Chapter No.

2
Risk management And basics of Derivatives

Definition of Risk
Risk is unplanned event with financial consequencies resulting in loss or reduced earnings. One can not escape from risk in forex market.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

Exchange Risk
Exchange Risk - Arising on account of
fluctuations in exchange rates and / or when mismatches 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.

Pre-Settlement risk
1) Pre settlement risk is the risk of failure of the counter party, due to bankcruptcy,closure or any other reason, before maturity of the contract thereby compelling the bank to cover the contract at the ongoing market rates. 2) This entails the risk of market differences and not an absolute loss for the bank. Example :- forward contract

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,

 Very high in case of countries which are facing problembs related with foreign exchange reserves, balance of payments,management of resources, liquidity ETC. In country risk,counter party is willing to make payment but local laws and directives force the party not to make the payment. Example: banned on cotton,banned countries Country risk is generally controlled by fixing countrywise exposure limit.

Country Risk

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.

Interest rate Risk

Gap Risk / Interest Rate Risk Bank buys and sells
currencies for spot and forward value. It may not be possible for the bank to match its forward purchase and sales and when it takes place for different value the bank may completely stand hedged on exchange front thus creating a mismatch between its assets and liabilities referred to as GAP. Bank fills in these gaps by paying / receiving appropriate forward differentials which in turn are a function of interest rates and any adverse movement in interest rates would result in adverse movement of forward differentials thus affecting the cash flows on the underlying open gaps or mismatches.

Liquidity Risk
Liquidity Risk Potential for liabilities to drain from the bank at a faster rate than assets. Mismatches in the maturity patterns of assets and liabilities give rise to liquidity risk. This risk arises when a party to Forex transaction is unable to meet its funding requirements or execute a transaction at a reasonable price.

Management of risk and guidelines on risk management

Risk management is a process that focusing upon step to contain or avoid risks and losses therefrom. The sound risk management process starts with
a detailed policy A specific limit structure A sound management information system Specific Control,monitoring and reporting process.

Foreign Exchange Exposures

Transaction Exposure Arises due to normal business
operations consequent to which the value of transactions will be affected by the transactions undertaken Translation Exposure Arises when firms have to revalue their assets and liabilities or receivables and payables in home currency at the end of each accounting period. Also pertinent during consolidating the accounts of all foreign operations. Loss or Gains are notional Operating Exposure This affects the bottom line of the firm / Company due to other external factors in the market / economy like changes in competition (Domestic / International), reduction in import duty, reduction in prices by other country exporters effecting exports, increase in import duty by other country trade tariff etc. leading to reduction in exports etc.

Guidelines on Risk Management

Overnight Limits Maximum amount of open
position or exposure a bank can keep overnight when markets in its time zone are closed Daylight Limit Maximum amount of open position the bank can expose itself at any time during the day to meet customers needs 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

Guidelines on Risk Management

contd

Country Risk Maximum exposure on a single country Dealer Limits Maximum amount a dealer can keep exposure during the operating hours Stop Loss Limit Maximum movement of rates Settlement Risk Maximum amount of
exposure to any entity, maturing on a singly day Deal Size Limit Highest amount for which a deal can be entered. The limits is fixed to restrict the operational risk on large deals

against the position held, which would trigger the limit or say maximum loss limit for adverse movement of rates

What are the derivatives

The derivates derive their value from underlying securities. The underlying securities can be A) Foreign Exchange B) Agriculture product C) Interest rate D) Stock and shares E) Financial insruments

 Hedgers,speculators,arbitrages helped the derivatives market to get depth and volume. The objective to use derivatives A) To reduce the exposure of the underlying contract. B) To neutralize the exposures of the underlying contract C) To hedge against uncertain movements of the prices of underlying contracts. Derivatives can be exchange traded or over the counter contract.

Types Of Derivatives

Forward Contract Futures Options Swaps

Forward Contract
A derivatives product in which the seller agrees to deliver goods to buyer on some future date at a fixed rate is called forward contract. Under a forward contract the risk of any adverse price movement of future is removed or covered because rate is fixed at the time of contract. Forward contract= Spot price + premium (Discount) A currency with lower interest rate would be at a Premium and currency with high interest rate would be at discount in future.

 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 the buyer and seller by way of keeping margin which is adjusted Each Day. The buyer and seller can set Off the future contract by packing the difference amount at the current rate of the underlying due to which delivery is not must.

Future Contract

Margin
The future contract are essentially magin based. Three types of margin are there. Initial Margin:- at the start of each new contract initial margin is to be paid in form of cash or another approved liquid securities. Variable margin:-it is calculated on daily basis, by marking to market the contract at the end of each day the margin is normally deposited in cash only. Maintenance Margin:-This margin is similar to minimum balance stipulation for undertaking and trades in the exchange and has to be maintained by the buyer and seller in the margin account with the seller.

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 requirement and 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.

Swaps
A transaction in foreign exchange where one currency is sold and purchased for another currencies simultaneously is called swap.