MohammedDanish M-4155 Mayank Sharma M-4153 Ayaz Momin M-4156 Muqsit Patel M-4132 Vishal Gajjar M-4110

FOREIGN RISK & EXPOSURE

PECULIARITIES THAT MAKES BUSINESS RISKY

Controls & Restrictions Imposed By Foreign Authorities Fluctuation In The Currency Rates 24 Hours Global Market Forex Rates Move Considerably Decision Making In Forex Market

TYPES OF RISK

The exchange rate risk associated with the time delay between entering into a contract and settling it. The greater the time differential between the entrance and settlement of the contract, the greater the transaction risk, because there is more time for the two exchange rates to fluctuate.

The exchange rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets. The greater the proportion of asset, liability and equity classes denominated in a foreign currency, the greater the translation risk.

Economic exposure measures the impact of changes in exchange rate on the firms & cash flows and earnings. Exchange rates, interest rates and inflation rates are linked to one another through a classical set of relationships which have import for the nature of corporate foreign exchange risk.

DIFFERENTIATION
Risk Definition Valuation Hedging Concept Exposure

RISK FACED BY COMMERCIAL BANK IN FOREX MARKET

INTRODUCTION
When the foreign currency denominated assets & liabilities are held by the bank two types of risk are faced....  Exchange Risk  Interest Rate Risk

RISK FACED BY COMMERCIAL BANK IN FOREX MARKET

Banks Contract to sell the currency which they have already contracted to buy or vice versa

When the bank has contracted to buy a currency but is yet to contract to sell, its position is not squared off. When the bank has contracted to sell a currency but is yet to contract to buy, its position is not squared off. Bank bid-ask transaction could be spot or forward contract.

The exchange risk on the net open Forex position is called the Position Risk

For E.g. where a net long position is in currency whose value is depreciating , the conversion of currency will resulting in a loss, a lower amount of the corresponding currency resulting in a loss whereas a net long position in an appreciating currency would result in a profit.

The most popular controls on open position risk are : 1. Daylight limit 2. Overnight limit

Where a foreign currency is bought and sold for different value dates , it creates no net position i.e. there is no Forex risk Mismatches expose one to risks of exchange losses that arises out of adverse moment in forward points and therefore controls need to be initiated The limits on GAP Risk are: 1.Individual gap limit 2. Aggregate gap limit 3. Total aggregate gap limit

Banks square off their bid ask position.

Such square off may not be favorable in terms of rates.

Pre-settlement risk leads to replacement risk.

If the customer fails to honor his contract on the day of settlement, then it is called as settlement risk

Settlement risk also leads to replacement risk

Also one day delay would cause an extra interest payable by bank.

When a bank undertakes a forex transaction, it is with a desire to book profit in term of spread

Forex market is so volatile that even if next customer transacts in 5 minutes, the forex rates might have changed adversely to remain profitable

HEDGING IN FOREX MARKET

INTRODUCTION
Hedging refers to risk management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies or securities  Hedging is used also in protecting ones capital against effects of inflation through investing in high yield financial instruments, real estate, or precious metals.  By utilizing a forex hedge properly, a trader that is a long a foreign currency pair, can protect themselves from downside risk; while the trader that is short a foreign currency pair can protect against upside risk

NEED TO COVER FOREX EXPOSURE

As by & large Purchase Power Parity (PPP) & Interest Rate Parity (IRP) hold well, exchange rate move accordingly and hence there is no need to cover risk for Forex rate change over a period of time Large MNCs have significant exposure in most strong currency. It is difficult to forecast change in each of them. Investor themselves are insulated by way of diversification from such risk.

Mitigation measures are exposure in opposite direction.

FOR
Forex risk holds potential of financial loss. Hedging reduces the possibilities

By & Large, natural hedging is used, for which costs are not explicit. Only the residual portion is hedged through instruments. With open positions, budgeting planning is tough

Managing Forex Risk Hedging may create administrative benefits.

AGAINST
If markets are near-efficient, then there is almost equilibrium in the market

Open position may result in marginal loss or marginal gain and on average, it would be really small amount lost or gained Futures, option may result in losses also.

Shareholders can diversify their own portfolios to compensate for forex risk. Risk mitigation is just a psychological comfort, with costs.

FOREX HEDGING STRATEGY

Analyze Risk

Determine Risk Tolerance

Determine forex hedging strategy

Implement & Monitor the strategy The forex currency trading market is a risky one.

NATURAL HEDGING
Natural hedging refers to operational changes that mitigate or eliminate forex risk without use of financial instrument or derivates. Currency denomination

Netting and offsetting

Leading and lagging

HEDGING BY CONTRACTS AND INSTRUMENTS

Forward contract

Future contract

FORWARD CONTRACT
It is the simplest form of contract in foreign exchange market.

It is Tailor made
Features

It is a perfect hedge Not available to all Not cancellable

FORWARD CONTRACT
A highly standardized foreign exchange contract written against the exchange clearing house.

Standardization
Features

Organized exchanges Cash Settlement Costs

DIFFERENTIATION
Forward Contract Future Contract Contract Size Maturity Date Liquidity Hedging Perfection Settlement

OPTION CONTRACT
It is optional to one party and obligated to other, is called as option Right to buy or sell specific quantity of specific assets at a fix price at or before future date. Right to buy Right to sell Option have standardized quantity Option are traded on exchanges

FEATURES OF OPTION CONTRACT

Cash settlement, No actual delivery Market is full of speculators Option is exercised or lapsed on maturity
Buyer will choose to exercise his option only if he has net gain

ADVANTAGEOUS FEATURES
Leverage Liquidity Suitable for uncertain transactions No default or settlement risk

TYPES OF OPTION CONTRACT

European Option American Option Bermudan Option

OTHER HEDGING CONCEPTS

Interest Rate Swap Currency Swap Money Market Hedge

THANK YOU.......