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Evaluation of Foreign Exchange Risk Capital Requirement Models

Author

Listed:
  • Claudio H. da S. Barbedo

    (Departamento de Estudos e Pesquisas do Banco Central do Brasil)

  • Gustavo S. Araújo

    (Departamento de Estudos e Pesquisas do Banco Central do Brasil)

  • João Maurício S. Moreira

    (Departamento de Estudos e Pesquisas do Banco Central do Brasil)

  • Ricardo S. Maia Clemente

    (Departamento de Estudos e Pesquisas do Banco Central do Brasil)

Abstract

This paper examines capital requirement for financial institutions in order to cover market risk stemming from exposure to foreign currencies. The models examined belong to two groups according to the approach involved: standardized and internal models. In the first group, we study the Basel model and the model adopted by the Brazilian legislation. In the second group, we consider the models based on the concept of value at risk (VaR). We analyze the single and the double-window historical model, the exponential smoothing model (EWMA) and a hybrid approach that combines features of both models. The results suggest that the Basel model is inadequate to the Brazilian market, exhibiting a large number of exceptions. The model of the Brazilian legislation has no exceptions, though generating higher capital requirements than other internal models based on VaR. In general, VaR-based models perform better and result in less capital allocation than the standardized approach model applied in Brazil.

Suggested Citation

  • Claudio H. da S. Barbedo & Gustavo S. Araújo & João Maurício S. Moreira & Ricardo S. Maia Clemente, 2005. "Evaluation of Foreign Exchange Risk Capital Requirement Models," Brazilian Review of Finance, Brazilian Society of Finance, vol. 3(2), pages 223-249.
    • Handle: RePEc:brf:journl:v:3:y:2005:i:2:p:223-249
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    More about this item

    Keywords

    capital requirements; Basle agreement; market risk; VaR; currency risk;
    All these keywords.

    JEL classification:

    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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