Risk Factors for VaR on FX Forwards
Summary
The document outlines a factor-based approach to estimating one-day value at risk for a currency portfolio containing forwards. A forward’s value is affected by its exchange rate and the interest rates of both currencies. For a USD/JPY forward, for example, the relevant factors are the USD/JPY spot rate, the USD rate, and the yen rate. A portfolio estimate therefore needs risk estimates for each factor and their correlations.
The discussion gives no calculation, dataset, or empirical comparison; it describes the inputs the calculation would require. It also cautions that VaR depends on assumptions about interest rates and may omit important exposures. In particular, VaR does not capture the risk that a counterparty defaults. How daily forward-value changes are treated can also depend on whether the contracts are managed as marked-to-market positions or mainly as hedges intended to lock in future prices.
Key ideas
- An FX forward is exposed to its spot exchange rate and the interest rates of both currencies.
- A portfolio VaR estimate needs risk estimates for the relevant factors and their correlations.
- VaR depends on modeling assumptions, including the choice of interest-rate data.
- VaR does not measure counterparty default risk.
- How forward price changes are treated may depend on the portfolio’s hedging and valuation practices.
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Full text
# VaR for FX forwards # VaR for FX forwards I am trying to figure out some of the commonly used approaches to deal with FX forwards (in a currency portfolio containing spots, forwards and swaps) that would allow me to calculate the one day VaR for the portfolio. I currently only have spot prices in my historic dataset. Any insight into this matter will be greatly appreciated. ## Answer by Matt Wolf (score 3, accepted) https://quant.stackexchange.com/a/9134 You need to isolate the risk factors that impact your forward contract, which is your spot fx rate, and the two rates of each currency that underlies the forward contract. You therefore need to estimate the VaRs of each of those risk factors. You also need the correlations between the underlying risk factors. For example, a forward to buy USD in exchange for Japanese yen breaks down to the following risk factors : - USDJPY spot rate - USD rate - Yen rate You also need: - The VaR of each of the above risk factors - The correlation between the above risk factors Take a look at the following which explains in very simple terms the basic concept: VaR of Forward Foreign Currency Contract Be careful, I find VaR a very flawed concept because it forces you to make tons of very shady assumptions, starting with the currency interest rates (in the past those were based on interbank lending rates which we all know were rigged). Edit: Also, VaR does not capture counter party risk that arises from entering into an agreement with another party that exhibits risk of default. Keeping a big picture in mind never hurts: If you entered into forward agreements to hedge exposure to the underlying then it depends on how your risk department is setup: Most desks value forward agreements like any other asset on a daily basis, some corporates do not do such because the sole reason of the forwards is to lock in prices for future delivery and hence they do not interpret daily fluctuations in the forwards as a risk component.
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