Risk Identification Process
Price or Rate Risk
Foreign Exchange Rate Movement Risk
Foreign exchange rate movement risk arises from net exchange position in a currency. If the position is long or overbought and there is depreciation in the currency, a loss occurs. On the other hand, if an appreciation occurs while the dealer is holding a long net position, there will be a profit from such change in exchange rates. The opposite will occur if the net positions were short or oversold in that currency. Price risk of this kind also exists on execution of a swap. This is also known as the ‘tail’, which arises because in a swap the effects of two foreign currency amounts, inflow and outflow, are different on account of present valuing all cash flows.
US$/INR FX Forwards Risk
10.150 Forward points (premia/discount) in the Indian markets are not entirely afunction of interest rate differentials but a function of demand and supply of forward currency. As a result, normally banks treat traded forward points (up to 1-year) as a market factor, and use this to compute the implied INR rate (MIFOR) up to the 1-year segment. Beyond 1-year, forward points are computed from the INR currency swap/ MIFOR quotes and US$ swap curve.
Timing Risk
As per market practice, FX contracts with timing discretion (Option Period Forwards or OPFs) versus INR are typically for a period of one week to a maximum of one month. The customer has the discretion to pick up the contract on any day of the window period. In case the customer is buying the foreign currency (‘FCY’), the swap points/contract rate is fixed based on the last date of the period in case the FCY is at a premium against the INR or the first date in case the FCY is at a discount. Hence, unless the swap points change from premium to discount or vice versa after entering into the contract, the counter party would not benefit by taking delivery before last date in case of premium or after first date in case of discount. In the unlikely event of this happening and if the bank has not hedged the contract similarly with another contract with discretion period, an adverse impact on Profit and Loss Account could arise. In such a case, the market counter party could pick up the contract early while the hedge contract would still be outstanding and the gap would have to be covered again at incremental cost.
Credit Risk
Credit risk is the risk that the counter party to a financial transaction -here a foreign exchange contract – may become unable to perform its obligation. The extent of risk depends on whether the other party’s inability to pay is established before the value date or is on the same value date of the foreign exchange contract.
Pre-Settlement Likely Exposure
Trading (or pre-settlement) exposure occurs when a counter party defaults on its contractual obligation before the settlement date and the bank has to defend the position in the market with another counter party at the then prevailing rate. The bank is exposed to possible adverse price fluctuations between the contract price and the market price on the date of default or final liquidation.
Settlement Risk
This occurs when items of agreed upon original equal value are not simultaneously exchanged between counter parties; and/or when Bank’s funds are released without knowledge that counter value items have been received by the bank. Typically, the duration is overnight/over weekend, or in some cases even longer i.e., until bank receives the confirmation of receipt of funds. The risk is that bank delivers but does not receive delivery. In this situation 100% of the principal amount is at risk.
Market risk
Market risk is the risk of loss due to adverse changes in the market value (the price) of an instrument or portfolio of instruments. Such exposure occurs with respect to derivative instruments when changes occur in market factors such as underlying interest rates, exchange rates, equity prices, and commodity prices or in the volatility of these factors.
Liquidity Risk
Liquidity risk refers to the ease with which a foreign exchange spots position or gap can be liquidated. The approved spot DV01 limit factors in the liquidity risk associated with the product. Tenor wise DV01 limits in the case of US$INR gaps factor in the liquidity in the forward markets. Institutions involved in derivatives activity face two types of liquidity risk: market liquidity risk and funding liquidity risk.
Market Liquidity Risk
Market liquidity risk is the risk that an institution may not be able to exit or offset positions quickly, and in sufficient quantities, at a reasonable price. This inability may be due to inadequate market depth in certain products (e.g. exotic derivatives, long-dated options), market disruption, or inability of the bank to access the market (e.g. credit down-grading of the institution or of a major counterparty).
Funding Liquidity Risk
Funding liquidity risk is the potential inability of the institution to meet funding requirements, because of cash flow mismatches, at a reasonable cost. Such funding requirements may arise from cash flow mismatches in swap books, exercise of options, and the implementation of dynamic hedging strategies.
Sovereign Risk or Cross Border Risk
This is the risk that the Government of a particular country may interfere with a payment due to the Bank from a client resident in that country and preclude the client from converting and/or transferring the funds. In such cases, bank’s obligor may be economically sound and capable of repaying its obligation, but its country’s Government may place an embargo on remittances for political/economic reasons.
Operations Risk
This can occur if an error in processing results in a loss and/or excess over prescribed risk/regulatory limits.
Legal risk
Legal risk is the risk of loss arising from contracts, which are not legally enforceable (e.g. the counterparty does not have the power or authority to enter into a particular type of derivatives transaction) or documented correctly.
Regulatory risk
Regulatory risk is the risk of loss arising from failure to comply with regulatory or legal requirements.
Reputation risk
Reputation risk is the risk of loss arising from adverse public opinion and damage to reputation.