Forex Risk Management for AD Banks
What risks a bank's forex book carries, and the two RBI limits that cap them.
Every time an AD bank buys dollars from an exporter or sells euros to an importer, it takes the other side of that customer's currency risk. Until the treasury squares the position in the interbank market, the bank itself is exposed. Forex risk management is the set of limits and controls that stops those positions from growing beyond what the bank's capital can absorb.
CCFE tests this from the bank's side: which risks a forex book carries, how RBI caps them, and how the open position is measured. Customer hedging products are covered on a separate page.
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The Risks a Forex Book Carries
- Exchange (open position) risk
- Loss from rate movement on any currency the bank is net long or net short. This is the risk the overnight open position limit controls.
- Gap (mismatch) risk
- Purchases and sales in a currency that match in amount but not in maturity. The bank is square overall yet exposed to swap points and interest rate moves across the gap. The aggregate gap limit controls this.
- Settlement risk
- The bank pays its leg of a deal but does not receive the counter leg, often because of time-zone differences. Often called Herstatt risk after the 1974 failure of a German bank mid-settlement.
- Counterparty credit risk
- The other side defaults before settlement, leaving the bank to replace the deal at a worse rate.
- Liquidity risk
- The bank cannot fund or close a position at a fair price when it needs to.
- Operational risk
- Loss from human error, failed systems or weak process: wrong value dates, unconfirmed deals, unrecorded late trades.
- Country risk
- Payments stuck because the counterparty's country restricts or delays the outflow of foreign exchange.
RBI's Two Limits on a Bank's Forex Exposure
Both limits are fixed by the bank's board and communicated to RBI. RBI sets only the ceiling.
Net Overnight Open Position Limit (NOOPL)
What it controls
Total net long or short position carried overnight, across all currencies
Ceiling under RBI's Master Direction
25% of the bank's total capital (Tier I plus Tier II)
Aggregate Gap Limit (AGL)
What it controls
Sum of maturity mismatches across all currencies and tenors
Ceiling under RBI's Master Direction
6 times total capital, unless the bank uses superior measures
PV01 and VaR limits (alternative to AGL)
What it controls
Sensitivity of the gaps to rate moves, and potential loss at a confidence level
Ceiling under RBI's Master Direction
Set by the bank itself where it has these superior measures, documented as internal policy
| Limit | What it controls | Ceiling under RBI's Master Direction |
|---|---|---|
| Net Overnight Open Position Limit (NOOPL) | Total net long or short position carried overnight, across all currencies | 25% of the bank's total capital (Tier I plus Tier II) |
| Aggregate Gap Limit (AGL) | Sum of maturity mismatches across all currencies and tenors | 6 times total capital, unless the bank uses superior measures |
| PV01 and VaR limits (alternative to AGL) | Sensitivity of the gaps to rate moves, and potential loss at a confidence level | Set by the bank itself where it has these superior measures, documented as internal policy |
How the Open Position Is Measured
RBI's method works currency by currency first. The open position in one currency is the sum of three parts: the net spot position, the net forward position and the net options position. Assets and purchases make the bank long; liabilities and sales make it short.
Suppose a bank buys USD 1 million forward from an exporter and sells USD 600,000 spot in the interbank market. Its net position is long USD 400,000, and a fall in the dollar costs it money on that amount. If the bought dollars are for three months and the sold dollars settle in two days, the bank also carries a maturity gap, which is why the two limits exist side by side.
Under FEDAI Rule 1.2, a bank dealing beyond the 9 a.m. to 5 p.m. market hours must still keep within its NOOP limit at all times, including the hours between end of day and the next morning's open.
NOOPL, gap limits and risk types, exam style. No signup.
Controls That Keep Risk Inside the Limits
- check_circleA board-approved treasury policy that fixes limits for each treasury function, as RBI requires before any interbank dealing.
- check_circleSegregation of trading from risk management, compliance, deal processing, accounting and settlement (FX Global Code, Principle 24).
- check_circleIndependent mark-to-market: a function outside the front office checks the prices used to value positions (Principle 31).
- check_circleDealer-wise and currency-wise limits, plus internal stop-loss limits, set by the bank under its own policy.
- check_circleSettlement through CCIL: FEDAI rules require member banks dealing in forex forwards to settle interbank forwards through CCIL's guaranteed forward segment, which removes counterparty settlement risk on those deals.
- check_circleCounterparty limits for every bank and corporate the treasury deals with, monitored against live exposure.
How CCFE Tests This
Expect direct recall questions: the NOOPL ceiling as a percentage of total capital, the AGL ceiling as a multiple, and the three components of a currency's open position. The common trap is swapping the two limits, or answering that RBI fixes each bank's limit. RBI sets the ceiling; the board fixes the actual limit within it. Scenario questions name a risk (a counterparty pays late across time zones) and ask you to label it.
FAQs
What is the net overnight open position limit for banks in India?expand_more
Each AD bank's board fixes its NOOPL, which cannot exceed 25% of the bank's total capital (Tier I plus Tier II), and communicates it to RBI.
What is the aggregate gap limit?expand_more
A cap on the total maturity mismatches in a bank's foreign currency book. It cannot exceed 6 times total capital, though banks using PV01 and VaR measures may set their own limits on those measures instead.
How is the open position in a currency calculated?expand_more
As the sum of the net spot position, the net forward position and the net options position in that currency.
What is settlement risk in forex?expand_more
The risk that a bank delivers one currency but does not receive the other, usually because the two legs settle in different time zones. It is also called Herstatt risk.
Next steps
- Swaps and optionsarrow_forward
- Dealing roomarrow_forward
- Forward Contractsarrow_forward
- FEMA & Trade Finance Conceptsarrow_forward
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