Futures and forwards are contracts in which two parties oblige themselves to exchange something in the future. They are thus useful to hedge or convert known currency or interest rate exposures. An option, in contrast, gives one party the right but not the obligation to buy or sell an asset under specified conditions while the other party assumes an obligation to sell or buy that asset if that option is exercised. Options being non-linear instruments are more difficult to price and therefore their risk profiles need to be well understood before they can be used. For example it needs to be understood that the value of a currency changes not just when exchange rate changes (the event for which the bank usually hedges using forwards/futures) but also if the underlying volatility of the currency pair changes, a risk banks are not directly concerned with while hedging.
Treasury operations.
The primary treasury operation of a bank is that of catering to customer needs, both in the spot as well as forward market. This lands the bank with net foreign exchange positions which it needs to manage on a real time basis. If the bank needs to sell Dollars forward to an importer, the bank has a short Dollar position. It can offset the position by buying matching forward Dollars in the market in which case all risks apart from the profit element are covered for the bank. However, it may be easier for the bank to immediately cover the forex risk with a purchase of Dollars in the spot market. Here again the exchange risk is fully covered except for the profit element.
However the bank now has a swap position. This is called a gap. The bank has a gap risk which affects it if interest rates change affecting the forward premia for Dollar. In the case of our domestic markets, in addition, premia could also change due to forward demand/supply factors. However, gap risks are easier to manage than exchange risks. So the bank can build up gaps, subject to the management mandated gap limits, and do offsetting swaps to reduce gap risks if it so desires periodically.
The bank’s treasury might also do transactions to take advantage of disequilibrium situations, subject to such transactions being permissible. For instance if the forward premium for 6 months is say 5% while the 6-month interest differential between Rupee
and Dollar is say 4%, the bank can receive in the forex market (buy spot, sell 6-month swap to earn 5% annualized for 6 months) and finance the transaction by borrowing in the money market (money market cost being 4% annualized for 6 months).
The bank can also do transactions to take advantage of expected interest rate changes. It can then use either the money market route (mismatched cash-flow maturities) or the forex market route (by running a gap risk). The bank of course also trades on currency movements with a view to make profits. Here the management must keep in place systems of stop loss discipline, proper monitoring and evaluation of open positions, etc.
Risk Control Systems:
The management of the bank need to lay out clear and unambiguous performance measurement criteria, accountability norms and financial limits in its treasury operations. Management must specify in operational terms the goals of exchange risk management.
It must also clearly recognise the risks of trading arising from open positions, credit risks, and operations risks. The bank must also keep in place a system to independently evaluate through marking to market the net positions taken. Marking to market should ideally be based on objective market prices provided by an external agency. All position limits should be made explicit and expressed in simple terms for easy control.
Sources and Referrences:
1.https://pages.stern.nyu.edu/~igiddy/articles/hedging_techniques.html
2.https://www.mbaknol.com/international-finance/tools-to-manage-foreign-exchange-risk-involved-due-to-fluctuations-in-exchange-rates-and-interest-rates/
3.https://www.diffen.com/difference/Forward_Contract_vs_Futures_Contract
