Bankers Training College

Foreign Exchange Risk

Management

P. Vasudevan, MoF

14/12/2006
                                                                                              
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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