International Banking (Module A) – Part II

Risk Management and Derivatives

Tanushree Mazumdar, IIBF

Dealing room (1)

• Foreign exchange dealing room operations comprise functions of a service branch to meet the needs of other branches/divisions to buy/sell foreign currency.

• Acts as a profit centre for the bank/financial institution

• A dealer has to maintain two positions- funds position and currency position

Dealing room (2)

• The funds position reflects inflows and outflows of funds i.e. receivables and payables

• A mismatch in funds position will throw open interest rate risks in the form of overdraft interest in the Nostro a/c, loss of interest income on credit balances, etc.

• Currency position deals with overbought and oversold positions, arrived after taking various merchant or inter-bank transactions and the dealer is concerned with the overall net position

Dealing room (3)

• The overall net position exposes the dealer to exchange risks from market movements

• The dealer has to operate within the permitted limits prescribed for the exchange position by the management

• Back office: Takes care of processing deals, accounts reconciliation. It plays a supportive as well as checking role

• Mid office: Mid-office deals with the risk management and parameterisation of risks for forex operations. Gives market information to dealers

Risks in foreign exchange dealings

• RBI and FEDAI issue guidelines to all banks to identify, measure and manage risks

• Risks can be classified under:– Market risk: Loss arising out of change in the

market price of an asset– Liquidity risk: risk that you will not be able to

easily sell your assets

Risks…(cont’d)

• Operational risk: Failure of internal processes, people, systems or external events

• Legal risk: Contracts are not legally enforceable or documented incorrectly

• Credit risk: Counterparty defaulting in payment– Pre-settlement: Credit risk before the maturity of a

transaction– Settlement risk: Timing differences in cash flows, e.g.

of Herstatt Bank in Germany failing in 1974

Risks (3)

• Country risk: Movement of funds across borders may be obstructed by sudden government controls

• Interest rate risk: Interest rate risk or gap risk arises out of adverse movement of interest rates a bank faces on its currency swaps/forward contracts or other interest rate derivatives

Management of risks

• Traditional measures adopted by bank managements to manage/limit risks are:– Limits on intra-day open position in each currency– Limits on overnight open positions in each currency

(lower than intra-day)– Limits on aggregate open position for all currencies– A turnover limit on daily transaction volume for all

currencies– Countrywise exposure limits

Guidelines on risk management

• Measure risks that can be quantified viz., exchange rate risk, interest rate risk using mathematical or statistical tools

• Have a detailed policy on risk management (given by the Board)

• A specific limit structure for various risks and operations

• A sound management information system• Specified control, monitoring and reporting

system

RBI guidelines on risk management

• RBI has issued internal control guidelines (ICG) for foreign exchange business

• It covers various aspects of dealing room operations, code of conduct for dealers and brokers and other aspects of risk control guidelines

• Specifies limits including gap limits, counterparty limit, dealer limit, deal size limit, etc.

Derivative Instruments

• Derivatives are management tools derived from underlying exposures such as currency, commodities, shares, etc.

• Used to neutralise the exposures on the underlying contracts

• Can be over the counter (OTC) i.e. customised products or exchange traded which are standardized in terms of quantity, quality, start and ending dates

Forward Contracts (1)

• Forward contracts: Typical OTC derivatives which involves fixing of rates (exchange rate, commodity price, etc.) in advance for delivery in future. Risk of adverse price movement is covered.

• Forward contracts are specified at forward rates which are spot rates plus cost of carry (interest rate differential in case of foreign exchange forward)

Forward Contract (2)

• Forward rate: spot rate + premium or – discount• Premium/discount: function of cost of carry

(interest rate differential)• The currency with lower interest rate would be at

a premium in future• Other factors affecting forward rate

– Demand and supply for forward currency– Perception about the movement in the currency– Political, fiscal and trade-related conditions in the

country and for the currency

Example of a forward differential

• If GBP/USD Spot = 1.8000• 6 months interest rate USD= 2%• 6 months interest rate GBP = 4%• Forward differential=• 1.8000 * (4-2)/100 * 6/12 or 0.018• 6 months forward rate (GBP/USD) = 1.7820• Since USD has a lower interest rate it will be at a

premium in the future

Futures (1)

• Futures: A version of exchange traded forward contracts.

• Standardized contracts as far as the quantity (amounts) and delivery dates (period) of the contracts.

• Conveys an agreement to buy a specific amount of commodity or financial instruments at a particular price on a stipulated future date

• An obligation on the buyer to purchase the underlying instrument and the seller to sell it

Futures (2)

• Types of Futures contracts– Commodities futures– Financial futures– Currency futures– Index futures

• There is a margin process– Initial margin: to be paid at the start of a contract– Variable margin: calculated daily by marking to

market the contract at the end of each day– Maintenance margin: Similar to minimum balance for

undertaking trades in the Exchange and has to be maintained by the buyer/seller in the margin account

Options (1)

• Options: An agreement between two parties in which one grants the other the right to buy (‘call’ option) or sell (‘put’ option) an asset under specified conditions (price, time) and assumes the obligation to sell or buy it.

• The party who has the right but not the obligation is the ‘buyer’ of the option and pays a fee or premium to the ‘writer’ or ‘seller’ of the option.

• The asset could be a currency, bond, share, commodity or futures contract

Options (2)

• The option holder or buyer would exercise the option (buy or sell) in case the market price moves adversely and would let it lapse if it moves favourably

• The option seller (usually a bank or a financial institution or an Exchange) is under obligation to deliver the contract if exercised at the agreed price

• Strike price/exercise price: The price at which the option may be exercised and the underlying asset bought or sold

Options (3)

• In the money: When the strike price is below the spot price (in case of a call option) or vice-versa in case of a put option the option is in the money giving gain to the buyer.

• At the money: When strike price is equal to the spot price

• Out of the money: The strike price is above the spot price (call option) or vice-versa (for a put option). It is better to let the option lapse here.

Options (4)

• Call option- The right, without the obligation, to buy an asset

• Put option- The right, without the obligation, to sell an asset

• American option- An option that can be exercised at any time until the expiry date

• European option- An option which can be exercised only on expiry

• Bermudan option- An option which is exercisable only during a pre-defined portion of its life

Options (5)

• Expiry: The last date on which the option may be exercised.

• Market participants often quote an expiration (calendar) month without specifying an actual date.

• In such cases it is understood that the expiration date is the Monday before the third Wednesday of the month

• Expiration time is usually specified in the contract. For example, for contracts entered in the Pacific Rim countries the time specified is 10:00 am New York time or 3:00 pm Tokyo time

Swaps

• In foreign exchange market, swap refers to simultaneous sale and purchase of one currency for another (currency swap).

• Financial or derivative swap refers to the exchange of two streams of cash flows over a defined period of time, between two counter-parties

Derivatives in India (1)

• Sodhani Committee (expert group on foreign exchange) was formed in 1992 to look into the issues in and development of the foreign exchange market in India

• Some recommendations– Corporates should be allowed to hedge upon

declaration of underlying assets– Banks may be permitted to initiate overseas

cross currency positions

Sodhani Committee..

• Banks should be allowed to borrow and lend in the overseas markets

• More participants be allowed in the foreign exchange market

• Corporates must be allowed to cancel and re-book option contracts

• Banks be permitted to use hedging instruments for their own ALM

• Banks to be allowed to fix interest rates on FCNR (B) deposits subject to caps fixed by RBI

Derivatives in India (2)

• The use of financial derivatives started in India is the nineties’ in the foreign exchange and stock market

• In 1992 RBI had permitted banks to offer cross currency options to their clients

• In 1996 banks were allowed to offer their corporate clients interest rate swaps, currency swaps, interest rate options and forward rate agreements

• The derivatives market in India is still in an evolving stage