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           A.1 Interest Rate Risk
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Part A - The standardised measurement method

A.3 Foreign Exchange Risk

1. This section sets out a minimum capital standard to cover the risk of holding or taking positions in foreign currencies, including gold.

2. Two processes are needed to calculate the capital requirement for foreign exchange risk. The first is to measure the exposure in a single currency position. The second is to measure the risks inherent in a bank's mix of long and short positions in different currencies.

I. Measuring the exposure in a single currency

3. The bank's net open position in each currency should be calculated by summing:

  • the net spot position (i.e., all asset items less all liability items, including accrued interest, denominated in the currency in question);
  • the net forward position (i.e., all amounts to be received less all amounts to be paid under forward foreign exchange transactions, including currency futures and the principal on currency swaps not included in the spot position);
  • guarantees (and similar instruments) that are certain to be called and are likely to be irrecoverable;
  • net future income/expenses not yet accrued but already fully hedged(at the discretion of the reporting bank);
  • depending on particular accounting conventions in different countries, any other item representing a profit or loss in foreign currencies;
  • the net delta-based equivalent of the total book of foreign currency options.

4. Positions in composite currencies, such as the ECU, need to be separately reported but, for measuring banks' open positions, may be either treated as a currency in their own right or split into their component parts on a consistent basis. Positions in gold should be measured in the same manner as described in paragraph 7 of A.4.

5. Three aspects call for more specific comment: the treatment of interest, other income and expenses; the measurement of forward currency positions and gold; and the treatment of "structural" positions.

    a) The treatment of interest, other income and expenses

6. Interest accrued (i.e., earned but not yet received) should be included as a position. Accrued expenses should also be included. Unearned but expected future interest and anticipated expenses may be excluded unless the amounts are certain and banks have taken the opportunity to hedge them. If banks include future income/expenses they should do so on a consistent basis, and not be permitted to select only those expected future flows which reduce their position.

    (b) The measurement of forward currency and gold positions

7. Forward currency and gold positions will normally be valued at current spot market exchange rates. Using forward exchange rates would be inappropriate since it would result in the measured positions reflecting current interest rate differentials to some extent. However, banks which base their normal management accounting on net present values are expected to use the net present values of each position, discounted using current interest rates and valued at current spot rates, for measuring their forward currency and gold positions.

    (c) The treatment of structural positions

8. A matched currency position will protect a bank against loss from movements in exchange rates, but will not necessarily protect its capital adequacy ratio. If a bank has its capital denominated in its domestic currency and has a portfolio of foreign currency assets and liabilities that is completely matched, its capital/asset ratio will fall if the domestic currency depreciates. By running a short position in the domestic currency the bank can protect its capital adequacy ratio, although the position would lead to a loss if the domestic currency were to appreciate.

9. Supervisory authorities are free to allow banks to protect their capital adequacy ratio in this way. Thus, any positions which a bank has deliberately taken in order to hedge partially or totally against the adverse effect of the exchange rate on its capital ratio may be excluded from the calculation of net open currency positions, subject to each of the following conditions being met:

  • such positions need to be of a "structural", i.e., of a non-dealing, nature (the precise definition to be set by national authorities according to national accounting standards and practices);
  • the national authority needs to be satisfied that the "structural" position excluded does no more than protect the bank's capital adequacy ratio;
  • any exclusion of the position needs to be applied consistently, with the treatment of the hedge remaining the same for the life of the assets or other items.

10. No capital charge need apply to positions related to items that are deducted from a bank's capital when calculating its capital base, such as investments in non-consolidated subsidiaries, nor to other long-term participations denominated in foreign currencies which are reported in the published accounts at historic cost. These may also be treated as structural positions.

II. Measuring the foreign exchange risk in a portfolio of foreign currency positions and gold

11. Banks will have a choice between two alternative measures at supervisory discretion; a "shorthand" method which treats all currencies equally; and the use of internal models which takes account of the actual degree of risk dependent on the composition of the bank's portfolio. The conditions for the use of internal models are set out in Part B.

12. Under the shorthand method, the nominal amount (or net present value) of the net position in each foreign currency and in gold is converted at spot rates into the reporting currency. The overall net open position is measured by aggregating:

  • the sum of the net short positions or the sum of the net long positions, whichever is the greater; plus
  • the net position (short or long) in gold, regardless of sign.
  • The capital charge will be 8% of the overall net open position (see example below).

Table 6

Example of the shorthand measure of foreign exchange risk

YEN DM GB£ FFR US$ GOLD
+ 50
+ 100
+ 150
- 20
- 180
- 35
+ 300
- 200
35

The capital charge would be 8% of the higher of either the net long currency positions or the net short currency positions (i.e., 300) and of the net position in gold (35) = 335 x 8% = 26.8.

13. A bank doing negligible business in foreign currency and which does not take foreign exchange positions for its own account may, at the discretion of its national authority, be exempted from capital requirements on these positions provided that:

  • its foreign currency business, defined as the greater of the sum of its gross long positions and the sum of its gross short positions in all foreign currencies, does not exceed 100% of eligible capital as defined on pages 7 and 8; and
  • its overall net open position as defined in the paragraph above does not exceed 2% of its eligible capital as defined on pages 7 and 8.

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