Foreign exchange risk
Category: Bank Management
Definition
This risk comes from the variation of foreign exchange rates and appears when a bank has assets and debts in foreign currencies. Depending on the variation, the situation of the bank will be as follows.
| Assets in foreign currency | Appreciating currency | Profit |
| Assets in foreign currency | Depreciating currency | Loss |
| Debts in foreign currency | Appreciating currency | Profit |
| Debts in foreign currency | Depreciate currency | Loss |
Measuring the foreign exchange risk
This risk is measured by the Exchange position, i.e. the net balance of the holdings in a given currency.
Let us take a simplified example of USD held by a French institution, at a fixed time t.
The position can be the following:
| Assets | Liabilities | ||
| Holding | 4 000 USD | Debt | 4 500 USD |
| Forward buy | 500 USD | Forward sale | 1 000 USD |
| 4 500 USD | 5 500 USD |
Net holdings: — 1 000 USD (short position — for a fall of USD)
At a reference ratio of 6 FRF to 1 USD, a variation of 1 % will give:
| Exchange rate | Amount | Counter value | Difference |
| 5,60 | 1 000 USD | 5 940 USD | 60 USD |
| 6 | 1 000 USD | 6 000 USD | 0 USD |
| 6,06 | 1 000 USD | 6 060 USD | — 60 USD |
A variation of 1 % of the exchange rate of the currency has an incidence of 60 USD on the result of the bank.
Either a gain of 60 USD in case of depreciation or a loss of 60 USD in case appreciation, for the position is on a downward trend.
With a short position, the situation of the bank is unfavourable in case of a rising ratio of the currency with a long position, the situation of the bank is favourable in case of depreciation of the value of the currency.
Managing the foreign exchange risk
a) Determining the exchange position
This position is visible thanks to various accounting balances, but it must be checked and approved to be sure that all operations have been registered properly.
But this position can be known only after a certain period of time to register, treat and edit, where as the dealers in the front office need a position in real time: operational position.
A comparison of the accounting position and the operational position has to be done carefully.
b) Limits have to be fixed by Management to determine a maximum loss in case of extremely unfavourable variation of the exchange rate
These limits depend on:
the size of the bank, its capital stock
the ability of the operators
the efficiency of the control system
These limits can be set during the day or at night. The risk is far more important overnight for many events can happen between the opening and the closing of the market.
c) Control over the position
Two levels of control are necessary:
control of the respect of the authorised limits
control of the results
At any time, the exchange rate position should be available to the management of the Bank who can decide to close a position and register a loss or a gain.
The main methods to manage the exchange rate risk are quite similar to those shown to manage liquidity risk and interest rate risk; an operation in one way can be backed by an inverse position, totally or partially, or the bank can use instruments on the derivatives Market.