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Exchange Rate Risk: Heads or Tails

  • Ana-Maria Gavril
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    More than forty years ago researchers started to reconsider the behavior of financial data. Since then, stylized facts about financial returns have become common knowledge in economics. Characteristics as fat-tailedness, leptokurtosis and serial dependence have been extensively analyzed. As the financial world became focused on risk management and prudential supervision, various risk models have been developed. However, the first generation of risk models is highly dependent on rough assumptions, empirically contradicted, but embraced by practitioners as they benefit from a fairly easy implementation. In the context of market risk, such a proxy was developed under the name of Value at Risk, which rapidly became a standard measure for both risk managers and supervisors. The current state of affairs brings us one step closer to the death of VaR. The need for a new approach is imperative. This paper aims to bring new evidence to the limited performance of Value at Risk and test the fit of Extreme Value Theory as a complementary risk management tool for stressed market conditions, in the context of exchange rate risk. We use exchange rate returns of four currencies against the Euro and analyze the relative performance of several VaR models and Extreme Value Theory, respectively. We show that in extreme market conditions, extreme measures are required, and that no single measure can perform proper for both the centre and the tails of an exchange rate distribution.

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    File URL: http://www.dofin.ase.ro/Working%20papers/Gavril%20Ana-Maria/gavril.ana-maria.dissertation.pdf
    File Function: First version, 2009
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    Paper provided by Bucharest University of Economics, Center for Advanced Research in Finance and Banking - CARFIB in its series Advances in Economic and Financial Research - DOFIN Working Paper Series with number 35.

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    Date of creation: Nov 2009
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    Handle: RePEc:cab:wpaefr:35
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    1. Brooks, C. & Clare, A.D. & Dalle Molle, J.W. & Persand, G., 2005. "A comparison of extreme value theory approaches for determining value at risk," Journal of Empirical Finance, Elsevier, vol. 12(2), pages 339-352, March.
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    12. Darryll Hendricks, 1996. "Evaluation of value-at-risk models using historical data," Economic Policy Review, Federal Reserve Bank of New York, issue Apr, pages 39-69.
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