RISK MANAGEMENT IN FOREIGN EXCHANGE

CHAPTER 1
OVERVIEW OF FOREX TRADE

"Forex" stands for foreign exchange; it's also known as FX. In a forex trade, you
buy one currency while simultaneously selling another - that is, you're
exchanging the sold currency for the one you're buying. The foreign exchange
market is an over-the-counter market.

Currencies trade in pairs, like the Euro-US Dollar (EUR/USD) or US Dollar /

Japanese Yen (USD/JPY). Unlike stocks or futures. All transactions happen via
phone or electronic network.

Historically, Forex has been dominated by inter-world investment and

commercial banks, money portfolio managers, money brokers, large
corporations, and very few private traders. Lately this trend has changed. With
the advances in internet technology, plus the industry's unique leveraging
options, more and more individual traders are getting involved in the market for
the purposes of speculation. While other reasons for participating in the market
include facilitating commercial transactions (whether it is an international
corporation converting its profits, or hedging against future price drops),
speculation for profit has become the most popular motive for Forex trading for
both big and small participants Traders generate profits, or losses, by
speculating whether a currency will rise or fall in value in comparison to
another currency. A trader would buy the currency which is anticipated to gain
in value, or sell the currency which is anticipated to lose value against another
currency.

Although good instincts and speculator skills are invaluable trader, there are
also other, more scientific indicators that traders use to decide whether they will
buy or sell a certain currency.
1|Page
RISK MANAGEMENT IN FOREIGN EXCHANGE

These are found by fundamental factors include economic and political events
(i.e. elections, wars) that occur worldwide. Monetary and fiscal policy,
government reports such as GDP, CPI, PPI, and measures such as the
unemployment rate also fall in this category. A trader that makes his or her
market decisions in response to these releases and events is using fundamental
analysis. The value of a currency in the forex market is essentially an indication
of the state of one nation's economy in comparison to another nation's

FOREX, an acronym for Foreign Exchange, is the largest financial market in

the world. With an estimated $1.5 trillion in currencies traded daily, Forex
provides income to millions of traders and large banks worldwide. The market
is so large in volume that it would take the New York Stock Exchange, with a
daily average of under $20 billion, almost three months to reach the amount
traded in one day on the Foreign Exchange Market.

The foreign exchange market operates 24 hours a day, and, unlike the stock
market, have no official openings or closings.

Trading volumes in a given region are always highest during its primary
business hours, when traders at financial institutions are busy filling and placing
orders. The most active times, meaning the times of most liquidity and
movement in the markets, is the London open (3 AM EST), and the overlap
between London/Euro close and New York's open (8-11 AM EST).

The hours below correspond to someone living in the EST time zone.

• New York session opens at 8:00 am and ends around 5:00 pm.

• Sydney session starts at 5:00 pm and ends around 2:00 am.

• Tokyo session begins at 7:00 pm and ends around 4:00 am.

• Frankfurt session opens at 2:00 am and ends around 11:00 am.

2|Page
RISK MANAGEMENT IN FOREIGN EXCHANGE

• London opens at 3:00 am and ends around 12:00 am.

Below is a figure showing business hours in the various regions, oriented for
someone in the EST time zone. In this figure you can see the overlap between
the European/London session and the New York session, between 8 am and 11
am EST. The currency markets experience the highest volatility and volume
during that overlap, which also coincides with the release of important US
economic figures.

3|Page
RISK MANAGEMENT IN FOREIGN EXCHANGE

CHAPTER 2
OVERVIEW RISK MANAGEMENT

Risk Management is the process of measuring, or assessing risk and then

developing strategies to manage the risk. In general, the strategies employed
include transferring the risk to another party, avoiding the risk, reducing the
negative effect of the risk, and accepting some or all of the consequences of a
particular risk. Traditional risk management focuses on risks stemming from
physical or legal causes (e.g. natural disasters or fires, accidents, death, and
lawsuits).Financial risk management, on the other hand, focuses on risks that
can be managed using traded financial instruments. Intangible risk management
focuses on the risks associated with human capital, such as knowledge risk,
relationship risk, and engagement-process risk. Regardless of the type of risk
management, all large corporations have risk management teams and small
groups and corporations practice informal, if not formal, risk management. In
ideal risk management, a prioritization process is followed whereby the risks
with the greatest loss and the greatest probability of occurring are handled first,
and risks with lower probability of occurrence and lower loss are handled later.
In practice the processing be very difficult, and balancing between risks with a
high probability of occurrence but lower loss vs. a risk with high loss but lower
probability of occurrence can often be mishandled .Intangible risk management
identifies a new type of risk - a risk that has a 100%probability of occurring but
is ignored by the organization due to a lack of identification ability. For
example, knowledge risk occurs when deficient knowledge is applied.
Relationship risk occurs when collaboration ineffectiveness occurs. Process-
engagement risk occurs when operational ineffectiveness occurs. These risks
directly reduce the productivity of knowledge workers, decrease cost
effectiveness, profitability, service, quality, reputation, brand value, and

4|Page
RISK MANAGEMENT IN FOREIGN EXCHANGE

earnings quality. Intangible risk management allows risk management to create

immediate value from the identification and reduction of risks that reduce
productivity.

Risk management also faces a difficulty in allocating resources properly. This is

the idea of opportunity cost. Resources spent on risk management could be
instead spent on more profitable activities. Again, ideal risk management spends
the least amount of resources in the process while reducing the negative effects
of risks as much as possible. The Forex Market is the largest and most liquid
financial market in the world. Since macroeconomic forces are one of the main
drivers of the value of currencies in the global economy, currencies tend to have
the most identifiable trend patterns. Therefore, the Forex market is a very
attractive market for active traders, and presumably where they should be the
most successful. However, success has been limited mainly for the following
reasons: Many traders come with false expectations of the profit potential, and
lack the discipline required for trading. Short term trading is not an amateur's
game and is not the way most people will achieve quick riches. Simply because
Forex trading may seem exotic or less familiar then traditional markets (i.e.
equities, futures, etc.), it does not mean that the rules of finance and simple
logic are suspended. One cannot hope to make extraordinary gains without
taking extraordinary risks, and that means suffering inconsistent trading
performance that often leads to large losses. Trading currencies is not easy, and
many traders with years of experience still incur periodic losses. One must
realize that trading takes time to master and there are absolutely no short cuts to
this process. The most enticing aspect of trading Forex is the high degree of
leverage used. Leverage seems very attractive to those who are expecting to
turn small amounts of money into large amounts in a short period of time.
However, leverage is a double-edged sword. Just because one lot ($10,000) of

5|Page
RISK MANAGEMENT IN FOREIGN EXCHANGE

currency only requires $100 as a minimum margin deposit, it does not mean that
a trader with$1,000 in his account should be easily able to trade 10 lots. One lot
is $10,000 and should be treated as a $100,000 investment and not the $1000
put up as margin. Most traders analyze the charts correctly and place sensible
trades, yet they tend to over leverage themselves (get in with a position that is
too big for their portfolio), and as a consequence, often end up forced to exit a
position at the wrong time.

For example, if your account value is $10,000 and you place a trade for 1 lot,
you are in effect, leveraging yourself 10 to 1, which is a very significant level of
leverage. Most professional money managers will leverage no more than 3 or 4
times. Trading in small increments with protective stops on your positions will
allow one the opportunity to be successful in Forex trading.

6|Page
RISK MANAGEMENT IN FOREIGN EXCHANGE

CHAPTER 3
PROCESS OF RISK MANAGENT

Risk management
objectives

Identifying risk

Risk assessment

Risk control measures

Risk controls
Implementation

Monitoring and
reviewing

Step 1: Risk management objectives

In order to effectively identify risk a company should first at least define
strategic, operational, reporting and compliance objectives.

What the organization wants to achieve and the external and internal factors that
may affect success in achieving those objectives. This step is called establishing
the context and is an essential precursor to risk identification.

7|Page
RISK MANAGEMENT IN FOREIGN EXCHANGE

A risk management strategy is also very significant and fundamental to

effective risk management. As this establishes barriers against an accumulation
of operational risks inherent in continuing operations. “Developing risk
intelligence maximizes the return on value from information risk management
investments”

Managing risk is about the logical sense making and implementing of a plan to
deal with potential losses. The main purpose of risk management for a process
or an activity owner is to avoid tortuous, contractual or statutory liability.

Management should establish four main categories of objectives related to the

firm:

 “Strategic – relating to high-level goals, aligned with and supporting the

entity’s mission.

 Operations – relating to effective and efficient use of the entity's

resources

 Reporting – relating to the reliability of the entity’s reporting

 Compliance – relating to the entity's compliance with applicable laws and

regulations.

The framework of risk management is based on the context in which the

organization-wide risk appetite is formulated and risk environment of an
organization is defined.

The context examines:

8|Page
RISK MANAGEMENT IN FOREIGN EXCHANGE

 Laws & regulations

 Economics & Markets

 Culture & Technologies

 Natural environment

 Stakeholders needs, issues and concerns

“The essence of risk management,” Bernstein concludes, “lies in maximizing

the areas where we have some control over the outcome while minimizing the
areas where we have absolutely no control over the outcome and the linkage
between effect and cause is hidden from us.”

Step 2: Identifying risk

A company should identify internal and external events that have the potential
to effect the company’s operations by analyzing the workflows and processes
and listing risks and causes, the extent of risk that is faced, and the impact of
identified risks on company’s operations. It is important that the internal and
external events that could affect the achievement of the objectives of the
organization are identified, distinguishing between risks and opportunities.
Opportunities are fed back to the strategy of the management or goal setting
process. During the process of risk identification, the following questions
should be answered.

9|Page
RISK MANAGEMENT IN FOREIGN EXCHANGE

What is the extent of risk faced?

What are the available options?
How large, and immediate are the outcomes resulting from the impact of risk?
Can the risk be controlled, reversed or avoided?
How do individuals and groups conceptualize risk?
What aspects of the problem seem most relevant?

Step 3: Risk assessment

A company should first prioritize and assess risks on an inherent & residual
basis and analyze and divide these into 2 main categories: probability and
consequences per risk event.

Companies must first prioritize risks to identify and limit and then assess further
prioritize and address the rest of the risks based on the needs of the
organization.

It is not surprising that man has always searched for methods to reduce
uncertainty and through time, devised methods and skills are developed to deal
with such uncertainties. The way in which consequences and likelihood are
expressed and the way in which they are combined to determine a level of risk
should reflect the type of risk. These types of risks should all be consistent with
the risk criteria. Three main aspects of risk handling are presented: Risk
identification, Risk estimation and Risk evaluation.

Risk assessment is the determination of quantitative or qualitative value of risk

associated with a particular event as it happens; this involves the process of
analysis and evaluation. Risk can be defined as the combination of the
probability of an event and its consequences.

10 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

Step 4: Risk control measures

A company should identify control choices and select the appropriate risk
control measures, determine risk priorities and make control decisions. This is
where management requires deciding upon what risks to avoid, accept, reduce
or transfer and development of a series of actions to tune the risks with the
entity's risk tolerance level and appetite for risk. Once the risks are stated, the
company must then proceed to prioritize such risks. It is improbable that a
company is able to mitigate all the risks mentioned; therefore it is of importance
that a firm identifies high priority risks and focuses first on them.

ISO 31000:2009 gives a set of general options to be considered when risk is

handled. The order of the list reflects preferred. It is important that one of the
options deal with both the risks that disadvantage and / or up-side effects. The
options are:

 “Avoiding the risk by deciding not to start or continue with the activity
that gives rise to the risk;

 Taking or increasing the risk in order to pursue an opportunity;

 Removing the risk source;

 Changing the likelihood;

 Changing the consequences;

 Sharing the risk with another party or parties (including contracts and risk
financing);

11 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

Step 5: Risk controls Implementation

A company should first define a clear structure with processes & procedures
and implement the risk control measures into its organization to establish
coherent authority and responsibility.

Control activities such as operational assessment and reporting, authorization,

verification, approval and distribution of tasks need to be implemented in order
to avoid the risks materializing. Identify control choices, determine priorities,
and make control decisions. “There is comprehensive, fully defined, and fully
accepted accountability for risks, controls, and risk treatment tasks”

Someone is responsible for something (actions, action consequences, states,

tasks etc.) in relation to an addressee and towards a criterion, in the context of a
given responsibility and action domain...”

Step 6 Monitoring and reviewing

A company should define monitoring Infrastructure by developing control
procedures that monitor and review business critical processes, the company
should also have audit procedures in place to determine if those risk related
control procedures are working effectively and should periodically perform
audits on the control procedures to determine or the risk monitoring process are
working effectively and as expected, if necessary make adjustments or
improvements to improve risk monitoring processes.

“COSO asserts the role of monitoring not only aids the financial reporting
process, but also ultimately the organization’s overall system of governance,
including operational decision-making”.

12 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

The monitoring shall include the assessment of the quality of control over time;
this can be accomplished by monitoring individual evaluation or both.

 Develop a strong understanding of the identified significant risks and

develop control procedures to monitor or correct for these risks.

 Create testing procedures to determine if those risk-related control

procedures are working effectively.

 Perform tests of the control procedures to determine if the risk-

monitoring process tested is working effectively and as expected.

 Make adjustments or improvements as necessary to improve risk-

monitoring processes.

Strengths: conceptual risk assessment framework

The conceptual risk process mentioned is mainly divided into 3 major sections
and 6 steps. It is a comprehensive stepwise approach to set risk management
objectives, identify and assess risks as well as selecting and implementing
appropriate risk controls and monitor and review activities. In summary the
conceptual risk process helps the company to effectively identify, estimate and
evaluate risks

Weaknesses: conceptual risk assessment framework

The conceptual risk process mentioned is mainly based on limited academic
literature and is general of nature. Therefore it is not scientifically justified in a
specific business environment, such as assessing risk of new business

13 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

partnerships. Therefor it should be further researched in such business

environment.

14 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

CHAPTER 4
OBJECTIVE OF RISK MANAGEMENT

The prime motive of corporate forex risk management is the protection of the
underlying business from foreign exchange risk. It is that risk to the business
which must be managed. Profit can never really be the prime motive for foreign
exchange risk management in a corporate. There is really a very thin line
dividing the objective of cost reduction or profit motive.

The first task in determining the most suitable system for managing foreign
exchange exposures is to clarify corporate objectives in this area. The objectives
generally outlined below form the base for strategies and technical models.

OBJECTIVES OF RISK MANAGEMENT

 Mere survival;

 Peace of mind;

 Lower risk management costs and thus higher profits;

 Fairly stable earnings;

 Little or no interruption of operations;

 Continued growth;

15 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

 Satisfaction of the firm’s sense of social responsibility desire for a good

image;

 Satisfaction of externally imposed obligations.

 Maintaining core cover to total exposures ratio, as per forecast of market

conditions.

 Periodical evaluation of unhedged exposures.

 Market intelligence and identification of seasonal factors.

 Diversification of currency mix to reduce interest cost on foreign

currency borrowings.

 Trading on non-dollar exposures to minimize the cross-currency risk and

achieve better core rate.

 Identifying market opportunities and operate to derive invisible

gains/opportunity benefits.

 Adopt appropriate hedging strategies to achieve lower interest cost on

foreign currency loans.

 Periodical review of interest rate exposures to devise options for reducing

the interest cost on foreign currency borrowings.

16 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

CHAPTER 5
FOREIGN EXCHANGE EXPOSURE & RISK

Foreign Exchange Exposure:

Description:
Foreign exchange risk is related to the variability of the domestic currency
values of assets, liabilities or operating income due to unanticipated changes in
exchange rates, whereas foreign exchange exposure is what is at risk.
Foreign currency exposures and the attendant risk arise whenever a company
has an income or expenditure or an asset or liability in a currency other than that
of the balance-sheet currency. Indeed exposures can arise even for companies
with no income, expenditure, asset or liability in a currency different from the
balance-sheet currency.
When there is a condition prevalent where the exchange rates become extremely
volatile, the exchange rate movements destabilize the cash flows of a business
significantly. Such destabilization of cash flows that affects the profitability of
the business is the risk from foreign currency exposures.
Classification of Exposures:
Financial economists distinguish between three types of currency exposures –
Transaction Exposures, Translation Exposures and Economic Exposures. All
three affect the bottom-line of the business.
• Transaction Exposure:
The transaction exposure component of the foreign exchange rates is also
referred to as a short-term economic exposure. This relates to the risk attached
to specific contracts in which the company has already entered that result in
foreign exchange exposures. A company may have a transaction exposure if it is
either on the buy side or sell side of a business transaction. Any transaction that

17 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

leads to an inflow or outflow of a foreign currency results in a transaction

exposure.
For example, Company a located in the United States has a contract for
purchasing raw material from Company B located in the United Kingdom for
the next two years at a product price fixed today. In this case, Company A is the
foreign exchange payer and is exposed to a transaction risk from movements in
the pound rate relative to dollar. If the pound sterling depreciates, Company A
has to make a smaller payment in dollar terms, but if the pound appreciates,
Company A has to pay a larger amount in dollar terms leading to foreign
currency exposure.

Transaction exposure arises from:

• Purchasing or selling on credit goods or services whose prices are stated
in foreign currencies.
• Borrowing or lending funds when repayment is to be made in a foreign
currency.
• Being a party to an unperformed foreign exchange forward contract.
• Otherwise acquiring assets or incurring liabilities denominated in foreign
currencies.
Strategy to manage Transaction Exposure:
• Hedging through invoice currency:
The firm can shift, share or diversify exchange risk by appropriately choosing
the currency of invoice. Firms can avoid exchange rate risk by invoicing in
domestic currency, thereby shifting the exchange rate risk on buyer.
As a practical matter, however, the firm may not be able to use risk shifting or
sharing as much as it wishes to for fear of losing sales to competitors. Only an
exporter with substantial market power can use this approach. Also, if the
currencies of both the importer and exporter are not suitable for settling

18 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

international trade, neither party can resort to risk shifting to deal with exchange
exposure.
• Hedging via lead and lag:
To “lead” means to pay or collect early, whereas “lag” means to pay or collect
late. The firm would like to lead soft currency receivables and lag hard currency
receivables to avoid the loss from depreciation of the soft currency and benefit
from the appreciation of the hard currency. For the same reason, the firm will
attempt to lead the hard currency payables and lag soft currency payables. To
the extent that the firm can effectively implement the lead/lag strategy, the
transaction exposure the firm faces can be reduced.

• Translation Exposure:
Translation exposure of foreign exchange is of an accounting nature and is
related to a gain or loss arising from the conversion or translation of the
financial statements of a subsidiary located in another country.
A company such as General Motors may sell cars in about 200 countries and
manufacture those cars in as many as 50 different countries. Such a company
owns subsidiaries or operations in foreign countries and is exposed to
translation risk. At the end of the financial year the company is required to
report all its combined operations in the domestic currency terms leading to a
loss or gain resulting from the movement in various foreign currencies.

• Economic Exposure:
Economic exposure is a rather long-term effect of the transaction exposure. If a
firm is continuously affected by an unavoidable exposure to foreign exchange
over the long-term, it is said to have an economic exposure. Such exposure to
foreign exchange results in an impact on the market value of the company as the
risk is inherent to the company and impacts its profitability over the years.

19 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

A beer manufacturer in Argentina that has its market concentration in the

United States is continuously exposed to the movements in the dollar rate and is
said to have an economic foreign exchange exposure.
Economic exposure consists of mainly two types of exposures. They are:
1) Asset Exposure
2) Operating Exposure
Economic risk is difficult to quantify but a favored strategy to manage it is to
diversify internationally, in terms of sales, location of production facilities, raw
materials and financing. Such diversification is likely to significantly reduce the
impact of economic exposure relative to a purely domestic company, and
provide much greater flexibility to react to real exchange rate changes.

Foreign Exchange Risk:

Nature of Foreign Exchange Risk:
Foreign Exchange dealing is a business that one gets involved in, primarily to
obtain protection against adverse rate movements on their core international
business. Foreign Exchange dealing is essentially a risk-reward business where
profit potential is substantial but it is extremely risky too.
Foreign exchange business has the certain peculiarities that make it a very risky
business. These would include:
• FOREX deals are across country borders and therefore, often foreign
currency prices are subject to controls and restrictions imposed by foreign
authorities. Needless to say, these controls and restrictions are invariably
dictated by their own domestic factors and economy.
• FOREX deals involve two currencies and therefore, rates are influenced
by domestic as well as international factors.
• The FOREX market is a 24-hour global market and overseas
developments can affect rates significantly.

20 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

• The FOREX market has great depth and numerous players shifting vast
sums of money. FOREX rates therefore, can move considerably, especially
when speculation against a currency rises.
• FOREX markets are characterized by advanced technology,
communications and speed. Decision-making has to be instantaneous.
Description of Foreign Exchange Risk
In simple word FOREX risk is the variability in the profit due to change in
foreign exchange rate. Suppose the company is exporting goods to foreign
company then it gets the payment after month or so then change in exchange
rate may effect in the inflows of the fund. If rupee value depreciated he may
lose some money. Similarly if rupees value appreciated against foreign currency
then it may gain more rupees. Hence there is risk involved in it.
Classification of Foreign Exchange Risk
• Position Risk
• Gap or Maturity or Mismatch Risk
• Translation Risk
• Operational Risk
• Credit Risk
1. Position Risk
The exchange risk on the net open FOR Exposition is called the position risk.
The position can be a long/overbought position or it could be a short/oversold
position. The excess of foreign currency assets over liabilities is called a net
long position whereas the excess of foreign currency liabilities over assets is
called a net short position. Since all purchases and sales are at a rate, the net
position too is at a net/average rate. Any adverse movement in market rates
would result in a loss on the net currency position.
For example, where a net long position is in a currency whose value is
depreciating, the conversion of the currency will result in a lower amount of the
corresponding currency resulting in a loss, whereas a net long position in an

21 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

appreciating currency would result in a profit. Given the volatility in FOREX

markets and external factors that affect FX rates, it is prudent to have controls
and limits that can minimize losses and ensure a reasonable profit.
The most popular controls/limits on open position risks are:
• Daylight Limit: Refers to the maximum net open position that can be
built up a trader during the course of the working day. This limit is set currency-
wise and the overall position of all currencies as well.
• Overnight Limit: Refers to the net open position that a trader can leave
overnight – to be carried forward for the next working day. This limit too is set
currency-wise and the overall overnight limit for all currencies. Generally,
overnight limits are about 15% of the daylight limits.
2. Mismatch Risk/Gap Risk
Where a foreign currency is bought and sold for different value dates, it creates
no net position i.e. there is no FX risk. But due to the different value dates
involved there is a “mismatch” i.e. the purchase/sale dates do not match. These
mismatches, or gaps as they are often called, result in an uneven cash flow. If
the forward rates move adversely, such mismatches would result in losses.
Mismatches expose one to risks of exchange losses that arise out of adverse
movement in the forward points and therefore, controls need to be initiated.
The limits on Gap risks are:
• Individual Gap Limit: This determines the maximum mismatch for any
calendar month; currency-wise.
• Aggregate Gap Limit: Is the limit fixed for all gaps, for a currency,
irrespective of their being long or short. This is worked out by adding the
absolute values of all overbought and all oversold positions for the various
months, i.e. the total of the individual gaps, ignoring the signs. This limit, too, is
fixed currency-wise.
• Total Aggregate Gap Limit: Is the limit fixed for all aggregate gap limits
in all currencies.

22 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

3. Translation Risk
Translation risk refers to the risk of adverse rate movement on foreign currency
assets and liabilities funded out of domestic currency.
There cannot be a limit on translation risk but it can be managed by:
1. Funding of Foreign Currency Assets/Liabilities through money markets
i.e. borrowing or lending of foreign currencies
2. Funding through FX swaps
3. Hedging the risk by means of Currency Options
4. Funding through Multi Currency Interest Rate Swaps
4. Operational Risk
The operational risks refer to risks associated with systems, procedures, frauds
and human errors. It is necessary to recognize these risks and put adequate
controls in place, in advance. It is important to remember that in most of these
cases corrective action needs to be taken post-event too. The following areas
need to be addressed and controls need to be initiated.
• Segregation of trading and accounting functions: The execution of deals
is a function quite distinct from the dealing function. The two have to be kept
separate to ensure a proper check on trading activities, to ensure all deals are
accounted for, that no positions are hidden and no delay occurs.
• Follow-up and Confirmation: Quite often deals are transacted over the
phone directly or through brokers. Every oral deal has to be followed up
immediately by written confirmations; both by the dealing departments and by
back-office or support staff. This would ensure that errors are detected and
rectified immediately.
• Settlement of funds: Timely settlement of funds is necessary not only to
avoid delayed payment interest penalty but also to avoid embarrassment and
loss of credibility.

23 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

• Overdue contracts: Care should be taken to monitor outstanding contracts

and to ensure proper settlements. This will avoid unnecessary swap costs,
excessive credit balances and overdrawn Nostrum accounts.
• Float transactions: Often retail departments and other areas are authorized
to create exposures. Proper measures should be taken to make sure that such
departments and areas inform the authorized persons/departments of these
exposures, in time. A proper system of maximum amount trading authorities
should be installed. Any amount in excess of such maximum should be
transacted only after proper approvals and rate.
5. Credit Risk
Credit risk refers to risks dealing with counter parties. The credit is contingent
upon the performance of its part of the contract by the counter party. The risk is
not only due to non-performance but also at times, the inability to perform by
the counter party.
The credit risk can be:
• Contract risk: Where the counter party fails prior to the value date. In
such a case, the FOREX deal would have to be replaced in the market, to
liquidate the FOREX exposure. If there has been an adverse rate movement, this
would result in an exchange loss. A contract limit is set counter party-wise to
manage this risk.
• Clean risk: Where the counter party fails on the value date i.e. it fails to
deliver the currency, while you have already paid up. Here the risk is of the
capital amount and the loss can be substantial. Fixing a daily settlement limit as
well as a total outstanding limit, counter party-wise can control such a risk.
• Sovereign Risk: refers to risks associated with dealing into another
country. These risks would be an account of exchange control regulations,
political instability etc. Country limits are set to counter this risk.

24 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

Differentiation of Exposure with Risk

Even though foreign exchange risk and exposure have been the central issues of
International Financial Management for many years, a considerable degree of
confusion remains about their nature and measurement.
For instance, it is not uncommon to hear the term “Foreign Exchange Exposure”
used interchangeably with the term ‘Foreign Exchange Risk” when in fact they
conceptually completely different. Foreign Exchange Risk is related to the
variability of domestic currency of assets, liabilities or operating incomes due to
unanticipated changes in exchange rates whereas Foreign Exchange Exposure is
what is at risk.

25 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

CHAPTER 6
TOOLS OF RISK MANAGEMENT

 TWO WAYS TO TRADE

There are two basic approaches to analyzing currency markets, fundamental
analysis and technical analysis. The fundamental analyst concentrates on the
underlying causes of price movements, while the technical analyst studies the
price movements themselves

TECHNICAL ANALYSIS
Technical analysis focuses on the study of price movements. Historical currency
data issued to forecast the direction of future prices. The premise of technical
analysis is that all current market information is already reflected in the price of
that currency; therefore, studying price action is all that is required to make
informed trading decisions. The primary tools of the technical analyst are
charts. Charts are used to identify trends and patterns in order to find profit
opportunities. The most basic concept of technical analysis is that markets have
a tendency to trend. Being able to identify trends in their earliest stage of
development is the key to technical analysis.

Technical analysts track historical prices and traded volumes in an attempt to

identify trends. They use graphs and charts to plot this information, and for this
reason are sometimes referred to as chartists. By attempting to quantify
historical performance, technical analysts seek to identify repeating patterns as a
means to signal future buy and sell opportunities.

26 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

The field of technical analysis is based on three important assumptions:

The price of a security automatically factors in economic conditions.

Technical analysts believe that the impact of events such as interest rate changes
or the latest inflation reports are automatically factored into the currency price
through the natural actions of buyers and sellers within the market.

When it comes to pricing, history tends to repeat itself.

Technical analysts believe that prices move in trends and price movements
generally follow established patterns that can be partly attributed to market
psychology (or, more euphemistically, "herd mentality"). Market psychology is
based on the widely-held belief that participants in markets, who for the most
part have the same goals and objectives, react in a similar fashion when faced
with similar situations.

Once established, trends tend to continue.

Technical analysts look for trends as a way to predict future prices. There are
three self-explanatory trends:

Up-trend
Down-trend
Sideways / horizontal trend

27 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

FUNDAMENTAL ANALYSIS
Fundamental analysis focuses on the economic, social and political forces that
drive supply and demand. Fundamental analysts look at various macroeconomic
indicators such as economic growth rates, interest rates, inflation, and
unemployment. However, there is no single set of beliefs that guide
fundamental analysis. There are several theories as to how currencies should be
valued.
Fundamental analysis is the interpretation of statistical reports and economic
indicators. Things like changes in interest rates, employment reports, and the
latest inflation indicators all fall into the realm of fundamental analysis.

Forex traders must pay close attention to economic indicators which can have a
direct – and to some degree, predictable – effect on the value of a nation's
currency in the forex market.

Given the impact these indicators can have on exchange rates, it is important to
know beforehand when they are due for release. It is also likely that exchange
rate spreads will widen during the time leading up to the release of an important
indicator and this could add considerably to the cost of your trade.

Therefore, you should regularly consult an economic calendar which lists the
release date and time for each indicator. You can find economic calendars on
Central Bank websites and also through most brokers.

Those trading in the foreign-exchange market (forex) rely on the same two basic
forms of analysis that are used in the stock market: fundamental analysis and
technical analysis. The uses of technical analysis in forex are much the same:

28 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

price is assumed to reflect all news, and the charts are the objects of analysis.
But unlike companies, countries have no balance sheets, so how can
fundamental analysis are conducted on a currency?

Since fundamental analysis is about looking at the intrinsic value of an

investment, its application in forex entails looking at the economic conditions
that affect the valuation of a nation's currency. Here we look at some of the
major fundamental factors that play a role in a currency's movement.
Fundamental indicator
Economic Indicators
Economic indicators are reports released by the government or a private
organization that detail a country's economic performance. Economic reports
are the means by which a country's economic health is directly measured, but
remember that a great deal of factors and policies will affect a nation's
economic performance.

These reports are released at scheduled times, providing the market with an
indication of whether a nation's economy has improved or declined. These
reports' effects are comparable to how earnings reports, SEC filings and other
releases may affect securities. In forex, as in the stock market, any deviation
from the norm can cause large price and volume movements.

You may recognize some of these economic reports, such as the unemployment
numbers, which are well publicized. Others, like housing stats, receive less
coverage. However, each indicator serves a particular purpose and can be
useful. Here we outline four major reports, some of which are comparable to
particular fundamental indicators used by equity investors:

29 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

Gross Domestic Product (GDP)

GDP is considered the broadest measure of a country's economy, and it
represents the total market value of all goods and services produced in a country
during a given year. Since the GDP figure itself is often considered a lagging
indicator, most traders focus on the two reports that are issued in the months
before the final GDP figures: the advance report and the preliminary report.
Significant revisions between these reports can cause considerable volatility.
The GDP is somewhat analogous to the gross profit margin of a publicly traded
company in that they are both measures of internal growth.

Retail Sales
The retail-sales report measures the total receipts of all retail stores in a given
country. This measurement is derived from a diverse sample of retail stores
throughout a nation. The report is particularly useful as a timely indicator of
broad consumer spending patterns that is adjusted for seasonal variables. It can
be used to predict the performance of more important lagging indicators, and to
assess the immediate direction of an economy. Revisions to advanced reports of
retail sales can cause significant volatility. The retail sales report can be
compared to the sales activity of a publicly traded company.

Industrial Production
This report shows change in the production of factories, mines and utilities
within a nation. It also reports their "capacity utilizations," the degree to which
each factory's capacity is being used. It is ideal for a nation to see a production
increase while being at its maximum or near maximum capacity utilization.

30 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

Traders using this indicator are usually concerned with utility production, which
can be extremely volatile since the utilities industry, and in turn the trading of
and demand for energy, is heavily affected by changes in weather. Significant
revisions between reports can be caused by weather changes, which in turn can
cause volatility in the nation's currency.

Consumer Price Index (CPI)

The CPI measures change in the prices of consumer goods across over 200
different categories. This report, when compared to a nation's exports, can be
used to see if a country is making or losing money on its products and services.
Be careful, however, to monitor the exports - it is a popular focus with many
traders, because the prices of exports often change relative to a currency's
strength or weakness

 STOPLOSS
Exposure Management should not be undertaken without having a Stop-Loss
policy in place. A Stop-Loss policy is based on the following two fundamental
principles: 1. to err is human2. A stitch in time saves nine it is appropriate to
recount here some words from a speech Dry Alan Greenspan, Chairman of the
US Federal Reserve, delivered in December 1997, on the Asian financial crisis.
He says,

“There is a significant bias in political systems of all varieties to substitute hope

(read, wishful thinking) for possibly difficult pre-emptive policy moves. There
is often denial and delay in instituting proper adjustments Reality eventually
replaces hope and the cost of the delay is a more abrupt and disruptive
adjustment than would have been required if action had been more preemptive.
Whether an Exposure is hedged or not, it is assumed that the decision to hedge/
not to hedge is backed by a View or Forecast, whether implicit or explicit. As
31 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

such, Stop Loss is nothing but a commitment to reverse a decision when the
view is proven to be wrong.

 HEDGING
This is the most visible and glamorized part of the Exposure Management
function. However, the Trader is like the Driver in a car rally, who needs to
follow the general directions of the Navigator.1. Hedging strategies will be
designed to meet the Exposure Management objectives, as represented by the
Benchmarks. The Exposure Management Cell will be accorded full operational
freedom to carry out the hedging function on a day to day basis. Hedges will be
undertaken only after appropriate Stop-Loss and Take-Profit levels have been
predetermined The Company will use all hedging techniques available to it, as
per need and requirement. In this regard, it will pass a Board Resolution
authorizing the use of the following:

Rupee-Foreign Currency Forward Contracts

Cross Currency Forward Contracts

Forward-to-Forward Contracts

FRAs

Currency Swaps

Interest Rate Swaps

Currency Options

Interest Rate Options

Others, as may be required.

32 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

CHAPTER 7
HOW RISK MANAGEMENT HELP TO IMPOTER
AND EXPOTER
Lies in understanding the export – import payment process. When a company
imports any good/service it makes payment in internationally acceptable
currencies, like USD. On the other hand, when a company exports any
good/service, it accepts USD from the buyer. However in both the cases, the
company has to do the rest of the business in domestic currency (INR – Indian
Rupees, as per our example) since, only domestic currency is considered as a
legal tender within a country. Hence, an importer has to first buy USD from a
bank by exchanging equivalent domestic currency, for making payments to the
international supplier and an exporter has to sell USD to a bank, received from
international buyer, and get equivalent domestic currency in return from the
bank. Let us take an example to understand this,

CASE 1: $1 is equal to 60 INR as on 21st Aug 2015

CASE 2: $1 is equal to 63 INR as on 21st Sep 2015

CASE 3: $1 is equal to 57 INR as on 21st Oct 2015

Now, for an importer, every product that he buys, he has to first buy USD from
a bank. If he buys a good which costs $100 in the international market, then, as
on 21st Aug 2015, the importer will have to buy $100 by giving 6,000 INR (60
X 100) to a bank. However, as on 21st Sep 2015 the INR has depreciated
against dollar (lost its value against dollar). Hence, if the importer now wants to
buy $100 from the bank, he will have to pay 6,300 (63 X 100) to the bank.
Thus, depreciation of domestic currency results in the increased cost for an
importer. Consider the last scenario, $1 = 57 INR, so when the importer wants

33 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

to buy $100 from a bank, he will now have to pay 5,700 (57 X 100). Thus,
appreciation of domestic currency reduces importers’ cost.

The exact reverse impact happens on an exporter. Consider an exporter, selling

a good worth $100 in the international market. Under first scenario, the exporter
will get $100 for selling a good and will exchange it for INR with a bank and
will get 6,000 INR (100 X 60). However, in the second case, the exporter will
end up getting 6,300 INR (100 X 63) for the same good sold. Hence,
depreciation of domestic currency increases exporter’s profit margins. But, in
case of last scenario, the export ends up getting only 5,700 INR (100 X 57) for
the same good. Hence, exporter loses on profit margins whenever domestic
currency appreciates.

The above example can be shown in a table as –

Case Situation INR position Cost of Good

1 $1 = 60 INR Stable $100 – –

2 $1 = 63 INR Depreciation $100 Loss Profit

3 $1 = 57 INR Appreciation $100 Profit Loss

The cost and quality of good remains the same, but the fluctuations in the
currency rates determine the profit and loss extent for the exporter and the
importer. Looking at the table one can infer that depreciation in the currency
always profits an exporter.

Any country would like to increase its exports so that the balance of trade
(Exports – Imports) stays positive and the exports also provide a country with
foreign exchange. This in turn strengthens the country’s economy. A country
can purposely depreciate its currency by increasing the supply of its domestic
currency in the market. Whenever a country does this, we term it as devaluation.

34 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

But if all countries follow this approach, then the exports will become more
competitive and the imports will keep reducing. However, for one country to
have good export sector, there must be importers in other countries who are
willing to buy their goods. If imports keep getting costlier, the importer would
just stop buying from the exporter, thereby adversely impacting exports of other
countries. The exporters will be left with no buyers for their products. Hence,
there is a mutual understanding within the countries to avoid such intentional
devaluation and allow the simply market forces determine the exchange rates. A
company that an import raw materials, exports finished goods, or has overseas
assets or subsidiaries is exposed to fluctuations in exchange rates. Adverse
movements can wipe out export profits, while positive changes can increase the
price of its products in the foreign market. Equally, the company could benefit
from windfall profits as a result of exchange rate fluctuations.

A company trading across national borders therefore has a number of choices. It

can take a chance with spot rates, buying currency when required. This leaves it
totally at the mercy of exchange rates. The risk can be removed if it books a
forward exchange contract that fixes the rate for the date on which it will be
needed for a transaction. If the rate improves, however, the company will not be
able to take advantage of the improvement.

Using a combination of flexible products allows the company to protect itself

against adverse movements while still giving it the ability to profit from
improvements. A wide variety of instruments are available that allow
companies to pursue this strategy. Which is chosen depends partly on the level
of risk and also on the ease of converting the currencies.

Case Studies

The Participating Forward

35 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

This product is similar to a forward exchange contract in that it limits risk by

offering a worst-case exchange rate for a transaction. If, however, there are a
favourable move in exchange rates, the company can take advantage—generally
with half its currency. There is usually no premium payable for this product.

Example

A company imports Cava wine from Spain to the United Kingdom. It is April,
and a supplier has to be paid €4 million in October in time to catch the
Christmas market.

The forward rate is 1.2100, and the company wants the certainty of a worst-case
rate but doesn’t want to lose out if the rate goes up. The foreign exchange
broker offers a rate of 1.1800, with the option to buy half the currency on the
spot market two days before completion of the transaction.

Possible Outcomes

Sterling strengthens against the euro and the rate rises to 1.2500. The customer
pays £1,694,915 for the first €2,000,000 at the low rate agreed in advance and
£1,600,000 for the second €2,000,000 at the spot rate. The average rate is
therefore 1.2150, slightly better than the forward rate, but not as good as the
spot rate.

Alternatively, the euro strengthens against sterling and the spot rate is 1.1600.
The company then pays the rate of 1.1800 for the whole transaction.

The advantages of a participating forward are: a guaranteed worst-case rate;

total protection against currency falls; a partial benefit from currency gains; and
no premium. The disadvantages are: if the currency weakens the rate will not be
as good as a forward exchange contract; and the spot rate will be better if there
is a positive move in currency.

36 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

The Protection Option

With this service a company pays a premium for an option to exchange

currency on a fixed forward date at a predetermined rate. If the spot rate on that
date is better than the predetermined rate, the company can decide not to
exercise its option to sell at the predetermined rate.

Example

A UK company is selling dresses to a customer in the United States. In six

months it will receive US$4,000,000. The current forward rate for this date is
2.0000. Fearing that sterling is going to strengthen against the dollar, the
company opts to buy a protection option at the forward rate.

Possible Outcomes

Sterling does strengthen against the dollar, taking the rate to 2.1500. The
company then exercises its right to sell dollars at 2.0000.

The dollar strengthens against sterling. The rate is now 1.8500. The company
takes the better rate on the spot market.

The advantages of the protection option are: a guaranteed worst-case rate; total
protection against negative currency fluctuations; and the ability to take full
advantage of positive currency movements. The disadvantage is that a premium
is payable to the

37 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

CHAPTER 8
CONCLUSION

The purpose of foreign exchange market is to permit transfers of purchasing

power denominated in one currency to another i.e. to trade one currency for
another. It helps in understanding various trend patterns and trend lines. What
considerations are kept in mind while trading n forex market and why one
should enter such market is studied under this project? Another part of this
project covers Risk Management in general as well as in forex market. Risk
Management is the process of measuring, or assessing risk and then developing
strategies to manage the risk. In general, the strategies employed include
transferring the risk to another party, avoiding the risk, reducing the negative
effect of the risk, and accepting some or all of the consequences of a particular
risk .A person has to face risk whether he’s in business or is entering the forex
market .So, he uses various strategies and methods to overcome that risk.

38 | P a g e
RISK MANAGEMENT IN FOREIGN EXCHANGE

CHAPTER 9
REFERENCE

 www.wikipidia.com
 www.investopedia.com
 www.infomedia.com
 ARTHAASHATRA.WORDPRESS.COM

39 | P a g e