International Finance Discussion Papers (IFDP)
June 1991
Determining Foreign Exchange Risk and Bank Capital Requirements
Michael P. Leahy
Abstract:
This paper examines three alternative measures of exchange rate risk that could be used to develop a risk-based capital requirement for banks with foreign-exchange exposure. One measure, the standard deviation of the portfolio, is constructed under the assumption that exchange rate changes are distributed normally. While this measure is widely used in a variety of financial applications, it is subject to the criticism that it fails to capture well the behavior of exchange rate changes in the tails of their density function. A second possible measure is developed that combines the standard deviation and a method used by the Bank of England to assess foreign exchange exposure. This measure fails to represent the tail behavior and correlation patterns of exchange rates. The third measure uses nonparametric methods to determine capital requirements. The third measure does not suffer from the deficiencies of the other two: it allows for a rich pattern of exchange rate correlations and for non-normal characteristics in the tails of the density function.
Because of the generality of the nonparametric method, it is used to quantitatively assess the deficiencies of the other two measures. In a sample of simulated portfolios of marks, yen, and sterling, it is shown that the standard deviation measure is likely to yield capital requirements that are too small relative to the nonparametric measure. The second measure behaves on average like the standard deviation measure but the capital requirement is more erratic: it generates too much capital for some portfolios and too little capital for others in larger proportions than the standard deviation measure.
PDF: Full Paper
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