DIFFERENT KINDS OF RISKS RELATED TO FOREX TRANSACTIONS
Foreign exchange operations face large no. of different type of risk due to a variety of reasons such as location of forex
markets without any single location, markets existing in different time zones, frequent fluctuations in the foreign currency
rates, effect of policies of the government and central banks of the related country etc.
Foreign exchange exposure: The exposure can be classified into 3 categories:
1. Transaction exposure : This arises on account of normal business operation. A transaction in foreign exchange can
exposure a firm to currency risk, when compared to the value in home currency.
2. Translation exposure : It arises on valuation of assts and liabilities created through foreign exchange and receivables or
payable in home currency, at the end of accounting period. These are notional and not actual.
3. Operating exposure : These are the factor external to a firm such as change in competition, reduction in import duty,
reduction in prices by other country exporters etc.
Exchange rate risk : Even the major currencies may experience substantial exchange rate movements over relatively short
periods of time. These can alter the balance sheet of a bank if the bank has assets or liabilities domiciled in those currencies.
An adverse movement of the rate can alter the value of the foreign exchange holdings, if not covered properly. The dealers
have to cover the position immediately.
Positions in a foreign currency : When the assets and the outstanding contracts to purchase that currency are more than the
liabilities plus and the outstanding contracts to sell that currency.
Long or overbought position : When the purchases (and outstanding contracts to purchase) are more than the sale (the
outstanding contracts to sell).
Short position or oversold position : When the purchases (and outstanding contracts to
purchase) are less than the sale (the outstanding contracts to sell).
Overbought or oversold position : It is called open position
Covering of position risk : The position is covered by fixing suitable limits (such as daylight position limit, overnight position limit,
single deal limit, gap-for-ward mismatch limits).
Prudent limit prescribed by RBI for open position : RBI has given discretion to bank Boards to fix their own open position limits
according to their own requirement, expertise and other related considerations.
Pre-settlement risk : It is the risk of failure of the counter party, due to bankruptcy or closure or other risk, before maturity of the
contract. This may force the bank to cover the contract at the ongoing market rates resulting into loss due to difference prevailing
between the contracted rate and rate at which the contract covered.
Settlement risk: Payment/delivery of one currency and received of other currency by both the parties. Settlement risk is the
risk of failure of the counter party during the course of settlement due to time zone differences between the two currencies
which are to be exchanged. For example, if a bank in the earlier time zone (say in Australia) performs its obligation and
delivers the currency and a bank in a later time zone (say USA) fails to deliver or delivers with delay, the loss may be caused to
the bank in the earlier time zone.
Foreign exchange settlement risk is also called temporal risk or Herstatt risk (named after failure of Bankhaus Herstatt in Germany)
The settlement risk can be taken care of by operating the system on a single time basis and also on real time gross settlement
(RTGS) basis.
Liquidity risk: The liquidity risk is where a market does not have the capacity to handle, at least without significant adverse
impact on the price, the volume of whatever the borrower buys or sells at the time he want to deal. Inability to meet debt
when they fall due could be another form of such risk.
For example, if there is deal of UK Pound purchase against the rupee and the party selling the UK Pound is short of pound in its
NOSTRO account, it may default in payment or it may meet its commitment by borrowing at a very high cost.
Country risk: It is the risk that arises when a counter party abroad, is unable to fulfill its obligation due to reasons other than the
normal risk related to lending or investment.
For example, a counter party is willing and capable to meet its obligation but due to restrictions imposed by the govt. of the
country or change in the polices of the govt., say on remittances etc. is unable to meet its repayment / remittance capacity.
Country risk can be very high in case of those countries that are having foreign exchange reserve problem.
Banks control country risk by putting restrictions on overall exposure, country exposure.
Country risk is in addition to normal credit risk. While the normal credit risk is due to failure on meeting obligation on the part of
counterparty on its own, the country risk arises due to actions initiated by the Govt. of that country due to which counterparty is not
able to perform its part.
Sovereign risk : It is larger than country risk. It arises when the counterparty is a foreign govt. or its agency and enjoys sovereign
immunity under law of that country. Due to this reason, legal action cannot be taken against that counterparty. This risk can be
reduced through disclaimers and by imposing 3,d country jurisdictions.
Interest rate risk: The potential cost of adverse movement of interest rates that the bank faces on its deposits and other
liabilities or currency swaps, forward contracts etc. is called interest rate risk. This risk arises on account of adverse
movement of interest rates or due to interest rate differentials. The bank may face adverse cost on its deposit or adverse
earning impact on its lending and investments due to such change in interest rates.
Interest rate can be managed by determining the interest rate scenario, undertaking appropriate sensitivity exercise to estimate the
potential profit or losses based on interest rate projections.
Gap risk : Banks on certain occasions are not able to match their forward purchase and sales, borrowing and lending which
creates a mismatch position, which is called gap risk. The gaps are required to be filled by paying or receiving the forward
differential. These differentials are the function of interest rates.
The gap risk can be managed by using derivative products such as interest rate swaps, currency
swaps, forward rate agreements.
Fledging risk: This occurs when one fails to achieve a satisfactory hedge for one's exposure, either because it could not be
arranged or as the result of an error. One may also be exposed to basic risk where the available hedging instrument closely
matches but does not exactly mirror or track the risk being hedged.
Operational risk : It is a potential catch that includes human errors or defalcations, loss of documents and records, ineffective
systems or controls and security breaches, how often do one consider the disaster scenario.
Legal, jurisdiction, litigation and documentation risks including netting agreements and cross border insolvency. Which country's
laws regulate individual contracts and the arbitration of disputes ? Could a plaintiff take action against a borrower in an
overseas court where they have better prospects of success or of higher awards ? There is a growing and widespread belief
that, whatever goes wrong, someone else must pay. The compensation culture whatever its justification or cause, is becoming
a big problem for many businesses.
Foreign exchange operations face large no. of different type of risk due to a variety of reasons such as location of forex
markets without any single location, markets existing in different time zones, frequent fluctuations in the foreign currency
rates, effect of policies of the government and central banks of the related country etc.
Foreign exchange exposure: The exposure can be classified into 3 categories:
1. Transaction exposure : This arises on account of normal business operation. A transaction in foreign exchange can
exposure a firm to currency risk, when compared to the value in home currency.
2. Translation exposure : It arises on valuation of assts and liabilities created through foreign exchange and receivables or
payable in home currency, at the end of accounting period. These are notional and not actual.
3. Operating exposure : These are the factor external to a firm such as change in competition, reduction in import duty,
reduction in prices by other country exporters etc.
Exchange rate risk : Even the major currencies may experience substantial exchange rate movements over relatively short
periods of time. These can alter the balance sheet of a bank if the bank has assets or liabilities domiciled in those currencies.
An adverse movement of the rate can alter the value of the foreign exchange holdings, if not covered properly. The dealers
have to cover the position immediately.
Positions in a foreign currency : When the assets and the outstanding contracts to purchase that currency are more than the
liabilities plus and the outstanding contracts to sell that currency.
Long or overbought position : When the purchases (and outstanding contracts to purchase) are more than the sale (the
outstanding contracts to sell).
Short position or oversold position : When the purchases (and outstanding contracts to
purchase) are less than the sale (the outstanding contracts to sell).
Overbought or oversold position : It is called open position
Covering of position risk : The position is covered by fixing suitable limits (such as daylight position limit, overnight position limit,
single deal limit, gap-for-ward mismatch limits).
Prudent limit prescribed by RBI for open position : RBI has given discretion to bank Boards to fix their own open position limits
according to their own requirement, expertise and other related considerations.
Pre-settlement risk : It is the risk of failure of the counter party, due to bankruptcy or closure or other risk, before maturity of the
contract. This may force the bank to cover the contract at the ongoing market rates resulting into loss due to difference prevailing
between the contracted rate and rate at which the contract covered.
Settlement risk: Payment/delivery of one currency and received of other currency by both the parties. Settlement risk is the
risk of failure of the counter party during the course of settlement due to time zone differences between the two currencies
which are to be exchanged. For example, if a bank in the earlier time zone (say in Australia) performs its obligation and
delivers the currency and a bank in a later time zone (say USA) fails to deliver or delivers with delay, the loss may be caused to
the bank in the earlier time zone.
Foreign exchange settlement risk is also called temporal risk or Herstatt risk (named after failure of Bankhaus Herstatt in Germany)
The settlement risk can be taken care of by operating the system on a single time basis and also on real time gross settlement
(RTGS) basis.
Liquidity risk: The liquidity risk is where a market does not have the capacity to handle, at least without significant adverse
impact on the price, the volume of whatever the borrower buys or sells at the time he want to deal. Inability to meet debt
when they fall due could be another form of such risk.
For example, if there is deal of UK Pound purchase against the rupee and the party selling the UK Pound is short of pound in its
NOSTRO account, it may default in payment or it may meet its commitment by borrowing at a very high cost.
Country risk: It is the risk that arises when a counter party abroad, is unable to fulfill its obligation due to reasons other than the
normal risk related to lending or investment.
For example, a counter party is willing and capable to meet its obligation but due to restrictions imposed by the govt. of the
country or change in the polices of the govt., say on remittances etc. is unable to meet its repayment / remittance capacity.
Country risk can be very high in case of those countries that are having foreign exchange reserve problem.
Banks control country risk by putting restrictions on overall exposure, country exposure.
Country risk is in addition to normal credit risk. While the normal credit risk is due to failure on meeting obligation on the part of
counterparty on its own, the country risk arises due to actions initiated by the Govt. of that country due to which counterparty is not
able to perform its part.
Sovereign risk : It is larger than country risk. It arises when the counterparty is a foreign govt. or its agency and enjoys sovereign
immunity under law of that country. Due to this reason, legal action cannot be taken against that counterparty. This risk can be
reduced through disclaimers and by imposing 3,d country jurisdictions.
Interest rate risk: The potential cost of adverse movement of interest rates that the bank faces on its deposits and other
liabilities or currency swaps, forward contracts etc. is called interest rate risk. This risk arises on account of adverse
movement of interest rates or due to interest rate differentials. The bank may face adverse cost on its deposit or adverse
earning impact on its lending and investments due to such change in interest rates.
Interest rate can be managed by determining the interest rate scenario, undertaking appropriate sensitivity exercise to estimate the
potential profit or losses based on interest rate projections.
Gap risk : Banks on certain occasions are not able to match their forward purchase and sales, borrowing and lending which
creates a mismatch position, which is called gap risk. The gaps are required to be filled by paying or receiving the forward
differential. These differentials are the function of interest rates.
The gap risk can be managed by using derivative products such as interest rate swaps, currency
swaps, forward rate agreements.
Fledging risk: This occurs when one fails to achieve a satisfactory hedge for one's exposure, either because it could not be
arranged or as the result of an error. One may also be exposed to basic risk where the available hedging instrument closely
matches but does not exactly mirror or track the risk being hedged.
Operational risk : It is a potential catch that includes human errors or defalcations, loss of documents and records, ineffective
systems or controls and security breaches, how often do one consider the disaster scenario.
Legal, jurisdiction, litigation and documentation risks including netting agreements and cross border insolvency. Which country's
laws regulate individual contracts and the arbitration of disputes ? Could a plaintiff take action against a borrower in an
overseas court where they have better prospects of success or of higher awards ? There is a growing and widespread belief
that, whatever goes wrong, someone else must pay. The compensation culture whatever its justification or cause, is becoming
a big problem for many businesses.
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