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:
- Funding of Foreign Currency Assets/Liabilities through money markets i.e. borrowing or lending of foreign currencies
- Funding through FX swaps
- Hedging the risk by means of Currency Options
- 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.