72534045 caiib super notes bank financial management module a international banking basics of forex...

7/29/2019 72534045 CAIIB Super Notes Bank Financial Management Module a International Banking Basics of Forex Derivatives

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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
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Contents

Coverage:

1. Introduction

2. Definition of Risk and Risksin ForEx Operations

3. Management of Risk and

associated guidelines

4. Derivatives History and

Development


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INTRODUCTION

1.


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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 theprice of the underlying related asset

Types: Forwards, Futures, Options, Swaps


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DEFINITION OF RISK AND RISKS IN FOREXOPERATIONS

2.


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Risk

An unplanned event with financial consequences resulting in

loss or reduced earnings


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Risks in ForEx Operations

Exchange RiskExchange RiskSettlement

RiskSettlement

RiskLiquidity RiskLiquidity Risk

CountryRisk/Sovereign

Risk

CountryRisk/Sovereign

Risk

Interest RateRisk

Interest RateRisk

OperationalRisk

OperationalRisk

Legal RiskLegal Risk


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Exchange Risk

Change in value of our foreign exchange holdings due to

movement in exchange rates

Controlled by prescribing limits: Daylight and overnight, SingleDeal- Trading Position and Volume, Overall overnight position,

Stop Loss, gap-forward mismatch limit etc.


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3 Types of For Ex Exposure

TransactionExposure

Transactions thatmay expose thecompany/firm tocurrency risk

TranslationExposure

Revaluation of theasset andliabilities orreceivables andpayables into a

different currency Notional in nature

Operating Exposure

External factors inthemarket/economythat may harmthe bottom line


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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


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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 areasonable price

Controlled by

Fixing limits for maturity mismatches

Reduction of open positions


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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 problemsrelated 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


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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


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Operational Risk

Due to deficiencies in information systems or internal control

or human errors or other infrastructure problems that could

lead to unexpected losses


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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


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MANAGEMENT OF RISK ANDASSOCIATED GUIDELINES

3.


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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


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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


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Dealing Limits specified under ICG

Maximum amount ofopen position orexposure whenmarkets in the banks

time zone are closed

OvernightLimit

Maximum amount ofopen position orexposure during theday

Daylight Limit

Maximum interperiod/ monthexposures which abank can keep

Gap Limits

Maximum exposureto a particularcounterparty

CounterpartyLimit

Maximum exposureon a single country

Country Risk

Maximum exposure adealer can take duringthe operating hours

Dealer Limits

Maximum movementof rates against theposition held

Stop LossLimit

Maximum amount ofexposure to anyentity, maturing on asingle day

SettlementLimit

Highest amount forwhich a deal can beentered

Deal sizeLimit


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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


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DERIVATIVES HISTORY ANDDEVELOPMENT

4.


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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 Woodsfixed Exchange Rate Regime as it increased volatility in exchange rates and

interest rates

Early 1970s, Chicago Mercantile Exchange: Worlds first exchange traded

currency future contract

1975: First interest rate future. Several exchanges thereafter introduced

exchange rate and interest rate future contracts


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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 thederivatives markets

Arbitrageurs also joined in


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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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Do you have any questions or queries or some feedback to give?

Just mark an email to [email protected]
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CAIIB Super-Notes M S Ahluwalia Sirf BusinessFor more Super Notes: Click Here

M S Ahluwalia, amongst other things, is a visual artist, blogger,

blog designer and of course an MBA and Banker from New

Delhi, India.

To know more about him you may visit his blog-site:Estudiante De La Vida
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