3. Risks in FX Flashcards
1
Q
What is FX exposure risks & how many types of exposure risks are there?
A
- relate to the vulnerability of an institution to changes in its profit/loss due to fluctuations in exchange rates.
- foreign currency: any other currency apart from an institution’s domestic or ‘home’ currency in which its published accounts are denominated.
- 4 main types of currency exposure risks:
• transaction exposure risk
• translation exposure risk
• economic exposure risk
• trading exposure risk
2
Q
What is Transaction exposure risk (aka business exposure risk) & how do companies mitigate it?
A
- risk of loss from the change in exchange rate during a biz transaction.
- occurs when a company has to pay/receive a foreign currency immediately/at some future date
- risk can be short/medium-term & are the result of business activities.
- to hedge, buy/sell foreign currencies for immediate/forward deliveries.
3
Q
What is Translation exposure risk aka accounting exposure risk.
A
- arises when a company has assets/liabilities denominated in foreign currencies.
- Movements in the exchange rates for the foreign currency exposures will alter (positively/negatively) the value of the company’s balance sheet.
- if negatively exposed to this risk, will end up with revaluation/book losses, which are paper losses — don’t affect the actual cash position of the company until realised.
4
Q
What is Economic exposure risk?
A
- arises when changes in exchange rates over a period of time affect the competitiveness of a company via its pricing & expenditure structure.
- Eg: sharp appreciation of the Japanese Yen in the mid-1990s caused Japanese exports to become more expensive compared to other countries — affecting the pricing competitiveness of the country’s exports.
- foreign importer of Japanese equipment would have to use more of its home currency to buy the Japanese Yen, thereby affecting the company’s cost structure.
5
Q
Who manages the different types of currency exposure risks?
A
- shorter-term transaction & translation exposure risks: finance executives & managers
- senior management: economic risks
6
Q
What is Trading exposure risk?
A
- deliberately takes on a currency exposure to profit from it — will only hedge when the exchange rates move in its favour
- Eg: A Malaysian company has committed receivables of USD10m in 3 months’ time which it can hedge by selling USD for MYR at USD/MYR forward rate of 4.29 but decides not to hedge — hoping USD to strengthen against MYR. If USD weakens sharply against MYR, the company may have to sell USD at a lower exchange rate.
- The company is exposed to a trading exposure risk, but can be avoided if hedge immediately once an exposure is ascertained.
7
Q
What is FX Counterparty Risks aka FX delivery risks?
A
- risk that one of the counterparties to a FX deal fails to honour its part of the contract, causing the other party to suffer financial losses.
- comprise of settlement and pre-settlement risks — settlement risk is riskier as it involves the non-receipt of the whole amount of the corresponding foreign currency.
8
Q
What is settlement risk aka delivery risk & how is it mitigated?
A
- risk that one of the counterparties may default on the delivery date — 1 party paying out the currency without receiving the corresponding foreign currency from the other counterparty.
- occurs in all immediate FX deals (value spot, tomorrow and today) & forward FX and swaps transactions.
- can be mitigated with:
1. Delivery-versus-Payment (DvP) settlement - ensure buyer’s account has sufficient funds & seller’s account has sufficient securities — transaction will then settle simultaneously.
- Payment-versus-Payment (PvP)
- ensure counterparties of FX transaction have sufficient funds in their account (in the respective currencies of the traded FX pair) to facilitate payment.
- direct link between RENTAS in Malaysia for the settlement of MYR & USD CHATS (Clearing House Automated Transfer System) in HK for settlement of Dollar, enable the simultaneous settlement of both currencies during Malaysian business hours — eliminates FX settlement risk.
- Another example of PvP infrastructure is CLS Settlement which facilitate multilateral payment netting of active currencies such as USD and EUR.
9
Q
Example of settlement risk & why is it not as risky as outright lending?
A
- On 12 July 2017, XYZ Bank Bhd purchased from RST Bank in USD10m at the USD/MYR rate of 4.2935 for value spot 14 July 2017. XYZ Bank pays the MYR43m to RST Bank value 14 July 2017 with the expectation that RST Bank will pay the USD10m to its account in New York later that day.
- The next day, XYZ Bank found out that the USD10m wasn’t credited into its account. XYZ Bank is thus exposed to a settlement risk.
- amount not credited could be due to: transaction was fraudulent/RST Bank became insolvent on the day of the payment/country was invaded & the bank ceased to exist/central bank imposed FX controls.
- settlement risk is less risky than outright lending — If XYZ Bank lends to RST Bank USD10m for 6 months, XYZ Bank is exposed to the full credit risk for the whole 6 months but in a spot foreign exchange settlement risk, both counterparties are exposed to the delivery risk for only 2 days.
- can be mitigated by DVP/PVP
10
Q
What is pre-settlement risk and give an example.
A
- risk that one of the parties defaults on an outstanding FX contract before the delivery date.
- exist in all forward FX deals and FX swaps — can happen when a party to a forward contract become insolvent before the delivery date
- one of the party is deemed as in default in making the foreign currency payment on the forward date & the other counterparty automatically stops payment of the other corresponding currency.
- non-defaulting party isn’t exposed to settlement risk but need to enter into a new deal to substitute the old one = exposed to a potential replacement risk — may work in or against the bank’s favour.
- Eg: On 12 July 2017, XYZ Bank purchased 10m USD/MYR 3-month forward for delivery 16 October 2017 at 4.3098 from ABC Bank (assume spot is 4.2935 + 0.0163 3 months forward points).
- 1 month later, ABC Bank went into liquidation. XYZ Bank stops forward payment of MYR43m to ABC Bank & is not exposed to settlement risk.
- XYZ Bank lost its counterparty & FX deal that was transacted on 12 July 2017 becomes null and void — XYZ Bank’s original FX exposure isn’t covered & must go to the market to replace this ‘lost’ deal.
- If the 2-month forward USD/MYR is currently trading at 4.3898 = XYZ Bank must buy the 10m USD/MYR at 4.3898 compared to the lower initial rate of 4.3098 = XYZ Bank pay more MYR to buy 10m USD & suffers a replacement risk of MYR800k (0.0800 × USD10m).
- but if the prevailing 2-month forward USD/MYR is 4.2398, XYZ Bank reaps a replacement windfall profit of MYR700k (0.0700 × USD10m).
11
Q
Why is pre-settlement risk less risky?
A
- pre-settlement risk doesn’t cause the lost of principal amount of the corresponding foreign currency — only exposed to a potential replacement risk which may work in his favour/against him & only loses the difference between the prevailing market rate & the original contracted rate if the market rate move against him
12
Q
Are there limits relating to FX deals?
A
- Set up authorised FX limits
- if nobody defaults, one of the parties may be exposed to a settlement risk on the actual forward delivery date if the other defaults — because FX limits must be set up to enable FX dealers to transact with other parties, whether banks or non-banks.
- Dealers must ensure that an FX line (both counterparty and country) exists before quoting to a particular bank/non-bank. - Utilisation limits must not be exceeded
- if exceeded, documented approval must be obtained from management. - prevent bankers’ defaults due to no limits.
- management will pass resolutions & set up official FX limits to enable them to transact FX with bankers.
- Such limits, like money market limits, are credit decisions & are normally set up & approved by the credit/international division.
- for foreign branches, limits are set up by head offices & allocated to various branches.
- validity of banks’ FX limits is normally up to 1 year — reviewed on a yearly basis — if banks are under ‘credit watch’, may review on 3/6 month basis.
- Hence, FX dealer who is requested by a customer to quote forwards for more than 1 year has to check & obtain management/relationship manager’s approval before proceeding to quote a price.
13
Q
What is Non-deliverable forward (‘NDF’)?
A
- outright forward/futures contract — counterparties settle the difference between the contracted NDF price/rate & the prevailing spot price/rate on an agreed notional amount on the contracted settlement date
- short-term, cash-settled — ‘non-cash’ when there’s no exchange of the principal amounts of the 2 currencies contracted.
- is an OTC market developed for emerging markets with capital controls, where the currencies could not be delivered offshore.
- commonly quoted for times periods from 1 month to 1 year with the USD as the reference currency + settlement amount is also in USD.
- OTC market is less regulated and can customise contract
14
Q
Example of Non-Deliverable Forward (NDF)
A
All NDF contracts set out the currency pair, notional amount, fixing date, settlement date, and NDF rate, and stipulate that the prevailing spot rate on the fixing date be used to conclude the transaction.
The fixing date is the date at which the difference between the prevailing spot market rate and the agreed-upon rate is calculated. The settlement date is the date by which the payment of the difference is due to the party receiving payment. The settlement of an NDF is closer to that of a forward rate agreement (FRA) than to a traditional forward contract.
If one party agrees to buy Chinese yuan (sell dollars), and the other agrees to buy U.S. dollars (sell yuan), then there is potential for a non-deliverable forward between the two parties. They agree to a rate of 6.41 on $1 million U.S. dollars. The fixing date will be in one month, with settlement due shortly after.
If in one month the rate is 6.3, the yuan has increased in value relative to the U.S. dollar. The party who bought the yuan is owed money. If the rate increased to 6.5, the yuan has decreased in value (U.S. dollar increase), so the party who bought U.S. dollars is owed money.
15
Q
Why is offshore trading of ringgit such as ringgit NDF is not recognised and facilitation of ringgit NDF is prohibited?
A
- because MYR is a non-internationalised currency
- Eg: a licensed onshore bank (LOB)/its appointed overseas office (AOO) transacting with a non-resident financial institution (NRFI) (other than for purposes such as international trade in goods & services, equities listed on Bursa Malaysia, spot transactions in capacity as custodian/MYR-denominated interest rate derivatives) would require an NDF attestation from the NRFI to ensure that FX transactions undertaken don’t facilitate the NDF market.
