Limits

Financial Risk Monitoring is the process of detecting, assesing and managing financial risk.There are
many types of risks.
Market risk
Market risk is the process of declining prices or volatility of prices in the financial markets will
result in a loss.There are two major types of risk absolute risk and relative risk.
i. Absolute risk focuses on the volatility of total returns.
ii. Relative risk is referred to as tracking error since it is relative to a benchmark index or
portfolio.
Liquidity risk
Liquidity risk is the possibility of sustaining significant losses due to the inability to sufficiently
liquidate a position at a fair price. Liquidity risk includes both funding liquidity risk and asset-
liquidity risk.
i. Asset liquidity risk is sometimes called market liquidity risk, results from a large position
size forcing transactions to influence the price of securities.
ii. Funding liquidity risk which is sometimes called cash flow risk refers to the risk that a
financial institution will be unable to raise the cash necessary to roll over its debt: to
fulfill the cash margin or collateral requirements of counterparties or to meet capital
withdrawals.
Credit risk
Credit risk is the possibility of default by a counterparty in a financial transaction. For credit risk,
exposure is the size or value of loss that would be realised if a credit event occurred. A credit
event relates to a change in a counterparty's ability to perform its previously agreed to financial
obligations.
i. Settlement risk
Settlement is the exchange of two payments or the exchange of an asset for payment.
Settlement risk is the risk that a counterparty will fail to deliver its obligation after the
party has made its delivery.
ii. Pre settlement risk
Pre settlement risk is lower than settlement risk because, with this measure, payments
will offset.

Types of Risk Monitored in Forex Markets.

Value at Risk.(VaR)
Value at risk is defined as the maximum loss over a defined period of time at a stated level of
confidence, given normal market conditions. VaR is an ex ante i.e. before the fact.
Fedai Var
A data base was built up initially from 08-Jun-1985 to 20-Jun-1996 as regards 1 month, 3 months and 6
months swap rates.

Using Lotus Spreadsheet, overnight variation in swap rates were worked out for 1 month, 3 months and
6 months.

Standard deviation of overnight variation in swap rates was calculated. In other words, variation swap
rates in paisa terms for every dollar was calculated. This is the volatality for the relevant period.

The resultant figure was multiplied by 2 to achieve 95 per cent level of confidence. Since we reckon only
losses, statistically this effectively gives 97.5 level of confidence. This means that there is only 2.6 per
cent chance of actual losses exceeded by the VaR arrived at.

Using the above parameter we calculated VaR periods for USD 1 mio position for different:
integrationf(i.e., B * 2)
Sr No. Details 1 Month 3 Months 6 Months
A No. of days 251 251 251
B Standard deviation
(para) i.e.,
Volatality
6.03 10.05 13.95
C 95% confidence
level (i.e., B * 2)
12.06 20.1 27.9
D 95% confidence
level if holding
period 3 days (C *
Root of 3)
20.88 34.82 48.31
E VaR for USD 1
mio (D * USD 1
mio) Rs. In lacs
2.08 3.48 4.83
F Total VaR 2.08 3.48 4.83 = Rs.10.39
lacs

Once the 250 day data is input in a PC, it can be updated every day by omitting day 1 and adding
the new day's data. The volatality can be adjusted for 2 standard deviation, i.e., Col. (D). This
will be announced by FEDAI. All that the Banks' have to do is multiply each day's aggregate gap
by the figures furnished by FEDAI. VaR for other maturities will be arrived at through the
process of interpolation.

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.
Individual Gap Limit
This determines the maximum mismatch for any calendar month; currency-wise.
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.
Stop-Loss Limit
Stop-Loss limit seeks to limit the amount of loss on a position by eliminating the position after a
cumulative loss threshold has been exceeded.
Country Limit
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.
Net Open Position Limit.
Calculate net open position for each currency. at sum of all net short positions. Arrive at sum of
all net long positions. Overall net open position is the higher of two.
Counterparty Risk
Counterparty risk is a type (or sub-class) of credit risk and is the risk of default by the
counterparty in many forms of derivative contracts.
Counterparty Group Limit is the risk of default by the counterparty group for e.g. If a bank has
an exposure against State Bank of travancore then it is likely that if State Bank of India defaults
then State Bank of Travancore will also default.
Potential Future Exposure
It is exposure which will have to be replaced with a new contract in the event of default by the
counterparty at that particular period of time(time at which PFE is measured).