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. The present section discusses exchange risk management by banks.

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 day‘s 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 bank‘s 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 bank‘s 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 bank‘s 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 bank‘s 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 bank‘s 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 bank‘s account with its correspondent bank abroad.

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