The concept of risk refers to uncertainty with regard to the outcome of an event. The uncertainty might imply potential future losses. Foreign exchange transactions involve risk in terms of uncertainty with regard to the actual amount that can be realised in domestic currency. This risk arises whenever there is an exposure to a foreign currency whose exchange rate with respect to the domestic currency is variable.
Hence, it is necessary to use a mechanism for eliminating, reducing or mitigating the risks involved. Commercial banks are the major players in the foreign exchange market.
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Reasons for Foreign Exchange Transactions
They might undertake foreign exchange transactions for any of the following reasons:
Merchant transactions
Merchant transactions refer to Foreign Exchange (FX) transactions undertaken by banks on behalf of their corporate customers. For example, when a corporate house needs to make a payment to its importer in foreign currency, it asks its bank to purchase foreign currency and credit it to the im- porter’s bank by debiting its bank account in domestic currency.
These transactions are carried out by the bank in inter-bank spot forex markets on behalf of corporate clients, and the banks make a profit from the bid-ask spreads involved. The bank might also include a commission to the inter-bank spot rate and these exchange rates quoted by the bank are termed as merchant rates. There is no exchange rate risk involved in these buy/sell merchant transactions except when the banks maintain open positions on these currencies for serving their clients.
Arbitrage transactions
Banks might also carry out forex transactions in order to take advantage of any arbitrage opportunities that might prevail between different money markets. For example, a bank might decide to borrow in a cheaper currency market and lend in some other money markets at higher interest rates.
Normally, these arbitrage opportunities are nullified by forward rates that are determined by the interest rate differential between the two currencies. This has been explained by Covered Interest Rate Parity Theorem (CIRP).
However, when CIRP does not hold good in the market, there is potential to make risk-free profits through arbitrage transactions. It is important to note that CIRP states that the ratio of forward to spot rate should be equal to the ratio of one plus interest rate of foreign currency and one plus interest rate of home currency, in order to avoid arbitrage between money markets.
Speculative transactions
Banks generally do not maintain huge open positions in any currency (beyond the limits set as per operational requirements). An open position means a net positive or negative (debit or credit) balance in any currency due to overbought or oversold positions that imply potential future profits/losses depending on the exchange rate movement.
For example, if a bank has huge US dollar balances in its nostro accounts and if the US dollar depreciates heavily against the Indian rupee, then the value of the nostro balances in terms of Indian currency is greatly reduced.
Similarly, if a bank has to make a huge payment in Euro at some future date to the counterparty, it implies an open short position. If the Euro appreciates against the Indian rupee, it results in huge losses. This is because the amount of money required in terms of domestic currency would have greatly increased.
Hence, banks generally do not maintain open positions beyond the operational minimum requirements. However, banks might decide to keep open positions when they are interested in speculative activities.
For example, if INR is expected to depreciate against the US dollar, there is no harm in maintaining US dollar balances (though it involves an exchange rate risk) if the bank is willing to take the risk and thereby profit from potential rupee depreciation.
Similarly, banks might also be interested in speculating on interest rate movements between currencies, which affect the forward rates through FX swap transactions. These speculative transactions help banks make profit from interest rate and exchange rate movements.
Hedging transactions
When a corporate wants to hedge its forex exposure due to imports/exports, it enters into a forward contract with its banker so that the future exchange rate can be fixed to eliminate the exchange rate risk. For example, if an importer has to make a payment of $1 million after three months, it can enter into a forward contract with its banker to purchase $1 million at a pre-fixed exchange rate called the forward rate that can be used after three months. This actually implies a transfer of exchange rate risk to the banker.
The bank would then have to hedge its exposure in US dollars by entering into a counter transaction in the inter-bank forex market by entering into a forward purchase contract with another bank for $1 million. After three months, the bank will purchase $1 million from another bank as per the for- ward contract and deliver the same to the importer. This counter-forward contract executed in the inter-bank market is an example of hedging transactions undertaken by the bank.
These hedging transactions might also take the form of money market transactions or FX swap transactions. Banks might also undertake hedging transactions for their own positions. All transactions that are undertaken for the books of the bank (other than merchant transactions) are termed as proprietary transactions. The exchange rate risks involved pertains to the overall position of the bank’s trading book in various currencies.
Types of Forex Risks
Though forex risks are mainly due to the volatility of the exchange rates, owing to the nature of forex operations undertaken by the banks in forex markets, there can be several other risks. The risks faced by banks due to forex operations can be discussed as follows:
Exchange rate risks
The first risk involved in forex operations is due to the exchange rate volatility, as discussed earlier. The changes in exchange rates can adversely affect the value of holdings of the bank in several currencies. As already mentioned, banks do not maintain exposures to foreign currencies due to the possible losses of adverse currency movements. As soon as a client transaction is carried out, the FX dealer immediately covers the transaction in the inter-bank market.
For example, if an exporter sells his/ her proceeds in Euro to his/her bank as per the merchant quote applicable for Euro vs. INR, the dealer immediately sells the EUR proceeds in the inter-bank market. If he/she does not, it is quite likely that the exchange rate between EUR and INR may turn adverse and he/she might be forced to sell at a price lower than the price at which he/she had purchased it from the client.
In general, the dealer does not get into the inter-bank market for every retail merchant transaction as these are carried out from balances maintained by him/her. However, he/she is required to maintain the positional limits applicable for various currencies and transactions and carry out the required hedging transactions in the inter-bank market. Hence, the dealer is required to keep a constant watch on his/her currency position and exchange rate movement.
Whenever FX transactions lead to an open position in a currency, banks face exchange rate risk. An open position arises when assets and outstanding contracts to purchase that currency exceeds the liabilities and outstanding contracts to sell that currency. A position is said to be long (or over-bought) when the assets and outstanding contracts to purchase a currency exceeds the liabilities and contracts to sell that currency at any particular point of time.
If the position is reverse (i.e., if the liabilities exceed the assets), it is termed as a short position or an oversold position. If the position is long and if the foreign currency depreciates, it results in losses. Alternatively, if the position is short and if the foreign currency appreciates, it leads to losses. Hence, if the dealer is not interested in taking a speculative stance, he/she will always ensure that there is no net overbought or oversold position, in order to ensure that there is no exchange rate risk.
However, it may not be practically possible to maintain a square position always (i.e. maintaining zero net position implying nei- ther an overbought nor an oversold position) by undertaking cover (or hedging) transactions in interbank market. Therefore, banks are required to set various limits.
Settlement risks
Apart from exchange rate risks, there is also a settlement risk involved in FX transactions. A settlement risk re- fers to the possibility that, after the FX trade has been undertaken in the inter-bank market, the counterparty might fail to deliver on its side of the contract. The transaction of foreign exchange is settled by involving the exchange of one currency for another between two counterparties. If the settlement mechanism requires simultaneous exchange of currencies, then there is no settlement risk.
However, in forex markets, the exchange of currencies may not be simultaneous. The possibility that a bank transfers currency from its nostro account to the counterparty while the counterparty fails in the meantime to perform its side of the contract is termed as settlement risk. This is also termed as the Herstatt risk, named after the failure of a German bank, Herstatt, due to settlement failure.
The term pre-settlement risk is used to refer to the failure of the counterparty to make payment due to reasons such as bankruptcy or closure before the settlement date of the contract. In such a case, the bank is required to cover its position with another hedging transaction in lieu of the failed transaction in the ongoing market rates, which might entail potential loss.
However, the loss will only be due to exchange rate movements unlike settlement risk. This implies total loss as the transaction from the side of the bank would have been carried out.
Liquidity risks
It is associated with an investment that is impossible to be bought or sold quickly. It further results in less marketability of the investment.
Liquidity risks for a bank refer to situations where:
- The bank is unable to meet its funding requirements without incurring additional costs
- The bank may be unable to execute a contract due to illiquid market conditions
- The bank may be unable to exit a position or cover its position quickly at a reasonable price
These situations arise when the bank requires funding its position or executing a contract to exit a position, but the market condition is not amenable for the same. In order to avoid such liquidity risks, banks enforce proper cash management practices.
The liquidity risks might arise due to:
- Chance of the bank’s assets draining out at a faster rate than its liabilities
- Mismatch between cash flows arising out of assets and liabilities
- Markets getting illiquid with higher bid-spread offers or lack of transactions
Liquidity risks are mitigated by properly forecasting fund and cash positions, maintaining appropriate balances, controlling mismatches between assets and liabilities and reducing the quantum of open positions.
Country risk
It refers to the possibility that contracts with counterparties from other countries might fail due to the inability of the counterparty to honour its side of the commitment. It may be due to the sudden imposition of controls by the central bank or government of the country due to various reasons. These reasons may include balance of payment problems, foreign exchange reserve management, political reasons, etc.
Country risk is different from credit risk as the former case, the counterparty fails due to local laws and restrictions that prevent it from honouring its commitment, though it might be of good credit risk. Country risk can also arise due to change in government or government policies that may invalidate contracts entered into during the tenor of the previous government, especially when the contracts are entered with state entities.
Country risks are mitigated by controlling the quantum of transactions carried out with counterparties from different countries by setting up ‘country exposure limits’. They are also mitigated by incorporating suitable clauses in the contracts to take care of the country risk and by subjecting the contract to third-country jurisdiction. The risky geographies and countries are also constantly monitored in order to take advance steps in the event of possible fructification of country risk.
Interest rate risks
The value of foreign currency assets and liabilities is affected not only by the exchange rates, but also by the changes in interest rates. For example, the interest rate differential between two currencies determines the forward rates.
Similarly, the value of foreign currency assets and liabilities acquired from money market operations can change when the interest rates change, leading to pricing and reinvestment risks applicable for any fixed income securities. Banks also undertake several other interest rate-dependent transactions, such as foreign currency swaps, interest rate swaps, forward rate agreements, etc. Changes in the interest rate affect the valuation of these instruments.
In addition, any mismatch between foreign currency assets and liabilities in terms of maturity dates can lead to potential losses when interest rates change. For example, since banks cannot always ensure an exact matching of the maturity of assets and liabilities— as these are acquired as part of business operations—the re-financing of assets/liabilities may have to be done at different interest rates leading to losses.
The maturity mismatch between assets and liabilities is termed as a gap. These gaps are filled by banks through transactions of paying/receiving an appropriate forward differential, which are a function of interest rates.
Any adverse movement in interest rates impact forward differentials, which affects the cash flows underlying the assets/liabilities due to the gaps. Interest rate risks are managed through dealers by undertaking money market operations to match assets and liabilities, using swaps and through other interest rate derivative products.
Operational risks
These risks refer to the risk of losses due to failure in operational control and procedures. Deficiencies in infrastructure, communication systems, operational procedures, human efficiency, and internal control and monitoring procedures can lead to unexpected losses.
Since forex operations are greatly affected by time and have the potential to result in major losses due to minor errors, it is essential that the dealing room and other back-office operations of the bank are error-proof. Operational risks are managed by instituting proper operational procedures and controls, state-of-the-art infrastructure, disaster recovery infrastructure and procedures, backup programmes and usage of mirror sites.
Legal risks
These risks arise when the contracts entered by the bank cannot be enforced in a court. This might be due to reasons such as the counterparty not being eligible to undertake such a contract or problems with contract clauses that breach government policy guidelines or the legal framework. Legal risks can be managed by ensuring that all contract-related procedures are vet- ted by a qualified legal opinion.
Limits for Managing and Controlling Forex Operations Risks
Banks generally use several limits for managing and controlling risks related to forex operations. These limits are discussed as follows:
Overnight limit
This is the maximum limit for the open position that a bank can keep overnight, when markets in its time zones are closed. As explained already, banks generally cover their merchant transactions with immediate counter transactions in the inter-bank market. However, it may not be possible to have a square (or zero net) position at the end of the day.
It is quite possible that a dealer might end up with an overbought or oversold position at the end of the day. Apart from market and time constraints, dealers may also deliberately keep open positions for speculative reasons. This overnight limit specifies the maximum amount that can be left open overnight (i.e., till the market opens the next day for the currency) by the dealer.
Daylight limit
During the day, the position of the dealer will keep changing depending on the transactions undertaken as per the client’s needs and for the trading position. Though the dealer might intent to square off the positions by the end of the day, he cannot avoid open positions during the trading day. This limit specifies the magnitude to which the open position can go during the day.
Gap limit
The gap between assets and liabilities maturing during a period has to be controlled and managed. The gap limit specifies the maximum gap that can exist for a particular month or period.
Counterparty limit
As discussed earlier, settlement risks require counterparty limits to be set up. This means the maximum exposure to any particular counterparty requires to be controlled. This limit is based on the evaluation of the dealer’s creditworthiness, country risk, etc.
Country risk exposure limit
To restrict country risks, a bank needs to specify the maximum exposure that forex operations can take for each country. The number of dealers that can transact with counterparties from politically or financially risky countries is restricted through this limit.
Dealer limit
Dealers might have the freedom to take positions during the trading day, but it requires being restricted as over-zealous dealers can take huge positions that can turn dangerous for the profitability of the bank, when there are unexpected currency movements. This limit specifies the maximum limit for each dealer.
Stop-loss limit
When dealers take speculative positions, they expect the currency to move in a particular direction. However, it is quite possible that the currency might move in the opposite direction. But small adverse movements cannot call for closing of speculative positions. At the same time, the dealer cannot allow adverse movements beyond a limit as the expected reverse move- ment may never happen, leading finally to huge losses for the position.
Hence, a stop-loss limit beyond which the trader should initiate transactions to close speculative positions is necessary. This limit specifies the maximum movement of exchange rates against the position held, which should trigger counter-transactions in order to limit the losses.
Settlement limit
This specifies the maximum settlement amount tolerable for any particular counterparty maturing on any particular date.
Deal-size limit
The maximum size of any deal that can be undertaken by a dealer is restricted through this limit.
Trading position limit
This specifies the maximum number of options or futures contracts that an investor is allowed to hold by underlying the given security.
