November 25, 2012

MA0042 [Treasury Management] Set2 Q5

Q.5 Detail Foreign exchange risk management and control procedure.

Ans:


Foreign Exchange Risk Management

Foreign exchange risk management is intended to preserve the value of currency inflows, investments and loans, while enabling international banks to compete abroad. Even though it is impossible to eradicate all risks, negative exchange outcomes can be predicted and managed effectively by individuals and corporate entities.

Although the foreign exchange risk management is different for various banks based on the nature and complexity of their foreign exchange activities, a foreign exchange risk management plan requires:

Establishing and executing comprehensive and prudent foreign exchange risk management policies.

Evolving and applying suitable and effective foreign exchange risk management and control procedures.

Objectives of foreign exchange risk management
Foreign exchange risk management in a bank requires well defined objectives which must reflect the organisations attitude towards foreign exchange risk. Primarily, the objectives of foreign exchange risk management must be in line with the corporate objectives set by the bank.

The objectives of foreign exchange risk management are as follows:
To minimise the possible currency losses.
To reduce the variability of the cash flows of business.
To assist individuals involved in foreign exchange management in the implementation of updated procedures of foreign exchange risk.
To develop possible solutions to avoid the negative influence of adverse currency movements in foreign exchange.
To outline enhanced procedural guidelines for ongoing control and management of foreign exchange risk.

Foreign exchange risk management policies
Well defined policies, set forth the objectives of the banks foreign exchange risk management strategy and its parameters. The foreign exchange risk management policies include the following:

A statement of forex risk principles and objectives - Before setting up the foreign exchange risk limits and management controls it is necessary for banks to decide the goals of foreign exchange risk management plan and in particular, readiness of the bank to assume risk. Therefore, the objective of foreign exchange risk management is to manage the influence of exchange rate changes within self-imposed limits after considering a wide range of possible foreign exchange rate scenarios.

Limits of forex risks - Risk limits are established according to the relationship between the foreign exchange position and the capital, or according to the foreign exchange volume which includes total cash and the number of transactions. The foreign exchange risk limits cover the following:
- The currencies in which the institution is permitted to experience risk exposure.
- The level of foreign currency exposure that the bank is willing to assume.

Delegation of authority - Clearly defined levels of delegated authority helps in ensuring that a banks foreign exchange positions does not surpass the limits established under the foreign exchange risk management policies. The delegation of authority needs to be clearly recognised, and must include the following:
- The absolute and/or incremental authority to be delegated.
- The units, entities, positions or committees to whom authority is being delegated.
- The ability of receivers to further delegate authority.
- The restrictions placed on the use of delegated authority.

Foreign exchange risk management tools and techniques

Various tools and techniques are used for measuring foreign exchange risk management. Some of the foreign exchange management tools used are as follows:
Forward contracts
Currency futures
Currency options
Currency swaps

Forward contracts
Foreign exchange forward contracts are the most common resources for hedging transactions in foreign currencies. A forward contract is an agreement to buy or sell foreign exchange for an amount determined in advance, at a specified exchange rate at a designated date in future. The specified rate is called the forward rate, the designated date the settlement date or delivery date. The difference between forward contract and other sales contracts is that the delivery and payment of the commodity occurs at a specified future date in case of forward contracts. Forward contracts are privately exchanged and are not standardized. This gives rise to counterparty risk or default risk arising out of failure of the other party to honour its commitment. For such situations currency futures are more suitable.

Currency futures
Currency futures are forward contracts in which two parties agree between them to exchange something in the future. As futures contracts are traded on exchange with appropriate controls, counter party risk as prevalent in Forward contracts is prevented. The major currency futures market is the EUR futures market, based upon the Euro to US Dollar exchange rate. The most popular currency futures are provided by the Chicago Mercantile Exchange group, and include the following futures markets:
EUR - It is the Euro to US Dollar futures market.
GBP - It is the British Pound (Sterling) to US Dollar futures market.
CAD - It is the Canadian Dollar to US Dollar futures market.
CHF - It is the Swiss Franc to US Dollar futures market.

Currency options
A currency option is an alternative tool for managing forex risk. A foreign exchange option is an agreement for future supply of a currency interchanged with another, where the owner of the option has the right to buy (or sell) the currency at a settled price. The right to buy is a call; the right to sell is called as put. For such a right the holder pays a price called the option premium. The option seller receives the premium and is indebted to make (or take) delivery at the agreed-upon price if the buyer exercises his option.

Currency swaps
Currency swaps deal with the exchange of payments in different currencies between two trading partners. For productivity currency swaps feature netting, in which the winning party obtains payment at the end of the swap term.

Foreign Exchange Risk Management (FERM) and control procedures
Each of the banks engaged in foreign exchange activities is responsible for evolving, applying and supervising procedures to manage and control foreign exchange risk based on the risk management policies. In devising a firms FERM policy, certain factors have to be taken into account the firms exposure, general attitude towards risk management, whether its risk-averse, risk-indifferent or risk-seeking, the firms ability to alter exposed positions i.e. the maximum exchange loss it can absorb without much impact, the competitors stance and most importantly regulatory requirements. Foreign exchange risk management procedures include the following:

Systems to measure and monitor foreign exchange risk Management of foreign exchange risk involves a clear understanding of the amount of risk and the influence of exchange rate changes on the foreign currency exposure. In order to make these determinations, adequate information must be readily available to permit suitable action to be taken within the acceptable time period. 

Therefore, each of the banking organisations engaged in foreign exchange activities must have an operative accounting and management information system in place that records and measures the following accurately:
- The risk exposures related to foreign exchange trading.
- The impact of potential exchange rate changes on the bank.

Control of foreign exchange activities: Though the controls of foreign activities vary widely among the banks depending upon the nature and extent of their foreign exchange activities, the main elements of any foreign exchange control plan are well-defined procedures governing:
- Organisational controls: To guarantee that there exists a clear and effective isolation of duties between those persons who initiate the foreign exchange transactions and are responsible for operational functions of foreign exchange activities.
- Procedural controls: To ensure that the transactions are completely recorded in the accounts of the banks, they are promptly and correctly settled and to identify unauthorised dealing instantly and reported to the management.
- Other controls: To make sure that the foreign exchange activities are supervised frequently against the banks foreign exchange risk, counterparty and other limits and those excesses are reported to the management.

Independent inspections/audits Independent inspections/audits are an important factor for managing and controlling a banks foreign exchange risk management plan. Banks must use them to ensure compliance with, and the integrity of, the foreign exchange policies and procedures. Independent inspections/audits should examine the banks foreign exchange risk management activities in order to:
- Ensure adherence to the foreign exchange management policies and procedures.
- Ensure operative management controls over foreign exchange positions.
- Verify the capability and accurateness of the management information reports regarding the institutions foreign exchange risk management activities.
- Ensure that the foreign exchange hedging activities are consistent with the banks foreign exchange risk management policies and procedures.
- Ensure that employees involved in foreign exchange risk management are given accurate and complete information about the institutions foreign exchange risk policies, risk limits and positions.

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