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The most popular methodology implemented in trading is minimizing losses and increasing the potential for return, in order to ensure that losses are kept within manageable limits. This common sense methodology includes:. A position limit is the maximum amount of any currency a trader is allowed to carry, at any single time. The loss limit is a measure designed to avoid unsustainable losses made by traders by means of setting stop loss levels. It is imperative that you have stop loss orders in place.
A method traders use as a guideline when trying to control exchange rate risk is to measure their intended gains against their possible losses.
Authorized Forex Dealer
This is illustrated in detail in a later section. Interest rate risk refers to the profit and loss generated by fluctuations in the forward spreads, along with forward amount mismatches and maturity gaps among transactions in the foreign exchange book. This risk is pertinent to currency swaps; forward outright, futures, and options. To minimize interest rate risk, one sets limits on the total size of mismatches.
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A common approach is to separate the mismatches, based on their maturity dates, into up to six months and past six months. All the transactions are entered in computerized systems in order to calculate the positions for all the dates of the delivery, gains and losses. Continuous analysis of the interest rate environment is necessary to forecast any changes that may impact on the outstanding gaps. Credit risk refers to the possibility that an outstanding currency position may not be repaid as agreed, due to a voluntary or involuntary action by a counterparty.
Credit risk is usually something that is a concern of corporations and banks. For the individual trader trading on margin , credit risk is very low as this also holds true for companies registered in and regulated by the authorities in G-7 countries.
This authority has the strictest rules of any country in making sure that FX companies under their jurisdiction are keeping qualified customer funds secure. It is important for all individual traders to thoroughly check out companies before sending any funds for trading. It is fairly easy to check out the companies you are considering by visiting the authorities' websites:.
Most companies are happy to answer inquiries from customers and often post notices pertaining to security of funds on their website. It should be noted, however, that minimum capital requirements for Futures Commission Merchants "FCMs" registered with the CFTC are much less than those of banks, and under present CFTC regulations and NFA rules, protections related to the segregation of customer funds for regulated futures accounts do not extend fully to funds deposited to collateralize off-exchange currency trading.
Role of Authorized Dealers in Foreign Exchange:
For these and other reasons, the CFTC and NFA discourage any representation that the registration status of a Futures Commission Merchant substantially reduces the risks inherent in over-the-counter Forex trading. Replacement risk occurs when counter-parties of a failed bank or Forex broker find they are at risk of not receiving their funds from the failed bank. Settlement risk occurs because of the difference of time zones on different continents.
Consequently, currencies may be traded at different prices at different times during the trading day.
Foreign Exchange Market and its Important Functions
Therefore, payment may be made to a party that will declare insolvency or be declared insolvent, prior to that party executing its own payments. In assessing credit risk, the trader must consider not only the market value of their currency portfolios, but also the potential exposure of these portfolios. The potential exposure may be determined through probability analysis over the time to maturity of the outstanding position. The computerized systems currently available are very useful in implementing credit risk policies. Credit lines are easily monitored.
In addition, the matching systems introduced in foreign exchange since April , are used by traders for credit policy implementation as well. Traders input the total line of credit for a specific counter-party. During the trading session, the line of credit is automatically adjusted. If the line is fully used, the system will prevent the trader from further dealing with that counter-party. After maturity, the credit line reverts to its original level.
Over-the-counter "OTC" spot and forward contracts in currencies are not traded on exchanges; rather, banks and FCM's typically act as principals in this market. Because performance of spot and forward contracts on currencies is not guaranteed by any exchange or clearing house, the client is subject to counter-party risk -- the risk that the principals with a trader, the trader's bank or FCM, or the counter-parties with which the bank or FCM trades, will be unable or will refuse to perform with respect to such contracts.
Furthermore, principals in the spot and forward markets have no obligation to continue to make markets in the spot and forward contracts traded. In addition, the non-centralized nature of the Foreign Exchange market produces the following complications:. A bank or FCM may decline to execute an order in a currency market which it believes to present a higher than acceptable level of risk to its operations.