Indian currency market risk analysis: Value-at-risk approach

Abstract

Emphasizing the need for risk mitigation arising out of excess volatility in rupee experienced by India post implementation of the market determined exchange rate regime in 1993, currency futures were introduced in India in 2008, and currency trading has become one of the most important financial operations since then. In this paper, an attempt has been made to measure and compare the market risk prediction ability of historical simulation, Monte-Carlo simulation, Exponentially Weighted Moving Average (EWMA) and linear parametric VaR approaches for Indian currency spot and futures market. Using the data from 2008 to 2013, the VaR associated with the three main currencies in the economy, namely, US dollar, euro and UK pound sterling, is calculated. Conditional and unconditional coverage tests have been applied to backtest the results of various VaR approaches. The results indicate that Monte-Carlo simulation is appropriate in predicting market risk. Further, it is also found that risk seems to be higher in the future market as compared to the underlying markets.