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Forex Managed Accounts

Managed Forex Account:

The rapid developments in the foreign exchange operations world- wide have brought many changes in the forex market. The trading in forex market involves purchase and sale of foreign currencies against rupee subject to exchange control regulations through the network of authorized dealers. Purchase and sale transactions in foreign currency ultimately measured in terms of dollars conducted on spot or is booked for delivery at a future date known as forward contract at predetermined premium or discount rate depending on market forces to cover the exchange rate fluctuations and also to assure availability of forex.

In the rapidly developing foreign exchange market world wide Cross Currency Option was introduced in India in 1994 to make Indian banks nimble enough to compete and survive in the global arena. This option provides a right to its holders to have an access to foreign currency at a pre-determined exchange rate for an upfront fee of premium without a necessary obligation to bye or sell. This new option is a vehicle to lay off exchange risk. But since risk profile of each derivative transaction changes continuously as markets and prices move up and down. But there are various instruments like cross-currency swaps, interest rate swaps, and options, which have always helped companies in better managing the currency risk. The introduction of options has facilitate corporate entities engaged in exim business mobilizing overseas funds through Euro issues and GDRs, removing the constraint in the sense that both the customer as well as the bank are under obligation to carry out the contract irrespective of eithers need.

The foreign reserves of a country, like India, include foreign exchange, gold and special drawing rights (SDR). The foreign exchange component is usually held as deposits with foreign banks of proven rating, central banks and as securities, preferably gilt securities of countries like the UK, the US and Japan. In a period of volatility, the main reserve management problem faced by Central Banks arises when the value of one or other of currencies and deposits declines. The total value of the foreign exchange reserves comes down when the currency in which significant part is denominated declines. Usually, the exchange holdings are measured in SDRs are built up of a basket of currencies. The total effective value of reserves in SDR terms will go down when the currency composition of the reserves is weighted towards the depreciated currency. The art of reserve management is to be able to anticipate which particular currencies are likely to decline or strengthen and move the currency composition away from potentially weak to potentially rich currency.

The problem of risk management is not peculiar to central banks, as even large corporates have the same problem. Indeed when large corporates move funds from one money center of world to another, mostly to preserve the value of their balances, there is a shake-up in the markets. In the Indian context, however, the Reserve Bank of India (RBI) is the countrys main holder of foreign exchange. Experts in

RBI have been active in evolving models to forecast currency movements. RBI has been successful in moving out of the potentially weak currencies at the appropriate time into stronger currencies. A potentially weak currency is tempting as deposits denominated in that currency usually offer higher interest rates. A risk-prone dealer may like to put more of the reserves into such a high yield currency. Deposits denominated in yen do yield low rates of interest, while those in sterling used to pay better rates. But, once sterling falls, all the benefits, which could have attracted higher rates of interest in sterling-denominated deposits, are wiped out in one blow. The currency composition of exchange reserves calls for the same blend of skills as needed by portfolio manager in an active stock market. The reserve manager has to be aware of the likely shifts both in interest rates and in exchange rates and this skill has to be continuously upgraded.

The next important thing is Debt management. Reserve management at the central bank level needs to be co-coordinated with debt management, which in India is not handled by RBI. The foreign debt of a country is also dominated in different currencies. Exposure to a particular currency of repayment could be costly if that currency strengthens. Thus the yen debt of India offers a serious potential problem as it is strengthening continuously. The merits of placing a major part of reserves if it be at lower rates of interest in strong currencies will help as it mitigates the problem of currency risk in debt. Various methods are available for hedging foreign exchange risks in debt servicing. The same techniques are also useful for reserve management. This is specialized subject and the RBI has already initiated action in this regard.

Besides currency risk central bank has also to hedge against interest risk. RBI investment in foreign bonds, for instance, can also carry risks since interest rate changes by the central banks of bond-issuing countries will change the investment value. It is here that derivatives can be useful, even though they carry certain risks.

Another is credit risk that has to be avoided. It is the risk associated with banks in which RBI has placed deposits. Certain central banks, such as Portugals central bank lost heavily because they placed deposits with BCCI. A golden rule in reserve management is to be safe and sound rather than to dare and despair. This would be risky. A lender of last resort, like the central bank, cannot afford to take such risks. Safety above all has to be the RBIs motto.

So at last we can say, it is necessary to hedge currency risk, interest risk and credit risk. Aggressive sterilization can also be a source of possible loss as it involves exchanging high-interest rupee for low interest earning dollars. Assumption of exchange risks, speculative trading and wrong appraisal of credit rating are the main weak spots in foreign exchange reserve management. We have seen that the path of reserve management is not smooth. While the RBI has been handling this with customary verve and panache, this will not turn its face against sophisticated methods of risk management.

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