Foreign Exchange Risk Management in Banking

Foreign Exchange Risk Management in Banking

In this area, there is a considerable difference in current practice. Most banking institutions view activity in the foreign exchange market beyond their franchise, while others are active participants. The different franchises in the banking industry can explain this.

The former will take virtually no principal risk, forward open positions, and expect trading volume. There is a clear distinction between those who restrict themselves from acting as agents for corporate and/or retail clients and those with active trading positions within the latter group.

The most active banks in this area have large trading accounts and multiple trading locations. And for these, reporting is rather straightforward. Currencies are kept in real-time, with spot and forward positions marked to market.

As is well known, however, reporting position is easier than measuring and limiting risk. Here, the latter is more common than the former. Limits are set by the desk and individual trader, with monitoring occurring in real-time by some banks and daily closing at other institutions.

As a general characterization, those banks with more active trading positions tend to have invested in the real-time VaR systems discussed above, but there are exceptions. Limits are the key elements of the risk management systems in foreign exchange trading for all trading businesses.

It is fairly standard for limits set by currency for both the spot and forward positions in the set of trading currencies. At many institutions, the derivation of exposure limits has tended to be an imprecise and inexact science.

For these institutions, risk limits are set currency-by-currency by subjective variance tolerance. Others, however, attempt to derive the limits using an analytically similar method to the approach used in the area of interest rate risk.

Even for banks without a VaR system, stress tests evaluate the potential loss associated with changes in the exchange rate. This is done for small deviations in exchange rates but may also be investigated for maximum historical movements.

The latter is investigated in two ways.

Historical events are captured, the worst-case scenario is simulated, or the historical events are used to estimate a distribution from which the disturbance is drawn.

In the latter case, one or two standard deviation change in the exchange rate is considered.

While some use these methods to estimate volatility, until recently, most did not use variability in setting individual currency limits or aggregating exposure across multiple correlated currencies.

Incentive systems for foreign exchange traders differ significantly between the average commercial bank and its investment-banking counterpart.

While trader performance is directly linked to compensation in the investment banking community, this is less true in the banking industry.

While some admit to a significant correlation between trader income and trading profits, many argue that there is absolutely none. This latter group tends to see such linkages leading to excessive risk-taking by traders who gain from successes but do not suffer losses.

Accordingly, the risk is reduced by separating foreign exchange profitability and trader compensation from their thinking.

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