Lesson #9

Interest rate risk

Interest rate risk refers to the profit and loss generated by fluctuations in the forward spreads, along with forward amount mismatches and maturity gaps among transactions in the foreign exchange book. This risk is pertinent to currency swaps, forward outright, futures, and options (See below).

To minimize interest rate risk, one sets limits on the total size of mismatches. A common approach is to separate the mismatches, based on their maturity dates, into up to six months and past six months.

All the transactions are entered in computerized systems in order to calculate the positions for all the dates of the delivery, gains and losses. Continuous analysis of the

interest rate environment is necessary to forecast any changes that may impact on the outstanding gaps.

Credit risk

Credit risk refers to the possibility that an outstanding currency position may not be repaid as agreed, due to a voluntary or involuntary action by a counter party. In these cases, trading occurs on regulated exchanges, such as the clearinghouse of Chicago.

The known forms of credit risk are:

Replacement risk

Replacement risk occurs when counter-parties of a failed bank find they are at risk of not receiving their funds from the failed bank.

Settlement risk

Settlement risk occurs because of the difference of time zones on different continents. Consequently, currencies may be traded at the different price at different times during the trading day. Australian and New Zealand dollars are credited first, then Japanese yen, followed by the European currencies and ending with the U.S. dollar. Therefore, payment may be made to a party that will declare insolvency or be declared insolvent, prior to that party executing its own payments.

In assessing credit risk, the trader must consider not only the market value of their currency portfolios, but also the potential exposure of these portfolios.

The potential exposure may be determined through probability analysis over the time to maturity of the outstanding position. The computerized systems currently available are very useful in implementing credit risk policies. Credit lines are easily monitored. In addition, the matching systems introduced in foreign exchange since April 1993 are used by traders for credit policy implementation as well. Traders input the total line of credit for a specific counter party. During the trading session, the line of credit is automatically adjusted. If the line is fully used, the system will prevent the trader from further dealing with that counter party. After maturity, the credit line reverts to its original level.