The business of foreign exchange dealing is confronted with multiple numbers of risks viz. Rate risk, Open Position risk, Maturity Mismatches risk, overtrading risk, Cash Balance Risk, Counterparty risk, Country risk, Fraud Risk, and so on. Nevertheless, like in any other business, risk taking in forex dealing is also inevitable as it also presents possibilities of a rewarding result. Let’s examine here how various types of risks arise in the foreign exchange dealings.
The foreign exchange rate risk arises when the financial instruments held in foreign currency. The value of foreign currency asset changes as and when the exchange rate of that foreign currency fluctuates. In certain events, the bank may lose money on its large foreign currency assets if the value of foreign currency asset depreciates in relation to domestic currency.
Open Position Risk:
The open position risk or the position risk refers to the risk of loss due to change in exchange rates affecting the overbought or oversold position in foreign currency held. The open position risk usually arises when the dealing room could not obtain reports of all purchases made by the branches in time. It may also occur when the bank is not able to carry out the cover operation in the interbank market or when the dealer deliberately keep the currency position beyond the fixed limit with the expectation that the concerned foreign currency would strengthen.
Maturity mismatches risk:
Maturity Mismatches Risk or gap risk (also known as liquidity risk) arises when the maturity period of forward purchase and sales of a foreign currency do not match each other. This situation normally arises in forward contract transactions where the customer exercise his option on any day during the month that does not match with the option under the cover contract with the market with maturity towards the month end. Such mismatch also takes place in the interbank contracts, where the buyer bank may pick up the contract on any day during the option period. Another possibility is non-availability of matching forward cover in the market for the volume and maturity desired. In certain cases, the aggregate of small value of merchant contracts may not match to the round sums for which cover contracts are available. It may be deliberate action of creating mismatch to minimize swap costs or to take advantage of changes in interest differential or the large swings in the demand for spot and near forward currencies.
If a bank indulges in a large volume of transactions which is beyond its administrative and financial capacity, then it is called overtrading. The bank indulged in such overtrading or speculative trading in anticipation of large profit in the transaction may incur huge loss. A prudent bank would avoid overtrading irrespective of its assessment of appreciation of a specific currency in the nearest future. Another risk is that once the other operators in the market come to know that the counterparty limit for a particular bank is exceeded, they would quote at higher premium for further transactions as they know that the counterparty is in dire need of a specific currency. In such events, expenses may increase at a faster rate than the earnings. The tendency of overtrading by a dealer can be curtailed, by the Risk Management Committee of a bank, by fixing a limit on the total value of all outstanding forward contracts; and a limit on the daily transaction value for all currencies together (turnover limit).
Cash Balance Risk:
Cash balance of foreign currency means actual balances of foreign currencies maintained in the Nostro accounts of the bank at the end-of each day. Similar to domestic current accounts maintained by a customer in the commercial banks, balances in Nostro accounts do not earn interest. Butr, any overdraft in the account implicates payment of interest. Therefore, thumb rule is to keep the minimum required balance in the Nostro accounts which is not possible in view of delay in communication of all purchases and sales made by the branches.
The counterparty risks (also known as default risks) arise in the transactions of derivatives trading which take place between two parties’ under prior agreement with set of terms and conditions. The parties involved in the trading are referred as counter- parties (viz. buyer and seller). The counterparty risk is linked with inability or unwillingness of a customer or counterparty to meet his commitments relating to trading, hedging, settlement and other financial transactions under the agreement.
Country risk refers to the risk when a country freezes outflow of its foreign currency. This would result into dishonor of all financial commitments of that country in foreign currency. The events of dishonor of financial commitments would cause the cascading effect on performance of other instruments like stocks, bonds, mutual funds, options and futures issued in that country. Thus, the investments made from other countries are exposed to transfer or conversion risk and thereby affects the value of assets.
Political risk refers to the abrupt change of investment policies of a sovereign state or the foreign policy decision of a country which harms the investments made from other countries.( Ex: The people of Britain voted for a British exit, or Brexit, from the EU in a historic referendum on June 23, 2016, which had a traumatic effect on Sterling Pounds and other currencies).
The term ‘fraud risk’ does not have a universal definition. However, in banking terms ‘fraud risk’ means the risk of the criminal conduct of a party that involves the use of dishonest or deceitful means to make a personal gain and make the loss to the bank. The fraud incidences are increasing in general and in foreign exchange portfolios in particular. It is common knowledge that many dealers try to conceal their earlier mistake which result into loss to the bank. There are cases where the dealers or other operational staff in the dealing room undertaking unnecessary deals to pass on brokerage for a kickback , sharing benefits by quoting overly better rate to customers for personal gain. With a view to avoid frauds in dealing room some of the measures taken by banks are separation of dealing form back-up and accounting functions, regular follow-up of deal slips and contract confirmations, scrutiny of branch reports and pipe line transactions etc. Besides, they need to maintain up-to date records of currency position, exchange position and counterparty registers, etc.