CAIIB Super Notes: Bank Financial Management: Module A: International Banking: Basics of Forex Derivatives

CAIIB – Super-Notes © M S Ahluwalia Sirf Business

Basics of Forex Derivatives

Module A: International Banking

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CAIIB – SUPER NOTES

Bank Financial Management: Basics of Forex Derivatives





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





INTRODUCTION

1.





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





DEFINITION OF RISK AND RISKS IN FOREX OPERATIONS

2.





Risk

• An unplanned event with financial consequences resulting in

loss or reduced earnings





Risks in ForEx Operations

Exchange Risk Exchange Risk Settlement

Risk Settlement

Risk Liquidity Risk Liquidity Risk

Country Risk/Sovereign

Risk

Country Risk/Sovereign

Risk

Interest Rate Risk

Interest Rate Risk

Operational Risk

Operational Risk

Legal Risk Legal Risk





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.





3 Types of For Ex Exposure

Transaction Exposure

Transaction Exposure

• Transactions that may expose the company/firm to currency risk

Translation Exposure

Translation Exposure

• Revaluation of the asset and liabilities or receivables and payables into a different currency

• Notional in nature

Operating Exposure Operating Exposure

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





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





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





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





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





Operational Risk

• Due to deficiencies in information systems or internal control

or human errors or other infrastructure problems that could

lead to unexpected losses





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





MANAGEMENT OF RISK AND ASSOCIATED GUIDELINES

3.





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





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





Dealing Limits specified under ICG

•Maximum amount of open position or exposure when markets in the bank’s time zone are closed

Overnight Limit Overnight Limit

•Maximum amount of open position or exposure during the day

Daylight Limit Daylight Limit

•Maximum inter period/ month exposures which a bank can keep

Gap Limits Gap Limits

•Maximum exposure to a particular counterparty

Counterparty Limit Counterparty Limit

•Maximum exposure on a single country

Country Risk Country Risk

•Maximum exposure a dealer can take during the operating hours

Dealer Limits Dealer Limits

•Maximum movement of rates against the position held

Stop Loss Limit Stop Loss Limit

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

Settlement Limit Settlement Limit

•Highest amount for which a deal can be entered

Deal size Limit Deal size Limit





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





DERIVATIVES – HISTORY AND DEVELOPMENT

4.





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: World’s first exchange traded

currency future contract

• 1975: First interest rate future. Several exchanges thereafter introduced

exchange rate and interest rate future contracts





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





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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Documents

CAIIB Super Notes: Bank Financial Management: Module A: International Banking: Basics of Forex Derivatives