Question

how does foreign exchange risk arise for an FI?

Answer 1

Foregin exchange risk is a matter of concern for every entity.Let me tell you how Financial institutions are bothered of such risks.

Exchange risk for banks emanates from their activities relating to currency trading,management of risks for their clients as also the risks of their own balance sheet and operations. Broadly, we can classify these risks in four categories :

(1) Exchange rate risk,

(2) Credit risk,

(3) Liquidity risk, and

(4) Operational risk.

Exchange Rate Risk

Exchange rate risk relates to appreciation or depreciation of currencies. Every hank that has a long position in a currency, runs a risk of loss if that currency depreciates. Like-wise, any bank that has short position in a currency, runs the risk of loss if that currency appreciates. The risk can result from the mismatch of amounts of assets and liabilities as well as from the mismatch of maturity dates of the assets and liabilities.

When an exchange dealer of a bank takes a position in a currency, he does so on the assumption that the currency is going to evolve in his favour. The currency, however, may move in the opposite direction resulting in a loss. In addition, the dealer also runs the risk of interest rate changes. If, for- example, the position taken by the dealer is financed by a loan which needs to be renegotiated during the period of the position, the dealer is exposed to a risk, as the interest rate of the borrowed currency may increase. That is why limits are prescribed by the banks on the total position as well as on the position per currency. These limits depend on the financial situation of the bank and on its reading of the ensuing risk. Likewise, the position of a dealer should be closed if he has already suffered a certain amount of loss.

Credit Risk

The second category of risks that banks are exposed to is credit risk. This risk arises from the possibility of a counterparty making a default. This risk may appear either during the period of contract or at the maturity date. It can be reduced by fixing the limits of operations per client, based on the creditworthiness of the client, by incorporating the clauses for rescinding the contract if the rating of a counterparty goes down.

Liquidity Risk

This is the risk of refinancing. It may happen when a dealer has placed funds for a period longer than that of the deposits that finance this placement. At the time of refinancing, the interest rate may go up, resulting in a loss for the dealer. Likewise, in a reverse situation, the dealer may increase his profits.

Operational Risk

This risk is related to the operations of the bank. The bank may be able to limit this type of risk by precisely identifying the problems: definition of responsibilities, reporting, accountability for operations and so on.

Need for Covering Exchange Risks

If exchange risk is not covered, it may result in significant losses for the enterprise, m the event of wide variations of exchange rates. Covering against exchange risk reduces the variability of cashflows and of financial results.The basic principle behind covering a risk is that the enterprise or financial institution that covers itself, compensates for the potential loss that it is likely to suffer by the gains resulting from covering the risk.