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Foreign Exchange Risk in Banks – Overview and Analysis

Disclaimer: This work has been submitted by a student. This is not an example of the work written by our professional academic writers. You can view samples of our professional work here.

Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Published: Wed, 28 Feb 2018

Objective of the Project:-

The objective of this project is to understand the various types of foreign exchange risks. And the potential impact of the foreign exchange risks on the institutions involved in foreign exchange trading.

Background:-

In this project, I have calculated the value of risk involved in foreign exchange transactions at United Bank of India.

Methodology:-

The data used in this project is obtained from secondary research. Historical method is used to calculate the Value at Risk (VaR). The Value at Risk is thus calculated is used to find the actual amount at risk in terms of INR.

Findings and Conclusion:-

By finding the total risk, we get to know the total amount that the organization can lose in the worst possible scenario. It happens if the allocation of fund is not based upon the possible value at risks. In carrying out this project, I have found that the bank has allocated more funds for its forex operations than required.

Recommendations:-

At present the bank is operating at the 99% confidence level to calculate the value at risk. As they are working at 99% confidence level, due to this they need to employ more capital for their forex operations. United Bank of India should operate at 95% confidence level. This will help them cut down funds employed for their forex operations.

Introduction to Foreign Exchange

The creator of the universe has not distributed resources needed by the civilised world evenly on our planet earth. What is available easily at one place is hardly available at another place. This has resulted in an environment of interdependency among the countries. The interdependency among countries has given rise to international trade. The growth of international trade of goods and services has necessitated a method of exchange.

Let us evaluate a transaction involving supply of goods from India to United Kingdom. The value of goods is known to the Indian supplier in INR. Thus the Indian supplier will price the goods so that he can make profit in INR. At the same time the purchasing power available with the UK customer is in GBP (Great Britain Pound). Therefore the customer will want to know the price in GBP. Now, if buyer and seller decide to settle the transaction in USD. Therefore to complete such transactions, the parties to the transaction need to know the value of one currency in terms of another. This mechanism of converting one currency in terms of another is known as “Foreign Exchange”.

Foreign Exchange is defined in Foreign Exchange management Act 1999 as:-

Ø All deposits, credits, balances payable in any foreign currency and any drafts, travellers cheque, letter of credit and bill of exchange expressed or drawn in Indian currency and payable in foreign currency.

Ø Any instrument payable at the option of the drawee 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 short, Foreign Exchange is the method of conversion of one currency into another.

As foreign currency is treated as a commodity, it is traded in a market. Trade constitutes a small portion of the “Foreign Exchange Market”. The cross border movement of capital forms the major portion.

Major participants of Foreign Exchange Market include commercial banks, central banking institutions, investment banks, foreign exchange brokers and merchants. The commercial banks become the vehicles for conversion, as most of the foreign exchange operation takes place through the account maintained with these banks.

Objective of the Project

A Project Report on FOREIGN EXCHANGE risks in Bank.

Foreign Exchange is a very large financial market. At times foreign exchange market becomes very volatile. This is responsible for the various risks in foreign exchange market. Everyone involved in the foreign exchange trading should we aware of foreign exchange risk.

To ascertain Foreign Exchange risk in Bank we need to execute the following tasks:-

  • Various types of foreign exchange services available at Banks.
  • The various types of foreign exchange risks.
  • The various foreign currencies which has significant demand.
  • The possible Hedging strategies that can be deployed to manage foreign exchange risks.
  • Determination of Value at Risk (Var).

Research Methodology

  • Data / Information Collection.
  • Study of data collected to calculate the value at risk (VAR).
  • Calculation of mean return.
  • Calculation of Standard Deviation.

Data/Information Collection

Data and information is collected from the various sources. These sources include data from the Bank, magazines, journals, books and newspapers. The information thus collected is used to calculate the Value at Risk.

Value at risk (VaR)

Risk is about odds of losing money and VaR is based on that common sense fact. Here risk is the odds of really big loss. Big loss is different for every investor depending on the investor’s appetite. But every investor whether big or small does wants to know his/her losses in the worst case. VAR answers the question, “What is my worst-case scenario?”

To calculate VaR we need three components. These three components are: a time period, a confidence level and a loss amount or loss percentage. Using VaR investor will get to know things like:

  • What is the most I can expect to lose with 95% confidence over a period of 10 days?
  • What is the maximum percentage I can expect to lose with 95% confidence over a period of 10 days?

We consider a relatively high level of confidence, mostly 95% or 99% confidence level.

Time period taken can be anything like a day, 10 day, a month or a year depending upon what investor is looking for.

A one day VAR of $10mm using a probability of 5% means that there is a 5% chance that the portfolio could lose more than $10mm in the next trading day.

There are three methods of calculating VaR: the Historical method, the parametric method also known as variance-covariance method and the Monte Carlo simulation.

The Historical Method: The historical method simply re-organizes actual historical returns, putting them in order from worst to best. It then assumes that history will repeat itself, from a risk perspective. We then put these data in the histogram that compare the frequency of return. Tiny bars in histogram represent the less frequent daily return while the highest point in histogram represents the most frequent daily return.

Parametric Method:This method assumes that the stock returns are normally distributed. In this method we estimate only two factors – an expected return and a standard deviation. These two factors allow us to plot a normal distribution curve.

Monte Carlo Simulation: The third method involves developing a model for future stock price returns and running multiple hypothetical trials through the model. A Monte Carlo simulation refers to any method that randomly generates trials, but by itself does not tell us anything about the underlying methodology. Every run of Monte Carlo Simulation gives different result. But differences between these results are likely to be very narrow.

Calculation of Value at Risk (VaR)

To calculate the value at risk, at first we need to collect the historical data. Historical data is the historical exchange rate of a particular foreign currency against INR. The foreign currencies which we are considering here are United States Dollar (USD), Great Britain Pound (GBP), Euro and Japanese Yen (JPY). We are considering these currencies because they are the major currencies as exchange is easily available for these currencies. We will calculate the value at risk the investor faces in case he/she invests in any of these currencies. At first we will consider the case in which an investor is investing in United States Dollar. The investor will buy United States Dollar in exchange of INR.

USD/INR

The historical exchange rate for USD/INR for a period of 22 days starting from 15th April 2011 to 6th May 2011 is as follows:

Date

Close

Periodic Return

06-05-2011

44.785

0.53%

05-05-2011

44.5499

0.08%

04-05-2011

44.515

0.34%

03-05-2011

44.3655

0.09%

02-05-2011

44.325

0.17%

01-05-2011

44.25

0.00%

30-04-2011

44.25

-0.24%

29-04-2011

44.3549

0.00%

28-04-2011

44.3549

-0.16%

27-04-2011

44.425

-0.34%

26-04-2011

44.5774

0.25%

25-04-2011

44.465

0.16%

24-04-2011

44.395

0.00%

23-04-2011

44.395

0.18%

22-04-2011

44.315

-0.05%

21-04-2011

44.335

-0.09%

20-04-2011

44.375

-0.48%

19-04-2011

44.59

0.55%

18-04-2011

44.345

0.01%

17-04-2011

44.34

0.00%

16-04-2011

44.34

-0.35%

15-04-2011

44.495

 

From the everyday exchange rate the periodic return is found by using the formula given below:

Natural Logarithm (Present date exchange rate/ previous date exchange rate)

The Value at Risk from the above data is calculated by using the given formula in excel:

PERCENTILE (array of the periodic return,5%)

Here the array of the periodic return is the everyday return of the period for which historical data is taken. The second attributes i.e., 5% tells that 95 times out of 100 the loss will not exceed the calculated VaR. Therefore we can say with 95% confidence that the loss will not exceed the Value at Risk (VaR) thus calculated.

From the above data the Value at Risk (VaR) calculated at 95% confidence level is: 0.35%

From the above data the Value at Risk (VaR) calculated at 99% confidence level is: 0.46%

Euro/INR

The historical exchange rate for Euro/USD for a period of 22 days starting from 15th April 2011 to 6th May 2011 is as follows:

Euro/USD Euro/INR

Date

Close

 

Date

Close

Periodic Return

06-05-2011

1.4501

 

06-05-2011

64.94273

-1.61%

05-05-2011

1.4814

 

05-05-2011

65.99622

-0.38%

04-05-2011

1.4882

 

04-05-2011

66.24722

1.02%

03-05-2011

1.478

 

03-05-2011

65.57221

-0.29%

02-05-2011

1.4837

 

02-05-2011

65.765

0.01%

01-05-2011

1.486

 

01-05-2011

65.7555

0.00%

30-04-2011

1.486

 

30-04-2011

65.7555

-0.24%

29-04-2011

1.486

 

29-04-2011

65.91138

0.45%

28-04-2011

1.4794

 

28-04-2011

65.61864

0.70%

27-04-2011

1.4668

 

27-04-2011

65.16259

0.01%

26-04-2011

1.4617

 

26-04-2011

65.15879

0.48%

25-04-2011

1.4584

 

25-04-2011

64.84776

0.16%

24-04-2011

1.4584

 

24-04-2011

64.74567

0.00%

23-04-2011

1.4584

 

23-04-2011

64.74567

0.18%

22-04-2011

1.4584

 

22-04-2011

64.629

-0.05%

21-04-2011

1.4584

 

21-04-2011

64.65816

0.38%

20-04-2011

1.4515

 

20-04-2011

64.41031

0.99%

19-04-2011

1.4302

 

19-04-2011

63.77262

0.74%

18-04-2011

1.4275

 

18-04-2011

63.30249

-1.21%

17-04-2011

1.445

 

17-04-2011

64.0713

0.00%

16-04-2011

1.445

 

16-04-2011

64.0713

-0.35%

15-04-2011

1.445

 

15-04-2011

64.29528

 

Historical exchange rate for Euro/INR is determined from the historical exchange rate of Euro/USD and USD/INR.

Exchange rate of Euro/INR = Exchange rate of Euro/USD * Exchange rate of USD/INR

In this case again the periodic return is found by using the formula given below:

Natural Logarithm (Present date exchange rate/ previous date exchange rate)

The Value at Risk from the above data is calculated by using the given formula in excel:

PERCENTILE (array of the periodic return, 5%)

Here the array of the periodic return is the everyday return of the period for which historical data is taken. The second attributes i.e., 5% tells that 95 times out of 100 the loss will not exceed the calculated VaR. Therefore we can say with 95% confidence that the loss will not exceed the Value at Risk (VaR) thus calculated.

From the above data the Value at Risk (VaR) calculated at 95% confidence level is: 1.21%.

From the above data the Value at Risk (VaR) calculated at 99% confidence level is: 1.53%.

GBP/INR

The historical exchange rate for GBP/USD for a period of 22 days starting from 15th April 2011 to 6th May 2011 is as follows:

GBP/USD GBP/INR

Date

Close

 

Date

Close

Periodic Return

06-05-2011

1.64057

 

06-05-2011

73.47293

0.05%

05-05-2011

1.64847

 

05-05-2011

73.43917

-0.24%

04-05-2011

1.65374

 

04-05-2011

73.61624

0.70%

03-05-2011

1.64781

 

03-05-2011

73.10591

-1.16%

02-05-2011

1.66858

 

02-05-2011

73.95981

0.30%

01-05-2011

1.66648

 

01-05-2011

73.74174

0.00%

30-04-2011

1.66648

 

30-04-2011

73.74174

-0.24%

29-04-2011

1.66648

 

29-04-2011

73.91655

0.12%

28-04-2011

1.66449

 

28-04-2011

73.82829

0.43%

27-04-2011

1.65478

 

27-04-2011

73.5136

0.09%

26-04-2011

1.64764

 

26-04-2011

73.44751

-0.18%

25-04-2011

1.65483

 

25-04-2011

73.58202

0.16%

24-04-2011

1.65483

 

24-04-2011

73.46618

0.00%

23-04-2011

1.65483

 

23-04-2011

73.46618

0.18%

22-04-2011

1.65483

 

22-04-2011

73.33379

-0.05%

21-04-2011

1.65483

 

21-04-2011

73.36689

0.99%

20-04-2011

1.63697

 

20-04-2011

72.64054

0.01%

19-04-2011

1.62893

 

19-04-2011

72.63399

0.68%

18-04-2011

1.62678

 

18-04-2011

72.13956

-0.49%

17-04-2011

1.63499

 

17-04-2011

72.49546

0.00%

16-04-2011

1.63499

 

16-04-2011

72.49546

-0.35%

15-04-2011

1.63499

 

15-04-2011

72.74888

 

Historical exchange rate for GBP/INR is determined from the historical exchange rate of GBP/USD and USD/INR.

Exchange rate of GBP/INR = Exchange rate of GBP/USD * Exchange rate of USD/INR

In this case again the periodic return is found by using the formula given below:

Natural Logarithm (Present date exchange rate/ previous date exchange rate)

The Value at Risk from the above data is calculated by using the given formula in excel:

PERCENTILE (array of the periodic return, 5%)

Here the array of the periodic return is the everyday return of the period for which historical data is taken. The second attributes i.e., 5% tells that 95 times out of 100 the loss will not exceed the calculated VaR. Therefore we can say with 95% confidence that the loss will not exceed the Value at Risk (VaR) thus calculated.

From the above data the Value at Risk (VaR) calculated at 95% confidence level is: 0.49%

From the above data the Value at Risk (VaR) calculated at 99% confidence level is: 1.03%

JYP/INR

The historical exchange rate for USD/JYP for a period of 22 days starting from 15th April 2011 to 6th May 2011 is as follows:

USD/JYP JPY/USD

Date

Close

 

Close

06-05-2011

80.3393

 

0.01244721

05-05-2011

79.7894

 

0.01253299

04-05-2011

81.0509

 

0.01233793

03-05-2011

80.7578

 

0.0123827

02-05-2011

81.4518

 

0.0122772

01-05-2011

81.2046

 

0.01231457

30-04-2011

81.2046

 

0.01231457

29-04-2011

81.2046

 

0.01231457

28-04-2011

81.7696

 

0.01222948

27-04-2011

82.2607

 

0.01215647

26-04-2011

81.7062

 

0.01223897

25-04-2011

81.9528

 

0.01220215

24-04-2011

81.9528

 

0.01220215

23-04-2011

81.9528

 

0.01220215

22-04-2011

81.9528

 

0.01220215

21-04-2011

81.9528

 

0.01220215

20-04-2011

82.7627

 

0.01208274

19-04-2011

82.6668

 

0.01209675

18-04-2011

82.8371

 

0.01207189

17-04-2011

83.301

 

0.01200466

16-04-2011

83.301

 

0.01200466

15-04-2011

83.301

 

0.01200466

Historical exchange rate for JPY/USD is determined from the historical exchange rate of USD/JPY.

Exchange rate of JPY/USD = 1/ (Exchange rate of USD/JPY)

JPY/INR

Date

Close

Periodic Return

06-05-2011

0.557448

-0.16%

05-05-2011

0.558344

1.65%

04-05-2011

0.549223

-0.03%

03-05-2011

0.549365

0.95%

02-05-2011

0.544187

-0.13%

01-05-2011

0.54492

0.00%

30-04-2011

0.54492

-0.24%

29-04-2011

0.546212

0.69%

28-04-2011

0.542438

0.44%

27-04-2011

0.540051

-1.02%

26-04-2011

0.545582

0.55%

25-04-2011

0.542568

0.16%

24-04-2011

0.541714

0.00%

23-04-2011

0.541714

0.18%

22-04-2011

0.540738

-0.05%

21-04-2011

0.540982

0.89%

20-04-2011

0.536171

-0.60%

19-04-2011

0.539394

0.76%

18-04-2011

0.535328

0.57%

17-04-2011

0.532287

0.00%

16-04-2011

0.532287

-0.35%

15-04-2011

0.534147

 

Historical exchange rate for JPY/INR is determined from the historical exchange rate of JPY/USD and USD/INR.

Exchange rate of JPY/INR = Exchange rate of JPY/USD * Exchange rate of USD/INR

In this case again the periodic return is found by using the formula given below:

Natural Logarithm (Present date exchange rate/ previous date exchange rate)

The Value at Risk from the above data is calculated by using the given formula in excel:

PERCENTILE (array of the periodic return, 5%)

Here the array of the periodic return is the everyday return of the period for which historical data is taken. The second attributes i.e., 5% tells that 95 times out of 100 the loss will not exceed the calculated VaR. Therefore we can say with 95% confidence that the loss will not exceed the Value at Risk (VaR) thus calculated.

From the above data the Value at Risk (VaR) calculated at 95% confidence level is: 0.60%

From the above data the Value at Risk (VaR) calculated at 99% confidence level is: 0.93%

Calculation of Standard Deviation

Standard deviation is a measure of how far apart the data are from the average of the data. If all the observations are close to their average then the standard deviation will be small.

In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment’s volatility. Standard deviation is also known as historical volatility and is used by investors as a gauge for the amount of expected volatility.

Suppose that an investor has INR 45,000 to invest and is considering buying the USD. Currently one USD is valued at INR 45. The investor assesses a 0.75 probability that the USD will appreciate against INR over a coming period, so that one USD will be equivalent to INR 46 and a 0.25 probability that the USD will depreciate against INR to become equal to INR 44.

INR 45,000 (at one USD equal to INR 45) = 45,000/45 = USD 1000

The payoffs from the proposed investment are as follows:-

If the USD appreciates (One USD becomes equal to INR 46):

USD 1000 *46 = INR 46,000

If the USD depreciates (One USD becomes equal to INR 44):

USD 1000*44 = INR 44,000

PAYOFF

(INR)

RATE OF

RETURN

PROBABILITY

EXPECTED

RATE OF

RETURN

VARIANCE

(1)

(2)

(3)

(4) = (2) x (3)

(5)

         

46,000

(46 – 45)/45 = 0.022

0.75

0.0165

(0.022 – 0.011)^2 x 0.75 = 0.


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