RISK is a four letter word and have many definitions in different aspects. In the financial context it can be described as the probability of not achieving targeted financial performance.
Although all the business carry risk but the international business carry few additional risk exchange rate and interest rate.
Among the various participants in the foreign market the risk is faced by end users who initiate the transactions a commercial banks who provide committed rates to their customers by transferring the risk on to themselves.
Lets analyse some of the risk faced by banks in foreign currency dealings
1) Transaction risk
2) Credit risk
3) Mismatched maturity risk
1) Transaction risk : When Bank quote their rates to customers the transaction risk gets transferred from customer to bank. This is because the bank normally cover mechant transaction through an opposite transactions in the interbank market. The idea is to ensure that the anticipated Profit in each transaction is locked through the cover transaction. Any adverse rate movement between quoting to the customer and covering the transaction is accepted as normal business risk. Bank do not hedge transaction risk.
Sometimes the bank dealer may deliberately leave a transaction uncovered in anticipation of a favorable rate movement, effectively a normal business transaction get converted in to a speculation transaction popularly known as “taking a position”. If the position is created through an uncovered purchase its known as over-bought or long position, where as if position created through sale transaction known as oversold or short position. The maximum accumulation dealer can make in terms of such uncovered transactions is called “Day light Limit”. It indicates the level up to which the bank is willing to accept the exposure on behalf of dealer. If the dealer is wrong in his views the bank stipulate a stop-loss limit at which a compulsory covering of transaction to be initiated. The stop-loss signifies the loss in terms of domestic currency which the bank is willing to accept on inaccurate decision.In case if the dealer is correct in his views he takes profits in stages and achieve a near square position at the end of trading day. The Gross outstanding in all currencies at the end of the day are controlled through an “overnight limit”.
The activity of freezing the possible loss on speculations through stop-loss are well-known as position risk.
2) Credit risk: Bank continuously contract each other for forward maturities in each such case both counterparties are exposed to counterpart risk. That is the counterparty not fulfilling contractual obligation if such an event occur any day prior to settlement the other party would enter in to replacement contract to square these exposure. If this replacement contract is at the adverse rate compare to original contract rate the bank suffers a replacement contract also described as pre settlement risk.
On settlement day if there is a counterparty failure after the bank has fulfilled its obligation than the principle amount would be lost in addition to which the bank may have to bear a replacement cost-plus minimum one day interest effectively the problem less on settlement today is more than 100% of contract value termed as settlement risk. These risk became a matter of risk management example Herstelle case of 1978. In india bank control exposure to foreign counterparties through a global limit which monitor the exposure to counterparty at universal level.With in this global limit the concentration of the contract on a particular future date are monitored to prevent excessive settlement risk.
3) Mismatched maturity risk: Bank continuously quote forward rate to their customers each such forward contract is required to covered for expected forward maturity. In active market its difficult to find counterparties for broker delivery maturities , the forward exchange rate represents two components : Spot rate and forward margin. Since exchange rates are more volatile than interest rates banks normally cover the transaction for nearest available maturity. This enables the bank to eliminate exchange risk but results in :
a) Liquidity mismatch between inflow and outflow
b) Under and over recovery of forward margin.
To simultaneously adjust botheffect these bank required to undertake Swap transaction. A delay in getting the necessary swap may result in a loss on forward margin due to a shift in interest rates . Such losses are described as mismatch maturity risk.