Foreign Exchange Risk

FOREIGN EXCHANGE RISK

The project is submitted by Tejal Darde

Roll no. 4

Smita Gujar

Roll no. 10

Aruna Gujarathi

Roll no. 11

Kavita Jadhav

Roll no. 14

Sonal Jethi

Roll no. 15

Praneela Patil

Roll no. 24

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INDEX INTRODUCTION OF FOREIGN EXCHANGE RISK

SR.NO

TOPIC

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INTRODUCTION

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CAUSES FOR FLUCTUATION

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IN FOREIGN CURRENCY

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TYPES OF FOREIGN

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EXCHANGE RISK

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TYPES OF EXPOSURE

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FOREIGN EXCHANGE RISK

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MANAGEMENT POLICY

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PROCEDURES AND SYSTEMS 2

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The risk of an investment's value changing due to changes in currency exchange rates. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate risk”. This risk usually affects businesses that export and/or import, but it can also affect investors making international investments. For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency. The risk that the exchange rate on a foreign currency will move against the position held by an investor such that the value of the investment is reduced. For example, if an investor residing in the United States purchases a bond denominated in Japanese yen, deterioration in the rate at which the yen exchanges for dollars will reduce the investor's rate of return, since he or she must eventually exchange the yen for dollars. Also called exchange rate risk.

In 1971, the Bretton Woods system of administering fixed foreign exchange rates was abolished in favor of market-determination of foreign exchange rates; a regime of fluctuating exchange rates was introduced. Besides market-determined fluctuations, there was a lot of volatility in other markets around the world owing to increased inflation and the oil shock. Corporate struggled to cope with the uncertainty in profits, cash flows and future costs. It was then that financial derivatives – foreign currency, interest rate, and commodity derivatives emerged as means of managing risks facing corporations. In India, exchange rates were deregulated and were allowed to be determined by markets in 1993. 3

The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. However derivative use is still a highly regulated area due to the partial convertibility of the rupee. Currently forwards, swaps and options are available in India and the use of foreign currency derivatives is permitted for hedging purposes only. The risks related to foreign exchange are many and are mainly on account of the fluctuations in foreign currency.

CAUSES OF FLUCTUATIONS IN FOREIGN CURRENCY 1.

Foreign exchange rates are influenced by domestic as well as international factors and happenings. 4

2. Foreign exchange dealings cross national boundaries and rates move on the basis of governmental regulations, fiscal policies, political instabilities and a variety of other causes. 3. Foreign exchange rate movements, like the stock market, are influenced by sentiments that may not always be logical. 4. Foreign exchange is traded hours a day at different markets and dealers cannot be in control at all times. 5. The ratings of credit agencies can affect the exchange rate. For instance, when Indian’s foreign exchange rating was downgraded by Moody’s in the mid—1990s, the value of rupee fell. 6.

A rate move instantaneously and very fast. A hesitation of a few seconds or minutes can change a profit to a loss and vice versa.

TYPES OF FOREIGN EXCHANGE RISK Risks associated with foreign exchange may be broadly classified as: 1. Transaction risk. 2. Position risk. 5

3. Settlement or credit risk. 4. Mismatch or liquidity risk. 5. Operational risk. 6. Sovereign risk. 7. Cross- country risk. A. Transaction risk: Any transaction leading to future receipts in any form or creation of long term asset. This consists of a number of: 1. Trading items (foreign currency, invoiced trade receivables and payables) and 2. Capital items (foreign currency dividend and loan payments) 3. Exposure associated with the ownership of foreign currency denominated assets and liabilities. A. Position risk: Bank dealings with customers continuously, both on spot and forward basis, results in positions (buy i.e. long position or sell i.e. short position) being created in currencies in which these transactions are denominated. A position risk occurs when a dealer in bank has an overbought (long) or an oversold (short) position. Dealers enter into these positions in anticipation of a favorable movement. The risk arising out of open positions is easy to understand. If one currency is overbought and it weakens, one would be able to square the overbought position only by selling the currency at a loss. The same would be the position if one is oversold and the currency hardens. 6

B. Settlement or credit risk: Also known as time zone risk, this is a form of credit risk that arises from transactions where the currencies settle in different time zones. A transaction is not complete until settlement has taken place in the latest applicable time zone. This is also referred to as “Herstatt Risk”. Arising from the failure or default of a counterparty. Technically, this is a credit risk where only one side of the transaction has settled. If a counterparty fails before any settlement of a contract occurs, the risk is limited to the difference between the contract price and the current market price (i.e. an exchange rate risk). Settlement risk is the risk of a counterparty failing to meet its obligations in a financial transaction after the bank has fulfilled its obligations on the date of settlement of the contract. Settlement risk exposure potentially exists in foreign exchange or local currency money market business. C.

Mismatch or liquidity risk: In the foreign exchange business it is not always possible to be in an ideal position where sales and purchases are matched or according to maturity and there are no mismatched situations. Some mismatching of maturities is in general unavoidable. Liquidity risk' arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade. 7

Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other. This is why liquidity risk is usually found higher in emerging markets or low-volume markets. Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk. D. Operational risk: Operational risk are related to the manner in which transactions are settled or handled operationally. Some of the risks are discussed below: 8

a) Dealing and settlement: This functions must be properly separated, as otherwise there would be inadequate segregation of duties. b) Confirmation: Dealing is usually done by telephone/telex/Reuters or some other electronic system. It is essential that these deals are confirmed by written confirmations. There is a risk of mistakes being made related to amount, rate, value, date and the likes. c) Pipeline transactions: There are, at times, faults in communication and often cover is not available for pipeline transactions entered into by branches. There can be delays in conveying details of transactions to the dealer for a cover resulting in the actual position of the bank being different from what is shown by the dealers position statement. d) Overdue bills and forward contracts: The trade finance departments of banks normally monitor the maturity of export bills and forward contracts. A risk exists in that the monitoring may not be done properly. A. Sovereign risk: Another risk which banks and other agencies that deal in foreign exchange have to be aware of is sovereign risk- the risk on the government of a country. B. Cross-country risk: It is often not prudent to have large exposures on any one country may go through troubled times. I such a situation, the bank/entity that has an exposure could suffer large losses. To control and limit risks arising out of 9

cross country exposures, management normally lay down cross country exposure limits. Risk management in foreign exchange is imperative as the lack of these could even result in the bankruptcy and closure of the organization.

TYPES OF EXPOSURE

An Exposure can be defined as a Contracted, Projected or Contingent Cash Flow whose magnitude is not certain at the moment. The magnitude depends on the value of variables such as Foreign Exchange rates and Interest rates. Exposures can be broadly classified into three groups, viz., Transaction, Economic and Translation exposure. 1. Transaction exposure: It is a measure of company’s vulnerability to currency related losses arising from known, contractual future cash payments or receipts in foreign currencies. The value of a firm’s cash inflows received in 10

various currencies will be affected by respective exchange rates of these currencies when converted into the currency desired. Similarly, value of a firm’s cash outflows in various currencies will be dependent on the respective exchange rates of these currencies. The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure. 2. Economic exposure: The degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations is referred to as economic exposure to exchange rates. Economic exposures thus is a comprehensive effect of potential transaction exposure on the project investment of an MNC.

3. Translation exposure: The exposure of MNC’s consolidated financial statement to exchange rate fluctuations is known as translation exposure. Accounting exposure, also called translation exposure, results from the need to restate foreign subsidiaries’ financial statements into the parent’s reporting currency and is the sensitivity of net income to the variation in the exchange rate between a foreign subsidiary and its parent.

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FOREIGN EXCHANGE RISK MANAGEMENT POLICY The foreign exchange risk management policy should clearly define instruments in which the bank is authorized to trade, risk limits commensurate with the bank’s activities, regularity of reports to management, and who is responsible for producing such reports. The policy should be reviewed on a regular basis, normally at least annually, to ensure that it remains appropriate. The main points that need to be considered when drawing up a policy are given below: a) Open position limits commensurate with customer driven turnover, and the banks’ appetite for market risk. b) Separate limits should be allocated for each currency, together with an “overall cap” limit. Banks that assume risk on a proprietary trading basis 12

should also introduce measures to limit intraday risk (normally a maximum of five times the overnight cap limit). c) Where a bank trades with counterparties other than members of their own group located in Zone A countries, settlement and country limits should be addressed and clearly defined. d) Forward foreign exchange mismatch limits. e) List of approved instruments. f) Use of foreign exchange derivatives. g) The expertise and experience of authorized personnel. h) Authority to trade with counterparties other than group companies. i) Monitoring and reporting systems. j) Recording and follow up of limit excesses. k) Impact on P&L of an adverse 10% movement in exchange rates on maximum permitted exposure. l) Imposition of a “stop loss” limit to restrict or prevent any further trading other than client deals and hedging. m) Segregation of duties. 13

n) Trading mandates for authorized personnel. o) Limitation on out of hours trading. p) List of authorized brokers (if applicable). q) Code of Conduct for authorized personnel.

PROCEDURES AND SYSTEMS The Commission requires banks to monitor their foreign exchange risk on a frequent and timely basis. The Commission would expect banks that assume any foreign exchange risk to be in a position to measure their positions on an ongoing basis and to report to management daily. It follows from this that a bank must have adequate procedures and systems for monitoring foreign exchange risk. This requires: a) A clear allocation of the responsibility for measuring and reporting foreign exchange risk. b) The maintenance of reliable systems that can produce accurate reports promptly. 14

c) Active senior management involvement in, and clearly allocated responsibility for, foreign exchange risk reporting. d) Regular reporting to group or parent companies. The system that produces the foreign exchange risk reports should be linked to the bank‘s core systems, and be capable of being reconciled to core data. Reports should follow the principles of good management information, for example: a) Clarity b) Highlight key information, in particular breaches or exceptions c) Highlight unutilized limit capacity d) Use of an exception based commentary

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