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Case analysis of
Foreign-exchange trading risk the Moroccan
management with value at risk market
Case analysis of the Moroccan market
273
Mazin A.M. Al Janabi
School of Business Administration, Al Akhawayn University in Ifrane,
Ifrane, Morocco

Abstract
Purpose – The aim of this paper is to fill a gap in the foreign-exchange trading risk-management
literature and particularly from the perspective of emerging and illiquid markets, such as in the
context of the Moroccan foreign-exchange market.
Design/methodology/approach – This paper, demonstrates a constructive approach, for the
management of trading risk exposure of foreign-exchange securities, which takes into account proper
adjustments for the illiquidity of both long and short trading positions. The approach is based on the
renowned concept of value at risk (VaR) along with the innovation of a software tool utilizing
matrix-algebra and other optimization techniques.
Findings – Several case studies, on the Moroccan Dirham, were achieved with the objective of
setting-up a practical framework of trading risk measurement, management and control reports, in
addition to the inception of a practical procedure for the calculation of optimum VaR limits structure.
Practical implications – In this work, the risk-management procedures that are discussed will aid
financial markets’ participants, regulators and policymakers, operating within emerging economies, in
founding sound and proactive policies to handle foreign-exchange trading risk exposures. The
document includes comprehensive theory, analyses sections, conclusions and recommendations, and
full real-world foreign-exchange trading risk-management reports.
Originality/value – Although a substantial literature has examined the statistical and economic
meaning of VaR models, this article provides real-world techniques and optimum asset allocation
strategies that are useful for trading portfolios in emerging and illiquid financial markets. This is with
the objective of setting-up the basis of a proactive methodology/procedure for the measurement,
management and control of foreign-exchange exposures in the day-to-day trading operations.
Keywords Emerging markets, Financial markets, Morocco, Foreign exchange, Risk management
Paper type Research paper

Introduction and overview

Currency risk is one of the major risks that investors in emerging markets may
undertake; however, these markets often have few financial instruments for creating
common hedges for such financial exposure. Emerging markets’ portfolio investments
have the potential of high returns; however, the associated risk, including currency
risk, can be significant. Many of the standard tools used to hedge currency risk, such as
futures, swaps and options contracts, are either not available in emerging markets or,
where available, are traded in illiquid and inefficient markets, making the overall
process of hedging and unwinding of a hedge a difficult task.
Managing foreign-exchange risks now constitutes one of the most difficult and The Journal of Risk Finance
Vol. 7 No. 3, 2006
persistent problems for financial managers of multinational firms. The primary goal in pp. 273-291
foreign-exchange risk management is to shelter corporate profits from the negative q Emerald Group Publishing Limited
1526-5943
impact of exchange rate fluctuations. The second goal is possibly to profit from DOI 10.1108/15265940610664951
JRF exchange rate exposure management. At a minimum, managing foreign-exchange
7,3 risks implies the attempt of making profits that are equal to those possible if the firm
did not engage in foreign-exchange transactions. Achieving this goal calls for both a
corporate structure that fosters accurate assessments of foreign-exchange risk
exposure and the implementation of successful foreign-exchange trading strategies.
The lack of adequate foreign-exchange risk measurement, management, and control
274 tools is one of the contributing factors that have led to major financial losses among
national/multinational corporations in emerging countries. The new Basle accord
(so-called Basle II), for the establishment of adequate internal models of risk
management, has motivated several emerging countries to be part of the agreement at
different implementation levels. Several emerging markets, in the Asian and Latin
American continents, are already in progressive steps to implement, by the end of the
year 2007, modified versions of the Basle agreement with its suggested internal
models.
Several Arab countries, such as Morocco, are also voluntarily joining the
implementation of ad-hoc versions of the Basle II accord. In fact, the Moroccan
financial markets, in general, are still in its early stages of implementing advanced
risk-management regulations and techniques. Moreover, in recent years some progress
has been done in cultivating the culture of risk management among local financial
institutions, nevertheless it is still in its embryonic stages.
The Moroccan banking industry, for instance, is generally sound, reflecting in part
the limited competition within the sector, or from other financial institutions. This is
exactly why Morocco continues to develop its banking system, which was originally
modeled after the French system, to the new financial needs of the national economy
and to allow its opening to the outside world. Consequently, some local banks have
already sold certain parts of their equity to foreign banks’ subsidiaries and have
started the process of modernizing their internal risk-management capabilities. Despite
the latest progress in the Moroccan financial markets, recently it has been deemed
necessary to adapt proper internal rules and procedures that financial entities,
regulators, and policymakers should consider in setting-up their daily trading
risk-management objectives.
Set against this background and as a result of the previous discussion,
foreign-exchange risk management has become an important theme in emerging
and illiquid markets, such as in the case of the Moroccan financial markets.
Accordingly, the goals of this work are to demonstrate the necessary analytical steps
and internal risk-management procedures that a foreign-exchange market’s participant
(dealer or market-maker) will need in his day-to-day positions’ taking.
In particular, the main aim of this paper is to fill a gap in the foreign-exchange
risk-management literature and especially from the perspectives of emerging and
illiquid markets. This paper provides foreign-exchange risk-management methodology
and procedures that can be applied to emerging markets’ foreign-exchange portfolio
investments and also to the day-to-day foreign-exchange trading activities, as
practiced on daily basis by major commercial banks, foreign-exchange dealers
(market-makers) and brokers. In this work, key foreign-exchange trading
risk-management methods, rules and procedures that financial entities, regulators
and policymakers should consider in setting-up their daily foreign-exchange trading
risk-management objectives are examined and adapted to the specific needs of
emerging and illiquid markets, such as in the context of the Moroccan Case analysis of
foreign-exchange market. In particular, the study investigates the application of the Moroccan
modern financial theory and financial risk-management tools and techniques to the
case of emerging markets’ trading portfolios that contain vast amount of illiquid market
foreign-exchange cash securities. It also provides an insight on how to measure and
report daily trading risk of both long and short-trading positions, within its authorized
risk limits constraints, in an innovative and proactive ways to senior management in 275
financial entities. In order to illustrate the proper use of value-at-risk (VaR) and
stress-testing methods, real-world examples and reports of foreign-exchange trading
risk management are presented for the Moroccan Dirham versus some major foreign
currencies.

Literature review and objective of present work

Risk management has become a major endeavor by academics, practitioners, and
regulators, and a cornerstone of recent interest is a class of models called value-at-risk
(VaR) techniques. The concepts of VaR and other advanced risk-management
techniques are in fact not new and are based – with some modifications – on modern
portfolio theory. The VaR method can alert you to the maximum loss that your
portfolio (investment or trading portfolios) could experience so that you can evaluate
such a loss’s potential on your business and to aid you in the decision of where and
when to trim redundant risk(s). The most common VaR models estimate
variance-covariance matrices of asset returns using historical time series, and
assume that the distributions of asset returns are normal. Portfolio risk is a function of
the risk of each asset and the correlation factors among the returns of all trading assets
within the portfolio. The VaR is then calculated from the standard deviation of the
portfolio, given the appropriate investment/liquidation horizon, and the specified
confidence interval.
Thanks to J.P. Morgan’s RiskMetricse (1994) document, the concept of VaR and
other modern risk-management techniques and procedures were popularized. Since
then the VaR concept was widespread and several specific applications were adapted
to credit risk-management and mutual fund investments. The general recognition and
use of large-scale VaR models has initiated a considerable literature including
statistical descriptions of VaR and assessments of different modeling techniques and
approaches. For a comprehensive survey, and the different VaR analysis and
techniques, one can refer to Jorion (2001). For the most part, VaR analyses in the public
domain have been limited to comparing different modeling approaches and
implementation procedures using illustrative portfolios (for instance, Hendricks,
1996; Marshall and Siegel, 1997; Pritsker, 1997).
In their paper Berkowitz and O’Brien (2001) questioned how accurate VaR models
are at commercial banks. Due to the fact that trading accounts at large commercial
banks have considerably grown and become increasingly diverse and complex, the
authors presented statistics on the trading revenues from such activities and on the
associated VaR forecasts internally estimated by banks. More rigorous mathematical
treatment of VaR analysis with dynamic copula models and extreme value theory has
received considerable treatment from Embrechts et al. (2003).
In their article Angelidis and Degiannakis (2005), enumerate the accuracy of
parametric, nonparametric and semi-parametric methods in predicting the
JRF one-day-ahead VaR in three types of markets (namely, stock exchanges, commodities
7,3 and foreign-exchange rates) and for both long and short trading positions. According
to Culp et al. (1998) VaR can be adapted for the use in asset management and for the
estimation of market risk in the long-term horizon. In their study, they explore the
application of VaR to asset management and with particular attention on the
importance of VaR for multi-currency asset managers. In another relevant study, Dowd
276 et al. (2004) tackle the problem of the estimation of VaR for long-term horizon. In their
paper they offer a different; however a rather straightforward, approach that avoids
the inherited problems associated with the square root-of-time rule, as well as those
associated with attempting to extrapolate day-to-day volatility forecasts over long
horizons.
In his research papers, Al Janabi (2005, 2006b) establishes a practical framework for
the measurement, management, and control of trading risk. The effects of illiquid
assets, that are dominant characteristics of emerging markets, were also incorporated
in his models. The established models and the general framework of risk calculations
were mainly based on matrix-algebra techniques. Moreover, in his latest research
paper, Al Janabi (2006a), the robust quantitative measurements and procedures of
market risk were applied to emerging markets’ equity trading portfolios combined
with foreign-exchange trading portfolios. Market risk-management models, which are
implemented in his latest work, were applied to both the Mexican foreign exchange and
stock markets.
Set against this background, the objective of this research paper is to provide
practical and robust guidelines, procedures and measurements of trading risk
(frequently it can be called market risk or price risk) for emerging markets’
foreign-exchange trading portfolios and also to assist these countries in the
establishment of sound risk-management practices within a prudential framework of
rules and policies. To this end, the parameters required for the construction of
appropriate and simplified value-at-risk and stress-testing methods are reviewed from
previous works and refined to the specific applications of these methods to emerging
markets’ foreign-exchange portfolios. Moreover, a simplified approach for the
incorporation of illiquid assets, in daily trading risk-management practices, is defined
and is appropriately integrated into the VaR and stress-testing models.
The trading risk models and procedures that are developed herein are based on the
renowned concept of value at risk (VaR) and the creation of a software tool utilizing
matrix-algebra and EXCELe built-in functions. Matrix-algebra method is a useful
tactic to avoid mathematical complexity, as more and more foreign-exchange securities
are added to the portfolio of assets. In addition, it can simplify the programming
process in EXCELe worksheets and can also permit easy incorporation of short (sell)
and long (buy) positions in the daily risk-management process. The latter effect on
trading positions can, in fact, aid in the setting-up of optimum structure of VaR limits.
In this work, a genuine model for the measurement of the illiquidity of both short and
long trading position is incorporated. In contrast to other commonly used liquidity
models, the liquidity model that is applied in this work is more appropriate for
real-world trading practices since it considers selling small fractions of the long/short
trading securities on a daily basis. Although the risk-measurement method that is
adopted in this work is based mainly on the variance covariance approach (that
assume normal distribution of returns), for emerging and illiquid markets it is possible
to correct for the assumption of normality by including stress-testing (under severe Case analysis of
market conditions) along with the aggregation of a realistic risk factor that takes into the Moroccan
account illiquid trading securities.
Trading risk-management models and procedures, which are innovated in this market
work, were applied to the Moroccan foreign-exchange market. This is with the
objective of setting-up the basis of a methodology/procedure in the Moroccan
foreign-exchange market for the measurement, management and control of 277
foreign-exchange transactions in the day-to-day trading operations. To this end,
databases (of more than one year) of daily foreign-exchange rates were obtained for the
Moroccan’s Central Bank (Bank al-Maghrib) and other database providers. Several
case studies were carried out with the objectives of calculating VaR numbers under
various possible scenarios in addition to the inception of a practical framework for the
establishment of optimum VaR limits setting. The different scenarios were performed,
first, with distinct asset allocation percentages, second, by studying the effects of
liquidity of trading assets (unwinding period of assets) and finally by taking into
account the possibilities of short selling in daily trading operations. Furthermore,
several tests of abnormal (asymmetric) distributions of returns were performed. To this
end, various tests of skewness and kurtosis were implemented. This was followed by a
study of daily and annual volatilities.
The remainder of the paper is organized as follows. In the following section, a brief
overview of the main activities and structures of the Moroccan’s foreign-exchange
market is described. This is preceded with detailed sections that lay down all the
mathematical/quantitative infrastructures of value at risk, and its limitations, and a
model that incorporates the effects of illiquid assets in daily trading risk management.
The results of the empirical tests are drawn in the final section along with conclusions
and recommendations. A full set of all trading risk-management reports is included in
the appendix.

Concise overview of the Moroccan foreign-exchange market

In Morocco, an inter-bank foreign-exchange market was set up in May 1996 to enable
commercial banks to buy and sell foreign currency at market rates. Previously,
foreign-exchange rates were fixed (on a daily basis) by Bank al-Maghrib (the central
bank). Most foreign-exchange transactions for current account purposes were
liberalized in 1993, however capital movements remain restricted. The full Dirham
convertibility, originally planned for 1997, has been delayed. It seems that the central
bank will maintain the Dirham’s peg against a composite basket of currencies
dominated by the Euro over the next couple of years. This peg has been helpful in
generating macroeconomic stability and keeping inflation at low levels. In fact, the
central bank uses a basket of currencies, weighted on a trade basis, to set the value of
the Dirham. The weightings are not disclosed, but by the end of 2003 the basket was
estimated to be weighted at 60 percent against the Euro and 40 percent against the US
Dollar, which roughly reflects the proportions in which Morocco’s exports are priced.
The government has preferred to maintain a relatively strong Dirham to preserve
hard-won macroeconomic benefits, such as low inflation. In fact, devaluation increases
the cost of imports and of servicing external debt, encourages demands for wage rises
and discourages investment. In April 2001, however, the central bank moved to
devalue the currency for the first time in 11 years, following persistent lobbying from
JRF exporters who claimed that they were losing out in export markets to rivals from states
7,3 with convertible currencies. The IMF and the World Bank welcomed the move and
urged Morocco to treat it as the first step to a more flexible exchange rate regime. This
view was supported by the IMF, which said after its 2004 Article IV consultation that
there were no signs that the exchange rate was wrongly aligned, and that pegging the
Dirham to a basket of currencies had helped to keep inflation low. The IMF said it
278 welcomed the government’s plan to look at alternative exchange-rate regimes before
opening the capital account further. The IMF is currently satisfied that the current
exchange rate is not misaligned, although it is keen to see the central bank move to a
more flexible regime in the medium term. Bank al-Maghrib has indicated that it is open
to this idea [The Economist Intelligence Unit (2005)].
Since 2001 the Dirham has appreciated against the Dollar, to the point where it is
stronger than before devaluation. By the end of 2004 the Dirham had reached 8.40
MAD/USD, from MAD/USD 11.56 at the end of 2001. The Dirham’s strengthening has
been caused almost exclusively by the change in the Euro-Dollar rate; against the Euro,
the Dirham lost 3 percent of its value in 2002, 3.9 percent in 2003 and 1.7 percent in
2004. This is broadly good news for Moroccan exporters selling into Europe. In 2005
pressure from exporters for a more competitive rate against the Euro will intensify as
competition in the key European textile market increases. A further depreciation of the
Dirham against the Euro will help prop up European demand for Moroccan
manufactured goods. European demand for Moroccan export will be supported by a
further gradual weakening of the Dirham against the Euro, a natural product of the US
Dollar’s continued weaknesses against the Euro. Nevertheless, the central bank is
unlikely to dismantle the peg and will rely instead on the Dollar component of the
basket to pull down the Dirham’s Euro value. Consequently, and according to the The
Economist Intelligence Unit (2005)], it is forecasted that the Dirham will average
MAD/USD 8.34 in 2005, strengthening to MAD/USD 8.29 in 2006. Against the Euro,
the Dirham will weaken to MAD/EURO 11.26 in 2005, edging lower to MAD/EURO
11.6 in 2006. This is unlikely to satisfy Moroccan exporters, however devaluation is not
expected in the near future.

Synopsis of the calculation of value at risk with the variance/covariance

(parametric) approach
Value at risk (VaR) is a method of assessing market risk that uses standard statistical
techniques routinely used in other technical fields. Formally, VaR measures the worst
expected loss over a given time interval under normal market conditions at a given
confidence level. Assuming the return of a financial product follows a normal
distribution, linear pay-off profile, and a direct relationship between the underlying
product and the income, the VaR is to measure the standard deviation of the income for
a certain confidence level. Although the method relies on several assumptions, it has
gained wide acceptance for the quantification of financial risks. As a result of the
generalization of this method, capital allocations for trading activities tend to be
calculated and adjusted with the VaR method.
To calculate VaR using the variance/covariance (also is known as the parametric)
method, the volatility of each risk factor is extracted from a pre-defined historical
observation period. The potential effect of each component of the portfolio on the
overall portfolio value is then worked out. These effects are then aggregated across the
whole portfolio using the correlations between the risk factors (which are, again, Case analysis of
extracted from the historical observation period) to give the overall VaR value of the the Moroccan
portfolio with a given confidence level. Many financial institutions have chosen a
confidence interval of 95 percent (or 97.5 percent if we only look at the loss side market
[one-tailed]) to calculate VaR. This means that once every 40 trading days a loss larger
than indicated is expected to occur. Some banks use a 99 percent (one-tailed) confidence
interval, which would theoretically lead to larger loss once every 100 trading days. Due 279
to fat tails of the probability distribution, such a loss will occur more often. Some
financial institutions feel that the usage of a 99 percent confidence interval would place
too much trust on the statistical model and, hence, some confidence level should be
assigned to the “art side” of the risk-measurement process.
A simplified calculation process of the estimation of VaR risk factors (using the
variance/covariance method) for a single and multiple assets’ positions is illustrated
(Al Janabi, 2005) as follows:
From elementary statistics it is well known that for a normal distribution, 68
percent of the observations will lie within 1s (standard deviation) from the expected
value, 95 percent within 2sand 99 percent within 3s from the expected value, thus the
VaR of a single asset in dollar terms is:VaRi ¼ a * Value of positioni in dollars *
si,where a is the confidence level and si is the standard deviation (volatility) of the
security that constitutes the single position. The value of the position, is the amount of
investment in dollars, of instrument i.
For multiple assets or portfolio of assets, VaR is a function of each individual
security’s risk and the correlation factor between the returns on the individual
securities as follows:
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
jVARj* jr j* jVARj :
T
VARP ¼

This formula is a general one for the calculation of VaR for any portfolio regardless of
the number of securities. It should be noted that this formula is presented in terms of
matrix-algebra – a useful form to avoid mathematical complexity, as more and more
securities are added. This approach can in fact simplify the programming process in
EXCELe worksheets and can also permit easy incorporation of short selling in the
market risk-management process.
This means that, in order to calculate the VaR (of a portfolio of any number of
securities), one needs first to create a matrix of the individual VaR positions, a
transpose matrix (indicated above by the letter “T” at the top of the matrix) of the
individual VaR positions, and finally a matrix of all correlation factors. Once one
multiplies the three matrices and then takes the square root of the result, he ends up
with the VaRP of any portfolio with any n-number of securities. This simple number
summarizes the portfolio’s exposure to market risk. Investors and senior mangers can
then decide whether they feel easeful with this level of risk. If the answer is no, then the
process that led to the estimation of VaR can be used to decide where to reduce
redundant risk. For instance, the riskiest securities can be sold, or one can use
derivative securities such as futures and options to hedge the undesirable risk.
Illiquid securities such as foreign-exchange rates and equities are very common in
emerging-markets. Customarily these securities are traded infrequently (at very low
volume). Their quoted prices should not be regarded as a representative of the traders’
JRF consensus vis-à-vis their real value but rather as the transaction price that arrived at
7,3 by two counterparties under special market conditions. This of course represents a real
dilemma to anybody who seeks to measure the market risk of these securities with a
methodology that is based on volatilities and correlation matrices. The main problem
arises when the historical price series are not available for some securities or, when
they are available, they are not fully reliable due to the lack of liquidity.
280 The choice of the time horizon or number of days to liquidate (unwind) a position is
very important factor and has big impact on VaR numbers, and it depends upon the
objectives of the portfolio, the liquidity of its positions and the expected holding period.
Typically for a bank’s trading portfolio invested in highly liquid currencies, a one-day
horizon may be acceptable. For an investment manager with a monthly re-balancing
and reporting focus, a 30-day period may be more appropriate. Ideally, the holding
period should correspond to the longest period for orderly portfolio liquidation.
In fact, if one assumes normal distribution, then he can convert the VaR horizon
parameter from daily to any t 2 day horizon. The variance of a t 2 day return should
be t times the variance of a 1 2 day return or s2 ¼ f ðtÞ. Thus, in terms of standard
deviation (or volatility), s ¼ f ðt 1=2 Þ and the daily VaR number can be adjusted for any
horizon as:
pffiffi
VAR ðt 2 dayÞ ¼ VAR ð1 2 dayÞ* t
The above square root-of-time rule was proposed and used by J.P. Morgan in their
earlier RiskMetricse methodology (1994). Unfortunately, the latter approach does not
consider real-life-trading situations, where traders can liquidate (or rebalance) small
portions of their trading portfolios on a daily basis. Moreover, this could generate
unreliable risk assessments and can lead to considerable overestimates of VaR figures,
especially for the purposes of economic capital allocation between trading units.
In order to perform the calculation of VaR under illiquid market conditions, one can
define the following (Al Janabi, 2005):
rffiffiffiffiffiffiffiffiffiffi
tþ1
VARadj ¼ VAR*
2
where t is the number of liquidation days (t 2 day to liquidate the entire asset fully),
VaR is value at risk under liquid market conditions and VaRadj is value at risk under
illiquid market conditions.
A linear liquidation procedure of the asset is assumed in the above formula, i.e.
selling equal parts of each asset every day till the last trading day (t), where the entire
asset is sold. The above approach can also be used to calculate the VaR for any time
horizon.
VaR method is only one approach of measuring market risk and is mainly
concerned with maximum expected losses under normal market conditions. For
prudent risk management, and as an extra management tool, firms should augment
VaR analysis with stress-testing and scenario procedures. From a risk-management
perspective, however, it is desirable to have an estimate for what potential losses could
be under severely adverse conditions where statistical tools do not apply.
In this paper, risk-management procedure was developed to assess potential
exposure due to an event risk (severe crisis) that is associated with large movements of
the Moroccan Dirham vis-à-vis major currencies, under the assumption that emerging Case analysis of
markets’ currencies have typical 5-10 percent leap during periods of financial turmoil.
The task here is to measure the potential risk exposure that is associated with a
the Moroccan
pre-defined leap under several correlation factors assumptions. market

Major limitations and pitfalls of the VaR methodology

Although the VaR method has gained wide acceptance and is currently used by both 281
financial and non-financial firms, there are some common limitations and pitfalls to
applying the method adequately, and they need to be highlighted in conjunction with
the benefits, as follows:
.
Value at risk is now one of the essential tools of risk management, but it is not the
whole story. Its purpose is to give an estimate of losses over a short period under
“normal market” conditions. It is not going to tell you what might happen during
a market crash. VaR estimations cannot be taken as a panacea, since they are
typically based on historical patterns that are not always a good guide to the
future – especially in times of turmoil. For that reason, most entities supplement
the analysis of VaR with other tools such as stress-testing and scenario analysis
(under severe market conditions) to grasp a better picture of hidden unexpected
events.
.
The main assumption underpinning VaR, which is also one of the concept’s main
drawbacks, is that the distribution of future price (or rate) changes will be similar
to that of past price variations. That is, the potential portfolio loss calculations
for VaR are worked out using distributions or parameters from historic price
data in the observation period.
.
The assumption that asset returns are “normally distributed” may
underestimate potential risk due to “fat tails” in the distribution of returns.
For this reason it will be useful to check the validity of the normality assumption
on different assets throughout other parameters such as skewness (a measure of
asymmetry) and kurtosis (a measure of flatness/peakedness) and to carry out
scenario analysis to fully understand the impact of extreme moves.
.
The VaR methodology is more appropriate for measuring the risk of cash
instruments (with linear payoffs) such as foreign-exchange rates, equities and
bonds. In dealing with complex instruments (with non-linear payoffs) such as
derivatives, the method might not give reasonable answers and may misstate
non-linear risks as in the case of options contracts.
.
Correlation assumptions in emerging markets must be taken seriously as
correlation can affect and even change signs. Correlation assumptions can be
either explicit or implicit. In some ways the implicit assumptions are more
dangerous in that they are more easily overlooked. A typical implicit assumption
is a correlation of either zero or one. For example, some emerging markets’
currencies are pegged to the US dollar and one can assume the correlation is very
close to one. This in not really a statistical fact, but rather reflects a policy
decision that could change abruptly.
.
As value at risk is not calculating standard deviations but rather estimating
what they may be in the immediate future. The impact of market volatility and
how to forecast its effects is a crucial issue for emerging markets that are
JRF characterized with low level of liquidity. The estimation of statistical parameters,
7,3 such as the volatility of a foreign-exchange rate, requires a time series of market
data. This can be particularly troublesome in markets in which the underlying
foreign exchange rate experiences only sporadic bursts of trading volume. While
techniques have been developed to account for this, the net result is that a lack of
liquidity reduces confidence in the forecasted volatility, which is an essential tool
282 for the pricing of options contracts.

Foreign exchange trading risk management – the case of the Moroccan

market
In measuring the market risk of a trading position the first step is to identify the
market risk factors that affect its mark-to-market value. For certain trading positions,
the identification of the market risk factors is quite straightforward. For instance, for a
trading position in cash foreign-exchange securities, the prices of the individual foreign
exchanges determine the value of the position and, therefore, the foreign-exchange
prices could be taken as the market risk factors. There is, however, a problem with this
approach: For a large and diversified trading book the number of risk factors becomes
very large and the risk measurement and aggregation becomes unmanageable.
Fortunately, financial theory and related empirical research provide ways of
simplifying the number of market risk factors for foreign-exchange positions.
To this end, historical time-series databases of the Moroccan Dirham vis-à-vis some
major hard currencies were gathered and adequately adapted for the purpose of this
research. The foreign-exchange rates that are used in this study are:
.
MAD/EURO [Moroccan Dirham per Euro Currency];
.
MAD/GBP [Moroccan Dirham per British Pound];
.
MAD/USD [Moroccan Dirham per US Dollar];
. USD/EURO [US Dollar per Euro Currency]; and
.
USD/GBP [US Dollar per British Pound].

Historical databases of daily prices were obtained from the Moroccan Central Bank
(Bank al-Maghrib) and other database’s providers. These databases were for more than
one year of daily prices, and were essential elements for carrying out this research, and
further for the construction of trading risk-management parameters and VaR risk
limits.
In the process of analyzing the data, first, the daily foreign-exchange returns (of the
Moroccan Dirham versus major hard currencies) have all been calculated. These daily
returns are, in fact, essential ingredients for the calculation of standard deviations,
correlation matrices, skewness and kurtosis of all currencies under consideration.
The analysis of data and discussions of most of the relevant findings and results of
this research will be organized and explained as follows:

Analysis of volatility, skewness, and kurtosis

In this section, descriptive statistics is used for the analysis of the particular risk of
each of the risk factors (foreign-exchange rates). In particular, we have examined daily
returns data, the daily and annual volatility, and finally a test of normality (symmetry)
is performed on the sample currencies.
 Table I illustrates the daily and annual volatility of each of the sample foreign Case analysis of
exchange rates under normal market and severe (crisis) market conditions. Crisis the Moroccan
market volatilities were calculated by multiplying the normal volatilities by a factor of
five. From the table one can see that the foreign-exchange rate with the highest market
volatility is USD/EURO whereas the MAD/EURO has the lowest volatility. Annualized
volatilities were performed by adjusting (multiplication) the daily volatilities, with the
square root of 260 – assuming that there are 260 trading days in the calendar year. 283
In another study, the measurements of skewness and kurtosis were achieved on the
sample foreign-exchange rates and market/sectors indices. The results are also
depicted in Table II. It is seen that in general all foreign-exchange rates have shown
slightly asymmetric behavior (both positive and negative values). Moreover, kurtosis
studies have shown similar patterns of abnormality (i.e. flat distributions). The
outcome of this study suggests the necessity of combining value-at-risk calculations –
which assumes normal distributions of returns – with other methods such as
stress-testing and scenario analysis to get a detailed picture of other remaining risks
that cannot be captured with the simple assumption of normality.

Matrices of correlations
On the basis of the daily return data, the correlation factors within the currency sample
were calculated to assess how and to what extent these currencies move together. In
other words, the analysis of correlation serves the purpose of identifying how changes
in foreign-exchange rates, of the different currencies of the trading portfolio, can offset
each other. To this end, three matrices of correlations were created in this study,
namely, correlation ¼ 1, 0, and exact correlations. The objective here was to establish
the necessary quantitative infrastructures for advanced risk-management analysis and
control that will follow shortly. The assembled correlation matrix is depicted in

Daily volatility Daily volatility Annual volatility Annual volatility

(normal market) (crisis market) (normal market) (crisis market)
Foreign exchange rates (%) (%) (%) (%)

MAD/EURO 0.16 0.78 2.53 12.64

MAD/GBP 0.34 1.69 5.46 27.29
MAD/USD 0.46 2.31 7.45 37.26 Table I.
USD/EURO 0.57 2.83 9.13 45.65 Risk analysis daily and
USD/GBP 0.52 2.59 8.36 41.80 annual volatility

Foreign exchange rates Maximum Minimum Median Arithmetic mean Skewness Kurtosis

MAD/EURO 0.45 20.49 0.01 0.00 20.03 0.63 Table II.

MAD/GBP 0.71 21.13 0.05 0.02 20.62 0.38 Risk analysis data:
MAD/USD 1.43 21.09 20.03 2 0.01 0.29 0.21 descriptive statistics of
USD/EURO 1.54 21.71 0.04 0.02 20.25 0.09 the daily returns,
USD/GBP 1.58 21.49 0.07 0.03 20.45 0.81 skewness and kurtosis
JRF Table III, for the exact correlation case, of all foreign-exchange rates. The latter
7,3 correlations matrix was an essential element, along with volatilities matrix, for the
creation of value-at-risk and stress-testing calculations for trading risk-management
analysis and control reports. It is interesting to note that the foreign-exchange rate
MAD/EURO has a negative correlation factor (2 57 percent) against the MAD/USD
exchange rate. This should come as no surprise, since the EURO has the biggest
284 percentage of the basket of currencies that composes the Moroccan Dirham. Moreover,
this observation is generally confirmed by the Moroccan foreign exchange market in
the sense that whenever the MAD/EURO exchange rate suffers slight devaluation,
there is a reciprocal revaluation in the MAD/USD rate. The latter effect has an
important influence on the measurement of foreign-exchange trading risk activities in
Morocco and on the establishment of adequate VaR optimum risk limits.

Trading risk-management and control reports

In this section, several case studies were carried out to emphasize the importance of
trading risk-management reports for daily risk taking practices. In the calculations
reported herein, the effects of different portfolio combinations, various liquidation
periods (unwinding horizons of currency holdings) and short selling of currencies, were
all investigated.
Figure 1 illustrates a practical sample report for the coverage of foreign-exchange
trading risk-management activities of a hypothetical foreign-exchange trading
portfolio. In this first case study, total portfolio value was MAD 700 millions with
different asset allocation values and a liquidity horizon of one trading day – i.e. one
day to unwind all trading positions. It is important to note here that all
foreign-exchange positions are in their equivalent positions – i.e. for instance,
converted from US Dollar or Euro to Moroccan Dirham at the prevailing
foreign-exchange rate of the Moroccan Dirham versus the US Dollar and the Euro
respectively. This table also illustrates the effects of stress-testing (VaR under severe
market conditions) and different correlation factors on daily VaR calculations. The
VaR report depicts also the overnight volatilities – that were calculated as the
volatility of the percentage price changes (daily returns) – of these currencies.
The VaR results were calculated (with confidence level of 97.5 percent [one-tailed]
and under normal and severe market conditions) by taking into account different
correlation factors (þ 1, 0, and exact correlations between the various risk factors).
Under correlation þ 1, one is assuming 100 percent positive relationships between all
risk factors (risk positions) all the times, whereas for the 0-correlation case, there is no
relationships between all positions at all times, however. The last correlation case takes

MAD/EURO (%) MAD/GBP (%) MAD/USD (%) USD/EURO (%) USD/GBP (%)

MAD/EUR 100
Table III. MAD/GBP 4 100
Risk analysis data: MAD/USD 2 57 19 100
correlation matrix of USD/EURO 74 214 297 100
foreign exchange rates USD/GBP 53 48 277 77 100
 Case analysis of
the Moroccan
market

285

Figure 1.
Trading risk management
and control report
(analysis of case study 1)

into account the real correlations between all positions and was calculated via
variance/covariance matrix.
As one might expect, the case with correlation þ 1 gives the highest VaR numbers
(MAD 6,253,343 and MAD 31,266,715), owing to the fact that under these
circumstances the total VaR of the portfolio is the weighted average of the
individual VaRi of each trading position. It is essential to include various correlation
factors in any stress-testing exercise, based on the fact that current trends in
correlations may break down with severe market movements, caused by unexpected
financial or political crises. The degree of diversification of this hypothetical trading
portfolio can also be displayed as the difference in the value of the two greatest VaRs;
i.e. the VaR of correlation ¼ þ 1 case versus the VaR of the exact correlation case
(MAD 2,555,460 or 69 percent for the normal market condition case).
Since the variations in daily VaR are mainly related to the ways in which the assets
are allocated in addition to the liquidation period of assets and the effects of short
selling, it is instructive to examine the way in which the VaR figures are influenced by
changes in such parameters. Figure 2 illustrates the changes in VaR numbers when the
liquidation period was increased to ten trading days for the currencies MAD/EURO,
MAD/GBP and MAD/USD and simultaneously to five trading days for the currencies
USD/EURO and USD/GBP respectively. It is quite obvious why in this case the VaR
numbers have increased substantially vis-à-vis the results obtained in Figure 1.
The effects of short selling (with one day liquidation factor) are depicted in Figure 3.
One of the interesting results of this study is the way in which the VaR numbers have
increased. This behavior might be explained by the nature of the various negative
correlation factors and in the way in which the overall currencies’ portfolio is funded –
in other words, some of the long positions have been funded with the short selling of
other currencies and consequently have led to the augmentation of the overall risk. In
fact, one of the best advantages of the calculation of VaR within the matrix-algebra
framework is the ability in which one can incorporate the effects of short selling
without tedious mathematical analysis.
JRF VaR limit-setting for foreign-exchange trading risk management
7,3 Trading risk limits are an important element for any trading risk-management unit
and it should be defined clearly and used wisely to ensure control on the trading unit’s
exposure to risk. All limit setting and control, monitoring, and reporting should be
performed by the trading risk-management unit, independently from the front office.
In this paper a simplified – however a practical approach – is presented for the
286 setting of optimum VaR limits. To this end, several case studies with different VaR
calculations have been examined in order to setup procedures for the establishment of
VaR trading limits and adequate policies for handling situations in which trading
desks (units) are above the authorized VaR limits.
These VaR limits procedure and methodology must be analyzed and approved by
the board of directors of the financial entity. All trading desks need to have such limits
of VaR as practical guidelines and also as a strict policy for their daily risk takings.
Any excess of VaR beyond the ratified limits must be reported to top management by
the trading risk-management unit. Moreover, traders need to give full and justified
explanations of the reasons of why their overnight VaRs are beyond the approved
limits.
Figures 4-7 represent four case studies for the setting of realistic VaR limits. In all
these four case studies the effects of various asset allocations were investigated for the

Figure 2.
Trading risk management
and control report
(analysis of case study 2)

Figure 3.
Trading risk management
and control report
(analysis of case study 3)
purpose of setting adequate VaR limits. Further, in all cases a liquidation horizon of Case analysis of
one trading day was assumed. For the sake of simplification of the analysis, a the Moroccan
volume-trading limit of MAD 200,000,000 was assumed as a constraint – i.e. the
financial entity must keep a maximum overall market value of different currencies of
market
no more than MAD 200,000,000 (between long and short positions). For optimization

287

Figure 4.
Trading risk management
and control report (VAR
limits setting, case study 1)

Figure 5.
Trading risk management
and control report (VAR
limits setting, case study 2)

Figure 6.
Trading risk management
and control report (VAR
limits setting, case study 3)
JRF
7,3

288
Figure 7.
Trading risk management
and control report (VAR
limit setting, case study 4)

purposes, a second constraint was imposed. This constraint specifies that at least 40
percent of total portfolio’s investment (i.e. MAD 80,000,000 of either long or short
positions) must be allocated to foreign-exchange trading activities in USD/EURO and
USD/GBP currencies respectively.
A summary of the VaR results for the four case studies is illustrated in Tables IV
and V.
As one might expect the highest VaR numbers calculated so far (with exact
correlation factors) is for case study 4, when the overall trading budget was divided
between long and short positions within currencies of the highest overnight volatilities.
This clearly is due to the fact that there were very little diversification benefits to be
taken into account. Moreover, the latter effect can be explained by the fact that long
and short trading positions have already suffered an extra risk component related to
the embedded effects of the negative correlation factors that we have observed earlier
in Table III.
As a conclusion of this study, the board of directors of the financial trading entity
can set the maximum daily trading VaR limits for the foreign-exchange portfolio as
follows:

Exact þ1 0
Table V.
Daily trading VaR in Case study 1 12,690,708 6,842,413 9,324,474
MAD (severe market Case study 2 14,427,806 4,424,374 11,341,269
conditions) with Case study 3 12,703,360 16,057,337 15,480,611
correlation factors Case study 4 16,993,071 8,533,092 13,363,115

Exact þ1 0
Table IV.
Daily trading VaR in Case study 1 2,538,142 1,368,483 1,864,895
MAD (normal market Case study 2 2,885,561 884,875 2,268,259
conditions) with Case study 3 2,540,672 3,211,467 3,096,122
correlation factors Case study 4 3,398,614 1,706,618 2,672,623
 .
Approved VaR limit under normal market conditions ¼ MAD 3,398,614. Case analysis of
.
Approved VaR limit under severe or crisis market conditions ¼ MAD the Moroccan
16,993,071.
market
. Approved volume limit ¼ MAD 200,000,000 (between long and short
foreign-exchange positions).
.
Approved asset allocation percentage ¼ MAD 80,000,000 (i.e. 40 percent of the 289
trading assets, of either long or short positions, must be allocated to
foreign-exchange positions in USD/EURO and USD/GBP currencies).

It should be noted here that the above-approved limits are in their converted (or
equivalent) Moroccan Dirham values at the current or prevailing foreign-exchange rate
of the Dirham.

Concluding remarks
In this document a simplified and robust procedures for calculating and reporting
trading risk exposure is presented for emerging economies, such as the Moroccan
foreign-exchange market. Matrix-algebra approach is used to simplify the calculation
process. This approach has several advantages owing to the fact that it can facilitate
the programming process in EXCELe worksheets and can also permit easy
incorporation of short selling of trading assets into the foreign-exchange trading
process. This can, in fact facilitate the setting of an optimum VaR limits structure.
Trading risk management and control models, which are adopted in this work, were
applied to the Moroccan foreign-exchange market. Thus, our analyses were carried out
for several foreign-exchange rates of the Moroccan Dirham versus major currencies. To
this end, databases of daily foreign-exchange rates were obtained, filtered, and
matched. Several case studies were carried out with the objectives of calculating VaR
numbers under various scenarios. The different scenarios were performed with distinct
asset allocation percentages in addition to analyzing the effects of illiquidity of trading
assets (unwinding horizon period of assets) and the possibilities of short selling.
The analyses that were performed include volatility, skewness, and kurtosis tests.
Our results suggest that in almost all tests, there are clear asymmetric behaviors in the
distribution of returns of the sample currencies. Trading risk-management analysis
and control reports were illustrated for several case studies. In all these case studies,
foreign-exchange trading risk reports with different asset allocation percentages, short
selling and unwinding periods were all investigated and depicted.
VaR limit setting is an important concern as part of the daily risk-management
process. To this end, a procedure was developed to illustrate a practical approach for
the setting of VaR limits for a foreign-exchange trading unit. In all case studies, the
volume limit in Moroccan Dirham (MAD 200,000,000) was assumed constant and was
used as a constraint (on the matrix-algebra’s complex mathematical function) for the
establishment of adequate and practical VaR limits. Moreover, for optimization
purposes a second asset allocation constraint of MAD 80,000,000 was imposed. This
constraint indicates that the trading unit must allocate a total of 40 percent (of either
long or short positions) of the trading budget to foreign-exchange trading activities in
USD/EURO and USD/GBP respectively. For this particular study, the VaR limits were
established for normal and severe market conditions. To this end, several case studies
and simulations were performed with different asset allocations and with the
JRF objectives of setting an optimum limits’ structure for a foreign-exchange trading
7,3 risk-management unit.
In conclusion, the implications of the findings of this study on the Moroccan Dirham
suggest that although there is a clear departure from normality in the distribution of
returns in emerging and illiquid markets, this issue can be tackled without the need of
complex mathematical and analytical procedures. In fact, it is possible to handle these
290 issues for foreign-exchange cash instruments with the simple use of the variance
covariance method (that assume normal distribution of returns) in its matrix-algebra
form; along with the incorporation of a credible stress-testing approach (under severe
market conditions); as well as by supplementing the risk analysis with a realistic
illiquidity risk factor that takes into account real-world trading circumstances. In this
research, a reasonable model for the measurement of the illiquidity of both short and
long trading position is incorporated. In contrast to other commonly used liquidity
models, the liquidity model that is applied in this work is more appropriate for
real-world trading practices since it considers selling small fractions of the long/short
trading securities on daily basis.

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Corresponding author
Mazin A.M. Al Janabi can be contacted at: m.aljanabi@aui.ma

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