Currency forecasting using var
-
Upload
kaustav-mukherjee -
Category
Data & Analytics
-
view
56 -
download
1
Transcript of Currency forecasting using var
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