Joi

nCAI
IBWI
THASHOKonYouTube

BFM MODULE-A
Chapt
er2:
BASI
CSOFFOREXDERI
VATI
VES
Whatwewi
llst
udy?
*
Whatar
ethev
ari
ousr
iski
nfor
ex?
Whati
sHer
stat
tri
sk?
*
Whati
sSet
tl
ementRi
sk?
DEFI
NITI
ONOFRI
SKANDRI
SKSI
NFOREX
OPERATI
ONS:
Ariskcanbedef inedasanunpl
annedeventwith
fi
nancialconsequencesr
esul
ti
nginlossorreduced
earni
ngs.
Anactiv
itywher ether esulti
suncer tai
nandt hereis
achanceofl oss,maybecal ledar iskypr oposi
ti
on,
duetotheuncer tai
ntyorunpr edict
abi l
it
yoft he
act
ivi
tyortradei nfuture,event hought hisacti
vit
y
mayulti
mat elyresultinprofitorgai n.
I
notherwordsi
tcanbedef
inedast
heuncer
tai
nty
oft
heoutcome.
 Joi
nCAI
IBWI
THASHOKonYouTube

Ari
skinanycurrency
, commodityoranobjecti
s
duetoanyexposurei
nt hatpar
ti
cularcur
rency,
commodityortheobject.
Asexpl ainedinUnit1, f
orexoper ati
onsand
mar ket
sar esomewhatdi fferentf r
om ot her
commodi tymarketsandpecul iarinnat ur e,duet o
thereasonst hattheyar elargelyov erthecount er
mar ket
, open24hour -a-day,withoutanysi ngle
l
ocat i
onandbar r
iers,
fluctuationsr egister edal most
everysecond, mov ement sinot hermar ket s,effect
s
ofcontrols/poli
ciesofrespect ivegov er nment s,
delayedset t
lementsduet otimedi fferences, etc.
Thesepeculi
ari
ti
esexposet
hepar
ti
cipant
sto
var
iousri
sks.
Thepart
ici
pant
s,assuch,hav
et oexer
ciseext
reme
caut
ioni
nmanagingforexoperati
ons.
Anylaxi
tyontheirpar
tmayresul
tinlossesand
exposur
es,r
uiningthewhol
ebusiness.
Someoft heverycommonri
sksf
acedi
nfor
eign
exchangeoperati
onsar
e:
 Joi
nCAI
IBWI
THASHOKonYouTube

exchanger
isk,
set
tl
ementr
isk,
l
iqui
dit
yri
sk,
count
ryr
isk,
sov
erei
gnr
isk,
i
nter
estr
ater
isk,
oper
ati
onalr
isk,
etc.
Letuscheckontheser
isksi
ndi
vi
dual
lywhi
chhav
e
beendi
scussedbelow:
A.ExchangeRi
sk
Mov ement si nexchanger atescanadv ersel
yaff
ect
thev alueofourf oreignexchangehol di
ngs,i.
e.
receivablesandpay abl
es( purchasesandsales)
,if
notcov er
edatt heappr opri
atetime,withduewatch
ont hemar ketmoves.
Normall
y,thedeal
eri
sexpectedtocoverthe
t
ransact
ionsimmediat
ely(byent
eri
nginto
matchi
ngandoppositetr
ansacti
ons)
,withoutl
oss
 Joi
nCAI
IBWI
THASHOKonYouTube

oft
ime.
Incasethi
sisnotdone,
thenhei
sexposedt
o
exchangeri
sk.
Thi
si st
hemostcommonandobv iousr
iski
n
for
eignexchangedeal
ingoper
ati
ons.
Themar
ket
smaymov
eagai
nsthi
m,r
esul
ti
ngi
n
l
oss.
Thus,thedealerhastoimmediat
elycov
erhis
posit
ionsandkeepconst antwat
chonhisposit
ions
andthemar ketmov es,
soasnottogetaff
ectedby
adversemov ements.
Apositi
oninagi v
encur r
encyariseswhenassets
andoutstandi
ngcontractstopurchasethat
curr
encyexceedtheli
abilit
iespl
ust heout
standi
ng
contr
actstosellt
hatcurrency.
Intheformercase,thebankwi l
lhavealong
(over
bought)positi
onandwoul dbeexposedt oa
ri
skifthecurr
encydepr eci
atesinval
ue.Inthelatt
er
case,t
hebankwi llhaveashort(oversol
d)posi
tion
 Joi
nCAI
IBWI
THASHOKonYouTube

andwouldstandtoloseift
hecurrencyappreci
ates
i
nv al
ue.Thisover
boughtorover
soldpositi
onisthe
openposit
ionforthedeal
er.

Reser v
eBankofIndi
ahasaut hor
izedt
heboar
dsof
respectiv
ebankstospecif
yandapprovel
imi
ts
rel
atingtofor
exoperat
ions.
Banks,accordi
ngtotheirmerchantturnover
requi
rements,t
radi
ngski l
lsandvolumes,asalso
consideri
ngthecapi
talbase,fi
xvariousli
mitsfor
thei
rforexdeal
ingoperati
ons.
Basi
cal
ly,
for
eignexchangeexposur
escanbe
cl
assi
fi
edint
ot hr
eetypes:
(i
)Transact
ionExposure:Ari
singduetonormal
busi
nessoperati
onsconsequentt owhicht
hevalue
oftr
ansacti
onswillbeaffect
ed.
Thisi
saffect
edbythetr
ansacti
onsunder
taken
whichmayexposethecompany/fi
rmtocurrency
ri
sk,whencomparedtotheval
ueinhomecur rency
.
 Joi
nCAI
IBWI
THASHOKonYouTube

(ii
)Translati
onExposure:Thi
sari
seswhenf i
rms
havetorev al
uethei
rassetsandli
abi
li
ti
esor
recei
vablesandpayablesinhomecurrency
,atthe
endofeachaccount i
ngper i
od.
Thisal
soisaf
fect
edduetoconsol
idat
ingt
he
account
sofal
lfor
eignoper
ati
ons.
(
ii
i)Oper
ati
ng/
Economi
cExposur
e:
Thisaf f
ectst hebot tom- l
ineoft hef i
rm/ company ,
notdi r
ectl
yduet oanyf oreignexchangeexposur e
oft hefi
rm/ company ,butduet oot herexternal
factorsinthemar ket/economy , l
ikechangesi n
compet it
ion,reductioni ni mportdut yincreasing
compet it
ionf rom impor tedgoods, reductionin
pricesbyot hercount r
yexpor t
ers-effect
ingexpor t
s,
i
ncr easeinimpor tdut ybyot hercount ry
-tradetari
ff
,
etc.causingr eductioni nexpor ts,etc.
Forexample,HMTwat cheswhichwashavingvery
gooddomest icdemandi n1970and1980'slostout
becauseofimpor tofcheaptechnol
ogyi
nthef orm
ofquart
zwat ches.
 Joi
nCAI
IBWI
THASHOKonYouTube

B.Set
tl
ementRi
sk(
Pre-
set
tl
ementandSet
tl
ement
Ri
sks):
Theinter
nati
onalf
inanci
alsyst
em ev
olv
esar
ound
for
eignexchangemarkets.
Forexmar ket
sfaci
li
tat
econversi
onofcur
rencies,
mov ementoffunds,gl
obali
nvest
ments,t
raveland
touri
sm, al
lcul
minati
ngint
oahugedailyt
urnover,
ofov erUS$5.1tr
il
li
on.
Thisvolumeistransact
edbetweenthemarket
parti
cipant
sworldwidewit
houttheuseofone
si
nglecentralcl
eari
nghouse-itist
rul
yanoverthe
countermarket.
Intheabsenceofsuchasi ngle,gl
obal
,central
ized
cl
earinghouse, eachfor
eignexchangemar ket
par
ticipanthast omakeandr eceiv
epayment son
anindividualbasis.
Thisent
ail
scount
er-
par
tycr
edi
tri
skf
oreach
tr
ansact
ion.
 Joi
nCAI
IBWI
THASHOKonYouTube

Anydisr upt
ioninthemar ketduetosuddendoubt
s
aboutt hesolvencyofoneoft hemarket
part
icipantscouldhaveser i
ousreper
cussi
onsfor
theglobaltradeandfinanceandf ort
he
i
nternat i
onalbanki
ngsy stem asawhole.
Thuscr editri
skinforei
gnexchangeoperations,
is
theriskoff ai
lur
eofacount erpar
ty,whetherabank
oracust omer ,t
omeetobl i
gati
onatmat uri
tyofthe
contract,whichcouldresul
tintheneedfor
resul
t antopenpositi
ontobecov er
edatanongoi ng
rate.
Thi
scouldhappenpri
ortosettl
ementbyoneoft
he
par
ti
esorsubsequenttoexecuti
onbyonepar
tybut
bef
oreexecut
ionbytheotherone.
Theri
skis,t
hus,cl
assi
fi
edi
ntopr
e-set
tl
ementr
isk
andsett
lementr
isk.
Pr
e-set
tl
ementr
isk:
Presettl
ementr i
skist
heri
skoffai
lur
eofthe
counterparty
,duetobankr
uptcy
,cl
osureorany
otherreason,bef
orematur
it
yofthecontr
act
 Joi
nCAI
IBWI
THASHOKonYouTube

therebycompel
li
ngthebanktocov
ert hecontr
act
attheongoingmarketr
ateswi
thothercounter
par
ty.
Thi
sent
ail
stheri
skofonlymarketdi
ff
erencesand
i
snotanabsol
utelossf
orthebank.
Set
tl
ementr
isk:
Sett
lementri
skisther
iskoffai
lur
eofthecount
er
part
yduri
ngthecourseofsettl
ementduetothe
ti
mezonedi f
fer
encesbetweenthetwocurr
encies
tobeexchanged.
Thatis,wherethebank,inearl
ierti
mezone, say
Japan,orAustral
ia,per
formsitspartofthe
contr
actbydel i
veri
ngthecurrencytobedelivered
byitbutthecounterparty
,anotherti
mezone, say
Germany ,f
ail
sbeforedeli
veri
ngt hecur
rencyt obe
del
iveredbythem.
Suchaneventmeanscompleter
iskandl
ossf
ort
he
bank,
whichisi
ntheearl
iert
imezone.
Inotherwords,
atit
score,set
tl
ementofaforei
gn
exchanget
raderequi
resthepaymentofone
 Joi
nCAI
IBWI
THASHOKonYouTube

curr
encyandt her eceiptofanother.Intheabsence
ofasettl
ementar r
angementt hatensur esthatthe
fi
naltr
ansferofonecur rencywil
loccuri fandonlyif
thefi
naltr
ansferoft heot hercurr
encyal sooccurs,
onepartytoaf oreignexchanget ransactioncould
payoutthecur r
encyi tsoldbutnotr eceivedthe
curr
encyitbought .
Thispri
nci
palriskintheset
tlementofforei
gn
exchangetr
ansactionisvar
iousl
ycalledfor
eign
exchangesett
lementr i
skortemporalri
skor
Herstat
tri
sk(namedaf tert
he1974f ail
ureofthe
BankhausHerstattinGermany).
Thiscanhappenbecausebanksoper
atei
ndi
ff
erent
ti
mezones.
Thesettl
ementr iskcouldbeav oi
ded,ifonl
y
sett
lementsy st
ems, operat
ingonasi nglet
ime
basi
s,asalsoonr eal
-t
imegr ossset
tl
ementbasis,
areputi
npl ace.
Thi
swoul
del
iminatet
hetimezoneprobl
emsand
al
sowoul
dpayonlyon‘i
frecei
ved'
basi
s.Thet
ime
 Joi
nCAI
IBWI
THASHOKonYouTube

zonedif
fer
encescoul
dbeeli
minat
ed,
ifthegl
obal
booksarel
inkedt
oasingl
eti
mezone,sayGMT
cl
osing.

C.Li
qui
dit
yRi
sk:
Whenapar tyt
oaf or
eignexchangetr
ansacti
onis
unabletomeetit
sfundingrequi
rementorexecut
ea
tr
ansacti
onatareasonablepri
ce,i
tcreat
es
Li
quidit
yRisk.
I
tisal
sotheriskofthepar
tynotbei
ngablet
oexit
orof
fsetposi
tionsqui
ckl
yatareasonabl
epr
ice.
Here,f
orwhat ev
erreason,
themarketturnsill
iqui
d
andpositi
onscannotbecov er
edorli
quidated,
exceptatahighpri
ce.
Li
qui
dit
yri
skist
hepot
ent
ialf
orli
abi
li
ti
estodr
ain
fr
om t
hebankataf
ast
err
atethanassets.
 Joi
nCAI
IBWI
THASHOKonYouTube

D.Count
ryRi
sk/
Sov
erei
gnRi
sk:
Countryri
skariseswhenaf orei
gnenti
tyora
count
erpar t
y,privateorsov
erei
gn,maybeunwill
ing
orunabletofulfi
llit
sobli
gati
onsforr
easons,
other
thantheusualreasons.
Deali
nginf or
eigncurr
enciesandwit
hcounter
part
iesinanothercountr
y,wil
lsometi
mesresulti
n
countr
yrisk.
Mov ementoffundsacr ossinter
nationalborders
createsuncer
taintywi
thr egar
dt otheirrecei
ptsand
payment sandthisuncertai
ntyisdefinedascount r
y
ri
sk.
Thef oreignparti
esmaybeunwi l
li
ngorunablet o
fulf
ill
theirobli
gati
onsforr
easons,suchas
i
mposi t
ionofexchangeandothercontrol
sbyt he
centralbankort hegov
ernmentregulat
ion,on
whicht heparti
esdonothav eanycontrol
(externali
zat
ion).
Count
ryri
ski
sconsi
deredver
yhighi
nthecaseof
count
ri
eswhi
charefaci
ngprobl
emsrel
atedto
 Joi
nCAI
IBWI
THASHOKonYouTube

f
orei
gnexchangereser
ves,
balanceofpayment
s,
managementofresour
ces,
li
quidi
ty,
etc.

E.I
nter
estRat
eRi
sk:
Int
erestrateri
skorGAPr i
sk,asitisot
herwi
se
known, ari
sesduetoadversemov ementofi
nter
est
rat
esori nter
estr
atedi
ff
erential
s.
Italsoreferstothepot enti
alcostofadv er
se
mov ementofi nt
erestratest hatthebankf
aceson
i
t sdeposi t
s/borrowings/ lending,ort
hecurrency
swaps, forwardcont r
acts,f orwardrat
eagreements,
orot herinter
estratederivat i
ves.
Whil
e,inthecour seofitsbusi
ness, t
hebankbuy s
andsell
scur renci
esforspotandf orwardv alue,
borr
owsandl endsforei
gncurrencies,entersint
o
swaps,futuresoropti
onsr el
ati
ngt ointerestrat
es,
i
tisnotpract i
calandalsoalwayspossi bletomat ch
i
tsforwardpur chaseandsales,borrowingand
l
ending,creati
ngami smat chbetweeni tsassets
andli
abili
ti
es.Thismismat chisreferr
edt oasGAP.
 Joi
nCAI
IBWI
THASHOKonYouTube

F.Oper
ati
onalRi
sk:
Bei
ngacr i
ti
calar
eaofoperat
ions,
operat
ionalr
isk
i
sanotherimport
antr
iskt
hatshouldbemanaged
byadeali
ngroom.
Itmayoccurduet odef i
cienci
esininf
ormat i
on
systemsorinternalcontr
olorhumaner rorsor
otherinf
rast
ructureprobl
emst hatcouldleadto
unexpectedlosses.
Ifthei
nfr
astr
uctureprovidedt othedealingroom,
suchascomput ersystems, communi cation
systems,i
ncludi
ngtelephonel i
nes,etc.failt
o
functi
onduet osomeer r
ororf ault,
theoper ati
ons
i
nt hedeal
ingroom wouldcomet oagrindinghalt
andexposedt ovar
iousrisks.
 Joi
nCAI
IBWI
THASHOKonYouTube

G.LegalRi
sk:
Legalriskar
iseswhenittranspi
resthatthecounter
partywithwhom thetr
ansactionhasbeen
undertaken,
doesnothav ethelegalorregul
ator
y
authori
tytoenteri
ntosucht r
ansacti
on.
Inotherwords,thecount
erpart
yisincapaci
tat
ed
forengaginginsuchadeal,
result
inginnon-
enforceabi
li
tyofcontr
act
.