Basics of Forex Derivatives: CAIIB Paper 2 (Module A), Unit 2

Basics of Forex Derivatives: CAIIB Paper 2 (Module A), Unit 2

Dear Bankers,
We all know that CAIIB exams are conducted by the Indian Institute of Banking and Finance (IIBF).  CAIIB is said to be one of the difficult courses to be cleared for the bankers. But we assure you that with the help of our “CAIIB study material”, you will definitely clear the CAIIB exam.
CAIIB exams are conducted twice in a year. Candidates should have completed JAIIB before appearing for CAIIB Exam. Here, we will provide detailed notes of every unit of the CAIIB Exam on the latest pattern of IIBF.
So, here we are providing “Unit 2: Basics of Forex Derivatives of “Module A: International Banking” from “Paper 2: Bank Financial Management (BFM)”.

 Definition of Risk and Risks in Forex Operations

A risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earning. An activity where the result is uncertain and there is a chance of loss, may be called a risky proposition, due to the uncertainty or unpredictability of the activity or trade in future, even though this activity may ultimately result in profit and gain.

Foreign exchange risk

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company.

Basically, foreign exchange exposures can be classified into three types:

  • Transaction Exposure: Arising due to normal business operations consequent to which the value of transactions will be affected. This is affected by the transactions undertaken which may expose the company/firm to currency risk, when compared to the value in home currency.
  • Translation Exposure: This arises when firms have to revalue their assets and liabilities or receivables and payables in home currency, at the end of each accounting period. This also is affected due to consolidating the accounts of all foreign operations. These are not actual costs or gains, but notional, as the actual loss or gain is booked at the time of actual translation of the exposure. It means any translation exposure would undergo a transaction exposure at a future date.
  • Operating/Economic Exposure: This affects the bottom-line of the firm/company, not directly due to any foreign exchange exposure of the firm/company, but due to other external factors in the market/economy, like changes in competition, reduction in import duty increasing competition from imported goods, reduction in prices by other country exporters-effecting exports, increase in import duty by other country – trade tariff, etc. causing reduction in exports, etc. For example, HMT watches which was having very good domestic demand in 1970’s and 1980’s lost out because of import of cheap technology in the form of quartz watches.

 Settlement Risk

  • Pre-settlement risk is the risk of failure of the counter party, due to bankruptcy, closure or any other reason, before maturity of the contract thereby compelling the bank to cover the contract at the ongoing the bank market rates with other counterparty. This entails the risk of only market differences and is not an absolute loss for the bank.
  • Settlement risk is the risk of failure of the counter party during the course of settlement due to the time zone differences between the two currencies to be exchanged. That is, where the bank, in earlier time zone, say Japan, or Australia, performs its part of the contract by delivering the currency to be delivered by it but the counter party, in another time zone, say Germany, fails before delivering the currency to be delivered by them. Such an event means complete risk and loss for the bank, which is in the earlier time zone.

 Liquidity Risk

  • Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.

Country Risk/ Sovereign Risk

  • Country risk refers to the uncertainty associated with investing in a particular country, and more specifically the degree to which that uncertainty could lead to losses for investors. This uncertainty can come from any number of factors including political, economic, exchange-rate, or technological influences.

Interest Rate Risk

  • Interest rate risk or GAP risk, as it is otherwise known, arises due to adverse movement of interest rate or interest rate differentials. It also refers to the potential cost of adverse movement of interest rates the banks faces on its deposits/borrowing/lending, or the currency swaps, forwards contracts, forward rate agreements, or other interest rate derivatives.
  • The increasing capital flows in the global financial markets by the day, the economic disparities between nations and the increased use of interest rates as a regulatory tool for macro-economic controls, to regulate global economies, have resulted in significant volatility in interest rates.

Operational Risk

  • Operational risk is the prospect of loss resulting from inadequate or failed procedures, systems or policies. Employee errors. Systems failures. Fraud or other criminal activity. Any event that disrupts business processes.

Legal Risk

  • Legal risk arises when it transpires that the counter party with whom the transaction has been undertaken, does not have the legal or regulatory authority to enter into such transaction.
  • In other words, counter party is incapacitated for engaging in such a deal, resulting in non-enforceability of contract. Legal risk also includes compliance and regulations related risks, arising out of non-compliance of prescribed guidelines or breach of governmental rules, leading to wrong understanding of rules and penalties by the enforcing agencies.

Management of Risk and Guidelines On Risk Management

To manage risk, it is important to identify and appreciate the process of measurement of risks as aq prerequisite. Some risks, like exchange risk, interest rate risk, etc., are easy to be quantified, while some other risks like country risk, operational risk, legal risk, etc., cannot be mathematically quantified and can only be qualitatively compared and measured. Some risks like gap risks in foreign exchange operations can be measured using modern mathematical and statistical tools like “value at risk’, etc. Thus, only after the risk is identified and assessed, question of management of risk arises.

RBI has issued Internal Control Guidelines (ICG) in 2011 for foreign exchange business, which covers various aspects of dealing room operations, code of conduct for dealers and brokers and other aspects of risk control guidelines, including set up of the dealing room, back office, and risk management structure. Under ICG, banks are required to put in place various dealing limits for their FOREX operations, which can be briefly summarized as under:

  • Overnight limit: Maximum amount of open position or exposure, a bank can keep overnight, when markets in its time zone are closed.
  • Daylight limit: Maximum amount of open position or exposure, the bank can expose itself at any time during the day, to meet customers’ needs or for its trading operations.
  • Gap limits: Maximum inter period/month exposures which a bank can keep, are called gap limits.
  • Counter party limit: Maximum amount that a bank can expose itself to a particular counter party
  • Country risk: Maximum exposure on a single country.
  • Dealer limits: Maximum amount a dealer can keep exposure during the operating hours.
  • Stop loss limit: Maximum movement of rates against the position held, so as to trigger the limit – or say maximum loss limit for adverse movement of rates.
  • Settlement risk: Maximum amount of exposure to any entity, upto spot date and also on future date.
  • Deal size limit: Highest amount for which a deal can be entered. The limits is fixed to restrict the operational risk on large deals

Derivatives

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or set of assets (like an index). Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes, and stocks.

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