Foreign Exchange Risks: What gives rise to foreign exchange transactions?

Basically, there are four important factors which give rise to foreign exchange deals or transactions: (a) trade (exports/imports); (b) transfer (remittances); (c) investment (say, FCNR transactions); and (d) speculation. If one were to ask what is the proportion of speculation to the first three in the global foreign exchange market, one would be shocked to know that speculation accounts for nearly 96 per cent of the foreign exchange turnover of about US$ 700 billion per day in the international foreign exchange market. As we are aware, banks have established huge dealing rooms, and foreign exchange dealers are consistently buying and selling foreign currencies to make profits for their own institutions. Although speculation or pure dealing, as opposed to a merchant transaction, is anathema to banking, it is not uncontrolled speculation, as most senior managements of banks have imposed stringent controls to contain exposures and, therefore, the expression used in the dealing rooms is normally that dealers are taking a view of the market based on their educated judgments. A corporate treasurer is puzzled by the concept of speculation by banks and questions whether the speculation of this magnitude is good for him. However, one cannot deny that without a number of participating banks, and the sizable volume of business transacted, foreign exchange markets would be very patchy, and the exchange rates would move in an erratic manner. It is, therefore, clear that a merchant customer is able to get competitive exchange rates which move very smoothly except in times of extraordinary situations. We can, therefore, conclude that speculation is in the interest of a corporate treasurer rather than against him. A corporate treasurer is able to talk to a number of banks to get the best possible rate for his merchant transaction and end up striking a good bargain with a competitive bank. Nature of Foreign Exchange Risk: Foreign Exchange dealing is a business that one get involved in, primarily to obtain protection against adverse rate movements on their core international business. Foreign Exchange dealing is essentially a risk-reward business where profit potential is substantial but it is extremely risky too. Foreign exchange business has the certain peculiarities that make it a very risky business. These would include:

Forex deals are across country borders and therefore, often foreign currency prices are subject to controls and restrictions imposed by foreign authorities. Needless to say, these controls and restrictions are invariably dictated by their own domestic factors and economy.

Forex deals involve two currencies and therefore, rates are influenced by domestic as well as international factors. The Forex market is a 24-hour global market and overseas developments can affect rates significantly.

The Forex market has great depth and numerous players shifting vast sums of money. Forex rates therefore, can move considerably, especially when speculation against a currency rises.

Forex markets are characterized by advanced technology, communications and speed. Decision-making has to be instantaneous. Description of Foreign Exchange Risk: In simple word FOREX risk is the variability in the profit due to change in foreign exchange rate. Suppose the company is exporting goods to foreign company then it gets the payment after month or so then change in exchange rate may effect in the inflows of the fund. If rupee value depreciated he may loose some money. Similarly if rupees value appreciated against foreign currency then it may gain more rupees. Hence there is risk involved in it.

Classification of Foreign Exchange Risk:

Position Risk Gap or Maturity or Mismatch Risk Translation Risk Operational Risk Credit Risk 1. Position Risk The exchange risk on the net open Forex position is called the position risk. The position can be a long/overbought position or it could be a short/oversold position. The excess of foreign currency assets over liabilities is called a net long position whereas the excess of foreign currency liabilities over assets is called a net short position. Since all purchases and sales are at a rate, the net position too is at a net/average rate. Any adverse movement in market rates would result in a loss on the net currency position. For example, where a net long position is in a currency whose value is depreciating, the conversion of the currency will result in a lower amount of the corresponding currency resulting in a loss, whereas a net long position in an appreciating currency would result in a profit. Given the volatility in Forex markets and external factors that affect FX rates, it is prudent to have controls and limits that can minimize losses and ensure a reasonable profit. The most popular controls/limits on open position risks are:

Daylight Limit : Refers to the maximum net open position that can be built up a trader during the course of the working day. This limit is set currency-wise and the overall position of all currencies as well.

Overnight Limit : Refers to the net open position that a trader can leave overnight to be carried forward for the next working day. This limit too is set currency-wise and the overall overnight limit for all currencies. Generally, overnight limits are about 15% of the daylight limits.

2. Mismatch Risk/Gap Risk: Where a foreign currency is bought and sold for different value dates, it creates no net position i.e. there is no FX risk. But due to the different value dates involved there is a mismatch i.e. the purchase/sale dates do not match. These mismatches, or gaps as they are often called, result in an uneven cash flow. If the forward rates move adversely, such mismatches would result in losses. Mismatches expose one to risks of exchange losses that arise out of adverse movement in the forward points and therefore, controls need to be initiated. The limits on Gap risks are:

Individual Gap Limit : This determines the maximum mismatch for any calendar month; currency-wise. Aggregate Gap Limit : Is the limit fixed for all gaps, for a currency, irrespective of their being long or short. This is worked out by adding the absolute values of all overbought and all oversold positions for the various months, i.e. the total of the individual gaps, ignoring the signs. This limit, too, is fixed currency-wise.

Total Aggregate Gap Limit : Is the limit fixed for all aggregate gap limits in all currencies. 3. Translation Risk: Translation risk refers to the risk of adverse rate movement on foreign currency assets and liabilities funded out of domestic currency. There cannot be a limit on translation risk but it can be managed by:

1. Funding of Foreign Currency Assets/Liabilities through money markets i.e. borrowing or lending of foreign currencies 2. Funding through FX swaps 3. Hedging the risk by means of Currency Options 4. Funding through Multi Currency Interest Race Swaps 4. Operational Risk The operational risks refer to risks associated with systems, procedures, frauds and human errors. It is necessary to recognize these risks and put adequate controls in place, in advance.

It is important to remember that in most of these cases corrective action needs to be taken post-event too. The following areas need to be addressed and controls need to be initiated.

Segregation of trading and accounting functions : The execution of deals is a function quite distinct from the dealing function. The two have to be kept separate to ensure a proper check on trading activities, to ensure all deals are accounted for, that no positions are hidden and no delay occurs.

Follow-up and Confirmation: Quite often deals are transacted over the phone directly or through brokers. Every oral deal has to be followed up immediately by written confirmations; both by the dealing departments and by back-office or support staff. This would ensure that errors are detected and rectified immediately.

Settlement of funds: Timely settlement of funds is necessary not only to avoid delayed payment interest penalty but also to avoid embarrassment and loss of credibility. Overdue contracts: Care should be taken to monitor outstanding contracts and to ensure proper settlements. This will avoid unnecessary swap costs, excessive credit balances and overdrawn Nostro accounts.

Float transactions: Often retail departments and other areas are authorised to create exposures. Proper measures should be taken to make sure that such departments and areas inform the authorised persons/departments of these exposures, in time. A proper system of maximum amount trading authorities should be installed. Any amount in excess of such maximum should be transacted only after proper approvals and rate.

5. Credit Risk Credit risk refers to risks dealing with counter parties. The credit is contingent upon the performance of its part of the contract by the counter party. The risk is not only due to non performance but also at times, the inability to perform by the counter party. The credit risk can be

Contract risk: Where the counter party fails prior to the value date. In such a case, the Forex deal would have to be replaced in the market, to liquidate the Forex exposure. If there has been an adverse rate movement, this would result in an exchange loss. A contract limit is set counter party-wise to manage this risk.

Clean risk: Where the counter party fails on the value date i.e. it fails to deliver the currency, while you have already paid up. Here the risk is of the capital amount and the loss can be substantial. Fixing a daily settlement limit as well as a total outstanding limit, counter party-wise, can control such a risk.

Sovereign Risk: refers to risks associated with dealing into another country. These risks would be an account of exchange control regulations, political instability etc. Country limits are set to counter this risk.

Foreign exchange risk management by banks: Exchange Dealings When the foreign currency denominated assets and liabilities are held, by the banks or the business concern, two types of risks are faced. Firstly, the risk that the exchange rates may vary and the change may affect the cash flows/profits. This is known as exchange risk. Secondly, the interest rate may vary and it may affect the cost of holding the foreign currency assets and liabilities. This is known as interest rate risk. Dealing Position Foreign exchange is such a sensitive commodity and subject to wide fluctuations in price that the bank which deals in it would like to keep the balance always near zero, The bank would endeavour to find a suitable buyer wherever it purchase so as to dispose of the foreign exchange acquired and be free from exchange risk. Likewise, whenever it sells it tries to cover its position by a corresponding purchase. But, in practice, it is not possible to march purchase and sale for each transaction. So the bank tries to match the total purchases of the day to the days total sales. This is done for each foreign currency separately. If the amount of sales and purchases of a particular foreign currency is equal, the position of the bank in that currency is said to be square. If the purchases exceed sales, then the bank is said to be in overbought or long position. If the sales exceed purchases, then the bank is said to be in oversold of short position. The banks endeavour would be to keep its position square. If it is in overbought or oversold position, it is exposing itself to exchange risk. There are two aspects of maintenance of dealing positions. One is the total of purchase or sale or commitment of the bank to purchase or sell, irrespective of the fact whether actual delivery has taken place or not. This is known as the exchange position. The other is the actual balance in the banks account with its correspondent abroad, as a result of the purchase or sale made by the bank. This is known as the cash position. Exchange Position Exchange position is the new balance of the aggregate purchases and sales made by the bank in particular currency. This is thus an overall position of the bank in a particular currency. All purchases and sales whether spot or forward are included in computing the exchange position. All transactions for, which the bank has agreed for a firm rate with the counterparty are entered into the exchange position when this commitment is made. Therefore, in the case of forward contracts, they will enter into the exchange position on the date the contract with the customer is concluded. The actual date of delivery is not considered here. All purchases add to the balance and all sales reduce the balance. The exchange position is worked out every day so as to ascertain the position of the bank in that particular currency. Based on the position arrived at, remedial measures as are needed may be taken. For example, if the bank finds that it is oversold to the extent of USD 25,000. It may arrange to buy this amount from the interbank market. Whether this purchase will be spot or forward will depend upon the cash position. If the bank has commitment of deliver foreign exchange soon, but it has no sufficient balance in the nostro account abroad, it may purchase spot. If the bank has no immediate requirement of foreign exchange, it may buy it forward. Examples of sources for the bank for purchase of foreign currency are:

Payment of DD, MT, TT, travellers cheques, etc.

Purchase of bills, Purchase of other instruments like cheques. Forward purchase contracts (entered to the postion of the date of contracts). Realisation of bills sent for collection. Purchase in interbank/international markets. Examples of avenues of sale are: Issue of DD, MT, TT, travelers cheques, etc. Payments of bills drawn on customers. Forward sale contract (entered in the position on the date of contracts). Sale to interbank/international markets. Exchange position is also known as dealing position. Cash Position Cash position is the balance outstanding in the banks nostro account abroad. The stock of foreign currency is held by the bank in the form of balances with correspondent bank in the foreign centre concerned. All foreign exchange dealings of the bank are routed through these nostro accounts. For example, an Indian bank will have an account with Bank of America in New York. If the bank is requested to issue a demand draft in Us dollars. It will issue the draft on Bank of America, New York. On presentation at New York the banks account with Bank of America will be debited. Likewise, when the bank purchase a bill in US dollars, it will be sent for collection to Bank of America. Alternatively, the bill may be sent to another bank in the USA, with instructions to remit proceeds of the bill are credited, on realisation, to the banks account with Bank of America. The purchase of foreign exchange by the bank in India increases the balance and sale of foreign exchange reduces the balance in the banks account with its correspondent bank abroad.

RBIs Role in Risk Management and Settlement of Transactions in the Foreign Exchange Market: The Indian Foreign Exchange (Forex) market is characterized by constant changes and rapid innovations in trading methods and products. While the innovative products and ways of trading create new possibilities for profit, they also pose various kinds of risks to the market. Central banks all over the world, therefore, have become increasingly concerned of the scale of foreign exchange settlement risk and the importance of risk mitigation measures. Behind this growing awareness are several events in the past in which foreign exchange settlement risk might have resulted in systemic risk in global financial markets, including the failure of Bankhaus Herstatt in 1974 and the closure of BCCI SA in 1991. The foreign exchange settlement risk arises because the delivery of the two currencies involved in a trade usually occurs in two different countries, which, in many cases are located in different time zones. This risk is of particular concern to the central banks given the large values involved in settling foreign exchange transactions and the resulting potential for systemic risk. Most of the banks in the EMEs use some form of methodology for measuring the foreign exchange settlement exposure. Many of these banks use the single day method, in which the exposure is measured as being equal to all foreign exchange receipts that are due

on the day. Some institutions use a multiple day approach for measuring risk. Most of the banks in EMEs use some form of individual counterparty limit to manage their exposures. These limits are often applied to the global operations of the institution. These limits are sometimes monitored by banks on a regular basis. In certain cases, there are separate limits for foreign exchange settlement exposures, while in other cases, limits for aggregate settlement exposures are created through a range of instruments. Bilateral obligation netting, in jurisdictions where it is legally certain, is an important way for trade counterparties to mitigate the foreign exchange settlement risk. This process allows trade counterparties to offset their gross settlement obligations to each other in the currencies they have traded and settle these obligations with the payment of a single net amount in each currency. Several emerging markets in recent years have implemented domestic real time gross settlement (RTGS) systems for the settlement of high value and time critical payments to settle the domestic leg of foreign exchange transactions. Apart from risk reduction, these initiatives enable participants to actively manage the time at which they irrevocably pay way when selling the domestic currency, and reconcile final receipt when purchasing the domestic currency. Participants, therefore, are able to reduce the duration of the foreign exchange settlement risk. Recognizing the systemic impact of foreign exchange settlement risk, an important element in the infrastructure for the efficient functioning of the Indian foreign exchange market has been the clearing and settlement of inter-bank USD-INR transactions. In pursuance of the recommendations of the Sodhani Committee, the Reserve Bank had set up the Clearing Corporation of India Ltd. (CCIL) in 2001 to mitigate risks in the Indian financial markets. The CCIL commenced settlement of foreign exchange operations for inter-bank USD-INR spot and forward trades from November 8, 2002 and for inter-bank USD-INR cash and tom trades from February 5, 2004. The CCIL undertakes settlement of foreign exchange trades on a multilateral net basis through a process of notation and all spot, cash and tom transactions are guaranteed for settlement from the trade date. Every eligible foreign exchange contract entered between members gets notated or replaced by two new contracts between the CCIL and each of the two parties, respectively. Following the multilateral netting procedure, the net amount payable to, or receivable from, the CCIL in each currency is arrived at, member-wise. The Rupee leg is settled through the members current accounts with the Reserve Bank and the USD leg through CCILs account with the settlement bank at New York. The CCIL sets limits for each member bank on the basis of certain parameters such as members credit rating, net worth, asset value and management quality. The CCIL settled over 900,000 deals for a gross volume of US $ 1,180 billion in 2005-06. The CCIL has consistently endeavoured the entire gamut of foreign exchange transactions under its purview. Intermediation, by the CCIL thus, provides its members the benefits of risk mitigation, improved efficiency, lower operational cost and easier reconciliation of accounts with correspondents. An issue related to the guaranteed settlement of transactions by the CCIL has been the extension of this facility to all forward trades as well. Member banks currently encounter problems in terms of huge outstanding foreign exchange exposures in their books and this comes in the way of their doing more trades in the market. Risks on such huge outstanding trades were found to be very high and so were the capital requirements for supporting such trades. Hence, many member banks have expressed their desire in several fora that the CCIL should extend its guarantee to these forward trades from the trade date itself which could lead to significant increase in the liquidity and depth in the forward market. The risks that banks

today carry in their books on account of large outstanding forward positions will also be significantly reduced (Gopinath, 2005). This has also been one of the recommendations of the Committee on Fuller Capital Account Convertibility. Apart from managing the foreign exchange settlement risk, participants also need to manage market risk, liquidity risk, credit risk and operational risk efficiently to avoid future losses. As per the guidelines framed by the Reserve Bank for banks to aligns and exposure in derivative markets as market makers, the boards of directors of ADs (category-I) are required to frame an appropriate policy and fix suitable limits for operations in the foreign exchange market. The net overnight open exchange position and the aggregate gap limits need to be approved by the Reserve Bank. The open position is generally measured separately for each foreign currency consisting of the net spot position, the net forward position, and the net options position. Various limits for exposure, viz., overnight, daylight, stop loss, gap limit, credit limit, value at risk (VaR), etc., for foreign exchange transactions by banks are fixed. Within the contour of these limits, front office of the treasury of ADs transacts in the foreign exchange market for customers and own proprietary requirements. These exposures are accounted, confirmed and settled by back office, while mid-office evaluates the profit and monitors adherence to risk limits on a continuous basis. In the case of market risk, most banks use a combination of measurement techniques including and managed by most banks on an aggregate counter-party basis so as to include all exposures in the underlying spot and derivative markets. Some banks also monitor country risk through cross-border country risk exposure limits. Liquidity risk is generally estimated by monitoring asset liability profile in various currencies in various buckets and monitoring currency-wise gaps in various buckets. Banks also track balances to be maintained on a daily basis in Nostro accounts, remittances and committed foreign currency term loans while monitoring liquidity risk. To sum up, the foreign exchange market structure in India has undergone substantial transformation from the early 1990s. The market participants have become diversified and there are several instruments available to manage their risks. Sources of supply and demand in the foreign exchange market have also changed in line with the shifts in the relative importance in balance of payments from current to capital account. There has also been considerable improvement in the market infrastructure in terms of trading platforms and settlement mechanisms. Trading in Indian foreign exchange market is largely concentrated in the spot segment even as volumes in the derivatives segment are on the rise. Some of the issues that need attention to further improve the activity in the derivatives segment include flexibility in the use of various instruments, enhancing the knowledge and understanding the nature of risk involved in transacting the derivative products, reviewing the role of underlying in booking forward contracts and guaranteed settlements of forwards. Besides, market players would need to acquire the necessary expertise to use different kinds of instruments and manage the risks involved. Management of Foreign Exchange Risks Generally, the corporate treasurers fall into one of the three categories: (a) Those who cover every exposure; (b) Those who do not cover all; and (c) Those who cover judiciously. The first category belongs to corporate which are extremely conservative and, therefore, cover every exposure immediately by entering into a forward exchange contract with a bank

their contention is that they should best concentrate on the line of their business rather than dabble in the speculative world of foreign exchange. If the corporate cover every exposure, obviously they eliminate the foreign exchange risk altogether. The second category belongs to corporate which believe in the do nothing approach and cover their exposure on a spot basis at whatever rate is offered on the date of remittance. This category of corporate, therefore, believes in keeping exposures open and, pays for the risk they assume. Although in some cases they might benefit by favorable movements of exchange rates, they do not crystallize their liabilities and will never know their rupee liabilities until the date of remittance. The third category belongs to corporate which cover their exposure judiciously by talking to corporate dealers of the respective banks and deciding whether to book exposure or not, depending upon short term / long-term trends of currencies, the rate of depreciation of the rupee against foreign currency, and the level of premier and discounts prevailing in the inter-bank market. It is, therefore, obvious that a corporate treasurer may belong to any one of the three categories and depending upon circumstances, decide his policy on foreign exchange objective may be stated to curtail losses on account of exchange risk fluctuations to the extent of I per cent of the cost of goods or projected cost during the period I January to 31 December 1990. Within these broad objectives, the operative staff can be given authority to book exposure within 1/4 per cent or 1/2 per cent of costs involved so that they do not have to revert to the senior management every time an exposure decision needs to be taken. The operating staff could then work in close co-ordination with the corporate dealers of banks and efficiently cover the exchange risk on an on-going basis. Suggestions Here are a few practical suggestions for corporate treasurers to manage their exchange risk, (a) Quotes from more than one bank: It is imperative that a corporate treasurer takes advantage of rates quoted by different banks. The corporate treasurers must take quotes from at least two banks before concluding business with any one of them. Exchange rates will not be the same with banks depending upon currency position of each bank, the nature of operation whether cover operation or trading operation, quality of dealers, and currency traded. Although it may not be possible for a corporate treasurer to take away business from one bank to another due to funded facilities, which may be made available, it at least improves his bargaining power with the bank, and in some cases he may be able to get an improved rate quoted to him. Banks normally quote indicative rates in the morning, which are subject to variation, and a firm rate is quoted only if a corporate treasurer wishes to do business at that point of time. (b) Indicate Your Interest: It is very important that a corporate treasurer establishes a close rapport with the corporate dealer in his bank and absolute confidence should exist between the two of them. It is desirable that a corporate treasurer confides in the corporate dealer and discloses his position, which he wishes to cover so that the corporate dealer can keep this in mind and revert to him whenever an opportunity arises to cover the position profitably. For instance, a corporate treasurer can inform the dealer that he wishes to cover his three months export exposure at US$ 5.56. A corporate dealer will call the client whenever the spot rate appreciates and the premiums are higher to give the benefit of the desired rate to the customer.

(c) Standing Instruction: If the corporate treasurer is not likely to be available in the office, for some reason, it is expedient to leave a standing instruction with a corporate dealer to cover his exposure, let us say, at US$ 5.56 so that the corporate treasurer does not lose out on an opportunity presented in the market (d) Stop Loss Order: Stop loss orders are also a kind of standing instruction to stop loss in a deteriorating market. For instance, if an importer does not want to cover his exposure at a rate worse than US$ 5.60, he should leave such instructions with a corporate dealer to stop loss at US $ 5.60, a limit up to which he can sustain loss. (e) Quick Decision: In a volatile foreign exchange market, quick decisions are of paramount importance and, therefore, a corporate treasurer should not keep dealers holding to give decisions. Once a rate is quoted, a dealer is also running the risk and if the market changes, the rate may not hold well. It is, therefore, important that the senior management in a company delegates authority within certain parameters to the operating staff so that they are able to quickly respond to the dealers on telephone. (f) Partial Hedge: When in doubt, partial hedge is the answer. There is no auspicious day for booking foreign exchange exposure and if one feels that the rate offered is reasonable, one should at least book a part of the exposure rather than leaving the entire exposure to be covered on a single day in the future. What matters are the average rate for a series of transactions rather than a good rate for one transaction? (g) Forward Period: There are spot rates and forward rates in the foreign exchange market. Forward rates are quoted at either premium or discount depending upon whether the currency is at premium or discount and it is, therefore, important that a corporate treasurer informs the appropriate period to the corporate dealer to enable him to quote an accurate rate. For example, if an exporter wants to ship his goods after a period of three months, he should ask for a three-month forward rate rather than the spot rate. Choice of Bank A corporate treasurer cannot efficiently manage his foreign exchange risk unless he is helped by a bank which has a well equipped dealing room with the necessary infrastructure facilities and trained dealers who have the support of over-seas dealing centers. The choice of a bank will also depend upon the individual currency requirement. Many banks have consultancy services, and publish newsletters, to keep their clients advised about the happenings in the international markets. The corporate treasurers should take advantage of such services and keep in close touch with trends of the currencies, and endeavor to manage their exposure in a professional manner. In the last few years, many corporate treasurers have come to grief for not appreciating exchange risks involved in foreign trade, resulting in the escalation of project costs, working capital, and cash flow problems. Although RBI has not allowed the introduction of sophisticated products, such as options or swaps in the local market, exchange risk can be managed more effectively by following the approaches discussed in this paper.