Tuesday, April 21, 2015

Foreign Exchange Risks

On the foreign exchange market one discerns the following kinds of the
• exchange rate risk;
• interest rate risk;
• credit risk;
• country risk.
7.1. Exchange Rate Risk
Exchange rate risk is a consequence of the continuous shift in the
worldwide market supply and demand balance on an outstanding foreign
exchange position. A position will be a subject to all the price changes as long
as it is outstanding. In order to cut losses short and ride profitable positions
that losses should be kept within manageable limits. The most popular steps
are the position limit and the loss limit. The limits are a function of the policy
of the banks along with the skills of the traders and their specific areas of
expertise. There are two types of position limits: daylight and overnight.
1. The daylight position limit establishes the maximum amount of a
certain currency which a trader is allowed to carry at any single time during.
The limit should reflect both the trader's level of trading skills and the amount
at which a trader peaks.
2. The overnight position limit which should be smaller

than daylight
limits refers to any outstanding position kept overnight by traders. Really, the
majority of foreign exchange traders do not hold overnight positions.
The loss limit is a measure to avoid unsustainable losses made by
traders; which is enforced by the senior officers in the dealing center. The
loss limits are selected on a daily and monthly basis by top management.

The position and loss limits can now be implemented more conveniently
with the help of computerized systems which enable the treasurer and the
chief trader to have continuous, instantaneous, and comprehensive access to
accurate figures for all the positions and the profit and loss. This information
may also be delivered from all the branches abroad into the headquarters

Interest Rate Risk
Interest rate risk is pertinent to currency swaps, forward out rights,
futures, and options. It refers to the profit and loss generated by both the
fluctuations in the forward spreads and by forward amount mismatches and
maturity gaps among transactions in the foreign exchange book. An amount
mismatch is the difference between the spot and the forward amounts. For an
active forward desk the complete elimination of maturity gaps is virtually
impossible. However, this may not be a serious problem if the amounts
involved in these mismatches are small. On a daily basis, traders balance the
net payments and receipts for each currency through a special type of swap,
called tomorrow/next or rollover.
To minimize interest rate risk, management sets limits on the total size
of mismatches. The policies differ among banks, but a common approach is to
separate the mismatches, based on their maturity dates, into up to six
months and past six months. All the transactions are entered in computerized
systems in order to calculate the positions for all the delivery dates and the
profit and loss. Continuous analysis of the interest rate environment is
necessary to forecast any changes that may impact on the outstanding gaps.

Credit Risk
Credit risk is connected with the possibility that an outstanding currency
position may not be repaid as agreed, due to a voluntary or involuntary action
by a counter party. In these cases, trading occurs on regulated exchanges,
where all trades are settled by the learing house. On such exchanges, traders
of all sizes can deal without any credit concern.
The following forms of credit risk are known:
1. Replacement risk which occurs when counter parties of the failed
bank find their books unbalanced to the extent of their exposure to the
insolvent party. To rebalance their books, these banks enter new
2. Settlement risk which occurs because of different time zones on
different continents. Such a way, currencies may be credited at different
times during the day. Australian and New Zealand dollars are credited first,
then Japanese yen, followed by the European currencies and ending with the
U.S. dollar. Therefore, payment may be made to a party that will declare
insolvency (or be declared insolvent) immediately after, but prior to executing
its own payments.

The credit risk for instruments traded off regulated exchanges is to be
minimized through the customers' creditworthiness. Commercial and
investment banks, trading companies, and banks' customers must have credit
lines with each other to be able to trade. Even after the credit lines are
extended, the counter parties financial soundness should be continuously
monitored. Along with the market value of their currency portfolios, end
users, in assessing the credit risk, must consider also the potential portfolios
exposure. The latter may be determined through probability analysis over the
time to maturity of the outstanding position. For the same purposes netting is
used. Netting is a process that enables institutions to settle only their net
positions with one another not trade by trade but at the end of the day, in a
single transaction. If signs of payment difficulty of a bank are shown, a group
of large banks may provide short-term backing from a common reserve pool.

Country Risk
The failure to receive an expected payment due to government
interference amounts to the insolvency of an individual bank or institution, a
situation described under credit risk. Country risk refers to the government's
interference in the foreign exchange markets and falls under the joint
responsibility of the treasurer and the credit department. Outside the major
economies, controls on foreign exchange activities are still present and
actively implemented.
For the traders it is important to know or be able to anticipate any
restrictive changes concerning the free flow of currencies. If this is possible,
though trading in the affected currency will dry up considerably, it is still a
manageable situation.

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