Following types of risks are involved in foreign exchange dealings.
- Market risk: Loss arising out of change in the market price of an asset
- Liquidity risk: risk that you will not be able to easily sell your assets
- Operational risk: Failure of internal processes, people, systems or external events
- Legal risk: Contracts are not legally enforceable or documented incorrectly
- Credit risk: Counterparty defaulting in payment
- Pre-settlement: Credit risk before the maturity of a transaction
- Settlement risk: Timing differences in cash flows
- Country risk: Movement of funds across borders may be obstructed by sudden government controls
- Interest rate risk: Interest rate risk or gap risk arises out of adverse movement of interest rates a bank faces on its currency swaps/forward contracts or other interest rate derivatives
Management of Risks
- Traditional measures adopted by bank managements to manage/limit risks are:
• Limits on intra-day open position in each currency
• Limits on overnight open positions in each currency (lower than intra-day)
• Limits on aggregate open position for all currencies
• A turnover limit on daily transaction volume for all currencies
• Country wise exposure limits
Guidelines on Risk Management
- Measure risks that can be quantified viz., exchange rate risk, interest rate risk using mathematical or statistical tools
- Have a detailed policy on risk management (given by the Board)
- A specific limit structure for various risks and operations
- A sound management information system
- Specified control, monitoring and reporting system
Risk Management Tools
- Derivatives are management tools derived from underlying exposures such as currency, commodities, shares, etc.
- Used to neutralize the exposures on the underlying contracts
- Can be over the counter (OTC) i.e. customized products or exchange traded which are standardized in terms of quantity, quality, start and ending dates
Forward Contracts
- Forward contracts: Typical OTC derivatives which involves fixing of rates (exchange rate, commodity price, etc.) in advance for delivery in future. Risk of adverse price movement is covered.
- Forward contracts are specified at forward rates which are spot rates plus cost of carry (interest rate differential in case of foreign exchange forward)
- The currency with lower interest rate would be at a premium in future
- Other factors affecting forward rate
• Demand and supply for forward currency
• Perception about the movement in the currency
• Political, fiscal and trade-related conditions in the country and for the currency
Futures
- Futures: A version of exchange traded forward contracts.
- Standardized contracts as far as the quantity (amounts) and delivery dates (period) of the contracts.
- Conveys an agreement to buy a specific amount of commodity or financial instruments at a particular price on a stipulated future date
- An obligation on the buyer to purchase the underlying instrument and the seller to sell it
- Types of Futures contracts
- Commodities futures
- Financial futures
- Currency futures
- Index futures
- There is a margin process
- Initial margin: to be paid at the start of a contract
- Variable margin: calculated daily by marking to market the contract at the end of each day
- Maintenance margin: Similar to minimum balance for undertaking trades in the Exchange and has to be maintained by the buyer/seller in the margin account
Options
- Options: An agreement between two parties in which one grants the other the right to buy (‘call’ option) or sell (‘put’ option) an asset under specified conditions (price, time) and assumes the obligation to sell or buy it.
- The party who has the right but not the obligation is the ‘buyer’ of the option and pays a fee or premium to the ‘writer’ or ‘seller’ of the option.
- The asset could be a currency, bond, share, commodity or futures contract
- The option holder or buyer would exercise the option (buy or sell) in case the market price moves adversely and would let it lapse if it moves favourably
- The option seller (usually a bank or a financial institution or an Exchange) is under obligation to deliver the contract if exercised at the agreed price
- Strike price/exercise price: The price at which the option may be exercised and the underlying asset bought or sold
- In the money: When the strike price is below the spot price (in case of a call option) or vice-versa in case of a put option the option is in the money giving gain to the buyer.
- At the money: When strike price is equal to the spot price
- Out of the money: The strike price is above the spot price (call option) or vice-versa (for a put option). It is better to let the option lapse here.
Swaps
- In foreign exchange market, swap refers to simultaneous sale and purchase of one currency for another (currency swap).
- Financial or derivative swap refers to the exchange of two streams of cash flows over a defined period of time, between two counter-parties
Points for Thought
- Corporate should be allowed to hedge upon declaration of underlying assets
- Banks may be permitted to initiate overseas cross currency positions
- Banks should be allowed to borrow and lend in the overseas markets
- More participants be allowed in the foreign exchange market
- Corporate must be allowed to cancel and re-book option contracts
- Banks be permitted to use hedging instruments for their own ALM
- Banks to be allowed to fix interest rates on deposits subject to caps fixed by SBP
Lecture delivered by Dr. Babar Zaheer Butt to the students of MS and Ph.D at Iqra University Islamabad Campus.