Let us measure the MTMs and understand where they lead to….FOR BANKS

As we understand in a forward contract, there are two parties, one is the buyer (party who has taken a long position) and the other one is the seller (party who takes short position). When the forward contracts are marked to market, based on the market value / spot price of the underlying asset, the parties in the forward contracts will have either Positive MTM or Negative MTM.

Having Positive MTM can be described as receivables (asset) as on that date and the Negative MTM refers to payables (Liability). Let us take one forward contract and understand the implications of the forward contract to Banks.

Current Date:	06.05.2016 (Assumption)
Forward price fixed by an Exporter with the Bank for USD to INR	$100,000 (The Bank agrees to buy USD from an exporter) The exporter agrees to sell $100,000 to the Bank.
Forward Contract price	$66.00
Date of Forward Contract /agreement	06.04.2016
Date of Delivery	06.04.2017
Items to be delivered	The exporter has to deliver $100,000 to the Bank
Place of Delivery	OTC contract, at one of the agreed branches
Today’s price /( INR / USD quote)	Rs68 per USD
Today’s MTM for the Bank	The MTM is positive by Rs200,000
Today’s MTM for the exporter (seller of the forward contract)	The MTM is negative by Rs200,000
Risk for the Bank	Counterparty Credit Risk (The definition of Counterparty Credit Risk) is already discussed earlier in my blog)
What does the positive MTM for Bank	It is receivable for the Bank (An Asset is created for the Bank – off Balance sheet)
Capital Adequacy Guidelines in this regard
Let us discuss the risks to the Bank in this regard..
1.      The exporter may not sell the USD to the Bank (Because he can sell in the market for Rs68 per USD,  instead of selling at Rs66 per USD to Bank)
2.      This means, the Bank may lose the Positive MTM (asset impairment)
3.      By the date of delivery, there are chances that the exporter’s credit worthiness may also go down.
4.      Further depreciation of Rupee against USD, would lead to increase of positive MTM for the Bank.
5.      This implies, the current exposure of the Bank is Rs200000 and the rupee depreciation may lead to future exposure of the Bank
6.      For creating all types of assets, the Bank has to provide capital. Let us look into the capital charge in these transactions
Total capital charge = (Current Exposure + Potential Future Exposure) x capital adequacy percentage in the respective country
ð  Current Exposure = Rs200000
ð  Potential future exposure: This is nothing but likely increase of the MTM of the Bank. The Bank is already having a positive MTM of Rs200000 and with the depreciation of rupee, the MTM of the Bank may increase in future
ð  How to compute the Potential Future Exposure (PFE): Banks use an add – on factor for computing the PFE. For all the forward contracts having a maturity within 1 year, the Banks use an add-on factor of 1%. This means, the Potential Future Exposure (likely chances of further positive MTM) is 1% of Notional Amount of the forward contract. ð  Notional amount of forward contract = $100000 x Rs66 = Rs6600000 ð  PFE = 1% of Rs6600000 ð  PFE = 66000
ð  Total Exposure of the Bank = Current Exposure + Potential Future Exposure ð  Current Exposure ( Rs200000) + Potential Future Exposure (Rs66000) ð  Total exposure of the Bank in this Forward Contract = Rs266000
ð  Capital Charge = 266000 x 9% capital charge ð  Capital Charge = Rs23940
LET US NOT DO THE THINGS MECHANICALLY….LET US UNDERSTAND THE CONCEPTS AND LOGIC BEHIND THE RULE