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Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them. Financial risk management can be qualitative and quantitative. As a specialization of risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk. The risks to which bank stands exposed in forex operations can be broadly classified as: Exchange risk, Credit risk/Counter party risk, Interest rate risk, Legal risk, and Operational risk. This project attempts to study the intricacies of the foreign exchange market. The main purpose of this study is to get a better idea and the comprehensive details of foreign exchange risk management. y y y y y y To know about the various concept and technicalities of forex. To know the various functions of forex market. To get the knowledge about the hedging tools used in forex risk management. To understand the valuation of various hedging tools. To understand risk modelling for calculating probable losses with a portfolio. To know various risk monitoring tools used by banks.



The Lakshmi Vilas Bank Limited (LVB) was founded eight decades ago ( in 1926) by seven people of Karur under the leadership of Shri V.S.N. Ramalinga Chettiar, mainly to cater to the financial needs of varied customer segments. The bank was incorporated on November 03, 1926 under the Indian Companies Act, 1913 and obtained the certificate to commence business on November 10, 1926, The Bank obtained its license from RBI in June 1958 and in August 1958 it became a Scheduled Commercial Bank. During 1961-65 LVB took over nine Banks and raised its branch network considerably. To meet the emerging challenges in the competitive business world, the bank started expanding its boundaries beyond Tamil Nadu from 1974 by opening branches in the neighboring states of Andhra Pradesh, Karnataka, Kerala, Maharashtra, Madhya Pradesh, Gujarat, West Bengal, Uttar Pradesh, Delhi and Pondicherry. Mechanization was introduced in the Head office of the Bank as early as 1977. At present, with a network of 273 branches,1 satellite branch and 9 extension counters, spread over 16 states and the union territory of Pondicherry, the Bank's focus is on customer delight, by maintaining high standards of customer service and amidst all these new challenges, the bank is progressing admirably. LVB has a strong and wide base in the state of Tamil Nadu, one of the progressive states in the country, which is politically stable and has a vibrant industrial environment. LVB has been focusing on retail banking, corporate banking and banc assurance. The Bank's business crossed Rs.15561.01 Crores as on March 31, 2011. The Bank earned a Net profit of Rs. 101.13 Crores. The Net owned Funds of the Bank reaches Rs. 739.00 Crores. With a fairly good quality of loan assets the Net NPA of the bank was pegged at 0.09 % as on March 31, 2011.


In today s world no economy is self-sufficient, so there is need for exchange of goods and services amongst the different countries. So in this global village, unlike in the primitive age the exchange of goods and services is no longer carried out on barter basis. Every sovereign country in the world has a currency that is legal tender in its territory and this currency does not act as money outside its boundaries. So whenever a country buys or sells goods and services from or to another country, the residents of two countries have to exchange currencies. So we can imagine that if all countries have the same currency then there is no need for foreign exchange. Let us consider a case where Indian company exports cotton fabrics to USA and invoices the goods in US dollar. The American importer will pay the amount in US dollar, as the same is his home currency. However the Indian exporter requires rupees, his home currency for procuring raw materials and for payment to the labour charges etc. Thus he would need exchanging US dollar for rupee. If the Indian exporters invoice their goods in rupees, then importer in USA will get his dollar converted in rupee and pay the exporter. From the above example we can infer that in case goods are bought or sold outside the country, exchange of currency is necessary. Sometimes it also happens that the transactions between two countries will be settled in the currency of third country. In that case both the countries that are transacting will require converting their respective currencies in the currency of third country. For that also the foreign exchange is required.



Particularly for foreign exchange there is no market place called the foreign exchange market. It is mechanism through which one country s currency can be exchanged i.e. bought or sold for the currency of another country. The foreign exchange market does not have any geographic location. Foreign exchange market is described as an OTC (over the counter) market as there is no physical place where the participant meets to execute the deals, as we see in the case of stock exchange.

The largest foreign exchange market is in London, followed by the New York, Tokyo, Zurich and Frankfurt. The market is situated throughout the different time zone of the globe in such a way that one market is closing the other is beginning its operation. Therefore it is stated that foreign exchange market is functioning throughout 24 hours a day. In most market US dollar is the vehicle currency, viz., the currency used to dominate international transaction. In India, foreign exchange has been given a statutory definition. Section 2 (b) of foreign exchange regulation ACT, 1973 states: y Foreign exchange means foreign currency and includes all deposits, credits and balance payable in any foreign currency and any draft, traveller s cheques, letter of credit and bills of exchange expressed or drawn in Indian currency but payable in any foreign currency. y Any instrument payable, at the option of drawer or holder thereof or any other party thereto, either in Indian currency or in foreign currency or partly in one and partly in the other. In order to provide facilities to public and foreigners visiting India, RBI has granted license to undertake money-changing business at seas/airport and tourism place of tourist interest in India to various firms and individuals. Besides certain authorized dealers in foreign exchange (banks) have also been permitted to open exchange bureaus.


Following are the major bifurcations: y Full fledge moneychangers they are the firms and individuals who have been authorized to take both, purchase and sale transaction with the public. y Restricted moneychanger they are shops, emporia and hotels etc. that have been authorized only to purchase foreign currency towards cost of goods supplied or services rendered by them or for conversion into rupees. y Authorized dealers they are one who can undertake all types of foreign exchange transaction. Bank is only the authorized dealers. The only exceptions are Thomas cook, western union, UAE exchange are AD but not a bank. Even among the banks RBI has categorized them as follows: y y Branch A They are the branches that have nostro and vostro account. Branch B The branch that can deal in all other transaction but do not maintain nostro and vostro a/c s fall under this category. For Indian we can conclude that foreign exchange refers to foreign money, which includes notes, cheques, bills of exchange, bank balance and deposits in foreign currencies.


The main players in foreign exchange market are as follows: 1. CUSTOMERS: The customers, who are engaged in foreign trade, participate in foreign exchange market by availing of the services of banks. Exporters require converting the dollars in to rupee and importers require converting rupee in to the dollars, as they have to pay in dollars for the goods/services they have imported.

2. COMMERCIAL BANK: They are most active players in the forex market. Commercial bank dealing with international transaction, offer services for conversion of one currency in to another. They have wide network of branches. Typically banks buy foreign exchange from exporters and sells foreign exchange to the importers of goods. As every time the foreign exchange bought or oversold position. The balance amount is sold or bought from the market.


3. CENTRAL BANK: In all countries Central bank have been charged with the responsibility of maintaining the external value of the domestic currency. Generally this is achieved by the intervention of the bank. 4. EXCHANGE BROKERS: A broker who operates predominantly or exclusively in currency markets. That is, a foreign exchange broker fills orders to buy and sell currencies in exchange for a commission. They are intermediaries who do not put their own money at risk.


Countries of the world have been exchanging goods and services amongst themselves. This has been going on from time immemorial. The world has come a long way from the days of barter trade. With the invention of money, problems of barter trade have disappeared. The barter trade has given way to exchange of goods and services for currencies instead of goods and services. The rupee was historically linked with pound sterling. India was a founder member of the IMF. During the existence of the fixed exchange rate system, the intervention currency of the Reserve Bank of India (RBI) was the British pound, the RBI ensured maintenance of the exchange rate by selling and buying pound against rupees at fixed rates. The interbank rate therefore ruled the RBI band. During the fixed exchange rate era, there was only one major change in the parity of the rupee- devaluation in June 1966. Different countries have adopted different exchange rate system at different time. The following are some of the exchange rate system followed by various countries. 1. BRETTON WOODS SYSTEM During the world wars, economies of almost all the countries suffered. In order to correct the balance of payments disequilibrium, many countries devalued their currencies. Consequently, the international trade suffered a deathblow. In 1944, following World War

II, the United States and most of its allies ratified the Bretton Woods Agreement, which set up an adjustable parity exchange-rate system under which exchange rates were fixed (Pegged) within narrow intervention limits (pegs) by the United States and foreign central banks buying and selling foreign currencies. This agreement, fostered by a new spirit of international cooperation, was in response to financial chaos that had reigned before and during the war. In addition to setting up fixed exchange parities (par values) of currencies in relationship to gold, the agreement established the International Monetary Fund (IMF) to act as the custodian of the system. Under this system there were uncontrollable capital flows, which lead to major countries suspending their obligation to intervene in the market and the Bretton Wood System, with its fixed parities, was effectively buried. Thus, the world economy has been living through an era of floating exchange rates since the early 1970. 2. FIXED RATE SYSTEM: A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged. 3. FLOATING RATE SYSTEM: In a truly floating exchange rate regime, the relative prices of currencies are decided entirely by the market forces of demand and supply. There is no attempt by the authorities to influence exchange rate. Where government interferes directly or through various monetary and fiscal measures in determining the exchange rate, it is known as management of dirty float.


4. PURCHASING POWER PARITY (PPP) Professor Gustav Cassel, a Swedish economist, introduced this system. The theory, to put in simple terms states that currencies are valued for what they can buy and the currencies have no intrinsic value attached to it. Therefore, under this theory the exchange rate was to be determined and the sole criterion being the purchasing power of the countries. As per this theory if there were no trade controls, then the balance of payments equilibrium would always be maintained. Thus if 150 INR buy a fountain pen and the same fountain pen can be bought for USD 2, it can be inferred that since 2 USD or 150 INR can buy the same fountain pen, therefore USD 2 = INR 150. For example India has a higher rate of inflation as compared to country US then goods produced in India would become costlier as compared to goods produced in US. This would induce imports in India and also the goods produced in India being costlier would lose in international competition to goods produced in US. This decrease in exports of India as compared to exports from US would lead to demand for the currency of US and excess supply of currency of India. This in turn, cause currency of India to depreciate in comparison of currency of US that is having relatively more exports.


Exchange rate is a rate at which one currency can be exchange in to another currency, say USD = Rs.48. This rate is the rate of conversion of US dollar in to Indian rupee and vice versa. There are two methods of quoting exchange rates. 1) Direct methods: Foreign currency is kept constant and home currency is kept variable. In direct quotation, the principle adopted by bank is to buy at a lower price and sell at higher price. 2) Indirect method: Home currency is kept constant and foreign currency is kept variable. Here the strategy used by bank is to buy high and sell low.


In India with effect from august 2, 1993, all the exchange rates are quoted in direct method. It is customary in foreign exchange market to always quote two rates means one for buying and another rate for selling. This helps in eliminating the risk of being given bad rates i.e. if a party comes to know what the other party intends to do i.e. buy or sell, the former can take the letter for a ride. There are two parties in an exchange deal of currencies. To initiate the deal one party asks for quote from another party and other party quotes a rate. The party asking for a quote is known as asking party and the party giving quotes is known as quoting party. The advantage of two way quote is as under: i. The market continuously makes available price for buyers or sellers. ii. Two way price limits the profit margin of the quoting bank and comparison of one quote with another quote can be done instantaneously. iii. As it is not necessary any player in the market to indicate whether he intends to buy or sale foreign currency, this ensures that the quoting bank cannot take advantage by manipulating the prices.

iv. It automatically insures that alignment of rates with market rates.

v. Two way quotes lend depth and liquidity to the market, which is so very essential for efficient market.



In free market, it is the demand and supply of the currency which should determine the exchange rates but demand and supply is the dependent on many factors, which are ultimately the cause of the exchange rate fluctuations. The volatility of exchange rates cannot be traced to the single reason and consequently, it becomes difficult to precisely define the factors that affect exchange rates. However, the more important among them are as follows: 1) EXCHANGE CONTROL: In a country with Exchange Control Regulations, fixing of an exchange rate becomes a policy matter. It is said that with the mechanism of exchange control, the actual degree of disequilibrium present in country s BOP position does not get revealed in exchange rate. The exchange rate is kept at an artificial level, as the exchange rate policy is required to be complementary to the exchange control regulations which in turn form a part of general economic policy. 2) BALANCE OF PAYMENT: BOP on current account influences a currency s exchange rate system relative to other currency. The demand for particular currency is mainly dependent on demand for goods and services of respective country. A favourable BOP indicates a greater demand for goods and services of that country abroad as compared to demand of foreign goods and services in by the residents of country. As demand for currency abroad ( i.e. supply of foreign currency at home ) is greater than demand for foreign currency at home, the home currency is likely to appreciate until equilibrium is reached. Normally a phenomenon is obvious in case of the currency which serves as the reserve currency for other countries. The reserve country can pursue an expansionary monetary and fiscal policy and resort to deficit financing to support its higher economic expansion. This can be managed with lesser degree of inflation if it can shift some of its excess demand to rest of world with adverse balance of trade. The adverse balance of trade, the other things being equal, will depreciate reserve currency vis--vis other currencies; but the countries
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having balance in reserve currency or who are exporting to that country would intervene and try to maintain the value of reserve currency so that the value of their financial assets is protected and demand for their goods in the reserve currency does not come down. In the process they keep their currency at a depreciated level and allow their economies to become inflationary. 3) INTEREST RATES: A sharp rise in interest rate can be anticipated to be accompanied by an increase in demand for currency resulting in marked strengthening of currency. 4) INFLATION: If a country is having a very high level of inflation and another country is having low inflation, country having low inflation will be in position to maintain the prices of its export commodities which will improve the demand for its goods and hence its currency and thus the currency of other country having higher level will depreciate to the extent of differential in inflation. 5) EXPACTATION OF THE FOREIGN EXCHANGE MARKET: Psychological factors also influence exchange rates. These factors include market anticipation, speculative pressures, and future expectations. A few financial experts are of the opinion that in today s environment, the only trustworthy method of predicting exchange rates is by gut feel. Bob Eveling, vice president of financial markets at SG, is corporate finance s top foreign exchange forecaster for 1999. Eveling s gut feeling has, defined convention, and his method proved uncannily accurate in foreign exchange forecasting in 1998.SG ended the corporate finance forecasting year with a 2.66% error overall, the most accurate among 19 banks. The secret to Eveling s intuition on any currency is keeping abreast of world events. Any event, from a declaration of war to a fainting political leader, can take its toll on a currency s value. Today, instead of formal modals, most forecasters rely on an amalgam that is part economic fundamentals, part model and part judgment.

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6) ASSETS MARKET: The demand for goods produced in a country explains partly the demand for the currency of the particular country. It has to be recognised that the demand for the currency also arises from the desire to hold stock of assets denominated in that currency. Therefore, it becomes necessary to consider the factors affecting the demand and supply of financial instruments denominated in that currency in relation to the factors affecting the demand and supply of financial instruments denominated in other currencies. 7) OTHER FACTORS: There are a large number of other factors viz. political developments like war, change in government, official intervention in money and exchange market, restriction on capital inflows, change in productivity levels, fiscal and monetary policy of government concerned and the underlying psychology of the market operators. The exchange rates get adjusted not only to the developments that have already taken place but also are influenced by the changes in the variables that are expected to take place in future. International investors and speculators move funds on the basis of such expected changes and as a result, anticipatory adjustments take place in currency level.

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The traditional approach to market risk management is hedging. Hedging consists of taking positions that lower the risk profile of the portfolio. Hedging consists of taking positions that lower the risk profile of the portfolio. This is a special case of minimizing the VAR of a portfolio with two assets,an inventory and a hedging instrument. Here, the hedging position is fixed and the value of the hedging instrument is linearly related to the underlying asset. More generally, we can distinguish between Static hedging which consists of putting on, and leaving, a position until the hedging horizon. This is appropriate if the hedge instrument is linearly related to the underlying asset price. Dynamic hedging which consists of continuously rebalancing the portfolio to the horizon. This can create a risk profile similar to positions in options. Dynamic hedging is associated with options, since options have nonlinear payoffs in the underlying asset, the hedge ratio, which can be viewed as the slope of the tangent to the payoff function, must be readjusted as the price moves.

Consider a hypothetical situation in which ABC co. has to import a raw material for manufacturing goods. But this raw material is required only after three months. However, in three months the price of raw material may go up or go down due to foreign exchange fluctuations and at this point of time it cannot be predicted whether the price would go up or come down. Thus he is exposed to risks with fluctuations in forex rate. If he buys the goods in advance then he will incur heavy interest and storage charges. However, the availability of derivatives solves the problem of importer. He can buy currency derivatives. Now any loss due to rise in raw material price would be offset by profits on the futures contract and vice versa. Hence, the derivatives are the hedging tools that are available to companies to cover the foreign exchange exposure faced by them.
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Derivatives are financial contracts of predetermined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rate, exchange rates, commodities, and equities. Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging. Hedging is the most important aspect of derivatives and also its basic economic purpose. There has to be counter party to hedgers and they are speculators. Derivatives have come into existence because of the prevalence of risk in every business. This risk could be physical, operating, investment and credit risk. Derivatives provide a means of managing such a risk. The need to manage external risk is thus one pillar of the derivative market. Parties wishing to manage their risk are called hedgers.


The common derivative products are forwards, options, swaps and Futures.

5.3.1 FORWARD CONTRACTS: Forward exchange contract is a firm and binding contract, entered into by the bank and its customers, for purchase of specified amount of foreign currency at an agreed rate of exchange for delivery and payment at a future date or period agreed upon at the time of entering into forward deal. The bank on its part will cover itself either in the interbank market or by matching a contract to sell with a contract to buy. The contract between customer and bank is essentially written agreement and bank generally stands to make a loss if the customer defaults in fulfilling his commitment to sell foreign currency.

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A foreign exchange forward contract is a contract under which the bank agrees to sell or buy a fixed amount of currency to or from the company on an agreed future date in exchange for a fixed amount of another currency. No money is exchanged until the future date. A company will usually enter into forward contract when it knows there will be a need to buy or sell for a currency on a certain date in the future. It may believe that today s forward rate will prove to be more favourable than the spot rate prevailing on that future date. Alternatively, the company may just want to eliminate the uncertainty associated with foreign exchange rate movements. The forward contract commits both parties to carrying out the exchange of currencies at the agreed rate, irrespective of whatever happens to the exchange rate. The rate quoted for a forward contract is not an estimate of what the exchange rate will be on the agreed future date. It reflects the interest rate differential between the two currencies involved. The forward rate may be higher or lower than the market exchange rate on the day the contract is entered into. Forward rate has two components: y y Spot rate Forward points

Forward points, also called as forward differentials, reflect the interest differential between the pair of currencies provided capital flow is freely allowed. This is not true in case of US $ / rupee rate as there is exchange control regulations prohibiting free movement of capital from / into India. In case of US $ / rupee it is pure demand and supply which determines forward differential. Forward rates are quoted by indicating spot rate and premium / discount. In direct rate, Forward rate = spot rate + premium / - discount.

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Example: The interbank rate for 31st March is 48.70. Premium for forwards are as follows:

Month April May June

Paisa 40/42 65/67 87/88

If a one month forward is taken then the forward rate would be 48.70 + .42 = 49.12 If a two months forward is taken then the forward rate would be 48.70. + .67 = 49.37. If a three month forward is taken then the forward rate would be 48.70 + .88 = 49.58.

Example: Let s take the same example for a broken date Forward Contract Spot rate = 48.70 for 31st March. Premium for forwards are as follows 30th April, 48.70 + 0.42 31st May, 48.70 + 0.67 30th June, 48.87 + 0.88

For 17th May the premium would be (0.67 0.42) * 17/31 = 0.137 Therefore the premium up to 17th May would be 48.70 + 0.557 = 49.507. Premium when a currency is costlier in future (forward) as compared to spot, the currency is said to be at premium vis--vis another currency. Discount when a currency is cheaper in future (forward) as compared to spot, the currency is said to be at discount vis--vis another currency.

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Example: A company needs DEM 235000 in six months time. Market parameters: Spot rate IEP/DEM = 2.3500 Six months Forward Rate IEP/DEM = 2.3300 Solutions available: y The company can do nothing and hope that the rate in six months time will be more favourable than the current six months rate. This would be a successful strategy if in six months time the rate is higher than 2.33. However, if in six months time the rate is lower than 2.33, the company will have to lose money. y It can avoid the risk of rates being lower in the future by entering into a forward contract now to buy DEM 235000 for delivery in six months time at an IEP/DEM rate of 2.33. y It can decide on some combinations of the above. VARIOUS OPTIONS AVAILABLE IN FORWARD CONTRACTS: A forward contract once booked can be cancelled, roll over, extended and even early delivery can be made.

1. Roll over forward contracts When extension or roll over of forward contract is sought by the customer the contract shall be cancelled at TT selling or TT buying rate on date of cancellation and rebooked only at current rate of exchange. The difference between the contracted rate and the rate at which contract is cancelled should be recovered from/paid to the customer at the time of extension. A corporate can book with the Authorised Dealer a forward cover on roll-over basis as necessitated by the maturity dates of the underlying transactions, market conditions and the need to reduce the cost to the customer.

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Example : An importer has entered into a 3 months forward contract in the month of February. Spot Rate = 48.65 Forward premium for 3 months (May) = 0.75 Therefore rate for the contract = 48.65 + 0.75 = 49.45 Suppose, in the month of May the importer realizes that he will not be able to make the payment in May, and he can make payment only in July. Now as per the guidelines of RBI and FEDAI he can cancel the contract, but he cannot re-book the contract. So for this the importer will go for a roll-over forward for May over July. The premium for May is 0.75 (sell) and the premium for July is 0.11975(buy). Therefore the additional cost i.e. (0.11975 0.75) = 0.4475 will have to be paid to the bank.

2. Cancellation of Forward Contract A corporate can freely cancel a forward contract booked if desired by it. It can again cover the exposure with the same or other Authorised Dealer. However contracts relating to nontrade transaction\imports with one leg in Indian rupees once cancelled could not be rebooked till now. This regulation was imposed to stem volatility in the foreign exchange market, which was driving down the rupee. Thus the whole objective behind this was to stall speculation in the currency. The following are the guidelines that have to be followed in case of cancellation of a forward contract. 1.) In case of cancellation of a contract by the client (the request should be made on or before the maturity date) the Authorised Dealer shall recover/pay as the case may be, the difference between the contracted rate and the rate at which the cancellation is effected. The recovery/payment of exchange difference on canceling the contract may be up front or back ended in the discretion of banks.

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2.) Rate at which the cancellation is to be effected : y Purchase contracts shall be cancelled at the contracting ADs spot T.T. selling rate current on the date of cancellation. y Sale contract shall be cancelled at the contracting ADs spot T.T. selling rate current on the date of cancellation. y Where the contract is cancelled before maturity, the appropriate forward T.T. rate shall be applied. 3.) In the absence of any instructions from the client, the contracts, which have matured, shall be automatically cancelled on 7th day, if it falls on a Saturday or holiday, the contract shall be cancelled on the next succeeding working day. In case of cancellation of the contract

1.) Swap, cost if any shall be paid by the client under advice to him. 2.) When the contract is cancelled after the due date, the client is not entitled to the exchange difference, if any in his favor, since the contract is cancelled on account of his default. He shall however, be liable to pay the exchange difference, against him. Example: 1) Cancellation before maturity: A forward contract entered into 3rd Aug 2009 for USD 100,000 @ USD 1 = Rs. 47.69 3 months forward is cancelled by customer 2 months before maturity of the contract. If the 2 months forward TT selling rate on the date of cancellation is Rs. 47.59. Then the difference in exchange is Rs. 0.10 per USD in favour of customer. So, the amount to be paid to the customer is Rs. 10000. If cancellation rate is higher than the original rate, the difference shall be recovered from customer.

2) Automatic cancellation on 7th day of maturity.

Suppose in above example the contract was cancelled after maturity on 7th working day automatically at USD 1 = Rs.46.24
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Here difference in exchange is in favour of customer but no amount will be paid to him since the contract gets cancelled automatically after maturity.

3. Early Delivery: Suppose an Exporter receives an Export order worth USD 500000 on 30/06/2000 and expects shipment of goods to take place on 30/09/2000. On 30/06/2000 he sells USD 500000 value 30/09/2000 to cover his FX exposure. Due to certain developments, internal or external, the exporter now is in a position to ship the goods on 30/08/2000. He agrees this change with his foreign importer and documents it. The problem arises with the Bank as the exporter has already obtained cover for 30/09/2000. He now has to amend the contract with the bank, whereby he would give early delivery of USD 500000 to the bank for value 30/08/2000. i.e. the new date of shipment. However, when he sold USD value 30/09/2000, the bank did the same in the market, to cover its own risk. But because of early delivery by the customer, the bank is left with a long mismatch of funds 30/08/2000 against 30/09/2000, i.e. + USD 500000 value 30/08/2000 (customer deal amended) against the deal the bank did in the interbank market to cover its original risk USD value 30/09/2000 to cover this mismatch the bank would make use of an FX swap. The swap will be 1.) Sell USD 500000 value 30/08/2000. 2.) Buy USD 500000 value 30/09/2000 The opposite would be true in case of an importer receiving documents earlier than the original due date. If originally the importer had bought USD value 30/09/2000 on opening of the L/C and now expects receipt of documents on 30/08/2000, the importer would need to take early delivery of USD from the bank. The Bank is left with a short mismatch of funds 30/08/2000 against 30/09/2000. i.e. USD 500000 value (customer deal amended) against the deal the bank did in the interbank market to cover its original risk + USD 500000. To cover this mismatch the bank would make use of an FX swap, which will be
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1. Buy USD value 30/08/2000. 2. Sell USD value 30/09/2000. The swap necessitated because of early delivery may have a swap cost or a swap difference that will have to be charged / paid by the customer. The decision of early delivery should be taken as soon as it becomes known, failing which an FX risk is created. This means that the resultant swap can be spot versus forward (where early delivery cover is left till the very end) or forward versus forward. There is likelihood that the original cover rate will be quite different from the market rates when early delivery is requested. The difference in rates will create a cash outlay for the bank. The interest cost or gain on the cost outlay will be charged / paid to the customer. 4. Substitution of Orders: The substitution of forward contracts is allowed. In case shipment under a particular import or export order in respect of which forward cover has been booked does not take place, the corporate can be permitted to substitute another order under the same forward contract, provided that the proof of the genuineness of the transaction is given. ADVANTAGES OF USING FORWARD CONTRACTS : y They are useful for budgeting, as the rate at which the company will buy or sell is fixed in advance. y y There is no up-front premium to pay when using forward contracts. The contract can be drawn up so that the exchange takes place on any agreed working day. DISADVANTAGES OF FORWARD CONTRACTS : y They are legally binding agreements that must be honoured regardless of the exchange rate prevailing on the actual forward contract date. y They may not be suitable where there is uncertainty about future cash flows. For example, if a company tenders for a contract and the tender is unsuccessful, all obligations under the Forward Contract must still be honoured.


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5.3.2 OPTIONS: An option is a Contractual agreement that gives the option buyer the right, but not the obligation, to purchase (in the case of a call option) or to sell (in the case of put option) a specified instrument at a specified price at any fixed date in future. Upon exercise of the right by the option holder, and option seller is obliged to deliver the specified instrument at a specified price. y y y y The option is sold by the seller (writer). To the buyer (holder). In return for a payment (premium). Option lasts for a certain period of time the right expires at its maturity OPTIONS ARE OF TWO KINDS 1.) Put Options: The buyer (holder) has the right, but not an obligation, to sell the underlying asset to the seller (writer) of the option.

2.) Call Options: The buyer (holder) has the right, but not the obligation to buy the underlying asset from the seller (writer) of the option. STRIKE PRICE: Strike price is the price at which calls & puts are to be exercised. AMERICAN OPTIONS: The buyer has the right (but no obligation) to exercise the option at any time between purchase of the option and its maturity. EUROPEAN OPTIONS: The buyer has the right (but no obligations) to exercise the option at maturity only.

23 | P a g e ASSETS : y y y Physical commodities like agricultural products, metal, oil. Currencies. Stock (Equities) INTRINSIC VALUE: For option which is in the money, the mathematical difference between the market price of the underlying asset and strike price of an option contract at the time of exercise is the intrinsic value of call option. Similarly, for put option it is difference between strike price and market price of underlying asset. Example : If the strike price is USD 5 and the current spot price is USD 4 then the buyer of put option has intrinsic value of USD 1. By the exercising the option, the buyer of the option, can sell the underlying asset at USD 5 whereas in the spot market the same can be sold for USD 4. The buyer s intrinsic value is USD 1 for every unit for which he has a right to sell under the option contract. In-the-money : An option whose strike price is more favourable than the current market exchange rate is said to be in the money option. Immediate exercise of such option results in an exchange profit.

Example : If the US $ call price is 1 = US $ 1.5000 and the market price is 1 = US $ 1.4000, the exercise of the option by purchaser of US $ call will result in profit of US $ 0.1000 per pound. Such types of option contract are offered at a higher price or premium.

24 | P a g e Out-of-the-money : If the strike price of the option contract is less favorable than the current market exchange rate, the option contract is said to be out-of-the money to its market price. At-the-money: If the market exchange rate and strike prices are identical then the option is called to be atthe-money option. In the above example, if the market price is 1 = US $ 1.5000, the option contract is said to be at the money to its market place. Naked Options : A naked option is where the option position stands alone, it is not used in the conjunction with cash marked position in the underlying asset, or another potion position. Pay-off for a naked long call : A long call, i.e. the purchaser of a call (option), is an option to buy the underlying asset at the strike price. This is a strategy to take advantage of any increase in the price of the underlying asset.

Example : Current spot price of the underlying asset : 100 Strike price: 100 Premium paid by the buyer of the call: 5 (Scenario-1) If the spot price at maturity is below the strike price, the option will not be exercised (since buying in the spot is more advantageous). Buyer will lose the premium paid. (Scenario-2) If the spot price is equal to strike price (on maturity), there is no reason to exercise the option. Buyer loses the premium paid.

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(Scenario-3) If the spot price is higher than the strike price at the time of maturity, the buyer stands to gain in exercising the option. The buyer can buy the underlying asset at strike price and sell the same at current market price thereby make profit CURRENCY OPTIONS A currency option is a contract that gives the holder the right (but not the obligation) to buy or sell a fixed amount of a currency at a given rate on or before a certain date. The agreed exchange rate is known as the strike rate or exercise rate. An option is usually purchased for an upfront payment known as a premium. The option then gives the company the flexibility to buy or sell at the rate agreed in the contract, or to buy or sell at market rates if they are more favourable, i.e. not to exercise the option. How are Currency Options are different from Forward Contracts ? A Forward Contract is a legal commitment to buy or sell a fixed amount of a currency at a fixed rate on a given future date. A Currency Option, on the other hand, offers protection against unfavourable changes in exchange raters without sacrificing the chance of benefiting from more favorable rates. How does the option work ? The company buys the option to buy USD 1000000 at a rate of 1.6000 on a date one month in the future (European Style). In this example, let s assume that the option premium quoted is 0.98 % of the USD amount (in this case USD 1000000). This cost amounts to USD 9800 or IEP 6125. Outcomes : If, in one months time, the exchange rate is 1.5000, the cost of buying USD 1000000 is IEP 666,667. However, the company can exercise its Call Option and buy USD 1000000 at 1.6000. So, the company will only have to pay IEP 625000 to buy the USD 1000000 and saves IEP 41667 over the cost of buying

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dollars at the prevailing rate. Taking the cost of the option premium into account, the overall net saving for the company is IEP 35542. On the other hand, if the exchange rate in one month time is 1.7000. The company can choose not to exercise the Call Option and can buy USD 1000000 at the prevailing rate of 1.7000. The company pays IEP 588235 for USD 1000000 and saves IEP 36765 over the cost of forward cover at 1.6000. The company has a net saving of IEP 30640 after taking the cost of the option premium into account. In a world of changing and unpredictable exchange rates, the payment of a premium can be justified by the flexibility that options provide.

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5.3.3 SWAPS: A swap can be simply described as the transformation of one stream of future cash flows into another stream of future cash flows with different features. The essence of swap contract is the binding of two counterparties to exchange two different payment streams over time, the payments being tied at least in part to subsequent and uncertain market price developments. In most cases, the prices concerned have been exchange rates or interest rates but they have increasingly reached out to equity indices and physical commodities, notably oil and oil products. For example, a 10-year currency swap could involve an agreement to exchange every year 5 million dollars against 3 million pounds over the next ten years, in addition to a principal amount of 100 million dollars against 50 million pounds at expiration. Another example is that of a 5-year interest rate swap in which one party pays 8% of the principal amount of 100 million dollars in exchange for receiving an interest payment indexed to a floating interest rate. In this case, since both payments are tied to the same principal amount, there is no exchange of principal at maturity. 5.3.4 FUTURES: A future contact like forward contract is an agreement between two parties to buy or sell an asset at certain time in future for a certain price. However, unlike forward contracts futures are normally traded on exchange. Future contracts are standardized, negotiable, and exchange-traded contracts to buy or sell an underlying asset. They differ from forward contracts as follows. 1. Trading on organized exchanges: In contrast to forwards, which are OTC contracts tailored to customers needs, futures are traded on organized exchanges (either with a physical location or electronic).

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2. Standardization: Futures contracts are offered with a limited choice of expiration dates. They trade in fixed contract sizes. This standardization ensures an active secondary market for many futures contracts, which can be easily traded, purchased or resold. In other words, most futures contracts have good liquidity. The trade-off is that futures are less precisely suited to the need of some hedgers, which creates basis risk (to be defined later). 3. Clearing house: Futures contracts are also standardized in terms of the counterparty. After each transaction is confirmed, the clearinghouse basically interposes itself between the buyer and the seller, ensuring the performance of the contract (for a fee). Thus, unlike forward contracts, counterparties do not have to worry about the credit risk of the other side of the trade. Instead, the credit risk is that of the clearinghouse(or the broker), which is generally excellent. 4. Mark to market: As the clearinghouse now has to deal with the credit risk of the two original counterparties, it has to develop mechanisms to monitor credit risk. This is achieved by daily marking-tomarket, which involves settlement of the gains and losses on the contract every day. The goal is to avoid a situation where a speculator loses a large amount of money on a trade and defaults, passing on some of the losses to the clearinghouse. 5. Margin: Although daily settlement accounts for past losses, it does not provide a buffer against future losses. This is the goal of , which represent up-front posting of collateral that provides some guarantee of performance.

29 | P a g e Forward rate agreement: FRA is a financial contract between two parties to exchange interest payment for a Notional Principal amount on settlement date, for a specified period from start date to maturity date. Accordingly, on the settlement date, cash payments based on contract (fixed) and settlement rate are made by parties to one another. The settlement rate is the agreed benchmark/reference rate prevailing on settlement date.


Pricing is the first step toward risk measurement. The second step consists of combining the valuation formula with the distribution of underlying risk factors to derive the distribution of contract values. 5.4.1. FORWARD CONTRACTS: Forward pricing: y When underlying asset gives no income:

When underlying asset pays known income, I :

When underlying asset pays known yield, Y :

For currency forward:

For commodity without storage cost:

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For commodity with storage cost:

Valuing a forward contract: y For long forward contracts:

For short forward contracts:

Alternatively: y For long contract with no income:

For long contract with known income, I:

For long contract with known yield, Y:

5.4.2. SWAPS: y Interest rate swaps:

These can be viewed as long position in one bond combined with short position in other.For a swap where floating is received and fixed is paid:

Currency swaps:

Currency swaps can be also viewed as long position in one bond and short in another. If foreign currency is home currency is received and foreign currency is paid:

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Where, S0 is spot exchange rate i.e. no. of units of home currency paid per unit of foreign currency. Similarly, if foreign currency is received and home currency is paid:

5.4.3. OPTIONS: Put call parity: Let us consider two portfolios: 1. It consists of one European call option and amount of cash equal to Ke-rt. 2. It consists of one European put option and one share. Final value of both the portfolio is same which is Max. (ST, K). So, initial value should be also same.

This is called put call parity and so, for European option we can find value of call option if we know value of put option. BLACK SCHOLES MODEL: For non-dividend paying European option:

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For dividend paying European option:


This method is used to hedge bond and equities using futures and forward contracts. Short hedging is done one somebody owns an asset and he has to sell it in future and long hedging is done when somebody has to purchase some commodity in future. Unitary hedge arises when amount transacted in two markets are same. 5.5.1 Basis risk: Basis risk arises when changes in payoffs on the hedging instrument do not perfectly offset changes in the value of the underlying position. It is basically due to standardized format of futures contract which leads to difference in commodity and underlying asset. E.g. a company trying to hedge heating oil should buy crude oil futures. 5.5.2 Basis: It is the difference of spot price of asset to be hedged and futures price of contract used. If the asset to be hedged and underlying asset are same basis is zero at the time of expiration.
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So, the hedge profit is given as: Q [(S2 S1) (F2 F1)] = Q [b2 b1] 5.5.3 OPTIMAL HEDGE RATIO:
Hedge ratio is the ratio of the size of position taken in futures contract to the size of exposure. Hedge ratio which minimizes the variance of hedger s position is called optimal hedge ratio.

Hedge effectiveness is defined as proportion of variance eliminated by hedging. It is So, optimal number of futures contract can be given by:

This concept can be used for:

1. Duration hedging: Modified duration can be viewed as a measure of the exposure of relative changes in prices to
movements in yields. So,


We get,

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2. Beta hedging:

The optimal number of contract to sort in case of shares is given by:


Hedging nonlinear risks, however, is much more complex. Because options have nonlinear payoffs, the distribution of option values can be sharply asymmetrical. Since options are ubiquitous instruments, it is important to develop tools to evaluate the risk of positions with options.

5.6.1 OPTION SENSITIVITIES: 1. Delta: It is change in price of option with change in price of underlying asset. 2. Gamma: It is the rate of change of delta of portfolio of options on an underlying asset with respect to price of underlying asset. 3. Theta: It is the rate of change of value of portfolio of options with time. 4. Vega: It is rate of change of value of portfolio of options with volatility. 5. Rho: It is rate of change of value of portfolio of options with interest rate.
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The table above shows worst loss for European call option for different sensitivities. It can be seen that most risk is associated with change in stock price so only delta hedging can give good result here. 5.6.2 DELTA HEDGING: Let delta of some stock option is 0.6. Now if somebody has sold 20 stock call options of 100 shares each he can hedge his position by buying 1200 stocks. So, if the stock price will go by Rs.1 option price will also increase by Rs.0.6 so gaining 1200 on stocks and loosing 1200 on options. In dynamic delta hedging delta value keeps changing with price and hence portfolio should be adjusted accordingly.

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The risks to which bank stands exposed in forex operations can be broadly classified as: Exchange risk, Credit risk/Counter party risk, Interest rate risk, Legal risk, and Operational risk. 1) Exchange risk: 2) Credit risk/Counter party risk: 3) Interest rate risk: 4) Legal risk: 5) Operational risk:

We need to monitor the above risks associated with the forex operations of the bank by fixing up suitable type of limits mentioned here: 1) Exchange risk: y y Day light and overnight limits/Net overnight position limit Stop loss limits

2) Credit risk/Counter party risk: y y Interbank exposure limit Individual deal limit

3) Interest rate risk: y y y Individual gap limit (IGL) Aggregate gap limit (AGL) Value at risk (VAR)

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Besides the above, we need certain guidelines for the dealing room: y y y y Fixing up dealing hours. Fixing up limits for holding balances in Nostro account. Merchant/Trading ratio up to which division can go while operating in market. Foreign currency borrowing, investment of foreign currency funds and arbitrage swaps. y y Overnight placement of orders with banks abroad. Brokerage payable to foreign exchange brokers.

7.1. DAY LIGHT EXPOSURE LIMITS: In the course of operations during the day both in customer as well as in interbank business, dealer may have to maintain open position in various currencies transacted by bank before covering in market. The management is therefore expected to lay down the maximum position limits in each currency that may remain uncovered during the day. 7.2. OVERNIGHT EXPOSURE LIMITS: Overnight limit is the size of limit, which a dealer can leave open at the close of business hours every day. 7.3. NET OVERNIGHT POSITION LIMIT: It measures the risks inherent in a Bank s mix of long and short position in different currencies. 7.4. STOP LOSS LIMITS: As a part of risk measurement mechanism, to limit the losses due to adverse movements of exchange rates, stop loss limits are to be fixed for dealers. This limit avoids holding on to open positions by dealer in anticipation of reversal of movement of rates. The moment rates move adversely the dealer has to liquidate the position and come out by booking loss within the prescribed limit.

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7.5. INDIVIDUAL DEAL LIMIT: It is the limit fixed for entering the size of one time deal by the dealer. It puts a check on one time transaction exposure. 7.6. GAP LIMITS (INDIVIDUAL GAP LIMIT/AGGREGATE GAP LIMIT): Banks buy and sell currencies not only for value cash/Tom/Spot but also for deliveries extending beyond spot dates i.e. forward value dates. At times, the purchase and sale of a currency for a particular forward value date may not match which is referred which is referred to as GAP or MISMATCH between foreign currency and asset. IGL is the limit which defines net over brought or oversold position for a particular forward month for a particular currency. AGL on the other hand is nothing but the sum of the gaps in each currency for all the forward months when aggregated. 7.7. VALUE AT RISK (VAR): VaR is a technique, which estimates the potential loss in a position over a given holding period at a given level of confidence. The main components of this concept are: y y y It measures risk which is defined as the probability of the loss. It is an estimate of loss likely to suffer not actual loss. It measures the possibility of loss for a given period which could one day, a few days, weeks or even a year. 7.8. FIXING UP LIMITS FOR HOLDING BALANCES IN NOSTRO ACCOUNT: Banks should fix upper limits to balances in foreign currency Nostro account with their overseas correspondent bank abroad. Surplus should be managed by overnight placement/Investment with overseas correspondents. 7.9. FOREIGN CURRENCY BORROWING: As per RBI guidelines, banks are permitted to avail loans/overdrafts from head office, overseas branches and correspondents up to 25% of their Unimpaired Tier 1 capital or USD
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10 Million or its equivalent whichever is higher. The fund so raised may be used for purposes other than lending in foreign currency to constituents in India and repaid without reference to RBI.

Risk modelling refers to the use of formal econometric techniques to determine the aggregate risk in a financial portfolio. Risk modelling is one of many subtasks within the broader area of financial modelling. Risk modelling uses a variety of techniques in order to analyse a portfolio and make forecasts of the likely losses that would be incurred for a variety of risks. Such risks are typically grouped into credit risk, market risk, and operational risk categories. Many large financial intermediary firms use risk modelling to help portfolio managers assess the amount of capital reserves to maintain and to help guide their purchases and sales of various classes of financial assets. VAR is generally used by banks and financial institutions for risk measurement.


In financial mathematics and financial risk management, Value at Risk (VaR) is a widely used risk measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level. For example, if a portfolio of stocks has a one-day 95% VaR of $1 million, there is a 0.05 probability that the portfolio will fall in value by more than $1 million over a one day period, assuming markets are normal and there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day in 20. A loss which exceeds the VaR threshold is termed a VaR break.

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VaR uses two methods for modelling risk: 1. Historical simulation: The second market model assumes that the market only has finitely many possible changes, drawn from a risk factor return sample of a defined historical period. Typically one performs a historical simulation by sampling from past day-on-day risk factor changes, and applying them to the current level of the risk factors to obtain risk factor price scenarios. These perturbed risk factor price scenarios are used to generate a profit (loss) distribution for the portfolio. 2. Monte Carlo simulation: The third market model assumes that the logarithm of the return, or, log-return, of any risk factor typically follows a normal distribution. Collectively, the log-returns of the risk factors are multivariate normal. Monte Carlo simulation generates random market scenarios drawn from that multivariate normal distribution. For each scenario, the profit (loss) of the portfolio is computed. This collection of profit (loss) scenarios provides a sampling of the profit (loss) distribution from which one can compute the risk measures of choice. 8.1.1 MARKET RISK MEASUREMENT USING VAR: Consider for instance a position of $4 billion short the yen, long the dollar. This position corresponds to a well-known hedge fund that took a bet that the yen would fall in value against the dollar. How much could this position lose over a day? To answer this question, we could use 10 years of historical daily data on the yen/dollar rate and simulate a daily return. The simulated daily return in dollars is then:

where is Q0 the current dollar value of the position and S is the spot rate in yen per dollar measured over two consecutive days. For instance, for two hypothetical days S1= 112.0 and S2 = 111.8. We then have a hypothetical return of

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So, the simulated return over the first day is -$7.2 million. Repeating this operation over the whole sample, or 2,527 trading days, creates a time-series of fictitious returns, which is plotted in Figure below. We can now construct a frequency distribution of daily returns. The histogram, or frequency distribution, is graphed in Figure. We can also order the losses from worst to best return. We now wish to summarize the distribution by one number. We could describe the quantile, that is, the level of loss that will not be exceeded at some high confidence level. Select for instance this confidence level as = 95 per cent. This corresponds to a right tail probability. We could as well define VAR in terms of a left tail probability which we write as: p=1 c

In this hedge fund example, we want to find the cut-off value R* such that the probability of a loss worse than R * is p = 1 - c = 5 per cent. With a total of T = 2 527 observations, this corresponds to a total of pT = 0.05* 2527 = 126 observations in the left tail. We pick from the ordered distribution the cut-off value, which is R * = $47.1 million. We can now make a statement such as: The maximum loss over one day is about $47 million at the 95 per cent confidence level.

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8.1.2 BASEL RULES FOR MARKET RISK MEASUREMENT: The Basel market risk charge requires VAR to be computed with the following parameters: a. A horizon of 10 trading days, or two calendar weeks. b. A 99 per cent confidence interval. c. An observation period based on at least a year of historical data and updated at least once a quarter. Market risk charge is given as follows:

which involves the average of the market VAR over the last 60 days, times a supervisor determined multiplier (with a minimum value of 3), as well as yesterday s VAR, and a specific risk charge SRCt. The Basel Committee allows the 10-day VAR to be obtained from an extrapolation of 1-day VAR figures. Thus VAR is really

8.1.3 MEASURING CREDIT RISK THROUGH VAR (CREDIT VAR): Consider for instance a portfolio of $100 million with 3 bonds A, B, and C, with various probabilities of default. To simplify, we assume (1) that the exposures are constant, (2) that the recovery in case of default is zero, and (3) that default events are independent across issuers. Table 18-3 displays the exposures and default probabilities. The second panel lists all possible states. In state one, there is no default, which has a probability of (1- P1) (1- P2)(1P3)= (1- 0.05)(1- 0.10)(1- 0.20)= 0.684, given independence. In state two, bond A defaults and the others do not, with probability P1 (1-P2) (1- P3) = 0.05(1- 0.10)(1- 0.20)= 0.036. And so on for the other states.
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So, Expected loss = $ 13.25 Million and standard deviation = 434.71/2 = 20.9. At 95% confidence level, credit var = 1.64 * standard deviation = 34 Million. 8.1.4 MEASURING OPERATING RISK THROUGH VAR:

Table above shows frequency and severity of operational losses found from historical data. We construct all possible situations that are possible with their probability of occurrence and severity of losses. Table shown below gives all possible outcome:

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Operational var at 95% = 1.64 * standard deviation.


Some activities have higher risk so return should also be higher. ROE and ROI as a measure of performance are unable to evaluate performance based on risk so RAROC is used to measure performance.

Where, k is discount rate and capital is risk capital calculated through var at any give confidence level.

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The methodologies described so far have covered market, credit, and operational risk. In each case, the distribution of profits and losses reveals a number of essential insights. First, the expected loss is a measure of reserves necessary to guard against future losses. At the very least, the pricing of products should provide a buffer against expected losses. Second, the unexpected loss is a measure of the amount of economic capital required to support the bank s financial risk. This capital, also called risk capital, is basically a value-at-risk (VAR) measure. Armed with this information, institutions can now make better informed decision about business lines. Each activity should provide sufficient profit to compensate for the risks involved. Thus, product pricing should account not only for expected losses but also for the remuneration of risk capital.

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y y y y y Hull J., fifth edition, OPTION, FUTURES & OTHER DERIVATIVES , Pentice hall. Jorion P., second edition, HANDBOOK FOR FINANCIAL RISK MANAGEMENT , GARP. FEDAI handbook on FOREIGN EXCHANGE http://www.wikipedia.org/ http://www.investopedia.com/

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