UNIT 14 FOREX MANAGEMENT

Objectives
The objectives of Ulis unit are to :
e understand forex treasury organisational structure.
e acquaint you wilh dealing room operations and its objectives.
a familiarise with the hnctions of front office, back office and mid office.
a describe the role of market maker, broker.
e identify the different types of risk in dealing room operations.

Structure
24.1 Introduction
Treasury Structure
Front Office
Back Office
Mid Office
Dealing Room
Quotes
Market Makers
Broker
Mechanics of Trading
Dealing Room Terminology
Support Systems in Dealings
Risks
EliminatinglReducing Risks
Reconciliation
Summary
Key Words
Self Assessnlent Questions
Further Readings

84.1 INTRODUCTION
Forex market is an over the counter market in which currencies are bought and sold
against each other. The market is basically characterised by - no physical presence, huge
size, dominated by financial flows, deep, highly liquid and efficient, pre-ponderance of
inter-bank flows, sleek being screen-based, highly volatile 24 hours a day market and yet
a profit centre with simultaneous potential for losses.
The global forex market is one of the largest in the world, the daily turnover being more
than a trillion US dollars and even Indian market is growing volumes, currently being
around 3.0 to 3.5 billion US dollars per day. With the liberalisation, these volumes are
likely to go up further demanding greater skills from the market operators. This unit
attempts to present an overview of the market mechanics.
- Forex Management
b
142 TREASURY STRUCTURE
Dealing operations is a highly specialised function and has to be performed by a set of
well trained personnel. The treasury structure for dealing department should consist of
Dealers, back up staff, responsible for the follow up of the deals made by the deaIers,
giving feedback of collated information to the dealers, helping dealers to get overseas
telexes, checking rates, etc. There is considerable scope for abuse by overlapping of
functions through manipulation of rates on contracts already concluded, manipulation of
position, mismatching, etc. The effectiveness of and control over the dealing operations
largely depend upon how the department is organised/structured. A Model of
organisational structure is suggested as under :

Head of Porex Treasury

C v C
Head Head Head
(Exchange Dealings) Back Office Mid Office
(Front Office) O erations
or Chief Dealer
C
4 L
I
C 4
------I
Co~poratcDealers Interbank Interbank Interbank
Taking Reporting Dealer Dealer Dealer
from branches (SPOT (SWAP (Cross Currency
Advising Tkansaction) Transaction) Transaction)
Customers USDIDEM
USDlYEN
GBPNSD, etc.

C
Reconciliation
4
Accounhg
settlements

Risk Accounting Information Compliances

Management Policies Technology Documentation

Figure 14.1: Organisntional Structure of Foreign Exchange lkcasury

The organisatior~chart of the forex treasury indicates that the dealings are the domain of
the head of the treasury, unless another Assistant Treasurer is exclusively looking after
dealings. Back office and Mid office work however, is looked after by other Heads.
Heads, Back-up supervises forex settlement, reconciliation of Nostro accounts and
accounting. The Head of Mid office looks after the work relating to formulation of
strategies for risk management, laying down accounting policies and work relating to
information technology. Let us know more about functioning of each of these offices, viz.
Front Office, Back Office and Mid Office.

FRONT OFFICE
Dealing Room Operations
In the morning, Head of the forex treasury, meets all in the Dealing Room operators
(Dealers) and after a brief discussion takes a view of the market which is duly recorded.
In the integrated set up the Corporate treasurer takes a view of fund position in Rupees
available, prevailing call rates, investment rates, etc, to take a view of arbitrage
hternaiiunal Unnkii~g opportullities with a view to earl1 more prolit.
Operatinn$ Ma~lsgenlel~t
The sitting arrairgement of Chief Dealer and all the dealers is made in the same room so
as to save time for consultation as ally delay in concluding deal may mean loss of the
transactions/business opportunitiesiprofit. This will also give Chief Dealex better
opportunities for continually monitoring the various exposure limits granted to h i by
getting timely feedback from the dealers on the spot.
Bank normally do not set out any profit targets for any of the dealers so as to operate in
a relaxed manner without resorting to any unnecessary speculative dealing.
Dealers keep a track of the Nostro Account balances transmitted through the swift or any
other electronic system daily in the morning by the overseas correspondents and the
Nostro Account Statements received from the overseas branches of the Bank.
Dealers maintain position pads and prepare sheets on an ongoing basis.
All the interbank deals done are itnmediately recorded in triplicate in the serially
numbered printed Deal slips in the prescribed form. One copy is retained by the Dealer,
one copy is sent to conlputer operator for keying in and the other is given to Back-up
Dept. fbr further processing.
All the spot merchant transactions reported by the branchesloffices are given a separate
docket number which is noted on the deal slip prepared for each such transaction. The
docket no. is required to be mentioned by the branch concerned in the relative reporting
form to be sent to the Head of Back Office, Accounts Wing while reporting the
transaction with a view to facilitating reconciliation work.
The operations of the dealers are controlled through limits fixed in respect of Day Light/
Over Night Exposures (both currency wise and overriding) individual gap limit, aggregate
gap limit, balances in Nostro Accounts, counter party bank limits and country limits.
Each dealer maintains a separate position padlsheet which is updated throughout the
dealing time to ensure effective control of operations in the dealing room.
There is a system of checking entry into the dealing room. Considering confidential
nature of business being handled and with a view to allow dealers to function without any
interruption, it is ensured that those who are required to access the dealing room, only get
entry into the Dealing Room. Banks may install electronic devices for controlling entry of
all eligible officials inside the Dealing Room. The above safeguards are necessvy from
security angle also.
The infrastructure to be made available to the dealing room should be such that the
dealers should be able to handle the large volume of business reported to them effectively
and have also some scope for handling larger volume of business in future. Provision of
Reuters Screen, Telex, Hot Lines, conlputer generated statements would facilitate the
operations of the Dealing Room. System of voice recording may be provided to record
conversation with brokershranch officials reporting transactions over telephone. Hot line
with branches reporting large volume of business be provided for efficient handling of
operations. A printer for the graphics showing movement of rates of different currencies
during the day is another important aid which should be provided, with a view to make
an indepth study and analysis of the trend on the basis of the printed copy of the graphs.
Such infrastructure will help the dealers to ensure improved performance and
enhancement of the profitability in dealing operations.
Financial newspapers, periodicals, journals, various forex publications both Indian &
Foreign are provided for keeping Ihe dealing officials abreast of the development in the
foreign exchange markets in India and abraod.'This definitely contributes to the
competence of the dealing officials and in turn lead to effective dealing ,operations.
Dealing hours should be fixed for carrying out dealing operations. The business timings
should be clearly laid down and the circumstances in which deals can be done beyond
working hours should also be clearly indicated. The deals done beyond the prescribed
working hours should be separately accounted for, monitored and controlled.
Internal Control system on dealing operations should be put in place such as :
a) Dealers sheets prepared by the dealers should be signed by Dealer and Chief Dealer.
-.- -

b) Deal slips nust be properly filled with all the details such as Tine of Deal. Date, Forex Management
BoughtJSold, FromA"I', Currency, Account, Rate, Usance, Delivery (CasWOMI
SPOTIFWD), Local Currency ~quivaleni,Funds, Name of Broker, Brokerage, Name ,

of Correspondent and the deal sliplticket should be duly signed by the concerned
dealer.
c) Any alt~rationloverwritingmust be authenticated under full signature of the dealer.
d) Deals slips should be used in serial order and suitable record should be kept of the
number of deal slips used, cancelled, etc. Cancelled deal slip should be properly
authenticated by the official who has cancelled and should be kept on record.
e) Proper control on customer's credit risk by fixing suitable limits per customer.
t) Up-to-date file containing various instructions, guidelines, etc., issued by Head Office1
international division should be kept for information of dealing officials. Rules of -
Foreign Exchange Dealer's Association of India, RBI guidelines for internal control
over foreign exchange business should dso be kept for the information of and use by
dealers and other officials.
g) Bank's own internal control guidelines should be Ermed and given to dealers for
strict complianca.
h) Dealing functions and back-up functions should he segregated. Dealers sl~ouldnot
have any access to records maintained by back-up staff and MID office staff.

14.4 BACK OFFICE

This department caters Lo the needs of the Forex Dealers as well as take care of follow-
up action in respect of interbanldmerchant deals as well as money market operations.
Back office looks after foreign exchange settlement, interbank confirmations, Nostro
mirror ledgers, returns, merchant forward contracts, advance bills, EEFC, reporting forms,
receipt Erom branches regarding purchase and sale of foreign exchange transactions. FBP
reversals, interbranch transactions, preparations of detailed reports on currency positions at
the end of the day, preparation and maintenance of fund's chart, statement of maturity
pattern of contracts, carry out matwity wise analysis of deals done, Preparation of rate
scan report. Any lapse on the part of backup department can cause a substantial drain on
earnings. Each days receipts and payments of foreign funds and counter values must be
closely watched. Reconciliation of interbank transaction must be closely supervised.
Backup department monitors receipt of exchange brokers' notes for deals concluded
through them and are checked with corresponding deal slips immediate.1~on receipt and
discrepancies in any are observed in the particulars of thc deals with those furnished in
broker's notes they are brought to the nolice of concerned dealer and corrective action is
taken. Statements giving broker-wise summary of deals put through during the month and
brokerage payable to each broker are qenaated on computerlprepared manually at the end
of each month. Payments due to brokers should be paid promptly.
Confirmation af contract advices are generated and sent to counter party banks for deals
done on each dzy. Or, rcceipi of coilfirmation of contracts from the counter party banks
backup officials recheck accuracy of the particulars of the deals furnished therein.
Head of backup checks .all the deals slips prepared by the dealers and verify particulars of
direct deals done in the inter-bank market with TelexReuters Print Out. He also checks
the rates quoted by the dealers vis-8-vis, the card rates in respect of merchant transactions
reported by the branches and also verifies rates quoted on merchant forward contracts .
booked and cancelled during the day. Forex hourly rates (both for major currencies and
exotic currencies) are preparedlgenerated by computers to undertake random checks of
some deals with reference to fhose rates to find out any significant variations in the rates
quoted for those deals. Head of back up attend to the work relating to validation of deals
recorded in Gold (Position) Book. A register is maintained to keep an account of deal
slips used, cancelled and keyed in the computers. Number of deals done should tally with
number of slips used and the same is tallied with the number of deals keyed in the .
computer. Opening balance of the printed sl.ock of deal slips in hand minus deal slips
used and cancelled during the day should t ~ l l ywith the printed stock of deal slips in hand
International Bmking at the end of the day. Verification of deals as per dealer's pad and those recorded in Gold
Operations Manccganent
(Position) Book is done at the end of the day. Back up staff needs to check every
computer print out very carefully and authenticate them. On computer print outs additions
alterations by handlmanually should not be allowed for obvious reasons. However, if thert
are compelling reasons, the same should be done under the instructions of Top
Management and should be properly authenticated by the competent official.
Co-ordination & Control : There should be proper co-ordination between the back-up
department and dealing room. Proper monitoring of the day light limits, overnight limits,
counter party bank limits, country limits. Cases where these limits are exceeded should bc
studied, reasons for exceeding the limits should be ascertained from the dealers and facts
should be reported to the Top Management without delay. True position statements
(currency wise) as of last Friday of each month should be generated for all transactions
including transactions of small amounts (specified as per card rates - not reported by the
branches over telephone or telegram on the date of deals done) reported by branches in
reporting forms for submission to international division, for proper monitoring of currencj
positions.

14.5' MID OFFICE

--- --

Mid-office continuously work for formulating the strategies for various risk management.
Normally the risks which the treasurer has to face are :
1. Political Risk :'Assets or Earningn in a Foreign Country may be frozen or
expropriated.
2. Regulatory Risk : Accounting procedure on taxation or taxation principles may be
altered either by domestic authorities or across the border.
3. Economic Risk : Long Term Contract with Foreign Suppliers or Purchasers may be
affected by changes in relative inflation rates.
4. Interest Rate Risk : Risk due to changes in interest rates, particularly at the time of
repricing.
5 . Exchange Rate Risk : Risk due to flucQations in the exchange rate.
6. Credit Risk : Risk of default by the counter party.
This dep~tmentalso attends to the work of laying down accounting policies keeping in
view the regulatory authority instructions/guidelines.

14.6 DEALING ROOM

Going by logistics we find that a dealing roqm is a centralized establishment, usually of :
commercial bank, which is willing to makdoffer a two way dealing price for different
currencies at all times even when they may not wish to deal, but all during prescribed
, business hours. It is a common practice amongst dealers to quote only the last 2 points 0
the rate as every dealer is expected to know the fill1 price. A dealer tries to make profit
while quoting his rate rather than attempting it from the quote made to him. Usually,
dealer call other dealing rooms for a quotation rather context/currency tends to quole his
spread in'such a way that it expresses itself his unwillingness to carry out the deal. At
times, the dealers also prefer to qualify his quote with words like "good for standard
lots", "choice price", etc. To sum up, the whole range of transactions in forex market are
carried out through the dealing rooms of participating banks.
Qualities of a Dealer
Dealer is supposed to be endowed with. traits viz :
e survival instincts
e being good at understanding the changing nature of markets;
e quick to react to new opportunities and situations;
e quick in reversing a previous stance;
- _ "_- - -
 e overcomes the liatural tendency to salvage something from a loss making situation; Forex Management

o hunches as to what market will do next rather than sticking with his own view; and
e able to work under stress;
To be effective, a dealer has to be trusted in the forex market. He can very quickly gain a
reputation as a good or bad dealer. Forex market is one place where dealer needs all the
friends that one can get.
Dealers ate freed from undertaking accounting work of any kind as otherwise they would
not be able to concentrate on the market. Dealers maintain ."deal slips" indicating the
name of the broker, if any, the counter-party bank, cutrency, amount, time, rate and due
date wder his signature as soos as the deal is struck with and pass-on to back office for
further processing, However, in an automatic system, separate "deal slips" are redundant.
Voice Recording
Some dealing rooms do maintain gadgets like voice recorders, etc., to record the dealing
room co~~versations for such taped conversations hasten resolution of differences. The
control box has to be with chief of treasury operations.
Dealing Room Operations - Objectives
o To give the best possible service to customers Dealing rohm should have adequate number
of well attended phones and the telexes, sound counselling about economic developments,
competitive rates and capability to transact the entire atnoant of currency deal requested
by the customer.
o To manage the bank's position so &at inventory in each foreign currency is kept at the
desired level. It is done through matching the inflows and outflows of various currencies
with matching deployment.
e To produce a profit for the bank while accomplishing the first two objectives through
exchange rate differentials etc.
Corporates/Organiss~tions/lndividualswho knocks on the dealing rooms?
* For payment towards imports, co~lversionof export receipts, hedging of receivables
and payables, payment of interest and principal of foreign currency loans,
* Giant multinationals, of course, do take speculalivepo~itionspurelyfor profit generation
through their own well-established treasuryldealing room. u
Commercial Banks
e 90% of forex trade is accounted for by inter bank transactions.
e Trade in currencies to meet client requirements;
r Buy and sell on their own account and carry inventory of currencies for speculative
purpose since foreign exchange trading profits have become an important source of
revenue for commercial banks.
Central Banks
, e Intervene to move exchange rates in a particular direction as desired by the local
govsrnnlent.
o Currencies : 19 currencies viz are dealt with in the dealing rooms.
o Multinational banks deal in large number of currencies.
e Major currencies : US Dollar, Euro, Markyen, Pound Sterling, French Franc, Swiss
Franc.
e Minor currencies : Lira, Spanish Peseta Singapore Dollar, Hong Kong Dollar,
Belgium Franc, Dutch Guilders, Austrian Schillings, Australian Dollar, Canadian
Dollar, Danish Kroner,
Activity 1
1. List out any five pre-cautions that are required to be taken while operating a front
office,
Intern;~tionalBanking
Operations Management

2. Identify some of the traits hat Dealer needs to have.

OUOTES
Direct QuntelForeign Currency Quote :
Unit of foreign currency is keptrconstant against the amount of home currency to be
exchanged for it.
It otherwise means how much of home currency is worth of one unit of foreign currency.
-
Example : US$ INR 47.00
Since 2.8.1993, Indian Forex Market switched over to direct quote system.
Indirect Quote/Home Cztrrency Quote :
It is just opposite of Direct Quote i.e. number of units of foreign currency which will be
exchanged for a fixed number of home currency units,
Example : INR 100 - USD 2.12
ow ever, this method of distinguishing rates, on the basis of home currency relationship,
may not always hold good say for example :
when neither is a home currency;
when global markets quote their rates as equivalent of US$ (which is a well-established
tradition) it looks indirect quotation in US while in other countries it sound as a direct
quotation.
It may, therefore, be sensible to differentiate the direct and indirect qugtes :
.
Based on cu*ency, which is dealt in i.e.'
-
Direct quote when currency dealt in is expressed as fixed unit e.g. USD -'IS440 DM
which means deals are done in dollar terms and parties contract to buy or sell.
-
Indirect quote currency dealt in is the one whose quantity is variable i.e. just reverse
to direct quote, e.g. DM 1 - USD A476
Two 'way Quote :
e In forex market, it is customrtty for a dealer to quote both the prices at which h e is
willing to buy and sell foreign currency, which in usual parlance known as two way
quotebid and offer rate e.g. US$ vls. Rupee = 47.10111
e While offering a hvo way quote, a trader will always ensure some profit margin by
fixing buying and selling prices differently.
It is needless to say that a dealer, while quoting a bid and offer rate, would always
work on it from bank's point of view i.e. desires to give less units of home currency
while purchasing foreign currency and give less units of foreign c m e ~ ~ cwhile
y
selling it against rupees.
e So, in a direct quotation, the market dictum would be buy low, sell high or give less
take more.
 Forex Management
-

Major commercial banks act as 'Market Makers' in most of the major currencies by
offering 'two-way' quotes and be prepared to take either side of the transaction.
e In a normal two-way market, a dealer expects 'to be hit' on both sides of his quotes
in roughly equal amounts. But, it is always not necessary. He may suddenly h d
"being hit" on one side of his quote, much more often than the other side. It means
that he is either buying many more dollars than he is selling or vice versa. This leads
to the trader building up "a position" :
If he has sold more $ thh he has bought, he is said to have a "short position";
If he has bought more $ than he has sold, then he is said to have a "long position".
e Iu a highly volatile forex market, a longfshort position for too long can be risky.
Q For instance, net short position may lead to a loss if it is to be covered at an
appreciated price or gliin if currency depreciated.
Similarly, a net lpng position may lead to loss if it is to b e covered at a lower price
or gain if it is to be covered at a higher price.
Q Therefore a dealer, realising that he has built up an undesirable net position; quickly
adjusts his bid offer quote in such a.manner that it discourages one type of deal
.
(which has already landed him in a over.. position) and encourages the opposite
deal.

14.9 BROKER
Act as middlemen between two market-users;
They provide information to market-making banks about prices at which there are
firm buyers and sellers in a pair of currencies;
Carry out bank's instructions to buy or sell a specific amount of currency at specified
rate and collects commission on conclusion of deal;
Banks also use brokers to acquire information about general state of the market.
In the Indian context;
Brokers are prohibited from acting as principals and maintaining positions in foreign
currencies;
Brokers notes should be received promptly by the dealers before close of the business
day to which it relates;
Nomination of brokers for deals not done through :h&nis not permitted;
Desirable to have panel of brokers and air-shuffling of business among them;
Dealers to be separated from maintaining broker-wise record and payment of
brokerage claims, etc.
Standard Lot : 1 milllion US $ (in Indian Market)

14.10 MECHANICS OF TRADING

Inter-bank market deals are done on the telephonefscreen (Reuter dealing).
A trader in bank A, needing GBP against dollars, calls his counterpart in Bank B and
ask for a quotation.
If the price is acceptable, deal is struck and both will enter the details - amount
bought/fiold, the price, identity of the counter party, etc. in their computerisql record
systems.
Written confitmations will be sent subsequently.
On the day of settlement, bank 'A' will transfer dollars to Bank B and 'B' GBP to A.
Non-bank customer transactions are entertained during normal banking business hours
while inter-bank transactions are carried-out upto 4 p.m.
Ihterriatiunal Biulkjng
Operations M:rn:~gc~~lent 14.11 DEALING ROOM TERMINOLOGY
Some of the expressions often repeated in the fotex market and their standardluniformly
accepted meaning are as under :
s Offered at; Comes at; I give ati I sell at; I offer at = Sellers or lender of currency
e 1 bid at; I pay at; I take at; I buy at = Buyers or borrower of currency
e Bid, Wanted, Firnl, Strong = Currency in question is appreciatinglin deniand/buyers
pre-dominant
a Offered, Weak = Currency in question is depreciatinglsellers pre-dominant
a Value today = Same day value
e Value tomorrow = next working/business day
e End/end = Forward swaps illtended for maturity on the last working day of the
appropriate future month are described as Endlend.
e Short dates = Deals for a broken number of days upto one week
e BrokenIOdd Date = Value date which is not the regular forward date.
e Overnight - TodaylTomorrow = Currency deposit transactionfsiinultaneous purchase
and sale of currency for value today against the next working day,
e Tomorrow/Next; TomINext = Currency deposit transaction/swap for value the next
working day against the spot value.
e SpotNext = Currency deposit transactionlswap for the spot vdue date against next
working day.
e Weekend = Currency deposit transactionlswap for value the last working day of the
week, normally Friday against the first working day of the following week, ~~ormall
Monday.
e Outrightfoutright = Purchase or sale of currency for delivery for any day other than
spot not being a swap transaction.
e Parity or same = No proposition on the rates quoted by the other party. It does not
imply that the party using the expression is ready to do a deal at the rates quoted,
e For indicationfinformation = Quotes no firm
a Details = Needs of a dealer regarding rate and dates following a transaction,
e Mine = Dealer takes the spotlforwardldeposit which ever has been quoted from the
counter party. It is dangerous to use the expression unless amounts have been
qualified first.
e Yours = Opposite of Mine.
e Pointlpip = Last decinlal place of a quotation.
Mio = One million
e Billion/Millard = One thousand millions.
e Art your risk - Quote is subject to change.
Qpes of transaction :

I
Outright-Cashheady Exchange of currencies takes place on the date of deal
I

TOM (Tomorrow) ( Exchange of currencies takes place on

I
the next working day
Exchange of currencies takes place on the 2"*working day, after
the date of deal
Forward I Delivery, for any day other than spot
I
Simultaneous sale and purchase of identical amounts of currency 1
, for different maturities !
I
 14.12 SUPPORT SYSTEMS IN DEALINGS
Information Systems
0 Real time on line prices
Information affecting and likely to affect currency prices;
e Ai~alysisof information
Available through - Reuters Monitor services - a million individual quotes are flashed on
the screen112 weeks.
Tele rate
Knight rider
2002-2-besides being a dealing system it also acts as an electronic broker, wherever it can
match the quoted rates of the subscribing banks. Trading is not confined to local markets
alone. A fellow in London trades with Banks in Frankfurt, New York, etc., and even with
places in diffetelit time zones.
Payment Systems
Olice a deal is done, the dealers will specify where they want the currencies to be
delivered. For example, in a $-Mark transaction, the buyer of the $ may want $ to be
credited to his account with New York Bank whereas the receiver of Marks may
want it to be credited to his account i n a bank located in Frankfurt.
To cope up with such mind boggling volumes, the banks have given up traditional
settlement style through cheques and instead developed electronic inter-bank funds
transfer systems. Best known of them are CHIPS in New York and CHOPS in
London.
"Netting" inter-bank payment arising out of Forex transactions is another development
-FmT.
a SWZFT - to transmit messages in standardised format - CHOPS have been designed
to reformat SWlFT messages electronically.

14.13 RISKS
I
Risks in Dealing Room Operations
With free flow of capital all around the globe and the concomitant rise in volumes, the
need for risk identification in dealing room operations and its management has become
quite imperative.
Management therefore, formulate policy - guidelines and control mechanism for smooth
functioning of the dealing room, perhaps covering broad parameters viz.
@ business strategies for trading in different product groups; markets;
limits for counter parties;
, procedures for measuring, analysing, monitoring and managing risks;
ceilings for risk position;
Procedures for reacting to situatiofi like over-shooting of limits and market
extremities;
Functions and responsibilities of front, middle and back office;
Internal accounting and reporting;
Internal control and monitoring systems;
Maintaining confidentiality.
It is also desirable to obtain written acknowledgement of such guidelines from the
operating staff of dealing rooms.
Let us take a look at different types of risk associated with forex dealing.
InternnfionnI B:mldng Open Position Risk
Operntions Ma11:agcnwni
0 Long - 1 B~ughtmore GBP
overboughtlplus 1 than sold

0 Short - 1 Sold more GBP

Oversoldlminus 1 than bought
If one is overbought and currency weakens, one will be able to square the overbought
position by selling the currency at a loss. Same is the case if one is oversold and
currency hardens. .
Maturity Misnniitch Risk
e Gaps arising out.of'- merchant transaction position - others. Unmatched forward
maturities may cause loss if forward differentials go against the bank.
Credit/Counter Party Risk
e Failure of counter party to honour his side of the contract.
Contract Risk
e Assume one has sold forward $ to a customer say at Rs 46.00 per $. Before ihc
contract matures, if the customer fails, we have to dispose of the earmarked dollars iir
the market at the going rate despite it has ,weakened to Rs. 47.00 per dollar. This is
nothing but replacement cost. It is also known as Pre-settlement Risk.
Clean Risk
e Assume we have sold Marks against $ and accordingly, we have credited Marks to
the bank account say in Gernlany and waiting for the German bank to deposit dollars
in our New ,York Account. Till German bank credits Dollars in our New York
Account, we will be running credit risk and if in between the bank fails, we have to
put up with the loss.
e This type of risk, also known as Settlement Risk, may arise in international
transactions owing to time-zone differences.
Interest Rate Risk
e Owing to adverse movements in implied interest rates or actual interest rate
differentials relating to foreign currency deposits, forward contracts, currency swaps,
FRAs, etc.
Legal Risk
- Defective/u~~enforceable
agreements likely to result in frustrating the deals.
Operational Risks
e Omissions/com~issionsin operational procedures viz.
e Dealing & Accounting functions
Follow up of dealings and contract confil~mation.,
Settlement of funds
Pipeline transactions
Overdue bills and contracts
Likely to result in losses.
Sovereign Risk
e Risk of externalisation
Basically political in nature
Generally for banks in other countries.

14.14 ELIMINATING/REDUCING RISKS

Banks, assessing the risk involved in trading and non-trading activities, usually come up
with a well-drafted risk management procedure that could be well understood by dealers,
back office staff, etc. Such a mechanism shall assist in limiting and monitoring risk prone
activities across the Dealing Room. Some of such time-tested mechanisms are :
Open Position Risk
e Since these positions are taken at a particular rate, any adverse movement in the rate leads
to loss.
To prevent/minimise such losses, banks prescribe various limits in consistent with adequacy of
its capital to undertake such activities.
s -
Day light limit Dealer cannot take a position of more than day light limit
prescribed by the bank.
e -
Overnight Limit Fixes overnight limit for a open position in each currency -
usually lesser than daylight limits - global limit for all the currencies put together is
also fixed.
e -
Cut-loss limit While undertaking uansactions, if the rate goes on moving against
the hank, one never knows, where the loss would end. Hence, banks fix a cut-loss
limit,. Irrespective of the dealer's view, if the rate moves so adversely that the
resultant loss is equivalent to the limit, the dealer has to liquidate the position and
book loss.
All deals done in a day should be accounted for against the corresponding limits. The
limits when exceeded should be promptly reported to the Senior Management giving
reasons and to get it approved.
111 Indian context, pipeline transactions and operations in foreign currency notes needs to
be specially attended to while assessing risks.
People not connected with dealing room operation should constantly monitor compliance
ta these limits through timely, accurate and comprehensive MS.
Maturity Mismatch Risk
Individ~~al Gap Limit (IGE) : Limit put on mismatch in the currency bought and sold
for a particular month.
Aggregate Gap Limit (AGL) : Aggregate of gap limits foi particular currency all h e O/
B & O/S positions for various months.
Total Aggregate Gap Limit : Aggregate of all' the AGLs in all currencies.
Credit Risk
Banks impose exposure limits on customers as well as on other banks. In general,
separate limits are fixed for spot and forward, the latter being lower than the spot. In case
of Forwards, the limits imposed, maximum level of the net outstanding forward contracts:
Operational Risk
Dealing <andexecution function are separated for early discovery of any transgression of the
imposed limits -by dividing dealing roominto front office solely concentrating on dealings
and back office for recording the transactions and pursuing settlements, etc.
Further contimations are obtained.
Prompt follow-up for execution of funds transfer instructions.
Monitor amalgam of transactions in accordance with the tenor.
Legal Risk
to obviate therisk involved in enforcing compliance with contractual obligationslsecurities,
banks usually enter into following master agreements with counter party bankslclients.
8 Spot a11d Forward Exchange - International foreign Exchange Master Agreement.
-
Foreign Exchange options International Currency Options Market Agreement.
-
All others International Swap Dealers' Association Master Agreement.
Banks also obtain Board Resolutions 40m their Corporate Clients, specifically authorising
their officials to deal and execute contracts.
Intenatinnat Rmking Banks also obtain specific confirmati011 for each transaction with full details regarding
Ol~crntiunsM:~naganent amount, rate, value date, etc., duly signed by the authorised signatories.
Sovereign Risks
0 Limits are fixed to overseas parties taking country risks too into consideration.

14.15 RECONCILIATION
Reconciliation Nostro Balances
Reconciliation of Nostro Account Balances is quite essential for ensuring that every
transaction undertaken through Nostro Account is correctly executed.
Reconciliation is undertaken through Bank Statements and Mirror Accounts. Unreconciled
entries nlust be followed up on an on-going basis else, cornputerised accounting system
and micro filming procedures practised by overseas/coirespondent brancheslbanks may
pose problems for back references.
No set off of debit and credit items of write-off/appropriation to Profit & Loss account of
uireconciled entries is attempted, unless permitted by the exchange control authorised
official of the bank.
Management of Risks in Vostro Account
Exchange Control in Isdia comniands close monitoring of funds flow in vostro accounts
with a view to averting hot money flowslspeculative dealings on Rupees. Similarly,
sudden variations in operations say unusually large operation in an otherwise inactive
account demands closer scrutiny for assessing genuineness of operation.
The amount of credit risk arising from drawings on branches can be itnnleasurable unless
flow of inf~rmationregarding paid drafts, etc., from drawee branches to account
maintaining office is prompt and accurate.
These risks are minimized by -
0 Reducing number of branches on whom drafts can be drawn;
0 Imposing drawing limits per day;
0 Securing draft advices directly from the correspondents/telex/SWlFT messages of
large payments from paying branches;
e Prompt value dating.
Monitoring of vostro accounts further ensures discipline in the usage of credit lines
extended to correspo~dentbanks, identification of concealed overdrafts and interest
recovery there against, etc.
Balance confirmation letters are mailed to the overseas banks maintaining vostro accounts
and confirmations are obtained.
Evaluation : Profits and Losses of foreign transactions are calculated at the end of each
month, using uniform standard accou~ntingprocedure prescribed.
Activity 2
What do you mean by :
a) Short Position : ............................................................................................................... ',

b) Long Position : ..........................................................;......................................................'

- Forex Mmugcment
14.16 SUMMARY
It may thus be seen that countries apex bank has moved from micro level operatio~is
control lo policy level risk control measures so that individual banks are free to formulate
h e nitty-gritty. With regard to routine operations to its own satisfactions risk control
mechx~ismsperse do not guarantee fool proof results. It is highly necessary that the
implementation of the risk control measures are adequately geared up. As India is gearing
itself into high volume forex trading besides the onset of derivative products it would be
necessary to satisfy that appropriate risk control mechanism exisrs and sub-systems are
subjected to regular review.

14,17 KEY WORDS

Back Office : A settlement desk watching out receipts of deal slips.
Front Office : The forex dealing room consist of trained dealers.
Mid Office : Office which efficiently reviews various functional departments,
Market Maker : Financial intermediary which will provide both bid and offer price.
Nostro : Account of Indian bank with foreign bank in foreign country in foreign currency.
Vostro : Accou~~t
of foreign bank with Indian bank in India in Indian rupees.
Loro : Paymelit are settled via reciprocal account-maintained by the bank.

14.18 SELF ASSESSMENT QUESTIONS

1. Draw the structure of Dealing room (Front Office, Back Office, MID Office)
2. What are Dealing room fu~~cgons/operations?
3. What infrastructure should be provided to the dealers for efficient and profitable
working?
4. What Internal Control System should be adopted for dealing operation?
5. What are back office filnctions?
6. Why front office & back office functions are clearly segregated and dealers are not .
allowed to have access to the back office records?
7. What are mid office functions?

14.19 FURTHER READINGS

1. Risk Managet~zenl Slysterns in Banks, Guidelines by Resave Bank of India, 1999.
2. Trivedi and Hassan, Treusury c7pelAationswnd Risk Management, Genesis Publishers,
Ml.lmb ai.
3. Banking in New Milleniutlz :Report an Conference of Cllairtnen of Banks, NIBM,
Pune, 2000.
4. Bhardwaj, H.P., Foreign Exchange Handbook, Bhardwaj Publishing Company,
Mumbai.
5. Rajwade, A.V., 2000, Foreign Exchange Risk Management and International Finance,
A.V. Rajwade & Co.
6. Jod Bessis, 1098, Risk Manclgetnent in Banking, John Willey Sons, New York.
7. Maurice Levi, 1996, International Finance : The Markets and Financial Management
of Multi-na~ianalBusiness, McGraw Hill, USA.