CAIIB-BFM-MODULE-A- Basics of Forex Derivatives Basics of Forex Derivates 1. Derivatives are the instruments to the exposure for neutralize or alter to acceptable levels, the uncertainty profile of the exposure. E.g: Forward contracts, options, swaps, forward rate agreements and futures.
2. A risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earnings.
3. Some of the very common risks faced in forex operations i. Exchange Risk ii. Settlement Risk/ Temporal Risk/ Herstatt Risk (Named after the 1974 failure of the Bankhaus Herstatt in Germany) iii. Liquidity Risk iv. Country Risk v. Sovereign risk vi. Intrest Rate Risk vii. Operational Risk
4. Movement in exchange rates may result in loss for the dealer’s open position.
5. In case of excess of assets over the liabilities, the dealer will have long position.
6. Country risk is a dynamic risk and can be controlled by fixing country limit.
7. Sovereign risk can be managed by suitable disclaimer clauses in the documentation and also by subjecting such sovereign entities to third jurisdiction.
8. Operational risk can be controlled by putting in place state of art system, specified contingencies.
9. RBI has issued Internal Control Guidelines (ICG) for Foreign Exchange Business.
10. Various Dealing Limits are as follows: a. Overnight Limit: Maximum amount of open position or exposure, a bank can keep overnight, when markets in its time zone are closed. b. Daylight Limit: Maximum amount of open position or exposure, the bank can expose itself at any time during the day, to meet customers’ needs or for its trading operations c. Gap Limits: Maximum inter period/month exposures which a bank can keep, are called gap limits d. Counter Party Limit: Maximum amount that a bank can expose itself to a particular counter party. e. Country Risk: Maximum exposure on a single country f. Dealer Limits: Maximum amount a dealer can keep exposure during the operating hours. g. Stop-Loss Limit: Maximum movement of rate against the position held, so as to trigger the limit or say maximum loss limit for adverse movement of rates. h. Settlement Loss Limit: Maximum amount of exposure to any entity, maturing on a single day. i. Deal Size Limit: Highest amount for which a deal can be entered. The limits are fixed to restrict the operational risk on large deals.
11. CCIL (Clearing Corporation of India Ltd) takes over the Settlement Risk, for which it creates a large pool of resources, called settlement Guarantee Fund, which is used to cover outstanding of any participant.
12. The Clearing Corporation of India Ltd. (CCIL) was set up in April, 2001 for providing exclusive clearing and settlement for transactions in Money, GSecs and Foreign Exchange. February 15, 2002 Negotiated Dealing System (NDS) November 2002 settlement of Forex transactions January 2003 Collateralized Borrowing and Lending Obligation (CBLO), a money market product based on Gilts as collaterals August 7, 2003. Forex trading platform “FX-CLEAR” April 6, 2005. settlement of cross-currency deals through the CLS Bank
13. Six 'core promoters' for CCIL - State Bank of India (SBI), Industrial Development Bank of India (IDBI), ICICI Ltd., LIC (Life Insurance Corporation of India), Bank of Baroda, and HDFC Bank.
14. Derivatives: A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.
15. In early 1970s, the Chicago Mercantile Exchange introduced world’s first Exchange traded currency future contract.