Click here to load reader
Upload
m-s-ahluwalia
View
4.495
Download
2
Embed Size (px)
DESCRIPTION
CAIIB Super Notes: If you are preparing for CAIIB- these are a must-have. Visit http://sirfbusiness.blogspot.com for more info.
Citation preview
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Basics of Forex Derivatives
Module A: International Banking
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
CAIIB – SUPER NOTES
Bank Financial Management: Basics of Forex Derivatives
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Contents
Coverage:
1. Introduction
2. Definition of Risk and Risks
in ForEx Operations
3. Management of Risk and
associated guidelines
4. Derivatives – History and
Development
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
INTRODUCTION
1.
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Derivatives
• A Financial contract whose value is derived from or depends
on the price of some underlying asset
• Value of derivative changes when there is a change in the
price of the underlying related asset
• Types: Forwards, Futures, Options, Swaps
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
DEFINITION OF RISK AND RISKS IN FOREX OPERATIONS
2.
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Risk
• An unplanned event with financial consequences resulting in
loss or reduced earnings
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Risks in ForEx Operations
Exchange Risk Exchange Risk Settlement
Risk Settlement
Risk Liquidity Risk Liquidity Risk
Country Risk/Sovereign
Risk
Country Risk/Sovereign
Risk
Interest Rate Risk
Interest Rate Risk
Operational Risk
Operational Risk
Legal Risk Legal Risk
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Exchange Risk
• Change in value of our foreign exchange holdings due to
movement in exchange rates
• Controlled by prescribing limits: Daylight and overnight, Single
Deal- Trading Position and Volume, Overall overnight position,
Stop Loss, gap-forward mismatch limit etc.
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
3 Types of For Ex Exposure
Transaction Exposure
Transaction Exposure
• Transactions that may expose the company/firm to currency risk
Translation Exposure
Translation Exposure
• Revaluation of the asset and liabilities or receivables and payables into a different currency
• Notional in nature
Operating Exposure Operating Exposure
• External factors in the market/economy that may harm the bottom line
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Settlement Risk
• Credit risk in ForEx operations is the risk of failure of a counterparty to meet
obligation at maturity of the contract
• Two Types:
– Pre settlement Risk: Failure of the counterparty before maturity of the contract.
• Entails risk of only market differences and is not an absolute loss for the bank
– Settlement Risk: Failure of the counterparty during course of settlement.
• Entails complete risk and loss for the bank
• Principal risk in settlement also known as Foreign Exchange Settlement Risk,
Temporal Risk and Herstatt Risk
• Controlled by applying credit lines and daily delivery limits for each bank
• Can be eliminated by Worldwide Realtime Gross Settlement System
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Liquidity Risk
• Unable to meet its funding requirement or execute a
transaction at a reasonable price
• Not being able to exit or offset positions quickly at a
reasonable price
• Controlled by
– Fixing limits for maturity mismatches
– Reduction of open positions
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Country Risk/Sovereign Risk
• Foreign entity or a counterparty private or sovereign may be unwilling or
unable to fulfill its obligations for reasons other than the usual reasons or
risks which arise in relation to all lending and investment
• Considered very high in case of countries which are facing problems
related to foreign exchange reserves, balance of payments, management
of resources, liquidity etc
• Controlled by
– fixing counterparty exposure limits
– inserting disclaimer clauses in documentation and
– making the contracts and sovereign counterparties subject to a third country
jurisdiction
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Interest Rate Risk
• Also known as GAP risk
• Arises due to adverse movement of interest rates or interest
rate differentials
• Gaps are to be filled by the bank by paying/receiving
appropriate forward differentials or resorting to other interest
rate derivatives
• Individual and aggregate limits are fixed for the international
banking operations
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Operational Risk
• Due to deficiencies in information systems or internal control
or human errors or other infrastructure problems that could
lead to unexpected losses
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Legal Risk
• Counterparty does not have legal or regulatory authority to
enter into a transaction
• Compliance and Regulations related risks
• Result in non-enforceability of contract
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
MANAGEMENT OF RISK AND ASSOCIATED GUIDELINES
3.
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Risk Management
• Process focusing upon steps to contain or avoid risks and losses there from
• Depends upon the risk appetite, expected rewards and the risk portfolio held
• Starts with detailed policy, specific limit structure for various risks and
operations, a sound management information system, and specified control,
monitoring and reporting process
• Policy for management of various risks being faced, or expected to be faced by
the bank. Also specifies limits for various types of trades, functions as also
upper limits for exposures
• Policy framework should cover the goals and objectives, delegation of
responsibilities, activities to be undertaken and level of acceptable risks,
besides the authority to undertake such functions and system for review
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Guidelines
• RBI has issued internal control guidelines (ICG) for ForEx business
• The dealing limits specified under ICG are given later
• Besides the limits, banks approve panel of brokers through whom
deals could be undertaken, the currencies in which the
bank/dealers would deal in, Value of Risk Limit, Nostro Balances
limit, Overdraft limit etc.
• Master circular on Risk Management and Interbank Dealings by RBI
specifies the risk management facilities that are available to
residents and non-residents to hedge their forex exposures
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Dealing Limits specified under ICG
•Maximum amount of open position or exposure when markets in the bank’s time zone are closed
Overnight Limit Overnight Limit
•Maximum amount of open position or exposure during the day
Daylight Limit Daylight Limit
•Maximum inter period/ month exposures which a bank can keep
Gap Limits Gap Limits
•Maximum exposure to a particular counterparty
Counterparty Limit Counterparty Limit
•Maximum exposure on a single country
Country Risk Country Risk
•Maximum exposure a dealer can take during the operating hours
Dealer Limits Dealer Limits
•Maximum movement of rates against the position held
Stop Loss Limit Stop Loss Limit
•Maximum amount of exposure to any entity, maturing on a single day
Settlement Limit Settlement Limit
•Highest amount for which a deal can be entered
Deal size Limit Deal size Limit
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Mitigation of Settlement Risk – Indian Scenario
• In India CCIL – Clearing Corporation of India Limited takes over the
settlement risk
• Settlement Guarantee Fund(SGF) is a large pool of resources created by
CCIL for this purpose
• Both counterparties should be members of CCIL in the related segments
• CCIL undertakes clearing and settlement in Repos, CBLOs, Gilts and inter
bank Forex deals.
• It handles USD/INR deal settlement with netted amounts being
paid/received to/from the participant banks
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
DERIVATIVES – HISTORY AND DEVELOPMENT
4.
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
History and Development
• Futures and options in use for hundreds of years:
– High sea cargoes bought and sold in future prices
– Rice produce sold for future delivery by Japanese farmers
• Explosion of the market coincided with collapse of the Bretton Woods
fixed Exchange Rate Regime as it increased volatility in exchange rates and
interest rates
• Early 1970s, Chicago Mercantile Exchange: World’s first exchange traded
currency future contract
• 1975: First interest rate future. Several exchanges thereafter introduced
exchange rate and interest rate future contracts
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
History and Development
• 1983, Philadelphia Stock Exchange: Currency options
• Early 1980s: Interest Rate Swaps
• Mid 1980s: Boost in the derivatives market with a host of exchange
rate, interest rate as also commodity price derivative tools/products
being traded in various exchanges
• Initially hedgers were the primary users
• Gradually, speculators joined in giving depth and volume to the
derivatives markets
• Arbitrageurs also joined in
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Reasons for Growth
• Increased volatility in financial and commodity assets during 1970
and 1980s followed by the oil shocks in 1971
• Need to insulate exchange risk for incomes in different currencies
• Technological advancements
• Development of pricing models and instruments
• Political Developments
• Increasing professionalism amongst market participants
CAIIB – Super-Notes © M S Ahluwalia Sirf Business
Do you have any questions or queries or some feedback to give?
Just mark an email to [email protected]
CAIIB – Super-Notes © M S Ahluwalia Sirf Business For more Super-Notes: Click Here
M S Ahluwalia, amongst other things, is a visual artist, blogger,
blog designer and of course an MBA and Banker from New
Delhi, India.
To know more about him you may visit his blog-site: Estudiante De La Vida