Risk management of exchange rate in forex trading case study of commercial banking system in ho chi minh city

NGÔ TRẦN KIẾN QUỐC RISK MANAGEMENT OF EXCHANGE RATE IN FOREX TRADING CASE STUDY OF COMMERCIAL BANKING SYSTEM IN HO CHI MINH CITY MAJOR: BANKING AND FINANCE MAJOR CODE: 60.31.12 MAS

UNIVERSITY OF

NGÔ TRẦN KIẾN QUỐC

RISK MANAGEMENT OF EXCHANGE RATE

IN FOREX TRADING CASE STUDY OF COMMERCIAL BANKING SYSTEM

IN HO CHI MINH CITY

MASTER THESIS

Faculty of Banking

Ho Chi Minh City – 2010

2010

NGÔ TRẦN KIẾN QUỐC

RISK MANAGEMENT OF EXCHANGE RATE

IN FOREX TRADING CASE STUDY OF COMMERCIAL BANKING SYSTEM

IN HO CHI MINH CITY

MAJOR: BANKING AND FINANCE

MAJOR CODE: 60.31.12

MASTER THESIS

SUPERVISOR Associate Professor Ph.D TRẦN HUY HOÀNG

Faculty of Banking

Ho Chi Minh City

2010

IN HO CHI MINH CITY

Certificate……… ……….… ……… …………i

Acknowledgement……… ……….….…………i

Abstract……….……….……….……….………… iii

Table of contents……… ……….………….…….……… iv

List of tables……….……….……….……… ………v

List of graphs.……….……….…….………….vi

Abbreviations………….……….…….………vii

Chapter one: Introduction to the study……… 1

1.1 Rationale of the study……….……… 2

1.2 Research problem……… ………… 3

1.3.1.1 Research questions……… 3

1.3.1.2 Research objectives……… ………… 3

1.3 Justification for the study……….……… ………… 4

1.4 Research methodology……… ……… ………… 4

1.5 Research subject and scope of the study……… ……… ……… 5

1.6 Significance of the study……… ……… ……….5

1.7 Structure of the study……… ……….6

1.8 Limitations of the study……….7

1.9 Conclusions ………8

Chapter two: Literature review………9

2.1 Introduction to the foreign exchange market……….10

2.1.1 Overview of establishment & development of forex market……….10

2.1.2 The Viet Nam foreign exchange market (VINAFOREX)……….………….14

2.2 Exchange rate and risk management of exchange rate….….……….………….………18

2.2.1 Definition of exchange rate……… ……….….……19

2.2.2 Classification of exchange rate.……… ……… 19

2.3 Types of foreign exchange transactions……….….21

2.3.1 Spot transaction……….……….21

2.3.2 Forward transaction……….……….……21

2.3.3 Swap transaction……….……….…21

2.4 Risk management of exchange rate……….……… …… ……… 23

2.4.1 Definition of risk management of exchange rate…… ……….23

2.4.2 Factors influence risk management of exchange rate……… 24

2.4.3 Identification of exchange rate risk…….… ………26

2.4.4 Exchange rate risk analysis and measurement of banks……….28

2.4.5 Risk management of exchange rate with Long or short position in net exposure……… ……… 29

2.4.6 Risk management of exchange rate with Long or Short position in net total exposure……….……… ……… 30

2.4.7 Classification of risks associated with foreign exchange operation.33 2.5 Legal foundations for spot transaction and derivative transaction ………34

2.6 Conclusions……… ……….35

Chapter three: Research Methodology……… ……….…….36

3.1 Introduction……….37

3.2 Research design ……… 38

3.3 Data collection……….41

3.3.1 Document Collection……….……… 42

3.3.2 Personal Interviews……….……… 43

3.4 Data analysis……… 46

3.5 Conclusions……….48

Chapter four: The current situation of risk management of exchange rate in foreign currency trading operation of commercial banking system in Ho Chi Minh city……… ……… ……50

4.1 Overview of commercial banking system in HCMC………51

4.2 Overall assessment of money market and banking operations in HCMC…53 4.3 Overview of Forex operations of commercial banking system in HCMC.56 4.3.1 Foreign currency trading operation……….……….……….62

4.3.2 Experience of risk management of exchange rate from Vietnam Bank for Agriculture and rural development’s transaction exposure…… ……… 64

4.3.3 Treasury organization and relation ship with other departments…66 4.3.4 Fluctuations of exchange rate USD/VND during year from 2007 to 2009……… ……71

4.3.6 Current risk management of exchange rate of commercial banking

system in HCMC……….76

4.4 The current application of derivative instruments for preventing exchange rate risk of commercial banking system in HCMC………80

4.4.1 Forward transactions……… ……….……….80

4.4.1.1 The current application of forward contracts of commercial banking system in HCMC….……….……… ………80

4.4.1.2 The current forward rate setting……….82

4.4.1.3 Factors affecting to forward transactions of commercial banking system in HCMC……….……… 83

4.4.1.4 Conclusion……….……….………87

4.4.2 Currency option……… ……….……… …………87

4.4.2.1 The current application of currency Option of commercial banking system in HCMC……… ……….87

4.4.2.2 Option premium………88

4.4.2.3 Conclusion……….……….90

4.5 The evaluation of outcome performance on risk management of exchange rate of commercial banking system in HCMC……….90

4.5.1 Achievements………90

4.5.2 Shortcomings….………92

4.5.2.1 Shortcomings from SBV’s forex management policy………92

4.5.2.2 Shortcomings from commercial banking system in HCMC………93

4.5.3 Causes……….………96

4.5.3.1 From forex management policy of SBV……….……… ….………….96

- No flexibility of exchange rate policy of SBV……….………… 97

- Objects participating interbank forex market is limited and less efficient intervention made by SBV ……… …… 98

- Situation of high inflation and trade deficit ……… ……… 98

- Unsuitable regulation of forward rate setting… ……….98

- Lack of legal framework guiding for forward and option transactions 98

4.5.3.2 From commercial banking system in HCMC….….………99

- Most of local commercial banks have not developed self-forex trading yet and rarely use derivative instruments for hedging risk of exchange rate 99

- In charge of combined responsibilities lead to lack of supervising and

checking trading limits, loss limit and forex report to SBV ……….10

- Depending on option premium of foreign banks……….………101

4.5.4 Conclusions….……….……….….101

Chapter five: Recommendations and Conclusions………103

5.1 Introduction……….……….….104

5.2 Recommendations for improvement of risk management of exchange rate of commercial banking system in HCMC……… ……… 104

5.2.1 Suggestions for State bank of Viet Nam………104

5.2.1.1 Improvement of spot market……….……… 104

5.2.1.2 Strengthening regulation on forex position……….105

5.2.1.3 Adjusting regulation to forward rate setting………106

5.2.1.4 Establishment of option interbank market ……….107

5.2.2 Recommendations for commercial banking system in HCMC………….107

5.2.2.1 Building business strategies and customer policy.……….107

5.2.2.2 Standardizing structure and process of operational Treasury…….108

5.2.2.3 Improvement of modern equipments and information technologies for treasury operation……… ……… ……….………109

5.2.2.4 Enhancing for training banking staffs to improve ability of analyzing and forecasting fluctuations of exchange rate in forex operation…109 5.2.2.5 Diversifying types of foreign currencies in the international trade……… 109

5.2.2.6 Strengthening the application of derivative instruments for hedging risk of exchange rate………110

5.3 Conclusions related to research questions……….110

5.4 Implication for further study……….112

References ……… viii

Appendices ix

Survey results… ……… x

Viet Nam has emerged as a rapidly growing economy in the last few years with the average growth rate of over 7% per year in which the banking system has developed strongly and efficiently and play a crucial role as connection between domestic and international financial market However with internal economic difficulties caused by high inflation, trade deficit and issues of government policy and unfavorable changes in the world economy, the banks, especially small and medium banks, have found obstacles on the way to develop due to lack of management experience and approaching new information technologies in banking field The thesis examines a case study of Commercial Banking System in Ho Chi Minh City to see the way they manage their risk of exchange rate and how strong financial instruments are used to prevent risk of exchange rate.

Objectives of the thesis are (1) to gain an understanding of risk management of exchange rate in theory; (2) to approach the recent method of risk management of exchange rate in foreign currency trading operation of commercial banking system in HCMC and the real application of derivative instruments for preventing risk of exchange rate of commercial banking system in HCMC from 2007 to 2009; (3) to figure out practical issues to be solved in risk management of exchange rate in foreign currency trading operation; (4) to suggest some recommendations for improving risk management of exchange rate of commercial banking system in HCMC

the research problem which can be clarified by research questions and research objectives By using survey method in combination with sources of secondary data of commercial banking system in HCMC for 2007 to 2009, the research problems of risk management of exchange rate in foreign currency trading operation of commercial banking system in HCMC have been explored and highlighted by pointing out factors affecting to the current method of risk management of exchange rate of CBS-HCMC Some practical issues of risk management of exchange rate of commercial banking system in HCMC are pointed out in which achievements, shortcomings and causes are investigated in order to raise some recommendations for improvement of risk management of exchange rate in foreign currency trading operations of commercial banking system in HCMC in particular

The research study focus on risk management of exchange rate in foreign currency trading operation of commercial banking system in HCMC by controlling forex position and using solutions for preventing risk of exchange rate on many types of forex transactions which include spot, forward, swap and option transactions Based on literature review, recent foreign exchange regulations issued by State bank of Viet Nam and current situation of risk management of exchange rate of CBS-HCMC, the research study hope for contributing some general and specific recommendations for commercial banking system in HCMC as well as practical forex market of Viet Nam in long run

1/ The thesis provided interesting assessments on Vinaforex and forex trading markets among commercial banking system in Ho Chi Minh city 2/ The thesis looked at one of heatly-debated topics with a different focus on the risk originated from the forex trading operation and the ways of management of such risk

3/ The study target is meaningful, both academically and practically

4/ The thesis has covered a wide range of outstanding practical issues in the area of foreign exchange risk and risk management in Viet Nam

5/ The thesis adds at least 02 importance contributions to the literature as follows:

- The thesis has reflected a number of perceptions on foreign exchange risk and risk management from senior level of related authorities and bankers

- The thesis has furnished evidence of the importance of the management of foreign exchange risk (Bank for agriculture and rural development of Viet Nam; Bank for foreign trade of Viet Nam’s experiences)

6/ The thesis also focus on the application of derivative instruments for hedging risk of exchange rate in forex trading by adjusting regulations to forward rate setting

The new points of forward rate setting as suggested are as follows:

+ Based on interest rates of deposit and loan of commercial banks, forward rate are consistent with real condition of market and narrow the difference between forward rate and spot rate at the same duration

+ Buying and selling forward rate are defined specifically making commercial banks comfortable to deal with customers and check it again

I would like to express my deep gratitude and warmest appreciation

to my research Supervisor, Dr Tran Huy Hoang for his precious guidance, share of experience, ceaseless encouragement and highly valuable suggestions throughout the course of my research I would like to thank to many of my colleagues from SBV, who have helped me during the collection of data as well as support me during doing research: Ms Nguyen Van Dung, Mr Nguyen Hoang Minh vice director, Mr Hoang Truong Giang,

Ms Nguyen Ngoc Binh, and my friends from operational Treasury departments of commercial banks in Ho Chi Minh city My special gratitude is extended to all instructors and staff at Faculty of Banking and Postgraduate Faculty, University of Economics Ho Chi Minh City (UEH) for their support and the valuable knowledge during my study in UEH I would also like to avail this opportunity to express my appreciation to Professor Nguyen Dong Phong, UEH Board of Directors for creating MBA program in English and Dr Tran Ha Minh Quan for his support during the course Specially, my thanks go to Ms Nguyen Thi Diem Thuy for her valuable and enthusiastic support for this research study and for her comments of English from early draft of my thesis Last but not least, the deepest and most sincere gratitude goes to my group of research for their boundless support, abundant love and encouragement throughout my period

of study I, therefore, dedicate this work as a gift to them all

HCMC : Ho Chi Minh City

EIB (Eximbank) : Export and Import joint stock commercial bank

Agribank : Bank for Rural and Agriculture of Viet Nam

Graph 4.1- Organization chart of credit institution system in HCMC………….52

Graph 4.2- The forex profit compared with income before tax of commercial

banks in HCMC from 2007 to 2009………58

Graph 4.3- The forex profit breakdown by four types of commercial banks in HCMC from 2007 to 2009……….….59 Graph 4.4- Graph of Forex profit breakdown by Spot-Gold-Other of CBS-

HCMC from 2007 to 2009……… 61 Graph 4.5- Forex profit column of Spot-Gold-Other breakdown by four types

of CBS-HCMC from 2007 to 2009……….61 Gragh 4.6- Forex turnover breakdown by four types of CBS-HCMC from

2007 to 2009……….64 Gragh 4.7- Treasury Organization of VCB……… 68 Graph 4.8- Relationship between forex trading department and other departments of VCB-HCMC………71 Graph 4.9- The fluctuations of exchange rate of SBV, VCB and free market between USD and VND during year 2007 to 2009……….74 Graph 4.10- Forward turnover compared with Forex turnover of CBS-HCMC during 2007 to 2009……….82

Graph 4.11 Forward rate in term of 01 month, 2 months and 3 months

compared with spot rate of CBS in HCMC from 2007 to 2009……… ……86 Graph 4.12 Research process

Table 3.1- Questionnaire for interview………44

Table 4.1- Net work of credit institution in HCMC……… ……….…………52

Table 4.2- Data of total charter capital, total fund mobilization, total loan

outstanding and Profit & Loss statement of CBS-HCMC from 2008-2009.53

Table 4.3- Profits from foreign exchange operation of CBS-HCMC from

2007 to 2009……….58

Table 4.4- Profitability arising from Spot, Gold and Other transactions

breakdown by four types of CBS in HCMC from 2007 to 2009……… …….60

Table 4.5- Forex turnover of commercial banks in HCMC from 2007 to

2009….……… ……… 63

Table 4.6- EURO/USD transactions and total losses of 28,3 million EURO at

Transaction office II of Agribank ……… 65

Table 4.7 : Growth rate of exchange rate USD/VND breakdown by three

types of SBV, VCB-TPHCM and free market from 2007 to 2009 ….…74

Table 4.8 : Report of position at the end of day from Asia bank………77

Table 4.9 : Growth rate of forward turnover of commercial banks in HCMC

from 1998 to 2009……….……….81

Table 4.10 : Turnover of Forward buying and selling in comparison with total

forex turnover from 2007 to 2009 ………81

Table 4.11- Forward rate and spot rate at the due date of forward contract

from year 2007-2009……… 85

No Full name Position Organization

CHAPTER I INTRODUCTION TO THE STUDY

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1.1 Rationale of the study

Viet Nam has gradually integrated into the global economy arena after officially becoming a member of the world trade organization (WITCO) at the end of year 2006 Together with the process of economy liberalization, the priority of economic sectors is financial banking industry This opportunity help Viet Nam banks get favorable conditions in banking activities but also face with a lot of pressure on competition The economy liberalization leads to liberalizing capital flows, interest rate and foreign exchange rate… The current financial crisis clearly shows how complex financial market is and that risk management of exchange rate will become more important to protect commercial banks from damages or losses toward their foreign exchange operation Basically, most Viet Nam banks’ profit focus on credit operations accounting for 70 - 75% of total income and not yet concern much about preventing risk of exchange rate Nowadays the fluctuations of exchange rate, interest rate, gold price in international market have effected strongly to domestic market creating many new types of financial derivative instruments and investment funds which forced commercial banks to protect themselves by using more hedging tools in foreign exchange operation; Therefore, Vietnamese banks need to upgrade capacity of risk management, especially risk of exchange rate that will be considered in this research study and contribute some improvements for managing risk of exchange rate of commercial banking system in Ho Chi Minh City (HCMC)

1.2 Research problem

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The research problem mentioned in this research study is the risk management of exchange rate in foreign currency trading operation of commercial banking system in HCMC so that the research study needs to investigate and describe the recent method risk management of exchange rate

of commercial Banking System in HCMC, then point out some practical issues

to be solved in and suggest recommendations for improving the current risk management of exchange rate of commercial banking system in HCMC

1.2.1 Research questions

The research study will answer for the following questions:

a Why does the risk management of exchange rate of commercial banks have to be considered and What are the factors affecting to risk

management of exchange rate?

b What are the current method of risk management of exchange rate and the practical issues to be solved in foreign currency trading operation of commercial banking system in HCMC?

c What are the recommendations for improvement of risk management

of exchange rate in foreign currency trading operation of commercial banking system in HCMC?

a To gain an understanding of risk management of exchange rate in theory

b To approach the recent method of risk management of exchange rate and the real application of derivative instruments for preventing exchange rate

in foreign currency trading operation of commercial banking system in HCMC from 2007 to 2009

c To figure out practical issues to be solved in risk management of exchange rate in foreign currency trading operation of CBS-HCMC

d To suggest some recommendations for improving risk management of exchange rate of commercial banking system in HCMC

1.3 Research methods

The methods used in this research study are survey method and secondary data method Survey method is conducted by using primary data through depth-interviews from banking experts of commercial banking system and secondary data method is performed by using secondary sources of data from banking magazines, annual reports of State bank of Viet Nam and a

number of Commercial Banking System’s report

1.4 Justification for the study

Basically, Viet Nam banks have to scope with many level of risks in foreign exchange operations such as exchange rate risk, interest rate risk, liquidity risk, settlement risk, counterparty risk, operational risk, country risk

in which commercial banks are always facing with exchange rate risk So the

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goal of risk management is to protest banks from non-estimated damages due

to the fluctuation of those elements mentioned above in the international and domestic market, reduce influences of sensitive market movements towards the foreign exchange operations, strengthen the ability of competition for banks So far the risk management of exchange rate has strongly developed in international financial markets However, Viet Nam banks as well as commercial banking system in HCMC are still unfamiliar with preventing damages or losses from their foreign exchange operation Therefore, the research study aims at helping Viet Nam banks to recognize some practical problems in risk management of exchange rate in foreign currency trading operation in comparison with theory as well as foreign exchange regulations

of State bank of Viet Nam and get more experiences of risk management of exchange rate to protect themselves from damages or losses due to fluctuations of exchange rate

1.5 Subjects and scope of the study

It is likely that the research study only focus on risk management of exchange rate in foreign currency trading operation of commercial banking system in HCMC for a period of three years from 2007 to 2009

The research study will not analyze risk management of exchange rate for gold trading operation, credit operations, fund mobilization, activities of investment and other banking services

1.6 Significant of the study

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Finalizing research problem will provide some recommendations for commercial banking system in HCMC to improve risk management of exchange rate in foreign currency trading operation; to help commercial banks

in HCMC to identify , measure and control transaction exposures efficiently;

to upgrade the ability of risk management of exchange rate to create value by maximizing the return for the level of risk that the banks are prepared to accept

1.7 Structure of the study: The research study consists of five chapters

Chapter I reviews the rationale of the study, and presents research problem, research methodology, subjects and scope of the study, significance

of the study

Chapter II examines the background information of the foreign exchange market, the characteristics and development of the Viet Nam foreign exchange market Especially, this chapter is also to review some foreign exchange literature and methods of exchange rate risk management used for commercial banks in theory to identify, analyze and measure risk of exchange rate in foreign currency trading operation

Chapter III is to describe, justify, and explain the research methodology used in the study The research process starts from problem definition, which include exploratory research conducted to clarify ambiguous problems After identifying research problem, the research design must be developed A research design is a master plan specifying the methods and procedures for

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collecting and analyzing the needed information to answer the research questions outlined in chapter I

Survey a real case of commercial Banking System in HCMC is presented in chapter IV This chapter presents descriptive findings of exchange rate risk management practices Objectives of this chapter are (1) to observe the current situation of foreign exchange operation in foreign currency trading operation of commercial Banking System in HCMC from

2007 to 2009 and the real application of derivative instruments for preventing exchange rate of commercial banking system in HCMC, (2) to point out practical issues to be solved in risk management of exchange rate (3) to evaluate outcome performance of risk management of exchange rate risk of commercial banking system in HCMC of which the highlights of achievements, shortcomings as well as main causes effects to risk management of exchange rate risk of commercial banks in HCMC

Finally, chapter V will provide some conclusions and recommendations for improving risk management of exchange rate of commercial banking system in HCMC

1.8 Limitations of the study

The foreign exchange market is one of complex financial market affected

by many economic factors in which Vietnamese bank is one of subjects participating in the market and facing with many difficulties Methods of risk management of exchange rate mentioned in this research study mainly focus

on risks of exchange rate towards foreign currency trading operation of

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commercial banking system without doing researching on interest rate risk, liquidity risk, operational risk, country risk, legal risk

To enhance risk management of exchange rate of commercial banking system efficiently, the research study needs to learn more about the risk management of exchange rate in relationship between foreign currency trading operation and credit operation, capital mobilization as well as other investment activities

Due to the restrain of author’s experiences, the research study could not solve all aspects of risk management of exchange rate that will continue to be completed by other research

1.9 Conclusion

The research problem of risk management of exchange rate in foreign currency trading operation of commercial banking system will be explored and clarified to provide some recommendations for improvement of risk management of exchange rate through practical issues pointed out in foreign currency trading operation of commercial Banking System in HCMC

The method of risk management of exchange rate of commercial banks

is more complicated than that of company because commercial banks have a lot of forex transactions with many types of foreign currency and different durations which create receivables and payables in foreign currency of balance sheet of commercial bank Therefore, the research study hopes for

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contributing a part of solutions on risk management of exchange rate in

foreign currency trading operation of commercial banking system in HCMC

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CHAPTER TWO LITERATURE REVIEW

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2.1 Introduction to the foreign exchange market

2.1.1 Overview of the establishment and development of Foreign exchange Market:

The establishment and development foreign exchange market has connected with demand of transactions and currency exchange among countries to serve for social economic activities, especially aims to support for development of foreign trade Compared with domestic trade, transactions in foreign trade are related to many kinds of foreign currencies from different countries Based on the practical import and export activities all over the world, a new mechanism that helps import-export companies to transfer their local currency into foreign currency to make oversea payments is the foreign exchange market Therefore, the establishment of foreign exchange market is original and associated with the progress of foreign trade So the world foreign exchange trading centers like London, New York, Tokyo or the region of foreign exchange trading platform such as Frankfurt, Zurich in Europe or Hong Kong, Singapore, Sydney, Bangkok, Shanghai, Manila in Asia that are almost established in relation with development of domestic and international commercial trade center in full range of business transactions

a Definition: Foreign exchange market is a market where people buy or sell

foreign currencies

b Characteristics of foreign exchange market:

Foreign exchange market trade in special commodity, “Money commodity”,

so it has specific characteristics that is not exist in normal commodity market

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- Firstly, foreign exchange market is foreign exchange trading centers that their scope of business is not working only in nationwide but also all over the world in order to meet the requirement of currency transactions among countries

- Secondly, foreign exchange market is a 24/24 working hours-market due to the difference of time zone among geography positions Next, currency transactions that could be carried out continuously depend on modern communication media such as telephone, fax, telex, computer network that get transactions done immediately and investors can deal with international foreign exchange market any time Therefore, the result of transactions through foreign exchange market could be done permanently A dealer working at Singapore foreign exchange market in the morning can transact business in the markets to the East such as Hong Kong, Tokyo If those markets closed, the other markets to the West like Frankfurt, London still open

so dealers can continue to do business

c Functions of foreign exchange market:

- Foreign exchange market meets the requirement of international payment arising from commercial trade and oversea investments

- Foreign exchange market provide financial instruments to protect investors against risks due to market movements through forward market, swap market, future market and option market

- Foreign exchange market creates favorable conditions for central bank to interfere and adjust foreign exchange rate, implement national monetary

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policy Through foreign exchange market, central bank can buy and sell the required amount of money to regulate relationship between supply and demand The volume of foreign currency bought or sold by central bank depend on not only supply and demand of foreign currency but also exchange rate mechanism (ERM), objectives of national monetary policy for each periods and exchange rate target pursued by central bank

d Organizational Structure and participants joining foreign exchange market:

- Based on the forms of organization, the structure of foreign exchange market consists of two types: the organized market and unorganized market In Viet Nam, the interbank market is an organized market meanwhile black market under the form of jewel shops around HCMC or foreign exchange counters without license on Nguyễn Trung Trực street etc… is an unorganized market

- Based on nature of business activities, foreign exchange market consists of many different markets such as spot market, forward market, swap market, future market and option market

- Based on the motives participating in the market or purpose of joining currency transactions, we can classify members of the foreign exchange market as follows:

+ Businessmen and investors: This group includes importers, exporters as well

as investors who have demand of currency transactions and oversea payments among countries

+ Commercial and investment banks: this group includes banks that join and invest their capital into foreign exchange market for their self-trading when

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implementing business targets or transact business as brokers on behalf of clients

+ Individuals and households: This group consists of persons who have demands of buying foreign currency for specific purposes or selling foreign currency when receiving dividends from activities of oversea investment or oversea remittance

+ Central bank: Most countries in the world, Central bank play the important role of organizing, controlling and joining foreign exchange transactions to aim at the stabilization of value of the currency, contribute to securing the safety of exchange rate and foreign exchange operations

- Based on the functions of foreign exchange market, we can separated participants of market into four groups

- Dealers: They are persons who join and do business permanently in order to earn profit from arbitrage trading Unlike brokers, dealers have to accept risks associated with the fluctuations of exchange rate when conducting transactions

- Brokers: act as intermediary in the market to do business on be half of customers to get commission on trading transactions Purpose of Brokers is to collect commission every transaction Unlike dealers, brokers work as intermediary without dealing transactions so they do not accept risks associated with market movements

- Speculators: persons who attend the foreign exchange market with hoping to earn money when the volatility of exchange rate in conformity with their

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market prediction or to tolerate level of risks associated with the fluctuations

of exchange rate that are opposite with their forecast These operations are considered as speculation with exchange rate going up and down Like dealers, speculators also participate in currency trading and earn profits from arbitrage trading However, speculators also tolerate higher level of risks than dealers do because the time of speculation between buying and selling currency is longer than time of normal trading

-Arbitrageurs: They are people who seek for profit from advantageous opportunities with the precept that buying currency with the low price and selling currency with high price at right place and right time to aim at earning profit without risks in short time Arbitrageurs basically explore the unbalance movements of exchange rate among regions to make trading decisions without risks However, opportunities of arbitrage trading seldom appear if existed they just happen in short time before arbitrageurs seek for that Afterwards, the market will be back to balance position and opportunities of arbitrage trading is over

2.1.2 The Viet Nam foreign exchange market (VINAFOREX)

The establishment and development of Vietnam foreign exchange market was

in connection with economic revolution in the late 1980s and in the early 1990s, the study focus on some important periods as follows:

a Foreign exchange center from 1991:

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With decision no 207/NH-QĐ dated 16/08/1991 issued by SBV regarding to establishment of foreign exchange centre operating as official foreign exchange market for following objectives:

- To establish an official foreign exchange market among commercial banks and economic units

- To assess and measure supply and demand of foreign currency in the market

- To issue official exchange rate between USD and VND

- To prepare initial conditions for establishment of financial market in the future

After working three years with two trading sessions per week on Tuesday and Friday at Hanoi Capital and Ho Chi Minh City, Foreign exchange center ended transactions by establishing an interbank foreign exchange market

b Interbank foreign exchange market from 1994 – 1998:

The Interbank foreign exchange market was established under decision no 203/NH-QĐ dated 20/09/1994 issued by Governor of SBV in order to set up an organized market for dealing foreign exchange transactions among commercial banks and create foundation for activities of foreign exchange market in the future In addition, through interbank foreign exchange market, the SBV can intervened into market efficiently in order to implement national monetary policy Before 1998, foreign exchange transactions in Vinaforex market primarily are spot transactions In 1998, Forward and Swap transactions have been taken officially

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c Market for Derivatives from 1998 until now:

Forward and Swap transactions have been conducted formally under decision

no 17/QĐ-NHNN7 dated 10/01/1998 guiding regulations of foreign exchange operations According to this foreign exchange regulations, almost commercial banks participating into transactions have to negotiate amount of currency to

be paid at the forward rate fixed in the future within the limit of margins stipulated by SBV recently At the beginning, SBV has granted operation licenses for 28 commercial banks to conduct forward and Swap transactions in which there are 21 foreign bank branches, 7 Viet Nam commercial banks (4 state-owned banks and 3 Joint stock commercial banks) From 1998 until now, almost commercial banks including state-owned banks, Joint stock commercial banks, Joint venture banks and foreign bank branches have launched out into forward and swap transactions

In 2002 with the approval by SBV, the Eximbank (EIB) experiments with option transactions of strong currencies like EUR, AUD, SGD against USD After that, some commercial banks in HCMC like ACB, VAB, and TCB also get permission of option transaction from SBV Option transactions could be expanded its scope of trading between USD and VND instead of trading on EUR/USD or AUD/USD as before Otherwise, it also used in gold option At present, SBV requested commercial banks to stop conducting option USD/VND by issuing decision no 1820/NHNN-QLNH 18/03/2009

d Organization and operation of VINAFOREX market:

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VINAFOREX market was established from 1991 when the Vietnamese economy transforms into market economy After 18 years, VINAFOREX market has developed significantly on scope of activities as well as types of transactions and has attracted the participation of enterprises and commercial banks in both international and domestic market

Regarding structure and operation of VINAFOREX could be described as model below:

Custom A,…

Custom B,…

International Market

2.2 Exchange rate and risk management of exchange rate

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2.2.1 Definition of Exchange rate

Exchange rate is the price at which one currency is exchanged for another or one currency to be presented by an amount of other currency

Example: 1 USD = 19.000 VND which mean that the price of 1 USD is displayed by amount of 19.000 VND

2.2.2 Classification of Exchange rates

In reality, we usually see some types of exchange rates as follows:

a Bid and Offer exchange rate:

Bid rate is a bank buying rate at which banks use to buy a reference currency Offer rate is a bank selling rate at which banks use to sell a reference currency Bid rate is often preceded and lower than Offer rate

Ex: Citibank quote EUR/USD = 1.4725 – 1.4735 in which the preceded rate of 1.4725 is bid rate of EUR (selling USD), the post rate of 1.4735 is Offer rate of EUR (buying USD)

b Spot and forward exchange rate:

Spot exchange rate is an exchange rate that is negotiated today but exercised

on the second working day after signing day of contract

Forward exchange rate is an exchange rate that is negotiated today but exercised over three working day after signing day of forward contract

c Banknote and transfer exchange rate:

Exchange rate of banknotes are listed for cash & cheque

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Transaction exchange rate are used for transaction currency Normally, bank note buying rate is lower than transaction rate and bank note selling rate is often equal or higher than transaction rate

d Open and Closing rate:

Open rate is an exchange rate used for the first deal of working day Closing rate is an exchange rate used for the last deal of working day Normally, banks

do not list all exchange rates signed in working day but announce closing rate The closing rate is an essential criterion showing fluctuation of foreign exchange rate within working day Note that closing rate today may be not open rate for tomorrow

e Official exchange rate:

Official exchange rate is an exchange rate issued by central bank, reflecting the value of domestic currency against foreign currency Official exchange rate often used in calculating import and export taxation and several foreign exchange activities of government such as short, medium and long term loans

In addition, the Official exchange rate established through Interbank averaged exchange rate market is the basis for commercial banks to define transaction rates within trading band regulated by central bank

f Free market exchange rate (free market exchange rate):

Free market exchange rate is set up depending on supply and demand of foreign currency in the free market

g Nominal and Real exchange rate:

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Nominal exchange rate is expressed as a rate between two currencies after taking inflation into account

Real exchange rate is an actual rate of exchange reflecting correlative purchasing power between two currencies

h Crossed exchange rate:

Crossed exchange rate is an exchange rate derived from the third currency (intermediate currency)

i Fixed and Floating exchange rate:

Fixed exchange rate is issued by central bank without changing Under the pressure of supply and demand in the market, to maintain Fixed exchange rate central bank must intervene into market permanently

Floating exchange rate is set up basing on supply and demand relation in the foreign exchange market, central bank do not need to interfere into foreign exchange market

2.3 Types of Foreign exchange transactions

2.3.1 Spot transaction is a transaction between currencies at fixed exchange

rate, the value date is the next 2 working days This kind of transactions are popular in Vinaforex market and being carried out by most commercial banks

2.3.2 Forward transaction is a transaction between two parties to enter a

binding obligation to buy or to sell a certain amount of currency at a agreed rate of exchange on a certain future date

pre-2.3.3 Swap transaction is a transaction between two parties to exchange cash

flow of two currencies at periodic intervals over a predetermined period of

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time (e.g swapping from USD to JPY) In a cross currency swap, there is physical exchanges of principals at maturity The equivalent amount based on the initial spot exchange rate unlike the standard interest rate swap There are two kinds of swap transactions as follows:

- Currency swap including spot and forward transaction: conducted at the same

time in buying spot transaction and selling forward transaction or vice versa This kind of currency swap is very popular in foreign exchange market

- Currency swap including two forward transactions: conducted at the same

time in buying and selling two forward transactions at a pre-agreed rate of exchange on two different future dates

2.3.4 Future transaction is a contract for specific quantities of given

currencies by which the exchange rate is fixed at the time the contract entered into and the delivery date is set by the exchange Actually, Futures contracts are the standardized forward contracts that trade on organized futures markets for specific delivery only Future contract is standardized on kind of currencies traded; size of contract; delivery date using as a hedging tool as well as speculation to take full advantage of foreign exchange rate in consistence with market trends

2.3.5 Option transaction is a financial instrument that gives its holder a right

but not obligation, to buy or sell a quantity of underlying asset at a predetermined price for a specific maturity (otherwise, to buy or sell a specific amount of currency at a specific exchange rate on or before a specific future date) For the right, the buyer typically pays a fixed price which is referred to

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as option premium The seller of the option correspondingly has obligation to meet the financial responsibilities in the event the buyer decides to exercise this right

There are two types of currency options as the following:

- European option can be exercised only on expiry date

- American option can be exercised on or before the expiry date

2.4 Risk management of exchange rate

2.4.1 Definition of risk management of exchange rate:

- Risk management is the process consisting in the identification, measurement

and control of risks within a level coherent with the risk appetite of the institution

- Risk management of exchange rate in foreign exchange operation includes the

contents of the identification, measurement and control of risks caused by fluctuations of exchange rate towards open forex position by using solutions for preventing risk of exchange rate

- Purposes of risk management of exchange rate

+ To protect commercial banks from serious losses without anticipating the worst in foreign exchange operation

+ To prepare for disadvantageous changes of exchange rate towards foreign exchange operations

+ To reduce the sensitive market movements towards foreign exchange operation

+ To strengthen the competitive advantages

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+ To regulate the risk of exchange rate and catch the business opportunities

2.4.2 Factors influencing risk management of exchange rate

- International trade comprises of import and export operations and other

foreign investments An increase in export activities will get supply of foreign currency raised, in condition that other factors remain unchanged exchange rate will be decreased On the contrary, an increase in import activities will get foreign exchange rate increased due to demand of foreign currency going

up Likewise an increasing foreign investment into host country will increase the supply of foreign currency that make exchange rate between foreign currency and local currency going down

- CPI (customer price index) affects the exchange rate between foreign

currency and local currency through an increase in price of domestic product higher than price of global product which means that import goods are cheaper and export goods become more expensive relatively so the supply of foreign currency will decreases and demand of foreign currency increases On the contrary if a decrease in price of domestic product lower than price of global product will cause the foreign exchange rate to raise

- Interest rate is the price of a capital used by borrower Thus if there is a

different interest rate of currencies among countries it make cash flow transfer In the event that real interest rate of local currency is higher than real interest rate of foreign currency, asset in local currency will be more attractive than asset in foreign currency and the cash flow of asset in foreign currency will transfer into asset in local currency In forex market, those activities cause

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