Risk Capital and Foreign Indirect Investment: Theory and Evidence from Banks in Asia

Abstract

This article presents an analytical value at risk (VaR) for financial institutions to manage the market risk of international portfolios in foreign indirect investment. The model incorporates the Kupiec’s (1999) model and the Chen and Liao (2009) model, but it more appropriately fits the real world. Taking Japan, Taiwan, and Korea as examples, the empirical results showed that the increase in the weight of a financial institution’s foreign assets strongly enabled its VaR capital allocation to be close to the actual capital. Additionally, the VaR capital bias and default probability bias trended to 1, implying that the VaR model accurately captured the actual risk capital for international portfolios over the subprime mortgage crisis. Alternatively, the relationship between the weights of foreign assets and the VaRs first decreased and then increased. Thus, the VaRs were minimized to obtain the optimal foreign and domestic weights. The empirical results illustrated that bank managers decreased the optimal proportions of foreign assets in Japan, Taiwan or Korea during the subprime crisis, while they increase the weights in a normal economy.