.com 44-12-0234-3386
612-9250-4733

Copyright ©2008 JPMorgan Chase & Co. All rights reserved.

 PRIVATE EQUITY

SPOTLIGHT
PRIVATE EQUITY FOR INSTITUTIONAL INVESTORS
by Karl Mergenthaler, CFA, and Chad Moten
J.P. Morgan Investment Analytics and Consulting
karl.c.mergenthaler@jpmorgan.com, chad.e.moten@jpmchase.com

Pension plans and other institutional investors are pouring money into private equity at an astounding rate. At this time, the
private equity industry accounts for approximately $1.5 trillion in invested capital, and private equity firms raised $300 billion
in fresh capital in 2007. Undoubtedly, there will be both winners and losers in this high-stakes, modern-day gold rush.
In our view, private equity involves a complicated risk and conducted by J.P. Morgan and Greenwich Associates, approx-
return proposition. Private equity investors may be attracted imately 62% of current investors in private equity expect to
to the potential for impressive returns that are not highly increase their allocations in the near term. In our view, plan
correlated with traditional equity and fixed income invest- sponsors should only consider allocations to private equity if
ments. Skeptics point to the multiple risks due to the illiquid they believe they are able to identify, and gain access to,
and opaque nature of the funds. managers that are likely to be in the top quartile.
The J.P. Morgan Investment Analytics and Consulting group
analyzed more than 5,500 private equity funds for vintage THE INVESTMENT CASE
years from 1990 through 2005, including both U.S. and In many ways, private equity holds the potential for huge
global funds and representing every major style. Our gains. Clearly, high rates of return are possible, particularly
analysis indicates that there is a wide range of performance among top-quartile funds. For example, top-quartile venture
between top quartile and median funds among every major capital funds that were raised between 1993-1997 generated
style. Moreover, the relative performance of private equity average internal rates of return of 52%. Likewise, buyout
funds versus the public equity markets has been mixed. funds that were raised between 2001-2005 generated
In our view, institutional investors face several hurdles to average internal rates of return of 40% for the top quartile.
investment success in private equity. Institutional investors In good times, private equity can generate outstanding
have to identify the funds, management teams, and deal investment results. In Exhibit 1, we summarize recent results
structures that are likely to result in positive results. for private equity.
Moreover, once attractive funds and strong managers are However, the risks are daunting. First, investment in private
identified, it is often difficult to gain access to the most equity is illiquid, and the money is often tied up for ten years
attractive funds. Finally, private equity partnerships typically or more. Second, the funds are often highly concentrated
involve annual fees of approximately 2% and carried interest and involve significant company-specific risks. Third, private
of 20% of profits. equity funds are not transparent, and there is frequently a
Nonetheless, investors seem willing to take their chances in lack of reliable, publicly-available information. Fourth, and
this challenging asset class. According to a recent survey perhaps most importantly, there is a wide dispersion
between the top performing funds and the rest of the pack.

Exhibit 1 – Private Equity Performance (as of Dec. 31, 2007)

1 Year 3 Year 5 Year 10 Year
U.S. Venture Capital Index 16.3% 14.1% 11.3% 35.2%
U.S. Private Equity Index 20.4% 25.1% 24.5% 14.1%
Global (ex-U.S.) Private Equity and Venture Capital 35.3% 36.0% 30.9% 19.7%
CSFB / Tremont Hedge Fund Index 6.7% 10.2% 10.8% 8.3%
Russell 2000 -1.6% 6.9% 16.3% 7.2%
Source: J.P. Morgan Investment Analytics & Consulting estimates, Cambridge Associates, CSFB/Tremont, Bloomberg.

Exhibit 2 – Fundraising
US Private Equity Fundraising Totals, 1993-2007
Venture Capital Other Mezzanine Capital Buyouts Fund of Funds
300,000

250,000
(US$ Millions)

200,000

150,000

100,000

50,000

0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: J.P. Morgan Investment Analytics & Consulting estimates, Dow Jones Private Equity Analyst.

SEPTEMBER 2008 EDITION — 2

 PRIVATE EQUITY

The amount of capital raised in private equity funds has
skyrocketed over the past five years. As shown in Exhibit 2,
the total amount of capital raised in private equity funds
increased to approximately $300 billion in 2007.
With the huge amount of capital raised, private equity funds
are searching for new markets to deploy the cash. For
example, emerging markets funds raised approximately $59
billion in 2007. In our opinion, the large inflow of capital
into private equity funds begs one question: Will future
results be as attractive as they have been historically?
HISTORICAL RETURNS – THE EVIDENCE IS MIXED
Our analysis suggests that investment success in private
equity is not a “lay-up.” First, there is a wide dispersion of
returns for similar funds, and top quartile funds tend to
perform much better than the median. Also, the relative
SPOTLIGHT
performance of private equity and the public markets is
mixed. Most importantly, our analysis suggests that the
ultimate returns of private equity funds that are raised in
years with high levels of fundraising are likely to be poor.
Clearly, there is a wide dispersion between top performing
funds and the median. Our analysis focuses on venture
capital and buyout funds, which together account for more
than 80% of assets invested in private equity. In Exhibits 3
and 4, we illustrate the top quartile and median returns for
venture capital and buyout funds with vintage years between
1990 and 2005.
As indicated in Exhibit 3, top quartile venture capital funds
out-performed median funds by 1,750 basis points for
vintage years between 1990 and 2005. Also, top quartile
buyout funds (see Exhibit 4) out-performed the median by
1,230 basis points during this time period.

Exhibit 3 – Venture Capital Exhibit 4 – Buyout Funds

Top Quartile Median Top Quartile Median
70.0% 70.0%

60.0% 60.0%

50.0% 50.0%

40.0% 40.0%
IRR
IRR

30.0% 30.0%

20.0% 20.0%

10.0% 10.0%
0.0%
0.0%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
-10.0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Vintage
Vintage

Source: J.P. Morgan Investment Analytics & Consulting estimates, Private Equity Source: J.P. Morgan Investment Analytics & Consulting estimates, Private Equity
Intelligence. Intelligence.

Exhibit 5 – Venture Capital Exhibit 6 – Buyout Funds

35.0 140,000
Buyout - Median IRR
20.0 Venture Capital - Median IRR 80,000 30.0 Russell 2000 (Annualized) 120,000
Russell 2000 (Annualized)
Fundraising 70,000 Fundraising
15.0 60,000 25.0 100,000
Fundraising ($M)

Fundraising ($M)

50,000
20.0 80,000
Returns
Returns

10.0 40,000
30,000 15.0 60,000
5.0 20,000
10,000 10.0 40,000
0.0 0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 5.0 20,000
-10,000
-5.0 -20,000
0.0 0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: J.P. Morgan Investment Analytics & Consulting estimates, Private Equity Source: J.P. Morgan Investment Analytics & Consulting estimates, Private Equity
Intelligence. Intelligence.

SEPTEMBER 2008 EDITION — 3

 PRIVATE EQUITY

SPOTLIGHT
Exhibit 7 – Diversification Benefits
Fund of
U.S. Small Lehman Wilshire Venture Private Hedge
Stocks AGG EAFE 5000 Capital Equity Timber Realty Funds
U.S. Small Stocks 1.00
Lehman AGG -0.20 1.00
EAFE 0.60 -0.14 1.00
Wilshire 5000 0.83 -0.12 0.76 1.00
Venture Capital 0.39 -0.17 0.33 0.44 1.00
Private Equity 0.58 -0.20 0.53 0.65 0.60 1.00
Timber -0.06 0.11 0.05 0.06 0.11 0.26 1.00
Realty -0.08 -0.18 0.10 -0.03 0.08 0.23 -0.21 1.00
Fund of Hedge Funds 0.37 -0.09 0.26 0.40 0.39 0.39 0.21 -0.13 1.00
Source: J.P. Morgan Investment Analytics & Consulting estimates, Cambridge Associates, Hedge Fund Research Inc.

The performance of private equity funds versus the public
equity markets has been mixed. We compared the internal
rate of return for private equity funds versus the annualized
time-weighted rate of return for the Russell 2000 over
comparable time periods. Although comparing results
between public and private equity is problematic due to the
different performance measurement methodologies, we
believe the comparison is directionally correct and provides
some useful information.
As indicated in Exhibit 5, venture capital funds that were
raised in the mid-1990’s posted returns in excess of the
Russell 2000. In our opinion, it is likely that many ventures
that were funded in the mid-1990’s were harvested in the
late-1990’s technology bubble. It is interesting to note that
funds raised in 1998-2002 (i.e., the strong fundraising years)
produced internal rates of return that were materially lower
than the public markets. In fact, based on our analysis, the
median venture capital fund has under-performed the Russell
2000 for most of the past decade.
Buyout funds raised over the past decade have out-
performed the Russell 2000 over the time period from 1995-
2005 (see Exhibit 6). In recent years, fundraising for buyout
funds sky-rocketed. Meanwhile, the differential between
median buyout funds and the Russell 2000 has been
declining in the most recent years.
DIVERSIFICATION
In order to assess the diversification benefits of private
equity, we analyzed the 20-year track record of the
Cambridge Venture Capital and Private Equity indices
relative to several traditional and alternative asset classes.
The results of our correlation analysis are summarized in
Exhibit 7.
The correlation of private equity to other asset classes is
low, which does indicate that there may be some diversifica-
tion benefit to participating in this asset class. However, we
would note that many of the correlations for other alterna-
tive assets, such as Timber and Funds of Hedge Funds, are
lower than those experienced by private equity. Also, we
believe the correlations may be understated due to the
infrequency of reporting for private equity and use of esti-
mates in calculating private equity returns. Therefore,
diversification should not be the sole reason to invest
in private equity.
CONCLUSIONS
In our view, an allocation to private equity may make sense
in the context of a large institutional portfolio. However,
investors in private equity should be aware of the wide
dispersion in results among funds with similar strategies. In
our view, the high levels of fundraising in recent years may
hinder the ability of private equity firms to generate stellar
results going forward.
We believe investors in private equity should take a long-
term view. It may make sense to spread out capital alloca-
tions over many years to dampen the impact of fundraising
cycles. We believe plan sponsors must analyze the details
of any individual private equity fund, and consider how that
fund is likely to perform in various market conditions.
Furthermore, plan sponsors should only consider alloca-
tions to private equity if they believe they are able to iden-
tify, and gain access to, managers that are likely to be in the
top quartile. In all, we believe it is worth the effort to
analyze private equity funds and consider allocating a
percentage of portfolio assets to this asset class.
For a copy of our complete white paper, “Private Equity for
Institutional Investors”, please contact Karl Mergenthaler at
karl.c.mergenthaler@jpmorgan.com.

SEPTEMBER 2008 EDITION — 4

 CURRENCY MANAGEMENT
CAN YOU MAKE CASH WITH CURRENCY?
by Paul Ha and Carlos Marenco
J.P. Morgan Investment Analytics and Consulting
paul.ha@jpmorgan.com, carlos.e.marenco@jpmorgan.com
Pension plans, endowments, and foundations allocate a significant portion of their total portfolio to foreign assets in both
developed and emerging markets. In a recent study of institutional investment strategies, the J.P. Morgan Investment Analytics
and Consulting group found that U.S. investors, on average, have targeted a 20% allocation to international investments.
This sizeable allocation, if left un-hedged, has benefited from the weakness in the U.S. Dollar over the last several years. For
the most recent year, the gain on currency has helped bolster these international equity returns by an estimated 9.64% (see
Exhibit 1). Even longer term, the currency gains as a proportion of the total international return has been significant.
Exhibit 1 - Foreign Currency Impact on Domestic Returns
(as of June 30, 2008)
YTD 1 Yr 3 Yr 5 Yr
EAFE - USD -10.96 -10.61 12.84 16.67
EAFE - Local -15.70 -20.25 6.66 11.22
Return from Currency 4.74 9.64 6.18 5.45
Source: J.P. Morgan Investment Analytics & Consulting estimates.
Since the U.S. Dollar is currently near all-time lows, we are
seeing an increasing number of U.S. institutional investors
revising, or at a minimum, reviewing their currency strategy.
In our opinion at this point in time, it is certainly possible that
the U.S. Dollar will bounce back, and that a strengthening
dollar could have an adverse effect on the returns of interna-
tional investments.
Foreign exchange rate risk and security valuation risk are the
two main types of investment risk associated with foreign
investments. Security valuation risk in foreign positions is
driven by a number of factors such as market, sector, industry
and stock specific – similar to the risk associated with
domestic investments. Foreign exchange rate risk is the risk
associated with the ownership of foreign securities that are
traded in a foreign currency. The FX risk is due to the implicit
currency exposure when holding these foreign positions.
Traditionally, when dealing with currency risk, institutional
investors have relied on three primary options: maintain
currency exposure, passively manage foreign currency expo-
sure, or actively manage foreign currency exposure. Recently,
J.P. Morgan Investment Analytics and Consulting has seen
more plan sponsors treat currency as a separate asset class in
an alpha-seeking strategy.
In this article, we will make a case for active currency manage-
ment through a pure currency alpha strategy. The argument
for an alpha-seeking currency mandate is threefold. First,
currency’s low correlation to other traditional asset classes
makes it an ideal candidate for diversification. Secondly, an
active currency manager can capitalize on the trending nature
of the currency market. Lastly, there are inefficiencies in the
currency market that present opportunities to capture profit.
SPOTLIGHT
HEDGING STRATEGIES
Some institutional investors may choose to leave their portfo-
10 Yr lios un-hedged. In this instance, the portfolio will experience
5.83 the full impact of the appreciation and depreciation of the
local currency. Although the currency returns over a long time
2.63
horizon should approach zero, the portfolio may experience an
3.20 increase in volatility due to exchange rate fluctuations.
Passive currency management is intended to reduce foreign
currency exposure and risk, not necessarily to increase return.
The sole purpose of a passive currency program is to elimi-
nate, to a degree, the impact from currency fluctuations on the
value of foreign investments. The degree to which the
currency risk is eliminated is dictated by the level of the hedge
ratio that is employed1. A hedge ratio of 50%, for example,
would indicate that half of the currency exposure has been
eliminated.
The goal of an active currency strategy is to capture gains
while reducing risk on international investments. This can be
achieved by altering the hedge ratio of the currencies to be
hedged. Depending on the guidelines and latitude provided
by the plan sponsor, the currency manager may be able to take
advantage of the movement and volatility in the foreign
exchange market.
For example, if the currency managers have a view that the
Euro will continue to appreciate relative to the U.S. Dollar,
they could under-hedge the Euro (or leave it completely un-
hedged) to capture the anticipated currency gain. Conversely,
if the currency managers have a view that the Swiss Franc
would depreciate relative to the U.S. Dollar, they could over-
hedge (or completely hedge) the Swiss Franc to offset the
impact of the falling Franc. By partially hedging, institutional
investors can enhance their portfolio returns by actively
managing their currency risk.
ALPHA-SEEKING STRATEGIES
Unlike traditional hedging programs, currency alpha strategies
are not constrained by the currency exposures of the portfolio.
By managing currency as a separate asset class, plan spon-
sors can make a pure alpha play by using forward contracts
and eliminating the need for any initial funding. In this
1
It is important to note that the effectiveness of the passive currency hedge is also
dependent upon the efficiency of the currency trade execution.
SEPTEMBER 2008 EDITION — 5
 CURRENCY MANAGEMENT
context, the currency managers are expected to add alpha
(i.e., increase the overall risk-adjusted returns of the port-
folio).
DIVERSIFICATION
The asset allocation of a typical institutional investor may
include domestic and foreign equity, fixed income, real estate,
and commodities. In our opinion, institutional investors may
be able to reduce the overall risk of the portfolio by incorpo-
rating an alpha currency program into an established asset
allocation. The addition of an asset class that is lowly or nega-
tively correlated to the other major asset classes is a way to
reduce the volatility of the overall plan and thus improve its
risk/return profile.
In Exhibit 2, it is evident that a currency allocation can help
offset some of the volatility that a “traditional” portfolio may
encounter. The currency markets, as measured by the U.S.
Dollar Index (DXY), have a low to negative correlation to the
stock, bond, real estate and commodity markets, making it an
attractive portfolio diversifier.
Exhibit 2 - Correlation of U.S. Dollar Index (DXY) with
Traditional Asset Classes2
USD Index 1.00
Domestic Equity 0.03
Foreign Equity -0.29
Fixed Income -0.21
Real Estate -0.07
Commodities -0.19
Source: J.P. Morgan Investment Analytics & Consulting estimates.
OPPORTUNITIES
The argument against active currency management is that the
long-term investment in a currency of a developed country is
essentially a zero-sum investment. The long-term expected returns
of the major currencies are zero. During times of economic pros-
perity, the host nation’s currency will become stronger relative to
other currencies. However, when the economic tides turn, it will
eventually give back the previous gains.
Currencies typically will move according to the outlook of a
country’s economic data, and exchange rates tend to gain
directional momentum and trend. In the short term, there is
an inherent volatility as with any other asset class. However,
over a longer time horizon, the economic health of the host
nation should keep the momentum moving in the same direc-
tion. Exchange rate trends do persist for some time, resulting
in an opportunity for skilled active managers to exploit
currency swings.
SPOTLIGHT
The currency market is the world’s largest and most liquid
market, with an average daily turnover of $3.2 trillion USD3.
The daily currency turnover is more than ten times that of all of
the world’s equity markets combined4. The volume can be
attributed to a number of factors, including the different type
of market participants and the various objectives they have for
currency exchange. Currency exchange is employed by central
banks to implement monetary policy, by commercial banks to
manage cash flow, and by institutional investors to hedge
exposure and enhance return.
For example, many investment managers execute foreign
exchange trades for the sole purpose of making funds avail-
able in the local trading currency to execute foreign stock or
bond trades. A central bank’s motivation for being players in
the currency market is to stabilize their domestic currency or
stave off the forces of inflation. In fact, central banks may
have to buy or sell currency at inopportune times to satisfy
their primary goals. Corporations can have significant
currency exposure from foreign operations, trading, or debt
servicing obligations. Their greater interest lies in neutralizing
their currency exposure rather than maximizing profits.
With any active management strategy, there should be an
exploitable market inefficiency in order for the strategy to be
successful. Usually, this inefficiency comes at the cost of
liquidity. In the currency market, we find the rare case where
both are available.
CONCLUSION
As institutional investors continue to increase their allocation
to international investments, especially in the emerging
markets, a clear currency mandate is becoming an increasingly
important part of portfolio management. Based on the goals,
requirements and restrictions of the plan, the plan sponsor
should review the currency policy in place and determine the
optimal strategy.
Leaving the portfolio completely un-hedged may leave the
portfolio exposed to unwanted volatility. While a passive
strategy will help neutralize the currency risk associated with
foreign investments, on a long-term basis, a 100% hedge can
only be right 50% of the time. Given the portfolio diversifica-
tion effects, the exploitable opportunities present in the
currency market, and the potential to increase the risk/reward
profile of the overall portfolio, institutional investors may want
to consider alpha-seeking strategies in order to cash on
currency.
2
The correlation coefficients are based on 17.5 years of historical data ending June
2008. The following indices were used as proxies for the asset classes shown in
the table. Domestic Equity - Russell 3000 Index; Foreign Equity - MSCI EAFE Index
(Net Div); Fixed Income - L.B. Aggregate Bond Index; Real Estate - NCREIF Property;
Commodities - Dow Jones AIG Commodities Index.
3
Source – Bank of International Settlements.
4
Source – Bloomberg.
SEPTEMBER 2008 EDITION — 6
 RISK MANAGEMENT

SPOTLIGHT
VALUE-AT-RISK: AN OVERVIEW OF ANALYTICAL VAR
by Romain Berry
J.P. Morgan Investment Analytics and Consulting
romain.p.berry@jpmorgan.com

In the last issue, we discussed the principles of a sound risk management function to efficiently manage and monitor the
financial risks within an organization. To many risk managers, the heart of a robust risk management department lies in
risk measurement through various complex mathematical models. But even one who is a strong believer in quantitative risk
management would have to admit that a risk management function that heavily relies on these sophisticated models cannot
add value beyond the limits of understanding and expertise that the managers themselves have towards these very models.
Risk managers relying exclusively on models are exposing their organization to events similar to that of the sub-prime crisis,
whereby some extremely complex models failed to accurately estimate the probability of default of the most senior tranches of
CDOs1. Irrespective of how you put it, there is some sort of human or operational risk in every team within any given organ-
ization. Models are valuable tools but merely represent a means to manage the financial risks of an organization.
This article aims at giving an overview of one of the most wide- that should always be kept in mind when handling VaR.
spread models in use in most of risk management departments VaR involves two arbitrarily chosen parameters: the holding
across the financial industry: Value-at-Risk (or VaR)2. VaR calcu- period and the confidence level. The holding period corre-
lates the worst expected loss over a given horizon at a given sponds to the horizon of the risk analysis. In other words, when
confidence level under normal market conditions. VaR esti- computing a daily VaR, we are interested in estimating the
mates can be calculated for various types of risk: market, credit, worst expected loss that may occur by the end of the next
operational, etc. We will only focus on market risk in this article. trading day at a certain confidence level under normal market
Market risk arises from mismatched positions in a portfolio that conditions. The usual holding periods are one day or one
is marked-to-market periodically (generally daily) based on month. The holding period can depend on the fund’s invest-
uncertain movements in prices, rates, volatilities and other rele- ment and/or reporting horizons, and/or on the local regulatory
vant market parameters. In such a context, VaR provides a requirements. The confidence level is intuitively a reliability
single number summarizing the organization’s exposure to measure that expresses the accuracy of the result. The higher
market risk and the likelihood of an unfavorable move. There the confidence level, the more likely we expect VaR to approach
are mainly three designated methodologies to compute VaR: its true value or to be within a pre-specified interval. It is there-
Analytical (also called Parametric), Historical Simulations, and fore no surprise that most regulators require a 95% or 99%
Monte Carlo Simulations. For now, we will focus only on the confidence interval to compute VaR.
Analytical form of VaR. The two other methodologies will be
treated separately in the upcoming issues of this newsletter. PART 2: FORMALIZATION AND APPLICATIONS
Part 1 of this article defines what VaR is and what it is not, and
describes the main parameters. Then, in Part 2, we mathemati- Analytical VaR is also called Parametric VaR because one of its
cally express VaR, work through a few examples and play with fundamental assumptions is that the return distribution
varying the parameters. Part 3 and 4 briefly touch upon two crit- belongs to a family of parametric distributions such as the
ical but complex steps to computing VaR: mapping positions to normal or the lognormal distributions. Analytical VaR can
risk factors and selecting the volatility model of a portfolio. simply be expressed as:
Finally, in Part 5, we discuss the pros and cons of Analytical
VaR. (1)

PART 1: DEFINITION OF ANALYTICAL VAR where

VaR is a predictive (ex-ante) tool used to prevent portfolio
managers from exceeding risk tolerances that have been devel-
oped in the portfolio policies. It can be measured at the port-
folio, sector, asset class, and security level. Multiple VaR
methodologies are available and each has its own benefits and
drawbacks. To illustrate, suppose a $100 million portfolio has a
monthly VaR of $8.3 million with a 99% confidence level. VaR
simply means that there is a 1% chance for losses greater than
$8.3 million in any given month of a defined holding period
under normal market conditions.
It is worth noting that VaR is an estimate, not a uniquely defined
value. Moreover, the trading positions under review are fixed
for the period in question. Finally, VaR does not address the
distribution of potential losses on those rare occasions when
the VaR estimate is exceeded. We should also bear in mind
these constraints when using VaR. The ease of using VaR is also
its pitfall. VaR summarizes within one number the risk exposure
of a portfolio. But it is valid only under a set of assumptions
• VaRαα is the estimated VaR at the confidence level
100 × (1 – α)%.
• xα is the left-tail α percentile of a normal distribution
is described in the expression
where R is the expected return. In order for VaR to be mean-
ingful, we generally choose a confidence level of 95% or
99%. xα is generally negative.
• P is the marked-to-market value of the portfolio.
The Central Limit Theorem states that the sum of a large number
of independent and identically distributed random variables
will be approximately normally distributed (i.e., following a
Gaussian distribution, or bell-shaped curve) if the random vari-
ables have a finite variance. But even if we have a large enough
sample of historical returns, is it realistic to assume that the
returns of any given fund follow a normal distribution? Thus, we
need to associate the return distribution to a standard normal
distribution which has a zero mean and a standard deviation of
1
CDO stands for Collaterized Debt Obligation. These instruments repackage a portfolio of
average- or poor-quality debt into high-quality debt (generally rated AAA) by splitting a
portfolio of corporate bonds or bank loans into four classes of securities, called tranches.
2
Pronounced V’ah’R.

SEPTEMBER 2008 EDITION — 7

 RISK MANAGEMENT
one. Using a standard normal distribution enables us to replace
xα by zα through the following permutation:
(2)
which yields:
(3)
zα is the left-tail α percentile of a standard normal distribution.
Consequently, we can re-write (1) as:
(4)
EXAMPLE 1 – ANALYTICAL VAR OF A SINGLE ASSET
Suppose we want to calculate the Analytical VaR at a 95% confi-
dence level and over a holding period of 1 day for an asset in
which we have invested $1 million. We have estimated3 μ
(mean) and σ (standard deviation) to be 0.3% and 3% respec-
tively. The Analytical VaR of that asset would be:
This means that there is a 5% chance that this asset may lose at
least $46,347 at the end of the next trading day under normal
market conditions.
EXAMPLE 2 – CONVERSION OF THE CONFIDENCE
LEVEL4
Assume now that we are interested in a 99% Analytical VaR of
the same asset over the same one-day holding period. The
corresponding VaR would simply be:
There is a 1% chance that this asset may experience a loss of at
least $66,789 at the end of the next trading day. As you can
see, the higher the confidence level, the higher the VaR as we
travel downwards along the tail of the distribution (further left
on the x-axis).
EXAMPLE 3 – CONVERSION OF THE HOLDING
PERIOD
If we want to calculate a one-month (21 trading days on
average) VaR of that asset using the same inputs, we can simply
apply the square root of the time5:
(5)
Applying this rule to our examples above yields the following
VaR for the two confidence levels:
EXAMPLE 4 – ANALYTICAL VAR OF A PORTFOLIO
OF TWO ASSETS
Let us assume now that we have a portfolio worth $100 million
that is equally invested in two distinct assets. One of the main
reasons to invest in two different assets would be to diversify
the risk of the portfolio. Therefore, the main underlying ques-
tion here is how one asset would behave if the other asset were
to move against us. In other words, how will the correlation
between these two assets affect the VaR of the portfolio? As we
aggregate one level up the calculation of Analytical VaR, we
SPOTLIGHT
replace in (4) the mean of the asset by the weighted mean of
the portfolio, μp and the standard deviation (or volatility) of the
asset by the volatility of the portfolio, σ p. The volatility of a
portfolio composed of two assets is given by:
(6)
where
• w1 is the weighting of the first asset
• w2 is the weighting of the second asset
• σ1 is the standard deviation or volatility of the first asset
• σ2 is the standard deviation or volatility of the second asset
• ρ1,2 is the correlation coefficient between the two assets
And (4) can be re-written as:
(7)
Let us assume that we want to calculate Analytical VaR at a 95%
confidence level over a one-day horizon on a portfolio
composed of two assets with the following assumptions:
• P = $100 million
• w1 = w2 = 50%6
• μ1 = 0.3%
• σ1 = 3%
• μ2 = 0.5%
• σ2 = 5%
• ρ1,2 = 30%
(8)
EXAMPLE 5 – ANALYTICAL VAR OF A PORTFOLIO
COMPOSED OF N ASSETS
From the previous example, we can generalize these calcula-
tions to a portfolio composed of n assets. In order to keep the
mathematical formulation handy, we use matrix notation and
can re-write the volatility of the portfolio as:
(9)
where
• w is the vector of the weights of the n assets
• w’ is the transpose vector of w
• Σ is the covariance matrix of the n assets
Practically, we could design a spreadsheet in Excel (Exhibit 1) to
calculate Analytical VaR on the portfolio in Example 4.
Note that these parameters have to be estimated. They are not the historical parame-
3
ters derived from the series.
4
Note that zα is to be read in the statistical table of a standard normal distribution.
5
This rule stems from the fact that the sum of n consecutive one-day log returns is the n-
day log return and the standard deviation of n-day returns is √n × standard deviation of
one-day returns.
6
These weights correspond to the weights of the two assets at the end of the holding
period. Because of market movements, there is little likelihood that they will be the
same as the weights at the beginning of the holding period.
SEPTEMBER 2008 EDITION — 8
 RISK MANAGEMENT

SPOTLIGHT
Exhibit 1 – Excel Spreadsheet to calculate Analytical VaR for PART 4: VOLATILITY MODELS
a portfolio of two assets We can guess from the various expressions of Analytical VaR we
Analytical VaR have used that its main driver is the expected volatility (of the
asset or the portfolio) since we multiply it by a constant factor
Expected
greater than 1 (1.6449 for a 95% VaR, for instance) – as
parameters
opposed to the expected mean, which is simply added to the
p 100,000,000 Asset 1 Asset 2 expected volatility. Hence, if we have used historical data to
Standard derive the expected volatility, we could consider how today’s
w1 50% Deviation 0.03 0.05 volatility is positively correlated with yesterday’s volatility. In
w2 50% that case, we may try to estimate the conditional volatility of the
Correlation asset or the portfolio. The two most common volatility models
μ1 0.3% Matrix 1 0.3 used to compute VaR are the Exponential Weighted Moving
σ1
Average (EWMA) and the Generalized Autoregressive
3% 0.3 1
Conditional Heteroscedasticity (GARCH). Again, in order to be
μ2 0.5% exhaustive on this very important part in computing VaR, we
σ2 5% will discuss these models in a future article.
Covariance
p1,2 30% Matrix PART 5: ADVANTAGES AND DISADVANTAGES OF
Σ 0.00090 0.00045 ANALYTICAL VAR
μp 0.40% 0.00045 0.00250 Analytical VaR is the simplest methodology to compute VaR and
σp 3.28% is rather easy to implement for a fund. The input data is rather
Exposures limited, and since there are no simulations involved, the
Confidence computation time is minimal. Its simplicity is also its main
level w1 0.5 0.5 drawback. First, Analytical VaR assumes not only that the histor-
95% -1.6449 ical returns follow a normal distribution, but also that the
changes in price of the assets included in the portfolio follow a
Σw 0.00068
normal distribution. And this very rarely survives the test of
0.00148
reality. Second, Analytical VaR does not cope very well with
securities that have a non-linear payoff distribution like options
σ 2=w’Σw 0.00108 or mortgage-backed securities. Finally, if our historical series
exhibits heavy tails, then computing Analytical VaR using a
σ 0.03279 normal distribution will underestimate VaR at high confidence
levels and overestimate VaR at low confidence levels.
VaR 4,993,012 .77
Grey = input cells
CONCLUSION
Source: J.P. Morgan Investment Analytics & Consulting. As we have demonstrated, Analytical VaR is easy to implement
as long as we follow these steps. First, we need to collect
It is easy from there to expand the calculation to a portfolio of n
historical data on each security in the portfolio (we advise using
assets. But be aware that you will soon reach the limits of Excel
at least one year of historical data – except if one security has
as we will have to calculate n(n-1)/2 terms for your covariance
experienced high volatility, which would suggest a shorter
matrix.
period of time). Second, if the portfolio has a large number of
underlying positions, then we would need to map them against
PART 3: RISK MAPPING a more manageable set of risk factors. Third, we need to calcu-
In order to cope with an increasing covariance matrix each time late the historical parameters (mean, standard deviation, etc.)
you diversify your portfolio further, we can map each security of and need to estimate the expected prices, volatilities and corre-
the portfolio to common fundamental risk factors and base our lations. Finally we apply (7) to find the Analytical VaR estimate
calculations of Analytical VaR on these risk factors. This process of the portfolio.
is called reverse engineering and aims at reducing the size of
As always when building a model, it is important to make sure
the covariance matrix and speeding up the computational time
that it has been reviewed, fully tested and approved, that a User
of transposing and multiplying matrices. We generally consider
Guide (including any potential code) has been documented and
four main risk factors: Spot FX, Equity, Zero-Coupon Bonds and
will be updated if necessary, that a training has been designed
Futures/Forward. The complexity of this process goes beyond
and delivered to the members of the risk management team and
the scope of this overview of Analytical VaR and will need to be
to the recipients of the outputs of the risk management function,
treated separately in a future article.
and finally that a capable person has been allocated the over-
sight of the model, its current use, and regular refinement.

Opinions and estimates offered in this Investment Analytics and Consulting newsletter constitute our judgment and are subject to change without notice, as are statements
of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or complete-
ness. References to specific asset classes, financial markets, and investment strategies are for information purposes only and are not intended to be, and should not be
interpreted as, recommendations or a substitute for obtaining your own investment advice.
This document contains information that is the property of JPMorgan Chase & Co. It may not be copied, published, or used in whole or in part for any purposes other than
expressly authorized by JPMorgan Chase & Co.
www.jpmorgan.com/visit/iac

SEPTEMBER 2008 EDITION — 9

 GLOBAL CAPITAL MARKETS

CORNER
U.S. CURRENCY
by Manpreet Hochadel, CFA AS OF AUGUST 2008
J.P. Morgan Investment Analytics and Consulting
manpreet.s.hochadel@jpmorgan.com

1.60 US Dollar vs. EURO and Japanese Yen 0.0110

1.50

1.40 0.0100
US Dollar vs. EURO

US Dollar vs. JPY

1.30
JPY Right Scale
1.20 0.0090

1.10

1.00 0.0080
EURO Left Scale
0.90

0.80 0.0070
Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08

Source: J.P. Morgan Investment Analytics and Consulting

• The U.S. Dollar recovered some of the losses of the past few years against both the Euro and Yen, as the Euro-zone and Japanese
economies showed signs of weakening and the U.S. Federal Reserve hinted at monetary tightening in the future.

U.S. FIXED INCOME

by Manpreet Hochadel, CFA AS OF AUGUST 2008
J.P. Morgan Investment Analytics and Consulting
manpreet.s.hochadel@jpmorgan.com

US Treasury Yield Curve

5.00%

4.00%
December 31, 2007
August 31, 2008
3.00%
June 30,
2008

2.00%

1.00%
2 5 10 20 30 Yr.

Source: J.P. Morgan Investment Analytics and Consulting, Bloomberg

• The U.S. Treasury yield curve steepened as rates continued to fall across the entire yield curve.

SEPTEMBER 2008 EDITION — 10

 GLOBAL CAPITAL MARKETS

CORNER
EUROPEAN AND ASIAN CURRENCIES
by Simreet Gill AS OF JULY 2008
J.P. Morgan Investment Analytics and Consulting
simreet.k.gill@jpmorgan.com

Pound Sterling vs USD and EUR Swiss Franc vs GBP, EUR & USD

2.2 1.1
1
2
0.9
1.8
0.8
1.6 0.7
0.6
1.4
0.5
1.2 0.4
1 0.3
2001 2002 2003 2004 2005 2006 2007 2008 2001 2002 2003 2004 2005 2006 2007 2008

GBP/USD GBP/EUR CHF/GBP CHF/EUR CHF/USD

Norwegian Krone vs EUR, USD & GBP

0.22
• The uptrend in EUR/GBP over the past six months
0.2
through July reflected the risk of an independent
0.18
implosion in the UK economy. The economy is
0.16
0.14
certainly buckling under the post-credit crisis strain
0.12 but so too is the Euro area, a story which is much more
0.1 recent. (Morgan Markets)
0.08
0.06
2001 2002 2003 2004 2005 2006 2007 2008
NOK/EUR NOK/USD NOK/GBP

Source: J.P. Morgan Investment Analytics and Consulting, Bloomberg

Japanese Yen vs GBP, EUR, USD & AUD Australian Dollar vs GBP, EUR & USD
0.018 1

0.015
0.8
0.012

0.009 0.6

0.006
0.4
0.003

0.000 0.2
2001 2002 2003 2004 2005 2006 2007 2008 2001 2002 2003 2004 2005 2006 2007 2008
JPY/GBP JPY/EUR JPY/USD JPY/AUD AUD/GBP AUD/EUR AUD/USD

Chinese Yuan vs EUR, USD & JPY

17 0.16
• There has been a growing divergence between the falling
16
0.14
equity markets and the lagged response of Asian FX
15
lately. The key concern is whether Asian currencies will
14
catch up with falling equities. At a superficial level, this
CNY/ USD & EUR

0.12
13
equity:FX correlation is being driven by international port-
CNY/JPY

12
0.1 folio equity flows. However, the ultimate drivers for these
11
flows are expectations for the global growth cycle and
10 0.08 how these may impact export and corporate earnings in
9
the future. (Morgan Markets)
8 0.06
2001 2002 2003 2004 2005 2006 2007 2008
CNY/EUR CNY/USD CNY/JPY

Source: J.P. Morgan Investment Analytics and Consulting, Bloomberg

SEPTEMBER 2008 EDITION — 11

 GLOBAL MARKET INDICES

CORNER
ASSET CLASS RETURN COMPARISON (INCLUDING U.S.)
by William Pometto AS OF AUGUST 2008
J.P. Morgan Investment Analytics and Consulting
william.m.pometto@jpmorgan.com

Monthly Trailing 3 Year To

Index 1 Year 2 Year 3 Year 5 Year 10 Year
Return Months Date
L.B. AGGREGATE BOND INDEX 0.95 0.79 2.00 5.86 5.56 4.26 4.61 5.58
M.L. HIGH YIELD INDEX 0.32 (3.91) (2.62) (1.42) 2.48 3.42 6.87 4.23
MSCI EMERGING MARKETS FREE (7.95) (20.18) (21.67) (9.83) 13.96 19.38 23.89 17.72
MSCI-Eafe (Net) (4.05) (14.73) (17.31) (14.41) 0.80 8.08 13.86 6.34
RUSSELL 1000 GROWTH (Gross) 1.08 (7.99) (9.83) (6.77) 4.76 4.39 6.10 2.59
RUSSELL 2000 VALUE (Gross) 4.75 (0.44) (0.71) (7.52) (0.69) 3.59 10.25 11.28
RUSSELL 3000 INDEX (Gross) 1.55 (7.57) (10.39) (10.22) 1.58 3.92 7.57 5.52
S & P 500 - CAP. WEIGHTED 1.45 (7.89) (11.39) (11.14) 1.15 3.67 6.93 3.11

30
25

20
15

10
5

-5
-10

-15

-20

-25
Current Month 3 Months Year to Date 1 Year 2 Year 3 Year 5 Year 10 Year
Return
MSCI EMERGING MARKETS FREE M.L. HIGH YIELD INDEX RUSS-Russell 1000 Growth (Gross) RUSS-Russell 3000 (Gross)
MSCI-Eafe (Net) L.B. AGGREGATE BOND INDEX S & P 500 - CAP. WEIGHTED RUSS-Russell 2000 Value (Gross)

U.S. EQUITY FIXED INCOME

• U.S. Stock Markets avoided a third straight down month, • Fixed Income Markets were a safe bet for August.
posting modest gains in August. • Government bonds continued to post respectable gains.
• Much of the upward momentum was driven by declining oil • The L.B. Government Long Term Index posted a 2.32 percent
prices. return for the month, putting it up 3.75 percent year to date.
• Value stocks experienced the biggest lift with the Russell
2000 Value Index posting a 4.75 percent gain for the month. REAL ESTATE
• The S&P 500 and NASDAQ Composite added 1.45 percent • Real Estate Markets haven't improved as mortgage concerns
and 1.92 percent respectively. still exist.
• Home sales continued to slow.
INTERNATIONAL EQUITY
• International Markets performed poorly in August.
• Investor concern continues over the slumping United States
economy and how it will affect international markets.
• The strengthening U.S. dollar has also negatively impacted
international market returns.
• The Emerging Markets were hit the hardest, as evidenced by
the 7.95 percent loss for the MSCI Emerging Markets Free
Index in August.

SEPTEMBER 2008 EDITION — 12

 GLOBAL MARKET INDICES

CORNER
GLOBAL EQUITIES (EXCLUDING U.S.)
by Simreet Gill AS OF JULY 2008
J.P. Morgan Investment Analytics and Consulting
simreet.k.gill@jpmorgan.com

Europe
12,000 180
160
10,000
140
8,000 120
100
6,000
80
4,000 60
40
2,000
20
0 0
2000 2001 2002 2003 2004 2005 2006 2007 2008

FTSE 100 CAC DAX Swiss Markets MSCI Europe

Source: J.P. Morgan Investment Analytics and Consulting, Bloomberg

• The financial markets have remained highly unstable in July,
owing in part to the troubles at GSEs such as Freddie Mac.
Equities have been slowly grinding through the cyclical slow-
down triggered by a housing bust, credit crunch, and
commodity price pressures.
• In July, equities saw a month of two halves with sharp falls in
the first half and a rebound of equal magnitude and intensity
in the second half. The downshift in global growth indicators
earlier in the month triggered further declines in global
equity markets. In particular, the abrupt weakening in
European and Japanese growth into midyear, combined with
signs that global industrial activity is now contracting,
marked a sharper downshift in momentum than the
consensus anticipated. Later in the month, sharply lower oil
prices and short covering in financials helped equity markets
to more than retrace their losses seen in the first two weeks
of July. (Morgan Markets)

Australia, Hong Kong, Singapore Japan (Nikkei 225)

5,000 250

4,000 200

3,000 150

2,000 100

1,000 50

0 0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2000 2001 2002 2003 2004 2005 2006 2007 2008
Australia (AS51) Hong Kong (Hang Seng) Singapore (Straits Times)

Source: J.P. Morgan Investment Analytics and Consulting, Bloomberg Source: J.P. Morgan Investment Analytics and Consulting, Bloomberg

Korean (KOSPI) • Resource-consuming emerging markets such as India and

1.8 China, which had been sharply sold off owing to growing
inflationary concerns on rising commodity prices, picked up.
1.5
The Japanese market had the second largest fall among
1.2 major developed nations after England. However, while the
Japanese market has tended to be as highly volatile as
0.9
emerging markets recently, we think movement in the
0.6 Japanese market in July was only slight compared with the
0.3 sharp movement in emerging markets. (Morgan Markets)

0
2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: J.P. Morgan Investment Analytics and Consulting, Bloomberg

SEPTEMBER 2008 EDITION — 13