Transcript What is an Interest Rate Risk?

International Banking
Risk Management
Session 8
--Hilla Shahpur Maneckji
International Banking
Introduction
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In this era of globalization, with an increase in syndicated
lending and consolidation within the banking industry, all the
banks operating internationally have become part and parcel of
various transactions taking place across the globe.
In the process they may be exposed to different risks that
emanate from various sources.
In this context, an understanding of international risk is
essential for the modem banker.
Let us see the risks affecting the international banking system
and the means to manage them.
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MEANING OF RISK
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What is Risk?
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A risk can be defined as an unplanned event with financial
consequences resulting in a loss or reduced earnings.
A risky proposition may be one with a potential profit or a
looming loss.
Risk can be defined as the volatility of the potential
outcome.
Banking, by its nature, entails taking a wide array of risks.
Banking supervisors need to understand these risks and be
satisfied that banks are adequately measuring and
managing them.
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Types of Risks
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What is Credit Risk? (1)
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The extension of loans is the primary activity of most banks.
Lending activities require banks to make judgments related to
the creditworthiness of borrowers.
These judgments may not always prove to be accurate and
the creditworthiness of a borrower may decline over time
due to various factors.
Since the clients may be situated in different countries, a
major risk that banks face is credit risk or the failure of a
counterparty to perform according to a contractual
arrangement.
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What is Credit Risk? (2)
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This risk applies not only to loans but also to other on and
off balance sheet exposures such as guarantees, acceptances
and securities investments.
Serious banking problems have arisen in the past from the
failure of banks to recognize impaired assets, to create
reserves for writing off these assets, and to suspend
recognition of interest income when appropriate.
Large exposures to a single borrower, or to a group of
related borrowers are a common cause of banking problems
in that they represent a credit risk concentration.
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What is Credit Risk? (3)
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Large concentrations can also arise with respect to particular
industries, economic sectors, or geographical regions or by
having sets of loans with other characteristics that make them
vulnerable to the same economic factors (example, highlyleveraged transactions).
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What is Country & Transfer Risk? (1)
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In addition to the counterparty credit risk inherent in
lending, international lending also includes country risk,
which refers to risks associated with the economic,
social and political environments of the borrower’s
home country.
Country risk may be most apparent when lending to
foreign governments or their agencies, since such
lending is typically unsecured, but is important to
consider when making any foreign loan or investment,
whether to public or private borrowers.International Banking
What is Country & Transfer Risk? (2)
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There is also a component of country risk called
“Transfer Risk” which arises when a borrower’s
obligation is not denominated in the local currency.
The currency of the obligation may become
unavailable to the borrower regardless of its particular
financial condition.
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What is Market Risk? (1)
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Banks face a risk of losses in on and off balance sheet
positions arising from movements in market prices.
Established accounting principles cause these risks to
be typically most visible in a bank’s trading activities,
whether they involve debt or equity instruments, or
foreign exchange or commodity positions.
One specific element of market risk is Foreign
Exchange Risk.
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What is Market Risk? (2)
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According to Maurice D Levi, foreign exchange risk is
defined as “the variance of the domestic-currency value of an asset,
liability, or operating income that is attributable to unanticipated
changes in exchange rates”.
Since banks act as “Market-Makers” in foreign exchange
by quoting rates to their customers and by taking open
positions in currencies, the risks inherent in foreign
exchange business, particularly in running open foreign
exchange positions, are increased during periods of
instability in exchange rates.
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What is an Interest Rate Risk? (1)
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Interest rate risk refers to the exposure of a bank’s financial
condition to adverse movements in interest rates.
This risk impacts both the earnings of a bank as well the
economic value of its assets, liabilities and off balance sheet
instruments.
The primary forms of interest rate risk to which banks are
typically exposed are:
Re-Pricing Risk, arising from timing differences in the
maturity (for fixed rate) and re-pricing (for floating rate) of
bank assets, liabilities and off balance sheet positions.
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What is an Interest Rate Risk? (2)
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Yield Curve Risk, arising from changes in the slope and
shape of the yield curve.
Basis Risk, arising from imperfect correlation in the
adjustment of the rates earned and paid on different
instruments with otherwise similar re-pricing characteristics.
Optionally, arising from the express or implied options
embedded in many bank assets, liabilities and off balance sheet
portfolios.
Although such risk is a normal part of banking, excessive
interest rate risk can pose a significant threat to a bank’s
earnings and capital base.
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What is an Interest Rate Risk? (3)
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Managing this risk is of growing importance in
sophisticated financial markets where customers
actively manage their interest rate exposure.
International banks need to pay special attention to
the interest rate risk, as interest rates in different
countries should be taken into consideration.
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Update—Interest Rate Derivatives (1)
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For banks the only thing certain about interest rates is
uncertainty.
They lose out on returns on their investments when interest
rates go down; and on the floating rate loans when the
interest rates go up.
Interest rate derivatives allows the banks to hedge risk arising
from the changes in the interest rates.
In this direction, the interest rate futures were launched on
the National Stock Exchange (NSE) in the last week of June,
2003.
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Update—Interest Rate Derivatives (2)
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The trading was launched in notional T-bill futures and Tbond futures so far.
The interest rate futures were expected to help widen the
underlying cash market while helping in evolving a better
term structure as well as in price discovery.
Interest rate futures can be used for three purposes:
Hedging against interest rate risks,
Arbitraging being a simultaneous buying and selling of
futures taking advantage of a temporary price difference or
mispricing in the market, resulting in an immediate and
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certain profit, and
Update—Interest Rate Derivatives (3)
3.
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Spreading, a speculative method, which allows a trader to
make gains from a potential change in the relative values of the
two different contracts.
As of now, banks are not allowed to trade in these derivative
products.
However it is expected that the future is bright for these kinds of
products once the participants in the market become
comfortable with these derivative products with more and more
players are entering into the market.
It is also expected that volumes shall increase significantly
whenever the banks would be allowed to trade in these derivative
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products.
Update—Interest Rate Derivatives (4)
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On the whole one can say that the market for interest rate
futures is still in an evolving stage.
One has to therefore move cautiously to overcome pitfalls.
For this, one has to proceed step by step, and mastering
the intricacies.
But, if these securities are used genuinely for risk hedging,
then it will definitely prove a useful tool, and one, that will
certainly move the market towards more efficiency.
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What is Liquidity Risk?
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Liquidity risk arises from the inability of a bank to
accommodate decreases in liabilities or to fund
increases in assets.
When a bank has inadequate liquidity, it cannot obtain
sufficient funds, either by increasing liabilities or by
converting assets promptly, at a reasonable cost,
thereby affecting profitability.
In most cases, insufficient liquidity may lead to the
insolvency of a bank.
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What is Operational Risk? (1)
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The most important types of operational risk involve
breakdowns in internal controls and corporate
governance.
Such breakdowns can lead to financial losses through
error, fraud, or failure to perform in a timely manner or
cause the interests of the bank to be compromised in
some other way.
For example, by its dealers, lending officers or other
staff exceeding their authority or conducting business in
an unethical or risky manner.
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What is Operational Risk? (2)
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Other aspects of operational risk include major failure
of information technology systems or events such as
major fires or other disasters.
When such things occur, the banks offering
international banking services are most affected.
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What is Legal Risk? (1)
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Banks are subject to various forms of legal risk.
This can include the risk that assets will turn out to be
worthless or liabilities will turn out to be greater than
expected because of inadequate or incorrect legal advice or
documentation.
In addition, existing laws may fail to resolve legal issues
involving a bank; a court case involving a particular bank
may have wider implications for banking business and
involve costs to it and many or all other banks; and, laws
affecting banks or other commercial enterprises may change.
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What is Legal Risk? (2)
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Banks are particularly susceptible to legal risks when
entering new types of transactions and when the legal
right of counterparty to enter into a transaction is not
established.
This is mostly true in the case of international banks.
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What is Reputational Risk?
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Reputational risk arises from operational failures, failure
to comply with relevant laws and regulations, or other
sources.
Reputational risk is particularly damaging for banks since
the nature of their business requires maintaining the
confidence of depositors, creditors and the general
marketplace.
For the international banks, though all these risks are
present, the most significant risk is due to the changes in
exchange rates, that is, the foreign exchange
risk.
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Banking
MEASUREMENT OF
RISK
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Introduction (1)
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Measurement of risk assumes a lot of significance in the
international banking operations.
Certain types of risks like operational risk, credit risk, legal risk,
reputational risk, etc., cannot be quantified.
They have to be assessed qualitatively depending on the past
experiences.
Whereas some risks like interest rate risk and foreign exchange
risk can be measured quantitatively.
Foreign exchange risk is alternatively known as foreign
exchange exposure.
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Introduction (2)
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It assesses the amount of assets, liabilities and operating income
exposed to exchange rate changes.
It can be said that foreign exchange exposure is “the sensitivity of
changes in the real domestic currency value of assets and liabilities or
operating incomes to unanticipated changes in exchange rates”.
This sensitivity can be measured by the slope of the regression
equation between two variables.
Here, the two variables are the unexpected changes in the
exchange rates and the resultant change in the domesticcurrency value of assets, liabilities and operating incomes.
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Introduction (3)
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The second variable can be divided into four categories for the
purpose of measurement of exposure.
These are:
Foreign currency assets and liabilities which have fixed foreign
currency values.
Foreign currency assets and liabilities with foreign currency
values that change with an unexpected change in the exchange
rate.
Domestic currency assets and liabilities.
Operating incomes.
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Exposure When Assets & Liabilities
Have Fixed Foreign Currency Values (1)
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The measurement of exposure for the first category is
comparatively simpler than for the remaining three.
Let us see an example to understand the process of measurement.
Assume that a Pakistani resident is holding a £1 million deposit.
The changes in the rupee-value of the deposit due to unexpected
changes in the Rs/£ rate can be plotted.
The unexpected changes in the exchange rate can be represented
on the X-axis, with a positive value denoting an appreciation in
the foreign currency.
The Y-axis represents the change in the rupee-value of the
deposit.
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Exposure When Assets & Liabilities
Have Fixed Foreign Currency Values (2)
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As the £ appreciates by Rs. 0.10, the value of the deposit
also increases by Rs. 0.1 million.
With an unexpected appreciation of Rs. 0.20 in the £ value,
the deposit’s value increases by Rs. 0.2 million.
Similarly, an unexpected depreciation of the £ by Rs. 0.10
will reduce the value of the deposit by Rs. 0.1 million,
while a depreciation of Rs. 0.2 will reduce the deposit’s
value by Rs. 0.2 million.
This gives us an upward sloping exposure line.
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Exposure When Assets & Liabilities
Have Fixed Foreign Currency Values (3)
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On the other hand, if there were a foreign liability which had its
value fixed in terms of the foreign currency, it would give a
downward sloping exposure line.
There may be a few assets or liabilities where the combinations
of the two variables may not lie exactly on a straight line.
In such a case, the exposure line would be the line of best fit.
Whether the points fall exactly on the exposure line or not,
there is one thing common among the assets and liabilities.
The common factor is that the quantum of change in the
foreign currency value of these assets and liabilities is
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predictable to a high degree.
Exposure When Assets & Liabilities
Have Fixed Foreign Currency Values (4)
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This predictability of the change in value makes it more
convenient to draw a regression line and hence, to measure
exposure.
Exposure can be measured as the slope of the regression
equation between unexpected changes in the exchange rate and
the resultant changes in the domestic value of assets and
liabilities.
Even when the exposure line is a downward sloping line (as will
be in case of a liability), the exposure can again be measured in
the same way.
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Exposure When Assets & Liabilities
Have Fixed Foreign Currency Values (5)
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A few points need to be noted:
When the foreign currency value of an asset or liability
does not change with a change in the exchange rate, the
exposure is equal to the foreign currency value.
When the slope of the exposure line is negative, the
exposure appears with a negative sign.
While an exposure with a positive sign is referred to as a
long exposure, the one with a negative sign is referred to
as a short exposure.
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Exposure When Assets & Liabilities
Have Fixed Foreign Currency Values (6)
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The unit of measurement of exposure is the foreign
currency in which the asset or liability is expressed.
This is because while calculating exposure, the
domestic currency gets canceled in the numerator and
the denominator, leaving the foreign currency as the
unit.
In the example, the Rs. in the numerator gets canceled
with that in the denominator, leaving the £ as the unit
of exposure.
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Exposure When Assets & Liabilities
Have Fixed Foreign Currency Values (7)
4.
While calculating exposure in this way, we are assuming that all
the change in the exchange rate is unexpected.
In real life, the unexpected change can be calculated using the
forward rate.
The forward rate can be used as the unbiased estimate of the
future spot rate.
Hence, in retrospective, the forward rate for a particular
maturity can be compared to the actual spot rate as on the date
of the maturity.
The difference between the two will be the unexpected change
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in exchange rate.
Exposure When the Foreign Currency
Value of Assets & Liabilities Changes
with a Change in the Exchange Rate (1)
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A change in the exchange rate may be accompanied by a
change in the foreign currency value of an asset or liability.
Though the change in the foreign currency value may not be
directly attributable to the movement in the exchange rate, the
link between the two is certainly there due to the common
underlying factors.
For example, inflation in a country, denoting a general increase
in price levels would result in the value of any asset like real
estate going up.
At the same time, it would also result in a depreciation of the
currency.
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Exposure When the Foreign Currency
Value of Assets & Liabilities Changes
with a Change in the Exchange Rate (2)
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Though the change in the asset’s value is not directly a
result of the change in the exchange rate, it may be
possible to establish a relationship between the two.
In such a case, the degree of exposure would depend on
the response of the exchange rate and of the asset’s (or
liability’s) value to the change in the underlying variable.
Sometimes, the exchange rate movement does affect the
foreign currency value of the foreign asset or liability,
albeit in an indirect way.
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Exposure When the Foreign Currency
Value of Assets & Liabilities Changes
with a Change in the Exchange Rate (3)
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For example, if there is a depreciation of the foreign currency,
the foreign Central Bank may consider it imperative to increase
the interest rates in the economy in order to defend its currency.
In such a situation, the value of an asset in the form of an
interest bearing security would stand reduced.
In such cases also, the degree of exposure would depend on the
movement of the two variables and the predictability of the
movement in the asset’s or liability’s value.
Depending on these movements, the exposure may be equal to,
lower than, or higher than the foreign currency value of the asset
or liability.
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Exposure When the Foreign Currency
Value of Assets & Liabilities Changes
with a Change in the Exchange Rate (4)
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Suppose there is a foreign asset whose value is $ 2,500,000 with
the exchange rate ruling at Rs. 83.50/$.
At this point its domestic currency value equals Rs. 208.75
million.
The US economy is facing an inflation rate of 4%, due to which
the asset’s price increases to $ 2,600,000.
At the same time, the dollar depreciates to Rs. 81.83/$.
The new value of the asset is again Rs. 212.76 million.
If with every change in the exchange rate, the asset’s value
changes in the same way, the two will be having a predictable
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relationship.
Exposure When the Foreign Currency
Value of Assets & Liabilities Changes
with a Change in the Exchange Rate (5)
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In that situation, the exposure can again be calculated as the
slope of the regression equation between these two variables.
a = AV/ ASu = Rs. 0 / (Rs.1.6731/$) = 0
Here, if we observe that though the exchange rate is variable,
the exposure is nil.
This is because in response to the exchange rate movements,
the foreign currency value of the asset is changing in such a way
as to leave the domestic currency value of the asset unchanged.
Without any movement in the domestic currency value of the
asset, the exposure on the asset becomes zero.
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Exposure When the Foreign Currency
Value of Assets & Liabilities Changes
with a Change in the Exchange Rate (6)
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Though a zero exposure may be an ideal condition, it would
be quite difficult to find such assets and liabilities.
Generally, the foreign currency values of assets and liabilities
move in the manner outlined, but not to the same extent.
Even if the prices of assets change as above, such change
may not occur simultaneously having an exposure.
Say, in the above example, the value of the asset may increase
only to $ 2,550,000 in response to the depreciation of the $.
This would result in a rupee value of Rs. 208,666,500.
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Exposure When the Foreign Currency
Value of Assets & Liabilities Changes
with a Change in the Exchange Rate (7)
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Again, if this value changes in a similar predictable manner
every time there is a dollar appreciation or depreciation, the
exposure would be equal to:
a = AV/ ASu = (Rs. 2,091,405) / (Rs.1.6731/$) = $ 1,250,018
It can be observed that the exposure is less than the value of
the asset (that is, $ 2.5 million).
If, on the other hand, the value of the asset had become $ 2.7
million, the exposure would have been:
a = AV/ ASu = Rs. 4,182,630 / (Rs.1.6731/$) = ($ 2,499,928)
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Exposure When the Foreign Currency
Value of Assets & Liabilities Changes
with a Change in the Exchange Rate (8)
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This makes the exposure almost equal to the value of the
asset.
If the value of the asset had instead moved to $ 2.75
million, the exposure would have been higher than the
value of the asset, that is, $ 3,749,910.
From these examples we can observe that the exposure on
an asset or liability whose foreign currency value changes
with a change in the exchange rate, could be nil or equal
to, less than, or more than the value of the asset/liability.
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Exposure When the Foreign Currency
Value of Assets & Liabilities Changes
with a Change in the Exchange Rate (9)
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In all the examples, the foreign currency value of the asset was
changing in such a way, as to make the relationship between the
movement in the domestic currency value of the asset and a
change in the exchange rate a predictable one.
In many situations, however, it may be very difficult to establish
a regression line, and hence, a predictable relationship, or even
impossible to do so.
In such cases, though the asset or liability may be exposed to
exchange rate movements, the measurement of exposure may
become impossible.
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Exposure on Domestic Assets &
Liabilities
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Domestic assets and liabilities of bank are not directly exposed to
exchange rate movements, as no conversion from a foreign
currency to the domestic currency is involved.
But these assets and liabilities may be indirectly affected through
interest rates.
In the case of these assets and liabilities, the possibility of
measurement of exposure and the degree of exposure would
again depend on the predictability of the change in the domestic
prices.
The calculation of exposure would also be done in the same way
as for foreign assets and liabilities whose value change with a
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change in the exchange rate.
Operating Incomes
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Due to unanticipated changes in interest rates and
exchange rates, the repayment by the events is at
stake, which in turn affects the incomes of the bank.
If the clients are in various countries, this risk is
even more.
Measurement of this risk is a slightly difficult task.
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MANAGEMENT OF RISK
International Banking
Introduction (1)
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Management of risk is traditionally seen as a process
designed to avoid risk.
Due to a fundamental relation between risk and
return, the total avoidance of risk necessarily may not
be in the interest of the bank.
Thus, an effective risk management system must allow
the management to make conscious decisions that are
consistent with its overall objectives.
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Introduction (2)
Various techniques can be used for hedging
risks:
1. Hedging Through the Forward Market.
2. Hedging Through Futures.
3. Hedging Through Options.
4. Hedging Through the Money Market.
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Hedging Through the Forward
Market (1)
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In order to hedge its transaction exposure, a company
having a long position in a currency (having a receivable)
will sell the currency forward, that is, go short in the
forward market, and a company having a short position in
a currency (having a payable) will buy the currency
forward, that is, go long in the forward market.
The idea behind buying or selling a currency in the
forward market is to lock the rate at which the foreign
currency transaction takes place, and hence, the costs or
profits.
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Hedging Through the Forward
Market (2)
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For example, if a Pakistani firm is importing computers from
the USA and needs to pay $100,000 after 3 months to the
exporter, it can book a 3-month forward contract to buy
$100,000.
If the 3-month forward rate is Rs.82.50/$, the cost to the
Pakistani firm will be locked at Rs.8,250,000.
Whatever be the actual spot price at the end of three months,
the firm needs to pay only the forward rate.
Thus, a forward contract eliminates transaction exposure
completely.
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Hedging Through the Forward
Market (3)
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Most of the times, when the transaction exposure is hedged,
the translation exposure gets automatically hedged.
In the above example, the translation exposure gets
automatically hedged as any loss/gain on the outstanding
payable gets set-off by the gain/loss on the forward contract.
But there may be situations where the translation exposure
may need to be hedged, either because the underlying
transaction exposure has not been hedged or because the
translation exposure arises due to the company holding some
long-term asset or liability.
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Hedging Through the Forward
Market (4)
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In such situations also, forward contracts may be used to hedge
the exposure.
The firm would need to determine its net exposure in a
currency and then book an opposite forward contract, thus
nullifying its exposure.
For example, if a firm has a net positive exposure of
$100,000, it will sell $100,000 forward so that any loss by
exchange rate movements on account of the main exposure
will be canceled off by the gain on the forward contract, and
vice versa.
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Hedging Through the Forward
Market (5)
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However, the gain/loss on the underlying exposure will be
notional while the loss/gain on the forward contract will be
real and involve cash outlay.
The cost of a forward hedge can be measured by the
opportunity cost, which depends on the expected spot rate at
which the currency needs to be bought or sold in the absence
of the forward contract.
Hence, the cost of a forward hedge is measured as the
difference between the forward rate and the expected spot
rate for the relevant maturity.
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Hedging Through the Forward
Market (6)
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In an efficient market, the forward rate is an unbiased
predictor of the future spot rate.
The process equating these two requires the
speculators to be risk-neutral.
Hence, when the markets are efficient and the
speculators are risk-averse, the cost of hedging through
the forward market will be nil.
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Hedging Through Futures (1)
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The second way to hedge exposure is through futures.
The rule is the same as in the forward market, that is, go short
in futures if you are long in the currency and vice versa.
Hence, if an importer needs to pay $250,000 after four months,
he can buy dollar futures for the required sum and maturity.
Futures can be similarly used for hedging translation exposure.
Hedging through futures has an effect similar to hedging
through forward contracts.
As the gain/loss on the futures contract gets canceled by the
loss/gain on the underlying transaction, the exposure gets
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almost eliminated.
Hedging Through Futures (2)
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Here it is assumed that basis remains constant.
Only a small part of the exposure is left due to the markto-market risk on the futures contract.
The main difference between hedging through forwards
and through futures is that while under a forward contract
the whole receipt/payment takes place at the time of
maturity of the contract, in case of futures, there has to be
an initial payment of margin money, and further
payments/receipts during the tenure of the contract on the
basis of market movements.
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Hedging Through Options (1)
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Options can prove to be a useful and flexible tool for
hedging transaction and translation exposure.
A firm having a foreign currency receivable can buy a
put option on the currency, having the same maturity as
the receivable.
Conversely, a firm having a foreign currency payable can
buy a call option on the currency with the same
maturity.
Hedging through options has an advantage over hedging
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through forwards or futures.
Hedging Through Options (2)
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While the latter fixes the price at which the currency will be
bought or sold, options limit the downside loss without limiting
the upside potential.
That is, since the firm has the right to buy or sell the foreign
currency but not an obligation, it can let the option expire by
not exercising its right in case the exchange rates move in its
favor, thereby making the profits it would not have made had it
hedged through forwards or futures.
But this advantage does not come free.
Because of this feature, options generally cost more than the
other tools of hedging.
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Hedging Through Options (3)
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Another advantage offered by options is flexibility.
There is only one exchange rate at which a currency
can be bought or sold under a forward or a futures
contract.
On the other hand, options are available at different
exchange rates.
Depending on the firm’s outlook about the future and
its risk-taking capacity, it can buy a suitable contract.
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Hedging Through the Money
Market (1)
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Money markets can also be used for hedging foreign currency
receivables or payables.
Let us say, a firm has a dollar payable after three months.
It can borrow in the domestic currency now, convert it at the
spot rate into dollars, invest those dollars in the money markets,
and use the proceeds to pay the payable after three months.
This process locks the exchange rate at which the firm needs to
buy dollars.
At the same time, it knows its total cost in advance in the form
of the principal and interest it needs to repay in the domestic
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markets.
Hedging Through the Money
Market (2)
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We have seen that in the absence of transaction
costs, the exchange rate arrived at in this manner
will be the same as the forward rate.
It needs to be added that in the presence of
transaction costs, the forward market gives a better
rate than the money market.
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Examples
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Example 1 (1)
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1.
2.
3.
4.
5.
6.
A company needs to pay $ 100,000 after three months.
The following options are available to it:
Can leave the position open.
Can book a forward contract at Rs. 45.40/$.
Can buy a futures contract at Rs. 45.40/$.
Can buy a call option at a strike price of Rs. 45.40, the premium
being Rs. 0.50 per $.
Can buy a call option at a strike price of Rs. 44.80, the premium
being Rs. 0.60 per $.
Can buy a call option at a strike price of Rs.75.80, the premium
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being Rs. 0.40 per $.
Example 1 (2)

The cost to the firm in various scenarios under all the options is:
(Rs. in 000)
Actual Rates After 3 Months
Technique
45.00
45.20
45.80
46.00
46.20
Unhedged
45.00
45.20
45.80
46.00
46.20
Forward Contract
45.40
45.40
45.40
45.40
45.40
Future Contract*
45.40
45.40
45.40
45.40
45.40
Call Option (45.40)**
45.50
45.70
45.90
45.90
45.90
Call Option (44.80)**
45.40
45.40
45.40
45.40
45.40
Call Option (45.80)**
45.40
45.60
46.20
46.20
46.20
* Does not include the opportunity cost of margin money.
** Does not include the opportunity cost of the premium paid.
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Example 1 (3)
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As we can observe, the cost, and hence, the attractiveness of the
various options depend on the actual spot rate at the end of
three months.
Thus, the correctness of a hedging decision can be found out
only in hindsight.
As the choice of the hedging technique has to be made in the
absence of such information, the view of the treasurer as to the
possible movements in the exchange rate assume great
importance.
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Example 2 (1)
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A Pakistani firm exports jeans to America.
Currently it sells 20,000 pieces at $ 30 per piece.
Its cost per piece of jeans is Rs. 300.
In addition, it needs to import certain raw material which costs $
10 per piece.
The fixed costs of the company are Rs. 2,000,000.
The current spot rate is Rs. 44.00/$.
Suppose that the rupee appreciates to Rs. 40.00/$, by how many
units should the company’s sales increase for its profits to
remain unchanged?
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Example 2 (2)

The company’s existing profits can be calculated as
follows:
Sales (20,000 * 30 * 44) = Rs. 26,400,000
Variable Costs (300 * 20,000 = 6,000,000 + 10 * 44 *
20,000 = 8,800,000) = Rs. 14,800,000
Fixed Costs = Rs. 2,000,000
Total Costs (14,800,000 + 2,000,000) = Rs. 16,800,000
Profit (26,400,000 - 16,800,000) = Rs. 9,600,000
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Example 2 (3)
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After the rupee appreciation, the company’s profits will
be:
Sales (20,000 * 30 * 40) = Rs. 24,000,000
Variable Costs (300 * 20,000 = 6,000,000 + 10 * 40 *
20,000 = 8,000,000) = Rs. 14,000,000
Fixed Costs = Rs. 2,000,000
Total Costs (14,000,000 + 2,000,000) = Rs. 16,000,000
Profit (24,000,000 - 16,000,000) = Rs. 8,000,000
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Example 2 (4)
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As a result of the appreciation of the domestic currency,
the profits of the company have come down despite it
selling the same number of units at the same dollar price,
as existed before the appreciation.
Let the number of units that need to be sold for keeping
the profits at the pre-appreciation level be ‘X’.
Here, we are assuming that the company can sell
unlimited quantity at the existing dollar price.
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Example 2 (5)
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Then:
9, 600,000 = (40 * 30 * X) – [(300 * X) + (10 * 40 * X) +
2,000,000]
9,600,000 = 1,200 X - 700 X - 2,000,000
11,600,000 = 500 X
X = 11,600,000 / 500 =
X = 23,200 units
Hence, the firm needs to increase its sales by 3,200 units to
maintain its pre-appreciation profits.
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Example 2 (6)
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While using these hedging techniques to hedge transaction
exposure, it needs to be remembered that their use may not
necessarily result in hedging the economic exposure arising out
of the transaction being hedged.
Take the example of an importer who imports shirts and sells
them in the local market.
There are other competitors in the market who do the same
thing.
Let us suppose this importer locks-in the domestic currency
price of his imports by buying forward contract, while his
competitors do not.
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Example 2 (7)
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In such a case, if the domestic currency appreciates, his
competitors would be able to reduce the price of the shirts,
which he would not be able to do due to his fixed costs.
Thus, his competitors would be successful in taking away his
business and profits.
On the other hand, in case of a depreciation of the domestic
currency, he would be able to sell the shirts at a much cheaper
rate than his competitors, thereby increasing his sales and profits.
Thus, though the domestic currency costs of the producer are
hedged, the variability of his profits arising out of economic
exposure is not.
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Example 2 (8)
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Management of economic exposure requires the use of specific
techniques.
The preliminary components of a sound management process
require the banks to follow a comprehensive risk measurement,
and management approach for controlling, monitoring and
reporting risks.
A successful establishment and development of a full-fledged
trading operation pre-supposes the adoption and use of tight
controls.
Risks like foreign exchange risk can be effectively managed only
when the intricacies are identified, measured and necessary
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controls are instituted.
Example 2 (9)
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1.
2.
3.
4.
The overall objective of a risk management strategy from the
bank’s perspective would be a system that—
Minimizes the risk of adverse movement of exchange and
interest rates.
Allows leeway to take advantage of favorable movements of
exchange and interest rates.
Is cost effective.
Is simple to administer and control.
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RISK MANAGEMENT
PROCESS
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Risk Management Process (1)
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1.
2.
3.
4.
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The process of risk management should consist of the
following steps:
Identification of all areas of risk.
Evaluation of the risks identified.
Setting of exposure limits for various types of
businesses, mismatches and counterparties.
Issuing clear policy guidelines/directives.
Risk management can defined as a dynamic process
needing consistent focus and attention.
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Risk Management Process (2)
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There can be no single prescription for all times.
Decisions once taken will have to be reversed at short notice.
Sometimes the positions shelved may have to be reacquired,
and views have to be charged.
Though the process of risk management seems to be
complex, it an interesting game for the banks.
Winners and losers are never known.
It depends on the alertness of the market participants.
There may not be permanent solution to any problem.
Solutions are only situational.
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Risk Management Process (3)
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In the entire risk management process, the top
management of the bank has to lay down clear-cut policy
guidelines in quantifiable and precise terms—for different
layers, line personnel, business parameters, limits, etc.
It is imperative for the banks top management to plan at
the macro level, keeping in view the banks objective and
mission, and implement these plans at the micro level.
For this the infrastructure should also cooperate for an
effective implementation of a good risk management
system.
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The End
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