Bankers Training College
Foreign Exchange Risk
Management
P. Vasudevan, MoF
14/12/2006
Bankers Training College
Forex Risk Management
• Forex turnover – huge and carries market risk
• Proprietary position
• Merchant transactions
• Currency & Derivatives – high operational risk
• Need for effective Risk Management system
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Forex Risk Management…
• Activities at branches
• Communication delays
• Wrong / Delayed / Non-reporting of
transactions
• Forged TCs, currency
• Lack of skilled personnel; specialisation
• Audit / Inspection of dealing room – expertise
needed
• Regulatory / Legal compliance / implications
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Types of Exposures
• Currency Exposures
• Risk universe
• Transaction Exposures
• Impacts P&L
• Translation Exposures
• Hedging policy
• Affects B/S
• Economic Exposures
• Direct
• Indirect
• Aids long term planning
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Transaction Exposures
• Transactions are invoiced in a different currency
• Subject to exchange rate movements
• Rate movements alter the cash flows
• May be partly / fully hedged
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Translation Exposures
• Arises on account of the balance sheet need to
convert assets / liabilities held in foreign
currency to home currency
• Exchange rate movement on the translation
dates alters the balance sheet
• Translation exposures become transaction
exposures on settlement dates
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Economic Exposures
• The economic factors of production in different
countries and the exchange rate movements of
different currencies can cause advantage /
disadvantage to exporters or importers
• More a management concept than an
accounting one
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Strategies for Risk Management
• Risk Avoidance
• Risk Hedging
• Risk Acceptance
• Risk Management
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Hedging
• Forward Rate Contracts - time / amount certain
• Currency Options - time, amount uncertain -
Insurance
• Currency Futures
• Currency Swaps, FRAs, IRS
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Types of Risks
• Position Risk
• Gap Risk
• Exposure Risk
• Settlement Risk
• Country Risk
• Liquidity Risk
• Technology Risk &
• Operational Risk
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Position Risk
• Position risk exposes the bank to the risk of price
movements
• Over-bought / Over-sold positions either due to
spot / forward dealings on account of Merchant
or Inter-bank deals, which can be either
domestic or overseas, or even cross- currency
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Position - Aspects to be seen
• Components of Exchange Position
• Calculation of Net Open Position in a single
currency -
• Net Spot, Net Forward and Net Options
Position
• Calculation of Overall Net Open Position for
authorised persons - Short-hand Method
• Forex Risk for merchants
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Preventive Controls
• Separation of dealing & back-up
• Fixing of Intra-day & Overnight limits
• Limits can be currency-wise, if the bank is very
active or can be equivalent of an amount for all
currencies together
• Daily volume turn-over limits
• Cut / Stop-loss, profit cutting / take profit
limits
• Counter-party limits / dealer limits
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Risk Measurement
• Methods of fixing net open position
• Net open position is an indicator of risk
Open position x Stop loss = Loss amount
• Related to capital, by regulatory prescription
• Suitable VaR models can also be used
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Shorthand Method
• Calculate net open position for each currency
• Calculate net open position in gold
• Convert them into rupees
• Arrive at sum of all net short positions
• Arrive at sum of all net long positions
• Overall net open position is the higher of two
• This must be kept within approved OPL
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Monitoring Position Limits
• Watching the limits
• Monitoring pipeline transactions
• Periodic returns
• Revaluation statements / positions
• Exception reports
• 100% risk weight for open positions for capital
adequacy
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Gap Risk
• Caused by mismatches in maturities
• Losses can arise between the time of occurrence
of mismatch and its correction
• The mismatch exposes the bank to interest rate
risk
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Managing the Gap Risk
• Currency-wise monthly gap limits
• Cumulative gap limits for all currencies
• Effective use of swaps for gap management
• Need to have control over gaps
• Liquidity
• Interest rate risk
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Aggregate Gap Limits
• Is the absolute total (ignoring plus or minus) of
all the individual mismatches bank is having for
all the months in a particular currency
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Aggregate Gap Limits…
• RBI removed AGL cap of Rs.100 crore in 1996, directing
banks to
• to review their AGL taking into account the capital
base, dealing expertise, composition of balance sheet,
etc., and set-up new AGL with RBI approval
• AGL at a maximum of 6 times capital funds
• follow an appropriate model for assessing “Value at
Risk”
• FEDAI announces VaR on a daily basis based on
volatilities in the 1, 3 and 6 month forwards
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Exposure Risks
• Exposure risk is nothing but credit risk
• Managed by fixing counter-party limits
• Resulting open position needs to be covered at
ongoing market rates
• Cost of replacing the contract is called
substitution cost / replacement cost
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Settlement Risk
• Also known as Herstat risk
• Arises on account of time-zone differences in
settlements
• Netting mechanism can be used
• CLS
• Role of CCIL
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Quantification of Settlement Risk
• Represents credit risk and exposures are to be
monitored on real-time basis
• Counter-party exposure limits and review at
periodic intervals
• Off-balance sheet exposures converted into
credit equivalent for CRAR
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Country Risk
• Risk profile of countries
• Exchange control regulations
• Legal implications
• Transfer risk
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Liquidity Risk
• Highly adverse movements due to events
• Breach of cut-loss limits
• Leads to defaults / reputational risk
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Operational Risk
• Arises on account of operational irregularities
• Can be on account of deficiencies in control
• Can be on account of non-observance of control
• Acts of God / individuals
• Credit Lyonnais – Burning of trading floor in
1996
• Mizuho Securities Co.
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Managing Operational Risk
• Proper operational controls / limits
• Monitoring of the controls through feedback
• Observance of IC guidelines
• Separation of dealing, mid-office (risk
management) and back-office (settlement and
reconciliation)
• Monitoring of nostro / vostro accounts
• Concurrent / Internal / External audit
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Dealing Room Procedures
• All deals to be captured
• Periodic matching of position on dealers pad
with back office
• Confirmation of deals by back office
• Check on deal rates vis-à-vis market
• Super profits to raise questions / scrutiny
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Reconciliation
• No set-off of debit-credit items
• Write off to be permitted only by top
management
• Minimise number of unreconciled entries
• Periodic report to top management
• Proper use of intermediary accounts
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Risk Management Policy for Corporates
• Risk Management policy
• Clear guidelines for concluding transactions
• Appropriateness and suitability policies
• Procter & Gamble
• Proper documentation / audit trail
• AD to obtain from corporates
• Periodical review of operations
• Annual audit of transactions to verify
compliance with the regulations
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Any Questions ??
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Thank you
