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Foreign Exchange Risk Management

P. Vasudevan, MoF

14/12/2006

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Forex Risk Management

• Forex turnover – huge and carries market risk•Proprietary position•Merchant transactions

• Currency & Derivatives – high operational risk

• Need for effective Risk Management system

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Forex Risk Management…

• Activities at branches• Communication delays• Wrong / Delayed / Non-reporting of

transactions• Forged TCs, currency• Lack of skilled personnel; specialisation

• Audit / Inspection of dealing room – expertise needed

• Regulatory / Legal compliance / implications

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Types of Exposures

• Currency Exposures• Risk universe

• Transaction Exposures• Impacts P&L

• Translation Exposures• Hedging policy• Affects B/S

• Economic Exposures• Direct• Indirect• Aids long term planning

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Transaction Exposures

• Transactions are invoiced in a different currency

• Subject to exchange rate movements• Rate movements alter the cash flows• May be partly / fully hedged

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Translation Exposures

• Arises on account of the balance sheet need to convert assets / liabilities held in foreign currency to home currency

• Exchange rate movement on the translation dates alters the balance sheet

• Translation exposures become transaction exposures on settlement dates

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Economic Exposures

• The economic factors of production in different countries and the exchange rate movements of different currencies can cause advantage / disadvantage to exporters or importers

• More a management concept than an accounting one

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Strategies for Risk Management

• Risk Avoidance

• Risk Hedging

• Risk Acceptance

• Risk Management

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Hedging

• Forward Rate Contracts - time / amount certain

• Currency Options - time, amount uncertain - Insurance

• Currency Futures• Currency Swaps, FRAs, IRS

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Types of Risks

• Position Risk• Gap Risk• Exposure Risk• Settlement Risk• Country Risk• Liquidity Risk• Technology Risk & • Operational Risk

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Position Risk

• Position risk exposes the bank to the risk of price movements

• Over-bought / Over-sold positions either due to spot / forward dealings on account of Merchant or Inter-bank deals, which can be either domestic or overseas, or even cross- currency

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Position - Aspects to be seen

• Components of Exchange Position• Calculation of Net Open Position in a

single currency -• Net Spot, Net Forward and Net Options

Position • Calculation of Overall Net Open Position

for authorised persons - Short-hand Method

• Forex Risk for merchants

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Preventive Controls

• Separation of dealing & back-up• Fixing of Intra-day & Overnight limits• Limits can be currency-wise, if the bank

is very active or can be equivalent of an amount for all currencies together

• Daily volume turn-over limits• Cut / Stop-loss, profit cutting / take

profit limits• Counter-party limits / dealer limits

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Risk Measurement

• Methods of fixing net open position• Net open position is an indicator of

riskOpen position x Stop loss = Loss amount

• Related to capital, by regulatory prescription

• Suitable VaR models can also be used

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Shorthand Method

• Calculate net open position for each currency• Calculate net open position in gold• Convert them into rupees• Arrive at sum of all net short positions• Arrive at sum of all net long positions• Overall net open position is the higher of two• This must be kept within approved OPL

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Monitoring Position Limits

• Watching the limits• Monitoring pipeline transactions• Periodic returns• Revaluation statements / positions• Exception reports• 100% risk weight for open positions for

capital adequacy

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Gap Risk

• Caused by mismatches in maturities• Losses can arise between the time of

occurrence of mismatch and its correction• The mismatch exposes the bank to

interest rate risk

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Managing the Gap Risk

• Currency-wise monthly gap limits• Cumulative gap limits for all currencies• Effective use of swaps for gap

management• Need to have control over gaps

• Liquidity• Interest rate risk

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Aggregate Gap Limits

• Is the absolute total (ignoring plus or minus) of all the individual mismatches bank is having for all the months in a particular currency

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Aggregate Gap Limits…

• RBI removed AGL cap of Rs.100 crore in 1996, directing banks to• to review their AGL taking into account the

capital base, dealing expertise, composition of balance sheet, etc., and set-up new AGL with RBI approval

• AGL at a maximum of 6 times capital funds• follow an appropriate model for assessing

“Value at Risk”• FEDAI announces VaR on a daily basis based

on volatilities in the 1, 3 and 6 month forwards

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Exposure Risks

• Exposure risk is nothing but credit risk• Managed by fixing counter-party limits• Resulting open position needs to be

covered at ongoing market rates• Cost of replacing the contract is called

substitution cost / replacement cost

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Settlement Risk

• Also known as Herstat risk• Arises on account of time-zone differences

in settlements• Netting mechanism can be used• CLS• Role of CCIL

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Quantification of Settlement Risk

• Represents credit risk and exposures are to be monitored on real-time basis

• Counter-party exposure limits and review at periodic intervals

• Off-balance sheet exposures converted into credit equivalent for CRAR

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Country Risk

• Risk profile of countries• Exchange control regulations• Legal implications• Transfer risk

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Liquidity Risk

• Highly adverse movements due to events• Breach of cut-loss limits• Leads to defaults / reputational risk

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Operational Risk

• Arises on account of operational irregularities

• Can be on account of deficiencies in control• Can be on account of non-observance of

control• Acts of God / individuals

• Credit Lyonnais – Burning of trading floor in 1996

• Mizuho Securities Co.

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Managing Operational Risk

• Proper operational controls / limits• Monitoring of the controls through

feedback• Observance of IC guidelines• Separation of dealing, mid-office (risk

management) and back-office (settlement and reconciliation)

• Monitoring of nostro / vostro accounts• Concurrent / Internal / External audit

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Dealing Room Procedures

• All deals to be captured• Periodic matching of position on dealers

pad with back office• Confirmation of deals by back office• Check on deal rates vis-à-vis market• Super profits to raise questions / scrutiny

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Reconciliation

• No set-off of debit-credit items• Write off to be permitted only by top

management• Minimise number of unreconciled entries• Periodic report to top management• Proper use of intermediary accounts

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Risk Management Policy for Corporates

• Risk Management policy• Clear guidelines for concluding

transactions• Appropriateness and suitability policies

• Procter & Gamble• Proper documentation / audit trail• AD to obtain from corporates

• Periodical review of operations• Annual audit of transactions to verify

compliance with the regulations

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Any Questions ??

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Thank you