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.

]]> http://moreinfo.2pt.net/2008/02/15/control-of-money-market/feed/ http://moreinfo.2pt.net/2007/10/30/the-currency-management-program/ http://moreinfo.2pt.net/2007/10/30/the-currency-management-program/#comments Tue, 30 Oct 2007 07:59:03 +0000 yallop Foreign Capital http://moreinfo.2pt.net/2007/10/30/the-currency-management-program/  

The next stage is to analyze the information gathered. Here is where you incorporate the information regarding the operations, transactions, and corporate objectives with an analysis of the currencies in which the company operates. You identify the risk, in dollar amount, and report the results, along with suitable recommendations. The procedure used to determine risk in each category of exposure is fairly straight forward. First, identify the currencies that denominate exposed positions. Next, measure the exposure in dollar value. Then, measure the degree of foreign currency volatility that can be expected. (This refers to the volatility of nominal exchange rates. Changes in real exchange rates that produce operating exposure require an examination of comparative economic and political conditions-a task for the fundamental research department.)  

Value at Risk  

Obviously, there is no way to determine whether any given exposed position will generate a profit, a loss, or just remain at its current dollar value. You can, however, assign probabilities of value change. There are several analytical tools for finding such probabilities. Value at Risk, or VAR is one tool growing in popularity. Used primarily for institutional investment portfolios, it can be easily adapted to exchange rate volatility.  

VAR is quantified by a measurement of standard deviations. A standard deviation, by definition, is the “dispersion of observations from the mean observation.” In other words, unless a currency price is immobilized at a fixed point (the mean observation), it can be expected to move back and forth from that point. By convention, the point used is the previous market close. A unit of standard deviation equals the expected variance, or price range, from each previous close over a given amount of time.  

As an example, assume that during the last two years, the British pound moved back and forth from the previous close to the next day’s opening about two cents, on an average, every trading day; therefore, a two-cent move in either direction is the overnight volatility of the British pound .We also know that, every so often, the pound makes sudden large overnight moves of four cents or more. What is the probability that the pound will move more than four cents in one direction between tonight’s close and tomorrow’s opening?  

To determine this, assume that the movements are completely random with regard to direction. Plotting the distance of the price move from one trading day to the next, all of the chart points should fall within the area under a bell curve. Because the expected change of value can be expressed as the standard deviation of this curve, one standard deviation is equal to two cents from the close of the previous day. By definition, approximately 95% of the area under a bell curve is contained within two standard deviations; therefore, there is no more than a 5% chance that an overnight move will exceed four cents in either direction from the previous close. Within these parameters, four cents is the maximum value at risk. In other words, our VAR is (no more than) four cents based on a 95% confidence interval, when analyzed with a two year period of historical market data and assuming a normal distribution curve.  

Of course, when assigning risk values to exposed positions, the previous close can be defined on a monthly, quarterly, or even annual bar chart. The expected variance from one quarter to the next would be quite different from the expected variance from one day to the next. After determining the U.S. dollar value of the foreign currency position and the expected variance, or standard deviation, for a given duration, you will know the change of value that probably will occur in the exposed position over time.  

This works well for transaction exposures with finite values and durations. It can also be used for ongoing cash flow exposure. For cash flow, however, an exposure duration must be chosen, such as monthly exposure, quarterly exposure, semi-annual exposure, and so forth.

It is becoming increasingly evident that the corporate currency manager and the currency speculator have much more in common than either are willing to own up to (the speculator considering himself a breed apart, and all). Both are at risk of financial loss in unpredictable markets. The cash exposure carried by the corporation is no different from the market exposure of the speculator. They are managed in a similar fashion.

Paradoxically, the risk disappears for both when the currency manager gets into the market and the speculator gets out; both assume exposure risk when the hedger steps out of the market and the speculator steps in.

This being the case, imagine a scenario in which one currency manager and one currency speculator transact with each other, each hoping to profit from a trade in which only one will. If the speculator is seasoned, he is probably trading as mechanically and impassively as he knows how, aided by a system that’s calling the shots. If he is doing it right, he planned the trade in advance, and now he’s trading the plan. The currency manager should do the same.

It is to the currency manager’s advantage, therefore, to know the rules of the game. They are listed below in no particular order. Most, but not all, were developed by speculators who validated them by painful experience. Others pertain specifically to hedging. They will all serve the currency manager equally well.

1.Do not “Texas hedge.” A “Texas hedge” is not a hedge at all-it is speculation. Unless the market exposure is in the opposite direction from the cash exposure, the company is not hedging. Also, to the extent that the exposure is over-hedged or under hedged, the company is speculating, either in cash or derivatives.

2.Be sure of your position. Simple transactions are obviously long or short, but the more complex a hedge becomes, the less obvious the positions may be. Convoluted option strategies and option embedded counterpart agreements may be difficult to unravel into component longs and shorts. Thoroughly pick apart all derivative strategies and identify each component by amount, duration, and position.

3.Calculate your equity balance daily. Foreign exchange and futures accounts should be marked to the market daily. It is all too common for huge losses to accrue undetected until it is too late to salvage the program.

4.Do not over-leverage. Figure out the worst case scenario and make sure funds are available to back up the market position if it occurs. In regard to futures positions, delays in meeting margin calls can result in unrealized losses suddenly becoming realized without the currency manager’s knowledge. Recognizing this, most brokers and dealers have standing instructions to liquidate an overdue margin position immediately, at the market, with or without the client’s approval.

5.Do not lift hedges prematurely simply to stem a loss. If the hedge is sound, liquidating it to cut a loss will leave the exposure vulnerable to a price reversal. There is nothing worse than getting out of the market with a realized loss only to see additional losses accumulate in the exposed position as prices suddenly go the other way.

6.Do not lift hedges prematurely simply to take a profit. It’s tempting to take profits, especially after agonizing through a string of trading losses. It is tempting to want hedging positions to produce profits, even more than cash positions. It is easy to rationalize profit-taking believing that the market has gone too far, too fast. It seems so certain that there will be an opportunity to re-establish the hedge at a better price. Too often, there is no better price. A characteristic of market trends is that they keep going much farther than anyone expects. Hedge profits can quickly dissipate as the now unheeded exposure generates losses.

Paradoxically, the risk disappears for both when the currency manager gets into the market and the speculator gets out; both assume exposure risk when the hedger steps out of the market and the speculator steps in.

This being the case, imagine a scenario in which one currency manager and one currency speculator transact with each other, each hoping to profit from a trade in which only one will. If the speculator is seasoned, he is probably trading as mechanically and impassively as he knows how, aided by a system that’s calling the shots. If he is doing it right, he planned the trade in advance, and now he’s trading the plan. The currency manager should do the same.

It is to the currency manager’s advantage, therefore, to know the rules of the game. They are listed below in no particular order. Most, but not all, were developed by speculators who validated them by painful experience. Others pertain specifically to hedging. They will all serve the currency manager equally well.

1.Do not “Texas hedge.” A “Texas hedge” is not a hedge at all-it is speculation. Unless the market exposure is in the opposite direction from the cash exposure, the company is not hedging. Also, to the extent that the exposure is over-hedged or under hedged, the company is speculating, either in cash or derivatives.  

2.Be sure of your position. Simple transactions are obviously long or short, but the more complex a hedge becomes, the less obvious the positions may be. Convoluted option strategies and option embedded counterparty agreements may be difficult to unravel into component longs and shorts. Thoroughly pick apart all derivative strategies and identify each component by amount, duration, and position.

3.Calculate your equity balance daily. Foreign exchange and futures accounts should be marked to the market daily. It is all too common for huge losses to accrue undetected until it is too late to salvage the program.

4.Do not over-leverage. Figure out the worst case scenario and make sure funds are available to back up the market position if it occurs. In regard to futures positions, delays in meeting margin calls can result in unrealized losses suddenly becoming realized without the currency manager’s knowledge. Recognizing this, most brokers and dealers have standing instructions to liquidate an overdue margin position immediately, at the market, with or without the client’s approval.

5.Do not lift hedges prematurely simply to stem a loss. If the hedge is sound, liquidating it to cut a loss will leave the exposure vulnerable to a price reversal. There is nothing worse than getting out of the market with a realized loss only to see additional losses accumulate in the exposed position as prices suddenly go the other way.

6.Do not lift hedges prematurely simply to take a profit. It’s tempting to take profits, especially after agonizing through a string of trading losses. It is tempting to want hedging positions to produce profits, even more than cash positions. It is easy to rationalize profit-taking believing that the market has gone too far, too fast. It seems so certain that there will be an opportunity to re-establish the hedge at a better price. Too often, there is no better price. A characteristic of market trends is that they keep going much farther than anyone expects. Hedge profits can quickly dissipate as the now unheeded exposure generates losses.

Now I just want to tell you something about Asian and US market which have different types of market like oil market commercial market.

Asian market 

         Oil market: Asian oil stocks skip on record crude oil prices for the very first time Asian oil stocks rose above $80 a barrel, paced by ‘Cnooc Ltd’,  and ‘Inpex ‘Holdings Ltd.’ after the closing price of crude-oil in yesterday. Oil producers are run towards the positive response come up from near record prices.                

    ‘Inpex’,Japan’s largest energy explorer rose 5.6 % to 1.13 ML yen. ‘Cnooc’, China’s major off-shore oil manufacturer, advanced 5.7 % to 10.30 Hong Kong dollars. Third-biggest oil producer in Australia ‘Santos Ltd’, jumped 5.7 percent to 13.80 Australian dollars.          

 Crude oil stopped up $80 per barrel in FX market running week for the first time, after Hurricane Hum-berto enforced the closure of 3 refineries inTexas that can be a course of combined 850k barrels of oil per day.                     

Commercial market: ‘Samsung Electronics Co.’ led exporters lesser on concern with United States expenses will dawdle after the unexpected unemployment in world’s biggest economy.Japan’s biggest lender- ‘Mitsubishi UFJ Financial Group Inc’, slip down after the country’s market shrank. ‘Nomura Holdings Ltd.’ cut its rating on bank inventories. Demand from China for commodities looks like it will continue to hold up despite aU.S. slowdown.'’ The world’s biggest chip packager and tester ‘Advanced Semiconductor Engineering Inc.’ licked a decline between I-Technology inventories after UBS now chip costs have peaked.                 

 ‘The Morgan Stanley Capital International has changed a little current week at 152.38, after climbed at 11 % in the earlier 3weeks. A gauge of energy inventories that includes ‘Inpex’ had the biggest profit among the benchmark’s ten industry groups, while technology inventories lost the most.                                   
Japan’s Nikkei’ 225 average inventories were changed at 16,127.42 while the broader Topix-Index lost 0.8 % current week. ‘Sun-Hung-Kai Properties Ltd.’ led ‘Hang Sang Index’ of Hong Kong to its 3rd direct record on previous day. Benchmark’s away in the region is superior except in India, South Korea, Malaysia, Indonesia and Philippines.  

U.S. Market                      
          U.S. inventories climbed, expanding the ‘Dow Jones Industrial’ largest weekly gain ever since the month of April, on increasing product costs and speculation the Fed. Reserves will offer lesser interest rates on up-coming week.     

             ‘Alcoa Inc. rallied the most in 3 weeks after ‘Merrill Lynch & Co.’ said the 2nd biggest aluminum producer might enhance the gain margins by acquiring venture associate Alumina Ltd. Hov-nanian Enterprises Inc. led builders to the steepest profit in one month. By an average ‘Dow’ rose 17.64/ 0.1%, to 13,442.52. NASDAQ Composite Index enlarged by 1.12% to 2,602.18.  ‘Standard & Poor’s’ 500 Index added 0.3% to 1,484.25.                  

 The Standard & Poor’s’ rose 2.1% during this week, while the ‘Dow’ goes at +2.5 % and the NASDAQ jumped 1.4% Speculation the Federal Reserve will lower its benchmark’s lending rate by as much as 0.5 % point on 18Sept’07 helped equities wipe out losses from the 2 preceding weeks.   

The swap rate is not an exchange rate; it is an exchange rate differential When the interest differential between the U.S. dollar and the pound sterling was 3 percent in favor of the pound, the swap rate for three-month delivery was .0180 below the Spot rate of $2.4000/£. This .0180 swap rate is equivalent to a 3 percent plenum discount of the forward pound rate relative to the spot pound rate. 

In the foreign exchange market, a rate is the price at which individuals are willing to exchange currencies.

At the swap rate of .0180, nobody is willing to exchange any currency. However, the swap rate of .0180 is related to the spot rate of $2.40/£ at which pounds are traded against dollars for two business days’ delivery. The swap rate is also related to the outright forward rate of $2 .3820/£ for three-month pound delivery (2.40 .0180). The rates at which transactions are carried out in the foreign exchange market are either the spot or the various forward rates. The swap rate is the link between the spot rate and the forward rate, or the link between two forward rates for two different maturity dates. This link is directly related to the net accessible interest differential between the two relevant currencies.

The fact that a swap rate is not an exchange rate becomes particularly clear when one wants to find reciprocal rates. For example, the exchange rate for German marks against U.S. dollars may be US$0.40/DM in U.S. terms or DM2.50/US$ in German terms. One rate can be derived from the other by simply finding the reciprocal of one of the rates; in other words,

2.50 =1/0.04 this calculation can be done with spot rates as well as forward outright rates, but it cannot be done with swap rates. If we have the following rates in U.S. terms:

Spot rate $0.40/DM
Three-month forward outright rate $0.41/DM
Three-month swap rate $O.Ol/DM.

And if we would like the same rate in German terms, we can get what we want by finding the reciprocal of the spot rate and the forward outright rate. The reciprocal of the swap rate would be meaningless.

To obtain the swap rate in German terms we have to find the difference between the spot and forward outright rates expressed in German terms.

Accordingly,

Spot rate (1 / 0.40) DM2.5000/$

Three-month forward outright rate (1 -:- 0.41)
DM2.4390/$
Three-month swap rate (2.50 - 2.4390)
DMO.0610/$

Swap rates are not true exchange rates and may not be reciprocated to change the terms in which they are expressed.

          The Federal Reserve Bank of the United States is not licensed to set foreign-exchange policy. When the Treasury intervenes, however, it has to use the facility of the Fed. In particular, the purchase and sale of foreign currencies on the open market is implemented by the Federal Reserve Bank of New York. While the Fed doesn’t have explicit authority to play this game, ever since the early 1960s, when the Fed stepped in to defend the dollar and the U.S. gold reserves, the Treasury and the attorney general have issued a number of legal decisions that have given the Fed the right to proceed.

          It’s a strange system. Theoretically, the Treasury and the Fed could go their separate ways if they so desired. The Treasury could buy dollars through the Exchange Stabilization Fund while the Fed was selling dollars through the Federal Reserve Bank of New York. The Treasury secretary has to report only to the president. The chairman of the Federal Reserve, once appointed by the president and confirmed by the Senate, doesn’t have to report to anyone except his own board, the Federal Open Market Committee, and ultimately Congress.

           Should this highly leveraged banking structure take further losses in the 1990s, the whole financial system would be under tremendous pressure. If the Japanese were to move into a recession and bankruptcies of financial institutions began to proliferate, systemic weaknesses would quickly come to light.

           Concerns about the general health of the Nikkei also restricted the maneuverability of monetary authorities in Japan. During the 1980s, the booming Tokyo stock market became an investment vehicle for everyone from individual housewives (who purchase stocks from door to-door securities brokers) to pension funds, banks, and such “nonblank” as leasing companies, credit-card firms, and consumer-finance companies. With that kind of involvement in the stock market, Japanese authorities find it difficult to impose strict money-tightening measures. If the authorities were to raise interest rates too high in an attempt to choke off inflationary pressures and lower over inflated land values and asset prices, then Japanese housewives and institutional investors might be prompted to flee stocks and reinvest in money-market instruments. Should that happen, the Nikkei would plummet even farther than it did in 1990.

        Germany left itself open to the possibility of rampant inflation in its support of the East. By 1991, however, European economic unification-an event that would provide a considerable boost to the overall German economy-was only a year away. With unfettered access to markets throughout Western Europe, the German industrial state could count on continually rising demand until at least the middle of the decade. Far less dependent on the U.S. market than in previous decades, Germany might face a recession of its own; but in all likelihood it would be unrelated to the U.S. economy.

             It is possible that the international investment community, through foreign exchange, may succeed in imposing a discipline on U.S. government spending and asset management that we have failed to impose on ourselves. Ongoing deflation (the cause and perpetuator of any depression) will lead to ever-increasing defaults on debt, as the United States begins to pay for the speculative frenzy of the 1980s characterized by takeovers, excessive consumer spending, reckless investments by the banking community, and the escalation of commercial property speculation.

           The currencies of nations in which these excesses did not occur will become increasingly attractive to a more discriminating international investment community. If the perception ever arises that the U.S. government has fully abandoned its responsibility to the domestic economy, the traditional confidence in the dollar will become a thing of the past. The international investor will have little incentive to pay a premium for a currency that once represented security, liquidity, and stable government, if in fact all three of these “premium values” are put into question.

          Without this alternative, its only recourses are to vastly increase its exports, to take out further loans from other nations-which are understandably reluctant to lend to a country that has defaulted on earlier dehtsor to reschedule its debt-repayment plan.)

          The increasing incentive is for foreign capital actually to take over U.S. production facilities-from farms and factories to financial services and stockyards. This certainly occurred in the 1980s. But it is unlikely to happen again-at least on an equivalent scale-if the dollar steadily declines. If dollar profits cannot be taken out of the United States at a favorable rate, foreign investors will find it difficult to justify new purchases of U.S.based assets.

             Can the United States become accustomed to being a partner among equals in the global economy-or are we locked into a leadership role, even if the role is meaningless and the leadership is lacking? There is no agenda for the dollar. And even if there were, we would not have any means of implementing or enforcing that agenda. Not only that, there are no meaningful plans to enact new policies-or, for that matter, to develop fiscal and monetary policies that will benefit the United States and, in the long run, the world. In theory, the initiative for new resolutions on global currency issues could come from the United States. But the United States in its current weakened economic position has no way to launch those initiatives without incurring a political risk.