Foreign Exchange Risk maybe defined as the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign currency. The banks are also exposed to interest rate risk, which arises from the maturity mismatching of foreign currency positions. Even in cases where spot and forward positions in individual currencies are balanced, the maturity pattern of forward transactions may produce mismatches. As a result, banks may suffer losses as a result of changes in premia/discounts of the currencies concerned.

In the forex business, banks also face the risk of default of the counterparties or settlement risk. While such type of risk crystallisation does not cause principal loss, banks may have to undertake fresh transactions in the cash/spot market for replacing the failed transactions. Thus, banks may incur replacement cost, which depends upon the currency rate movements. Banks also face another risk called time-zone risk or Herstatt risk which arises out of time-lags in settlement of one currency in one centre and the settlement of another currency in another time-zone. The forex transactions with counterparties from another country also trigger sovereign or country risk (dealt with in details in the guidance note on credit risk).

The three important issues that need to be addressed in this regard are:

1. Nature and magnitude of exchange risk

2. The strategy to be adopted for hedging or managing exchange risk.

3. The tools of managing exchange risk

The risk inherent in running open foreign exchange positions have been heightened in recent years by the pronounced volatility in forex rates, thereby adding a new dimension to the risk profile of banks' balance sheets.

The first aspect of management of foreign exchange risk is to acknowledge that such risk does exist and that it must be managed to avoid adverse financial consequences. Many banks refrain from active management of their foreign exchange exposure because they feel that financial forecasting is outside their field of expertise or because they find it difficult to measure currency exposure precisely. However not recognising a risk would not make it go away. Nor is the inability to measure risk any excuse for not managing it. Having recognized this fact the nature and magnitude of such risk must now be identified.

The basic difficulty in measuring exposure comes from the fact that available accounting information which provides the most reliable base to calculate exposure (accounting or translation exposure) does not capture the actual risk a bank faces, which depends on its future cash flows and their associated risk profiles (economic exposure). Also there is the distinction between the currency in which cash flows are denominated and the currency that determines the size of the cash flows. For instance a borrower selling jewellery in Europe may keep its records in Rupees, invoice in Euros, and collect Euro cash flow, only to find that its revenue stream behaves as if it were in U.S. dollars! This occurs because Euro-prices for the exports might adjust to reflect world market prices which could be determined in U.S. dollars.

Another dimension of exchange risk involves the element of time. In the very short run, virtually all local currency prices for goods and services (although not necessarily for financial assets) remain unchanged after an unexpected exchange rate change. However, over a longer period of time, prices and costs respond to price changes. It is therefore necessary to determine the time frame within which the bank can react to (unexpected) rate changes.

For a bank, being a financial entity, it is relatively easier to gauge the nature as well as the measure of forex risk simply because all financial assets/liabilities are denominated in a currency. A bank's future cash streams are more predictable than those of a non-financial firm. Its net exposure, or position, completely encapsulates the measure of its exposure to forex risk.

In order to manage forex risk some forex market relationships need to be understood well. The first and most important of these is the covered interest parity relationship. If there is free and unrestricted mobility of capital, the interest differential between two currencies will equal the forward premium/discount for either of the currency. This relationship must hold under the assumptions; otherwise arbitrage opportunities will arise to restore the relationship. However, in the case of Rupee, since it is not totally convertible, this relationship does not hold exactly. Although interest rate differentials are the driving factor for the Dollar premium against the Rupee, it also is a factor of forward demand / supply factors. This brings in typical complications to forward hedging which must be taken into account.

From the above it can easily be determined that a currency with a lower interest rate will be at a premium to a currency with a higher interest rate. The other relationships in the forex market are not as deterministic as the covered interest parity, but needs to be recognised to manage forex exposure because they are the theoretical tools used for predicting exchange rate movements, essential to any hedging strategy particularly to economic risk as opposed to accounting risk. The most important of these is the Purchasing Power Parity relationship which says exchange rate changes are determined by inflation differentials. The Uncovered Interest Parity theory says that the forward exchange rate is the best and unbiased predictor of future spot rates under risk neutrality. These relationships have to be clearly understood for any meaningful forex risk management process

For a bank therefore the first major decision on forex risk management is for the management to fix its open foreign exchange position limits. Although typically this is a management decision, it could also be subject to regulatory capital and could also be required to be in tune with the regulatory environment that prevails. These open position limits have two aspects, the Daylight limit and the Overnight limit. The daylight limit could typically be substantially higher for two reasons, (a) It is easier to manage exchange risk when the market is open and the bank is actively present in the market and (b) the bank needs a higher limit to accommodate client flows during business hours. Overnight position, being subject to more uncertainty and therefore being more risky should be much lower.

Having decided on the overall open position limits, the next step is to allocate these limits among different operating centres of the bank (in the case of banks which hold positions at multiple centres). Within a centre there could be a further allocation among different dealers. It must however be ensured that the bank has a system to monitor the overall open position limit for the bank on a real time basis

There are various tools, often substitutes, available for hedging of foreign exchange risk like over the counter forwards, futures, money market instruments, options and the like. Most currency management instruments enable the bank to take a long or a short position to hedge an opposite short or long position. In equilibrium and in an efficient market the cost of all will be the same, according to the fundamental relationships. The tools differ to the extent that they hedge different risks. In particular, symmetric hedging tools like futures cannot easily hedge contingent cash flows where risk is non-linear: options may be better suited to the latter.

Foreign exchange forward contracts are the most common means of hedging transactions in foreign currencies. However since they require future performance, and if one party is unable to perform on the contract, the hedge disappears, bringing in replacement risk which could be high. This default risk also means that many banks may not have access to the forward market to adequately hedge their exchange exposure. For such situations, futures may be more suitable, where available, since they are exchange traded and effectively minimise default risk. However, futures are standardised and therefore may not be as versatile in terms of quantity and tenor as over the counter forward contracts. This in turn gives rise to assumption of basis risk.

Money market borrowing to invest in interest-bearing assets to offset a foreign currency payment - also serves the same purpose as forward contracts. This follows from the covered interest parity principle. Since the carrying cost of a position is the same in both, the forex or the money market hedging can also be done in either market. For instance, let us say a bank has a short forward Dollar position. It can of course hedge the position by buying forward Dollars. Alternatively it can borrow Rupees now, buy Dollar with the proceeds, and place the Dollars in a forward deposit to meet the short Dollar position on maturity. The Rupees received on the sale on maturity are used to pay off the Rupee borrowing. The cost of this money market hedge is the difference between the Rupee interest rate paid and the US dollar interest rate earned. According to the interest rate parity theorem, the interest differential equals the forward exchange premium, the percentage by which the forward rate differs from the spot exchange rate. So the cost of the money market hedge should be the same as the forward or futures market hedge.

Currency options are another tool for managing forex risk. A foreign exchange option is a contract for future delivery of a currency in exchange for another, where the holder of the option has the right to buy (or sell) the currency at an agreed price, the strike or exercise price, but is not required to do so. The right to buy is a call; the right to sell, a put. For such a right he pays a price called the option premium. The option seller receives the premium and is obliged to make (or take) delivery at the agreed-upon price if the buyer exercises his option. In some options, the instrument being delivered is the currency itself; in others, a futures contract on the currency. American options permit the holder to exercise at any time before the expiration date European options, only on the expiration date

Futures and forwards are contracts in which two parties oblige themselves to exchange something in the future. They are thus useful to hedge or convert known currency or interest rate exposures. An option, in contrast, gives one party the right but not the obligation to buy or sell an asset under specified conditions while the other party assumes an obligation to sell or buy that asset if that option is exercised. Options being non-linear instruments are more difficult to price and therefore their risk profiles need to be well understood before they can be used. For example it needs to be understood that the value of a currency changes not just when exchange rate changes (the event for which the bank usually hedges using forwards/futures) but also if the underlying volatility of the currency pair changes, a risk which banks are not directly concerned with while hedging.

The primary treasury operation of a bank is that of catering to customer needs, both in the spot as well as forward market. This lands the bank with net foreign exchange positions which it needs to manage on a real time basis. If the bank needs to sell Dollars forward to an importer, the bank has a short Dollar position. It can offset the position by buying matching forward Dollars in the market in which case all risks apart from the profit element are covered for the bank. However, it may be easier for the bank to immediately cover the forex risk with a purchase of Dollars in the spot market. Here again the exchange risk is fully covered except for the profit element. However the bank now has a swap position. This is called a gap. The bank has a gap risk which affects it if interest rates change affecting the forward premia for Dollar. In the case of our domestic markets, in addition, premia could also change due to forward demand/supply factors. However, gap risks are easier to manage than exchange risks. So the bank can build up gaps, subject to the management mandated gap limits, and do offsetting swaps to reduce gap risks if it so desires periodically.

The bank's treasury might also do transactions to take advantage of disequilibrium situations, subject to such transactions being permissible. For instance if the forward premium for 6 months is say 5% while the 6-month interest differential between Rupee and Dollar is say 4%, the bank can receive in the forex market (buy spot, sell 6-month swap to earn 5% annualised for 6 months) and finance the transaction by borrowing in the money market (money market cost being 4% annualised for 6 months).

The bank can also do transactions to take advantage of expected interest rate changes. It can then use either the money market route (mismatched cash-flow maturities) or the forex market route (by running a gap risk).

The bank of course also trades on currency movements with a view to make profits. Here the management must keep in place systems stop loss discipline, proper monitoring and evaluation of open positions etc.

The management of the bank need to lay out clear and unambiguous performance measurement criteria, accountability norms and financial limits in its treasury operations. Management must specify in operational terms the goals of exchange risk management. It must also clearly recognise the risks of trading arising from open positions, credit risks, and operations risks. The bank must also keep in place a system to independently evaluate through marking to market the net positions taken. Marking to market should ideally be based on objective market prices provided by an external agency. All position limits should be made explicit and expressed in simple terms for easy control