FINANCIAL INNOVATIONS IN INTERNATIONAL BANKING :
Over the years and decades international banking has been part of many innovations. According to the changed environment on account of more and more cross border operations banks have to handle many risks. To mitigate such risks many innovative financial instruments and products have been introduced. Broadly such products can be termed as “derivatives”.
Forward Exchange Contract: Foreign Exchange Rate Risk: This arises due to market movements and on account of market forces (demand and supply). The foreign exchange rate risk can be mitigated by using a forward exchange contract. By predetermining the exchange rate well in advance, the counterparties peg the price (exchange rate) and thereby mitigate the exchange rate risk.
Forward Rate Agreement (FRA): An FRA is an agreement between the bank and a customer to pay or receive the difference (called settlement money) between an agreed fixed rate (FRA rate) and the interest rate which is expected to prevail on a stipulated future date (the fixing date) based on a notional amount for an agreed period (the contract period). In short, in this type of a contract the interest rate is fixed now for a future period. The basic purpose of the FRA is to hedge the interest rate risk. For example, if a borrower decides to avail of an External Commercial Borrowing (ECB) for a period of six months, at LIBOR rate, after 3 months, the borrower can buy an FRA whereby he can fix the interest rate for the loan.
Interest Rate Swap (IRS): An Interest Rate Swap is another example of a derivative, and is used to mitigate the interest rate risk. It is a financial transaction in which two counterparties agree to exchange streams of cash flows during the contract period. One party agrees to pay a fixed interest rate on a notional principal amount and the counter party agrees to pay a floating interest rate on the same notional amount. IRS is used as a hedging tool to mitigate the interest rate risks.
In International Banking System, Interest Rate Swaps are used to manage the asset liability mis match as part of their Asset Liability Management. IRS is also helpful for the banks to structure their asset and liability to hedge the gap risk (mismatch) based on their respective cash flows.
Currency Swap: It is an agreement between two counter parties to exchange obligations in different currencies at various stages of the contract period- At the start, during the tenure and at the end of the transaction. At the beginning the initial principal amount is exchanged (it is not obligatory) periodic interest payments (either fixed or floating) are exchanged throughout the tenor of the contract. The principal amount is exchanged invariably at the end, at the exchange rate decided at the start of the transaction (contract). In view of the market volatility and to hedge exchange rate risks, the counterparties opt for currency swap, to enable them to reduce their funding costs in international markets.
Options: Another popular derivative instrument used in international banking arena, is a contract between the bank and its customers in which the customer has the right to buy/ sell a specified amount of an underlying asset at fixed price within a specific period of time, but has no obligation to actually buy or sell. In this type of contract, the customer has to pay specified amount upfront to the counterparty which is known as premium. This is in contrast of the forward contract in which both parties have as binding contract.
In international forex markets, this type of facility is generally offered to customers to enable them to book Forward Contracts in Cross Currencies at a target rate or price. This facility helps the customer to take advantage of the currency movements in late European market, New York market and early Asian market.
Different Type of Credit Derivatives:
The credit derivatives are designed to separate and then transfer the credit risk of non-payment vor partial payment by a corporate or sovereign borrower, by transferring it to an entity other than the lender or debt holder. This synthetic securitization process has become increasingly popular over the last decade with the simpler version of these structures being known as synthetic collateralized debt obligations (CDOs), credit linked notes (CLNs), single tranche CDOs etc. which are funded credit derivative products. There are unfunded credit derivative products also like Total Return Swaps, Portfolio Credit default Swaps, Credit spread options etc.
Pricing of these products is not easy due to complexity in monitoring the market price of the underlying credit obligations. Risks involving credit derivatives are a concern among the regulators of financial markets.
Concurrent Audit and Internal Control:
As required by the RBI, the banks operating in India have a concurrent audit of all forex transactions. Auditors are required to give daily and monthly reports covering:
– Compliance with approved open position limit
– Compliance with overnight exposure limits
– Compliance with aggregate and individual gap limits
– Compliance with value at risk norms