A Report on Foreign Exchange Risk Management by Banks in Bangladesh 2 .

2 Risk management system and process 3.4 Risk management in commercial banks: An assessment IV.4 Foreign Exchange Risk: Process and techniques 2.1 Introduction 2.2 Objective of the report 1.1 Risk perceptions 3. Foreign Exchange Risk Management: Basic Concept and Techniques 2.CONTENTS Pages Acknowledgments Executive Summary Literature Review I.2 Foreign Exchange Risks faced by banks 2. Introduction 1. Conclusion 4 5 6 7 8-12 13-15 16 3 .3 Other issues and concern 3. A survey on 2 commercial banks of Bangladesh 3.5 Management processes of specific risks III.1 Origin of the report 1.3 Foreign Exchange Risk: background and evolution 2.3 Outline of the report II.

Ataur Rahman Junior Assistant Vice. Mahabubur Rahman Assistant Vice. 4 . We are grateful to Mutual Trust Bank and Islamic Bank of Bangladesh that have responded to our questionnaire.ACKNOWLEDGEMENTS A number of people have contributed with comments. At first we would like to thank our honorable course instructor.President Islamic Bank of Bangladesh. 3) Md. 2) Md. We gratefully acknowledge the cooperation and assistance of the following persons in providing us with all the relevant information: 1) Md. The study surveyed foreign exchange risk management issues on banks.President Mutual Trust Bank Ltd.President Mutual Trust Bank Ltd. Mossaraf Hossain Senior Vice. and input at different stages of writing of this paper. Bilkis Akhter who encouraged us to apply our achieved theoretical knowledge in a broad practical way and gave valuable suggestions on the proposal of the paper. suggestions.

the system now incorporates the performance of other auxiliary functions such as financial advisory services. All these reasons prove that banks are facing more dynamic and complex foreign exchange risks. 5 . foreign exchange transaction of both domestic and international payment systems. Conventionally the banking system was focused on receipts of deposits from customers on demand. But today the banking system has transcended beyond that scope. So banks and financial institutions need to equip themselves with the up-to-date management skills and operational systems to cope with this environment.Executive Summary When we talk about the growth and development of a nation¶s economy. hardly can there be any living soul that will not agree with me that the Spur Catalyst is the nation¶s bank.

foreign exchange brokers and dealers whose function is to bring together buyers and sellers of foreign exchange. Exchange rates represent the number of units of a given currency of one country that can be exchanged for unit of another currency (Van Horne. regulations and mechanisms that determine the rate at which each currency is exchange for another (Shapiro. practices. 1988). Today foreign exchange has been the talk of the town. commercial customer¶s primarily multi-national corporations and Central Banks which intervene from time to time in the market to smooth exchange rate fluctuations or to maintain target exchange rates.Literature Review The international monetary systems refer primarily to the set policies. 6 . but is dispersed throughout the leading financial centers of the world (Shapiro. of two tiers. 1986). foreign exchange brokers in the interbank market. international trade and investment also includes in this definition. The purpose of foreign exchange market is to enhance transfer of purchasing power dominated in one currency for another currency. Foreign exchange market consists. The major participants in the foreign exchange market are the large commercial banks. the Interbank market in which major banks trade with each other and the Retail market in which banks deal with their commercial customers (Redhead and Hughesis. Broadly speaking foreign exchange is held and managed to facilitate international transactions. 1997). This has played over such areas as risk management and active portfolio management. 1999). and this is because foreign exchange plays a very crucial role in the overall performance of the national economy. The foreign exchange market is not a physical place rather it is an electronically linked network of banks. 1991). institutions. (Anifowoshe. The practice of managing foreign exchange resources has therefore evolved broadly in line with the globalization and liberalization of economies and financial market. If there were a single international currency there would be no need for a foreign exchange market. It is not confined to any one country. Trading of currencies.

To determine the various exchange risks which the treasurer of the selected bank is exposed to in its foreign exchange transaction 2. The last section concludes the paper and presents policy implications for developing risk management culture in banks of Bangladesh. the section touches on the regulatory aspects for banks. To investigate how these risks can be effectively managed and 3. and Islami Bank of Bangladesh. Among others. The results covers the perspectives of bankers towards this risk. it covers issues related to capital requirements in banks and different approaches to manage foreign exchange risks. The section ends with identifying the nature of risks found in banks operating in Bangladesh. reports results from a survey on foreign exchange risk management issues in banks. the process of risk management in these institutions. the proposals of Bangladesh Bank.2 Objectives of the report: 1. among others. Based on. 1. 1. 1 Origin of the report: Introduction We have prepared this report as our course requirement of ³Laws and Theories of Banking and Bank Accounts (3101)´ course. 1. To check whether these foreign exchange risk management is complied with Bangladesh Bank guidelines.3 Outline of the report: In section two. To get a clear and practical concept about how the banks follow the foreign exchange risk management guidelines in accordance with guidelines suggested by Bangladesh Bank is the primary concern of this report. The survey covered two commercial banks: Mutual Trust Bank Ltd. To identify risk and exposure management techniques required for treasury management 4. and some other aspects related to Islamic financial institutions. we discuss the basic concepts of foreign exchange risks and their management as practiced in the conventional financial sector. Section four discusses the risk management aspects from the regulatory viewpoints.I. This section also provides details of the various processes to manage this risk. Section three. \ 7 .

is the risk that an organization does not pay out on a bond. accounting and other types of fraud. Ultimately.[1] The methods by which money may be laundered are varied and can range in sophistication from simple to complex Interest rate risk: Interest rate risk is the risk (variability in value) borne by an interest-bearing asset. otherwise known as default risk. corruption. and tax evasion. as rates rise. Counterparty risk Counterparty risk.2 Common foreign risks faced by banks: As we talk of foreign exchange risks. This risk usually affects businesses that export and/or import. Money laundering: Money laundering is the practice of disguising the origins of illegally-obtained money. there are myriad of risks but we pointed out the main risks that are principally foreign exchange based. They are presented below: Transaction exposure: Transaction exposure refers to the extent to which future cash transactions of a firm may be affected by any changes in the currency exchange rate. then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency. 2. Translation exposure: Translation exposure means accounting exposure. For example. the price of a fixed bond will fall. Foreign exchange risk management: Basic concept and techniques 2.1 Introduction: Foreign exchange risk is the risk of an investment's value changing due to changes in currency exchange rates. Interest rate risk is commonly measured by the bond's duration.II. due to variability of interest rate. including drug dealing. It measures the impact of changes in exchange rate on the financial statements of the group of company. In general. credit derivative. The money involved can be generated by any number of criminal acts. such as a loan or a bond. or other trade or transaction when it is supposed to. if money must be converted to another currency to make a certain investment. Economic exposure: Economic exposure means the impact of changes in exchange rates of the firms¶ cash flows and earnings. credit insurance contract. but it can also affect investors making international investments. and vice versa. it is the process by which the proceeds of crime are made to appear legitimate. Even organizations who think that they have hedged their bets by buying credit 8 .

4 Foreign exchange risk: Process and techniques The practice of managing foreign exchange resources has therefore evolved broadly in line with the globalization and liberalization of economies and financial market. Fifty one percent is in spot transactions followed by thirty two percent in currency swaps and forward outright transaction represents another five percent of the daily turnover. equities. The market directly affects each country¶s bond. The foreign exchange market has played a vital role in the last decade or so in guiding the purchase and sale of goods. There is in excess of one trillion dollars of average daily turnover in the global foreign exchange market. The Bangladesh Taka. services and raw materials globally. manufacturing and all assets that are available to foreign investors. Broadly speaking foreign exchange is held and managed to facilitate international transactions. Bangladesh Bank used to publish a daily foreign exchange rate sheet that had two sets of rates. The market has its own momentum and therefore it is crucial to follow a universal time tested policy to tackle the forces behind the free market system with minimal risk involvement. which is the domestic currency of Bangladesh and the country¶s foreign exchange. liquidity. one being the rates for commercial banks to transact with their customers and the other being rates for the commercial banks to transact with Bangladesh Bank. The market is a stabilizing factor in the world system of monetary exchange and was created not by design but necessity. 9 . which buys equities in companies and literally effects and influences the economic scenario of every nation to cope with the foreign exchange risk in an open market economy.3 Foreign exchange risk: Background and evolution With the demise of the foreign currency exchange rates during the 1970¶s and after the collapse of the Bretton Woods Agreement. some of the objectives which management of foreign reserve seeks to achieve include security. 2. This has planned over such areas as risk management and active portfolio management. either due to temporary liquidity issues or longer term systemic issues. At that time. Foreign exchange rates also play a major role in determining who finances government deficits. Consequently. Bangladesh Bank used to regulate the local Bangladesh Bank Focus Group 1 currency¶s parity against the international currencies. the world economy has undergone drastic changes. 2. The cross border movement of currencies was also regulated. This has signaled an increase in currency market volatility and trading opportunity. had been strictly regulated until the early 1990s. private of some sort still face the risk that the insurer will be unable to pay.

Hedges will be undertaken only after appropriate Stop-Loss and Take-Profit levels have been predetermined 4. 1991). The Exposure Management Cell will be accorded full operational freedom to carry out the hedging function on a day to day basis 3. most of the instruments and techniques for addressing these other risks particularly the interest rate risk are frequently used for managing foreign currency exposure risks (CBN Review. raises deal ticket and sends ticket to the treasury office Treasury backoffice exchanges deal confirmation with counterparty Passes all necessary entries Settles the deal Reconciles exchange position Advices trasury of accurate position 2. the need to adequately manage the associated exposure is becoming increasingly important. Accordingly. With the expansion of treasurer¶s business activities. They are described here: Hedging: 1. as per need and requirement. The company will use all hedging techniques available to it. it will pass a Board Resolution authorizing the use of the following: 10 . Hedging strategies will be designed to meet the Exposure Management objectives. Some treasury functions today have introduced and others are planning to introduce an overall exposure monitoring and management system.5 Management processes of specific risks For managing foreign exchange risk the following strategies will be effective. In this regard. The process flowchart suggested by Bangladesh Bank is given below: The Process Flowchart Dealer strikes a deal Enters deal into blotter. This is done by consolidating all information elements relevant to risk and exposure offering a comprehensive view that facilitates control.profitability and adequacy of the reserves. able to integrate balance sheet and off balance sheet business activities. as represented by the Benchmarks 2.

y y y y y y y y y 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. The contract can be set between two dates and the currency can be 'drawn' in any amounts between these dates. A Forward Contract allows you to agree an exchange rate today to buy or sell currency at a date in the future. For an effective foreign exchange risk management. 11 . A Forward Contract is especially attractive if the prevailing exchange rate is in your favor as you get the added benefit of this. Payments or receivables in the future can be priced in your currency with certainty and so you can accurately budget and forecast. Reduce risk to foreign currency fluctuations in money markets and achieve exchange rates that work best for your business. A Forward Contract is a risk management tool that helps you manage your currency requirements. Indeed many customers will buy forward when the rate is good. The exchange Business can also offer 'Time option Forward Contracts' which allow more flexibility. as may be required Forecast Exchange Rate: A key factor in operating in export markets is the currency exchange rate movements. The nature of the worldwide currency markets means that predicting the future is almost impossible. On agreeing a Forward Contract a 5% deposit is required (10% is more than 6 months forward). managers have to understand these factors which will help them to forecast exchange rate. A Forward Contract offers many benefits in the exchange currency markets. The 95% balance is payable before the contract date allowing your own funds to be employed elsewhere. Forward contract: This is a tool for the protection against fluctuations in the exchange rate. There are many factors that affect the currency exchange rates and from all around the globe but good old supply and demand make the rates.

When a buyer pays immediately for any type of goods or services that are also delivered at once. In some cases. usually less than forty-eight hours after the deal is struck. the terms of a spot transaction may allow the buyer to pay for the purchase within a specified period of time. While common in currency trading deals. the concept of the spot transaction is also used in other types of purchase situations.Spot transaction: Spot transactions are financial transactions that often occur with foreign exchange purchases. the purchase of any type of goods and services where the buyer pays in cash. usually at a specified rate and in the currency preferred by the seller. can be classified as a spot transaction. and renders the full price to the seller at the time of the purchase. The terms of this type of transaction call for immediate payment for the currency. 12 . From this perspective. that can be said to be a form of spot transaction.

Yes Yes of Yes Yes Yes The Banks are regarded as the bed rock of a nation¶s economy. This survey was carried out in a new generation bank that is fully engaged in transaction of foreign exchange. The most common risk faced by two banks are given below: 13 . As a result management of a bank always concern about risks related to foreign exchange.2 Risk management system and process: Based on our questionnaire. An efficient management of foreign exchange risk is just like winning a gold medal in Olympic game. A survey on 2 commercial banks of Bangladesh 3. because of its positive corresponding effects on the national economic development. which is regarded as the ³life wire´ of a nation¶s economy.III. they are the harbinger of economic development through a prudent management of both domestic and foreign currencies. monitoring. political and market factors. economic. Having a formal system of Foreign Yes Exchange Risk Management Having section/committee responsible Yes for identifying. 3. and controlling Yes Having internal guidelines / rules and concrete procedures Responsibility of Internal Auditor to Yes review and identify the risk management systems and guidelines Bangladesh Bank foreign exchange risk Yes management guidelines equally applicable to your bank about the general foreign Islami Bank Bangladesh Ltd. And in fact a nation regardless of its economic status cannot neglect or negate the importance of the badly needed foreign exchange. The attitude of management of our surveyed two banks is participative toward foreign exchange activities.1 Risk perceptions Foreign exchange activity is a very sensitive sector for any bank and financial institutions as it is affected greatly by various international. we have got the following information exchange risk management: Questions Mutual Trust Bank Ltd.

14 . Strategy 1.Name of the banks Mutual Trust Bank Ltd. Banks usually faces risk more during payment. The conversion language on the Reuters dealing system and over telephone is English. The banks do not face any information technology risk in achieving foreign exchange risk management. Invoicing in strong currencies. Islamic Bank also faces risk in payment of imported goods and services. Spot transaction rate Islami Bank of Bangladesh Ltd. The persistent and inconsistent policies of the government in foreign exchange are a deterrent to the foreign exchange risk management. Forecasting in exchange movement. In order to crown it all. Furthermore. According to our survey JAVP of Mutual Trust Bank said that due to exchange rate fluctuation they face risk in importing goods and services. Hedging 2. Type of risk Economic risk Interest rate risk Money laundering risk. The techniques used by the two banks for managing risk are given below: Name of the banks Mutual Trust Banks Ltd. The banks produce foreign exchange risk report at regular interval. Islami Bank of Bangladesh Ltd. the effective and efficient use of risk trading has been regarded as the best form of risk management. Spot transaction technique was founded to be effective in minimizing foreign exchange risk. 1. invoicing in strong currencies was revealed to be a factor in foreign exchange risk management. 2.

All foreign exchange transactions are revalued at Mark-to. annually. All NOSTRO Accounts are reconciled on monthly basis and the management for its settlement reviews outstanding entries beyond 30 days.Market rate as determined by Bangladesh Bank at the month end. This bank publishes its foreign exchange report daily. Islami Bank of Bangladesh Ltd.3 Other issues and concern Mutual Trust Bank Ltd. International Department independently conducts the transactions relating to foreign exchange and is responsible for verification of the deals and passing of their entries in their books of accounts. followed by operational risk. 3.Market rate as determined by Bangladesh Bank at the month end. 15 . monthly.4 Foreign exchange risk management by banks in Bangladesh: An assessment The above analysis has touched on different aspects of risk management in banks. Foreign exchange risk is defined as the potential as the potential change in earnings arising due to change in market prices. Among the traditional risks faced by banks economic risk is ranked the highest. They always operate their foreign activity according to the guidelines of Bangladesh bank. It first identifies the severity of different risks and then examines the risk management process in these banks.3. The foreign exchange risk of the bank is minimal as all the transactions are carried out on behalf of the customers against underlying L/C commitments and other remittance of single borrower limit are properly recorded and disclosed. All foreign exchange transactions are revalued at Mark-to. These banks reveal that some of these risks are considered more serious than the conventional risks faced in other risk management sector. All NOSTRO Accounts are reconciled on monthly basis and the management for its settlement reviews outstanding entries beyond 30 days.

16 . forecasting in exchange rates movement for profit. protection against exchange rates fluctuation and effective and efficient use of risk trading.IV. spot transaction. such as avoidance of risk. Conclusively foreign exchange can be regarded as the life wire of a national economic growth and development and even the life blood of any economic development. Conclusion The research revealed that the exposure to risk comes from diverse areas.

3. 4. Dionco Adetayo and B. Department of Management and 6. 2. Adetayo. 5. www. General Banking by L. Financial Express.bangladeshbank. Howladar. Oladejo. 7. 17 . Nigeria.References: 1. CORE RISK MANAGEMENT IN BANKING Mutual Trust Bank Ltd. Obafemi Awolowo University.R Chowdhary. E. Islamic Bank Bangladesh Ltd.A. www.A. Banking Laws and Practice by Syed Ashraf Ali & R.

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