CURRENCY FORECASTING USING VAR

Exploring alternative applications of traditional Market Risk measurement

FROM RISK LIMITS TO VALUE GENERATION

• Traditionally VaR models have been used to focus on only 1-tail of the loss distribution

• It has been used as a measure to reflect the risk ‘appetite’ of the institution

• This presentation explores an alternative application of VaR utilizing both tails

CURRENCY FORECASTING – THE PROBLEM STATEMENT

• Corporate advances requires quoting a Fx rate at inception of the deal

• It could take anywhere from 2 to 30 days to close a typical Currency advance

• Quoted Fx needs to incorporate Volatility to protect margin

CURRENCY FORECASTING – USUAL APPROACH

• Multiple approaches available involving Auto-regressive models, Macro-economic based models, GBM based Fx Vol models among others

• Often such approaches are a divergence to stated risk policies of the bank in setting Fx limits

• Involves separate modeling outside of risk management and typically Economist cells

CURRENCY FORECASTING – AN ALTERNATIVE APPROACH

• As an alternate approach one could also use the established VaR model and extend its application

• Any VaR model could be employed – for this illustration Historical simulation approach was adopted

• VaR model chosen was un-weighted Historic simulation over rolling 4years of daily Fx Rates

• As with any other VaR based model, this model also performed satisfactorily over the shorter horizons of 1-2 months over ‘normal’ market periods

CURRENCY FORECASTING – THE SOLUTION• The daily end of day (EOD) spot forex

rates vs USD for 90+ currencies were obtained for the last 4 years

• An utility was created wherein user chooses any currency pair and the forecast period in days

• For any chosen forecast period, the utility will calculate the VaR for various confidence intervals using the ‘natural’ risk horizon days

• For a chosen forecast horizon, the model provides point estimates of “appreciation” or “depreciation” at certain chosen levels of significance

MODEL PERFORMANCE AND BACK-TESTING

• The model has been back-tested effectively and benchmarked against the usual methods and compared favorably

• This approach is an elegant extension of the base VaR model that typically organizations use and hence easier to execute and document within broader risk policy

• Adoption of historical simulation facilitates better communication to senior stakeholders

• Median prediction approach provides for sufficient cushion against Fx volatility

FURTHER EXTENSIONS

• This approach can be further extended for other use cases:

• Determine incremental VaR on the portfolio and hence optimize counterparty that aids maximum diversification benefit

• Estimate Intra-day VaR, a critical application now for Intra-day large exposure movement

• Assess pre-trade profitability and impact on initial margin

IN CONCLUSION

• As with any VaR model the limitations of this model is consistent with limitations of VaR itself

• Basic premise of un-weighted historical simulation approach is that past events have an equal likelihood of occurrence in the future

• Tighter class intervals and weighting of observations among the first things to look at refinement within the aegis of historical simulation approach of VaR modeling

• The purpose was to illustrate an alternative application of VaR utilizing both tails of the distribution function

KAUSTAV MUKHERJEEMARKET RISK PRACTICE

Photo Credits: Shutterstock; Google Images; PixabayWhite Paper: Originally published in GARP, Nov 2013