Management of Foreign Exchange Risk
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Management of Foreign Exchange Risk

Evidence from Developing Economies

Y. C. Lum, Sardar M. N. Islam

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eBook - ePub

Management of Foreign Exchange Risk

Evidence from Developing Economies

Y. C. Lum, Sardar M. N. Islam

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About This Book

This book provides a technical and specialised discussion of contemporary and emerging issues in foreign exchange and financial markets by addressing the issues of risk management and theory and hypothesis development, which have general implications for finance theory and foreign exchange market management. It offers an in-depth, comprehensive analysis of the issues concerning the volatility of exchange rates.

The book has three main objectives. First, it applies the integrated study of exchange rate volatility in terms of depth and breadth. Second, it applies the integrated study of exchange rate volatility in Malaysia, as a case study of a developing country. Malaysia had imposed capital control measures in the past and has now liberalised its exchange rate market and will continue to liberalise it further in the long run. Hence, the need to understand exchange rate volatility measurement and management will be even more important in the future. Third, the book highlights new conditional volatility models for a developing country, such as Malaysia, and develops advanced econometric models which have produced results for sound risk management strategies and for achieving risk management in the financial market and the economy. Additionally, the authors recommend risk management themes which may be of relevance to other developing countries.

This work can be used as a reference book by fund managers, financial market analysts, researchers, academics, practitioners, policy makers and postgraduate students in the areas of finance, accounting, business and financial economics. It can also be a supplementary text for Ph.D. and Masters' students in these areas.

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1 Strategic overview

Background of the study

Every economy in the world experiences change. Changes in technology, tastes of individuals, institutions, law, economic policies and regulations have effects on resource allocation in the economy. Changes outside a country have impacts through trade and capital interactions. These changes generate a variety of risks for all individuals and companies. In this book, “risk” is defined as exposure to an uncertain event and also the movements of the underlying fundamentals.
Risk measurement is becoming increasingly important in financial risk management of banks and other institutions associated with the financial markets. The need to quantify risk typically arises when a financial institution has to determine the amount of capital to hold as protection against unexpected losses. In fact, risk measurement is concerned with all types of risks encountered in finance. Some major forms of risk are as follows. Credit risk is the risk of not receiving repayments on outstanding loans as a result of borrower’s default. Operational risk is the risk of losses resulting from failed internal processes, people and systems or external events. Liquidity risk occurs when, due to a lack of marketability, an investment cannot be bought or sold quickly enough to prevent a loss. Model risk can be defined as the risk due to the use of a misspecified model for risk measurement. Market risk is the risk of change in the value of a financial position. This book focuses on market risk and model risk as discussed above.
Foreign exchange markets are extremely interesting for statistical studies because of the vast number and quality of data they produce. The markets have no business-hour limitations. They are open worldwide, 24 hours a day including weekends, except perhaps a few worldwide holidays. Trading is essentially continuous, the markets (at least for the most traded currencies) are extremely liquid and the trading volumes are huge. Daily volumes are in the order of USD1012, approximately the gross national product of Italy. Typical sizes are deals in the order of USD106–107 and most of the deals are speculative in origin. As a consequence of the liquidity, good databases contain about 1.5 million data points per year and data have been collected from over many years. Relevant statistics on the global foreign exchange rates are summarised in the Bank for International Settlements (BIS) Triennial Central Bank Survey.
Many empirical studies have examined the movements of exchange rate markets. For instance, Mun (2007) applied Exponential GARCH (EGARCH) by Nelson (1991) to the dynamic movements of both stock market and exchange rate volatility. He found that exchange rate movements have a significant influence on equity market volatility but have no measurable influence on the US/local market correlation for most cases. Tai (2004) examined four Asian foreign exchange markets, namely Japan, Hong Kong, Singapore and Taiwan, during the 1997 Asian financial crisis and found that the time-varying risk premium is a very strong candidate in explaining the predictable excess return puzzle (proposed by Lewis, 1994) as the risk premiums are both statistically and economically significant. Hurley and Santos (2001) found that for ASEAN currencies prior to the financial crisis in 1997, the Indonesian rupiah was the most volatile, followed by the Philippine peso, while the Singapore dollar was the least variable. They also found that the switch to de facto pegging against the US dollar in the mid-1980s was found to stabilise the variability in the currencies of all ASEAN nations, with the exception of the Malaysian Ringgit. Gan and Soon (2003) found that Malaysia has the largest current account reversal among the four East Asian economies; the other three economies were Indonesia, Thailand and South Korea, suggesting that Malaysia had managed to achieve reduction in domestic absorption due to the transfer of resources overseas. The expansionary macroeconomic policies in combination with the expenditure-switching effect of a large real exchange rate depreciation and favourable international demand for Malaysian exports had allowed the current account surplus to be maintained and the economic activity to recover rather quickly.
This book looks at the unique natures of foreign exchange markets of developing countries. There are different definitions of developing countries classified by different organisations – examples include the United Nations Development Programme, the World Bank and the International Monetary Fund which have different classification systems based on countries’ development attainment. Nielsen (2011) did however propose a trichotomous taxonomy that would better capture the observed diversity between developing and developed countries as well as within developing countries. Many developing countries did not and do not have the resources to stimulate the economy and protect their socially disadvantaged populations to the same extent as the industrialised countries. The experiences of several emerging market economies suggest that the sustainability of exchange rate policy depends both on adequate policy responses to the shocks to the economy and on the fragility of the economic, financial and political system. Many developing countries did not have the resources to stimulate the economy and protect their socially disadvantaged populations to the same extent as the industrialised countries. The experiences of several emerging market economies suggested that the sustainability of exchange rate policy depends both on adequate policy responses to the shocks to the economy and on the fragility of the economic, financial and political system. Some pieces of research that looked at these exchange rate policies of developing countries that were hot by currency crisis include Frankel and Rose (1996), Chang and Velasco (2000) and Frankel (2005). Prasad et al. (2005) suggested that financial integration should be approached cautiously, with good institutions and macroeconomic frameworks being viewed as important. The review of the available evidence does not, however, provide a clear road map for the optimal pace and sequencing of integration. For instance, there is an unresolved tension between having good institutions in place before undertaking capital market liberalisation and the notion that such liberalisation can, itself, help a country import best practices and provide an impetus to improve domestic institutions.
Given that many issues can be found in foreign exchange markets, this book focuses on the unique features of Malaysia, a developing country, and examines various aspects of foreign exchange risk in Malaysia so that one can have a clearer understanding of the movements of the exchange rate market. Malaysia’s economy has been experiencing liberalisation of the foreign exchange market since 2005. Liberalisation has helped convert the steady stream of change in the real economy into a steady stream of price changes. This has yielded a changed environment of price volatility in the economy. In this new environment, we need to improve our understanding of risk in order to measure it more effectively and create new kinds of financial instruments which allow for risk reduction through hedging.
In 2013, the Central Bank of Malaysia (Bank Negara Malaysia) further liberalised the foreign exchange administration rules to enhance the economy’s competitiveness and further develop the domestic financial market. The liberalisation measures were driven by the introduction of the Financial Services Act (FSA) and the Islamic Financial System Act (IFSA). The measures include allowing residents to freely invest in onshore foreign currency-denominated assets to spur the domestic foreign exchange market through greater demand for foreign currency products and services. Another measure allows resident takaful operators to undertake investments abroad of any amount of their resident clients. This measure would further promote the development of the Islamic financial markets through an increased flow of cross-border Islamic financial activities and greater use of Islamic financial intermediaries. The liberalisation measures would also enhance regulatory efficiency, as resident takaful operators and resident insurers would only be subject to their risk-based capital framework when undertaking investment abroad for their own accounts.
To further promote a risk-management culture and support the development of the foreign exchange market, residents and non-residents would now be permitted to undertake anticipatory hedging involving the ringgit for financial account transactions with onshore banks. Furthermore, non-residents would be permitted to hedge ringgit exposure arising from the ringgit investments acquired prior to 1 April 2005 with onshore banks, in addition to the current flexibility, to hedge the ringgit investments acquired from 1 April 2005.
The main objective of this book is to concentrate on risk measurement and risk management of the foreign exchange market in developing countries, using Malaysia as a case study. There have been many recent developments in the area of volatility modelling, especially time-varying volatility for explaining the behaviour of nominal spot exchange rate movements (see Baillie and McMahon (1989), Campbell et al. (1997), Verbeek (2000) and Knight and Satchell (2002)). The book shows the analysis of exchange rate volatility through standard methods like variance-covariance and standard deviations of past exchange rate movements are limited in terms of risk management implications.
This book will analyse five main trading currencies with respect to Malaysian ringgit to provide breadth of study in terms of risk modelling, measurement and management. The depth of this book is achieved through three ways of extending the standard time-varying approach of the stochastic modelling of exchange rate volatility. The first approach is the application and analysis of a non-Gaussian approach due to non-Gaussian density functions of the volatility exhibited in most empirical exchange rate studies. The second way is to extend the asymmetric and leverage effects (see Black, 1976) of the exchange rate volatility. The third approach to increase the depth of research for this book is to extend the above univariate analysis to multivariate approaches. This multivariate approach gives rise to better tools for decision making in various areas such as asset pricing models, portfolio selection and hedging decisions. Through these different approaches of breadth and depth of analysis to various risk measurement of Malaysia’ foreign exchange markets, we are able to understand the important issues in relation to how quickly exchange rate volatility information flows in the market.

Contribution to knowledge

By focusing on the measurement and management of foreign exchange volatility from the perspective of public and private entities, it is hoped that a better understanding of the underlying volatility structure will help academics, investors and regulators to predict and simulate foreign exchange volatility more effectively in the future. The importance of this book lies in its attempt to improve current financial econometric modelling, particularly in analysing and forecasting volatility of exchange rates, which originated from Engle (1982) and Bollerslev (1986). The extremely low statistical explanatory power of these time-varying volatility models requires more research in this area and this book aims to improve on these models by calibrating new ones that perform better, especially for model fitting, so that better risk management techniques can be applied. Risk measurement is essentially a statistical issue based on historical observations and given a specific model, a statistical estimate of the distribution of the change in value of the exchange rate is calculated.
Another contribution of this book is its focus on an appropriate methodology for simulating the behaviour of the foreign exchange markets, which is the application of non-Gaussian density functions. Summarised in Jondeau et al. (2007), the violations of normality distribution and asymmetric effects of the volatility density functions are common among financial data found in foreign exchange markets.
A comprehensive study of exchange rate volatility provides in-depth analysis not only of the univariate properties of exchange rate volatility between Malaysia and five major trading economies (the USA, the UK, European Union, Japan and Switzerland), but also of the multivariate properties between those five different economies. The extension of univariate to multivariate analysis is important to understand not only individual curren...

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