Currency risk

Currency risk is also called foreign exchange risk (forex risk). Certain financial intermediaries' asset portfolios are made up of domestic and foreign securities. In the case of the latter the portfolio will usually include foreign bank deposits and securities such as treasury bills of the US and UK (or other) governments. In addition to their foreign portfolios, banks also play a major role in the spot, forward and derivative foreign exchange markets. Internationally, banks also have liabilities in foreign currencies.

Most large banks are exposed to currency risk, which may be defined as the risk of changes in currency values unfavorably affecting the values of assets and liabilities that are denominated in currencies other than the domestic currency. Because certain financial intermediaries, particularly the banks, are highly leveraged, their exposure to currency risk can be devastating on their profitability and to their capital position.

Currency management is the management of the exposure to levels that are acceptable. Exposure can be managed by various means, and the main instruments that are used are derivative instruments:

• Currency swaps.

• Forwards.

The first step in managing currency exposure is to measure it.34 The net currency (C) exposure in any given currency, A, is calculated according to:

Table 2 will elucidate (home currency = USD):

Table 2: net currency exposure report

Net exposure GBp = (10 000 - 15 000) + (65 000 - 50 000)

= (-5 000) + (15 000) = 10 000

Net exposure JpY = (30 000 - 20 000) + (100 000 – 125 000)

Net exposure CHF = (4 000 - 10 000) + 000 - 55 000)

= (-6 000) + (-S 000) = -11 000

This means that the US bank is "long" of GBP, and "short" in both JPY and CHF. Thus, if the GBP appreciates (remember home currency = USD), and/or the JPY and the CHF depreciates, the intermediary will make a profit (on this part of the portfolio). However, if they do the opposite, the bank will make a loss (on this part of the portfolio).

With the above currency exposure report the financial intermediary is in the picture and is able to manage the exposure. It may, for example, do currency swaps or forward deals that coincide with the terms of the exposure: sell GBP forward for USD and buy JPY and CHF forward for USD.

While these transactions will cancel out the exposure (approximately depending on terms negotiated, maturities, etc), it should be clear that if the USD generally appreciates (i.e. appreciates against the main currencies of the world), the financial intermediary would be hurt by the depreciating GBP (remember it is long GBP), but would gain by the extent of the depreciating JPY and CHF (remember it is short JPY and CHF). Thus, there is an offsetting effect, meaning that the net exposure is not so large. In practice, most banks take on some currency exposure, and manage it according to their views of future currency movements.

Bank regulators require monthly returns in respect of currency exposure. The purpose:

"...is to determine...(a) the month-end effective net open foreign-currency position in selected currencies and in all currencies taken together in respect of the reporting bank and its foreign branches and foreign subsidiaries; and (b) the maturity ladder of foreign assets, liabilities and commitments"

Counterparty risk

Each party to a deal has a party on the other side of the deal. Thus, each party is the counterparty to the other party, and each party is exposed to the other in that the other party may renege on the deal or be a fraudulent party to the deal (i.e. may not perform in terms of the conditions of the deal). If a party fails to settle a deal the counterparty will do another deal which may not be as favorable (and may result is a loss) as the unsettled deal. This risk is termed counterparty or settlement risk.

There are many different types of deals, each involving a different risk profile. A few examples of hazards with deals follow:

• A seller to a bank may deliver tainted scrip to the bank.

• A buyer from a bank may present a cheque to the broker drawn on an account that is not funded.

• The buyer or seller may decide not to settle because prices may have changed between deal date and settlement date.

• A broker may take an excessive commission or 'turn' (i.e. margin between buying and selling rate or price).

Management of counterparty risk includes:

• As the risk lies with large dealers in the financial markets, banks ensure that transactions are conducted only with known reputable parties and with guaranteed payments.

• Dealing, where applicable, with financial exchanges which are regulated and supervised. The exchanges in turn supervise broker-dealer members.

• Banks have been at the forefront of the formation of a central securities depository (CSD), which brings about scrip dematerialization / immobilization. This eliminates the hazard of tainted scrip, and ensures payment against electronic delivery.

• Many countries have a specialized large-transactions payments system (operated by the central bank) that functions on RTGS (real-time gross settlement). This applies to the large deals of the financial markets.

Bank regulators36 require monthly returns in respect of currency exposure. The purpose is:

"...to measure the counterparty risk for all unsettled transactions, including forward rate agreements, interest-rate swaps, derivatives, etc, relating to a bank's banking and trading activities when non-performance by a counterparty could cause a financial loss to the reporting bank"