Foreign Exchange Risk Foreign Exchange risk arises when a bank holds assets or liabilities in foreign currencies and

impacts the earnings and capital of bank due to the fluctuations in the exchange rates. No one can predict what the exchange rate will be in the next period, it can move in either upward or downward direction regardless of what the estimates and predictions were. This uncertain movement poses a threat to the earnings and capital of bank, if such a movement is in undesired and unanticipated direction. Foreign Exchange Risk can be either Transactional or it can be Translational. When the exchange rate changes unfavorably it give rise to Transactional Risk, as the name implies because of transactions in Foreign Currencies, can be hedged using different techniques. Other one Translational Risk is an accounting risk arising because of the translation of the assets held in foreign currency or abroad Foreign Exchange Risk in Commercial Banks Commercial banks, actively deal in foreign currencies holding assets and liabilities in foreign denominated currencies, are continuously exposed to Foreign Exchange Risk. Foreign Exchange Risk of a commercial bank comes from its very trade and non-trade services. Foreign Exchange Trading Activities (Saunders & Cornett, 2003) include: The purchase and sale of foreign currencies to allow customers to partake in and complete international commercial trade transactions. The purchase and sale of foreign currencies to allow customers (or the financial institution itself) to take positions in foreign real and financial investments. The Purchase and sale of foreign currencies for hedging purposes to offset customer (or FI itself) exposure in any given currency. To purchase and sale of foreign currencies for speculative purposes base on forecasting or expecting future movements in Foreign Exchange rates. The above mentioned Trade Activities do not expose a commercial bank to foreign exchange risk as a result of all of the above. The commercial bank is exposed to foreign exchange risk only up to the extent to which it has not hedged or covered its position. Wherever there is any uncertainty that the future exchange rates will affect the value of financial instruments, there lies the foreign exchange risk of a commercial bank. Foreign Exchange risk does not lie where the future exchange rate is predefined by using different instruments and tools by the bank. The abovementioned trade activities are the typical trade activities of a commercial bank and all of these activities do not involve risk exposure of the bank. The first 2 activities are done by the commercial bank on behalf of its customers and the foreign exchange risk is transferred to the customers as the bank takes Agency Role in this case. Third activity of bank involves hedging and there is no risk in this as well as the bank has hedged its risk by predetermining the exchange rate with other financial institutions using different financial instruments. The fourth one involves the risk which may result in the gain or loss due to unexpected outcome. Ready, spot, forward & swap are the principal FX related contracts whereas banking products and services in foreign exchange give rise to non-traded foreign currency exposure. Foreign Currency Exposure of a Commercial Bank

Any unhedged position in a particular currency gives rise to FX risk and such a position is said to be Open Position in that particular currency. If a bank has sold more foreign currency than he has purchased, it is said to be Net Short in that currency, alternatively if it has purchased more foreign currency than it has purchased than it is in Net Long position. Both of these positions are exposed to risk as the foreign currency may fall in value as compared to local or home currency and becomes a reason for substantial loss for the bank if it is in Net Long position or the foreign currency may rise in value and cause losses if the bank is Net Short in that currency. Long Position is also known as over bought or Net Asset Position and Short Position is also known as Net Liability or Oversold Position. Sum of all the Net Asset positions & Net Liability positions is known as Net Open Position or Net Foreign Currency Exposure. Net Foreign Currency Exposure gives the information about the Foreign Exchange Risk that has been assumed by the bank at that point of time. This figure represents the unhedged position of bank in all the foreign currencies. A negative figure shows Net Short Position whereas positive figure shows Net Open Position Exchange Rate Volatility There is a real time fluctuation in floating exchange rate. The Exchange rate volatility measures the degree to which the exchange rate fluctuates or varies over a period of time. Exchange rate is said to be more volatile if there are more frequent ups and downs or less volatile if there are lesser changes in it over a period of time. Foreign Exchange Risk Management Whenever a commercial bank deals in foreign currency, it is exposed to risk of exchange rate. When these transactions are done on the behalf of customers, the risk is also transferred to them and the bank has no exposure. Banks assets &liabilities in foreign currencies or assets and liabilities in other countries give rise to Foreign exchange risk which has to be managed by the bank. It is the risk that the bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position in an individual foreign currency. In addition, the bank is also exposed to interest are risk and settlement risk on account of its foreign exchange business. Foreign exchange risks are measured and monitored by Treasury Division. To evaluate the extent of foreign exchange risk, a Liquidity Gap Report is prepared for each currency. Gap or mismatch of maturities can arise either because of speculative trading positions or due to a customer transaction resulting in a long or a short position for the bank. The overall foreign currency exposure limit is USD 36.15 million equivalents to Tk 2,557.60 million or on overnight basis as stipulated by the central bank. The sum of the net overall positions in the different currencies results in a positive net assets position of Tk 690.64 million. The overall exposure does not exceed the stipulated limit. Foreign Currency Exposure of Prime Bank To understand the foreign currency exposure of Prime Bank, below mentioned questions are designed: Whether the Bank take any foreign currency exposure or not? Does there exist any relationship between Foreign Currency exposure & other factors like Size of Bank (net asset) and Exchange Rate Volatility? Which of these factors is most significant? Net Foreign Currency Exposure

The very first research question is to check whether there is any Net Foreign Currency Exposure assumed by bank. For this purpose, Annual Financial Statements of the bank is studied. As per the statutory requirements, all the banks operating in Bangladesh including commercial banks have to mention in the NOTES to Financial statements Net Foreign Currency Exposure in Bangladeshi taka, the calculated net position by bank, under the heading of Foreign Exchange Risk. If a bank has zero Net Foreign Currency Exposure, it means it has all of his assets and liabilities hedged and offset against other currencies or in the same currency. It can be analyzed either relative to Total Assets or Net Assets of the bank; however, it is more appropriate to analyze it with its relativeness to Net Assets. Therefore, a new variable is constructed i.e. Net Foreign Currency Exposure relative to Net Assets, denoted by NFXNA. Factors that Affect Foreign Currency Exposure Does this variable NFXNA depends on different factors like Size of Bank & Exchange Rate Volatility and which of these factors is the most significant one? Using Linear Regression to Explore Relationship between NFX and Size & Exchange Rate Volatility The below mentioned Regression Model is used to find out the relationship between Foreign currency exposure and the factors that influence it: NFXNA= Size+ ERV ERV+ + size Model 1: NFX depends on Size & Exchange Rate Volatility Where, NFXNA = NFX relative to Net Assets Size = Size of the Bank ERV = Exchange rate volatility = Population parameter, intercept = Population parameter, slope, regression coefficient Hypothesis Testing: Using this model below mentioned hypothesis will be tested to check the significance of the model as a whole along with individual s as well Hypothesis H0: There is no relationship between NFXNA & Size & ERV H1: There is a relationship between NFXNA & Size & ERV Net Foreign Currency Exposure Relative to Net Asset Net Foreign Currency Exposure relative to Net Assets is calculated for the comparison purpose. Therefore, it shows Net foreign currency exposure of a bank relative to its size, otherwise using only NFX in the model will show its maximum dependence on Net assets of bank and the effect of other factors will be not taken into account.Net Foreign Currency Exposure is calculated by using the following formula:

NFXNA = NFX/NA