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Evaluation of Foreign Exchange Risk Capital Requirement Models

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Author(s): Claudio H. da S. Barbedo | Gustavo S. Araújo | João Maurício S. Moreira | Ricardo S. Maia Clemente

Journal: Revista Brasileira de Finanças
ISSN 1679-0731

Volume: 3;
Issue: 2;
Start page: 223;
Date: 2005;
Original page

Keywords: capital requirements | Basle agreement | market risk | VaR | currency risk

ABSTRACT
This paper examines capital requirement for financial institutions in order to cover market risk stemming from exposure to foreign currencies. The models examined belong to two groups according to the approach involved: standardized and internal models. In the first group, we study the Basel model and the model adopted by the Brazilian legislation. In the second group, we consider the models based on the concept of value at risk (VaR). We analyze the single and the double-window historical model, the exponential smoothing model (EWMA) and a hybrid approach that combines features of both models. The results suggest that the Basel model is inadequate to the Brazilian market, exhibiting a large number of exceptions. The model of the Brazilian legislation has no exceptions, though generating higher capital requirements than other internal models based on VaR. In general, VaR-based models perform better and result in less capital allocation than the standardized approach model applied in Brazil.
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