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Chapter No.2
Risk management And basics of
Derivatives
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Risk is unplanned event with financialconsequencies resulting in loss or reduced
earnings.
One can not escape from risk in forexmarket.however if risk is managed by a person
with efficiently and effectively, it can be minimized
or at the same time maximize the profit.
Types of risk .
1) Transaction Risk
2) Translation risk
Definition of Risk
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Exchange Risk
Exchange Risk- Arising on account offluctuations in exchange rates and / or whenmismatches occur in assets / liabilities and
receivables / payables.
Example:-When a dealer purchase more currencies
and is unable to dispose off it,the bank is exposed
to exchange risk.
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Pre-Settlement risk
1) Pre settlement risk is the risk of failure of thecounter party, due to bankcruptcy,closure orany other reason, before maturity of the
contract thereby compelling the bank tocover the contract at the ongoing marketrates.
2) This entails the risk of market differences andnot an absolute loss for the bank.
Example :- forward contract
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Settlement
Settlememt risk is the risk of failure of the
counter party,during the course of settlement
due to time zone differences between the two
currencies to be exchanged.
This can happen because banks operates in
different time horizons.
Example :-herstatt Risk,
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Country Risk Very high in case of countries which are facing
problembs related with foreign exchangereserves, balance of payments,managementof resources, liquidity ETC.
In country risk,counter party is willing to makepayment but local laws and directives forcethe party not to make the payment.
Example: banned on cotton,banned countries Country risk is generally controlled by fixing
countrywise exposure limit.
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Operational Risk It may occur due to defficiencies in
information system or internal control or
human errors or other infrastructure problems
that could lead to unexpected losses.
Example:- The operation in a dealing room of
a bank came to halt due to failure of
telephone lines.
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Liquidity Risk
Liquidity Risk Potential for liabilities to drain fromthe bank at a faster rate than assets. Mismatches inthe maturity patterns of assets and liabilities giverise to liquidity risk.This risk arises when a party toForex transaction is unable to meet its fundingrequirements or execute a transaction at areasonable price.
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Foreign Exchange Exposures
Transaction Exposure Arises due to normal businessoperations consequent to which the value of transactions will beaffectedby the transactions undertaken
Translation Exposure Arises when firms have to revalue theirassets and liabilities or receivables and payables in home currency
at the end of each accounting period. Also pertinent duringconsolidating the accounts of all foreign operations.Loss or Gainsare notional
Operating Exposure This affects the bottom line of the firm/Company due to other external factors in the market / economylike changes in competition (Domestic / International), reduction inimport duty, reduction in prices by other country exporterseffecting exports, increase in import duty by other country tradetariff etc. leading to reduction in exports etc.
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Guidelines on Risk Management
Overnight Limits Maximum amount of openposition or exposure a bank can keep overnight whenmarkets in its time zone are closed
Daylight Limit
Maximum amount of open positionthe bank can expose itself at any time during the dayto meet customersneeds or for its trading operations
Gap Limits Maximum interperiod / month
exposures which a bank can keep Counter Party Limit Maximum amount that a
bank can expose itself to a particular counter party
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Guidelines on Risk Management
contd
Country Risk Maximum exposure on a singlecountry
Dealer Limits Maximum amount a dealer cankeep exposure during the operating hours
Stop Loss Limit Maximum movement of ratesagainst the position held, which would trigger thelimit or say maximum loss limit for adverse movementof rates
Settlement Risk Maximum amount ofexposure to any entity, maturing on a singly
dayDeal Size Limit Highest amount for which adeal can be entered. The limits is fixed torestrict the operational risk on large deals
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What are the derivatives
The derivates derive their value fromunderlying securities.
The underlying securities can be
A) Foreign Exchange
B) Agriculture product
C) Interest rate
D) Stock and shares
E) Financial insruments
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Hedgers,speculators,arbitrages helped the
derivatives market to get depth and volume.
The objective to use derivativesA) To reduce the exposure of the underlying
contract.
B) To neutralize the exposures of the underlyingcontract
C) To hedge against uncertain movements of
the prices of underlying contracts. Derivatives can be exchange traded or over
the counter contract.
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Types Of Derivatives
Forward Contract
Futures Options
Swaps
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F C
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Future Contract A derivatives product that is based on an agreement
to buy and sell of an assets at a certain price at
certain time of future is called futures. Futures are standardized contracts with regards to
Quantity and delivery date only.
Future exchanges ensure Creditworthiness of thebuyer and seller by way of keeping margin which is
adjusted Each Day.
The buyer and seller can set Off the futurecontract
by packing the difference amount at the current rateof the underlying due to which delivery is not must.
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Margin The future contract are essentially magin based.
Three types of margin are there.
Initial Margin:- at the start of each new contractinitial margin is to be paid in form of cash or anotherapproved liquid securities.
Variable margin:-it is calculated on daily basis, by
marking to market the contract at the end of eachday the margin is normally deposited in cash only.
Maintenance Margin:-This margin is similar tominimum balance stipulation for undertaking and
trades in the exchange and has to be maintained bythe buyer and seller in the margin account with theseller.
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Difference Between Futures and Forwards
Futures
An Exchange traded Contract.
Standardized amount of
Contract.
Standardized time period,say
three Months Six Months. Delivery of underlying is not
essential.
Contract Risk is on Exchanges.
Works on margin requirementand marked to market
everyday.
Forwards
An OTC product
Can be made for any odd
amount based on need.
Can be made for any odd
period.
Delivery is essential.
Credit Risk is on counter
party.
Margin is not compulsory
.Not Marked to market
everyday.
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Swaps
A transaction in foreign exchange where one
currency is sold and purchased for another
currencies simultaneously is called swap.
