Foreign Exchange risk arises when a bank holds assets or liabilities in foreign
currencies and impacts the earnings and capital of bank due to the fluctuations in
the exchange rates. No one can predict what the exchange rate will be in the next
period, it can move in either upward or downward direction regardless of what the
estimates and predictions were. This uncertain movement poses a threat to the
earnings and capital of bank, if such a movement is in undesired and
unanticipated direction.
Foreign Exchange Risk can be either Transactional or it can be Translational.
When the exchange rate changes unfavorably it give rise to Transactional Risk, as
the name implies because of transactions in Foreign Currencies, can be hedged
using different techniques. Other one Translational Risk is an accounting risk
arising because of the translation of the assets held in foreign currency or abroad.
Foreign Exchange Risk in Commercial Banks
Commercial banks, actively deal in foreign currencies holding assets and
liabilities in foreign denominated currencies, are continuously exposed to Foreign
Exchange Risk. Foreign Exchange Risk of a commercial bank comes from its
very trade and non-trade services.
Foreign Exchange Trading Activities (Saunders & Cornett, 2003)include:
1. The purchase and sale of foreign currencies to allow customers to partake
in and complete international commercial trade transactions.
2. The purchase and sale of foreign currencies to allow customers (or the
financial institution itself) to take positions in foreign real and financial
investments.
3. The Purchase and sale of foreign currencies for hedging purposes to offset
customer (or FI itself) exposure in any given currency.
4. To purchase and sale of foreign currencies for speculative purposes base
on forecasting or expecting future movements in Foreign Exchange rates.
The above mentioned Trade Activities do not expose a commercial bank to
foreign exchange risk as a result of all of the above. The commercial bank is
exposed to foreign exchange risk only upto the extent to which it has not hedged
or covered its position. Wherever there is any uncertainty that the future exchange
rates will affect the value of financial instruments, there lies the foreign exchange
risk of a commercial bank. Foreign Exchange risk does not lie where the future
exchange rate is predefined by using different instruments and tools by the bank.
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