The variety of techniques ranges from simple maturity fixed rate and repricing floating rate gaps and duration gaps to static simulation, based on current on-and-off-balance sheet positions, to highly sophisticated dynamic modelling techniques that incorporate assumptions on behavioural pattern of assets, liabilities and off-balance sheet items and can easily capture the full range of exposures against basis risk, embedded option risk, yield curve risk, etc.
At the micro level, the banks have to strengthen their Management Information System MIS and computer processing capabilities for accurate measurement of interest rate risk in their banking books, which impact, in the short-term, their net interest income NII or net interest margin NIM or "spread" and in the long-term, the economic value of the bank. Most of the liabilities of banks, like deposits and borrowings are on fixed interest rate basis while their assets like loans and advances are on floating rate basis.
There is still some regulation in place on interest rates in the system, such as savings bank deposit, export credit, refinances, etc. There is no definite interest rate repricing dates for floating Prime Lending Rate PLR based products like loans and advances, thereby placing them in accurate time buckets for measurement of interest rate risk difficult. The RBI has taken a number of measures to correct the systemic rigidities, like introduction of:.
For pricing of rupee interest rate derivatives, banks have been allowed to use interest rate implied in foreign exchange forward market, etc. Now, the entire investment portfolio is required to be classified under three categories, viz.
The Reserve Bank of India has prescribed 2. It may be mentioned here that the Basle Committee on Banking Supervision BCBS of the Bank for International Settlements BIS has introduced capital charge for market risk, inter alia, for the interest rate related instruments and equity positions in the trading book and gold and forex position in both trading and banking books.
FX Risk Tool | Oxford Economics
The banks in India are required to apply the 2. In the "New Capital Adequacy Framework" consultative paper, the BCBS recognises the significance of interest rate risk in some banking books and proposes to develop a capital charge for interest rate risk in the banking book for banks where interest rate risks are significantly above average "outliers". The proposed Basel Capital Accord is separately covered in Chapter 7 and annexure. Internationally banks use VaR models for management of equity position risk.
Market risk
The banks should devise specific price risk structure like sensitivity limits, VAR, stop-loss limits and the methods to measure liquidity of shares to mitigate equity position risk. 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. 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. 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. 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.
This occurs because Euro-prices for the exports might adjust to reflect world market prices which could be determined in U. 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.
Its net exposure, or position, completely encapsulates the measure of its exposure to forex risk. The first and most important of these is the covered interest parity relationship. 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. This brings in typical complications to forward hedging which must be taken into account. 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.
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. 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. 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.
Risk of Two Cash Positions
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. 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.
8.5.2 Specific Portfolio
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.
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.
- type of forex transactions?
- Risk of a Single Position!
- About the FX Risk Tool.
- binomo binary option nedir.
- forex trading crash course?
- Using VAR to Lower Risk.
- Market risk | European Banking Authority.
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 option s permit the holder to exercise at any time before the expiration date; European options , only on the expiration date. 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.