Interest Rate Risk

Interest rate risk is the profit and loss generated by both the fluctuations in the forward spreads and by forward amount mismatches and maturity gaps among transactions in foreign exchange. (An amount mismatch is the difference between the spot and the forward amounts.) For an active forward desk the complete elimination of maturity gaps is virtually impossible; however, this may not be a serious problem if the amounts involved in these mismatches are small.

On a daily basis, traders balance the net payments and receipts for each currency through a special type of swap, called tomorrow/next or rollover.

To minimize this type of risk, management sets limits on the total size of mismatches.

The policies differ among banks, but 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 delivery dates and the profit and loss. Continuous analysis of the interest rate environment is necessary to forecast any changes that may impact on the outstanding gaps.

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