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
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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