Forex Queries

      We all are aware of the risks in foreign exchange and money market operations and identified them as rate risk, credit risk, and liquidity risk. In this chapter we shall discuss ways of controlling these three risks as they apply to operations in the foreign exchange and the money markets. To facilitate presentation, we shall consider these risks in a different order from the one used in the last chapter.

Credit risk

    In order to control credit risk, lines of credit must be established for each party with whom we deal. These lines should specify separate credit lines for exchange transactions and money market transactions. If several operators have authority to extend credit to a single party, as international banks operating in the international money market can do, it may be useful to establish at headquarters one global line for exchange transactions and one line for money market placements. The individual operators should then receive allocations from this total line.

Credit risk in the foreign exchange market

    Credit risk in foreign exchange operations is either a so-called 10 percent or a 100 percent risk, depending on whether the other party to the contract defaults before or at the maturity date. Thus, any operator in the foreign exchange market should have both a limit on the aggregate amount of exchange contracts outstanding with a particular party to cover the so-called 10 percent risk and a sublimit on transactions maturing on A bank might be willing to have a total of U5$I 0 million Outstanding in exchange Contracts with a given Customer and to bear the 10 percent risk on this total. However, the line might specifically stipulate that no more than U5$2 million may mature on a single day.

    This means that the bank can have U5$2 million worth of contracts maturing on every day of a week Monday through Friday. This would make an aggregate of U5$1O million, and the total maturity per day would not exceed $2 million. A maximum loss in this situation would, in theory, be as million s: The customer defaults on Monday, and the bank suffers a 100 percent loss on the $2 million maturing on that day (assuming the bank has already paid for its part of the Contract). Losses on the Tuesday through Friday maturities of the remaining $8 million would be limited to the extent to which the exchange rate has deteriorated since the time the original forward contract was made. If we assume that this deterioration usuaJIy does not exceed ] 0 percent, the loss would be $.8 million. The total loss on the entire U5$] 0 million outstanding at the beginning of the week would be $2.8 million. The actual foreign exchange line could be worded: “U5$IO million or equivalent, for aggregate exchange transactions outstanding with a sublimity of U5$2 million, or equivalent, for transactions maturing on anyone day.”

    Of course, by defining the sublimity so that it controls Contracts maturing on anyone day, it is assumed that the bank has a system for assuring itself at the end of each day that “good” Counterpart funds have been received in its depository. If it does not have such a system, or if liquidation is not made by direct credit to its account (e.g., if the bank receives payment by means of a check which has to be cleared to make sure the funds are good), the sublimity will have to be redefined so that it reflects the exposure more precisely.

    The international trade practices of many businesses make it necessary for them to buy and sell certain currencies in order to settle their accounts in various countries. In these cases it is wise for a bank to have specific knowledge as to which currencies its Customers must buy and semi as a result of their normal business. Then, the exchange lines can be more specific and may possibly be limited to transactions in these specific currencies. These sublimates will alert the bank whenever a Customer decides to deal in currencies which are not related to that Customer’s usual commercial business transactions. The bank may very well honor the request, but it may be useful to note that such transactions are out of the ordinary for the Customer.