Extreme Moves in Daily Foreign Exchange Rates and Risk Limit Setting
Dr Michel Dacorogna, Converium Ltd, Zurich, Switzerland

Abstract:
Foreign exchange rates can be subject to considerable daily fluctuations (up to 5 percent within one day). This can, in certain cases, cause serious losses on open overnight positions. Given a maximum tolerable loss for a company, limits have to be set on open overnight positions in foreign currencies. Usually, these limits are determined by using a normal ("Gaussian") model for the daily fluctuations. In our study we illustrate how this common model sometimes quite strongly underestimates the actual extreme risks and, based on methods from the Extreme Value Theory (EVT), we propose and justify a more accurate model. We also show how to use these estimations to compute limits that a risk manager can set to open positions to avoid unexpected huge losses.