Banks are involved in foreign currency operations. When buying/selling them, an asset (requirement) is formed in that currency and a liability (obligation) is formed in another. Therefore, banks have claims and liabilities in several different currencies that are heavily influenced by currency exchange rates.
The probability of loss or gain as a result of adverse changes in the exchange rate is called foreign exchange risk.
The relationship of assets and liabilities of the bank in foreign currency determines its monetary position. If the requirements and obligations of a bank in a given currency are the same, the currency position is closed, but if there is a mismatch, it is called an opening. The closed deal is a relatively stable state of the banking sector. But making a profit from the change in the exchange rate with this arrangement is impossible. The open in turn can be “long” and “short”. The position is called “long” (if the requirements exceed the obligations) and “short” (the obligations exceed the requirements). The long position in a given currency (when the Bank’s assets in the currency exceed its liabilities in it) is at risk of loss if the exchange rate for that currency falls The short foreign exchange position (when the Bank’s liabilities in that currency exceed its assets) runs the risk of losing if the exchange rate of this currency rises.
The following operations influence the foreign exchange positions of banks:
• Receive interest and other income in foreign currency.
• Conversion operations with immediate delivery of funds
• Transactions with Derivatives (forwards and futures, settlement forwards, swaps, etc.), for which there are requirements and liabilities in foreign currency, regardless of the method and manner of settlement of such operations.
To avoid currency risk, one should strive to have a closed position for each currency. It is possible to offset the imbalance of assets and liabilities with the volume of currency bought and sold. Therefore, commercial banks must create effective foreign exchange risk management systems. The authorized bank may have an open foreign exchange position from the date of receipt from the National Bank of a license to conduct operations in foreign currency securities. To avoid risk or loss in foreign exchange transactions; the Central Bank sets the standards for an open foreign exchange position. This approach to foreign exchange risk regulation is based on international banking practices, as well as the recommendations of the Basel Committee on banking supervision. In the UK, the parameters of the open currency position are restricted to 10% and 15% of the Bank’s capital and in France to 15% and 40%, the Netherlands to 25% respectively.
Currency positions are posted to the account at the end of the day. If the bank has an open foreign exchange position, changes in the exchange rate generate profit or loss. Therefore, the Central Bank takes measures to exclude a strong fluctuation in the exchange rate