Forex Trading – Foreign Exchange Risks

Banks have to face exchange risks because of their activities relating to currency trading, control management of risk on behalf of their clients and risks of their own balance sheet and operations. We can classify these risks into four different categories −

  • Exchange rate risk
  • Credit risk
  • Liquidity risk
  • Operational risk

Exchange Rate Risk

This relates to the appreciation or depreciation of one currency (for example, the USD) to another currency (base currency like INR). Every bank has a long or short position in a currency, depreciation (in case of long position) or appreciation (in case of short position), runs the risk of loss to the bank.

This risk mainly affects the businesses but it can also affect individual traders or investors who make investment exposure.

For example, if an Indian has a CD in the United States of America worth 1 million US Dollar and the exchange rate is 65 INR: 1 USD, then the Indian effectively has 6,50,00,000 INR in the CD. However, if the exchange rate changes significantly to 50 INR: 1 USD, then the Indian only has 5,00,00,000 INR in the CD, even though he still has 1 million dollars.

Credit Risk

Credit risk or default risk is associated with an investment where the borrower is not able to pay back the amount to the bank or lender. This may be because of poor financial condition of the borrower and this kind of risk is always there with the borrower. This risk may appear either during the period of contract or at the maturity date.

Credit risk management is the practice of avoiding losses by understanding the sufficiency of a bank’s capital and loan loss reserves at any given time. Credit risk can be reduced by fixing the limits of operations per client, based on the client’s creditworthiness, by incorporating the clauses for overturning the contract if the rating of a counterparty goes down.

The Basel committee recommends the following recommendations for containment of risk −

  • Constant follow up on risk, their supervision, measurement and control
  • Effective information system
  • Procedures of audit and control

Liquidity Risk

Liquidity refers to how active (buyers and sellers) a market is. Liquidity risk refers to risk of refinancing.

Liquidity risk is the probability of loss arising from a situation where −

  • there is not enough cash to meet the needs of depositors and borrowers.
  • the sale of illiquid assets will yield less than their fair value
  • the sale of illiquid asset is not possible at the desired time due to lack of buyers.

Operational Risk

The operational risk is related to the operations of the bank.

It is the probability of loss occurring due to internal inadequacies of a bank or a breakdown in its control, operations or procedures

Interest Rate Risk

The interest rate risk is the possibility that the value of an investment (for example, of a bank) will decline as a result of an unexpected change in interest rate.

Generally, this risk arises on investment in a fixed-rate bond. When the interest rate rises, the market value of the bond declines, since the rate being paid on the bond is now lower than the current market rate. Therefore, the investor will be less inclined to buy the bond as the market price of the bond goes down with a demand decline in the market. The loss is only realized once the bond is sold or reaches its maturity date.

Higher interest rate risk is associated with long-term bonds, as there may be many years within which an adverse interest rate fluctuation can occur.

Interest rate risk can be minimized either by diversifying the investment across a broad mix of security types or by hedging. In case of hedging, an investor can enter into an interest rate swap.

Country Risk

Country risk refers to the risk of investing or lending possibly due to economic and/or political environment in the buyer’s country, which may result in an inability to pay for imports.

Following table lists down the countries, which have lower risks when it comes to investment −

Rank Rank Change (from previous year) Country Overall Score (out of 100)
1 Singapore 88.6
2 Norway 87.66
3 Switzerland 87.64
4 Denmark 85.67
5 2 Sweden 85.59
6 HTML-5 1 Luxembourg 83.85
7 HTML-5 2 Netherlands 83.76
8 HTML-5 3 Finland 83.1
9 Canada 82.98
10 HTML-5 3 Australia 82.18

Source: Euromoney Country risk – published January 2018

Trading Rules To Live By

Money Management and Psychology

Money management is an integral part of risk management.

Understanding and implementation of proper risk management is as much more significant than understanding of what moves the market and how to analyse the markets.

If you as a trader making huge profits in the market on a very small trading account because your forex broker is providing you 1:50 leverage, it is most likely that you are not implementing sound money management. May be you are lucky for one or two days but you have exposed yourself to obscene risk because of an abnormally high “trade size”. Without proper risk management and if you continue trading in this fashion, there is a high probability that very soon you would land with series of losses and your loose you entire money.

Against the popular belief, more traders fail in their trade not because they lack the knowledge of latest technical indicator or do not understand fundamental parameters, but rather because traders do not follow most basic fundamental money management principals. Money management is the most overlooked, yet also the most important part of financial market trading.

Money management refers to how you handle all aspects of your finances involving budgeting, savings, investing, spending or otherwise in overseeing the cash usage of an individual or a group.

Money management, risk to rewards works in all markets, be it equity market, commodity or currency market.