4. Foreign Exchange Banking in PK (Guide)

CHAPTER - IV

Exchange Position

Cash flow position

There is said to be a 'position' if circumstances are such that a change in a rate will create a profit or loss. If cash inflows and cash outflows are unequal or have mismatched value dates, there is a 'net cash flow position'. 

Separate net cash flow positions apply for each value date.

  Net cash flow position = cash Inflow - cash Outflow

A positive net cash flow position reflects an excess of cash inflow, over cash outflow, on the relevant value date. The surplus cash will be available for investment. If interest rates rise the return will be higher. If interest rates 

fall, the return will be lower.

A negative net cash flow position reflects an excess of cash outflow over cash inflow on the relevant value date. Assuming there are no idle balances, the account will become overdrawn. The shortfall of cash will require funding. If interest rates rise it will become more expensive to fund the account. If 

interest rates fall it will become less expensive to fund the account.

A negative net cash flow position also implies a 'liquidity position'. There is a risk that there will be insufficient funds available for borrowing, in which case the account must remain overdrawn. Being overdrawn may involve 

financial and non-financial penalties.

If cash inflow equals cash outflow on a particular value date, then the net cash flow position is zero. This is referred to as a 'square cash flow position'. 

Changes in interest rates will have no net impact on profits or losses.

Exchange position

Foreign exchange position is the balances of bank foreign exchange assets and liabilities that generate the risk of obtaining additional revenues or expenditures upon the modification of exchange rates. A positive Net position reflects an excess of inflow, over outflow, on the relevant value date. The surplus will be available for investment. If interest rates rise the return will be higher. If interest rates fall, the return will be lower.

A negative Net F C position reflects an excess of outflow over inflow on the relevant value date. If there are no idle balances, the account will become overdrawn. The shortfall will require funding. If interest rates rise it will become more expensive to fund the account. If interest rates fall it will become less expensive to fund the account.

Net Exchange Position

In Pakistani money market it is recommended that banks should keep their

exchange position square, neither over bought nor over sold. If the amount of foreign currency purchased equals the amount of that currency that has been sold, then the net exchange position will be zero. This is called as a 'square exchange position'.

Buying and selling foreign currencies creates exposure to changes in exchange rates. Buying a foreign currency creates an asset. The position is said to be 'long' the foreign currency. If the foreign currency appreciates there will be an exchange gain. If the currency depreciates there will be an exchange loss.

Selling a foreign currency creates a liability. The position is said to be 'short' the foreign currency. If the foreign currency depreciates there will be an exchange gain. If the foreign currency appreciates there will be an exchange loss.

The excess amount of a foreign currency which has been purchased over the amount of the same foreign currency which has been sold is described as the 'net exchange position'. There is a separate net exchange position for each foreign currency. 

Net exchange position = foreign currency purchased - foreign currency sold

Being long a currency implies having a net exchange position which is positive. Provided the exchange rate is quoted with the foreign currency as the base currency, a rise in the exchange rate will yield an exchange gain and a fall in the exchange rate will result in an exchange loss.

Being short a currency implies having a net exchange position which is negative. Provided the foreign currency is the base currency, a rise in the exchange rate will result in an exchange loss, and a fall in the exchange rate will cause an exchange gain. 

If the amount of foreign currency purchased equals the amount of that currency that has been sold, then the net exchange position will be zero. This is referred to as a 'square exchange position'. Changes in exchange rates will have no impact on profit or loss.

A net exchange position is created or removed at the time the purchase or sale of foreign currency is contracted, not at the time when the related cash flows occur. For example, if a spot contract is entered  today to purchase USD 1 million against JPY at a rate of USD 1 = 120.50, the buyer immediately becomes long USD and short JPY regardless of the fact that he or she will not receive the USD or pay away the JPY until two business days hence. Similarly, forward purchases or sales of foreign currency 

immediately create, or remove a net exchange position. 

Distinction between Net Exchange Position and Net Cash Flow Position

It is important to appreciate the distinction between a net exchange position, and a net cash flow position. Money market transactions create net cash

flow positions, but do not create net exchange positions. Only buying or selling a currency can create a net exchange position - merely borrowing or lending a foreign currency does not.

Borrowing CHF for three months will cause a positive cash flow of Swiss Francs now and a negative cash flow of CHF in three months time, but no exposure to the exchange rate. Unless the CHF are sold (which create a net exchange position), they will be available to repay the loan on maturity and so exchange rate changes will have no effect on profit or loss.

Foreign exchange transactions create both net cash flows positions and net exchange positions. Mismatched cash flows may be offset by either money market transactions or foreign exchange transactions. However, 

net exchange positions can only be offset by foreign exchange transactions. 

Open Foreign Exchange position

The foreign exchange position shall be considered open if foreign exchange assets in a certain foreign currency are not equal to foreign exchange liabilities in the respective foreign currency. The value of the open foreign exchange position represents the difference between the amount of foreign exchange assets in a certain foreign currency and the amount of foreign exchange liabilities in that currency. 

The open foreign exchange position is long if the sum of foreign exchange assets in a certain foreign currency exceeds the sum of foreign exchange liabilities in the respective foreign currency. The open foreign exchange position is short if the sum of foreign exchange liabilities in a certain foreign currency exceeds the sum of foreign exchange assets in the respective foreign currency.

Managing Exchange Risk

Banks dealing in foreign exchange transactions are open to risks from movements in competitors' prices, competitors' cost of currency/ capital, foreign and exchange rates and interest rates, all of which need to be perfectly managed. This is called the task of managing exposure to Foreign Exchange movements.

Exchange risk is simple in concept; it is a potential gain or loss that occurs as a result of an exchange rate change. For example, if an individual owns a share in, the British company or deposit in British pound, he or she will lose if the values of the British pound will drops.

Risk is not risk if it is anticipated. In most currencies there are futures or forward exchange contracts whose prices give an indication of where the market expects currencies to go. And these contracts offer the ability to lock in, the anticipated change. So perhaps a better concept of exchange risk is unanticipated exchange rate changes. 

An Exposure can be defined as a Contracted, Projected or Contingent Cash Flow whose size is not certain at the moment. The level depends on

the value of variables such as Foreign Exchange rates and Interest rates. The Risk Management Guidelines should be understood, and slowly implemented so that, the deal results positive benefits to the bank. It is very important for the banks management to be aware of these practices and update their policy. Once it is done, it becomes easier for the Exposure 

Managers at treasury to get along efficiently with their task. 

Determination of risk

The following cash flows/ transactions will be considered for the purpose of exposure management.

• It is advisable for the management to decode a limit for branch 

management, such as Cash Flows above $25,000/- in value will be 

brought to the notice of the Exposure Manager, as soon as they are 

projected. 

• It is the responsibility of the Exposure Manager to ensure that he 

receives the requisite information on exposures from various branches 

of the bank in time (daily activity report). 

These exposures should be analyzed and the following aspects must be studied: 

• Foreign Currency Cash Flows/ Schedules 

• Variability of Cash flows - how certain are the amounts and/ or value 

dates? 

• Inflow-Outflow Mismatches / Gaps 

• Time Mismatches / Gaps 

• Currency Portfolio Mix 

• Floating / Fixed Interest Rate ratio 

Hedging

Hedging can be defined as “making an investment to reduce the risk of adverse price movements in an asset”. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. An example of a hedge would be if you owned a stock/ currency, then sold a futures contract stating that you will sell your stock/ currency at a set price,

therefore avoiding market fluctuations. 

Perfect hedging 

Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge). A  on an  is that, which eliminates the  on another investment entirely. Perfect hedges are quite rare as most investments carry at least a little unique risk that cannot be hedged. However, an example of a perfect hedge is a  on  that completely offsets a position in the . While perfect hedges eliminate risk, they also greatly reduce or sometimes eliminate the potential for a good.

Risk hedging

Risk hedging is the taking of an offsetting position in related assets so as to profit from relative price movements. For example, an investor might purchase futures contracts on one currency say US dollar and sell futures contracts on Euro in the belief that Euro will become relatively more valuable compared with US Dollar over the life of the contracts.

Short hedging

It is an investment transaction, which is intended to provide protection against a decline in the value of an asset. For example, an investor who holds shares of Exxon chemical and expects the stock to decline may enter into a short hedge by purchasing a put option on Exxon. If Exxon does subsequently decline, the value of the put option should increase. Same is applicable for currencies and commodities.