Risk analysis, reporting and control of equity trading exposure: Viable applications to the Mexican financial markets

Abstract

This paper provides real-world techniques and optimum asset allocation strategies that can be applied to equity trading portfolios in emerging and illiquid financial markets. Key market risk management methods and procedures that financial entities, regulators and policymakers should consider in formulating their daily market risk management objectives are examined and are adapted to the specific needs of emerging countries. The aim of this paper is to fill a gap in the trading risk management literature and particularly from the perspective of emerging and illiquid markets, such as in the context of the Mexican financial markets. In this paper, we demonstrate a comprehensive and proactive approach for the measurement, management and control of equity trading risk exposure, which takes into account proper adjustments for the illiquidity of both long and short trading/investment positions under normal and severe market conditions and within a multi-security setting. Our approach is based on the renowned concept of Value-at-Risk (VAR) along with the innovation of a software tool utilising matrix-algebra and other optimisation techniques. To illustrate the proper use of VAR and stress-testing (scenario analysis) methods, real-world examples and practical reports of market risk management are calculated and presented for a selected portfolio from the Mexican Stock Market (BMV). To this end, several case studies were achieved with the objective of creating a realistic framework of trading risk measurement and control reports in addition to the inception of procedures for the calculation of the maximum authorised VAR limits.