Forex Risk Management
The following are the major risks in foreign exchange dealings
- Open Position Risk
- Cash Balance Risk
- Maturity Mismatches Risk
- Credit Risk
- Country Risk
- Overtrading Risk
- Fraud Risk, and
- Operational Risks
Open Position Risk
The open position risk or the position risk refers to the risk of change in exchange rates affecting the overbought or oversold position in foreign currency held by a bank. Hence, this can also be called the rate risk. The risk can be avoided by keeping the position in foreign exchange square. The open position in a foreign currency becomes inevitable for the following reasons:
- The dealing room may not obtain reports of all purchases of foreign currencies made by branches on the same day.
- The imbalance may be because the bank is not able to carry out the cover operation in the interbank market.
- Sometimes the imbalance is deliberate. The dealer may foresee that the foreign currency concerned may strengthen.
Cash Balance Risk
Cash balance refers to actual balances maintained in the nostro accounts at the end-of each day. Balances in nostro accounts do not earn interest: while any overdraft involves payment of interest. The endeavour should, therefore, be to keep the minimum required balance in the nostro accounts. However, perfection on the count is not possible. Depending upon the requirement for a single currency more than one nostro account may be maintained. Each of these accounts is operated by a large number of branches. Communication delays from branches to the dealer or from the foreign bank to the dealer may result in distortions.
Maturity Mismatches Risk
This risk arises on account of the maturity period of purchase and sale contracts in a foreign currency not coinciding or matching. The cash flows from purchases and sales mismatch thereby leaving a gap at the end of each period. Therefore, this risk is also known as liquidity risk or gap risk
Mismatches in position may arise out of the following reasons:
- Under forward contracts, the customers may exercise their option on any day during the month which may not match with the option under the cover contract with the market with maturity towards the month end.
- Non-availability of matching forward cover in the market for the volume and maturity desired.
- Small value of merchant contracts may not aggregative to the round sums for which cover contracts are available.
- In the interbank contracts, the buyer bank may pick up the contract on any day during the option period.
- Mismatch may deliberately created to minimise swap costs or to take advantage of changes in interest differential or the large swings in the demand for spot and near forward currencies.
Credit Risk is the risk of failure of the counterparty to the contract Credit risk as classified into (a) contract risk and (b) clean risk.
- Contract Risk: arises when the failure of the counterparty is known to the bank before it executes its part of the contract. Here the bank also refrains from the contract. The loss to the bank is the loss arising out of exchange rate difference that may arise when the bank has to cover the gap arising from failure of the contract.
- Clean Risk Arises when: the bank has executed the contract, but the counterparty does not. The loss to the bank in this case is not only the exchange difference, but the entire amount already deployed. This arises, because, due to time zone differences between different centres, one currently is paid before the other is received.
Also known as ‘sovereign risk’ or ‘transfer risk’, country risk relates to the ability and willingness of a country to service its external liabilities. It refers to the possibility that the government as well other borrowers of a particular country may be unable to fulfil the obligations under foreign exchange transactions due to reasons which are beyond the usual credit risks. For example, an importer might have paid for the import, but due to moratorium imposed by the government, the amount may not be repatriated.
A bank runs the risk of overtrading if the volume of transactions indulged by it is beyond its administrative and financial capacity. In the anxiety to earn large profits, the dealer or the bank may take up large deals, which a normal prudent bank would have avoided. The deals may take speculative tendencies leading to huge losses. Viewed from another angle, other operators in the market would find that the counterparty limit for the bank is exceeded and quote further transactions at higher premium. Expenses may increase at a faster rate than the earnings. There is, therefore, a need to restrict the dealings to prudent limits. The tendency to overtrading is controlled by fixing the following limits:
- A limit on the total value of all outstanding forward contracts; and
- A limit on the daily transaction value for all currencies together (turnover limit).
Frauds may be indulged in by the dealers or by other operational staff for personal gains or to conceal a genuine mistake committed earlier. Frauds may take the form of the dealings for one‘s own benefit without putting them through the bank accounts. Undertaking unnecessary deals to pass on brokerage for a kick back, sharing benefits by quoting unduly better rates to some banks and customers, etc. The following procedural measures are taken to avoid frauds:
- Separation of dealing form back-up and accounting functions.
- On-going auditing, monitoring of positions, etc., to ensure compliance with procedures.
- Regular follow-up of deal slips and contract confirmations.
- Regular reconciliation of nostro balances and prompt follow-up unreconciled items.
- Scrutiny of branch reports and pipe-line transactions.
- Maintenance of up-to records of currency position, exchange position and counterparty registers, etc.
These risks include inadvertent mistakes in the rates, amounts and counterparties of deals, misdirection of funds, etc. The reasons may be human errors or administrative inadequacies. The deals are done over telecommunication and mistakes may be found only when the written confirmations are received later.