Foreign Exchange Risk Management

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FOREIGN EXCHANGE RISK MANAGEMENT

BACKGROUND

With the demise of the foreign currency exchange rates during the 1970’s and after the collapse of the Bretton Woods Agreement, the world economy has undergone drastic changes. This has signaled an increase in currency market volatility and trading opportunity. The foreign exchange market has played a vital role in the last decade or so in guiding the purchase and sale of goods, services and raw materials globally. The market directly affects each country’s bond, equities, private property, manufacturing and all assets that are available to foreign investors. The Bangladesh Taka, which is the domestic currency of Bangladesh and the country’s foreign exchange, had been strictly regulated until the early 1990s. At that time, Bangladesh Bank used to regulate the local currency’s parity against the international currencies. The cross border movement of currencies was also regulated. Bangladesh Bank used to publish a daily foreign exchange rate sheet that had two sets of rates; one being the rates for commercial banks to transact with their customers and the other being rates for the commercial banks to transact with Bangladesh Bank. The year of 1993 saw a significant shift in the country’s foreign exchange regulatory policies and the Bangladesh Taka (BDT) was declared convertible in the current account. Most restrictions related to current account activities were relaxed where commercial banks were given the responsibility to ascertain genuineness of the transactions and the central bank’s prior approval requirements in these regards were withdrawn. The responsibility of exchange rate quotation was left to the commercial banks where Bangladesh Bank only committed support to the commercial banks to plug any net foreign currency gaps in the market at their pre-specified buying and selling rates. Many circulars and guidelines were issued at that time to communicate the changes as well as to guide the market participants. Subsequently, a new “Guidelines for Foreign Exchange Transactions” was issued summarizing instructions as of 31s t December, 1996 replacing the old Exchange Control Manual (1986 edition). From May 31, 2003, the Bangladesh Taka exchange rate was declared floating and the band of the central bank’s US Dollar buying selling rate were withdrawn. To adapt to the changed environment, many banks established dealing rooms and some centralized their foreign exchange and money market activities under a single functional area which is still in its rudimentary stage. Bangladesh Bank, in order to take the local market further ahead, decided to form a focus group to prepare a strategy paper to address the major risk elements involved in the foreign exchange activities

POLICY

All financial activities involve a certain degree of risk and particularly, the financial institutions of the modern era are engaged in various complex financial activities requiring them to put proper attention to every detail. The success of the trading business depends on the ability to manage effectively the various risks encountered in the trading environment, and the organization’s policies and processes require development over time to ensure that this is done in a controlled way. The key risk areas of a financial institution can be broadly categorized into: - Credit risk

- Market risk and
- Operational risk

In view of the significance of the market risk and in order to aggregate all such risks at a single department and to bring expertise in such functions, the concept of TREASURY has evolved. Today’s financial institutions engage in activities starting from import, export and remittance to complex derivatives involving basic foreign exchange and money market to complex structured products. All these require high degree of expertise that is difficult to achieve in the transaction originating departments and as such the expertise is housed in a separate department i.e. treasury. The main...
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