This document discusses risk management and derivatives in foreign exchange dealings. It covers the functions of a bank's foreign exchange dealing room, the types of risks involved like market risk, liquidity risk, and credit risk. It then discusses various derivative instruments like forwards, futures, options, and swaps. It provides examples and explanations of how these derivatives work. It also outlines RBI guidelines for risk management in foreign exchange and the evolution of derivatives markets in India.

1. International Banking
(Module A) – Part II
Risk Management and Derivatives
Tanushree Mazumdar, IIBF

2. Dealing room (1)
• Foreign exchange dealing room
operations comprise functions of a service
branch to meet the needs of other
branches/divisions to buy/sell foreign
currency.
• Acts as a profit centre for the
bank/financial institution
• A dealer has to maintain two positions-
funds position and currency position

3. Dealing room (2)
• The funds position reflects inflows and outflows
of funds i.e. receivables and payables
• A mismatch in funds position will throw open
interest rate risks in the form of overdraft interest
in the Nostro a/c, loss of interest income on
credit balances, etc.
• Currency position deals with overbought and
oversold positions, arrived after taking various
merchant or inter-bank transactions and the
dealer is concerned with the overall net position

4. Dealing room (3)
• The overall net position exposes the dealer to
exchange risks from market movements
• The dealer has to operate within the permitted
limits prescribed for the exchange position by
the management
• Back office: Takes care of processing deals,
accounts reconciliation. It plays a supportive as
well as checking role
• Mid office: Mid-office deals with the risk
management and parameterisation of risks for
forex operations. Gives market information to
dealers

5. Risks in foreign exchange dealings
• RBI and FEDAI issue guidelines to all
banks to identify, measure and manage
risks
• Risks can be classified under:
– Market risk: Loss arising out of change in the
market price of an asset
– Liquidity risk: risk that you will not be able to
easily sell your assets

6. Risks…(cont’d)
• Operational risk: Failure of internal processes,
people, systems or external events
• Legal risk: Contracts are not legally enforceable
or documented incorrectly
• Credit risk: Counterparty defaulting in payment
– Pre-settlement: Credit risk before the maturity of a
transaction
– Settlement risk: Timing differences in cash flows, e.g.
of Herstatt Bank in Germany failing in 1974

7. Risks (3)
• Country risk: Movement of funds across
borders may be obstructed by sudden
government controls
• Interest rate risk: Interest rate risk or gap
risk arises out of adverse movement of
interest rates a bank faces on its currency
swaps/forward contracts or other interest
rate derivatives

8. Management of risks
• Traditional measures adopted by bank
managements to manage/limit risks are:
– Limits on intra-day open position in each currency
– Limits on overnight open positions in each currency
(lower than intra-day)
– Limits on aggregate open position for all currencies
– A turnover limit on daily transaction volume for all
currencies
– Countrywise exposure limits

9. Guidelines on risk management
• Measure risks that can be quantified viz.,
exchange rate risk, interest rate risk using
mathematical or statistical tools
• Have a detailed policy on risk management
(given by the Board)
• A specific limit structure for various risks and
operations
• A sound management information system
• Specified control, monitoring and reporting
system

10. RBI guidelines on risk management
• RBI has issued internal control guidelines
(ICG) for foreign exchange business
• It covers various aspects of dealing room
operations, code of conduct for dealers
and brokers and other aspects of risk
control guidelines
• Specifies limits including gap limits,
counterparty limit, dealer limit, deal size
limit, etc.

11. Derivative Instruments
• Derivatives are management tools derived
from underlying exposures such as
currency, commodities, shares, etc.
• Used to neutralise the exposures on the
underlying contracts
• Can be over the counter (OTC) i.e.
customised products or exchange traded
which are standardized in terms of
quantity, quality, start and ending dates

12. Forward Contracts (1)
• Forward contracts: Typical OTC
derivatives which involves fixing of rates
(exchange rate, commodity price, etc.) in
advance for delivery in future. Risk of
adverse price movement is covered.
• Forward contracts are specified at forward
rates which are spot rates plus cost of
carry (interest rate differential in case of
foreign exchange forward)

13. Forward Contract (2)
• Forward rate: spot rate + premium or – discount
• Premium/discount: function of cost of carry
(interest rate differential)
• The currency with lower interest rate would be at
a premium in future
• Other factors affecting forward rate
– Demand and supply for forward currency
– Perception about the movement in the currency
– Political, fiscal and trade-related conditions in the
country and for the currency

14. Example of a forward differential
• If GBP/USD Spot = 1.8000
• 6 months interest rate USD= 2%
• 6 months interest rate GBP = 4%
• Forward differential=
• 1.8000 * (4-2)/100 * 6/12 or 0.018
• 6 months forward rate (GBP/USD) = 1.7820
• Since USD has a lower interest rate it will be at a
premium in the future

15. Futures (1)
• Futures: A version of exchange traded forward
contracts.
• Standardized contracts as far as the quantity
(amounts) and delivery dates (period) of the
contracts.
• Conveys an agreement to buy a specific amount
of commodity or financial instruments at a
particular price on a stipulated future date
• An obligation on the buyer to purchase the
underlying instrument and the seller to sell it

16. Futures (2)
• Types of Futures contracts
– Commodities futures
– Financial futures
– Currency futures
– Index futures
• There is a margin process
– Initial margin: to be paid at the start of a contract
– Variable margin: calculated daily by marking to
market the contract at the end of each day
– Maintenance margin: Similar to minimum balance for
undertaking trades in the Exchange and has to be
maintained by the buyer/seller in the margin account

17. Options (1)
• Options: An agreement between two parties in
which one grants the other the right to buy (‘call’
option) or sell (‘put’ option) an asset under
specified conditions (price, time) and assumes
the obligation to sell or buy it.
• The party who has the right but not the
obligation is the ‘buyer’ of the option and pays a
fee or premium to the ‘writer’ or ‘seller’ of the
option.
• The asset could be a currency, bond, share,
commodity or futures contract

18. Options (2)
• The option holder or buyer would exercise the
option (buy or sell) in case the market price
moves adversely and would let it lapse if it
moves favourably
• The option seller (usually a bank or a financial
institution or an Exchange) is under obligation to
deliver the contract if exercised at the agreed
price
• Strike price/exercise price: The price at which
the option may be exercised and the underlying
asset bought or sold

19. Options (3)
• In the money: When the strike price is below the
spot price (in case of a call option) or vice-versa
in case of a put option the option is in the money
giving gain to the buyer.
• At the money: When strike price is equal to the
spot price
• Out of the money: The strike price is above the
spot price (call option) or vice-versa (for a put
option). It is better to let the option lapse here.

20. Options (4)
• Call option- The right, without the obligation, to
buy an asset
• Put option- The right, without the obligation, to
sell an asset
• American option- An option that can be
exercised at any time until the expiry date
• European option- An option which can be
exercised only on expiry
• Bermudan option- An option which is exercisable
only during a pre-defined portion of its life

21. Options (5)
• Expiry: The last date on which the option may be
exercised.
• Market participants often quote an expiration
(calendar) month without specifying an actual
date.
• In such cases it is understood that the expiration
date is the Monday before the third Wednesday
of the month
• Expiration time is usually specified in the
contract. For example, for contracts entered in
the Pacific Rim countries the time specified is
10:00 am New York time or 3:00 pm Tokyo time

22. Swaps
• In foreign exchange market, swap refers
to simultaneous sale and purchase of one
currency for another (currency swap).
• Financial or derivative swap refers to the
exchange of two streams of cash flows
over a defined period of time, between two
counter-parties

23. Derivatives in India (1)
• Sodhani Committee (expert group on
foreign exchange) was formed in 1992 to
look into the issues in and development of
the foreign exchange market in India
• Some recommendations
– Corporates should be allowed to hedge upon
declaration of underlying assets
– Banks may be permitted to initiate overseas
cross currency positions

24. Sodhani Committee..
• Banks should be allowed to borrow and lend in
the overseas markets
• More participants be allowed in the foreign
exchange market
• Corporates must be allowed to cancel and re-
book option contracts
• Banks be permitted to use hedging instruments
for their own ALM
• Banks to be allowed to fix interest rates on
FCNR (B) deposits subject to caps fixed by RBI

25. Derivatives in India (2)
• The use of financial derivatives started in India is
the nineties’ in the foreign exchange and stock
market
• In 1992 RBI had permitted banks to offer cross
currency options to their clients
• In 1996 banks were allowed to offer their
corporate clients interest rate swaps, currency
swaps, interest rate options and forward rate
agreements
• The derivatives market in India is still in an
evolving stage