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1 INTRODUCTION 3
3 TYPES OF FOREIGN 6
EXCHANGE RISK
4 TYPES OF EXPOSURE 11
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position in a foreign currency at a loss due to an adverse movement in exchange
rates. Also known as "currency risk" or "exchange-rate risk”. This risk usually
affects businesses that export and/or import, but it can also affect investors making
international investments. For example, if money must be converted to another
currency to make a certain investment, then any changes in the currency exchange
rate will cause that investment's value to either decrease or increase when the
investment is sold and converted back into the original currency.
The risk that the exchange rate on a foreign currency will move against the
position held by an investor such that the value of the investment is reduced. For
example, if an investor residing in the United States purchases a bond denominated
in Japanese yen, deterioration in the rate at which the yen exchanges for dollars
will reduce the investor's rate of return, since he or she must eventually exchange
the yen for dollars. Also called exchange rate risk.
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The economic liberalization of the early nineties facilitated the introduction
of derivatives based on interest rates and foreign exchange. However derivative
use is still a highly regulated area due to the partial convertibility of the rupee.
Currently forwards, swaps and options are available in India and the use of foreign
currency derivatives is permitted for hedging purposes only. The risks related to
foreign exchange are many and are mainly on account of the fluctuations in foreign
currency.
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2. Foreign exchange dealings cross national boundaries and rates move on the
basis of governmental regulations, fiscal policies, political instabilities and a
variety of other causes.
3. Foreign exchange rate movements, like the stock market, are influenced by
sentiments that may not always be logical.
4. Foreign exchange is traded hours a day at different markets and dealers
cannot be in control at all times.
5. The ratings of credit agencies can affect the exchange rate. For instance,
when Indian’s foreign exchange rating was downgraded by Moody’s in the
mid—1990s, the value of rupee fell.
6. A rate move instantaneously and very fast. A hesitation of a few seconds or
minutes can change a profit to a loss and vice versa.
1. Transaction risk.
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2. Position risk.
3. Settlement or credit risk.
4. Mismatch or liquidity risk.
5. Operational risk.
6. Sovereign risk.
7. Cross- country risk.
A. Transaction risk:
Any transaction leading to future receipts in any form or
creation of long term asset. This consists of a number of:
1. Trading items (foreign currency, invoiced trade
receivables and payables) and
2. Capital items (foreign currency dividend and loan
payments)
3. Exposure associated with the ownership of foreign
currency denominated assets and liabilities.
B. Position risk:
Bank dealings with customers continuously, both on spot and
forward basis, results in positions (buy i.e. long position or sell
i.e. short position) being created in currencies in which these
transactions are denominated. A position risk occurs when a
dealer in bank has an overbought (long) or an oversold (short)
position. Dealers enter into these positions in anticipation of a
favorable movement.
The risk arising out of open positions is easy to understand. If
one currency is overbought and it weakens, one would be able
to square the overbought position only by selling the currency
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at a loss. The same would be the position if one is oversold and
the currency hardens.
C. Settlement or credit risk:
Also known as time zone risk, this is a form of credit risk that
arises from transactions where the currencies settle in
different time zones. A transaction is not complete until
settlement has taken place in the latest applicable time zone.
This is also referred to as “Herstatt Risk”. Arising from the
failure or default of a counterparty. Technically, this is a
credit risk where only one side of the transaction has settled.
If a counterparty fails before any settlement of a contract
occurs, the risk is limited to the difference between the
contract price and the current market price (i.e. an exchange
rate risk).
Settlement risk is the risk of a counterparty failing to meet its
obligations in a financial transaction after the bank has
fulfilled its obligations on the date of settlement of the
contract. Settlement risk exposure potentially exists in foreign
exchange or local currency money market business.
D. Mismatch or liquidity risk:
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the market wants to trade that asset. Liquidity risk becomes
particularly important to parties who are about to hold or
currently hold an asset, since it affects their ability to trade.
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E. Operational risk:
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F. Sovereign risk: Another risk which banks and other agencies
that deal in foreign exchange have to be aware of is sovereign
risk- the risk on the government of a country.
TYPES OF EXPOSURE
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An Exposure can be defined as a Contracted, Projected or Contingent Cash
Flow whose magnitude is not certain at the moment. The magnitude depends on
the value of variables such as Foreign Exchange rates and Interest rates. Exposures
can be broadly classified into three groups, viz., Transaction, Economic and
Translation exposure.
1. Transaction exposure:
2. Economic exposure:
The degree to which a firm’s present value of future cash flows can be
influenced by exchange rate fluctuations is referred to as economic
exposure to exchange rates. Economic exposures thus is a
comprehensive effect of potential transaction exposure on the project
investment of an MNC.
3. Translation exposure:
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exposure, also called translation exposure, results from the need to
restate foreign subsidiaries’ financial statements into the parent’s
reporting currency and is the sensitivity of net income to the variation
in the exchange rate between a foreign subsidiary and its parent.
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The foreign exchange risk management policy should clearly define
instruments in which the bank is authorized to trade, risk limits commensurate with
the bank’s activities, regularity of reports to management, and who is responsible
for producing such reports. The policy should be reviewed on a regular basis,
normally at least annually, to ensure that it remains appropriate. The main points
that need to be considered when drawing up a policy are given below:
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h) Authority to trade with counterparties other than group companies.
m) Segregation of duties.
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PROCEDURES AND SYSTEMS
The system that produces the foreign exchange risk reports should be linked
to the bank‘s core systems, and be capable of being reconciled to core data.
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b) Highlight key information, in particular breaches or exceptions
c) Highlight unutilized limit capacity
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