A practical approach to market risk analysis and control: empirical test of the Mexican foreign exchange and stock markets

Abstract

The Mexican financial markets, like many other emerging markets, are generally portrayed as illiquid, volatile, segmented and politically unpredictable. Despite all these shortcomings, portfolio investments and trading activities in emerging markets have immense rewards for markets' participants. These investment alternatives may create unique expected return opportunities and substantial inherent risks. Risk measurement, management and control in such economies are in fact wearisome tasks; however, it may be addressed through art and science risk management practices. In this research paper, key market risk management methods and procedures that financial institutions, regulators and policymakers should consider in devising their daily market risk management objectives are examined and are adapted to the specific needs of emerging financial markets. The proper use of Value At Risk (VAR) and stress-testing methods are illustrated with real-world examples and practical reports of market risk analysis and control. The calculations and conclusions that are presented herein where applied to both, the Mexican foreign exchange and stock markets. To this end, several case studies were achieved with the objective of setting a practical framework of market risk measurement and control reports in addition to the inception of procedures for the setting of VAR's limits. The effects of hedging equity trading exposures with reciprocal foreign exchange trading positions were examined and quantified.