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

Purpose – It 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/approach – In 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. Findings – A 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 implications – The 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/value – Although 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.