Exchange Risk.

Bankers also act as market makers, as well as agents, by taking positions in foreign currencies, thereby exposing themselves to exchange risk. The immediate adjustment of quotes as traders receive and interpret new political and economic information is the source of both exchange losses and gains by banks active in the foreign exchange market. For instance, suppose a trader quotes a rate of £1:$1.9712 for £500,000, and it is accepted. The bank will receive $985,600 in return for the £500,000. If the bank does not have an offsetting transaction, it may decide within a few minutes to cover its exposed position in the interbank market. If during this brief delay, news of a lower-than-expected British trade deficit reaches the market, the trader may be unable to purchase pounds at a rate lower than $1.9801. Because the bank would have to pay $990,050 to acquire £500,000 at this new rate, the result is a $4,450 ($990,050 − $985,600) exchange loss on a relatively small transaction within just a few minutes. Equally possible, of course, is a gain if the dollar strengthens against the pound.

Clearly, as a trader becomes more and more uncertain about the rate at which she can offset a given currency contract with other dealers or customers, she will demand a greater profit to bear this added risk. This expectation translates into a wider bid-ask spread. For example, during a period of volatility in the exchange rate between the Swiss franc and U.S. dollar, a trader will probably quote a customer a bid for francs that is distinctly lower than the last observed bid in the interbank market; the trader will attempt to reduce the risk of buying francs at a price higher than that at which she can eventually resell them. Similarly, the trader may quote a price for the sale of francs that is above the current asking price.

The Mechanics of Spot Transactions

The simplest way to explain the process of actually settling transactions in the spot market is to work through an example. Suppose a U.S. importer requires HK$1 million to pay his Hong Kong supplier. After receiving and accepting a verbal quote from the trader of a U.S. bank, the importer will be asked to specify two accounts: (1) the account in a U.S. bank that he wants debited for the equivalent dollar amount at the agreed exchange rate—say, U.S.$0.1280 per Hong Kong dollar, and (2) the Hong Kong supplier’s account that is to be credited by HK$1 million.

On completion of the verbal agreement, the trader will forward to the settlement section of her bank a dealing slip containing the relevant information. That same day, a contract note—which includes the amount of the foreign currency (HK$1 million), the dollar equivalent at the agreed rate ($128,000 = 0.1280 × 1,000,000), and confirmation of the payment instructions—will be sent to the importer. The settlement section will then cable the bank’s correspondent (or branch) in Hong Kong, requesting transfer of HK$1 million from its nostro account—working balances maintained with the correspondent to facilitate delivery and receipt of currencies—to the account specified by the importer. On the value date, the U.S. bank will debit the importers account, and the exporter will have his account credited by the Hong Kong correspondent.

At the time of the initial agreement, the trader provides a clerk with the pertinent details of the transaction. The clerk, in turn, constantly updates a position sheet that shows the bank’s position by currency, as well as by maturities of forward contracts. A number of the major international banks have fully computerized this process to ensure accurate and instantaneous information on individual transactions and on the bank’s cumulative currency exposure at any time. The head trader will monitor this information for evidence of possible fraud or excessive exposure in a given currency.

As spot transactions are normally settled two working days later, a bank is never certain until one or two days after the deal is concluded whether the payment due the bank has actually been made. To keep this credit risk in bounds, most banks will transact large amounts only with prime names (other banks or corporate customers).

A different type of credit risk is settlement risk, also known as Herstatt risk. Herstatt risk, named after a German bank that went bankrupt after losing a fortune speculating on foreign currencies, is the risk that a bank will deliver currency on one side of a foreign exchange deal only to find that its counterparty has not sent any money in return. This risk arises because of the way foreign currency transactions are settled. Settlement requires a cash transfer from one bank’s account to another at the central banks of the currencies involved. However, because those banks may be in different time zones, there may be a delay. In the case of Herstatt, German regulators closed the bank after it had received Deutsche marks in Frankfurt but before it had delivered dollars to its counterparty banks (because the New York market had not yet opened).

Because central banks have been slow to deal with this problem, some banks have begun to pool their trades in a particular currency, canceling out offsetting ones and settling the balance at the end of the day. In early 1996, a total of 17 of the world’s biggest banks went further and announced plans for a global clearing bank that would operate 24 hours a day. If and when this proposal is implemented, banks would trade through the clearing bank, which would settle both sides of foreign exchange trades simultaneously, as long as the banks’ accounts had sufficient funds.