The peculiarities of foreign exchange markets are
– An Over The Counter market
– Only market open 24 hours, seven days a week, 365 days a year
– No single location; no barriers
– Very large capital flows and trade flows
– Exchange rates fluctuate almost every four second
– Other markets (like money market, capital market, debt market) also affect foreign exchange market
– Regulations/Controls/Policies of respective governments also affect foreign exchange market
– Settlement of foreign exchange transactions do take place at different points of time
These peculiarities themselves throw open/expose the market players to various kinds of risks.
Since our foreign exchange dealer is a service provider, he has to exercise extreme caution. If he becomes risk averse, though he may not be making loss, he may not also make profit, as profits will be transferred from risk avoiders to risk seekers (mongers!). Therefore he will have to manage the risk to his advantage and to maximise returns/profit
Credit Risk
It is the risk of loss due to inability or unwillingness of the counterparty to meet its obligations. Every deal in foreign exchange market has a payment of one currency and a receipt of another (in different time zones), often in currencies other than the dealer’s domestic currency. As currencies are exchange are exchanged on the same day (the value date) a dealer is at risk in that the purchased currency may not be received after the sold currency is paid.
This risk is also known as Herstadt Risk or settlement risk as this risk has first arisen and become popular due to Bank Herstadt affair. Normally market participants apply credit lines to each and every counterparty to reduce the risk. This risk can be avoided if one opts for Real Time Gross Settlement.
Liquidity Risk
Liquidity risk is the risk that a party to a foreign exchange dealing not able to meet its funding requirement or execute a transaction at a reasonable price. It is also the risk of the party not being able to exit or offset positions quickly at a reasonable price. For example, in a US Dollar Sale – Indian Rupee Purchase deal, if the party selling US Dollar is short of funds in its Nostro account, then it has to fund this account. If for any reason the dealing party is unable to do this, then liquidity risk is said to have arisen. For this, proper funds and cash management practices have to be put in place and followed by the dealers.
Country Risk
Dealing in foreign currencies and with participants domiciled outside the country of our foreign exchange dealer will sometimes result in country risk. When funds move across international borders, uncertainty is created with regard to their receipts and payments and this uncertainty is defined as country risk. The foreign participants may be unwilling or unable to fulfil their obligations for reasons beyond their control (such as imposition of exchange and other controls). Normally country risk is a very high in the case of countries with problems in areas like exchange reserves, balance of payments, management of resources, etc. Country risk is different from usual credit and other risks associated with lending decisions and this should be clearly understood and appreciated.
Sovereign Risk
It is a sub category of country risk and this arises due to immunity enjoyed by the sovereign entity from legal and other recovery processes in which the lender has no legal recourse against the sovereign entity which fails to fulfil its obligations. Country risk can be controlled by fixing country limits and this risk has to be constantly monitored as it is a dynamic risk. Sovereign risk can be overcome and avoided by inserting suitable disclaimer clauses in the documentation and also subjecting such sovereign entities to jurisdiction other than their own
Exchange Risk
Movements in exchange rates can adversely affect the value of our foreign exchange dealer’s receivable and payables (purchases and sales) in foreign currencies if they are not covered at the appropriate time. Normally our dealer is expected to cover (by entering into matching and opposite transaction) then and there, the transactions he enters into. Though it may not be possible to cover each and every transaction individually, this risk can be controlled and managed by prescribing open position limit (day light and over night), gap (forward mismatch) limit, trading position limit, volume limit, Stop loss limit, etc. In fact, it is a practice to accumulate and keep positions opens, taking a view on the movement of exchange rates, like possible depreciation/appreciation of currencies, etc
Considering the number of branches/offices reporting to the dealing room, number and volume of foreign exchange transactions undertaken at these branches, our foreign exchange dealer may also desire and decide that branches/offices report such transactions, beyond a certain value, then and there and obtain firm rates for the transactions. This may result in, transactions below this prescribed value being unreported then and there for coverage. However these transactions would be taken into account at the dealing room and covered after receipt of transaction reports from branches/offices. Such transactions in our dealer’s parlance are called Pipeline Transactions and it would be the duty of our dealer and the transacting branches to ensure that the number and volume of such pipeline transactions are kept low.
Interest Rate Risk
Interest rate risk occurs when applying different bases of interest rates to assets and corresponding liabilities. If the degrees of fluctuations in the two different interest rates are different, affecting the spread originally envisaged, then interest rate risk is said to have occurred. When our foreign exchange and money markets integrate fully, such interest rate risks will be frequented and managed by our dealer. This risk is usually managed by monitoring the interest rate movements and effecting appropriate steps. Some pro-active dealers determine the interest rate outlook, estimate the potential profit or loss based on such interest rate projections and devise suitable hedging strategy in the form of appropriate interest rate risk management models.
Operational Risk
Operational risk is the next very important risk that should be managed by a dealing room. It may occur due to factors like premises and locations of the dealing room, the equipments like computer support provided to the dealing room, lax supervision/control over the activities of dealers, etc.
Normally in foreign exchange any risk identification and management process involve the following steps
– Identifying all the areas of risk
– Evaluating these risks
– Settling various exposure limits for
- Types of business
- Mismatches
- Counterparties
- Issuing clear policy guidelines/directives
The limits decided for the dealing room would reflect the management’s considered and balanced view of their appetite for risk and the potential for profit. This decision would be made in the context of nature of markets, regulatory requirements, capital adequacy, potential volatility and availability of skilled personnel.
In order to ensure that foreign exchange operations are properly conducted, bank managements would normally prefer an internal audit. Such internal audit would look into whether correct procedures are followed, whether all limits are respected and observed and risk controls and systems are in place.
Almost all central banks have issued guidelines/directives to ensure order and correct practices in the foreign exchange dealing rooms, as they are keen to maintain stability and appropriate parity in their markets.
In our dealing functions, back office section (processing office) plays a vital role, as this office receives and pays monies, accounts all transactions, etc. Therefore this office is probably the most important one in keeping the dealings operations up and running. For obvious reasons, this back office is entirely kept separate from the dealing desks.
Foreign exchange business is both a complex and evolutionary subject. It is therefore essential to understand the norms, the nuances and appreciate the risks associated with it and to put in place, maintain and review clearly defined control procedures that are properly understood by all associated with the business.
Without an understanding and appreciation of associated risks, chances of success are not good in foreign exchange business.
So, let us make a beginning – in the right direction.