Foreign Exchange Risks

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

terminals.

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

transactions.

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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