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Transcript
International Banking Risk Management Session 8 --Hilla Shahpur Maneckji International Banking Introduction In this era of globalization, with an increase in syndicated lending and consolidation within the banking industry, all the banks operating internationally have become part and parcel of various transactions taking place across the globe. In the process they may be exposed to different risks that emanate from various sources. In this context, an understanding of international risk is essential for the modem banker. Let us see the risks affecting the international banking system and the means to manage them. International Banking MEANING OF RISK International Banking What is Risk? A risk can be defined as an unplanned event with financial consequences resulting in a loss or reduced earnings. A risky proposition may be one with a potential profit or a looming loss. Risk can be defined as the volatility of the potential outcome. Banking, by its nature, entails taking a wide array of risks. Banking supervisors need to understand these risks and be satisfied that banks are adequately measuring and managing them. International Banking Types of Risks International Banking What is Credit Risk? (1) The extension of loans is the primary activity of most banks. Lending activities require banks to make judgments related to the creditworthiness of borrowers. These judgments may not always prove to be accurate and the creditworthiness of a borrower may decline over time due to various factors. Since the clients may be situated in different countries, a major risk that banks face is credit risk or the failure of a counterparty to perform according to a contractual arrangement. International Banking What is Credit Risk? (2) This risk applies not only to loans but also to other on and off balance sheet exposures such as guarantees, acceptances and securities investments. Serious banking problems have arisen in the past from the failure of banks to recognize impaired assets, to create reserves for writing off these assets, and to suspend recognition of interest income when appropriate. Large exposures to a single borrower, or to a group of related borrowers are a common cause of banking problems in that they represent a credit risk concentration. International Banking What is Credit Risk? (3) Large concentrations can also arise with respect to particular industries, economic sectors, or geographical regions or by having sets of loans with other characteristics that make them vulnerable to the same economic factors (example, highlyleveraged transactions). International Banking What is Country & Transfer Risk? (1) In addition to the counterparty credit risk inherent in lending, international lending also includes country risk, which refers to risks associated with the economic, social and political environments of the borrower’s home country. Country risk may be most apparent when lending to foreign governments or their agencies, since such lending is typically unsecured, but is important to consider when making any foreign loan or investment, whether to public or private borrowers.International Banking What is Country & Transfer Risk? (2) There is also a component of country risk called “Transfer Risk” which arises when a borrower’s obligation is not denominated in the local currency. The currency of the obligation may become unavailable to the borrower regardless of its particular financial condition. International Banking What is Market Risk? (1) Banks face a risk of losses in on and off balance sheet positions arising from movements in market prices. Established accounting principles cause these risks to be typically most visible in a bank’s trading activities, whether they involve debt or equity instruments, or foreign exchange or commodity positions. One specific element of market risk is Foreign Exchange Risk. International Banking What is Market Risk? (2) According to Maurice D Levi, foreign exchange risk is defined as “the variance of the domestic-currency value of an asset, liability, or operating income that is attributable to unanticipated changes in exchange rates”. Since banks act as “Market-Makers” in foreign exchange by quoting rates to their customers and by taking open positions in currencies, the risks inherent in foreign exchange business, particularly in running open foreign exchange positions, are increased during periods of instability in exchange rates. International Banking What is an Interest Rate Risk? (1) 1. Interest rate risk refers to the exposure of a bank’s financial condition to adverse movements in interest rates. This risk impacts both the earnings of a bank as well the economic value of its assets, liabilities and off balance sheet instruments. The primary forms of interest rate risk to which banks are typically exposed are: Re-Pricing Risk, arising from timing differences in the maturity (for fixed rate) and re-pricing (for floating rate) of bank assets, liabilities and off balance sheet positions. International Banking What is an Interest Rate Risk? (2) 2. 3. 4. Yield Curve Risk, arising from changes in the slope and shape of the yield curve. Basis Risk, arising from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar re-pricing characteristics. Optionally, arising from the express or implied options embedded in many bank assets, liabilities and off balance sheet portfolios. Although such risk is a normal part of banking, excessive interest rate risk can pose a significant threat to a bank’s earnings and capital base. International Banking What is an Interest Rate Risk? (3) Managing this risk is of growing importance in sophisticated financial markets where customers actively manage their interest rate exposure. International banks need to pay special attention to the interest rate risk, as interest rates in different countries should be taken into consideration. International Banking Update—Interest Rate Derivatives (1) For banks the only thing certain about interest rates is uncertainty. They lose out on returns on their investments when interest rates go down; and on the floating rate loans when the interest rates go up. Interest rate derivatives allows the banks to hedge risk arising from the changes in the interest rates. In this direction, the interest rate futures were launched on the National Stock Exchange (NSE) in the last week of June, 2003. International Banking Update—Interest Rate Derivatives (2) 1. 2. The trading was launched in notional T-bill futures and Tbond futures so far. The interest rate futures were expected to help widen the underlying cash market while helping in evolving a better term structure as well as in price discovery. Interest rate futures can be used for three purposes: Hedging against interest rate risks, Arbitraging being a simultaneous buying and selling of futures taking advantage of a temporary price difference or mispricing in the market, resulting in an immediate and International Banking certain profit, and Update—Interest Rate Derivatives (3) 3. Spreading, a speculative method, which allows a trader to make gains from a potential change in the relative values of the two different contracts. As of now, banks are not allowed to trade in these derivative products. However it is expected that the future is bright for these kinds of products once the participants in the market become comfortable with these derivative products with more and more players are entering into the market. It is also expected that volumes shall increase significantly whenever the banks would be allowed to trade in these derivative International Banking products. Update—Interest Rate Derivatives (4) On the whole one can say that the market for interest rate futures is still in an evolving stage. One has to therefore move cautiously to overcome pitfalls. For this, one has to proceed step by step, and mastering the intricacies. But, if these securities are used genuinely for risk hedging, then it will definitely prove a useful tool, and one, that will certainly move the market towards more efficiency. International Banking What is Liquidity Risk? Liquidity risk arises from the inability of a bank to accommodate decreases in liabilities or to fund increases in assets. When a bank has inadequate liquidity, it cannot obtain sufficient funds, either by increasing liabilities or by converting assets promptly, at a reasonable cost, thereby affecting profitability. In most cases, insufficient liquidity may lead to the insolvency of a bank. International Banking What is Operational Risk? (1) The most important types of operational risk involve breakdowns in internal controls and corporate governance. Such breakdowns can lead to financial losses through error, fraud, or failure to perform in a timely manner or cause the interests of the bank to be compromised in some other way. For example, by its dealers, lending officers or other staff exceeding their authority or conducting business in an unethical or risky manner. International Banking What is Operational Risk? (2) Other aspects of operational risk include major failure of information technology systems or events such as major fires or other disasters. When such things occur, the banks offering international banking services are most affected. International Banking What is Legal Risk? (1) Banks are subject to various forms of legal risk. This can include the risk that assets will turn out to be worthless or liabilities will turn out to be greater than expected because of inadequate or incorrect legal advice or documentation. In addition, existing laws may fail to resolve legal issues involving a bank; a court case involving a particular bank may have wider implications for banking business and involve costs to it and many or all other banks; and, laws affecting banks or other commercial enterprises may change. International Banking What is Legal Risk? (2) Banks are particularly susceptible to legal risks when entering new types of transactions and when the legal right of counterparty to enter into a transaction is not established. This is mostly true in the case of international banks. International Banking What is Reputational Risk? Reputational risk arises from operational failures, failure to comply with relevant laws and regulations, or other sources. Reputational risk is particularly damaging for banks since the nature of their business requires maintaining the confidence of depositors, creditors and the general marketplace. For the international banks, though all these risks are present, the most significant risk is due to the changes in exchange rates, that is, the foreign exchange risk. International Banking MEASUREMENT OF RISK International Banking Introduction (1) Measurement of risk assumes a lot of significance in the international banking operations. Certain types of risks like operational risk, credit risk, legal risk, reputational risk, etc., cannot be quantified. They have to be assessed qualitatively depending on the past experiences. Whereas some risks like interest rate risk and foreign exchange risk can be measured quantitatively. Foreign exchange risk is alternatively known as foreign exchange exposure. International Banking Introduction (2) It assesses the amount of assets, liabilities and operating income exposed to exchange rate changes. It can be said that foreign exchange exposure is “the sensitivity of changes in the real domestic currency value of assets and liabilities or operating incomes to unanticipated changes in exchange rates”. This sensitivity can be measured by the slope of the regression equation between two variables. Here, the two variables are the unexpected changes in the exchange rates and the resultant change in the domesticcurrency value of assets, liabilities and operating incomes. International Banking Introduction (3) 1. 2. 3. 4. The second variable can be divided into four categories for the purpose of measurement of exposure. These are: Foreign currency assets and liabilities which have fixed foreign currency values. Foreign currency assets and liabilities with foreign currency values that change with an unexpected change in the exchange rate. Domestic currency assets and liabilities. Operating incomes. International Banking Exposure When Assets & Liabilities Have Fixed Foreign Currency Values (1) The measurement of exposure for the first category is comparatively simpler than for the remaining three. Let us see an example to understand the process of measurement. Assume that a Pakistani resident is holding a £1 million deposit. The changes in the rupee-value of the deposit due to unexpected changes in the Rs/£ rate can be plotted. The unexpected changes in the exchange rate can be represented on the X-axis, with a positive value denoting an appreciation in the foreign currency. The Y-axis represents the change in the rupee-value of the deposit. International Banking Exposure When Assets & Liabilities Have Fixed Foreign Currency Values (2) As the £ appreciates by Rs. 0.10, the value of the deposit also increases by Rs. 0.1 million. With an unexpected appreciation of Rs. 0.20 in the £ value, the deposit’s value increases by Rs. 0.2 million. Similarly, an unexpected depreciation of the £ by Rs. 0.10 will reduce the value of the deposit by Rs. 0.1 million, while a depreciation of Rs. 0.2 will reduce the deposit’s value by Rs. 0.2 million. This gives us an upward sloping exposure line. International Banking Exposure When Assets & Liabilities Have Fixed Foreign Currency Values (3) On the other hand, if there were a foreign liability which had its value fixed in terms of the foreign currency, it would give a downward sloping exposure line. There may be a few assets or liabilities where the combinations of the two variables may not lie exactly on a straight line. In such a case, the exposure line would be the line of best fit. Whether the points fall exactly on the exposure line or not, there is one thing common among the assets and liabilities. The common factor is that the quantum of change in the foreign currency value of these assets and liabilities is International Banking predictable to a high degree. Exposure When Assets & Liabilities Have Fixed Foreign Currency Values (4) This predictability of the change in value makes it more convenient to draw a regression line and hence, to measure exposure. Exposure can be measured as the slope of the regression equation between unexpected changes in the exchange rate and the resultant changes in the domestic value of assets and liabilities. Even when the exposure line is a downward sloping line (as will be in case of a liability), the exposure can again be measured in the same way. International Banking Exposure When Assets & Liabilities Have Fixed Foreign Currency Values (5) 1. 2. A few points need to be noted: When the foreign currency value of an asset or liability does not change with a change in the exchange rate, the exposure is equal to the foreign currency value. When the slope of the exposure line is negative, the exposure appears with a negative sign. While an exposure with a positive sign is referred to as a long exposure, the one with a negative sign is referred to as a short exposure. International Banking Exposure When Assets & Liabilities Have Fixed Foreign Currency Values (6) 3. The unit of measurement of exposure is the foreign currency in which the asset or liability is expressed. This is because while calculating exposure, the domestic currency gets canceled in the numerator and the denominator, leaving the foreign currency as the unit. In the example, the Rs. in the numerator gets canceled with that in the denominator, leaving the £ as the unit of exposure. International Banking Exposure When Assets & Liabilities Have Fixed Foreign Currency Values (7) 4. While calculating exposure in this way, we are assuming that all the change in the exchange rate is unexpected. In real life, the unexpected change can be calculated using the forward rate. The forward rate can be used as the unbiased estimate of the future spot rate. Hence, in retrospective, the forward rate for a particular maturity can be compared to the actual spot rate as on the date of the maturity. The difference between the two will be the unexpected change International Banking in exchange rate. Exposure When the Foreign Currency Value of Assets & Liabilities Changes with a Change in the Exchange Rate (1) A change in the exchange rate may be accompanied by a change in the foreign currency value of an asset or liability. Though the change in the foreign currency value may not be directly attributable to the movement in the exchange rate, the link between the two is certainly there due to the common underlying factors. For example, inflation in a country, denoting a general increase in price levels would result in the value of any asset like real estate going up. At the same time, it would also result in a depreciation of the currency. International Banking Exposure When the Foreign Currency Value of Assets & Liabilities Changes with a Change in the Exchange Rate (2) Though the change in the asset’s value is not directly a result of the change in the exchange rate, it may be possible to establish a relationship between the two. In such a case, the degree of exposure would depend on the response of the exchange rate and of the asset’s (or liability’s) value to the change in the underlying variable. Sometimes, the exchange rate movement does affect the foreign currency value of the foreign asset or liability, albeit in an indirect way. International Banking Exposure When the Foreign Currency Value of Assets & Liabilities Changes with a Change in the Exchange Rate (3) For example, if there is a depreciation of the foreign currency, the foreign Central Bank may consider it imperative to increase the interest rates in the economy in order to defend its currency. In such a situation, the value of an asset in the form of an interest bearing security would stand reduced. In such cases also, the degree of exposure would depend on the movement of the two variables and the predictability of the movement in the asset’s or liability’s value. Depending on these movements, the exposure may be equal to, lower than, or higher than the foreign currency value of the asset or liability. International Banking Exposure When the Foreign Currency Value of Assets & Liabilities Changes with a Change in the Exchange Rate (4) Suppose there is a foreign asset whose value is $ 2,500,000 with the exchange rate ruling at Rs. 83.50/$. At this point its domestic currency value equals Rs. 208.75 million. The US economy is facing an inflation rate of 4%, due to which the asset’s price increases to $ 2,600,000. At the same time, the dollar depreciates to Rs. 81.83/$. The new value of the asset is again Rs. 212.76 million. If with every change in the exchange rate, the asset’s value changes in the same way, the two will be having a predictable International Banking relationship. Exposure When the Foreign Currency Value of Assets & Liabilities Changes with a Change in the Exchange Rate (5) In that situation, the exposure can again be calculated as the slope of the regression equation between these two variables. a = AV/ ASu = Rs. 0 / (Rs.1.6731/$) = 0 Here, if we observe that though the exchange rate is variable, the exposure is nil. This is because in response to the exchange rate movements, the foreign currency value of the asset is changing in such a way as to leave the domestic currency value of the asset unchanged. Without any movement in the domestic currency value of the asset, the exposure on the asset becomes zero. International Banking Exposure When the Foreign Currency Value of Assets & Liabilities Changes with a Change in the Exchange Rate (6) Though a zero exposure may be an ideal condition, it would be quite difficult to find such assets and liabilities. Generally, the foreign currency values of assets and liabilities move in the manner outlined, but not to the same extent. Even if the prices of assets change as above, such change may not occur simultaneously having an exposure. Say, in the above example, the value of the asset may increase only to $ 2,550,000 in response to the depreciation of the $. This would result in a rupee value of Rs. 208,666,500. International Banking Exposure When the Foreign Currency Value of Assets & Liabilities Changes with a Change in the Exchange Rate (7) Again, if this value changes in a similar predictable manner every time there is a dollar appreciation or depreciation, the exposure would be equal to: a = AV/ ASu = (Rs. 2,091,405) / (Rs.1.6731/$) = $ 1,250,018 It can be observed that the exposure is less than the value of the asset (that is, $ 2.5 million). If, on the other hand, the value of the asset had become $ 2.7 million, the exposure would have been: a = AV/ ASu = Rs. 4,182,630 / (Rs.1.6731/$) = ($ 2,499,928) International Banking Exposure When the Foreign Currency Value of Assets & Liabilities Changes with a Change in the Exchange Rate (8) This makes the exposure almost equal to the value of the asset. If the value of the asset had instead moved to $ 2.75 million, the exposure would have been higher than the value of the asset, that is, $ 3,749,910. From these examples we can observe that the exposure on an asset or liability whose foreign currency value changes with a change in the exchange rate, could be nil or equal to, less than, or more than the value of the asset/liability. International Banking Exposure When the Foreign Currency Value of Assets & Liabilities Changes with a Change in the Exchange Rate (9) In all the examples, the foreign currency value of the asset was changing in such a way, as to make the relationship between the movement in the domestic currency value of the asset and a change in the exchange rate a predictable one. In many situations, however, it may be very difficult to establish a regression line, and hence, a predictable relationship, or even impossible to do so. In such cases, though the asset or liability may be exposed to exchange rate movements, the measurement of exposure may become impossible. International Banking Exposure on Domestic Assets & Liabilities Domestic assets and liabilities of bank are not directly exposed to exchange rate movements, as no conversion from a foreign currency to the domestic currency is involved. But these assets and liabilities may be indirectly affected through interest rates. In the case of these assets and liabilities, the possibility of measurement of exposure and the degree of exposure would again depend on the predictability of the change in the domestic prices. The calculation of exposure would also be done in the same way as for foreign assets and liabilities whose value change with a International Banking change in the exchange rate. Operating Incomes Due to unanticipated changes in interest rates and exchange rates, the repayment by the events is at stake, which in turn affects the incomes of the bank. If the clients are in various countries, this risk is even more. Measurement of this risk is a slightly difficult task. International Banking MANAGEMENT OF RISK International Banking Introduction (1) Management of risk is traditionally seen as a process designed to avoid risk. Due to a fundamental relation between risk and return, the total avoidance of risk necessarily may not be in the interest of the bank. Thus, an effective risk management system must allow the management to make conscious decisions that are consistent with its overall objectives. International Banking Introduction (2) Various techniques can be used for hedging risks: 1. Hedging Through the Forward Market. 2. Hedging Through Futures. 3. Hedging Through Options. 4. Hedging Through the Money Market. International Banking Hedging Through the Forward Market (1) In order to hedge its transaction exposure, a company having a long position in a currency (having a receivable) will sell the currency forward, that is, go short in the forward market, and a company having a short position in a currency (having a payable) will buy the currency forward, that is, go long in the forward market. The idea behind buying or selling a currency in the forward market is to lock the rate at which the foreign currency transaction takes place, and hence, the costs or profits. International Banking Hedging Through the Forward Market (2) For example, if a Pakistani firm is importing computers from the USA and needs to pay $100,000 after 3 months to the exporter, it can book a 3-month forward contract to buy $100,000. If the 3-month forward rate is Rs.82.50/$, the cost to the Pakistani firm will be locked at Rs.8,250,000. Whatever be the actual spot price at the end of three months, the firm needs to pay only the forward rate. Thus, a forward contract eliminates transaction exposure completely. International Banking Hedging Through the Forward Market (3) Most of the times, when the transaction exposure is hedged, the translation exposure gets automatically hedged. In the above example, the translation exposure gets automatically hedged as any loss/gain on the outstanding payable gets set-off by the gain/loss on the forward contract. But there may be situations where the translation exposure may need to be hedged, either because the underlying transaction exposure has not been hedged or because the translation exposure arises due to the company holding some long-term asset or liability. International Banking Hedging Through the Forward Market (4) In such situations also, forward contracts may be used to hedge the exposure. The firm would need to determine its net exposure in a currency and then book an opposite forward contract, thus nullifying its exposure. For example, if a firm has a net positive exposure of $100,000, it will sell $100,000 forward so that any loss by exchange rate movements on account of the main exposure will be canceled off by the gain on the forward contract, and vice versa. International Banking Hedging Through the Forward Market (5) However, the gain/loss on the underlying exposure will be notional while the loss/gain on the forward contract will be real and involve cash outlay. The cost of a forward hedge can be measured by the opportunity cost, which depends on the expected spot rate at which the currency needs to be bought or sold in the absence of the forward contract. Hence, the cost of a forward hedge is measured as the difference between the forward rate and the expected spot rate for the relevant maturity. International Banking Hedging Through the Forward Market (6) In an efficient market, the forward rate is an unbiased predictor of the future spot rate. The process equating these two requires the speculators to be risk-neutral. Hence, when the markets are efficient and the speculators are risk-averse, the cost of hedging through the forward market will be nil. International Banking Hedging Through Futures (1) The second way to hedge exposure is through futures. The rule is the same as in the forward market, that is, go short in futures if you are long in the currency and vice versa. Hence, if an importer needs to pay $250,000 after four months, he can buy dollar futures for the required sum and maturity. Futures can be similarly used for hedging translation exposure. Hedging through futures has an effect similar to hedging through forward contracts. As the gain/loss on the futures contract gets canceled by the loss/gain on the underlying transaction, the exposure gets International Banking almost eliminated. Hedging Through Futures (2) Here it is assumed that basis remains constant. Only a small part of the exposure is left due to the markto-market risk on the futures contract. The main difference between hedging through forwards and through futures is that while under a forward contract the whole receipt/payment takes place at the time of maturity of the contract, in case of futures, there has to be an initial payment of margin money, and further payments/receipts during the tenure of the contract on the basis of market movements. International Banking Hedging Through Options (1) Options can prove to be a useful and flexible tool for hedging transaction and translation exposure. A firm having a foreign currency receivable can buy a put option on the currency, having the same maturity as the receivable. Conversely, a firm having a foreign currency payable can buy a call option on the currency with the same maturity. Hedging through options has an advantage over hedging International Banking through forwards or futures. Hedging Through Options (2) While the latter fixes the price at which the currency will be bought or sold, options limit the downside loss without limiting the upside potential. That is, since the firm has the right to buy or sell the foreign currency but not an obligation, it can let the option expire by not exercising its right in case the exchange rates move in its favor, thereby making the profits it would not have made had it hedged through forwards or futures. But this advantage does not come free. Because of this feature, options generally cost more than the other tools of hedging. International Banking Hedging Through Options (3) Another advantage offered by options is flexibility. There is only one exchange rate at which a currency can be bought or sold under a forward or a futures contract. On the other hand, options are available at different exchange rates. Depending on the firm’s outlook about the future and its risk-taking capacity, it can buy a suitable contract. International Banking Hedging Through the Money Market (1) Money markets can also be used for hedging foreign currency receivables or payables. Let us say, a firm has a dollar payable after three months. It can borrow in the domestic currency now, convert it at the spot rate into dollars, invest those dollars in the money markets, and use the proceeds to pay the payable after three months. This process locks the exchange rate at which the firm needs to buy dollars. At the same time, it knows its total cost in advance in the form of the principal and interest it needs to repay in the domestic International Banking markets. Hedging Through the Money Market (2) We have seen that in the absence of transaction costs, the exchange rate arrived at in this manner will be the same as the forward rate. It needs to be added that in the presence of transaction costs, the forward market gives a better rate than the money market. International Banking Examples International Banking Example 1 (1) 1. 2. 3. 4. 5. 6. A company needs to pay $ 100,000 after three months. The following options are available to it: Can leave the position open. Can book a forward contract at Rs. 45.40/$. Can buy a futures contract at Rs. 45.40/$. Can buy a call option at a strike price of Rs. 45.40, the premium being Rs. 0.50 per $. Can buy a call option at a strike price of Rs. 44.80, the premium being Rs. 0.60 per $. Can buy a call option at a strike price of Rs.75.80, the premium International Banking being Rs. 0.40 per $. Example 1 (2) The cost to the firm in various scenarios under all the options is: (Rs. in 000) Actual Rates After 3 Months Technique 45.00 45.20 45.80 46.00 46.20 Unhedged 45.00 45.20 45.80 46.00 46.20 Forward Contract 45.40 45.40 45.40 45.40 45.40 Future Contract* 45.40 45.40 45.40 45.40 45.40 Call Option (45.40)** 45.50 45.70 45.90 45.90 45.90 Call Option (44.80)** 45.40 45.40 45.40 45.40 45.40 Call Option (45.80)** 45.40 45.60 46.20 46.20 46.20 * Does not include the opportunity cost of margin money. ** Does not include the opportunity cost of the premium paid. International Banking Example 1 (3) As we can observe, the cost, and hence, the attractiveness of the various options depend on the actual spot rate at the end of three months. Thus, the correctness of a hedging decision can be found out only in hindsight. As the choice of the hedging technique has to be made in the absence of such information, the view of the treasurer as to the possible movements in the exchange rate assume great importance. International Banking Example 2 (1) A Pakistani firm exports jeans to America. Currently it sells 20,000 pieces at $ 30 per piece. Its cost per piece of jeans is Rs. 300. In addition, it needs to import certain raw material which costs $ 10 per piece. The fixed costs of the company are Rs. 2,000,000. The current spot rate is Rs. 44.00/$. Suppose that the rupee appreciates to Rs. 40.00/$, by how many units should the company’s sales increase for its profits to remain unchanged? International Banking Example 2 (2) The company’s existing profits can be calculated as follows: Sales (20,000 * 30 * 44) = Rs. 26,400,000 Variable Costs (300 * 20,000 = 6,000,000 + 10 * 44 * 20,000 = 8,800,000) = Rs. 14,800,000 Fixed Costs = Rs. 2,000,000 Total Costs (14,800,000 + 2,000,000) = Rs. 16,800,000 Profit (26,400,000 - 16,800,000) = Rs. 9,600,000 International Banking Example 2 (3) After the rupee appreciation, the company’s profits will be: Sales (20,000 * 30 * 40) = Rs. 24,000,000 Variable Costs (300 * 20,000 = 6,000,000 + 10 * 40 * 20,000 = 8,000,000) = Rs. 14,000,000 Fixed Costs = Rs. 2,000,000 Total Costs (14,000,000 + 2,000,000) = Rs. 16,000,000 Profit (24,000,000 - 16,000,000) = Rs. 8,000,000 International Banking Example 2 (4) As a result of the appreciation of the domestic currency, the profits of the company have come down despite it selling the same number of units at the same dollar price, as existed before the appreciation. Let the number of units that need to be sold for keeping the profits at the pre-appreciation level be ‘X’. Here, we are assuming that the company can sell unlimited quantity at the existing dollar price. International Banking Example 2 (5) Then: 9, 600,000 = (40 * 30 * X) – [(300 * X) + (10 * 40 * X) + 2,000,000] 9,600,000 = 1,200 X - 700 X - 2,000,000 11,600,000 = 500 X X = 11,600,000 / 500 = X = 23,200 units Hence, the firm needs to increase its sales by 3,200 units to maintain its pre-appreciation profits. International Banking Example 2 (6) While using these hedging techniques to hedge transaction exposure, it needs to be remembered that their use may not necessarily result in hedging the economic exposure arising out of the transaction being hedged. Take the example of an importer who imports shirts and sells them in the local market. There are other competitors in the market who do the same thing. Let us suppose this importer locks-in the domestic currency price of his imports by buying forward contract, while his competitors do not. International Banking Example 2 (7) In such a case, if the domestic currency appreciates, his competitors would be able to reduce the price of the shirts, which he would not be able to do due to his fixed costs. Thus, his competitors would be successful in taking away his business and profits. On the other hand, in case of a depreciation of the domestic currency, he would be able to sell the shirts at a much cheaper rate than his competitors, thereby increasing his sales and profits. Thus, though the domestic currency costs of the producer are hedged, the variability of his profits arising out of economic exposure is not. International Banking Example 2 (8) Management of economic exposure requires the use of specific techniques. The preliminary components of a sound management process require the banks to follow a comprehensive risk measurement, and management approach for controlling, monitoring and reporting risks. A successful establishment and development of a full-fledged trading operation pre-supposes the adoption and use of tight controls. Risks like foreign exchange risk can be effectively managed only when the intricacies are identified, measured and necessary International Banking controls are instituted. Example 2 (9) 1. 2. 3. 4. The overall objective of a risk management strategy from the bank’s perspective would be a system that— Minimizes the risk of adverse movement of exchange and interest rates. Allows leeway to take advantage of favorable movements of exchange and interest rates. Is cost effective. Is simple to administer and control. International Banking RISK MANAGEMENT PROCESS International Banking Risk Management Process (1) 1. 2. 3. 4. The process of risk management should consist of the following steps: Identification of all areas of risk. Evaluation of the risks identified. Setting of exposure limits for various types of businesses, mismatches and counterparties. Issuing clear policy guidelines/directives. Risk management can defined as a dynamic process needing consistent focus and attention. International Banking Risk Management Process (2) There can be no single prescription for all times. Decisions once taken will have to be reversed at short notice. Sometimes the positions shelved may have to be reacquired, and views have to be charged. Though the process of risk management seems to be complex, it an interesting game for the banks. Winners and losers are never known. It depends on the alertness of the market participants. There may not be permanent solution to any problem. Solutions are only situational. International Banking Risk Management Process (3) In the entire risk management process, the top management of the bank has to lay down clear-cut policy guidelines in quantifiable and precise terms—for different layers, line personnel, business parameters, limits, etc. It is imperative for the banks top management to plan at the macro level, keeping in view the banks objective and mission, and implement these plans at the micro level. For this the infrastructure should also cooperate for an effective implementation of a good risk management system. International Banking The End International Banking