Foreign Exchange Risk Management

Foreign Exchange Risk Management

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Foreign Exchange Risk Management

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. 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 requires making payment to its importer in foreign currency, it asks its bank to purchase foreign currency and credit it to the importer’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

The 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 cheaper currency and lend in 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 the CIRP does not hold good in the market, there is potential to make risk-free profits through arbitrage transactions.

Speculative Transactions

The banks generally do not maintain huge open positions in any currency (beyond 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 a counterparty, it implies an open short position. If the Euro appreciates against 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 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 likes 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 forward 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. Let us discuss various types of forex risks in the next section.

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 due to 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, the bank faces exchange rate risk. An open position arises when as sets 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 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., maintain zero net position implying neither an overbought nor an oversold position) by undertaking cover (or hedging) transactions in inter-bank market.

Hence, banks will set various limits that are considered as manageable risks (these limits include daylight limits, overnight limits, trading position limits, stop loss limits, etc.). We have already studied these limits in chapter 6 in the context of dealing room operations.

Settlement Risks

Apart from exchange rate risks, there is also a settlement risk involved in FX transactions. The settlement risk refers 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 counter parties.

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 unable to perform its side of the contract is termed as settlement risk. This is also termed as 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 due to reasons such as bankruptcy or closure before the settlement date of the contract. In such case the bank is required to cover its position with another hedging transaction in lieu of the failed transaction in the on-going 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 difficulty in prevention or minimisation due to the less marketability of the investment.

Liquidity risks for a bank refer to situations wherein:

  • The bank is unable to meet its funding requirements without incurring additional costs or

  • The bank may be unable to execute a contract due to illiquid market conditions or

  • 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 counterparty fails in this case 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 the 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 is also mitigated by incorporating suitable clauses in the contracts to take care of country risk and by subjecting the contract to a 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 are 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.

The 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 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 cash flows underlying the assets/liabilities due to 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 highly time-dependent 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 control, 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 the government policy guidelines or legal framework. Legal risks can be managed by ensuring that all contract-related procedures are vetted by a qualified legal opinion.

Management of Risks

Risk management is an important discipline for banks and owing to the same, risk management is related to the capital adequacy norms of the central banks. Risk management at the forex operations level is a part of the overall risk management framework of the bank in terms of three components viz., credit risk, market risk and operational risk. The risk management process for forex operations starts with a sound risk management policy approved by the Board of Directors, implementing policies and procedures pertaining to risk management and measuring and controlling the risk parameters.

With regard to forex operations, a limits-based control structure is the core aspect of the risk management framework. The limits are both based on regulatory minimum requirements (where applicable) and the risk appetite of the bank. Some risks, such as operational risks or legal risks, cannot be quantified and completely avoided.

On the other hand, exchange rate risks or interest rate risks can be measured and controlled by appropriate risk identification and measurement techniques, while some may even be avoided fully depending on the transactions allowed to be undertaken by dealers as per policy guidelines. However, if the bank does not take any risk, it cannot aspire to make much profit from forex operations.

Banks generally use several limits for management and control of risks related to forex operations. These are discussed as follows:

Overnight Limit

This is the maximum limit for an open position; 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 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 keeps changing depending on the transactions undertaken as per client needs and for trading position. Though the dealer might want to square off the positions by the end of the day, he/she cannot avoid open positions during the trading day. This limit specifies the magnitude at 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 already discussed, settlement risks require counterparty limits to be set up. This means the maximum exposure to any particular counterparty requires to be controlled. This limit specifies the transaction limit for each counterparty, based on the evaluation of their credit worthiness, country risk, etc.

Country Risk Exposure Limit

To restrict country risks, a bank needs to specify maximum exposure the forex operations can take for each country. The amount that dealers can transact with counterparties from politically or financially risky countries is restricted through this limit.

Dealer Limit

Dealers have the freedom to take positions during the trading day. However, it requires being restricted as overzealous 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. However, 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 movement may never happen, leading to huge losses for the position.

Hence, a stop loss limit beyond which the trader should initiate transactions to close the speculative positions is necessary. This limit specifies the stop loss limit on the maximum movement of exchange rates against the position held that should trigger counter transaction 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.

Apart from limiting controls, banks also incorporate several other policy measures for managing the risks associated with forex operations.

These include:

  • Nostro balances limit
  • Overdrafts in Nostro accounts
  • Eligible brokers with whom dealers can transact
  • Eligible currencies in which dealers can transact
  • Value-at-risk limits

In this regard, RBI’s circular on “Internal Control Guidelines”, issued in 2011, has prescribed several guidelines with regard to risk management in forex operations of banks.

It requires senior management of the banks to approve the policy measures pertaining to the following areas (RBI, 2011):

  • Business strategies on which trading in the individual product groups is based

  • Markets in which trading is allowed

  • Nature, scope, legal framework and documentation of trading activities

  • List of counterparties with whom trade may be conducted

  • Procedures for measuring, analysing, monitoring and managing the risk

  • Ceiling for risk positions according to the type of business or risk organisational unit or portfolio

  • Procedure for reacting to (i) any overshooting of the limits and (ii) to extreme market developments

  • Functions and responsibilities of individual members of staff and work units

  • Internal accounting and external/internal reporting

  • Staffing and technical equipment

  • Internal control and monitoring system

  • Maintenance of confidentiality in respect of trades

  • ‘Suitability and Appropriateness’ guidelines

  • Electronic trading platforms

  • Access control to dealing room, with audit trails

  • Access control management and review

The guidelines require the determination of global limits by banks for local inter-bank business as well as for overseas transactions consistent with the bank’s overall risk management process, expertise and adequacy of its capital to undertake such activities. The RBI’s master circular on Risk Management and Inter-bank Dealings require the following two limits to be approved by it, after the approval of the Board/Management committee of the bank: Net Open Exchange Position Limit (NOOPL) and Aggregate Gap Limits (AGL). NOOPL is meant for calculating the capital charge associated with forex risk. The circular also provides detailed guidelines for the calculation of these limits.

It is a summation of Net Spot Position, Net Forward Position and Net Options Position for each currency. This is calculated for each currency and the sum of all net short positions and net long positions are derived. NOOPL is the higher of the sum of net short positions and the sum of net long positions. It cannot exceed 25% of the total capital of the bank. AGL is fixed by the board of respective banks and communicated to the RBI. It should not exceed six times the total capital of the bank. Banks can also use superior measures, such as Value-at-Risk (VaR) limits and PV01 limits based on their capital, risk bearing capacity, etc., and communicate the same to the RBI, instead of AGL limits.

Exposure of Firms

In the previous sections, we have discussed foreign exchange risk management as it pertains to the trading book of the bank. One of the important functions of the bank is to help its corporate clients manage their currency exposures. In this section, we will study about the exposures of firms. Economic and operating exposures cannot be managed through currency hedges offered by banks but through internal corporate strategies.

We shall study about the first two types of currency exposures viz., transaction and translation exposures.

Transaction Exposure

Transaction exposures are exposures to contracts denominated in foreign currencies that might result in uncertain realisation of cash flows due to exchange rate volatility. Examples are export contracts and import contracts denominated in foreign currencies. The risk inherent in these contracts is that the value of the invoice currency might appreciate or depreciate between the invoice date and date of realisation.

If an Indian exporter invoices an export to the US in US dollars, at say, an exchange rate of USD/INR 65, and if on the date of receipt of the export payment, the exchange rate is only USD/INR 60, then he/ she faces a loss of 7.69% in terms of the amount that can be realised in the home currency, INR.

This definition of transaction exposure implies that there will be no transaction exposure and the consequent exchange rate risk, if the invoicing is done in the home currency.

For example, the US exporter, who invoices in the home currency of USD, will not face any exchange rate risk while the corresponding importer in India will face exchange rate risk. If the currency of the importer and exporter are the same, as in the case of international trade between European Union countries, then there will be no transaction risk associated with currency exposures for either the importer or exporter.

Some typical transaction exposures faced by firms are:

  • Receivables and payables arising out of exports and imports when invoicing is done in a foreign currency

  • Receivables and payables denominated in foreign currency arising out of foreign currency liabilities and assets

  • Payment and receipt of dividends denominated in foreign currency

Another important characteristic of transaction exposure is that the quantum of exposure is precisely known. This is because these arise out of contracts already entered in a foreign currency. The risk associated with transaction exposure depends on the sensitivity of the value of exposure to the exchange rate volatility. For instance, if an exporter exports goods to the two countries in their respective currencies (say in USD and Chinese Yuan), the transaction risk will be higher in the case of the currency that is more volatile (USD) than the less volatile currency (CNY).

Since transaction exposures are financial and the amounts of exposures are clearly known, they are amenable for hedging through currency derivatives. Banks offer several hedging facilities, such as forward contracts, over-the-counter derivatives, currency swaps and interest rate swaps, etc., to manage transaction exposures of corporates. Transaction exposures are also applicable for banks themselves for their payments and receipts denominated in foreign currencies.

Translation Exposure

Translation exposure is related to foreign currency assets, liabilities, payments and receipts in the financial statements of corporates. It refers to the potential that a firm’s profitability and valuation will get affected by exchange rate volatility in terms of accounting values. Translation exposure arises when the foreign currency amounts in financial statements are converted into home currency equivalent. The process of converting foreign currency values into home currency values for preparation of financial statements is termed as ‘Translation” in accounting.

The home currency amounts of these components’ financial statements depend on the exchange rate used for translation. Depending on the exchange rate chosen for the marked-to-market process, there could be profits or losses, which are required to be recognised in the balance sheet and profit & loss. This could adversely affect the reported profit and valuation of a company. Since translation exposure can impact financial statement reporting and companies can manipulate the values by appropriately choosing the exchange rates, accounting standard bodies need to follow standardised methods for the translation process.

The different translation methods required to be followed by companies following international accounting standard are:

  • Current/non-current method
  • Monetary/non-monetary method
  • Temporal method
  • Current rate method

Translation exposure is especially important for companies that have subsidiaries abroad. This is so because the accounting profitability and valuation reflected by consolidated financial statements can be greatly impacted by the translation process. Translation exposures cannot be hedged with currency derivatives, such as those of transaction exposures.

A balance sheet hedge that offsets assets/liabilities in foreign currency with equivalent liabilities/ assets in the same currency can be affected by corporates. The translation exposures measure the degree of ex-post economic exposure in terms of accounting values. Banks also face translation exposure-related foreign exchange risks in the same way as companies with international operations.

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