Foreign exchange rate risk
Foreign exchange rate risk is the potential impact of adverse currency rate movements on earnings and economic value. This involves settlement risk which arises when a banking institution incurs financial loss due to foreign exchange positions taken in both the trading and banking books.
Foreign exchange positions and subsequent risk arise from the following activities:
● trading in foreign currencies through spot, forward and option transactions as a market maker or position taker, including the unhedged positions arising from customer-driven foreign exchange transactions;
● holding foreign currency positions in the banking book (e.g. in the form of loans, bonds, deposits or cross-border investments); or
●engaging in derivative transactions (e.g. structured notes, synthetic investments and structured deposits) that are denominated in foreign currency for trading or hedging purposes.
Foreign exchange risk identification and measurement:
Foreign exchange rate risk exposures fall into the following structural and trading categories: ● Translation exposure: which arises from accounting based changes in consolidated financial statements caused by changes in exchange rates; ● Transaction exposure: which occurs when exchange rates change between the time that an obligation is incurred and the time it is settled, thus affecting actual cash flows; and
Banking institutions should conduct stress tests on their foreign currency positions. The stress tests for exchange rate risk assess the impact of changes in exchange rates on the profitability and economic value of a banking institution’s equity. The effects of significant exchange rate movements, including sharp reductions in liquidity, of individual currencies should be considered when setting stress scenarios.
To understand translation and transactional risk better an emphasis has been made on SBM dealings. SBM exercises strict control over its transactional foreign currency exposures by setting conservative prudential limits over its foreign currency exposures. The Treasury Division of SBM effectively monitors open positions of individual currencies to gauge foreign exchange risk. In addition, the aggregate forward gap limit is closely monitored with a view to prevent future loss out of foreign exchange, interest rate and liquidity risks. SBM’s investments in overseas operations create capital resources denominated in foreign currency. Changes in the value of the investments due to currency movements are captured in the currency translation reserve, resulting in movement in capital.
Foreign exchange risk management
In order to manage foreign currency exposures, the Treasury dealers of Banks operate within regulatory limits as prescribed by the BOM and also within more conservative prudential limits approved by the Board including the intraday/overnight open position limits, deal size limit, and stop losses limits.
At SBM as an example, independent of the Treasury Front Office, the Middle Office closely examines foreign exchange exposure taken by the Front Office by robust measurement techniques, limit monitoring, daily reporting and oversight. Excesses and deviations from approved limits are reported to the Head of Risk Management, Chief Executive, monthly to the Market Risk Forum and to the Board Risk Management Committee on quarterly basis.
Banks also use Value-at-Risk (VaR) to quantify the potential loss arising from adverse foreign exchange movements under normal market conditions. Value at Risk (VaR) is a method of assessing the market risk using standard statistical techniques. It is a statistical measure of risk exposure and measures the worst expected loss over a given time interval under normal market conditions at a given confidence level of say 95% or 99%. Thus VaR is simply a distribution of probable outcome of future losses that may occur on
a portfolio. The actual result will not be known until the event takes place.
At SBM for instance, stress testing conducted captures the Bank’s exposure to unlikely but plausible events in abnormal market conditions, while VaR reflects the potential losses in a normal market environment. The methodology used to calculate VaR is based on historical data and assumes that historical changes in market values are representative of future movements. The VaR is based on data for the previous twelve months. SBM calculates VaR using a ten days holding period and based on a 99% one-tailed confidence interval; this implies that only once in every 100 trading days, SBM would expect to incur losses greater than the VaR estimates, or about two to three times a year. The methodology of SBM to use ten days holding period and a one year historical observation period are in line with Basel II recommendations on quantitative standards for market risk measurement.
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