CHAPTER 19
Foreign Exchange Risk Management
19.1 EXCHANGE RISK IMPLICATION
Foreign exchange risk is the risk of loss from foreign currency exposures of banks, which occurs due to the unfavorable change in the exchange ratio between domestic currency and foreign currencies. The risk sensitivity of banks has significantly changed due to the volatility in exchange rate movements. The larger the volume of foreign currency exposure and the more the fluctuations in the exchange rate, the greater is the risk of loss. The disparities in growth rate and inflation rate, and interest rate differentials on financial instruments between countries are important factors that cause volatility in exchange rates. Besides, the level of foreign currency reserves and current account deficits, the differences in fiscal and monetary policy stances of governments and central banks, and the relative disparities in the purchasing power of domestic currencies are significant factors that influence exchange rate movements.
Banks raise foreign currency resources through various sources like acceptance of deposits, issue of bonds, borrowings in foreign financial markets, and securing credit lines or term loans from foreign banks and multilateral financial institutions. They hold foreign currency assets in different forms like cash balances with foreign central banks, investments in foreign securities, foreign currency loans to domestic and overseas clients, and placement of funds with other institutions in ...
