LV Thạc sỹ_Exchange risk management at Agribank

NATIONAL ECONOMICS UNIVERSITY
ADVANCED EDUCATIONAL PROGRAM
*****************************

BACHELOR’S THESIS IN FINANCE

EXCHANGE RISK MANAGEMENT
AT AGRIBANK


ACKNOWLEDGEMENT
This thesis owes its existence to the help, support, and inspiration of many
people. In the first place, I would like to express my sincere appreciation and gratitude
to my instructor Ph.D… for his support and encouragement through obstacles in the
completion of this paper.
Besides, I am heartily thankful to Ms. … – Head of risk management
department and Mr….– Head of FX trading department of Agribank for giving me the
great opportunity to work there. And also my thanks to all the staffs of both
departments who shared and showed me a lot of FX trading experiences in practice.
Last but not least, I offer my regards and blessings to my family for continuous
and unconditional support of all my undertakings, scholastic and otherwise that help
me a lot accomplish my research.

ABSTRACT


The paper explores the foreign currency trading activities in commercial banks
and penetrates the tactics to manage exchange risk in those transactions underlying
using derivatives instruments. The purposes of this thesis are to understand the current
situation of currency trading in commercial banks and give out some solutions to
enhance exchange risk management in FX market.

My thesis’s idea comes from the need to apprehend the actual FX trading in
interbank market via Electronics Brokering Services (EBS) or Reuter Dealings and risk
management in FX transactions. This paper includes introduction, general summary,
report of Agribank, problem findings and recommendations. To conduct the research, I
analyzed and comprehended all the theories and the facts that the bank applied to have
an overview of FX market and foreign currency trading in commercial bank.
Moreover, I spent a lot of time at FX trading department to observe the real trade in
Reuter Dealings. And I also exchanged and discussed methodologies and experiences
to take profit and stop loss in the FX market with the staffs in there. According to
problem findings that I figured out, I will draw my own conclusions to strengthen the
risk management system for commercial banks.
Because of time limitation, available sources and my ability, I just described and
evaluated the current situation and the problems in Agribank for reference. Hopefully,
the paper could be helpful for anyone who wants to understand the working
mechanism of commercial bank in terms of forex trading and risk management in FX
market.

TABLE OF CONTENTS
ACKNOWLEDGMENT


ABSTRACT
TABLE OF CONTENTS
LIST OF ABBREVIATION
LIST OF CHARTS AND TABLES
CHAPTER I: INTRODUCTION...............................................................................1
1.1. Rationale................................................................................................................. 1
1.2. Research objective..................................................................................................1
1.3. Research methodology...........................................................................................2
1.4. Scope of researches................................................................................................2

1.5. Structure of thesis...................................................................................................3
CHAPTER II: THEORETICAL BACKGROUND OF EXCHANGE RISK IN FX
MARKET AT COMMERCIAL BANK.....................................................................4
2.1. Overview of FX market..........................................................................................4
2.1.1. Definitions of FX market..........................................................................4
2.1.2. FX market structure..................................................................................7
2.1.3. Operation of FX market............................................................................9
2.1.3.1. Traded currencies........................................................................9
2.1.3.2. Market participants....................................................................10
2.1.3.3. Banking operations....................................................................12
2.2. Exchange risk in foreign currency trading in commercial banks...........................14
2.2.1. Banking involved risks in FX market......................................................14
2.2.1.1. Cash flow position and interest risk...........................................14
2.2.1.2. Foreign exchange position and exchange risk...........................15
2.2.2. Foreign exchange risk in commercial banks............................................17
2.2.3. Consequences of exchange risk...............................................................19
2.2.4. Hedge against exchange risk...................................................................19
2.2.4.1. Matching foreign currency assets and liabilities........................19


2.2.4.2. Using derivatives.......................................................................20
2.2.4.3. Diversification of foreign asset-liability portfolio.....................20
2.2.4.4. Golden rules in FX market........................................................20
CHAPTER III: CURRENT SITUATION IN FOREIGN CURRENCY TRADING
AND ECHANGE RISK MANAGEMENT AT AGRIBANK..................................22
3.1. Introduction to Agriculture bank...........................................................................22
3.2. Organization structure...........................................................................................25
3.3. Operation results of Agribank in 2010 – 2011.......................................................27
3.3.1. Financial highlights.................................................................................27
3.3.2. Mobilizing capitals..................................................................................31

3.3.3. Lending activities ...................................................................................32
3.3.4. Payment activities...................................................................................32
3.3.5. FX trading activities................................................................................34
3.4. Current situation in exchange risk management at Agribank................................35
3.4.1. Introduction to FX trading department....................................................35
3.4.2. Foreign exchange products of FX trading department.............................36
3.4.2.1. Foreign exchange spot...............................................................37
3.4.2.2. Forward contract........................................................................39
3.4.2.3. Swap contract............................................................................39
3.4.2.4. Option contract..........................................................................40
3.4.3. Performance of foreign currency trading activities in Agribank..............40
3.4.3.1. Current situation........................................................................40
3.4.3.2. Transactions by types of customers...........................................42
3.4.3.3. Transactions by types of currencies...........................................44
3.4.3.4. Transactions by types of FX products........................................45
3.4.4. Risk management applied in Agribank ...................................................47
3.4.4.1. Using FX position limits (risk management department) .........47


3.4.4.2. Using derivatives (FX trading department) ..............................49
3.4.5. Evaluation the effectiveness of exchange risk management....................51
3.4.5.1. Achievements............................................................................51
3.4.5.2. Limitations and reasons ............................................................52
CHAPTER IV: SOLUTIONS AND RECOMMENDATIONS...............................54
4.1. Development trend of currency trading at Agribank in the future.........................54
4.2. Solutions to enhance exchange risk management in Agribank..............................55
4.2.1. For risk management department............................................................55
4.2.2. For FX trading department......................................................................57
4.2.3. Using modern technology and opening training courses.........................58
4.2.4. Diversification in currency trading..........................................................59

4.2.5. Using orders............................................................................................60
4.2.6. Forecast exchange rate movement...........................................................62
4.2.6.1. Fundamental analysis................................................................62
4.2.6.2. Technical analysis......................................................................64
4.2.6.3. Sentiment analysis.....................................................................65
4.3. Recommendation to SBV......................................................................................66
CHAPTER V: CONCLUSION.................................................................................71
APPENDIX................................................................................................................. 72
REFERENCES

LIST OF ABBREVIATION
Agribank

Vietnam bank for Agriculture Rural Development

AUD

Australia Dollar


CAD

Canadian Dollar

CHF

Swiss France

EBS

Electronics Brokering Services

ECN

Electronics Communications Network

EUR

European

FX or forex

Foreign exchange

GBP

Great Britain Pound

JPY

Japan Yen

NZD

New Zealand Dollar

LLC

Limited Liability Company

OTC

Over the Counter

SBV

State Bank of Vietnam

SWIFT

Society for Worldwide Interbank Financial Telecommunications

USD

US Dollar

Vinaforex

Vietnam foreign exchange market

VND

Vietnam Dong

WTO

World Trade Organization

LIST OF CHARTS
Chart 2.1: Average Trading Volume 2010......................................................................4

Chart 2.2: Role of commercial banks in FX..................................................................5


Chart 2.3: Decentralized FX Market..............................................................................7
Chart 2.4: FX Market Hierarchies.................................................................................8
Chart 2.5: Relation amongst market participants in FX market...................................12
Chart 3.1: Organization Structure................................................................................25
Chart 3.2: Total assets and change rate.........................................................................29
Chart 3.3: Bottom line of Agribank..............................................................................30
Chart 3.4: Growth of fund resources period 2008 - 2011.............................................31
Chart 3.5: Breakdown of fund resources in 2011.........................................................31
Chart 3.6: Loans structure 2011...................................................................................32
Chart 3.7: International payment volumes...................................................................33
Chart 3.8: Gain/loss from FX trading...........................................................................34
Chart 3.9: Organization Structure of FX trading department.......................................35
Chart 3.10: Transactions by types of currencies...........................................................45
Chart 3.11: Transactions by types of FX products........................................................46
Chart 3.12: Risk matrix associated with derivatives instruments.................................50
Chart 4.1: Support and resistance trend line.................................................................65
Chart 4.2: Exchange rate and FX reserve in 2011........................................................66

LIST OF TABLES
Table 2.1: Major Currencies..........................................................................................9
Table 2.2: Major Currencies Pairs................................................................................10
Table 2.3: Example of cash flow position at the end of trading day (t)........................15


Table 2.4: Example of exchange position of currency F and exchange risk.................16
Table 2.5: Money market verses FX market ................................................................17
Table 2.6: Golden rules in FX market..........................................................................21

Table 3.1: Specific goals in 2011 .................................................................................29
Table 3.2: Exchange rate of currency in Operating Centre...........................................37
Table 3.3: Live price in Reuters...................................................................................38
Table 3.4: Outright Forward Rates between VND and USD........................................39
Table 3.5: Total foreign currency trading converted to USD........................................41
Table 3.6: Structure of buying foreign currency by types of customers.......................42
Table 3.7: Structure of selling foreign currency by types of customers........................42
Table 4.1: Business result of spot transactions ............................................................56
Table 4.2: Business result of forward transactions ......................................................57

CHAPTER I: INTRODUCTION
1.1. Rationale
Without a doubt, internationalization is becoming a stronger and stronger trend
and it is a necessary process for development of particular country. Integrating in the
WTO since 2007, Vietnam is step by step expanding in international transactions,
foreign trades, and global activities. As the linkage between domestic economy and the


rest of the world, FX market plays an important role in controlling and balancing the
foreign currency in the economy, and supporting for export and import companies.
Recently, Vietnam foreign exchange market (VinaFX) is shaping and developing
gradually. Even in the very first step, VinaFX has created a platform for all commercial
banks to operate FX trading transactions. Inevitably, these transactions cope with a lot
of risks that could be harm for commercial banks, especially the exchange risk.
Because our market is young and fresh, exchange rate risk management research will
be useful for better performance of commercial banks to out of the fog in FX market.

1.2. Research objectives
The paper was conducted for my first objective is to comprehend the operation
of VinaFX and currency trading of commercial banks in interbank market. Moreover, I

want to take a look insight the way to trade currency and derivatives at FX trading
department.
According to the understanding of working mechanism of the market, I can find
out challenges and obstacles in FX transactions that lead to the need of intensive
exchange risk management. Taking the case of Agribank, I aim to penetrate not only
reality but also to learn any problems in Agribank’s exchange risk management system.
Via my study, definitely, I prefer to give out some solutions to overcome
concerned issues at Agribank and recommendations for SBV in action.

1.3. Research methodology
Based on Agribank intramural financial report, I will collect all data and analyze
its financial statements and evaluate its operation results. Besides, I still make a
comparison between two fiscal year 2011 and 2010 following economics situation and
business outcomes.
Additionally, I will take all papers that regulate FX transactions at risk
management department and explore FX trading revenues at FX trading department to


access the effectiveness of cooperation between the two departments. Indispensably, I
also study the real trading in interbank market via Electronics Brokering Services
(EBS) and Reuter Dealings to figure out some tactics to minimize exchange risk in FX
market.
Technically, I cannot draw conclusions without computer aid of professional
soft-ware that specializes in FX business. And some are used for statistic and analysis
purposes.

1.4. Scope of research
The scope of study focuses on foreign currency trading and techniques applied
in exchange risk management at Operation Centre of Agribank. Based on the
organization structure of Agribank, the study related directly to both risk management

department and FX trading department. Inevitably, the outcomes are not compared
perfectly due to different organization structure of particular credit institutions and lack
of industry data, thus I cannot compare Agribank with other commercial banks.
On the other hand, with the limitation of time to access intramural information,
my findings and suggestions are just the merit on the surface. I hope my attempts to
comprehend this research can be fulfilled and the paper can help readers have some
ideas about real trades in FX market, however.

1.5. Structure of thesis
Taking internship at Agribank, I had a chance to penetrate all functions of
Agribank and especially trading activities in FX market. My paper is the outcomes
within 12 weeks at Agribank and it includes five main parts:
Chapter 1: Introduction
Chapter 2: Theoretical background of exchange risk management in FX market at
commercial bank


Chapter 3: Current situation in foreign currency trading and exchange risk management
at Agribank
Chapter 4: Solutions and recommendations
Chapter 5: Conclusions

CHAPTER

II:

THEORETICAL

BACKGROUND

OF

EXCHANGE RISK IN FX MARKET AT COMMERCIAL BANK
2.1. Overview of FX market
2.1.1. Definitions of FX market
A foreign exchange market is a market where a convertible currency is
exchanged for another convertible currency. In the transaction or execution of
conversion, one currency is considered domestic and the other is regarded as foreign,


from a certain geographical point of view, so is the term foreign exchange derived. FX
markets are not reserved for traders or finance professionals only but for almost
everyone, from multinational corporations operating in several countries to tourists
travelling across two currency zones.
The FX market is global worldwide decentralized financial market to exchange
currencies. It is made up of banks, commercial companies, central banks, investment
management firms, hedge funds, and retail FX brokers and investors all over the world
via internet and telecoms systems. Hence, it is considered to be the largest financial
market and also the youngest one. We can look at the comparison chart as below
amongst FX market and some giant stocks markets to see the differentiation.
Chart 2.1 Average Trading Volumes 2010

As

the

chart

reveals the currency market is 53 times bigger than stock markets. That huge $4 trillion
number covers the entire global foreign exchange market, but retail traders trade the

spot market and that's about $1.49 trillion. So you see, the FX market is definitely
huge. FX market is also unique because it is opened and traded 24 hours a day except
weekends (see appendix 1 about over-lap trading sessions) and its vast trading volume
represents the largest asset in the world leading to high liquidity.


In fact, FX transactions are usually taken place between commercial banks
(occupied 85% of total transactions). Thus, in another perspective we can conclude
that FX market is a place to buy, sell, exchange and speculate on currencies amongst
commercial banks, called interbank market (or OTC).
Chart 2.2 Role of commercial banks in FX

The chart above shows the significant proportion of interbank market
transactions in FX (85%) or commercial banks (99%). There are inter-bank activity for
foreign exchange, or the wholesale FX business, and the retail FX business for the
clients of the banks. International commercial banks communicate with each other
through, SWIFT for instance, to settle their FX transactions.
There are many benefits and advantages of trading FX. Here are just a few
reasons why so many people are choosing this market. First of all, there are no
commissions in FX market. In fact, it is no clearing fees, no exchange fees, no
government fees, and no brokerage fees. Most retail brokers are compensated for their
services through something called the "bid-ask spread". Second, it is no fixed lot size.
In the futures markets, lot or contract sizes are determined by the exchanges. In spot
FX, traders determine their own lot, or position size. This allows traders to participate


with accounts as small as $25. Furthermore, in compared with stock market, FX market
requires traders a lower transaction costs. The retail transaction cost (the bid/ask
spread) is typically less than 0.1% under normal market conditions. At larger dealers,
the spread could be as low as 0.07%, of course this depends on traders’ leverage.

Especially, FX market is opened 24-hour a day. So, there is no waiting for the
opening bell. From the Monday morning opening in Australia to the afternoon close in
New York, the FX market never sleeps. This is awesome for those who want to trade
on a part-time basis, because you can choose when you want to trade: morning, noon,
night, during breakfast, or in your sleep. Additionally, no one can corner the market.
The foreign exchange market is so huge and has so many participants that no single
entity (not even a central bank) can control the market price for an extended period of
time.
Besides, FX market allows traders to use leverage in order to advance their
position before trading. Indeed, a small deposit can control a much larger total contract
value. Leverage gives the trader the ability to make nice profits, and at the same time
keep risk capital to a minimum. For example, a FX broker may offer 50-to-1 leverage,
which means that a $50 dollar margin deposit would enable a trader to buy or sell
$2,500 worth of currencies.
Lastly, because the FX market is so enormous, it is also extremely liquid. This
means that under normal market conditions, with a click of a mouse you can
instantaneously buy and sell at will as there will usually be someone in the market
willing to take the other side of your trade. You are never "stuck" in a trade. You can
even set your online trading platform to automatically close your position once your
desired profit level (a limit order) has been reached, and/or close a trade if a trade is
going against you (a stop loss order). Due to it high liquidity, you would think that
getting started as a currency trader would cost a ton of money. The fact is, when
compared to trading stocks, options or futures, it does not. Online FX brokers offer
"mini" and "micro" trading accounts, some with a minimum account deposit of $25.


Hence, FX trading much more accessible to the average individual who does not have
a lot of start-up trading capital.

2.1.2. FX market structure

Unlike in trading stocks or futures, traders do not need to go through a
centralized exchange like the New York Stock Exchange with just one price. In the FX
market, there is no single price that for a given currency at any time, which means
quotes from different currency dealers vary. Even though the FX market is
decentralized, it is not pure and utter chaos. Participants in the FX market can be
organized into a ladder (chart 2.4 below).
Chart 2.3 Decentralized FX Market

Chart 2.4 FX Market Hierarchies


At the very top of the FX market ladder is the interbank market. Composed of
the largest banks of the world and some smaller banks, the participants of this market
trade directly with each other or electronically through the EBS or the Reuters Dealing
3000-Spot Matching. For the EBS platform, EUR/USD, USD/JPY, EUR/JPY,
EUR/CHF, and USD/CHF are more liquid. Meanwhile, for the Reuters platform,
GBP/USD, EUR/GBP, USD/CAD, AUD/USD, and NZD/USD are more liquid. All the
banks that are part of the interbank market can see the rates that each other is offering,
but this doesn't necessarily mean that anyone can make deals at those prices.
Next on the ladder are the hedge funds, corporations, retail market makers, and
retail ECNs. Since these institutions do not have tight credit relationships with the
participants of the interbank market, they have to do their transactions via commercial
banks. This means that their rates are slightly higher and more expensive than those
who are part of the interbank market. At the very bottom of the ladder are the retail
traders. It used to be very hard for us little people to engage in the FX market but,
thanks to the advent of the internet, electronic trading, and retail brokers, the difficult
barriers to entry in FX trading have all been taken down. This gave us the chance to
play with those high up the ladder and poke them with a very long and cheap stick.

2.1.3. Operation of FX market

2.1.3.1. Traded currencies
Currencies are traded through a broker or dealer, and are traded in pairs; for
example the euro and the U.S. dollar (EUR/USD) or the British pound and the
Japanese Yen (GBP/JPY). When trading in the FX market, we buy or sell in currency


pairs. Exchange rates fluctuate based on which currency is stronger at the moment. The
price of the currency is a direct reflection of what the market thinks about the current
and future health of the one’s economy. In general, the exchange rate of a currency
versus other currencies is a reflection of the condition of that country's economy,
compared to other countries' economies.
Currency symbols always have three letters, where the first two letters identify
the name of the country and the third letter identifies the name of that country's
currency. As I listed some major currencies symbols as follow:
Table 2.1 Major Currencies

Additionally, from major currencies, we also have major currency pairs (table
2.2), major cross-currency pairs and exotic pairs in FX (appendix 2).


Table 2.2 Major Currencies Pairs

In those, major currency pairs all contain the U.S. dollar (USD) on one side and
are the most frequently traded. The majors are the most liquid and widely traded
currency pairs in the world. Meanwhile, currency pairs that do not contain the U.S.
dollar (USD) are known as cross-currency pairs or simply as the "crosses". Major
crosses are also known as "minors". The most actively traded crosses are derived from
the three major non-USD currencies: EUR, JPY, and GBP.

2.1.3.2. Market participants

Until the late 1990s, only the "big guys" could play this game. The initial
requirement was that traders must have at least about ten to fifty million USD to start
with. FX was originally intended to be used by bankers and large institutions, and not
by us "little guys." However, because of the rise of the internet, online FX trading firms
are now able to offer trading accounts to "retail" traders. Without further ado, here are
the major market players:
• The Super Banks
Since the FX spot market is decentralized, it is the largest banks in the world
that determine the exchange rates. Based on the supply and demand for currencies,
they are generally the ones that make the bid/ask spread. These large banks,
collectively known as the interbank market, take on a large amount of FX transactions


each day for both their customers and themselves. A couple of these super banks
include UBS (Union Bank of Switzerland), Barclays Capital, Deutsche Bank, and
Citigroup.
• Governments and Central Banks
Governments and central banks, such as the European Central Bank, the Bank
of England, and the Federal Reserve, are regularly involved in the FX market. Just like
companies, national governments participate in the FX market for their operations,
international trade payments, and handling their foreign exchange reserves.
Meanwhile, central banks affect the FX market when they adjust interest rates to
control inflation. By doing this, they can affect currency valuation. There are also
instances when central banks intervene, either directly or verbally, in the FX market
when they want to realign exchange rates. Sometimes, central banks think that their
currency is priced too high or too low, so they start massive sell/buy operations to alter
exchange rates.
• The Speculators/ Retail Traders
Comprising close to 90% of all trading volume, speculators come in all shapes
and sizes. Some have fat pockets, some roll thin, but all of them engage in the FX

simply to make bucket loads of cash.
• Commercial Banks(CBs)
Indeed, commercial banks join in FX market have two purposes. First, CBs are
representative for retail clients by selling and buying foreign currencies. Because this is
a service of CBs, they do not face with any risks. They trade in other people’ money so
it does not affect on-balance sheet of CBs. Second, CBs trade for their own profits or in
other word, CBs will seek profits by the difference between the rates (carry trade).
Due to this operation, CBs will be suffered from exchange risk and it might change


both on-balance sheet and off-balance sheet of CBs, in return. In interbank, CBs trade
with each other in two methods:
• Trading directly amongst commercial banks (direct interbank)
• Trading indirectly via brokers (indirect interbank)
In the context of my thesis, I will focus on the roles of commercial banks in FX
market. The relationship connecting all market players is summarized as the chart 2.5
shows.
Chart 2.5 Relation amongst market participants in FX market

2.1.3.3. Banking operations
Under banking context, FX operations are classified by five types: the spot
operations, the forward operations, the swap operations, the currency futures, and the
currency options. I will go through those one after another.
• Spot Market
The spot market is also called the "cash market" or "physical market", because
prices are settled in cash on the spot at current market prices. In the spot market,
currencies are traded immediately or "on the spot”, using the current market price. The
spot market is simplicity, liquidity, tight spreads, and round-the-clock operations.
Therefore, the spot market is also the most active one in banking operation.
• Futures Operations

Futures are contracts to buy or sell a certain asset at a specified price on a future
date (that's why they're called futures). FX futures were created by the Chicago
Mercantile Exchange (CME) way back in 1972, when bell bottoms and platform boots
were still in style. Since futures contracts are standardized and traded through a
centralized exchange, the market is very transparent and well-regulated. This means
that price and transaction information are readily available.
• Forwards Operations
A forward contract is an agreement between two parties to buy or sell an asset in
the future.

A futures contract is a version of a forward contract that has been

standardized. There are several distinctions between forward and futures contracts.
First, forward contracts are generally traded by large institutional investors who are
geographically dispersed, while futures contracts trade on centralized exchanges. As of
1992, the Chicago Mercantile Exchange launched GLOBEX (global exchange), which
allows after-hours trading of listed futures contracts.
Second, as previously mentioned forward contracts are customized, while
futures contracts are standardized. One aspect of this standardization is in the form of
payment risk.

With futures contracts, clearinghouses such as banks take the

responsibility for settlement, while forward contracts have possible counterparty risk as
the losing party might default at the time of payment. Finally, with a forward contract
no cash flows take place until the final maturity of the contract, but a futures contract
requires an initial margin amount and are “marked-to-market” allowing customers
greater liquidity.

• Swaps Operations
An interest rate swap is a means of transforming fixed payments into variable
obligations or vice versa. Foreign exchange swaps allow a firm to quickly restructure
its balance sheet, by giving it the opportunity to exchange fixed obligations for interestsensitive obligations (or vice versa). The rapid growth of the swap market has created


increased concern about credit risk. Additionally, new variations of the basic swap
arrangement have been introduced, such as interest rate caps, interest rate floors, and
collars. An interest rate cap is an agreement in which the buyer makes a payment
today in exchange for possible future payments if a reference interest rate (commonly
LIBOR1) exceeds a specified limit (the cap) on a series of pre-specified settlement
dates. An interest rate floor pays the holder if, in any period, the interest rate falls
below a limit (known as the “floor”). A collar combines the two previous instruments.
• Currency Options
An "option" is a financial instrument that gives the buyer the right or the option,
but not the obligation, to buy or sell an asset at a specified price on the options’
expiration date. If a trader "sold" an option, then he or she would be obliged to buy or
sell an asset at a specific price at the expiration date. Just like futures, options are also
traded on an exchange, such as the Chicago Board Options Exchange. However, the
disadvantage in trading FX options is that market hours are limited for certain options
and the liquidity is not nearly as great as the futures or spot market.

2.2. Exchange risk in foreign currency trading in commercial banks
2.2.1. Banking involved risks in FX market
2.2.1.1. Cash flow position and interest risk
Interest rate risk means the cash flow and financial performance uncertainty
arising from interest rate fluctuations. In order to penetrate this concept, we define:
• Positive cash flow – PCF (inflow of cash): the incomes from other clients. PCF
is calculated in specific period.
• Negative cash flow – NCF (outflow of cash): the expenses for others. NCF is

calculated in specific period.
• Net cash flow position – NETCF: the difference between PCF and NCF at the
same period, as a result, it reveals the balance at particular period of time.
1

LIBOR refers to London Interbank Offered Rate


Via those definitions, we can see that:
- Trading in the money market (borrowing/lending) will generate a positive cash
flow or negative one of exact one type of currency at different points of time.
- Trading in FX market (going long/going short) will generate a positive cash
flow or negative one of both currencies at the same time.
Table 2.3 Example of cash flow position at the end of trading day (t)
NETCF (t-1) PCF (t)

NCF (t)

NETCF (t)

Economic Interpretation
Net PCF position:

-20

+320

-200

+100

- Potential income if interest rate increases
- Accrued loss if interest rate decreases
Net NCF position:

-30

+230

-350

-150

- Potential income if interest rate decreases

+10

+90

-100

0

- Accrued loss if interest rate increases
Square cash flow position:
Not depend on interest rate

2.2.1.2. Foreign exchange position and exchange risk
Foreign exchange risk means the cash flow and financial performance
uncertainty arising from exchange rate fluctuations. In this part, we also define some

terminologies:
• Long the Foreign Currency – LFC: is made when commercial banks buys a
currency because they expects the currency to later rise in value. If that happens,
they will be able to sell the currency they bought for a higher price than what
they paid for it. LFC is calculated for specific time.
• Short the Foreign Currency – SFC: is maintained when commercial banks sells
a currency in the expectation that it will depreciate in value. Contrary to
common sense, commercial banks want the currency to drop, and only then will
they make a profit. SFC is calculated for specific time.


• Net Exchange Position – NEP: the difference between LFC and SFC (both onbalance sheet and off-balance sheet) at the same period, as a result, it reveals
the balance at particular period of time.
In FX concepts, the time generate exchange position is the time when the
contracts are signed not the settlement time. It is the same for both spot market and
forward market.
Table 2.4 Example of exchange position of currency F and exchange risk
NEPF (t-1)

LFCF (t)

SFCF (t)

NEPF (t)

Economic Interpretation
Net LFC position:

-10

+50

-30

+10

- Profit or loss if exchange rate* increases or
decreases
Net SFC position:

+10

+10

-40

-20

- Profit or loss if exchange rate decreases or
increases

+5

+15

-20

0

Square position:

No profit, loss if exchange rate changes
*Quoted rate followed: foreign currency is
base currency, domestic one is quote currency

According to the understanding above, we can see that interest risk can result
from discrepancies between the interest rates in two countries represented by the
currency pair in a FX quote. Meanwhile, exchange risk occurred may cause the prices
fall rapidly, resulting in substantial losses unless stop loss orders are used when trading
FX. We will distinguish between cash flow position and exchange position, interest
rate risk and exchange risk to penetrate the essence of exchange risk as the table 2.5
presents.

Table 2.5 Money market verses FX market
MONEY MARKET
1.

Borrowing and lending

FX MARKET
Long and short