Caiib Gbm Moda PartII

8/8/2019 Caiib Gbm Moda PartII

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International Banking

(Module A) Part II

Risk Management and Derivatives

Tanushree Mazumdar, IIBF


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Dealing room (1)

Foreign exchange dealing roomoperations comprise functions of a servicebranch to meet the needs of other

branches/divisions to buy/sell foreigncurrency.

Acts as a profit centre for the

bank/financial institution A dealer has to maintain two positions-

funds position and currency position


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Dealing room (2)

The funds position reflects inflows and outflowsof funds i.e. receivables and payables

A mismatch in funds position will throw open

interest rate risks in the form of overdraft interestin the Nostro a/c, loss of interest income oncredit balances, etc.

Currency position deals with overbought and

oversold positions, arrived after taking variousmerchant or inter-bank transactions and thedealer is concerned with the overall net position


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Dealing room (3)

The overall net position exposes the dealer toexchange risks from market movements

The dealer has to operate within the permittedlimits prescribed for the exchange position bythe management

Back office: Takes care of processing deals,accounts reconciliation. It plays a supportive aswell as checking role

Mid office: Mid-office deals with the riskmanagement and parameterisation of risks forforex operations. Gives market information todealers


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Risks in foreign exchange dealings

RBI and FEDAI issue guidelines to all

banks to identify, measure and manage

risks Risks can be classified under:

Market risk: Loss arising out of change in the

market price of an asset

Liquidity risk: risk that you will not be able to

easily sell your assets


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Risks(contd)

Operational risk: Failure of internal processes,

people, systems or external events

Legal risk: Contracts are not legally enforceable

or documented incorrectly

Credit risk: Counterparty defaulting in payment

Pre-settlement: Credit risk before the maturity of a

transaction

Settlement risk: Timing differences in cash flows, e.g.

of Herstatt Bank in Germany failing in 1974


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Risks (3)

Country risk: Movement of funds across

borders may be obstructed by sudden

government controls Interest rate risk: Interest rate risk or gap

risk arises out of adverse movement of

interest rates a bank faces on its currency

swaps/forward contracts or other interestrate derivatives


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Management of risks

Traditional measures adopted by bank

managements to manage/limit risks are:

Limits on intra-day open position in each currency

Limits on overnight open positions in each currency(lower than intra-day)

Limits on aggregate open position for all currencies

A turnover limit on daily transaction volume for all

currencies Countrywise exposure limits


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Guidelines on risk management

Measure risks that can be quantified viz.,exchange rate risk, interest rate risk usingmathematical or statistical tools

Have a detailed policy on risk management(given by the Board)

A specific limit structure for various risks andoperations

A sound management information system Specified control, monitoring and reporting

system


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RBI guidelines on risk management

RBI has issued internal control guidelines(ICG) for foreign exchange business

It covers various aspects of dealing roomoperations, code of conduct for dealersand brokers and other aspects of riskcontrol guidelines

Specifies limits including gap limits,counterparty limit, dealer limit, deal sizelimit, etc.


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Derivative Instruments

Derivatives are management tools derivedfrom underlying exposures such ascurrency, commodities, shares, etc.

Used to neutralise the exposures on theunderlying contracts

Can be over the counter(OTC) i.e.

customised products orexchange tradedwhich are standardized in terms ofquantity, quality, start and ending dates


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Forward Contracts (1)

Forward contracts: Typical OTCderivatives which involves fixing of rates(exchange rate, commodity price, etc.) in

advance for delivery in future. Risk ofadverse price movement is covered.

Forward contracts are specified at forward

rates which are spot rates plus cost ofcarry (interest rate differential in case offoreign exchange forward)


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Forward Contract (2)

Forward rate: spot rate + premium or discount

Premium/discount: function of cost of carry(interest rate differential)

The currency with lowerinterest rate would be ata premium in future

Other factors affecting forward rate Demand and supply for forward currency

Perception about the movement in the currency Political, fiscal and trade-related conditions in the

country and for the currency


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Example of a forward differential

If GBP/USD Spot = 1.8000

6 months interest rate USD= 2%

6 months interest rate GBP = 4%

Forward differential=

1.8000 * (4-2)/100 * 6/12 or 0.018

6 months forward rate (GBP/USD) = 1.7820

Since USD has a lower interest rate it will be at a

premium in the future


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Futures (1)

Futures: A version of exchange traded forwardcontracts.

Standardized contracts as far as the quantity

(amounts) and delivery dates (period) of thecontracts.

Conveys an agreement to buy a specific amountof commodity or financial instruments at a

particular price on a stipulated future date An obligation on the buyer to purchase the

underlying instrument and the seller to sell it


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Futures (2)

Types of Futures contracts Commodities futures

Financial futures

Currency futures

Index futures

There is a margin process Initial margin: to be paid at the start of a contract

Variable margin: calculated daily by marking to

market the contract at the end of each day Maintenance margin: Similar to minimum balance for

undertaking trades in the Exchange and has to bemaintained by the buyer/seller in the margin account


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Options (1)

Options: An agreement between two parties inwhich one grants the other the right to buy (calloption) or sell (put option) an asset under

specified conditions (price, time) and assumesthe obligation to sell or buy it.

The party who has the right but not theobligation is the buyer of the option and pays afee or premium to the writer or seller of theoption.

The asset could be a currency, bond, share,commodity or futures contract


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Options (2)

The option holder or buyer would exercise theoption (buy or sell) in case the market pricemoves adversely and would let it lapse if it

moves favourably The option seller (usually a bank or a financial

institution or an Exchange) is under obligation todeliver the contract if exercised at the agreedprice

Strike price/exercise price: The price at whichthe option may be exercised and the underlyingasset bought or sold


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Options (3)

In the money: When the strike price is below the

spot price (in case of a call option) or vice-versa

in case of a put option the option is in the money

giving gain to the buyer. At the money: When strike price is equal to the

spot price

Out of the money: The strike price is above the

spot price (call option) or vice-versa (for a put

option). It is better to let the option lapse here.


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Options (4)

Call option- The right, without the obligation, tobuy an asset

Put option- The right, without the obligation, tosell an asset

American option-An option that can beexercised at any time until the expiry date

European option-An option which can beexercised only on expiry

Bermudan option-An option which isexercisable only during a pre-defined portion ofits life


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Options (5)

Expiry: The last date on which the option may beexercised.

Market participants often quote an expiration(calendar) month without specifying an actualdate.

In such cases it is understood that the expirationdate is the Monday before the third Wednesdayof the month

Expiration time is usually specified in thecontract. For example, for contracts entered inthe Pacific Rim countries the time specified is10:00 am New York time or 3:00 pm Tokyo time


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Swaps

In foreign exchange market, swap refers to

simultaneous sale and purchase of one

currency for another (currency swap).

Financial or derivative swap refers to the

exchange of two streams of cash flows

over a defined period of time, between two

counter-parties


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Derivatives in India (1)

Sodhani Committee (expert group on

foreign exchange) was formed in 1992 to

look into the issues in and development of

the foreign exchange market in India

Some recommendations

Corporates should be allowed to hedge upon

declaration of underlying assets

Banks may be permitted to initiate overseas

cross currency positions


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Sodhani Committee..

Banks should be allowed to borrow and lend inthe overseas markets

More participants be allowed in the foreign

exchange market Corporates must be allowed to cancel and re-

book option contracts

Banks be permitted to use hedging instruments

for their own ALM Banks to be allowed to fix interest rates on

FCNR (B) deposits subject to caps fixed by RBI


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Derivatives in India (2)

The use of financial derivatives started in India isthe nineties in the foreign exchange and stockmarket

In 1992 RBI had permitted banks to offer crosscurrency options to their clients

In 1996 banks were allowed to offer theircorporate clients interest rate swaps, currencyswaps, interest rate options and forward rate

agreements The derivatives market in India is still in anevolving stage

Caiib Gbm Moda PartII

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