StudyDriver in your
Smartphone!

# Foreign Exchange Risk in Banks

### Objective of the Project:-

The objective of this project is to understand the various types of foreign exchange risks. And the potential impact of the foreign exchange risks on the institutions involved in foreign exchange trading.

### Background:-

In this project, I have calculated the value of risk involved in foreign exchange transactions at United Bank of India.

### Methodology:-

The data used in this project is obtained from secondary research. Historical method is used to calculate the Value at Risk (VaR). The Value at Risk is thus calculated is used to find the actual amount at risk in terms of INR.

### Findings and Conclusion:-

By finding the total risk, we get to know the total amount that the organization can lose in the worst possible scenario. It happens if the allocation of fund is not based upon the possible value at risks. In carrying out this project, I have found that the bank has allocated more funds for its forex operations than required.

### Recommendations:-

At present the bank is operating at the 99% confidence level to calculate the value at risk. As they are working at 99% confidence level, due to this they need to employ more capital for their forex operations. United Bank of India should operate at 95% confidence level. This will help them cut down funds employed for their forex operations.

### Introduction to Foreign Exchange

The creator of the universe has not distributed resources needed by the civilised world evenly on our planet earth. What is available easily at one place is hardly available at another place. This has resulted in an environment of interdependency among the countries. The interdependency among countries has given rise to international trade. The growth of international trade of goods and services has necessitated a method of exchange. Let us evaluate a transaction involving supply of goods from India to United Kingdom. The value of goods is known to the Indian supplier in INR. Thus the Indian supplier will price the goods so that he can make profit in INR. At the same time the purchasing power available with the UK customer is in GBP (Great Britain Pound). Therefore the customer will want to know the price in GBP. Now, if buyer and seller decide to settle the transaction in USD. Therefore to complete such transactions, the parties to the transaction need to know the value of one currency in terms of another. This mechanism of converting one currency in terms of another is known as “Foreign Exchange”. Foreign Exchange is defined in Foreign Exchange management Act 1999 as:- Ø All deposits, credits, balances payable in any foreign currency and any drafts, travellers cheque, letter of credit and bill of exchange expressed or drawn in Indian currency and payable in foreign currency. Ø Any instrument payable at the option of the drawee or holder thereof or any other party thereto, either in Indian currency or in foreign currency or partly in one and partly in the other. In short, Foreign Exchange is the method of conversion of one currency into another. As foreign currency is treated as a commodity, it is traded in a market. Trade constitutes a small portion of the “Foreign Exchange Market”. The cross border movement of capital forms the major portion. Major participants of Foreign Exchange Market include commercial banks, central banking institutions, investment banks, foreign exchange brokers and merchants. The commercial banks become the vehicles for conversion, as most of the foreign exchange operation takes place through the account maintained with these banks. Objective of the Project

### A Project Report on FOREIGN EXCHANGE risks in Bank.

Foreign Exchange is a very large financial market. At times foreign exchange market becomes very volatile. This is responsible for the various risks in foreign exchange market. Everyone involved in the foreign exchange trading should we aware of foreign exchange risk. To ascertain Foreign Exchange risk in Bank we need to execute the following tasks:-

• Various types of foreign exchange services available at Banks.
• The various types of foreign exchange risks.
• The various foreign currencies which has significant demand.
• The possible Hedging strategies that can be deployed to manage foreign exchange risks.
• Determination of Value at Risk (Var).

Research Methodology

• Data / Information Collection.
• Study of data collected to calculate the value at risk (VAR).
• Calculation of mean return.
• Calculation of Standard Deviation.

### Data/Information Collection

Data and information is collected from the various sources. These sources include data from the Bank, magazines, journals, books and newspapers. The information thus collected is used to calculate the Value at Risk.

### Value at risk (VaR)

Risk is about odds of losing money and VaR is based on that common sense fact. Here risk is the odds of really big loss. Big loss is different for every investor depending on the investor’s appetite. But every investor whether big or small does wants to know his/her losses in the worst case. VAR answers the question, “What is my worst-case scenario?” To calculate VaR we need three components. These three components are: a time period, a confidence level and a loss amount or loss percentage. Using VaR investor will get to know things like:

• What is the most I can expect to lose with 95% confidence over a period of 10 days?
• What is the maximum percentage I can expect to lose with 95% confidence over a period of 10 days?

We consider a relatively high level of confidence, mostly 95% or 99% confidence level. Time period taken can be anything like a day, 10 day, a month or a year depending upon what investor is looking for. A one day VAR of \$10mm using a probability of 5% means that there is a 5% chance that the portfolio could lose more than \$10mm in the next trading day. There are three methods of calculating VaR: the Historical method, the parametric method also known as variance-covariance method and the Monte Carlo simulation. The Historical Method: The historical method simply re-organizes actual historical returns, putting them in order from worst to best. It then assumes that history will repeat itself, from a risk perspective. We then put these data in the histogram that compare the frequency of return. Tiny bars in histogram represent the less frequent daily return while the highest point in histogram represents the most frequent daily return. Parametric Method:This method assumes that the stock returns are normally distributed. In this method we estimate only two factors – an expected return and a standard deviation. These two factors allow us to plot a normal distribution curve. Monte Carlo Simulation: The third method involves developing a model for future stock price returns and running multiple hypothetical trials through the model. A Monte Carlo simulation refers to any method that randomly generates trials, but by itself does not tell us anything about the underlying methodology. Every run of Monte Carlo Simulation gives different result. But differences between these results are likely to be very narrow.

### Calculation of Value at Risk (VaR)

To calculate the value at risk, at first we need to collect the historical data. Historical data is the historical exchange rate of a particular foreign currency against INR. The foreign currencies which we are considering here are United States Dollar (USD), Great Britain Pound (GBP), Euro and Japanese Yen (JPY). We are considering these currencies because they are the major currencies as exchange is easily available for these currencies. We will calculate the value at risk the investor faces in case he/she invests in any of these currencies. At first we will consider the case in which an investor is investing in United States Dollar. The investor will buy United States Dollar in exchange of INR.

### USD/INR

The historical exchange rate for USD/INR for a period of 22 days starting from 15th April 2011 to 6th May 2011 is as follows:

 Date Close Periodic Return 06-05-2011 44.785 0.53% 05-05-2011 44.5499 0.08% 04-05-2011 44.515 0.34% 03-05-2011 44.3655 0.09% 02-05-2011 44.325 0.17% 01-05-2011 44.25 0.00% 30-04-2011 44.25 -0.24% 29-04-2011 44.3549 0.00% 28-04-2011 44.3549 -0.16% 27-04-2011 44.425 -0.34% 26-04-2011 44.5774 0.25% 25-04-2011 44.465 0.16% 24-04-2011 44.395 0.00% 23-04-2011 44.395 0.18% 22-04-2011 44.315 -0.05% 21-04-2011 44.335 -0.09% 20-04-2011 44.375 -0.48% 19-04-2011 44.59 0.55% 18-04-2011 44.345 0.01% 17-04-2011 44.34 0.00% 16-04-2011 44.34 -0.35% 15-04-2011 44.495

From the everyday exchange rate the periodic return is found by using the formula given below: Natural Logarithm (Present date exchange rate/ previous date exchange rate) The Value at Risk from the above data is calculated by using the given formula in excel: PERCENTILE (array of the periodic return,5%) Here the array of the periodic return is the everyday return of the period for which historical data is taken. The second attributes i.e., 5% tells that 95 times out of 100 the loss will not exceed the calculated VaR. Therefore we can say with 95% confidence that the loss will not exceed the Value at Risk (VaR) thus calculated. From the above data the Value at Risk (VaR) calculated at 95% confidence level is: 0.35% From the above data the Value at Risk (VaR) calculated at 99% confidence level is: 0.46%

### Euro/INR

The historical exchange rate for Euro/USD for a period of 22 days starting from 15th April 2011 to 6th May 2011 is as follows: Euro/USD Euro/INR

 Date Close Date Close Periodic Return 06-05-2011 1.4501 06-05-2011 64.94273 -1.61% 05-05-2011 1.4814 05-05-2011 65.99622 -0.38% 04-05-2011 1.4882 04-05-2011 66.24722 1.02% 03-05-2011 1.478 03-05-2011 65.57221 -0.29% 02-05-2011 1.4837 02-05-2011 65.765 0.01% 01-05-2011 1.486 01-05-2011 65.7555 0.00% 30-04-2011 1.486 30-04-2011 65.7555 -0.24% 29-04-2011 1.486 29-04-2011 65.91138 0.45% 28-04-2011 1.4794 28-04-2011 65.61864 0.70% 27-04-2011 1.4668 27-04-2011 65.16259 0.01% 26-04-2011 1.4617 26-04-2011 65.15879 0.48% 25-04-2011 1.4584 25-04-2011 64.84776 0.16% 24-04-2011 1.4584 24-04-2011 64.74567 0.00% 23-04-2011 1.4584 23-04-2011 64.74567 0.18% 22-04-2011 1.4584 22-04-2011 64.629 -0.05% 21-04-2011 1.4584 21-04-2011 64.65816 0.38% 20-04-2011 1.4515 20-04-2011 64.41031 0.99% 19-04-2011 1.4302 19-04-2011 63.77262 0.74% 18-04-2011 1.4275 18-04-2011 63.30249 -1.21% 17-04-2011 1.445 17-04-2011 64.0713 0.00% 16-04-2011 1.445 16-04-2011 64.0713 -0.35% 15-04-2011 1.445 15-04-2011 64.29528

Historical exchange rate for Euro/INR is determined from the historical exchange rate of Euro/USD and USD/INR. Exchange rate of Euro/INR = Exchange rate of Euro/USD * Exchange rate of USD/INR In this case again the periodic return is found by using the formula given below: Natural Logarithm (Present date exchange rate/ previous date exchange rate) The Value at Risk from the above data is calculated by using the given formula in excel: PERCENTILE (array of the periodic return, 5%) Here the array of the periodic return is the everyday return of the period for which historical data is taken. The second attributes i.e., 5% tells that 95 times out of 100 the loss will not exceed the calculated VaR. Therefore we can say with 95% confidence that the loss will not exceed the Value at Risk (VaR) thus calculated. From the above data the Value at Risk (VaR) calculated at 95% confidence level is: 1.21%. From the above data the Value at Risk (VaR) calculated at 99% confidence level is: 1.53%.

### GBP/INR

The historical exchange rate for GBP/USD for a period of 22 days starting from 15th April 2011 to 6th May 2011 is as follows:

### GBP/USD GBP/INR

 Date Close Date Close Periodic Return 06-05-2011 1.64057 06-05-2011 73.47293 0.05% 05-05-2011 1.64847 05-05-2011 73.43917 -0.24% 04-05-2011 1.65374 04-05-2011 73.61624 0.70% 03-05-2011 1.64781 03-05-2011 73.10591 -1.16% 02-05-2011 1.66858 02-05-2011 73.95981 0.30% 01-05-2011 1.66648 01-05-2011 73.74174 0.00% 30-04-2011 1.66648 30-04-2011 73.74174 -0.24% 29-04-2011 1.66648 29-04-2011 73.91655 0.12% 28-04-2011 1.66449 28-04-2011 73.82829 0.43% 27-04-2011 1.65478 27-04-2011 73.5136 0.09% 26-04-2011 1.64764 26-04-2011 73.44751 -0.18% 25-04-2011 1.65483 25-04-2011 73.58202 0.16% 24-04-2011 1.65483 24-04-2011 73.46618 0.00% 23-04-2011 1.65483 23-04-2011 73.46618 0.18% 22-04-2011 1.65483 22-04-2011 73.33379 -0.05% 21-04-2011 1.65483 21-04-2011 73.36689 0.99% 20-04-2011 1.63697 20-04-2011 72.64054 0.01% 19-04-2011 1.62893 19-04-2011 72.63399 0.68% 18-04-2011 1.62678 18-04-2011 72.13956 -0.49% 17-04-2011 1.63499 17-04-2011 72.49546 0.00% 16-04-2011 1.63499 16-04-2011 72.49546 -0.35% 15-04-2011 1.63499 15-04-2011 72.74888

Historical exchange rate for GBP/INR is determined from the historical exchange rate of GBP/USD and USD/INR. Exchange rate of GBP/INR = Exchange rate of GBP/USD * Exchange rate of USD/INR In this case again the periodic return is found by using the formula given below: Natural Logarithm (Present date exchange rate/ previous date exchange rate) The Value at Risk from the above data is calculated by using the given formula in excel: PERCENTILE (array of the periodic return, 5%) Here the array of the periodic return is the everyday return of the period for which historical data is taken. The second attributes i.e., 5% tells that 95 times out of 100 the loss will not exceed the calculated VaR. Therefore we can say with 95% confidence that the loss will not exceed the Value at Risk (VaR) thus calculated. From the above data the Value at Risk (VaR) calculated at 95% confidence level is: 0.49% From the above data the Value at Risk (VaR) calculated at 99% confidence level is: 1.03%

### JYP/INR

The historical exchange rate for USD/JYP for a period of 22 days starting from 15th April 2011 to 6th May 2011 is as follows:

### USD/JYP JPY/USD

 Date Close Close 06-05-2011 80.3393 0.01244721 05-05-2011 79.7894 0.01253299 04-05-2011 81.0509 0.01233793 03-05-2011 80.7578 0.0123827 02-05-2011 81.4518 0.0122772 01-05-2011 81.2046 0.01231457 30-04-2011 81.2046 0.01231457 29-04-2011 81.2046 0.01231457 28-04-2011 81.7696 0.01222948 27-04-2011 82.2607 0.01215647 26-04-2011 81.7062 0.01223897 25-04-2011 81.9528 0.01220215 24-04-2011 81.9528 0.01220215 23-04-2011 81.9528 0.01220215 22-04-2011 81.9528 0.01220215 21-04-2011 81.9528 0.01220215 20-04-2011 82.7627 0.01208274 19-04-2011 82.6668 0.01209675 18-04-2011 82.8371 0.01207189 17-04-2011 83.301 0.01200466 16-04-2011 83.301 0.01200466 15-04-2011 83.301 0.01200466

Historical exchange rate for JPY/USD is determined from the historical exchange rate of USD/JPY. Exchange rate of JPY/USD = 1/ (Exchange rate of USD/JPY)

### JPY/INR

 Date Close Periodic Return 06-05-2011 0.557448 -0.16% 05-05-2011 0.558344 1.65% 04-05-2011 0.549223 -0.03% 03-05-2011 0.549365 0.95% 02-05-2011 0.544187 -0.13% 01-05-2011 0.54492 0.00% 30-04-2011 0.54492 -0.24% 29-04-2011 0.546212 0.69% 28-04-2011 0.542438 0.44% 27-04-2011 0.540051 -1.02% 26-04-2011 0.545582 0.55% 25-04-2011 0.542568 0.16% 24-04-2011 0.541714 0.00% 23-04-2011 0.541714 0.18% 22-04-2011 0.540738 -0.05% 21-04-2011 0.540982 0.89% 20-04-2011 0.536171 -0.60% 19-04-2011 0.539394 0.76% 18-04-2011 0.535328 0.57% 17-04-2011 0.532287 0.00% 16-04-2011 0.532287 -0.35% 15-04-2011 0.534147

Historical exchange rate for JPY/INR is determined from the historical exchange rate of JPY/USD and USD/INR. Exchange rate of JPY/INR = Exchange rate of JPY/USD * Exchange rate of USD/INR In this case again the periodic return is found by using the formula given below: Natural Logarithm (Present date exchange rate/ previous date exchange rate) The Value at Risk from the above data is calculated by using the given formula in excel: PERCENTILE (array of the periodic return, 5%) Here the array of the periodic return is the everyday return of the period for which historical data is taken. The second attributes i.e., 5% tells that 95 times out of 100 the loss will not exceed the calculated VaR. Therefore we can say with 95% confidence that the loss will not exceed the Value at Risk (VaR) thus calculated. From the above data the Value at Risk (VaR) calculated at 95% confidence level is: 0.60% From the above data the Value at Risk (VaR) calculated at 99% confidence level is: 0.93%

### Calculation of Standard Deviation

Standard deviation is a measure of how far apart the data are from the average of the data. If all the observations are close to their average then the standard deviation will be small. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment’s volatility. Standard deviation is also known as historical volatility and is used by investors as a gauge for the amount of expected volatility. Suppose that an investor has INR 45,000 to invest and is considering buying the USD. Currently one USD is valued at INR 45. The investor assesses a 0.75 probability that the USD will appreciate against INR over a coming period, so that one USD will be equivalent to INR 46 and a 0.25 probability that the USD will depreciate against INR to become equal to INR 44. INR 45,000 (at one USD equal to INR 45) = 45,000/45 = USD 1000 The payoffs from the proposed investment are as follows:- If the USD appreciates (One USD becomes equal to INR 46): USD 1000 *46 = INR 46,000 If the USD depreciates (One USD becomes equal to INR 44): USD 1000*44 = INR 44,000

### (5)

46,000 (46 – 45)/45 = 0.022 0.75 0.0165 (0.022 – 0.011)^2 x 0.75 = 0.00009075
44,000 (44 – 45)/ 45 = -0.022 0.25 -0.0055 (-0.022 – 0.011)^2 x 0.25 = 0.00027225
sum (x) 0.011 Add the above two results to get ?² = 0.000363

The standard deviation is the square root of the variance. In the above example, the standard deviation is square root of 0.000363 i.e. 0.01905 or 1.905%.

### Mean Return

The average expected return of a given investment, when all possible outcomes are considered. To calculate mean return, estimate the probability of each possible return, and then take a weighted average of those returns. To calculate mean return, at first we need to calculate all the possible rate of return of the investment with their respective probability. Let’s say we invest Rs100, which is called our capital. One year later, if we expect our investment to yield Rs110 with 40% probability and Rs 112 with 60 % probability. What is the rate of return of our investment in the two cases and also what is our mean return? We calculate rate of return by using the following formula: ((Return – Capital) / Capital) × 100% = Rate of Return For the return of Rs110, the rate of return is ((Rs110 – Rs100) / Rs100) × 100% = 10% Therefore, our rate of return is10%. For the return of Rs112, the rate of return is ((Rs112 – Rs100) / Rs100) × 100% = 12% Therefore, our rate of return is12%. Mean return of investment: To find the mean return, we take the probability of each possible return outcome and multiply it by the return outcome itself. The value so found in each case is added to get the mean return of investment. 10*(40/100) + 12*(60/100) = 4 + 7.2 = 11.2 Therefore the mean return of our investment is 11.2%.

### Major currencies in Foreign Exchange

The four currencies which have been identified as major currencies:

• United States Dollar (USD)
• Great Britain Pound (GBP)
• Euro
• Japanese Yen (JPY)

These currencies are called major currencies because exchanges for these currencies are easily available everywhere around the globe. Apart from these major currencies there are exotic currencies. Exotic currencies are thinly traded currencies. They are illiquid, lack market depthand trade at low volumes. Trading an exotic currency can be expensive, as the bid-ask spread is usually large. Exotics are not considered major currencies because they are noteasily traded in a standard brokerage account. Examples of exotic currencies include the Thai baht, Uruguay peso or Iraqi dinar.

### Forex Markets in India

India’s share in world forex market has shown growth of 0.9% last year and will grow further. It is the fastest growth of any country. The growth rates of developed countries is much lower compared with developing countries.UK and US have shown the lowest change in contribution of foreign exchange. In India people are now more aware of the kinds of trading like derivative markets, options, swapping, hedging etc. The most important characteristic of forex is the impact on various currencies by the change in one currency rates. Any economic activity in world affects the forex market immediately. The overall approach to the management of India’s foreign exchange reserves takes into account the changing composition of the balance of payments and endeavours to reflect the ‘liquidity risks’ associated with different types of flows and other requirements.

### Foreign Exchange Rates

Foreignexchange rateis the rate at which one currencycan be exchanged for another. In other words, it is the value of another country’s currency compared to that of our own. If we are travelling to another country, you need to “buy” the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency. Suppose we are travelling to Egypt, and the exchange rate forINR to Egyptian poundsis 7.5:1, this means that to buy every Egyptian pounds we need to spend INR 7.5.

### Types of Foreign Exchange Rates

The various types of foreign exchange rates are:

1. Floating Rates
2. Fixed Rates
3. Pegged Rates

Floating Rates: When the value of the currencies fluctuates freely due to market forces, these frequent changes in the values of currencies are termed as floating rates. Floating rates are preferred by a country if there are reasons to believe that the country can cope up with the constant change in the value of its currency. There are a number of reasons for the fluctuation in the value of a currency. The most common reason is that of demand and supply. If there is a trade deficit than it will cause less demand for the currency, as a result the value of currency will go down. In case of trade surplus than it will cause more demand for the currency, as a result the value of currency will rise. Fixed Rates: Fixed rates are generally used by smaller economies. Smaller economies uses fixed exchange rate because it is difficult for them to keep pace with the frequently changing exchange rate. Fixed exchange rate secures the foreign investor from any loss due to exchange rate fluctuation. Fixed exchange rates do have their disadvantages on the economic front. Due to fixed exchange rate the monetary policies of the country becomes ineffective. Pegged Rates: It is a compromise between fixed rates and floating rates. In pegged rate the currency fluctuate within a fixed band around central value. It is better for developing economy in comparison with the other two exchange rates as it allows certain degree of market adjustment as well as stability.

### Exchange rate depending upon type of transaction

Exchange rate also depends upon the type of transaction. Here the type of transactions are sale transaction and purchase transaction. Authorised Dealer does quote different rates for sales and purchase of foreign currency. Purchase of foreign currency is called inward remittance of foreign currency. Similarly, sale of foreign currency is called outward remittance of foreign currency. Settlement of Foreign Exchange Transaction There are two aspects in a transaction involving sales or purchase of foreign currency, 1. Rate of conversion. 2. The date of delivery i.e., the date on which the transaction is to be completed. The delivery under a foreign exchange transaction can be settled in one of the following ways:- Ø Ready or Cash: The transaction is to be settled on the same day. Ø TOM : The delivery of the foreign exchange/currency is to be made on the next working day. Ø SPOT : The delivery of the foreign exchange/currency is to be made on the second working day. Ø Forward : The delivery of foreign exchange will take place on third working day or any future date from the third working date. Factors influencing Foreign Exchange Rates An exchange rate is determined by supply and demand factors. These are the various factors which determine the demand and supply of a currency.

### 1. Inflation

If inflation in the India is lower than elsewhere, then Indian exports will become more competitive and there will be an increase in demand for INR. Also foreign goods will be less competitive and so Indian citizens will supply less INR to buy foreign goods. Therefore the rate of INR will tend to increase.

### 2. Interest Rates

If interest rates in India rise relative to elsewhere, it will become more attractive to deposit money in the India. Therefore demand for INR will rise. This is known as “hot money flows” and is an important short run determinant of the value of a currency.

### 3. Speculation

If speculators believe the INR will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value of INR to rise. Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets. For example, if markets see news which makes an interest rate increase more likely, the value of the INR will probably rise in anticipation.

### 4. Change in competitiveness

If Indian goods become more attractive and competitive, this will cause the value of the Exchange Rate to rise. This is important for determining the long run value of the INR.

### 5. Relative strength of other currencies

INR will rise if there is depreciation in the values of other currencies. For example, if USD depreciates then this will result in the relative appreciation in the value of INR.

### 6. Balance of Payments

A large deficit on the current account means that the value of imports is greater than the value of exports. If this is financed by a surplus on the financial / capital account then this is okay. But a country who struggles to attract enough capital inflows will see depreciation in the currency.

### Foreign Exchange Risk and Hedging

There is a spectrum of opinions regarding various foreign exchange risks and methods to hedge them. Some firms feel hedging techniques are speculative or do not fall in their area of expertise and hence do not venture into hedging practices. Other firms are unaware of being exposed to foreign exchange risks. There are a set of firms who only hedge some of their risks, while others are aware of the various risks they face, but are unaware of the methods to guard the firm against the risk. There is yet another set of companies who believe shareholder value cannot be increased by hedging the firm’s foreign exchange risks as shareholders can themselves individually hedge themselves against the same using instruments like forward contracts available in the market or diversify such risks out by manipulating their portfolio.

### Different categories of risk

The various risks associated with foreign exchange are:

• Interest Rate Risk
• Exchange Rate Fluctuation Risk
• Counter-party Risk
• Political Risk
• Translation Risk

Interest Rate Risk: Interest rate riskrefers to the profit and loss generated by fluctuations in the forward spreads. Along with fluctuations in forward spread, forward amount mismatches and maturity gaps among transactions in the foreign exchange book also plays a significant role towards the interest rate risk. The forward amount mismatch is the difference between the spot and the forward amounts. Exchange Rate Fluctuation Risk: Exchange rate fluctuation risk refers to the risks to which investors are exposed because of the change in exchange rate of that foreign currency against INR. If the value of the foreign currency goes down with respect to INR then investors are bound to lose. In case foreign currency appreciates against INR then the investor will gain more. Counter-party risk: Counter-party risk refers to the risk of each party of the contract that the counterparty will not leave up to his contractual obligations. Counterparty risk is also referred to as “Default Risk”. Political Risk: Political Risk refers to the reaction of the foreign exchange market due to the change in the business environment of a country. However, the reaction of the foreign exchange market is more dramatic for unfavourable events than for favourable events. Translation Risk: Translation risk is encountered when there is a need to translate foreign currency assets or liabilities into the home currency for accounting purpose in a given period.

### Hedging of Forex Risk

Hedging refers to managing risk to an extent that makes it bearable. In international trade and dealings, foreign exchange plays an important role. Fluctuations in the foreign exchange rate can have significant impact on business decisions and outcomes. Hedging is the process by which the party involved in foreign exchange transaction can protect the price of financial instrument at a date in the future. It is done by taking an opposite position in the present. The opposite direction in the present is taken by using derivatives like currency options, currency futures, forward contracts, swap, money market etc. Hedging involves:

• Foreign Exchange exposure identification
• Value of exposure
• Creation of offsetting positions through derivatives
• Measurement of Hedge ratio
• Degree of risk acceptable to management
• Expectations regarding future movement of exchange rates

Foreign Exchange exposure identification: Foreign exchange exposures arise from many different activities. A traveller going to visit another country has the risk that if that country’s currency appreciates against their own their trip will be more expensive. An exporter who sells its product in foreign currency has the risk that if the value of that foreign currency falls then the revenues in the exporter’s home currency will be lower. An importer who buys goods priced in foreign currency has the risk that the foreign currency will appreciate thereby making the local currency cost greater than expected. Fund Managers and companies who own foreign assets are exposed to falls in the currencies where they own the assets. This is because if they were to sell (repatriate) those assets their exchange rate would have a negative effect on the home currency value. Other foreign exchange exposures are less obvious and relate to the exporting and importing in ones local currency but where the negotiated price is being affected by exchange rate movements. Value of Exposure: There is a risk that the company’s equities, assets, liabilitiesor incomewill change in value as a result of exchange rate changes. Therefore the value of exposure in foreign exchange is the possible financial loss due to the foreign exchange operations. Creation of offsetting positions through derivatives: Offset position is created by liquidating a futures position. This is done by entering an equivalent, but opposite, transaction using derivatives. It eliminates the delivery obligation. Hence reduces an investor’s net position in an investment to zero, so that no further gains or losses will be experienced from that position. Measurement of Hedge ratio: The Hedge ratio is the ratio comparing thevalue of a positionprotected via a hedge with the size of the entire position itself. Suppose a person is holding\$10,000 inforeign equity, which exposes him to currency risk. Ifhe hedges \$5,000 worth of the equity with acurrency position,then his hedge ratio is 0.5 (50 / 100). This means that50% of his equity position is sheltered from exchange rate risk. Degree of risk acceptable to management: Degree of risk acceptable It is very important for an organization to know the degree or amount of risk that they can bear in foreign exchange transactions. In a transaction if the risk is more than what the organization sees as acceptable risk, then the organization needs to hedge the risk such that it comes under the acceptable category. Expectations regarding future movement of exchange rates: Future movement of exchange rate depends upon a number of factors. An analysis of all these factors and their impact on foreign exchange rate gives us the fair idea of what to expect from the movement of exchange rate in future. Depending upon the expectations the risk is determined.

### Forex Operation at UBI

The various Foreign Exchange Operations at United Bank of India are:

• Foreign Exchange Operations
• Correspondent Banking
• International Treasury
• NRI Services
• Remittance Facility for Resident Indians

Foreign Exchange Operations: Through its large network of authorized branches, the Bank caters to the foreign exchange needs of its clientele engaged in export and import trade. The dealing room at H.O. provides rates for conversion of all major world currencies like U S Dollar, Sterling Pounds, Euro, Swiss Francs, Japanese Yen and other exotic currencies. The services to the customers of the Bank include hedging of foreign currency risks. The bank grants pre-shipment credit in foreign currency and Rupee to exporter customers. It is also involved in Purchasing/Discounting/Negotiating of export bills. Correspondent Banking: Correspondent banking is the service provided by the bank or other financial institution on behalf of another, equal or unequal, financial institutions. A correspondent bankcan conduct business transactions, accept deposits and gather documents on behalf of the other financial institution. Correspondent banks are more likely to be used to conduct business in foreign countries, and act as a domestic bank’s agent abroad. United Bank of India has correspondent banking relationship with more than 400 International banks around the globe. The correspondent banks are selected with great care to ensure that the customers get the best and most reliable service in the foreign lands at most competitive rates. International Treasury: United Bank of Indiahas a strong presence in the Treasury Market in India. The Foreign Exchange treasury at Head office is equipped with state of art technology, highly experienced and skilled professionals. The Bank deal in all the major international currencies i.e. US\$, GBP, Euro, Yen as well as other currencies. The treasury undertakes the following treasury related activities:

• Foreign Exchange Inter Bank Placements / Borrowings
• Sale & Purchase of currency on behalf of customers
• Forward Cover Bookings
• Cross Currency Swaps
• Interest Rate Swaps (IRS)
• Foreign Exchange Money Market Operations

NRI Services: The various services available for NRI at United Bank of India are

• Opening of account and source of credit
• Remittance Facilities from India
• Remittance Facility to India by NRI
• Loans against deposits to NRI
• Housing loan for NRI

Remittance Facility for Resident Indians: The remittance facility for resident Indians are provided on the following ground

• Medical Treatment
• Private Visits
• Emigration
• International Credit Card
• International Debit Card
• Endorsement on Passport

### SWIFT Codes

SWIFT stands for “Societyfor WorldwideInterbankFinancial Telecommunicationcode”. It is an internationally-recognized identification code forbanksaroundtheworld. SWIFT codes are most commonly used for international wire transfers.SWIFT code comprises of 8 or 11alphanumeric characters. TheInternational Organizationof Standardization(IOS) was the authoritative body that approved the creation of SWIFT codes. SWIFT code enables bank around the world to be identified without the need to specify an address or bank number. SWIFT codes are used mainly for automatic payment transactions. A SWIFT code consists of four parts. These four parts identifies the different attributes to uniquely identify any branch of a bank. The first part in a SWIFT code gives the bank code, second part represents the country code, third part gives is location code and the fourth part is branch code. This way SWIFT code helps in uniquely identifying any branch of a bank. Foreign Exchange SWAPs Foreign Exchange SWAPs is a Foreign Exchange agreement between two parties to exchange a set amount of one currency for another and, after a certain specified period of time, to give back the original amounts swapped. In the FOREX market, most inter-bank trading of forwards is done through the trade of FOREX swaps. A FOREX swap is simply two transactions entered into simultaneously; an agreement is made to exchange currencies now at the prevailing spot rate and also to exchange the currencies back in the future at the prevailing forward rate. For example, when a swap trader enters a swap he/she may agree to give INR and receive USD now (with amounts determined by the current spot) and also agree to give USD and get INR in one year (amounts determined by the prevailing one year forward rate). Therefore, the FOREX swap is just a spot trade and a forward trade rolled into one.

### Origin:

The terms “nostro” is derived from Latin terms meaning “ours” in English language.

### Meaning:

It is an account at a foreignbankwhere a domestic bank keeps reserves of aforeign currency. A bank keeps a nostro account so that it does not have to make a currency conversion (which brings with itforeign exchange risk) should an account holder make adepositor awithdrawalin that foreign currency. In simple words, it is an account that a bank holds with a foreign bank. This facilitates easy cash management because currency doesn’t need to be converted. When a customer puts his or her money into a bank, the bank is then holding the money for the customer. The customer can call that account a Nostro account because they own the money in the account. The bank calls it a Vostro account because it is the customer’s money that the bank is holding.

### Example:

If X lives in the United States and ask his local bank to set up a Euro account for him, they will most likely open a “Nostro Account” with a correspondent agent bank in the European Union that they have a banking relationship with for that specific purpose. The Euro bank will set up the account, but it is not a typical checking account. These accounts are treated differently on the books of the bank. In short, if someone refers to a Nostro account, they are referring to an account which they own.

### Purpose/Benefits:

Generally, companies use these types of accounts when they often either buy or sell in another country but do not have a physical presence that would afford them usage of a typical checking account arrangement. Vostro Account

### Origin:

The terms “vostro” is again derived from same Latin terms meaning “yours” in English language.

### Meaning:

It is the account which is held by a foreign bank with a local bank. In this, bank holds on behalf another bank in another country. In other words, Local currencyaccountmaintained by alocalbankfor a foreign(correspondent) bank. For the foreign bank it is a nostro account. In a vostro account, the administrators are not actually the owners of the money. They must keep this account solvent on behalf of its owner. Vostro account administrators, often banks, frequently pay interest to other parties for the use of their money.

### Example:

When X (Buyer) a trader in Base Country wants to purchase \$5000 worth of goods by paying cash. Mr.X deposits the cash in his local bank in the country’s currency for the corresponding amount (\$5000) then a swift message is sent to the corresponding bank in the foreign country where the local bank holds a NOSTRO account requesting the bank to make the payment to Y (Seller) in his local currency i.e. US Dollars. Thus facilitating the trade between X & Y. IF Y wanted to buy something from X then the foreign bank would complete the deal using their VOSTRO account in X’s country.

### Purpose/Benefits:

A vostro account is useful in theForex, or foreign exchange, industries, where money “go to market” in foreign markets and traded into foreign currency, or alternately, kept as a foreign currency to that destination market. Parties holding vostro accounts are acting on behalf of their customers to get returns. This also happens in a wide variety of stock trading orstock optionstrading situations, where a broker is the party that holds the vostro account for clients. The system of both nostro and vostro accounts facilitate foreign exchange dealings and settlements and allow the settlement of currency transactions between the Country’s (Local) Bank and foreign banks.

Did you like this example?

Foreign exchange risk in banks. (2017, Jun 26). Retrieved July 24, 2021 , from
https://studydriver.com/foreign-exchange-risk-in-banks/

This paper was written and submitted by a fellow student

Our verified experts write
your 100% original paper on any topic

Check Prices

## Stuck on ideas? Struggling with a concept?

Studydriver writers will make clear, mistake-free work for you!

##### Leave your email and we will send a sample to you.
Didn't find the paper that you were looking for?
We can create an original paper just for you!