The dependence structure and portfolio risk of Malaysia's foreign exchange rates: the Bayesian GARCH–EVT–copula model

Abstract

PurposeThis paper investigates the dependence structure and market risk of the currency exchange rate portfolio from the Malaysian ringgit perspective.Design/methodology/approachThe marginal return of the five major exchange rates series, i.e. United States dollar (USD), Japanese yen (JPY), Singapore dollar (SGD), Thai baht (THB) and Chinese Yuan Renminbi (CNY) are modelled by the Bayesian generalized autoregressive conditional heteroskedasticity (GARCH) (1,1) model with Student's t innovations. In addition, five different copulas, such as Gumbel, Clayton, Frank, Gaussian and Student's t, are applied for modelling the joint distribution for examining the dependence structure of the five currencies. Moreover, the portfolio risk is measured by Value at Risk (VaR) that considers the extreme events through the extreme value theory (EVT).FindingsThe finding shows that Gumbel and Student's t are the best-fitted Archimedean and elliptical copulas, for the five currencies. The dependence structure is asymmetric and heavy tailed.Research limitations/implicationsThe findings of this paper have important implications for diversification decision and hedging problems for investors who involving in foreign currencies. The authors found that the portfolio is diversified with the consideration of extreme events. Therefore, investors who are holding an individual currency with VaR higher than the portfolio may consider adding other currencies used in this paper for hedging.Originality/valueThis is the first paper estimating VaR of a currency exchange rate portfolio using a combination of Bayesian GARCH model, EVT and copula theory. Moreover, the VaR of the currency exchange rate portfolio can be used as a benchmark of the currency exchange market risk.

Editorial statement and research ideas for behavioral financial economics in the emerging market

“…Examining the market risk, the dependence structure and the joint distribution of the portfolio formed by currency exchange rates and the extreme events through the extreme value theory, Yeap et al (2021) find that the marginal returns of CNY, USD, SGD, THB and JPY follow the Bayesian GARCH(1,1) model with Student's t errors and show that Student's t and Gumbel are the best elliptical and Archimedean copulas, respectively, for CNY, USD, SGD, THB and JPY. Last, Wong (2021) discusses some research ideas and provides an editorial statement in behavioral financial economics.…”

“…In this special issue, we invite academics and practitioners to submit their research or review manuscripts that fit in the spirit and scope of our special issue. The special issue of Behavioral Financial Economics in Emerging Markets has published five papers including Hong et al (2021), Lo et al (2021), Shen et al (2021), Wong (2021) and Yeap et al (2021).…”