Information-theoretic approach to quantifying currency risk

Abstract

Purpose

This paper aims to present a framework enriching currency risk analyses based on information theory.

Design/methodology/approach

Information-theoretic measures of predictability (entropy rate) and co-dependence (mutual information) are used to enhance existing methods of analysing and measuring currency risk.

Findings

The currency exchange rates have varying degrees of predictability, which should be accounted for in currency risk analyses. In case of baskets of currencies, a network approach rooted in portfolio theory may be useful.

Research limitations/implications

The currency exchange rate time series must be discretised for the information-theoretic analysis (although the results are robust). An agent-based simulation may be a necessary further study to show what the impact of accounting for predictability in managing currency risk is.

Practical implications

Practical analyses measuring currency risk should take predictability of currency rate changes into account wherever the currency exposure is actively managed.

Originality/value

The paper introduces predictability into measuring currency risk, which has previously been ignored, despite the nature of the risk being inherently tied to uncertainty of the currency rate changes. The paper also introduces a portfolio theory-based approach to quantifying currency risk, which accounts for non-linear co-dependence in the currency markets.

Citation

Fiedor, P. and Hołda, A. (2016), "Information-theoretic approach to quantifying currency risk", Journal of Risk Finance, Vol. 17 No. 1, pp. 93-109. https://doi.org/10.1108/JRF-03-2015-0029