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Basics of Forex Derivatives

Module A: International Banking

© M S Ahluwalia

CAIIB – Super-Notes

Sirf Business

Bank Financial Management: Basics of Forex Derivatives

CAIIB – SUPER NOTES

© M S Ahluwalia

CAIIB – Super-Notes

Sirf Business

Contents Coverage: 1. Definition of Risk and Risks in ForEx Operations 3. Management of Risk and associated guidelines 4. Derivatives – History and Development © M S Ahluwalia CAIIB – Super-Notes Sirf Business . Introduction 2.

1. INTRODUCTION © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

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 the price of the underlying related asset • Types: Forwards. Futures. Swaps © M S Ahluwalia CAIIB – Super-Notes Sirf Business . Options.

DEFINITION OF RISK AND RISKS IN FOREX OPERATIONS © M S Ahluwalia CAIIB – Super-Notes Sirf Business .2.

Risk • An unplanned event with financial consequences resulting in loss or reduced earnings © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Risks in ForEx Operations Exchange Risk Settlement Risk Liquidity Risk Country Risk/Sovereign Risk Interest Rate Risk Operational Risk Legal Risk © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Exchange Risk • Change in value of our foreign exchange holdings due to movement in exchange rates • Controlled by prescribing limits: Daylight and overnight. Stop Loss. gap-forward mismatch limit etc. Single Deal. © M S Ahluwalia CAIIB – Super-Notes Sirf Business .Trading Position and Volume. Overall overnight position.

3 Types of For Ex Exposure Transaction Exposure • Transactions that may expose the company/firm to currency risk Translation Exposure • Revaluation of the asset and liabilities or receivables and payables into a different currency • Notional in nature Operating Exposure • External factors in the market/economy that may harm the bottom line © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

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. 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 © M S Ahluwalia CAIIB – Super-Notes Sirf Business . • Entails complete risk and loss for the bank • • • Principal risk in settlement also known as Foreign Exchange Settlement Risk.

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 a reasonable price • Controlled by – Fixing limits for maturity mismatches – Reduction of open positions © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

management of resources.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 problems related to foreign exchange reserves. 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 © M S Ahluwalia CAIIB – Super-Notes Sirf Business . balance of payments.

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 © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Operational Risk • Due to deficiencies in information systems or internal control or human errors or other infrastructure problems that could lead to unexpected losses © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

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 © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

3. MANAGEMENT OF RISK AND ASSOCIATED GUIDELINES © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

specific limit structure for various risks and operations. a sound management information system. monitoring and reporting process • Policy for management of various risks being faced.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. Also specifies limits for various types of trades. delegation of responsibilities. besides the authority to undertake such functions and system for review © M S Ahluwalia CAIIB – Super-Notes Sirf Business . and specified control. or expected to be faced by the bank. activities to be undertaken and level of acceptable risks. functions as also upper limits for exposures • Policy framework should cover the goals and objectives.

Nostro Balances limit. Value of Risk Limit. the currencies in which the bank/dealers would deal in. • 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 © M S Ahluwalia CAIIB – Super-Notes Sirf Business .Guidelines • RBI has issued internal control guidelines (ICG) for ForEx business • The dealing limits specified under ICG are given later • Besides the limits. Overdraft limit etc. banks approve panel of brokers through whom deals could be undertaken.

maturing on a single day •Highest amount for which a deal can be entered Dealer Limits Stop Loss Limit Settlement Limit Deal size Limit © M S Ahluwalia CAIIB – Super-Notes Sirf Business .Dealing Limits specified under ICG •Maximum amount of open position or exposure when markets in the bank’s time zone are closed •Maximum amount of open position or exposure during the day •Maximum inter period/ month exposures which a bank can keep •Maximum exposure to a particular counterparty •Maximum exposure on a single country Overnight Limit Daylight Limit Gap Limits Counterparty Limit Country Risk •Maximum exposure a dealer can take during the operating hours •Maximum movement of rates against the position held •Maximum amount of exposure to any entity.

It handles USD/INR deal settlement with netted amounts being paid/received to/from the participant banks © M S Ahluwalia CAIIB – Super-Notes Sirf Business . Gilts and inter bank Forex deals. CBLOs.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.

4. DERIVATIVES – HISTORY AND DEVELOPMENT © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

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 Woods fixed Exchange Rate Regime as it increased volatility in exchange rates and interest rates • • Early 1970s. Several exchanges thereafter introduced exchange rate and interest rate future contracts © M S Ahluwalia CAIIB – Super-Notes Sirf Business . Chicago Mercantile Exchange: World’s first exchange traded currency future contract 1975: First interest rate future.

History and Development • 1983. 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 the derivatives markets • Arbitrageurs also joined in © M S Ahluwalia CAIIB – Super-Notes Sirf Business . Philadelphia Stock Exchange: Currency options • Early 1980s: Interest Rate Swaps • Mid 1980s: Boost in the derivatives market with a host of exchange rate.

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 © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Do you have any questions or queries or some feedback to give? Just mark an email to super.com © M S Ahluwalia CAIIB – Super-Notes Sirf Business .msahluwalia@yahoo.

is a visual artist.M S Ahluwalia. To know more about him you may visit his blog-site: Estudiante De La Vida © M S Ahluwalia For more Super-Notes: Click Here CAIIB – Super-Notes Sirf Business . blog designer and of course an MBA and Banker from New Delhi. blogger. amongst other things. India.