Question

How does market risk due to currency fluctuation affects a bank? What are 3 plans to mitigate this risk in the bank?

Answer 1

Market Risk or systematic risk arises due to the overall market conditions like political unstability, recession, change in interest rates etc.
Banks generally have good amount of collaterals situated in different location(considering the worldwide presence of the Bank) for this reason Banks get into Currency market to offset(hedge) their risks.So, banks participate in the currency markets not only to offset their own foreign exchange risks and that of their clients, but also to increase wealth of their stock holders. Each bank has a dealing desk responsible for order execution, market making and risk management. The role of the foreign exchange dealing desk can also be to make profits trading currency directly through hedging, arbitrage or a different array of strategies.
   So suppose if a Bank has USD 200000 in foregin reserves and the US Fed decides to slash down the interest rate.Accounting to the lower interest rates now Banks from all over the countries would look for countries with better interest rate to invest inturn depreciating the US dollar value.The depreciation in the dollar value will lower the investment amount made by the Bank so now USD 200000 investment made is worth only USD 195000 to avoid this Banks hedge this risk using different methods.

3 plans to mitigate Risk:
1) Hedge with specialized Exchanged Traded Funds(ETFs): Currency ETFs are designed to track the performance of a single currency in the foreign exchange market against the US dollar or a basket of currencies. This is accomplished by multiple methods like cash deposits, short-term debt denominated in a currency, and future or swap contracts.

2) Currency Forward Contracts: Currency forward contracts are another option to mitigate currency risk. A forward contract is an agreement between two parties to buy or sell a specific asset on a specific future date, at a specific price. For hedging purposes, they enable an investor to lock in a specific currency exchange rate.

3) Currency Options: Currency options give the investor the right, but not the obligation, to buy or sell a currency at a specific rate on or before a specific date. They are similar to forward contracts, but the investor is not forced to engage in the transaction when the contract's expiration date arrives.