Price risk
Category: Corporate Governance
Price risk (or market risk). The risk arising from changes in the value of portfolios of financial instruments. This risk arises from market-making, dealing, and position-taking activities in interest rate, foreign exchange, equity, and commodities markets.
In the pricing of a product, pricing to risk is important. In the example of loan products, there is an opposing pull between pricing to «market» and pricing to risk. Aside from the price covering the overhead of the product, it should ideally reflect the risk premium that the Bank puts on the product and the customer’s probability of repaying the obligation. The use of collateral security, of course, mitigates the repayment risk.
NBU in the future will be assessing the banks’ position exposures to changes in rates and prices; policies andprocedures adopted by the bank in identifying, monitoring and controlling market risk.
Foreign exchange risk
Foreign exchange risk. The risk arising from movement of foreign exchange rates. This risk is found in cross-border investing and operating activities. Market-making and position-taking in foreign currencies is price risk.
Currently, NBU regulates the limits for banks’ open foreign currency position. In the future it plans to assess how banks hedge their currency exposures, structure of positions in foreign currencies, policies and procedures for foreign currency risk management.
Example
In February 2002, the Allied Irish Bank had announced the loss of about 750$ million from the foreign exchange transactions.
Apart from the internal controls holes and fraudulent activities, the loss was incurred from the fact that the trader entered into large number of foreign exchange deals. Allied Irish has confirmed these deals involved buying and selling Japanese yen and US dollars. These were both «spot» contracts, involving on-the-spot deals and «forwards», which are agreements to purchase foreign exchange at a specified date in the future at a specified exchange rate.
He appeared to have offset risk with ‘options’ deals.
Most observers assume that the original forex deals proved bad, causing big losses. The most likely scenario is that the trader built up big bets that the yen would strengthen against the dollar. Instead, it had weakened considerably over the past 12 months — the period in question.
The bank discovered that the losses had not been offset by profits from the options deals. What had happened is that the purchase orders were entered into the bank’s system «artificially». That is, it was made to appear as if options contracts had been bought when, in fact, they had not.