Estimating foreign currency exposure in the Canadian Department of National Defence

ABSTRACT Quantifying foreign currency risk is not a trivial process, although it is generally accepted that the standard method for reporting financial risk today is the value-at-risk (VaR) method, which provides a quantitative measure of the downside risk of exposure in all foreign currency transactions. This paper documents the theory and application of a model that is built on forecasting expenditures related to departmental materiel procurement and capital equipment accounts, and the time-varying volatility of foreign currency returns. These diverse methodologies are combined into an overall VaR model to determine the maximum expected loss from adverse exchange rate fluctuations over the budget year. This is recognized as the first step the Canadian Department of National Defence must take before considering risk mitigation strategies to reduce and, hopefully, eliminate foreign transaction exposure.