International Banking (Module A)

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International Banking (Module A) Part II

• Risk Management and Derivatives
• Tanushree Mazumdar, IIBF

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Dealing room (1)

• Foreign exchange dealing room operations comprise
  functions of a service branch to meet the needs
  of other branches/divisions to buy/sell foreign
  currency.
• Acts as a profit centre for the bank/financial
  institution
• A dealer has to maintain two positions- funds
  position and currency position

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Dealing room (2)

• The funds position reflects inflows and outflows
  of funds i.e. receivables and payables
• A mismatch in funds position will throw open
  interest rate risks in the form of overdraft
  interest in the Nostro a/c, loss of interest
  income on credit balances, etc.
• Currency position deals with overbought and
  oversold positions, arrived after taking various
  merchant or inter-bank transactions and the
  dealer is concerned with the overall net position

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Dealing room (3)

• The overall net position exposes the dealer to
  exchange risks from market movements
• The dealer has to operate within the permitted
  limits prescribed for the exchange position by
  the management
• Back office Takes care of processing deals,
  accounts reconciliation. It plays a supportive as
  well as checking role
• Mid office Mid-office deals with the risk
  management and parameterisation of risks for
  forex operations. Gives market information to
  dealers

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Risks in foreign exchange dealings

• RBI and FEDAI issue guidelines to all banks to
  identify, measure and manage risks
• Risks can be classified under
• Market risk Loss arising out of change in the
  market price of an asset
• Liquidity risk risk that you will not be able to
  easily sell your assets

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Risks(contd)

• Operational risk Failure of internal processes,
  people, systems or external events
• Legal risk Contracts are not legally enforceable
  or documented incorrectly
• Credit risk Counterparty defaulting in payment
• Pre-settlement Credit risk before the maturity
  of a transaction
• Settlement risk Timing differences in cash
  flows, e.g. of Herstatt Bank in Germany failing
  in 1974

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Risks (3)

• Country risk Movement of funds across borders
  may be obstructed by sudden government controls
• Interest rate risk Interest rate risk or gap
  risk arises out of adverse movement of interest
  rates a bank faces on its currency swaps/forward
  contracts or other interest rate derivatives

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Management of risks

• Traditional measures adopted by bank managements
  to manage/limit risks are
• Limits on intra-day open position in each
  currency
• Limits on overnight open positions in each
  currency (lower than intra-day)
• Limits on aggregate open position for all
  currencies
• A turnover limit on daily transaction volume for
  all currencies
• Countrywise exposure limits

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Guidelines on risk management

• Measure risks that can be quantified viz.,
  exchange rate risk, interest rate risk using
  mathematical or statistical tools
• Have a detailed policy on risk management (given
  by the Board)
• A specific limit structure for various risks and
  operations
• A sound management information system
• Specified control, monitoring and reporting system

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RBI guidelines on risk management

• RBI has issued internal control guidelines (ICG)
  for foreign exchange business
• It covers various aspects of dealing room
  operations, code of conduct for dealers and
  brokers and other aspects of risk control
  guidelines
• Specifies limits including gap limits,
  counterparty limit, dealer limit, deal size
  limit, etc.

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Derivative Instruments

• Derivatives are management tools derived from
  underlying exposures such as currency,
  commodities, shares, etc.
• Used to neutralise the exposures on the
  underlying contracts
• Can be over the counter (OTC) i.e. customised
  products or exchange traded which are
  standardized in terms of quantity, quality, start
  and ending dates

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Forward Contracts (1)

• Forward contracts Typical OTC derivatives which
  involves fixing of rates (exchange rate,
  commodity price, etc.) in advance for delivery in
  future. Risk of adverse price movement is
  covered.
• Forward contracts are specified at forward rates
  which are spot rates plus cost of carry (interest
  rate differential in case of foreign exchange
  forward)

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Forward Contract (2)

• Forward rate spot rate premium or discount
• Premium/discount function of cost of carry
  (interest rate differential)
• The currency with lower interest rate would be at
  a premium in future
• Other factors affecting forward rate
• Demand and supply for forward currency
• Perception about the movement in the currency
• Political, fiscal and trade-related conditions in
  the country and for the currency

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Example of a forward differential

• If GBP/USD Spot 1.8000
• 6 months interest rate USD 2
• 6 months interest rate GBP 4
• Forward differential
• 1.8000 (4-2)/100 6/12 or 0.018
• 6 months forward rate (GBP/USD) 1.7820
• Since USD has a lower interest rate it will be at
  a premium in the future

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Futures (1)

• Futures A version of exchange traded forward
  contracts.
• Standardized contracts as far as the quantity
  (amounts) and delivery dates (period) of the
  contracts.
• Conveys an agreement to buy a specific amount of
  commodity or financial instruments at a
  particular price on a stipulated future date
• An obligation on the buyer to purchase the
  underlying instrument and the seller to sell it

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Futures (2)

• Types of Futures contracts
• Commodities futures
• Financial futures
• Currency futures
• Index futures
• There is a margin process
• Initial margin to be paid at the start of a
  contract
• Variable margin calculated daily by marking to
  market the contract at the end of each day
• Maintenance margin Similar to minimum balance
  for undertaking trades in the Exchange and has to
  be maintained by the buyer/seller in the margin
  account

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Options (1)

• Options An agreement between two parties in
  which one grants the other the right to buy
  (call option) or sell (put option) an asset
  under specified conditions (price, time) and
  assumes the obligation to sell or buy it.
• The party who has the right but not the
  obligation is the buyer of the option and pays
  a fee or premium to the writer or seller of
  the option.
• The asset could be a currency, bond, share,
  commodity or futures contract

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Options (2)

• The option holder or buyer would exercise the
  option (buy or sell) in case the market price
  moves adversely and would let it lapse if it
  moves favourably
• The option seller (usually a bank or a financial
  institution or an Exchange) is under obligation
  to deliver the contract if exercised at the
  agreed price
• Strike price/exercise price The price at which
  the option may be exercised and the underlying
  asset bought or sold

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Options (3)

• In the money When the strike price is below the
  spot price (in case of a call option) or
  vice-versa in case of a put option the option is
  in the money giving gain to the buyer.
• At the money When strike price is equal to the
  spot price
• Out of the money The strike price is above the
  spot price (call option) or vice-versa (for a put
  option). It is better to let the option lapse
  here.

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Options (4)

• Call option- The right, without the obligation,
  to buy an asset
• Put option- The right, without the obligation, to
  sell an asset
• American option- An option that can be exercised
  at any time until the expiry date
• European option- An option which can be exercised
  only on expiry
• Bermudan option- An option which is exercisable
  only during a pre-defined portion of its life

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Options (5)

• Expiry The last date on which the option may be
  exercised.
• Market participants often quote an expiration
  (calendar) month without specifying an actual
  date.
• In such cases it is understood that the
  expiration date is the Monday before the third
  Wednesday of the month
• Expiration time is usually specified in the
  contract. For example, for contracts entered in
  the Pacific Rim countries the time specified is
  1000 am New York time or 300 pm Tokyo time

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Swaps

• In foreign exchange market, swap refers to
  simultaneous sale and purchase of one currency
  for another (currency swap).
• Financial or derivative swap refers to the
  exchange of two streams of cash flows over a
  defined period of time, between two
  counter-parties

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Derivatives in India (1)

• Sodhani Committee (expert group on foreign
  exchange) was formed in 1992 to look into the
  issues in and development of the foreign exchange
  market in India
• Some recommendations
• Corporates should be allowed to hedge upon
  declaration of underlying assets
• Banks may be permitted to initiate overseas cross
  currency positions

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Sodhani Committee..

• Banks should be allowed to borrow and lend in the
  overseas markets
• More participants be allowed in the foreign
  exchange market
• Corporates must be allowed to cancel and re-book
  option contracts
• Banks be permitted to use hedging instruments for
  their own ALM
• Banks to be allowed to fix interest rates on FCNR
  (B) deposits subject to caps fixed by RBI

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Derivatives in India (2)

• The use of financial derivatives started in India
  is the nineties in the foreign exchange and
  stock market
• In 1992 RBI had permitted banks to offer cross
  currency options to their clients
• In 1996 banks were allowed to offer their
  corporate clients interest rate swaps, currency
  swaps, interest rate options and forward rate
  agreements
• The derivatives market in India is still in an
  evolving stage