On the use of value at risk for managing foreign‐exchange exposure in large portfolios

Abstract

PurposeIt is the purpose of this article to empirically test the risk parameters for larger foreign‐exchange portfolios and to suggest real‐world policies and procedures for the management of market risk with the aid of value at risk (VaR) methodology. The aim of this article is to fill a void in the foreign‐exchange risk management literature and particularly for large portfolios that consist of long and short positions of multi‐currencies of numerous developed and emerging economies.Design/methodology/approachIn this article, a constructive approach for the management of risk exposure of foreign‐exchange securities is demonstrated, which takes into account proper adjustments for the illiquidity of both long and short trading/investment positions. The approach is based on the renowned concept of VaR along with the innovation of a software tool utilizing matrix‐algebra and other optimization techniques. Real‐world examples and reports of foreign‐exchange risk management are presented for a sample of 40 distinctive countries.FindingsA number of realistic case studies are achieved with the objective of setting‐up a practical framework for market risk measurement, management and control reports, in addition to the inception of a practical procedure for the calculation of optimum VaR limits structure. The attainment of the risk management techniques is assessed for both long and short proprietary trading and/or active investment positions.Practical implicationsThe main contribution of this article is the introduction of a practical risk approach to managing foreign‐exchange exposure in large proprietary trading and active investment portfolios. Key foreign‐exchange risk management methods, rules and procedures that financial entities, regulators and policymakers should consider in setting‐up their foreign‐exchange risk management objectives are examined and adapted to the specific needs of a model of 40 distinctive economies.Originality/valueAlthough a substantial literature has examined the statistical and economic meaning of VaR models, this article provides real‐world techniques and optimum asset allocation strategies for large foreign‐exchange portfolios in emerging and developed financial markets. This is with the objective of setting‐up the basis of a methodology/procedure for the measurement, management and control of foreign‐exchange exposures in the day‐to‐day trading and/or asset management operations.