Foreign Exchange and Interest Rate Risk Management
Market risk management identifies FX and interest rate exposures, quantifies them, and neutralises those the institution does not wish to retain. The exam tests exposure classification, hedge instrument selection, forward pricing logic and the measurement limits of common risk metrics.
Exposure types
Transaction exposure is a known future foreign-currency cash flow. Translation exposure arises on consolidating foreign operations. Economic exposure is the longer-run sensitivity of competitiveness to exchange rates. Hedging tools are forwards and futures (binding), money market hedges (borrow and invest), FX swaps (funding and rolling), and options (a premium buys protection with upside retained). For interest rate risk, the tools are the repricing gap, duration, and swaps, futures or caps and floors. IFRS 9 hedge accounting requires documented relationships and effectiveness testing.
Worked example
An importer owes USD 1m in 90 days. Spot is 280.00 PKR/USD, the PKR rate is 20% and the USD rate 5% (simple, 360-day). Forward = 280 × (1 + 0.20 × 90/360) / (1 + 0.05 × 90/360) = 280 × 1.05/1.0125 = 290.37. Total cost 290.37m. The money market hedge: discount the USD 1m at 1.25% to 987,654, buy spot for 276.54m, borrow that for 90 days at 5% and repay 290.37m. The two are identical - covered interest parity - so choose on transaction cost and balance sheet impact, not on a belief that one is cheaper.
Measuring rate risk
A bond with duration 4.2 facing a 50bp parallel rise loses approximately 4.2 × 0.005 = 2.1% of value. Duration is a local approximation and understates losses for large or non-parallel shifts; convexity and scenario analysis correct for this.
Traps that cost marks
Netting exposures in different currencies or maturities; using the wrong day-count; ignoring the forward premium offsetting the interest differential; using duration for large rate shocks; hedging without hedge documentation.