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Choosing Risk Factors for Foreign-Exchange Stress Tests

Article Quant Q&A · Author: Carol.Kar
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Summary

The note asks how to define risk factors for scenario testing of a portfolio containing several currency pairs. It outlines a basic stress-testing workflow: identify portfolio-relevant drivers, specify scenarios, shock those drivers, and interpret the results.

For an FX portfolio, the response suggests considering macroeconomic variables available from market data or research sources, then assessing their ability to explain or predict portfolio returns. Correlation, adjusted fit from regression, and in suitable cases Granger-causality are offered as possible assessment tools. Expert judgment is another option when it can be supported by a coherent economic rationale. The note does not name a definitive set of FX factors or prescribe a particular R package; factor selection remains dependent on the portfolio, data, and modeling objective.

Key ideas

  • Risk factors should reflect the assets and exposures in the portfolio.
  • Macroeconomic variables can be candidates for explaining foreign-exchange returns.
  • Use statistical evidence such as correlations or regressions to assess candidate variables.
  • Expert judgment can guide factor selection when supported by an economic explanation.
  • The document offers no universal factor list or specific R implementation.

Tags

ForexRisk managementStatistics
Full text
# Definition of risk factors for market risk scenario testing


# Definition of risk factors for market risk scenario testing












I am doing a research for stress testing in market risk. The usual process I found out for scenario testing is:

- Define risk factors upon the portfolio

- Define the desired scenarios

- Vary the risk factors and execute the different scenarios

- Interprete the scenarios

I do not know how to define the risk factors for a portfolio? Which `R` functionality could I use? For example, what are the risk factors for a simple FX portfolio when I consider the portfolio: `EURUSD`, `USDMXN`, `AUDUSD`, `USDJPY` and `USDKRW`?

## Answer by Quantopik (score 1)

https://quant.stackexchange.com/a/18709

There exist a lot of way to choose risk factors and the choice differs according to the kind of underlying assets.

In your case, particularly, since the portfolio is composed by currencies, I would choose the risk factors mainly among all the macroeconomic variables available in your dataset or data provider.

After that, to choose on which of them basing the stress test, evaluate which ones are more predictive of the portfolio returns; again, there exists in academic literature different ways to evaluate the predictive ability of a variable and it is up to you choose which one (correlation, linear regression model $adj-R^2$, granger-causality (particular cases only),...). I suggest to read:

> Wickens, Michael R., and Peter N. Smith. "Macroeconomic sources of FOREX risk." Univ. of York Econ. Discussion Paper 2001/13 (2001).

that shows synthetic measures of risk in the forex market.

Alternatively, choose them on judgemental/expert way, trying to give an economic/rational explanation.

Hope this helps.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.