International Banking

(Module A) Part II
Risk Management and Derivatives
Tanushree Mazumdar, IIBF

Dealing room (1)

Foreign exchange dealing room
operations comprise functions of a service
branch to meet the needs of other
branches/divisions to buy/sell foreign
currency.
Acts as a profit centre for the
bank/financial institution
A dealer has to maintain two positionsfunds position and currency position

Dealing room (2)

The funds position reflects inflows and outflows
of funds i.e. receivables and payables
A mismatch in funds position will throw open
interest rate risks in the form of overdraft interest
in the Nostro a/c, loss of interest income on
credit balances, etc.
Currency position deals with overbought and
oversold positions, arrived after taking various
merchant or inter-bank transactions and the
dealer is concerned with the overall net position

Dealing room (3)

The overall net position exposes the dealer to
exchange risks from market movements
The dealer has to operate within the permitted
limits prescribed for the exchange position by the
management
Back office: Takes care of processing deals,
accounts reconciliation. It plays a supportive as
well as checking role
Mid office: Mid-office deals with the risk
management and parameterisation of risks for
forex operations. Gives market information to
dealers

Risks in foreign exchange dealings

RBI and FEDAI issue guidelines to all
banks to identify, measure and manage
risks
Risks can be classified under:
Market risk: Loss arising out of change in the
market price of an asset
Liquidity risk: risk that you will not be able to
easily sell your assets

Risks(contd)
Operational risk: Failure of internal processes,
people, systems or external events
Legal risk: Contracts are not legally enforceable
or documented incorrectly
Credit risk: Counterparty defaulting in payment
Pre-settlement: Credit risk before the maturity of a
transaction
Settlement risk: Timing differences in cash flows, e.g.
of Herstatt Bank in Germany failing in 1974

Risks (3)
Country risk: Movement of funds across
borders may be obstructed by sudden
government controls
Interest rate risk: Interest rate risk or gap
risk arises out of adverse movement of
interest rates a bank faces on its currency
swaps/forward contracts or other interest
rate derivatives

Management of risks
Traditional measures adopted by bank
managements to manage/limit risks are:
Limits on intra-day open position in each currency
Limits on overnight open positions in each currency
(lower than intra-day)
Limits on aggregate open position for all currencies
A turnover limit on daily transaction volume for all
currencies
Countrywise exposure limits

Guidelines on risk management

Measure risks that can be quantified viz.,
exchange rate risk, interest rate risk using
mathematical or statistical tools
Have a detailed policy on risk management
(given by the Board)
A specific limit structure for various risks and
operations
A sound management information system
Specified control, monitoring and reporting
system

RBI guidelines on risk management

RBI has issued internal control guidelines
(ICG) for foreign exchange business
It covers various aspects of dealing room
operations, code of conduct for dealers
and brokers and other aspects of risk
control guidelines
Specifies limits including gap limits,
counterparty limit, dealer limit, deal size
limit, etc.

Derivative Instruments
Derivatives are management tools derived
from underlying exposures such as
currency, commodities, shares, etc.
Used to neutralise the exposures on the
underlying contracts
Can be over the counter (OTC) i.e.
customised products or exchange traded
which are standardized in terms of
quantity, quality, start and ending dates

Forward Contracts (1)

Forward contracts: Typical OTC
derivatives which involves fixing of rates
(exchange rate, commodity price, etc.) in
advance for delivery in future. Risk of
adverse price movement is covered.
Forward contracts are specified at forward
rates which are spot rates plus cost of
carry (interest rate differential in case of
foreign exchange forward)

Forward Contract (2)

Forward rate: spot rate + premium or discount
Premium/discount: function of cost of carry
(interest rate differential)
The currency with lower interest rate would be at
a premium in future
Other factors affecting forward rate
Demand and supply for forward currency
Perception about the movement in the currency
Political, fiscal and trade-related conditions in the
country and for the currency

Example of a forward differential

If GBP/USD Spot = 1.8000

6 months interest rate USD= 2%
6 months interest rate GBP = 4%
Forward differential=
1.8000 * (4-2)/100 * 6/12 or 0.018
6 months forward rate (GBP/USD) = 1.7820
Since USD has a lower interest rate it will be at a
premium in the future

Futures (1)
Futures: A version of exchange traded forward
contracts.
Standardized contracts as far as the quantity
(amounts) and delivery dates (period) of the
contracts.
Conveys an agreement to buy a specific amount
of commodity or financial instruments at a
particular price on a stipulated future date
An obligation on the buyer to purchase the
underlying instrument and the seller to sell it

Futures (2)
Types of Futures contracts

Commodities futures
Financial futures
Currency futures
Index futures

There is a margin process

Initial margin: to be paid at the start of a contract
Variable margin: calculated daily by marking to market
the contract at the end of each day
Maintenance margin: Similar to minimum balance for
undertaking trades in the Exchange and has to be
maintained by the buyer/seller in the margin account

Options (1)
Options: An agreement between two parties in
which one grants the other the right to buy (call
option) or sell (put option) an asset under
specified conditions (price, time) and assumes
the obligation to sell or buy it.
The party who has the right but not the obligation
is the buyer of the option and pays a fee or
premium to the writer or seller of the option.
The asset could be a currency, bond, share,
commodity or futures contract

Options (2)
The option holder or buyer would exercise the
option (buy or sell) in case the market price
moves adversely and would let it lapse if it
moves favourably
The option seller (usually a bank or a financial
institution or an Exchange) is under obligation to
deliver the contract if exercised at the agreed
price
Strike price/exercise price: The price at which the
option may be exercised and the underlying
asset bought or sold

Options (3)
In the money: When the strike price is below the
spot price (in case of a call option) or vice-versa
in case of a put option the option is in the money
giving gain to the buyer.
At the money: When strike price is equal to the
spot price
Out of the money: The strike price is above the
spot price (call option) or vice-versa (for a put
option). It is better to let the option lapse here.

Options (4)
Call option- The right, without the obligation, to
buy an asset
Put option- The right, without the obligation, to
sell an asset
American option- An option that can be
exercised at any time until the expiry date
European option- An option which can be
exercised only on expiry
Bermudan option- An option which is exercisable
only during a pre-defined portion of its life

Options (5)
Expiry: The last date on which the option may be
exercised.
Market participants often quote an expiration
(calendar) month without specifying an actual
date.
In such cases it is understood that the expiration
date is the Monday before the third Wednesday
of the month
Expiration time is usually specified in the
contract. For example, for contracts entered in
the Pacific Rim countries the time specified is
10:00 am New York time or 3:00 pm Tokyo time

Swaps
In foreign exchange market, swap refers
to simultaneous sale and purchase of one
currency for another (currency swap).
Financial or derivative swap refers to the
exchange of two streams of cash flows
over a defined period of time, between two
counter-parties

Derivatives in India (1)

Sodhani Committee (expert group on
foreign exchange) was formed in 1992 to
look into the issues in and development of
the foreign exchange market in India
Some recommendations
Corporates should be allowed to hedge upon
declaration of underlying assets
Banks may be permitted to initiate overseas
cross currency positions

Sodhani Committee..
Banks should be allowed to borrow and lend in
the overseas markets
More participants be allowed in the foreign
exchange market
Corporates must be allowed to cancel and rebook option contracts
Banks be permitted to use hedging instruments
for their own ALM
Banks to be allowed to fix interest rates on
FCNR (B) deposits subject to caps fixed by RBI

Derivatives in India (2)

The use of financial derivatives started in India is
the nineties in the foreign exchange and stock
market
In 1992 RBI had permitted banks to offer cross
currency options to their clients
In 1996 banks were allowed to offer their
corporate clients interest rate swaps, currency
swaps, interest rate options and forward rate
agreements
The derivatives market in India is still in an
evolving stage