TOPIC LIST Syllabus Ref

1 Foreign Exchange Exposure Limit 1/b/(iii)

2 Methodology for computing the Foreign Exchange Exposure Limit 1/b/(iii)
3 Maximum Foreign Exchange Exposure Limit 1/b/(iii)
4 Exceeding the Foreign Exchange Exposure Limit 1/b/(iii)

INTRODUCTION
The Foreign Exchange Exposure Limit represents a cap on the maximum foreign exchange
exposure that a Bank can undertake at the end on any given day. This limit has been imposed by
the State Bank of Pakistan and serves as a Risk Management Tool.

STUDY GUIDE
You should understand the methodology for computing the foreign exchange exposure limit for
currencies as well being able to apply the concept of open positions to commodities as well.

EXAM GUIDE
You may be asked to compute the Foreign Exchange Exposure limit and comment if the bank is
in compliance with the applicable regulations.
You could also be asked to compute the open position for a company dealing in commodities.
The concept is identical to the one used for currencies and therefore if you understand the
concept for currencies you will be able to apply it to commodities as well.

1. Foreign Exchange Exposure Limit

The Foreign Exchange Exposure Limit (FEEL) represents a cap on the maximum foreign
exchange exposure that a Bank can undertake at the end on any given day. This limit has been
imposed by the State Bank of Pakistan and serves as a Risk Management Tool. To ensure that
the Banks adhere to this limit they are required to report the foreign exchange exposure and its
detailed computation to the SBP on a daily basis. The SBP has issued circulars from time to time
providing guidance to the Banks on how to compute / report the FEEL. The following are the two
most important circulars issued by the SBP on the subject:

 Circular Letter No. Cir. 11/FEP.16(326)N-98 dated April 03, 1998 - Guidelines for
calculating the exposure limit

 F.E. Circular No. 12 dated May 29, 1999 – Maximum Foreign Exchange Exposure
Limit

The Banks that are permitted to deal in foreign currencies are called Authorised Dealers.
Therefore all circulars of the SBP to Banks refer to them as Authorised Dealers. It is also
important to remember that the foreign exchange exposure limit was previously referred to as the
Net Open Position and these terms may be used interchangeably.

2. Methodology for computing the Foreign Exchange Exposure Limit

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Circular Letter No. Cir. 11/FEP.16 (326) N-98 dated April 03, 1998 provides a framework for
foreign currency exposure regulation, monitoring, and reporting for commercial banks. The
requirements of this circular have been summarized in the following paragraphs.

The per currency and the overall position limit has been fixed at ten percent of the capital base in
Pakistan of each authorized dealer. The open position is firstly measured separately for each
foreign currency in which the bank is performing transactions or has assets of liabilities. The
open position in a single currency is the sum of:

(a) the spot position and

(b) the off-balance sheet position.

The following steps should be followed when computing the Foreign Exchange Exposure:

1. The net position in each currency is calculated by adding together the net spot position
and net-off balance sheet position for each currency separately. For example, a spot
deposit liability (Foreign Currency Account) matched by an SBP contract (an off-balance
sheet asset) would translate to a zero net open foreign exchange position.

2. Once the exposure has been determined in each individual currency, the second step
is to measure the bank’s overall exposure to foreign exchange risk.

3. Conversion of the net open position in each currency into the equivalent amount of
domestic currency is done by using spot exchange rates. The forward transactions will be
revalued at relevant forward rates instead of spot rates as required vide FE Circular No. 2 of
1999. This means that the banks will have to revalue on daily basis each individual
outstanding forward transaction by taking the forward rate for the remaining tenor of the
contract.

Exchange rates

The spot rates and forward rates are notified by the SBP and are also referred to as Mid-
rates. In an exam question you will be given these rates and will simply use them to convert
the foreign currency amount into domestic currency.

4. Aggregation of the domestic currency equivalent values of all foreign currency short
positions and of all foreign currency long positions.

5. Comparison of the two totals, and selection of the greater of the two, which is defined as
the overall exposure of the bank.

The foreign exchange exposure limit can be divided into the following two types of limits:

 Single currency exposure limit

 Overall currency exposure limit

2.1 Single Currency Exposure

Single currency exposure limit is the maximum foreign exchange risk exposure on any single
currency (foreign or local).

The Banks is required to maintain its foreign exchange risk position as at close of business each
day in any single currency within 10 percent of its capital. In addition, the Banks also maintains its
intraday foreign exchange risk position in any single currency within prudent boundaries.

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The foreign exchange risk position of a commercial bank in a given single currency shall mean
the domestic currency equivalent amount multiplied by the currently prevailing spot buying foreign
exchange rate, of the foreign currency amount in connection with which the bank will be subject
to a gain or loss if there is a variation in the exchange rate of that currency.

2.2 Overall currency exposure

Overall currency Limit refers to the maximum overall foreign exchange risk exposure that a bank
may undertake.

The overall foreign exchange risk position as at close of business each day of any commercial
bank shall not exceed 10% of the capital of the bank. In addition the Bank shall maintain its
intraday overall foreign exchange risk position within prudent boundaries.

The overall foreign exchange risk exposure is the sum of the equivalent amount in domestic
currency of all net short or long positions (whichever is greater) in currencies in which the
commercial bank has positions.

In calculating, foreign currency exposure in each single currency is defined as the domestic
currency equivalent sum, currency by currency, of all foreign currency denominated assets and
liabilities. No foreign currency denominated assets or liabilities can be deleted, unless it has been
explicitly agreed with the supervisory authorities not to include that item (structural positions).
Furthermore, the calculation shall include also the net forward (off-balance sheet) position in each
currency.

2.3 Spot position – items to include

The spot position in a currency is the difference between assets and liabilities denominated in
that currency, as they appear in the balance sheet. In particular, this includes

accrued income and expenses:

interest on loans and
inter bank borrowing and
other income earned but not yet received,
interest due to depositors,
interbank providers of funds
administrative expenses not yet paid,

as they appear in the relevant accounts of the bank applying the accrual principle.

According to this principle, unearned future interest and expenses should not be included in the
position, since they are not yet recorded in the books. For instance, a bank borrows in foreign
currency on the interbank market for one year, with all interest payable at the end. The principal
amount is of course included in the position as soon as it is received. The appropriate amount of
accrued interest is booked at the end of each month in the account tracing interest due but not
yet paid. Therefore, interest is included in the position in monthly tranches.

However since banks should know exactly how much interest they will have to pay at the end of
the year, some banks find it more prudent to hedge the total amount of interest immediately. To
hedge these interest payments without creating an artificial position, they need to include this
interest in the position, even before it has been booked. Such a procedure, based on a prudent
approach, should be considered as acceptable, provided that it is fully documented and applied
by the bank in a consistent way.

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Structural positions, like long-term participation in the capital of other banks and enterprises, are
usually also deducted from the spot position.

2.4 Off-balance sheet (forward) position

Off-balance sheet items included all foreign currency denominated assets and liabilities not
included in the balance sheet, these transactions are recorded in the off-balance sheet section of
the bank’s books. Among these, forward transactions are typically the most common. The forward
position includes all amounts to be received less all amounts to be paid at a future value date as
a result of foreign exchange transactions which have already taken place.

Off-balance sheet items include:

 Spot foreign exchange transactions which have not yet been settled. When the day’s deal
is done, banks must record the amount to be received of the bought currency and the
amount of the sold currency to be delivered in specific off-balance sheet accounts. When
the deal is actually settled (usually two working days later), the off-balance sheet account
are purged and the relevant accounts of the balance sheet incremented.

 Forward foreign exchange transactions: A procedure identical to the one fore

outstanding spot transactions should be used, with the difference that the delay between
transaction and settlement dates will be longer.

 Guarantees and similar commitments denominated in foreign currencies, but only if they
are certain to be called upon and likely to be irrecoverable.

Other principles

The following principles shall be applied:

- no undervaluation shall take place. Assets are to be marked to market.

- Accrued interest is to be included, wherever applicable.
- Balance sheet and off-balance sheet (forward etc) exposures to be
reported separately but added together to arrive at overall exposure.

2.5 Sample calculation of Foreign Exchange Risk Exposure

This section provides an example of how to calculate the actual outstanding related to the limit of
the overall foreign exchange risk exposure and to the limit of the foreign exchange risk exposure
on any single foreign currency of a bank with capital of 900,000 and the following foreign
exchange positions:

Currency On balance sheet Off balance sheet Net Position

Assets Liabilities Assets Liabilities Long Short
(Expected (Expected + -
Inflows) Outflows)
A B C D TOTAL ASSETS (A+C) > TOTAL LIABILTIES (B+D)
TOTAL LIABILITIES (B+D) > TOTAL ASSETS (A+C)
USD 100,000 (50,000) 25,000 (25,000) 50,000
GBP 50,000 (54,000) 35,000 (45,000) (14,000)
EURO 35,000 (35,000) 45,000 (19,000) 26,000
CHF 45,000 (48,000) 32,000 (34,000) (5,000)
JPY 20,000 (18,000) 39,000 (33,000) 8,000

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 Total Long / Short position 84,000 19,000

Capital of the bank: Rs 900,000

COMPARING THE LIMIT WITH THE ACTUAL EXPOSURE COMPUTATION

The maximum permitted foreign exchange exposure limit = Capital x 10%

900,000 x 10% = 90,000
The Foreign Exchange Exposure of the bank = 84,000
(higher of the long / short
position in absolute terms)

Conclusion:
The bank is in compliance with the overall foreign exchange exposure limit set by the State Bank
of Pakistan as its total exposure is within the limit prescribed by the State Bank of Pakistan.

Important terminologies – Types of positions

The amount of assets and liabilities determine the position of the Bank. The following 3 positions
are possible.

 If total assets are greater than total liabilities the bank is overbought and the position is
long.

 It total liabilities are greater than total assets the bank is oversold and the position is
short.

 If assets and liabilities are equal the position has been squared.

SUMMARY OF STEPS TO FOLLOW WHEN COMPUTING THE FOREIGN EXCHANGE

EXPOSURE-

1. Prepare the format in which you are going to plot the positions – be sure to include
enough space to incorporate all the currencies.
2. Multiply the on balance sheet positions with the spot rate and the forward positions with
the applicable forward rate (if a forward rate has not been given in the question use the
spot rate and mention that the forward rate has not been used as it has not been
provided)
3. Plot the total position either in the long or short column for each currency
4. Total the long and short positions columns
5. Select the higher of the long / short positions
6. Compare the higher figure with the capital of the bank and comment if the bank is in
compliance with the applicable regulations.
7. Also compare the individual positions currency wise with the capital of the bank. If the
bank is in compliance with the overall exposure limit set by the SBP it will be surely in
compliance with the individual currency exposure limit. This is because if the total
exposure of the bank is within the limit prescribed the individual exposure will definitely be
within limit. Another way of looking at this is that the total exposure is a sum of the
individual exposures and therefore if total exposure is within limits the individual exposure

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can not be out of bounds.

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EXAM TIPS -

The question in the exam will require you to compute the Foreign Exchange Exposure / Net open
position for a particular bank and you will be provided with details of on and off balance sheet
exposures. Keep the following instructions in mind when attempting such question:-

1. Only take into account foreign currency assets / liabilities when computing the FEEL i.e.
do not take into account Pak Rupee assets and liabilities as these do not need to be
included when computing the FEEL.
2. Included the forward contracts at the forward rates. If the forward rates have not been
provided in the question use the spot rates. Make a note mentioning that you have used
the spot rates because the forward rates were not available and that the correct rates to
use are the forward rates.
3. Do not long and short positions. Place all long positions in a separate column and do the
same for the short positions. Then select the higher of the two totals i.e this can be either
the long or short position. This figure is the current foreign exchange exposure of the
bank and should be compared with the limit to arrive at a conclusion regarding the bank’s
compliance with the applicable regulations.
4. You also need to demonstrate to the examiner that you are aware of the existing
regulations. Therefore if figure for capital has not been given, the appropriate thing to do
is just to write down that the maximum exposure that the bank is permitted to undertake is
10% of capital and since the figure for capital has not been given it is not possible
comment on the bank’s compliance with the applicable regulations.

 A variation to the usual question on the FEEL / NOP is asking the students to calculate
the open position on a commodity (QS XX ATTEMPT: XX-XXX). You don’t need to get
confused because the concept used to calculate the open position of a currency can be
applied to commodities as well.
 For commodities the stock in hand is an asset, forward purchase contracts are future
inflows and therefore will be added to your existing position. The sale of the product is an
outflow and therefore needs to subtracted when arriving at the net position. If you are
required to square the position take the stock in hand and deduct sales from this figure to
arrive at a balancing figure. This figure represents the current open / unhedged position.
To cover this position you can use forward purchase contracts of appropriate maturity /
quantity.

2.6 Summary of on and off balance sheet assets / liabilities

The following table summarises the classification of various types of on and off balance sheet
assets and liabilities:
ON BALANCE SHEET OFF BALANCE SHEET
Assets Liabilities Assets Liabilities
Cash balances Foreign Currency Forward foreign Forward foreign currency
Deposits currency purchase sale contracts
contracts
Interest receivable Interest payable Foreign Bills
Purchased
Nostro balances All liabilities Unsettled spot Unsettled spot
denominated in foreign transactions buy transactions sale
currency
Foreign currency investments
Foreign currency placements
Foreign currency loans
All assets denominated in
foreign currency

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3. Maximum Foreign Exchange Exposure Limit

The F.E. Circular No. 12 dated May 29, 1999 contains further guidance by the SBP on the
maximum limit of FEEL. The FEEL set by the State Bank is computed with reference to the
paid up capital of the Bank (Authorized Dealers) and is denominated in Pak. Rupees.

The aggregate exposure limit for every bank is equivalent to 10% of its paid-up capital with
maximum and minimum limits of Rs. 500 million and Rs. 50 million respectively. The
assigned capital required to be maintained by branches of foreign banks in Pakistan under
section 13(3) of Banking Companies Ordinance 1962 is deemed as paid-up capital for the
purpose computing FEEL. For banks incorporated in Pakistan the limit covers all the branches
including overseas branches, if any. If the paid-up capital of a bank is increased, it may apply
for the enhancement of its Exposure limit to the State Bank.

All foreign exchange activities including those arising out of trade transactions, remittances etc.,
shall be conducted within the given Exposure Limit.

4. Exceeding the Foreign Exchange Exposure Limit

If a Bank intends to exceed the maximum limit prescribed by the SBP it is required to obtain
prior approval. Once approval has been obtained the Bank can exceed the limit up to the extent
permitted by the SBP. If the Bank does not obtain approval or if after obtaining approval exceeds
the revised threshold it may be subject to penalties.

The bank may also be subject to penalty if the Foreign Exchange Exposure is not computed in
accordance with the methodology prescribed by the SBP.