Vinu:

Manu: Sure, Vinu! Let’s take an example. Imagine ABC Ltd., an Indian company, enters into a forward contract with a bank to buy $1 million in six months at a fixed exchange rate of ₹82 per USD. This means ABC Ltd. agrees to pay ₹82 million in six months to purchase $1 million, regardless of what the exchange rate is in the market at that time.

Vinu: So, the deal is fixed at ₹82 per USD. How does this become risky for the bank?

Manu: The risk arises because the exchange rate between INR and USD can fluctuate over those six months. Let’s say the market rate moves to ₹85 per USD during this period. This means that $1 million in the open market would now cost ₹85 million. However, since ABC Ltd. has locked in a rate of ₹82, they only have to pay ₹82 million, which benefits them.

Vinu: I see. So, ABC Ltd. benefits from the locked-in rate if the market moves to ₹85, but what’s the bank’s concern here?

Manu: Right! From ABC Ltd.’s perspective, they’re getting a good deal. But the bank’s concern is counterparty risk, which means they’re worried about ABC Ltd.’s ability to fulfill the contract. Even if ABC Ltd. benefits from the exchange rate, the bank still faces the risk that ABC Ltd. might not be able to pay ₹82 million on the due date.

Vinu: Why would ABC Ltd. default if the deal is in their favor?

Manu: Good point! While it’s true that ABC Ltd. is getting a good deal with the ₹82 rate, the bank is looking at the overall financial health of ABC Ltd. Let’s say ABC Ltd. experiences financial trouble—cash flow issues, business losses, or other problems—between now and the contract’s settlement. Even though the contract is favorable, they might not have the funds to make the ₹82 million payment.

Vinu: Oh, so the default risk isn’t because of the exchange rate but due to the company's financial issues?

Manu: Exactly! If ABC Ltd. is in financial distress, they may not be able to pay the agreed ₹82 million, even if the contract benefits them. This is why the bank is concerned about counterparty risk—the risk that ABC Ltd. won’t be able to honor the contract, not because the exchange rate moved against them, but because of their own liquidity or business issues.

Vinu: Got it. How does the bank calculate the LER in this case?

Manu: The Loan Equivalent Risk (LER) calculation looks at the potential movement of the exchange rate and factors in the risk of ABC Ltd.’s default. For instance, if the exchange rate moves to ₹85, the value of the contract increases by ₹3 million (₹85 million - ₹82 million). The bank will calculate LER based on this potential exposure and reserve some capital or collateral to cover that risk. If they believe there’s a chance ABC Ltd. might default, they prepare for the worst-case scenario by setting a limit on how much they could potentially lose.

Vinu: So the LER could be around ₹3 million if the exchange rate moves from ₹82 to ₹85?

Manu: Yes, that’s the exposure, but the LER calculation is more nuanced. It also takes into account the volatility of the currency, ABC Ltd.’s creditworthiness, and the probability of default. The bank may not necessarily reserve the full ₹3 million but will set aside a portion based on their internal risk models.

Vinu: Okay, so even though the USD is becoming stronger, and ABC Ltd. is more likely to honor the contract, the bank is worried about their financial stability?

Manu: Exactly. The stronger USD makes the contract more attractive for ABC Ltd., but the bank still worries about ABC Ltd.’s ability to pay. If they default due to cash flow issues, the bank would be stuck with a $1 million obligation, and with the USD now at ₹85, the bank would have to buy USD at a higher rate, leading to a loss.

Vinu: Oh! That’s why the bank is concerned about LER—it’s not just the currency risk but the risk of default?

Manu: Yes! The bank uses LER to protect itself against multiple risks. Even if ABC Ltd. wants to honor the contract, other factors like financial health, market volatility, and liquidity issues can come into play. LER allows the bank to quantify these risks and ensure they’re prepared.

Vinu: That makes sense now. The LER is like a safety net for the bank, even if the currency movement is in favor of ABC Ltd.?

Manu: Exactly! It’s the bank’s way of being proactive and ensuring they’re covered in case something goes wrong. It helps them avoid any major financial hit if ABC Ltd. can’t fulfill its obligations.

Vinu: Thanks for explaining that so clearly, Manu! Now I understand why the bank is still worried even if the exchange rate is favorable for ABC Ltd.