Basics of Forex Derivatives

Module A: International Banking

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Bank Financial Management: Basics of Forex Derivatives

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Contents
Coverage: 1. Introduction

2. Definition of Risk and Risks

in ForEx Operations 3. Management of Risk and associated guidelines 4. Derivatives History and

Development
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1.

INTRODUCTION

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Derivatives
A Financial contract whose value is derived from or depends on the price of some underlying asset Value of derivative changes when there is a change in the price of the underlying related asset Types: Forwards, Futures, Options, Swaps

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2.

DEFINITION OF RISK AND RISKS IN FOREX OPERATIONS

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Risk
An unplanned event with financial consequences resulting in loss or reduced earnings

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Risks in ForEx Operations

Exchange Risk Settlement Risk Liquidity Risk

Country Risk/Sovereign Risk

Interest Rate Risk

Operational Risk

Legal Risk

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Exchange Risk
Change in value of our foreign exchange holdings due to movement in exchange rates Controlled by prescribing limits: Daylight and overnight, Single Deal- Trading Position and Volume, Overall overnight position, Stop Loss, gap-forward mismatch limit etc.

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3 Types of For Ex Exposure

Transaction Exposure Transactions that may expose the company/firm to currency risk

Translation Exposure Revaluation of the asset and liabilities or receivables and payables into a different currency Notional in nature

Operating Exposure External factors in the market/economy that may harm the bottom line

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Settlement Risk
Credit risk in ForEx operations is the risk of failure of a counterparty to meet obligation at maturity of the contract Two Types:
Pre settlement Risk: Failure of the counterparty before maturity of the contract.
Entails risk of only market differences and is not an absolute loss for the bank

Settlement Risk: Failure of the counterparty during course of settlement.

Entails complete risk and loss for the bank

Principal risk in settlement also known as Foreign Exchange Settlement Risk,

Temporal Risk and Herstatt Risk Controlled by applying credit lines and daily delivery limits for each bank Can be eliminated by Worldwide Realtime Gross Settlement System

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Liquidity Risk
Unable to meet its funding requirement or execute a transaction at a reasonable price Not being able to exit or offset positions quickly at a reasonable price Controlled by
Fixing limits for maturity mismatches Reduction of open positions

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Country Risk/Sovereign Risk

Foreign entity or a counterparty private or sovereign may be unwilling or unable to fulfill its obligations for reasons other than the usual reasons or risks which arise in relation to all lending and investment Considered very high in case of countries which are facing problems related to foreign exchange reserves, balance of payments, management of resources, liquidity etc

Controlled by
fixing counterparty exposure limits inserting disclaimer clauses in documentation and making the contracts and sovereign counterparties subject to a third country jurisdiction
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Interest Rate Risk

Also known as GAP risk Arises due to adverse movement of interest rates or interest rate differentials Gaps are to be filled by the bank by paying/receiving appropriate forward differentials or resorting to other interest rate derivatives Individual and aggregate limits are fixed for the international banking operations
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Operational Risk
Due to deficiencies in information systems or internal control or human errors or other infrastructure problems that could lead to unexpected losses

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Legal Risk
Counterparty does not have legal or regulatory authority to enter into a transaction Compliance and Regulations related risks Result in non-enforceability of contract

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3.

MANAGEMENT OF RISK AND ASSOCIATED GUIDELINES

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Risk Management
Process focusing upon steps to contain or avoid risks and losses there from Depends upon the risk appetite, expected rewards and the risk portfolio held Starts with detailed policy, specific limit structure for various risks and operations, a sound management information system, and specified control, monitoring and reporting process Policy for management of various risks being faced, or expected to be faced by

the bank. Also specifies limits for various types of trades, functions as also
upper limits for exposures Policy framework should cover the goals and objectives, delegation of responsibilities, activities to be undertaken and level of acceptable risks, besides the authority to undertake such functions and system for review
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Guidelines
RBI has issued internal control guidelines (ICG) for ForEx business The dealing limits specified under ICG are given later Besides the limits, banks approve panel of brokers through whom deals could be undertaken, the currencies in which the bank/dealers would deal in, Value of Risk Limit, Nostro Balances

limit, Overdraft limit etc.

Master circular on Risk Management and Interbank Dealings by RBI specifies the risk management facilities that are available to residents and non-residents to hedge their forex exposures
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Dealing Limits specified under ICG

Maximum amount of open position or exposure when markets in the banks time zone are closed Maximum amount of open position or exposure during the day Maximum inter period/ month exposures which a bank can keep Maximum exposure to a particular counterparty Maximum exposure on a single country

Overnight Limit

Daylight Limit

Gap Limits

Counterparty Limit

Country Risk

Maximum exposure a dealer can take during the operating hours

Maximum movement of rates against the position held

Maximum amount of exposure to any entity, maturing on a single day

Highest amount for which a deal can be entered

Dealer Limits

Stop Loss Limit

Settlement Limit

Deal size Limit

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Mitigation of Settlement Risk Indian Scenario

In India CCIL Clearing Corporation of India Limited takes over the settlement risk Settlement Guarantee Fund(SGF) is a large pool of resources created by CCIL for this purpose Both counterparties should be members of CCIL in the related segments CCIL undertakes clearing and settlement in Repos, CBLOs, Gilts and inter bank Forex deals. It handles USD/INR deal settlement with netted amounts being paid/received to/from the participant banks

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4.

DERIVATIVES HISTORY AND DEVELOPMENT

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History and Development

Futures and options in use for hundreds of years:
High sea cargoes bought and sold in future prices Rice produce sold for future delivery by Japanese farmers

Explosion of the market coincided with collapse of the Bretton Woods fixed Exchange Rate Regime as it increased volatility in exchange rates and interest rates

Early 1970s, Chicago Mercantile Exchange: Worlds first exchange traded

currency future contract 1975: First interest rate future. Several exchanges thereafter introduced exchange rate and interest rate future contracts
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History and Development

1983, Philadelphia Stock Exchange: Currency options Early 1980s: Interest Rate Swaps Mid 1980s: Boost in the derivatives market with a host of exchange rate, interest rate as also commodity price derivative tools/products being traded in various exchanges Initially hedgers were the primary users Gradually, speculators joined in giving depth and volume to the derivatives markets Arbitrageurs also joined in
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Reasons for Growth

Increased volatility in financial and commodity assets during 1970 and 1980s followed by the oil shocks in 1971 Need to insulate exchange risk for incomes in different currencies Technological advancements Development of pricing models and instruments Political Developments Increasing professionalism amongst market participants

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M S Ahluwalia, amongst other things, is a visual artist, blogger, blog designer and of course an MBA and Banker from New Delhi, India.
To know more about him you may visit his blog-site: Estudiante De La Vida

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