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 or Foreign Exchange 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.
Types 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 Forex 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 Forex 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 foreign exchange swaps.
- Hedging the risk by means of foreign currency options.
- Funding through multi-currency interest rate 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 authorized to create exposures. Proper measures should be taken to make sure that such departments and areas inform the authorized 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 in foreign exchange transactions 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.
Management of Foreign Exchange Risk or FOREX Risk
Foreign exchange risk is an unforeseen event, and to avoid risk proactive measures could be taken so as to either eliminate the same or reduce the same. Thus Forex risk management is a process focusing upon steps to contain or avoid risks and losses there from.
To manage foreign exchange risk, it is important to identify and appreciate the process of measurement of risks as a prerequisite. Some risks, like exchange risk, interest rate risk, etc., are easy to be quantified, while some other risks like country risk, operational risk, legal risk, etc., cannot be mathematically quantified and can only be qualitatively compared and measured. Some risks like gap risk in foreign exchange operations can be measured using modern mathematical and statistical tools like ‘value at risk’, etc. Thus only after the risk is identified and assessed, question of management of risk arises.
Foreign exchange risk is an unforeseen event, and to avoid risk proactive measures could be taken so as to either eliminate the same or reduce the same. Thus foreign exchange risk management is a process focusing upon steps to contain or avoid risks and losses there from. Since certain risks may not be avoided totally, its management would depend upon the expected rewards, risk appetite as also profile of the risk portfolio held.
A sound foreign exchange risk management process would start with a detailed policy, a specific limit structure for various risks and operations, a sound management information system, and specified control, monitoring and reporting process. Putting in place sound risk management policies, understood and laid down by the top management/board, would be a prerequisite for determining the risk exposures being faced by the bank. Measures to determine the market risks, credit or liquidity risks can be put in place in accordance with the laid down policies.
Thus the foreign exchange risk management process starts from the top, i.e. the Board of Directors, which should prescribe and approve a detailed policy for management of various risks being faced or expected to be faced by the bank. This policy would also specify limits for various types of trades, functions as also upper limits for exposures. All these limits would be based on the risk appetite of the bank in relation to the expected rewards in taking the risks. (Risk-reward equilibrium)
After the benchmarks are set out by the board, the top management has to involve in implementation of the plans, by putting in place required manpower, various infrastructure, tools, etc., to help the dealing staff in better functioning so as to avoid risks as also to measure and contain risks. The top management has not only to implement the policies approved by the board, but also ensure compliance of regulatory requirements.
The risk policy framework should cover the goals and objectives, delegation of responsibilities, specify activities to be undertaken and level of acceptable risks, besides the authority to undertake such functions and a system of review.
While implementing the risk policies, the top management has also to take appropriate measures to ensure proper and regular measuring and monitoring of the risks.
Foreign exchange risk management policies require constant focus and attention and need to be reviewed on a regular basis. The natures of risks keep on changing with the business portfolio, also market scenario as also the tools, MIS (Management Information Systems), and risk containment measures. Forex risk management is dynamic and needs to remain in constant focus of the users as well as the top management.