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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