METAC Workshop Sensitivity to Market Risk. Sensitivity to Market Risks

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1 Sensitivity to Market Risk 1

2 I A OVERVIEW DEFINITION is one of the most complex areas of banking and it s an area where most examiners have limited experience. refers to the risk that changes in market conditions could adversely impact the earnings and/or the capital of a bank. 2

3 Market risks encompasses exposures associated with changes in interest rates, foreign exchange rates, commodity prices, equity prices, etc. While all of these items are important, the primary risk in most banks is Interest Rate Risk (IRR) 3

4 B MAIN TYPES OF MARKET RISKS Interest-Rate Risk Interest-rate risk is the potential that changes in interest rates may adversely affect the value of a financial instrument or portfolio, or the condition of the bank as a whole. 4

5 Although interest-rate risk arises in all types of financial instruments, it is most pronounced in debt instruments, derivatives that have debt instruments as their underlying reference asset, and other derivatives whose values are linked to market interest rates. In general, the values of longer term instruments are often more sensitive to interest-rate changes than the values of shorter term instruments. 5

6 Risk in trading activities arises from open or un hedged positions and from imperfect correlations between offsetting positions. With regard to interest-rate risk, open positions arise most often from differences in the maturities or repricing dates of positions and cash flows that are asset-like (i.e., longs ) and those that are liabilitylike (i.e., shorts ). 6

7 The exposure that such mismatches represent to a bank depends not only on each instrument s or position s sensitivity to interest-rate changes and the amount held, but also on how these sensitivities are correlated within portfolios and, more broadly, across trading desks and business lines. 7 In sum, the overall level of interest-rate risk in an open portfolio is determined by the extent to which the risk characteristics of the instruments in that portfolio interact.

8 Foreign-Exchange Risk Foreign-exchange risk is the potential that movements in exchange rates may adversely affect the value of a bank s holdings and, thus, its financial condition. Foreign-exchange rates can be subject to relatively large and sudden swings ; understanding and managing the risk associated with exchange-rate volatility can be especially complex. 8

9 Although it is important to acknowledge exchange rates as a distinct market-risk factor, the valuation of foreign-exchange instruments generally requires knowledge of the behavior of both spot exchange rates and interest rates. Any forward premium or discount in the value of a foreign currency relative to the domestic currency is determined largely by relative interest rates in the two national markets. 9

10 As with all market risks, foreign-exchange risk arises from both open or imperfectly offset or hedged positions. Imperfect correlations across currencies and international interest-rate markets pose particular challenges to the effectiveness of foreign-currency hedging strategies. 10

11 Equity-Price Risk Equity-price risk is the potential for adverse changes in the value of a bank s equity-related holdings. Price risks associated with equities are often classified into two categories : - general (or un diversifiable) equity risk, and ; - specific (or diversifiable) equity risk. 11

12 General equity-price risk refers to the sensitivity of an instrument s or portfolio s value to changes in the overall level of equity prices. As such, general risk cannot be reduced by diversifying one s holdings of equity instruments. Many broad equity indexes, for example, primarily involve general market risk. 12

13 Specific equity-price risk refers to that portion of an individual equity instrument s price volatility that is determined by the firm-specific characteristics. This risk is distinct from market-wide price fluctuations and can be reduced by diversification across other equity instruments. 13

14 By assembling a portfolio with a sufficiently large number of different securities, specific risk can be greatly reduced because the unique fluctuations in the price of any single equity will tend to be canceled out by fluctuations in the opposite direction of prices of other securities, leaving only general-equity risk. 14

15 C SOUND PRACTICES FOR BANKS ENGAGING IN MARKET ACTIVITIES 15

16 Capital-markets and trading operations vary significantly among banks, depending on the size of the trading operations, trading and management expertise, organizational structures, the sophistication of computer systems, the institution s focus and strategy, historical and expected income, past problems and losses, risks, and types and sophistication of the trading products and activities. 16

17 As a result, the risk management practices, policies, and procedures expected in one bank may not be necessary in another. However, at a minimum, the following sound practices should be applied by any bank engaging in significant capital-markets or/and trading operations : 17

18 The bank should have a risk management function that is independent of its trading staff. The bank should have a risk management policy that is approved by the Board of Directors annually. 18

19 The policy should outline products traded, parameters for risk activities, the limit structure, overlimit approval procedures, and frequency of review. In addition, the bank should have a process to periodically review limit policies, pricing assumptions, and model inputs under changing market conditions. In some markets, frequent, high-level review of such factors may be warranted. 19

20 The bank should have a new-product policy that requires review and approval by all operational areas affected by such transactions (for example, risk management, credit management, trading, accounting, regulatory reporting, Back Office, audit, compliance, and legal). This policy should be evidenced by an audit trail of approvals before a new product is introduced. 20

21 The bank should be able to aggregate each major type of risk on a single common basis, including market, credit, and operational risks. Ideally, risks would be evaluated within a Value-at- Risk framework to determine the overall level of risk to the bank. 21

22 The risk-measurement system should also permit disaggregation of risk by type and by customer, instrument, or business unit to effectively support the management and control of risks. The bank should have a methodology to stress test its portfolios with respect to key variables or events to create plausible worst-case scenarios for review by senior management. 22

23 The limit structure of the bank should consider the results of the stress tests. The bank should have an integrated management information system that controls market risks and provides comprehensive reporting. 23

24 The sophistication of the system should match the level of risk and complexity of trading activity. The bank should have adequate financial applications in place to quantify and monitor risk positions and to process the variety of instruments currently in use. A minimum of manual intervention should be required to process and monitor transactions. 24

25 Risk management or the control function should be able to produce a risk-management report that highlights positions, limits, and excesses on a basis commensurate with trading activity. This report should be sent to senior management, reviewed, signed, and returned to control staff. 25

26 Counterparty credit exposure on derivative transactions should be measured on a replacementcost and potential-exposure basis. The bank should perform a periodic assessment of credit exposure to redefine statistical parameters used to derive potential exposure. 26

27 With regard to credit risk, a bank that employs netting should have a policy related to netting agreements. Appropriate legal inquiry should be conducted to determine enforceability by jurisdiction and counterparty type. 27

28 Netting should be implemented only when legally enforceable. The bank should have middle and senior management inside and outside the trading room who are familiar with the stated philosophy on market and credit risk. 28

29 Also, pricing methods employed by the traders should be well understood. The bank should be cognizant of other types of risks (such as operational risks), have an approach to assessing them, and have guidelines and trading practices to control them. 29

30 A bank with a high level of trading activity should be able to demonstrate that it can adjust strategies and positions under rapidly changing market conditions and crisis situations on a timely basis. 30

31 For business lines with high levels of activity, risk management should be able to review exposures on an intraday basis. Management Information Systems (MIS) should provide sufficient reporting for decision making on market and credit risks, as well as operational data including profitability, unsettled items, and payments. 31

32 A periodic compliance review should be conducted to ensure conformity with laws and regulatory guidelines. The bank should have a compensation system that does not create incentives which may conflict with maintaining the integrity of the risk-control system. 32

33 Auditors should perform a comprehensive review of risk management annually, emphasizing segregation of duties and validation of data integrity. Additional test work should be performed when numerous new products or models are introduced. Models used by both the Front and Back Offices should be reassessed periodically to ensure sound results. 33

34 II EXAMINATION OF FOREIGN EXCHANGE RISKS A THE FOREIGN EXCHANGE MARKET Foreign Exchange (FX) is the exchange of money of one country for money of another. 34

35 FX transactions arise out of international trade or the movement of capital between countries. FX transactions can be conducted between any business entity, government, or individual ; but banks, by virtue of their position as financial intermediaries, have historically been ideal FX intermediaries, as well. 35

36 Banks are on one side or the other of the majority of the transactions in the FX market worldwide. Bank FX transactions take place between other banks (referred to as inter bank trading) and between banks and their customers (generally referred to as corporate trading). 36

37 The volume of FX activity varies widely among banks. The degree of a bank s involvement is largely dictated by customer demand but increasingly is being driven by inter bank trading for a bank s own account. 37

38 Multinational or global banks are the most active in terms of both trading volume and the number of currencies traded. These banks trade FX across virtually any currency. Other banks may trade actively in only a few currencies, while other banks will have only limited activity. 38

39 While banks of any size can and do engage in FX transactions on behalf of their customers, generally only the world s largest banks and certain smaller banks specializing in international business enter into transactions for their own account. 39

40 B FOREIGN EXCHANGE TRADING FX trading is an integral part of international trade and can be an important activity and source of income for banks. However, only banks specializing in this complex and specialized field, particularly those banks which trade FX for their own account, will maintain a FX department with qualified dealers. 40

41 It is these banks which present the most complex risks. Banks that only execute their customer s instructions and do no business on their own account - essentially maintaining a matched book - will generally use the services of another bank or FX intermediary to place customer transactions. While these banks present less supervisory risk, examiners of such institutions should still be familiar with these activities. 41

42 C FOREIGN EXCHANGE RISK Trading in FX or holding assets and liabilities denominated in foreign currency entail certain risks. These risks fall into five categories : exchange rate risk, interest-rate risk, credit risk, operational risk, and country risk. 42

43 Exchange Rate Risk Exchange Rate Risk occurs when a bank takes an open position in a currency. When a bank holds, buys, or agrees to buy more foreign currency than it sells, or agrees to sell more than it buys, an exposure is created which is known as an open position. 43

44 Open positions are either long or short. When a bank buys more of a currency, either spot or forward, than it sells, it has a long position. Conversely, if more of a currency is sold than bought, a short position is created. 44

45 Until an open position is covered by the purchase or sale of an equivalent amount of the same currency, the bank risks an adverse move in exchange rates. A long position in a depreciating currency results in exchange loss relative to book value. 45

46 As the foreign currency depreciates, it is convertible into fewer units of local currency. Similarly, a short position in a currency that is appreciating results in an exchange loss relative to book value because, as the foreign currency increases in value it costs more units of local currency to close or square the position. To control exchange risk, bank management should establish limits for net open positions in each currency. 46

47 To cover or match trade open positions, banks will generally hedge these positions with a forward contract, matching an expected requirement to deliver with a future contract to receive. The hedging of open positions can be very complex, sometimes using multiple contracts, different types of contracts, and even different currencies. 47

48 It is important to remember that the amount of exchange rate risk a bank is exposed to is not necessarily dependent on the volume of contracts to deliver or receive foreign currency, but rather the extent that these contracts are not hedged either individually or in aggregate. 48

49 Also, while various types of forward contracts are typically used for hedging open positions resulting from commercial or financial transactions, forward contracts are also ideal for speculative purposes (called outright deals or single forward transactions), because often no funds are actually exchanged at the time the contract is entered into. 49

50 All banks which engage in FX activity should monitor their open positions at least daily. Banks which actively trade FX will monitor their open positions constantly, closing out or matching exposures at various times during the day. 50

51 Maturity-Gap Risk Maturity-Gap Risk is the FX term for interest-rate risk. It arises whenever there are mismatches or gaps in a bank's total outstanding spot and forward contracts. 51

52 Gaps result in days or longer periods of uneven cash inflows or outflows. For example, a maturity spread of a bank's assets, liabilities, and future contracts may reflect a prolonged period over which large amounts of a particular currency will be received in advance of any scheduled offsetting payments. 52

53 The exposure to the bank is that of shifts in interest rates earned on funds provided by cash inflows or on interest rates paid on funds required to meet cash outflows. 53

54 In this situation, the bank must decide whether: (1) to hold the currency in its "nostro" accounts ; (2) to invest it short term ; (3) to sell it for delivery at the time the gap begins and repurchase it for delivery at the time the gap closes ; or (4) to use any combination of the above. Banks control interest-rate risk by establishing limits on the volume of mismatches in their total FX position. 54

55 The problems of managing gaps are complex. The decision whether to close a gap when it is created, or to leave it until a later date, is based upon analysis of money market interest rates, and spot and FX rates. 55

56 Credit Risk When entering into a FX transaction, the bank must be confident that its customer or counterparty (individual, company, or bank) has the financial means to meet its obligations at maturity. 56

57 Two types of credit risk exist in FX trading, one is called the percent risk or the cost cover, the second is delivery or settlement risk. The percent risk is that a customer might not be able to deliver the currency as promised in order to settle the contract. 57

58 The bank's FX position is suddenly unbalanced and the bank is exposed to any movements in exchange rates. The bank must either dispose of the currency it had acquired for delivery under the contract, or it must purchase the currency it had expected to receive and probably had contracted to sell to a third party. In either case, the bank must enter into a new transaction and may suffer a loss if there has been an adverse change in exchange rates. 58

59 Generally, exchange rates will fluctuate no more than percent in the short-term and usually much less, hence the term percent risk. Delivery or settlement risk refers to the risk of a counterparty taking delivery of currency from the bank but not delivering the counterpart currency. 59

60 In this situation the bank is exposed not just to currency fluctuations but for 100 percent of the transaction. To limit both types of risk, a careful evaluation of the customer's creditworthiness is essential. The credit review should be used to establish an overall limit for exchange contracts for each customer. 60

61 For example, after careful analysis of the customer's financial soundness, the bank may determine an overall limit for FX contracts for the customer in the equivalent amount of, say, $2 million. With this total limit the bank might establish a settlement limit of no more than the equivalent of $200,000 in any one day. In this manner it has limited its percent risk to 10 percent of any outstanding contracts to a maximum of $2 million. 61

62 At the same time it has limited its delivery or settlement risk by imposing a $200,000 settlement limit. If the customer fails to deliver counterpart funds, the bank can cancel remaining contracts and limit its risk of loss. 62

63 Country s Control of Exchange- Exchange control regimes imposed by a country s Central Bank can limit the amount of currency that can be exchanged in any single transaction, by any given customer, or within a particular period. In any case, the exchange rate for the currency may be subject to additional supply and demand influences, and sources of covering the desired currency may vanish. 63

64 Conclusion Focus on the following Foreign Exchange Risk Exchange Rate Risk Interest Rate Risk Trading credit risk 64

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