1.1 Introduction: - The global financial environment is more risky than earlier. The world s most successful banks and financial institute are the major affected one by this. Among the foremost riskier area FOREX market is a major area to look into, with regards to risk. The currency or the FOREX market by but not far the world s largest growing financial market with trading volume of more than US$4 trillions everyday in which 80% of the transaction and trading are done by global banks.
What is foreign exchange?
It is the system by which one countries currency is exchanged with other country to enable international transaction. Any currency other than the local currency which helps to carry out international operation is known as foreign exchange also called as foreign currency.
What is risk?
Risk, is the chances or the uncertainty of returns. Risk arises from many reasons, but it can be widely differentiate as business risk or financial risk. Business risks are caused due to business transaction, competitors, technology, and innovation. Financial risks are those which are subject to financial markets, monetary and credit risk.
1.2 Statement of the problem:- since the revolution of bank existed, banks has many risk that must be considered and managed properly, especially when banks uses large amount of leverages, but without proper management and consideration banks can easily become in debt. There are many factors which have lead banks to such condition, and foreign exchange is one among them. This fear of bank failure was the major cause of financial and credit crises between 2005- 2009.
1.3 Background and Significance of the study: - this report signifies the importance and impact of foreign exchange which took place in banking sector recently. Bank failures are widely perceived when the market value of its assets declines its liabilities and thus lead to market risk and failure. There are more than 250 bank failures between (2000 2009) in which US contributes to about 90% of this figure. This is due to the lack of improper management and ignorance to arrived risk. Since 1970 s the world has witnessed increasingly change in the explosive nature of exchange rates in banks and also governed the risk related to this change. Banks have always been under this risk, thus now banks have equipped with such instruments, technique, and methods to manage and overcome their FOREX risk. The most important and widely used tools to manage this risk are Derivatives.
LITERATURE REVIEW
2.1 Introduction: -
To perform this study further, it was necessary to understand the factors of foreign exchange risk and how do banks manages those risk and what tool are used by them to overcome this risk. This literature review explores many dominant themes of the research questions and problems relating to the banks management of FOREX risks, its main tools and technique to control and minimize their risk and maximizes the profit of the bank and its investors and also to withstand in this prevailing market. Mr. Dickson Yap, Publisher & Managing Editor, The Forex Journal ( 10 Feb. 2010) have stated that currency or the FOREX market by but not far the world s largest growing financial market with trading volume of more than US$4 trillions everyday in which 80% of the transaction and trading are done by global banks.
a. Risk management tools:-
A financial derivative is a monetary instrument based on another more basic monetary instrument. The significance of the financial derivative is therefore based upon, or resultant from the value of an underlying asset, rate or instrument.
Recently a financial article have reported that group of major banks, like Citigroup, deutsche bank, HSBC, and J P Morgan chase & co are coming together into a amalgamation to standardize process of clearing the high volume of hedge funds and currency exchange trade which will lead into the reduction in cost and risk. In addition to this 3 more banks were announced into this merger including Morgan Stanley, bank of America and credit Suisse. (An American banker, Bills Steve, 27/7/2009)
According to Bretton woods accord (1944) has established a policy of pegging currencies (fixed exchange rate) against the US dollars in order to stabilize the world economy, no doubt the British pound were the prominent ruler in the currency market till when the Nazi s undertook the counterfeiting against the British pound and damages its standing.
On (15 August 1971) the president Richard Nixon has apparently suspended the convertibility of dollars into gold and asked for the agreement. December 1971 a new agreement was signed between G-10 in which it was agreed that there will be a fixed currency exchange rate against the US dollars, but however in March 1973 this agreement came to an end because of its criticism, arguments and risky rate.
Some of the important techniques banks imply to reduce or transform their FOREX risks are:-
Hedging:- hedging is kind of trading in which its main objective is to hold the underlined security in which he willing bear some cost of transaction to aim protection against unfavorable currency exchange rate.
Hedging as a risk management tool:-
Paul Tudor Jones is one of the most successful global macro fund managers out there. He manages in excess of $17 billion at his hedge fund, Tudor Investment Corp. Although these quotes are older (taken from around 2000- 2001), they are much generalized and still serve as great advice for banks to minimize their foreign exchange risk.
Citibank s CEO Vikram Pandit (2008) said in a media, FOREX market is an emerging financial market in future and to transact with it we need to be more objective.
Speculation is one of technique used to tackle against the FOREX risk. Banks like Lloyds TSB and Halifax often speculate in order to regain or make larger gain. Speculation means to take large risk with respect to predict future and gamble with hopes to make quick and large profits.
Innovative technologies and systems
There are number of aspects of technology applied to foreign exchange trading and the analysis of foreign exchange risk for banks. The question is considered in light of the 2008-09 international financial crisis and subsequent global recession. It is noted that a number of Internet trading and analysis applications are used in the foreign currency markets are being offered by banks to their customers. (Davidson and Ryan in Feb. 2009).
The article talks on the implications of subprime crisis to various asset classes and the emergence of a generation of indexes which based on forex volatility. It states the subprime crisis have affected most banks, experiencing write downs in credit while structured investment vehicles were expected to become extinct. It examines the potential of the forex market in becoming a popular investment tool during the crises.
(Sawyer, Nick , Risk; Aug2008, Vol. 21 Issue 8, p37-37, 1/3p, 1 Color Photograph)
CLS Bank International, the new foreign exchange settlement facility designed to reduce settlement risk, finally opened for business with the general forex trading community. It is the first global utility expressly designed to reduce risk in the financial markets, and one that has been surrounded by controversy and doubt since its outset. CLS Bank was already settling more than 30,000 payment instructions on deals worth more than &dollor300 billion a day with a 100% success rate. CLS settles both legs of a forex deal simultaneously, eliminating the danger of a bank failing to pay its side of a deal after a counter party has already made its payment. To achieve its payment-versus-payment process, CLS Bank operates in five-hour time windows staffing at 7am Central European Time, with a strict Rota of paying and settling times. This compressed and rigid schedule led to worries about liquidity problems if participants could not manage their payment flows efficiently enough. A bigger concern is how settlement members will manage liquidity now that they operate third-party services for their customers.
(Davidson, Clive , journals)
Derivatives as a tool:-
The German derivatives market is getting more competitive, that's the lesson from a survey of derivatives users in German banks. Although heavyweight global derivatives dealers performed well, Deutsche Bank took 11 first positions spread across all categories and JP Morgan managed to dominate forex options with first places in the euro/dollar forex options and individual dollar and euro denominated exotic forex options. The more than 100 voters in the survey were asked to nominate their top three banks based on their ability to provide the best prices, the most liquid markets and the best dealing advice. Much interest for the bank's derivatives products stems from structured product demand. The latter have tended to incorporate more exotic derivatives structures that have let the bank develop its exotics business.
(Schwarz, Steffen, July 2004)
2.3 Conclusion:-
This literature review focuses on the enhancements in the treasury and asset management front-to-back office systems. It notes on the inclusion of foreign exchange (forex) trading tools, price discovery and booking, as well as cash and treasury positions in user interface. It says that support for various rates forward and options, for new security index and derivatives, and for corporate forex are added in its processing system. (Dec2009) The report examines the advantages and operation of a number of these platforms in to banking foreign exchange system. It cites that the eFibo strategy is a helpful tool in determining trend and countertrend.
3.1 Data and methodology:-
Although online research holds promise, its potential should not be exaggerated: many of the issues and problems of conventional research still apply in the practical venue.
(Madge and O'Connor, 2002)
3.2 Research question and purpose:-
The research methodology is a systematic and critical investigation about the presumed relation into the study. This research gives a brief detail and justifies the report by using some of the qualitative and hypothetical data used in regards of the foreign exchange risks of banks. This data and analysis gives us a practical view of the problem and purpose of banks managing their FOREX risk.
The recent report, on beginning of the week, euro moved away of about 3% against the US dollars and a small percentage of dip of about 2% in its banking FOREX market. It is clarified that the euro banks were good to perform, or is it just temporary positive response. The chart below gives a clear picture about the recent euro exchange against US dollars.
According to the BSI s quarterly review the amounts outstanding of OTC foreign exchange derivatives in foreign currency are given below in billions of US dollars.
risk associated
42%
56%
60%
82%
67%
Year Amount O/ST % held by banks
Dec 2005 31360.382 67%
Dec 2006 40270.899 72%
Dec 2007 56238.245 79%
Dec 2008 44199.561 87%
Dec 2009 49196.367 80%
3.3. Data analysis
The table above gives a clear picture of the currency held and the risk associated with it, this risk of the banks are always diversified and managed and some of the tools used to do so are:-
Maintaining portfolio management: - it is a course of action to develop, manage and build the assets and securities of product or project.
Speculation: - it is a process of investing into higher portfolio to profit more than the average profit. It is not a part of pure gambling but some were the risk associated with it is too high.
Arbitrage: - one of most successful and widely used trading derivative. Arbitrageurs try to make risk-less profit by simultaneously entering into transactions in two or more markets or two or more contracts.
3.4 Aims and objectives: - this proposal signifies and understands the risk related to the FOREX market worldwide and gives a concise idea about how banks manage those risks.
i. To identify the core area of FOREX risk and banks involvement in those risk.
ii. To implement strategies and systems to overcome those risk.
iii. To understand the management and organization of risk-free FOREX trading in free market and instruments used to overcome or reduce risk.
iv. Brief discussion on risk management tools used by banks like derivatives, portfolio management, F&O and so on.
3.5. Scope and limitation: - this research has gone an in-depth study about the subject and its core area and has come across some scope and limitation about the proposal.
i. No practical knowledge about the topic which is greatly important.
ii. The proposal consists of three areas like Risk, Banks, and FOREX market, to find any accurate data about this was a big difficulty.
iii. Due to time constrained and restriction to word limits the proposal size is small and less informative.
3. 6. Conceptual framework: - here is the list of two figures relating to FOREX market. The first figure gives a concise picture about the turnover took place in global foreign exchange market (2007) and the float of currency from highest to lowest. The second figure gives an idea about exchange rate conversion with regard to other foreign currency. Both the charts use US dollars as their base currency against other world currency.
Figure 1 Figure 2
4.1. Conclusion and discussion: -
Since the middle age till World War I, the currency exchange market was stable and firm and also involved less risk, but after WWI this market became unpredictable and more risky than earlier. Due to high risk, forex was deemed unfavorable by public and banks. There are many other causes for the fluctuation and instability in forex which has to be observed and managed properly. This proposal gives a brief idea about how banks have been managing and facing the forex risk right from 1950 till today. All the above data and research are the evident of such speculation in the market and it can be said that till now banks far away from handling those risk. According to the US president Barack Obama on The independent (2009) "even commonsense regulations are unnecessary and unwise", with the result that the administration had sat on its hands as problems turned into crises.
This research proposal covers most of all the core and concerned part of the study to give the viewer an in-depth knowledge about the research proposal. The report has gone through several stages to prove the point of Risk and its management and control.
4.2. Recommendations: - Banks must clearly define and adopt some of the foreign exchange risk management policies to avoid concealed and unseen Risk, some of the recommended policies are:
i. Uses of foreign exchange derivatives.
ii. Forward FOREX mismatch limits.
iii. Separate limits should be allocated for each currency, together with an overall cap limit. Banks that assume risk on a proprietary trading basis.
iv. Trade in some of approved instruments.
v. New and improved monitoring and reporting systems.
vi. Trade in risk-free or risk-less instrument to recover the loss or risk of FOREX market.
vii. Impose a stop loss technique; so that the trade can t be taken place after the fixed margin of loss have occurred.
All this policies and techniques must be implemented properly and should be reviewed on regular basis normally at least every quarterly, to make sure that it remains appropriate and effective and thus banks can make much more profit in future.
