FOREIGN EXCHANGE RISK MANAGEMENT

Peculiarities of foreign exchange market are An over the counter the market Only market open 24 hours a day No single location; no barriers Very large capital and trade flows Exchange rates fluctuate widely Other markets interact/intervene No simultaneous settlement These peculiarities throw open / expose the market players to various kinds of risks.

The various risks are Credit risk (Default risk / Settlement risk) Liquidity risk Country risk Sovereign risk Exchange risk Interest rate risk Operational risk

Credit risk (Default risk / Settlement risk) Basically arise due to the inability or unwillingness of the counter party to meet its obligations. This risk is also known as Herstadtt Risk or Settlement Risk. It will not be possible to avoid this risk totally. However by applying credit limits to each and every counter party this risk can be substantially managed. Group 10 countries have mooted Real Time Gross Settlement for inter bank transfers to overcome this altogether

Liquidity risk This risk arises due to the inability of the counter party to meet its funding requirement or execute a transaction at a reasonable price. It is also the risk of the party not being able to exit or offset positions quickly at a reasonable price.

Liquidity risk…. For example in a US $ Sale – Rupee Purchase deal, if the party selling US $ is short of funds in the nostro account, then it has to fund this account. If for any reason the dealing party is unable to do this, then liquidity risk is said to have arisen. For this proper funds and cash management practices are to be followed

Country risk When funds move across international borders, uncertainty is created with regard to their receipts and payments and this uncertainty is defined as country risk. The foreign participants may be unwilling or unable to fulfill their obligations for reasons beyond their control – such as imposition of exchange and other controls.

Country risk….. Normally country risk very high in the case of countries with problems in areas like exchange reserve, balance of payment, management of resources etc. Country risk can be controlled by fixing country limits and this risk has to be constantly monitored as it is a dynamic risk

Country risk…. Country risk is different from the usual credit risk associated with lending decisions and this should be understood and appreciated

Sovereign risk It is a sub category of country risk and this arises due to immunity enjoyed by the sovereign entity from legal and other recovery processes in which the lender has no legal recourse against the sovereign entity which fails to fulfill the obligations. Sovereign risk can be overcome and managed by inserting suitable disclaimer clauses in the documentation and also subjecting such sovereign entities to jurisdiction other than their own

Exchange risk Movements in exchange rates can adversely affect the value of receivables and payables (purchases and sales) in foreign currencies if they are not covered at the appropriate time. Normally, foreign exchange transactions are to be covered then and there by entering into matching and opposite transactions.

Exchange risk…. It may not be possible to cover each and every transaction individually from time constraints and cost angle. This risk can be controlled and managed by prescribing open position limits (day light and overnight), gap limit (forward mismatch), volume limit, etc

Interest rate risk Interest rate risk occurs when applying different bases of interest rates to assets and corresponding liabilities. If the degree of fluctuations in the two different interest rate bases is different, affecting the spread originally envisaged then interest rate risk is said to have occurred. Where the foreign exchange and money markets are integrated fully, such interest rate risk would be frequented.

Operational risk It occurs due to factors like premises and location of the dealing room, the equipments like computer / Reuter support provided, departure of key employees, etc. If the communication facilities break down or fail due to some accident, the functioning of the dealing room would come to a grinding halt and this will expose the dealing room to various other risks.

Operational risk… It can be managed by providing time tested, state of the art modern equipments to the dealing room and provide for alternate arrangements in times of exigencies.

Measurement of risk Measurement of risk is a very important step in risk management process. Some risks can be easily quantified like exchange risk and interest rate risk while risks like country risk and operational risk cannot be mathematically deduced. They can only be qualitatively compared and measured. Some risks like gap risks can be measured using modern mathematical and statistical tools like value at risk.

Management of risk Identify all areas of risk Evaluate these risks Set various exposure limits for types of business, mismatches and counterparties Issue clear policy guidelines/directives

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