Foreign exchange risk may be defined as the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign currency. The banks are also exposed to interest rate risk, which arises from the maturity mismatching of foreign currency positions. Even in cases where spot and forward positions in individual currencies are balanced, the maturity pattern of forward transactions may produce mismatches. As a result,banks may suffer losses due to changes in premium/discounts of the currencies concerned.
In the forex business, banks also face the risk of default of the counterparties or settlement risk. While such type of risk crystallisation does not cause principal loss, banks may have to undertake fresh transactions in the cash/spot market for replacing the failed transactions. Thus, banks may incur replacement cost, which depends upon the currency rate movements. Banks also face another risk called time-zone risk or “Herstatt risk” which arises out of time lags in settlement of one currency in one centre and the settlement of another currency in another time zone. The forex transactions with counterparties from another country also trigger sovereign or country risk. The three important issues that need to be addressed in this regard are:
(a) Nature and magnitude of exchange risk;
(b) Strategy to be adopted for hedging or managing exchange risk; and
(c) Tools of managing exchange risk
