INSTITUT UNIVERSITAIRE ET

STRATEGIQUE DE L’ESTUAIRE

ESTUARY ACADEMIC AND

STRATEGIC INSTITUTE
(IUEs / INSAM)

DEPARTMENT: INTERNATIONAL TRADE

LEVEL: II

COURSE:: FOREIGN EXCHANGE RISK MANAGEMENT

COURSE FACILITATOR: MR.TAMEUKONG ROMARIO

 COURSE GENERAL OBEJECTIVES
Students have to understand how to:

 Be Correcting Balance of Payments: ADVERTISEMENTS: ...

 To Protect Domestic Industries: ...
 To Maintain an Overvalued Rate of Exchange: ...
 To Prevent Flight of Capital: ...
 Policy of Differentiation: ...
 Other Objectives:
 CHAPTER 1: SCOPE OF FOREIGN EXCHANGE RISK
Chapter objectives
This chapter provides an overview of the issues associated with understanding and
managing foreign exchange risk

I.1 History

Many businesses were unconcerned with, and did not manage, foreign exchange
risk under the international Bretton Woods system. It wasn't until the switch to floating
exchange rates, following the collapse of the Bretton Woods system, that firms became
exposed to an increased risk from exchange rate fluctuations and began trading an
increasing volume of financial derivatives in an effort to hedge their exposure. [5]
[6]
 The currency crises of the 1990s and early 2000s, such as the Mexican peso
crisis, Asian currency crisis, 1998 Russian financial crisis, and the Argentine peso crisis,
led to substantial losses from foreign exchange and led firms to pay closer attention to
their foreign exchange risk.[

1.2 What is foreign exchange risk?

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk)

is a financial risk that exists when a financial transaction is denominated in
a currency other than the domestic currency of the company. The exchange risk arises
when there is a risk of an unfavorable change in exchange rate between the domestic
currency and the denominated currency before the date when the transaction is
completed.
Foreign exchange risk also exists when the foreign subsidiary of a firm maintains
financial statements in a currency other than the domestic currency of the consolidated
entity.
Investors and businesses exporting or importing goods and services, or making
foreign investments, have an exchange-rate risk but can take steps to manage (i.e. reduce)
the risk.
Foreign exchange risk is the risk that a business’s financial performance or
position will be affected by fluctuations in the exchange rates between currencies. The
risk is most acute for businesses that deal in more than one currency (for example, they
export to another country and the customer pays in its own currency). However, other
businesses are indirectly exposed to foreign exchange risk if, for example, their business
relies on imported products and services. Foreign exchange risk should be managed
where fluctuations in exchange rates impact on the business’s profitability. In a business
where the core operations are other than financial services, the risk should be managed in
 such a way that the focus of the business is on providing the core goods or services
without exposing the business to financial risks.
It can also refers to the losses that an international financial transaction may incur
due to currency fluctuations. Also known as currency risk, FX risk and exchange-rate
risk, it describes the possibility that an investment’s value may decrease due to changes
in the relative value of the involved currencies. Investors may experience jurisdiction
risk in the form of foreign exchange risk.

1.3 Understanding Foreign Exchange Risk

Foreign exchange risk arises when a company engages in financial transactions

denominated in a currency other than the currency where that company is based. Any
appreciation/depreciation of the base currency or the depreciation/appreciation of the
denominated currency will affect the cash flows emanating from that transaction. Foreign
exchange risk can also affect investors, who trade in international markets, and
businesses engaged in the import/export of products or services to multiple countries.

The proceeds of a closed trade, whether its a profit or loss, will be denominated in
the foreign currency and will need to be converted back to the investor's base currency.
Fluctuations in the exchange rate could adversely affect this conversion resulting in a
lower than expected amount.

An import/export business exposes itself to foreign exchange risk by

having account payables and receivables affected by currency exchange rates. This risk
originates when a contract between two parties specifies exact prices for goods or
services, as well as delivery dates. If a currency’s value fluctuates between when the
contract is signed and the delivery date, it could cause a loss for one of the parties.

I.4 Types of foreign exchange risk

Economic risk
A firm has economic risk (also known as forecast risk) to the degree that its market
value is influenced by unexpected exchange-rate fluctuations, which can severely affect
the firm's market share with regard to its competitors, the firm's future cash flows, and
ultimately the firm's value. Economic risk can affect the present value of future cash
flows. An example of an economic risk would be a shift in exchange rates that influences
the demand for a good sold in a foreign country.
Another example of an economic risk is the possibility that macroeconomic
conditions will influence an investment in a foreign country. [8] Macroeconomic
conditions include exchange rates, government regulations, and political stability. When
financing an investment or a project, a company's operating costs, debt obligations, and
the ability to predict economically unsustainable circumstances should be thoroughly
calculated in order to produce adequate revenues in covering those economic risks. [9] For
instance, when an American company invests money in a manufacturing plant in Spain,
the Spanish government might institute changes that negatively impact the American
company's ability to operate the plant, such as changing laws or even seizing the plant, or
to otherwise make it difficult for the American company to move its profits out of Spain.
As a result, all possible risks that outweigh an investment's profits and outcomes need to
be closely scrutinized and strategically planned before initiating the investment. Other
examples of potential economic risk are steep market downturns, unexpected cost
overruns, and low demand for goods.
International investments are associated with significantly higher economic risk
levels as compared to domestic investments. In international firms, economic risk heavily
affects not only investors but also bondholders and shareholders, especially when dealing
with the sale and purchase of foreign government bonds. However, economic risk can
also create opportunities and profits for investors globally. When investing in foreign
bonds, investors can profit from the fluctuation of the foreign-exchange markets and
interest rates in different countries.[9] Investors should always be aware of possible
changes by the foreign regulatory authorities. Changing laws and regulations regarding
sizes, types, timing, credit quality, and disclosures of bonds will immediately and directly
affect investments in foreign countries. For example, if a central bank in a foreign
country raises interest rates or the legislature increases taxes, the return on investment
will be significantly impacted. As a result, economic risk can be reduced by utilizing
various analytical and predictive tools that consider the diversification of time, exchange
rates, and economic development in multiple countries, which offer different currencies,
instruments, and industries.
When making a comprehensive economic forecast, several risk factors should be
noted. One of the most effective strategies is to develop a set of positive and negative
risks that associate with the standard economic metrics of an investment.[10] In a
macroeconomic model, major risks include changes in GDP, exchange-rate fluctuations,
and commodity-price and stock-market fluctuations. It is equally critical to identify the
stability of the economic system. Before initiating an investment, a firm should consider
the stability of the investing sector that influences the exchange-rate changes. For
instance, a service sector is less likely to have inventory swings and exchange-rate
changes as compared to a large consumer sector.
Contingent risk
A firm has contingent risk when bidding for foreign projects, negotiating other
contracts, or handling direct foreign investments. Such a risk arises from the potential of
a firm to suddenly face a transnational or economic foreign-exchange risk contingent on
the outcome of some contract or negotiation. For example, a firm could be waiting for a
project bid to be accepted by a foreign business or government that, if accepted, would
result in an immediate receivable. While waiting, the firm faces a contingent risk from
the uncertainty as to whether or not that receivable will accrue.
Transaction risk
Companies will often participate in a transaction involving more than one
currency. In order to meet the legal and accounting standards of processing these
transactions, companies have to translate foreign currencies involved into their domestic
currency. A firm has transaction risk whenever it has contractual cash flows (receivables
and payables) whose values are subject to unanticipated changes in exchange rates due to
a contract being denominated in a foreign currency. To realize the domestic value of its
foreign-denominated cash flows, the firm must exchange, or translate, the foreign
currency for domestic.
When firms negotiate contracts with set prices and delivery dates in the face of a
volatile foreign exchange market, with rates constantly fluctuating between initiating a
transaction and its settlement, or payment, those firms face the risk of significant loss.
[11]
 Businesses have the goal of making all monetary transactions profitable ones, and the
currency markets must thus be carefully observed.
Applying public accounting rules causes firms with transnational risks to be
impacted by a process known as "re-measurement". The current value of contractual cash
flows are remeasured on each balance sheet.
Translation risk
A firm's translation risk is the extent to which its financial reporting is affected by
exchange-rate movements. As all firms generally must prepare consolidated financial
statements for reporting purposes, the consolidation process for multinationals entails
translating foreign assets and liabilities, or the financial statements of foreign
subsidiaries, from foreign to domestic currency. While translation risk may not affect a
firm's cash flows, it could have a significant impact on a firm's reported earnings and
therefore its stock price.
Translation risk deals with the risk to a company's equities, assets, liabilities, or
income, any of which can change in value due to fluctuating foreign exchange rates when
a portion is denominated in a foreign currency. A company doing business in a foreign
country will eventually have to exchange its host country's currency back into their
domestic currency. When exchange rates appreciate or depreciate, significant, difficult-
to-predict changes in the value of the foreign currency can occur. For example, U.S.
companies must translate Euro, Pound, Yen, etc., statements into U.S. dollars. A foreign
subsidiary's income statement and balance sheet are the two financial statements that
 must be translated. A subsidiary doing business in the host country usually follows that
country's prescribed translation method, which may vary, depending on the subsidiary's
business operations.
Subsidiaries can be characterized as either an integrated or a self-sustaining foreign
entity. An integrated foreign entity operates as an extension of the parent company, with
cash flows and business operations that are highly interrelated with those of the parent. A
self-sustaining foreign entity operates in its local economic environment, independent of
the parent company. Both integrated and self-sustaining foreign entities operate
use functional currency, which is the currency of the primary economic environment in
which the subsidiary operates and in which day-to-day operations are transacted.
Management must evaluate the nature of its foreign subsidiaries to determine the
appropriate functional currency for each.
There are three translation methods: current-rate method, temporal method, and
U.S. translation procedures. Under the current-rate method, all financial statement line
items are translated at the "current" exchange rate. Under the temporal method, specific
assets and liabilities are translated at exchange rates consistent with the timing of the
item's creation.[13] The U.S. translation procedures differentiate foreign subsidiaries
by functional currency, not subsidiary characterization. If a firm translates by the
temporal method, a zero net exposed position is called fiscal balance. [14] The temporal
method cannot be achieved by the current-rate method because total assets will have to be
matched by an equal amount of debt, but the equity section of the balance sheet must be
translated at historical exchange rates.[15]

I.5 Measuring risk

If foreign-exchange markets are efficient—such that purchasing power
parity, interest rate parity, and the international Fisher effect hold true—a firm or investor
needn't concern itself with foreign exchange risk. A deviation from one or more of the
three international parity conditions generally needs to occur for there to be a significant
exposure to foreign-exchange risk.
Financial risk is most commonly measured in terms of the variance or standard
deviation of a quantity such as percentage returns or rates of change. In foreign exchange,
a relevant factor would be the rate of change of the foreign currency spot exchange rate.
A variance, or spread, in exchange rates indicates enhanced risk, whereas standard
deviation represents exchange-rate risk by the amount exchange rates deviate, on
average, from the mean exchange rate in a probabilistic distribution. A higher standard
deviation would signal a greater currency risk. Because of its uniform treatment of
deviations and for the automatically squaring of deviation values, economists have
criticized the accuracy of standard deviation as a risk indicator. Alternatives such
 as average absolute deviation and semi variance have been advanced for measuring
financial risk.[4]
Value at risk
Practitioners have advanced, and regulators have accepted, a financial risk
management technique called value at risk (VaR), which examines the tail end of a
distribution of returns for changes in exchange rates, to highlight the outcomes with the
worst returns. Banks in Europe have been authorized by the Bank for International
Settlements to employ VaR models of their own design in establishing capital
requirements for given levels of market risk. Using the VaR model helps risk managers
determine the amount that could be lost on an investment portfolio over a certain period
of time with a given probability of changes in exchange rates.

I.6 Sources of foreign exchange risk

Foreign exchange risk for a business can arise from a number of sources, including:

- Where the business imports or exports

- where other costs, such as capital expenditure, are denominated in foreign currency
- where revenue from exports is received in foreign currency
- where other income, such as royalties, interest, dividends etc, is received in foreign
currency
- where the business’s loans are denominated (and therefore payable) in foreign currency
- where the business has offshore assets such as operations or subsidiaries that are valued
in a foreign currency, or foreign currency deposits

Companies that are subject to FX risk can implement hedging strategies to mitigate that
risk. This usually involves forward contracts, options, and other exotic financial products and, if
done properly, can protect the company from unwanted foreign exchange moves.

Foreign Exchange Risk Example

An American liquor company signs a contract to buy 100 cases of wine from a
French retailer for €50 per case, or €5,000 total, with payment due at the time of delivery.
The American company agrees to this contract at a time when the Euro and the US Dollar
are of equal value, so €1 = $1. Thus, the American company expects that when they
accept delivery of the wine, they will be obligated to pay the agreed upon amount of
€5,000, which at the time of the sale was $5,000.

However, it will take a few months for delivery of the wine. In the meantime, due to unforeseen
circumstances, the value of the US Dollar depreciates versus the Euro to where at the time of
delivery €1 = $1.10. The contracted price is still €5,000 but now the US Dollar amount is
$5,500, which is the amount that the American liquor company will have to pay.

I.7 Methods of measuring foreign exchange risk

There are many ways to measure foreign exchange risk, ranging from simple to quite
complex. Sophisticated measures such as ‘value at risk’ may be mathematically complex and
require significant computing power. This guide provides some examples of the simpler
measures which can be applied and understood by most businesses.
Register of foreign currency exposures
A very simple method is to maintain a register of exposures and their associated foreign
exchange hedges. Basically the details of each hedge are recorded against its relevant exposure.
This type of approach may also assist with compliance with accounting standards (for hedging),
such as AASB 139: Financial Instruments: Recognition and Measurement.
Table of projected foreign currency cash flows
Where the business both pays and receives foreign currency, it will be necessary to
measure the net surplus or deficit for each currency. This can be done by projecting foreign
currency cash flows. This not only indicates whether the business has a surplus or is short of a
particular currency, but also the timing of currency flows
Sensitivity analysis
A further extension of the previous measure is to undertake sensitivity analysis to
measure the potential impact on the business of an adverse movement in exchange rates. This
may be done by choosing arbitrary movements in exchange rates or by basing exchange rate
movements on past history. For example, the business may wish to know how much it will gain
or lose for a given change in exchange rates. Where commodities are involved, businesses
sometimes develop a matrix showing the combined result of currency and commodity price
movements.
Value at risk
Some businesses, particularly financial institutions, use a probability approach when
undertaking sensitivity analysis. This is known as ‘value at risk’. While it is useful to know the
potential impact of a given change in exchange rates (say a USD one cent movement) the
question will arise: how often does this happen? Accordingly, we can do a sensitivity analysis
using past price history and apply it to the current position. Then, given the business’s current
position, and based on exchange rates observed over the last two years, it can be 99 per cent
confident that it will not lose more than a certain amount, given a certain movement in
exchange rates. In effect, the business has used actual rate history to model the potential impact
of exchange rate movements on its foreign currency exposures
 Question for revision
1. What do you understand by Foreign exchange?
2. Can you differentiate between Transaction Risk and Translation Risk
3. List the various sources of foreign exchange risk
4. How can you measure foreign exchange risks

Answers to questions for revision

1. Foreign exchange risk also exists when the foreign subsidiary of a firm maintains
financial statements in a currency other than the domestic currency of the consolidated
entity.
2. A firm has transaction risk whenever it has contractual cash flows (receivables and
payables) whose values are subject to unanticipated changes in exchange rates due to
a contract being denominated in a foreign currency. While Translation risk deals with
the risk to a company's equities, assets, liabilities, or income, any of which can change
in value due to fluctuating foreign exchange rates when a portion is denominated in a
foreign currency
3. The variouse sources of risks are :
- Where the business imports or exports
- where other costs, such as capital expenditure, are denominated in foreign currency
- where revenue from exports is received in foreign currency
- where other income, such as royalties, interest, dividends etc, is received in foreign
currency
- where the business’s loans are denominated (and therefore payable) in foreign currency
- where the business has offshore assets such as operations or subsidiaries that are valued
in a foreign currency, or foreign currency deposits
4. You can measure the foreign exchange risk as follows
- Register of foreign currency exposures
- Table of projected foreign currency cash flows
- Sensitivity analysis

CHAPTER 2: FOREIGN EXCHANGE RISK MANAGEMENT

Chapter objectives: the main objective of this chapter is to see how we can tackle and manage
the various risk involve in foreign trade

Managing risk
1. Transaction hedging
Firms with exposure to foreign-exchange risk may use a number of hedging
strategies to reduce that risk. Transaction exposure can be reduced either with the use
of money markets, foreign exchange derivatives—such as forward
contracts, options, futures contracts, and swaps—or with operational techniques such as
currency invoicing, leading and lagging of receipts and payments, and exposure netting.
[17]
 Each hedging strategy comes with its own benefits that may make it more suitable
than another, based on the nature of the business and risks it may encounter.
Forward and futures contracts serve similar purposes: they both allow transactions
that take place in the future—for a specified price at a specified rate—that offset
otherwise adverse exchange fluctuations. Forward contracts are more flexible, to an
extent, because they can be customized to specific transactions, whereas futures come in
standard amounts and are based on certain commodities or assets, such as other
currencies. Because futures are only available for certain currencies and time periods,
they cannot entirely mitigate risk, because there is always the chance that exchange rates
will move in your favor. However, the standardization of futures can be a part of what
makes them attractive to some: they are well-regulated and are traded only on exchanges.
[18]

Two popular and inexpensive methods companies can use to minimize potential
losses is hedging with options and forward contracts. If a company decides to purchase
an option, it is able to set a rate that is "at-worst" for the transaction. If the option expires
and it's out-of-the-money, the company is able to execute the transaction in the open
market at a favorable rate. If a company decides to take out a forward contract, it will set
a specific currency rate for a set date in the future.
Currency invoicing refers to the practice of invoicing transactions in the currency
that benefits the firm. It is important to note that this does not necessarily eliminate
foreign exchange risk, but rather moves its burden from one party to another. A firm can
invoice its imports from another country in its home currency, which would move the
risk to the exporter and away from itself. This technique may not be as simple as it
sounds; if the exporter's currency is more volatile than that of the importer, the firm
would want to avoid invoicing in that currency. If both the importer and exporter want to
avoid using their own currencies, it is also fairly common to conduct the exchange using
a third, more stable currency.
 If a firm looks to leading and lagging as a hedge, it must exercise extreme caution.
Leading and lagging refer to the movement of cash inflows or outflows either forward or
backward in time. For example, if a firm must pay a large sum in three months but is also
set to receive a similar amount from another order, it might move the date of receipt of
the sum to coincide with the payment. This delay would be termed lagging. If the receipt
date were moved sooner, this would be termed leading the payment.[22]
Another method to reduce exposure transaction risk is natural hedging (or netting
foreign-exchange exposures), which is an efficient form of hedging because it will reduce
the margin that is taken by banks when businesses exchange currencies; and it is a form
of hedging that is easy to understand. To enforce the netting, there will be a systematic-
approach requirement, as well as a real-time look at exposure and a platform for initiating
the process, which, along with the foreign cash flow uncertainty, can make the procedure
seem more difficult. Having a back-up plan, such as foreign-currency accounts, will be
helpful in this process. The companies that deal with inflows and outflows in the same
currency will experience efficiencies and a reduction in risk by calculating the net of the
inflows and outflows, and using foreign-currency account balances that will pay in part
for some or all of the exposure.[23]
2. Translation hedging
Translation exposure is largely dependent on the translation methods required by
accounting standards of the home country. For example, the United States Federal
Accounting Standards Board specifies when and where to use certain methods. Firms can
manage translation exposure by performing a balance sheet hedge, since translation exposure
arises from discrepancies between net assets and net liabilities solely from exchange rate
differences. Following this logic, a firm could acquire an appropriate amount of exposed
assets or liabilities to balance any outstanding discrepancy. Foreign exchange derivatives
may also be used to hedge against translation exposure
A common technique to hedge translation risk is called balance-sheet hedging, which
involves speculating on the forward market in hopes that a cash profit will be realized to
offset a non-cash loss from translation.[24] This requires an equal amount of exposed foreign
currency assets and liabilities on the firm's consolidated balance sheet. If this is achieved for
each foreign currency, the net translation exposure will be zero. A change in the exchange
rates will change the value of exposed liabilities to an equal degree but opposite to the
change in the value of exposed assets.
Companies can also attempt to hedge translation risk by purchasing currency swaps or
futures contracts. Companies can also request clients to pay in the company's domestic
currency, whereby the risk is transferred to the client.
3. Strategies other than financial hedging
Firms may adopt strategies other than financial hedging for managing their economic
or operating exposure, by carefully selecting production sites with a mind for lowering costs,
using a policy of flexible sourcing in its supply chain management, diversifying its export
market across a greater number of countries, or by implementing strong research and
development activities and differentiating its products in pursuit of less foreign-exchange
risk exposure.
By putting more effort into researching alternative methods for production and
development, it is possible that a firm may discover more ways to produce their outputs
locally rather than relying on export sources that would expose them to the foreign exchange
risk. By paying attention to currency fluctuations around the world, firms can
advantageously relocate their production to other countries. For this strategy to be effective,
the new site must have lower production costs. There are many factors a firm must consider
before relocating, such as a foreign nation's political and economic stability.

4. Statement of Objectives

To provide a standard of best practice to banks for the implementation of an effective

and sound Foreign Exchange Risk Management System.
Foreign exchange risk is the exposure of a company’s financial strength to the
potential impact of movements in foreign exchange rates. The risk is that adverse
fluctuations in exchange rates may result in a reduction in measures of financial strength.
It is acknowledged that specific foreign exchange risk practices may differ among
banks depending upon factors such as the institution’s size, and the nature and
complexity of its activities. However, a comprehensive foreign exchange risk programme
should deal with, at a minimum, good management information systems, contingency
planning and other managerial and analytical techniques.

5. General
a. Board of Directors and Senior Management Oversight
i. A Board of Directors should:
1. approve a policy on foreign exchange risk;
2. review, at least once a year, the policy, techniques, procedures, and
information systems referred to in that policy
 3. ensure adherence to the policy techniques, procedures and
informational systems referred to in that policy;
4. ensure that qualified and competent persons i.e. senior management,
are employed to manage and control the bank’s exposure to foreign
exchange; and
5. Direct senior management to submit a comprehensive written report
to the board of directors of the bank on the management of exposure
to foreign exchange risk at least once a year, and to submit such other
reports at such intervals as the board may require.
b. Strategy, Monitoring and Control
i. A bank should establish a written policy on foreign exchange risk that:
1. includes a statement of principles and objectives governing the extent
to which a bank is willing to assume foreign exchange risk;
2. establishes prudent limits on a bank’s exposure to foreign exchange
risk; and
3. Clearly defines the levels of personnel who have the authority to trade
in foreign exchange.
4. Clearly identifies the different currencies, which have been approved
for transaction within the company.
ii. A bank should also develop and implement techniques that accurately and
continually measure its exposure to foreign exchange risk and its foreign
exchange gains and losses.
This would include the development and implementation of procedures and information
systems that will ensure adherence to the aforementioned policy. The following sections
address topics relating to both Foreign Exchange and its relationship with Settlement Risk.

iii. Internal audit

 1. Banks should have in place adequate internal audit coverage of the
foreign exchange and the settlement process to ensure that operating
procedures are adequate to minimise risk. A bank’s board of directors
– either directly or through its audit committee - should ensure that the
scope and frequency of the foreign exchange internal audit
programme is appropriate to the risks involved.

2. The board of directors or its audit committee should ensure that audit
reports are distributed to appropriate levels of management for
information and so that timely corrective action can be taken.
Management should detail, in writing, the action taken. The board of
directors or its audit committee should regularly review this and
consider any outstanding issues. Where appropriate it should ensure
that a follow-up audit is undertaken.

3. When audit findings identify areas for improvement in the foreign

exchange or settlement area, other areas of the bank on which this
may have an impact should be notified. This could include credit risk
management, reconciliations/accounting, systems development, and
management information systems. In automated settlement
processing, the internal audit department should have some level of
specialisation in information technology auditing, especially if the
bank maintains its own computer facility.

6. Foreign Exchange Settlement Risk

When dealing with foreign exchange transactions the issue of settlement risk often
arises. Foreign Exchange Settlement risk is the risk of loss when a bank in a foreign
exchange transaction pays the currency it sold but does not receive the currency it
bought. Settlement risk exists for any traded product, but the size of the foreign
exchange market makes foreign exchange transactions the greatest source of settlement
risk for many market participants. In light of the aforementioned, a bank should have
systems that provide appropriate and realistic estimates of foreign exchange exposures
on a timely basis. These systems would include policies and procedures similar to
those mentioned in the previous section with emphasis on understanding settlement risk
and formulating a clear and firm plan on its management.

i. ordination necessary to achieve this. Management information systems

should also support the integration of the necessary information.

ii. Accordingly, senior management should ensure that they fully understand
the foreign exchange settlement risks incurred by the bank and should
clearly define lines of authority and responsibility for managing these risks.
Adequate training should be provided to all staff responsible for the various
aspects of foreign exchange settlement risk. Senior management and staff
should understand that counter-party default is not so rare as to obviate the
need for strong risk management. While defaults by major banks are
uncommon, the extremely large foreign exchange trading exposures,
including those that can last for several days, merit more prudent risk
management than is currently found in many banks.

b. Duration of foreign exchange settlement exposure

i. Foreign Exchange-related payments generally are made in two primary

steps: the sending of payment orders and the actual transmission of funds. It
is important to distinguish between these two steps: the first is
an instruction to make a payment, while the second involves an exchange of
credits and debits across correspondent accounts and the accounts of the central
bank of the currency involved. The first step is normally effected one or two days
before settlement date (although there are some variations according to currency
and institution) while the second stage takes place on the settlement date itself.

ii. A bank’s foreign exchange settlement exposure runs from the time that its
payment order for the currency sold can no longer be recalled or cancelled
with certainty – the unilateral payment cancellation deadline – and lasts until
the time that the currency purchased is received with finality. Note that this
is the duration of the exposure. It says nothing about the probability of
failure and thus the degree of risk faced by the bank during the period.
Depending on the information available to the bank about the
creditworthiness of the counter-party or the status of the funds it is due to
receive, its assessment of the probability of failure and thus the degree of
risk may change during the time the exposure is outstanding. This is, of
course, normal for any credit exposure.

iii. To measure and manage their foreign exchange exposures, banks need to be
certain of the unilateral cancellation deadline for each currency. It might be
expected that banks could cancel payment orders up until the moment before
the funds are finally paid to a counter-party. However, correspondent and
payment system practices, as well as operational and even legal
arrangements, typically result in payment orders becoming effectively
irrevocable significantly before the time of payment.

iv. A key factor in determining the unilateral cancellation deadline is the latest
time a correspondent can guarantee to satisfy a cancellation request. The
documentation covering a correspondent’s service agreement should identify
this cancellation cut-off time. This documentation is particularly important
because, in the event the bank wishes to cancel its payment instruction, the
bank and its correspondent are likely to rely upon the terms and conditions
stipulated in the agreement. However, in some cases banks may have no
written agreement at all with their correspondent or the agreement may not
 specify a guaranteed cut-off time. Where this is the case, banks should
negotiate with their correspondent; this may require a change in nature of the
relationship between the bank and its correspondent, recognising that the
two need to work together to manage risks effectively.

v. In assessing their unilateral payment cancellation deadlines, banks should be

able to demonstrate that they can in practice identify and hold particular
payments up to the cut-off times guaranteed by their correspondents, as
internal processes and other practical factors may limit their ability to do so.
In many cases, the effective unilateral payment cancellation deadline will be
earlier than the guaranteed cutoff time - indeed, in some cases the unilateral
payment cancellation deadline may even be earlier than the time the
payment order is normally sent to the correspondent. These earlier times
could occur, for example, if payment orders were normally processed
automatically but cancelling an order required time-consuming manual
intervention. Moreover, due to automated processing, a bank may not be
able to stop one payment instruction without ceasing or disrupting all
outgoing payment instructions. Because a bank’s management is unlikely to
want to suspend payments to their solvent counter-parties (and face
subsequent demands for compensation), an all or nothing capability to cease
outgoing payment instructions should not be accepted as the ability to effect
unilateral cancellation of payments to a single counterparty. Finally, some
deadlines quoted by correspondents may fall outside normal working hours,
in which case the bank may need additional time to meet the deadline.
Because of these and other factors, banks should consider testing their
procedures with their branches and correspondents in simulations of
emergencies in order to
help determine the effective unilateral payment cancellation deadline.

c. Measurement of Foreign Exchange settlement exposures

 i. The actual duration of foreign exchange settlement exposure - namely, the
interval from the unilateral payment cancellation deadline for the sold
currency until final receipt of the bought currency - is generally referred to
as the period of irrevocability. When trades are settled gross, the full face
value of the trade is at risk during this period, which can last overnight and
up to two or three full days. If weekends and holidays are included, the
period of irrevocability – and consequent exposure – can exist for several
more days.

ii. A bank’s minimum foreign exchange settlement exposure at a specified time

includes the value of all outstanding trades where payment is irrevocable; it
also includes any known failed receipts since, by definition, the fact the
trade has failed to settle means the funds have not yet been received.
Because the irrevocable period can last several days, this minimum measure
of exposure may be equal to several days’ worth of trades. In this situation, a
bank might find itself in the position of paying a counter-party on one day
when it had not been paid on the previous day(s).

iii. A bank's measurement of its exposure also needs to take account of the
process of reconciling incoming payments with expected receipts. The actual
exposure of the bank ends when the bought currency is received with
finality. However, in the interval between expected receipt and
reconciliation, referred to as the period of uncertainty, the bank does not
know whether it has received payments from particular counter-parties and
will therefore be acting in ignorance of any failed receipts. When measuring
its exposure, a prudent bank will therefore assume that during this uncertain
period the funds have not been received. Consequently, the maximum
settlement exposure at a specified time equals the minimum exposure plus
the value of all uncertain receipts at that time.
iv. Note that the period of uncertainty only ends when a bank has positively
confirmed that the funds have been received. Positive confirmation means
that a bank not only has received information from its correspondents about
the payments credited to its nostro accounts but also has processed that
information to determine which trades have successfully settled and which,
if any, have failed. It is not enough for banks to measure their exposure on
the basis that provided they have no news of the counter-party having
defaulted, it is safe for them to assume that the funds either have been or will
be received. Until the receipt of the funds has been positively confirmed,
there always remains the possibility that in fact they have not been received
and that the counter-party will default.

v. Measuring FX settlement exposures requires a bank to identify explicitly

both the unilateral payment cancellation deadlines and the reconciliation
process times involved in each type of currency transaction. An exact
measure of FX exposures has to recognise that the duration of exposures
varies by currency pair and that a bank's exposures are likely to change
during the day. Exact measurement has the advantage of avoiding
overestimation as well as underestimation. Nevertheless, the process
involved is relatively complex and so, for operational and system reasons,
most banks do not measure their exposures exactly. Instead various
estimation methods are used. In particular, many banks define and measure
their daily settlement exposures as the total receipts coming due on
settlement day.

vi. Estimation techniques can be appropriate – but only if they do not

significantly underestimate exposures. However, in practice simple
estimation techniques frequently do understate settlement exposures. One
problem is that even where exposures last for less than 24 hours,
this period may overlap more than one calendar day. For example, the period
may start during the evening of the day before settlement and run until late
 afternoon of the settlement day; in this case, estimating the daily exposure as the
receipts due on the settlement day could underestimate the actual exposure late in
the day. Moreover, as noted in paragraph 4.3.2 above, exposures often last more
than one day. Simple approximation methods for improving this technique, such
as using multiples of daily trades, may not sufficiently account for variations in
the value of daily trades.

vii. Where estimation techniques are used, management should therefore be able
to demonstrate clearly how settlement exposure is measured, and that, even
in abnormal circumstances, the estimation techniques will not significantly
underestimate the exposure. Even estimation techniques require a bank to
have a thorough understanding of both the unilateral payment cancellation
deadlines and the reconciliation process times involved in each type of
currency transaction.

viii. Finally, it is critical that banks' measurements of FX settlement exposures

and associated risks are integrated into their overall risk measurement and
management processes. In particular, banks have increasingly adopted
consolidated risk measurement and capital allocation methodologies, a trend
that CIMA supports. Where such methodologies are used, appropriate
measures of FX settlement risk should be included so that internal capital
allocations properly reflect the risks associated with this activity.

d. Setting and using limits

i. Banks should ensure that settlement exposures to counter-parties are subject

to prudent limits. FX settlement exposures should be subject to an adequate
credit control process, including credit evaluation and review and
determination of the maximum exposure the bank is willing
to take with a particular counter-party. Through this process, an FX settlement
limit should be established for each counter-party. The FX settlement exposure
limit should be subject to the same procedures used to devise limits on other
exposures of similar duration and size to the same counter-party. For example, in
cases where the FX settlement exposure to a counter-party lasts overnight, the
limit might be assessed in relation to the bank’s willingness to lend funds to its
counter-party on an overnight basis. Limits should be based on the level of credit
risk that is prudent and should not be set at an arbitrary, high level just to
facilitate trading with a counter-party.

ii. The limits applied by a bank to its FX settlement exposures should be

binding – i.e. FX deals should not be struck that would cause counterparty
limits to be exceeded. Any planned excesses should be subject to approval
by the appropriate credit management personnel in advance of the excess
occurring. However, unplanned excesses may sometimes occur. This may be
because, when the deal is struck, the headroom apparently available under a
limit has not yet been reduced to reflect other deals recently struck. Or it
may be because, when the time comes for the deal to be settled, unexpected
events (such as the failure of other transactions to settle) cause exposures to
be higher than planned. Banks should take steps to minimise these
possibilities. Exposure measures should be updated promptly when new
deals are struck or when events (such as fails) mean that the exposures from
existing trades last longer than expected. Effective monitoring is crucial to
the management of FX settlement risk, and banks with large exposures
should have systems that enable them to monitor developments in realtime
(or close to real-time) in order to ensure that these exposures do not exceed
settlement limits. A bank may want to put additional emphasis on those
exposures that are particularly large or are with less-creditworthy counter-
parties or where there has been a series of fails that may indicate an
underlying credit-worthiness problem. However, if, despite these
precautions, unauthorised excesses do still
occur, a review by the credit management personnel should take place shortly
thereafter so that any necessary corrective action can be taken.
e. Procedures for managing fails and other problems

i. Operational errors are the most common source of fails. While such
mistakes may be inadvertent and corrected within a reasonable time, they
may in some cases be indicative of more fundamental problems, including
credit problems, and so banks should have procedures for quickly
identifying fails and taking appropriate action. Such action should normally
involve informing the credit department, so that a judgement can be made
about the seriousness of the problem. Because a fail represents continued
exposure to the counter-party for the full principal value of the trade, banks
should include fails in their measures of current and expected exposure (as
noted in paragraph 18 above). Banks may also need to take steps to obtain
the funds due and to try to avoid recurrences.

ii. When reacting to a fail or to another potential problem with the settlement of
an FX deal, banks need to strike a balanced approach. If there appears to be
an underlying credit-worthiness problem, the bank may decide that it is
prudent to reduce its limit for that counter-party. In more extreme cases, it
may decide that, to protect itself from settlement risk, it needs to suspend
issuing payment instructions for outstanding deals with that counter-party or
to cancel existing payment instructions (if possible). However, failure to pay
could have serious consequences; it could constitute a breach of contract by
the bank and may cause liquidity problems for the counter-party. Such
action should thus only be taken when, after a careful but prompt review of
the circumstances, the bank's senior management judges that the situation
warrants it.

f. Contingency planning
 i. Contingency planning and stress testing should be an integral part of the FX
settlement risk management process. Contingency plans should be
established to include a broad spectrum of stress events, ranging from
internal operational difficulties to individual counter-party failures to broad
market related events. Adequate contingency planning in the FX settlement
risk area includes ensuring timely access to key information, such as
payments made, received or in process, and developing procedures for
obtaining information and support from correspondent institutions. An
institution should also have a contingency plan in place to ensure continuity
of its FX settlement operations if its main production site becomes unusable.
This plan should be documented and supported by contracts with outside
vendors, where such vendors provide services to the bank that are necessary
either to the bank's normal FX settlement or to its contingency plans.
Because in many cases the action taken will be similar, contingency
planning for FX settlement problems should be coordinated with the
planning for other problems (such as payment system or trading room
failures). Contingency plans should be tested periodically.

g. Improving the management of FX settlement exposures

i. Banks should actively manage their exposures. There are various steps banks
can take to reduce the duration or size of the settlement exposures relating to
their FX deals. The duration of exposures can be reduced by improving
unilateral payment cancellation deadlines by, for example, negotiating better
cancellation cut-off times with correspondents and improving internal
processing. It is important to note that banks should not simply regularly
delay sending payment instructions to their correspondents as a way of
improving their periods of irrevocability. Doing so without the
correspondents’ consent could increase the correspondents’ operational risks
and thus the risk that payment instructions are incorrectly processed. Instead,
banks should seek to negotiate explicit cancellation cut-off times with their
 correspondents. Banks need to have realistic expectations of what
correspondent banks can be expected to achieve, since later cancellation cut-
off times have operational and liquidity consequences for the correspondent.
Banks also need to be aware of the possible liquidity risk in payment
systems if late cut-off times cause FX-related payments to be concentrated
towards the end of the settlement day, adversely affecting system liquidity.

ii. Better management of exposures can also be achieved by identifying

receipts sooner, thereby bringing the maximum measure of exposure close to
the minimum. To reduce the amount of time it takes to identify final or
failed receipts, banks will need to consider improving both arrangements for
receipt of information from correspondents and the time they conduct their
own reconciliations.

iii. Appropriately managed collateral arrangements and legally sound netting

agreements (see below) are also important risk management tools that can
reduce the amount of a bank’s exposure to a particular counter-party for a
particular level of trading.

h. Use of bilateral netting

i. Banks can reduce the size of their counter-party exposures by entering into
legally binding agreements to net settlement payments bilaterally. Legally
binding payment netting arrangements permit banks to offset trades against
each other so that only the net amount in each currency is paid or received
by each institution. Such payment netting arrangements are contemplated in
the industry standard bilateral master agreements covering foreign exchange
transactions.

ii. Depending on trading patterns, bilateral payment netting can significantly

reduce the value of currencies settled. It also reduces the number of
 payments to one per currency either to or from each counter-party. Bilateral
payment netting is most valuable when the counter-parties have a
considerable two-way flow of business; as a consequence it may only be
attractive to the most active banks. To take advantage of risk reducing
opportunities, banks should be encouraged to establish procedures for
identifying payment netting opportunities.

iii. Use of bilateral payment netting requires some modification to the method
of measuring settlement exposures explained earlier. When bilateral
payment netting is used, all the transactions with a particular counter-party
due to settle on that day have to be considered together: the bank will make a
single payment to the counter-party in each of the currencies where it has a
net debit position, and receive a single payment in each of the currencies
where it has a net credit position. The maximum value of the resulting
settlement exposure is simply equal to the sum of the amounts due to be
received from the counterparty. However, measuring the actual duration of
the exposure is more complicated because netted transactions result in a set
of payments in a number of currencies, no two of which can simply be
paired to calculate the period of irrevocability. Rather, the exposure will
build up to its maximum value as the cancellation deadline for each of the
net debit currencies paid is reached, and will fall as each of the net credit
currencies is received. Any method of measurement – whether an exact
measure or an approximation – needs to make appropriate allowance for
this.

iv. Moreover, to allow exposures to be measured on a net basis, the legal basis
for payment netting arrangements should be sound. In particular, banks
should ensure that a netting arrangement is legally enforceable in all relevant
jurisdictions.
 v. Some banks use informal payment netting - i.e. where there is no formal
netting contract between the counter-parties. In this instance, the back
offices of each counter-party confer by telephone before settlement and
agree to settle only the net amount of the trades falling due. Since there may
not be a sound legal basis underpinning such procedures, banks should
ensure that they fully understand and appropriately manage the legal, credit,
and liquidity risks of this practice. In particular, counter-party exposures
should be treated on a gross basis for risk management purposes unless the
bank has obtained clear legal advice that the informal payment netting is
legally sound. Additionally, the practice and associated risks should be
described in the bank’s policy and procedures.

vi. While bilateral netting arrangements can significantly reduce FX settlement

risk, they are usually not capable of removing credit risk entirely. In
addition, significant liquidity, legal and operational risks may remain. For
example, if, because of operational problems, transactions that had been
scheduled to be settled through a netting arrangement had unexpectedly to
be settled gross, a bank might not have the liquidity to settle those
transactions on a timely basis.

i. Alternative arrangements for FX settlement risk reduction

i. Banks with significant foreign exchange settlement exposures should give

strong consideration to using such risk-reducing arrangements, either by
participating in them directly or by taking advantage of thirdparty services.
In evaluating whether to do this, banks should carefully assess the costs
associated with the exposures, including both expected losses and the cost of
economic capital associated with unexpected losses. While ultimately the
decision to make use of riskreducing arrangements should be based on the
balance of all costs and benefits, it is particularly important that banks do not
 underestimate the benefits of risk reduction by assuming that sudden bank
failures are impossible.

ii. Banks should understand that, while risk-reducing arrangements are

intended to significantly reduce important settlement risks, they may not
eliminate all such risks. Thus, banks using such arrangements should have a
thorough understanding of them and of the remaining risks they face - for
example, liquidity, legal and operational risks. Moreover, even if banks use
alternative arrangements for deals with major counter-parties, they are likely
to continue to use the traditional gross settlement method for certain counter-
parties and currencies. Therefore, banks should incorporate their use of
alternative settlement arrangements into measures of and limits on FX
settlement exposures, understanding that use of such arrangements does not
eliminate the need for all such tools.

j. A bank's responsibilities to its counter-parties

i. The emphasis in this guidance has been on the steps banks take to manage
the settlement risk that they themselves face. However, settlement risk is a
two-way process – a bank also needs to be aware that its own behaviour
affects the settlement risk faced by its counterparties. As discussed in
paragraph 4.5.2 above, banks should react in a balanced and considered way
to any perceived counter-party problems. Banks should also minimise the
possibility that, as part of their routine processing of FX settlements, they
are the cause of settlement failures. For example, banks may want to
consider whether, given the size and pattern of their transactions in the
currencies concerned, they have enough liquidity on their nostro accounts to
avoid payments being delayed because of shortages of funds. Further, the
use of standardised settlement instructions may reduce the risk that
payments are unintentionally mis-routed, particularly when there are
changes to those instructions. Effective communication can also help to
 minimise the adverse impact of problems; it may therefore be helpful for
banks
to ensure they have procedures for informing key counter-parties when
significant operational problems arise. By taking such steps to avoid routine,
operational fails, or to minimise their impact, banks will make it easier to identify
those cases where there is a more serious underlying problem.

Question for revision

Clearly differentiate between transaction hedging and translation hedging in the
management of foreign exchange risk?
Answer for question for revision
With transaction hedging Firms with exposure to foreign-exchange risk may use a number
of hedging strategies to reduce that risk. Transaction exposure can be reduced either with the
use of money markets, foreign exchange derivatives—such as forward
contracts, options, futures contracts, and swaps—or with operational techniques such as
currency invoicing, leading and lagging of receipts and payments, and exposure netting.[17] Each
hedging strategy comes with its own benefits that may make it more suitable than another,
based on the nature of the business and risks it may encounter
While with translation hedging exposure is largely dependent on the translation methods
required by accounting standards of the home country. For example, the United States Federal
Accounting Standards Board specifies when and where to use certain methods. Firms can
manage translation exposure by performing a balance sheet hedge, since translation exposure
arises from discrepancies between net assets and net liabilities solely from exchange rate
differences. Following this logic, a firm could acquire an appropriate amount of exposed assets
or liabilities to balance any outstanding discrepancy. Foreign exchange derivatives may also be
used to hedge against translation exposure