What it means
The idea is simple. If a bank holds more of a foreign currency than it owes in that currency, it is exposed to a fall in that currency's value.
The open position ratio expresses that mismatch as a proportion of capital, so exposure can be compared across firms of different sizes. Definitions vary between institutions and regulators, so it is wise to check which one applies.
A common approach takes the net open position, which is the difference between assets and liabilities in each currency, and then combines the long and short positions. A widely used shorthand takes the larger of the total net long positions and the total net short positions.
The ratio is used mainly as a limit and a monitoring tool. A treasury committee might state that the net open position must never exceed a set percentage of capital, and breaches are reported to senior management.
The limit controls the worst-case loss from a sudden currency move. For non-banks the same logic applies in a simpler form.
A company with large foreign currency receivables and payables can compare its unhedged balance with its equity or its annual profit to judge whether the exposure is tolerable. If it is too high, hedging with forwards or options reduces it.
Reporting frequency matters as well. Positions can change by the hour in a trading environment, so firms calculate the ratio at least daily and sometimes intraday, and they distinguish between the position at the end of the day and the peak position during it.
The ratio has limits as a measure. It shows size, not volatility, so a position in a stable currency and one in a volatile currency look the same.
Most firms therefore use it alongside other risk measures such as value at risk.
In practice
Real-world examples.
Example
A regional bank reports its currency positions at the end of each day. The risk team compares the net open position with capital and escalates to the treasurer when the ratio passes an internal warning level. The warning level is set below the hard limit so there is time to act.
Example
An exporter with $4,000,000 of unhedged foreign receivables and equity of $20,000,000 calculates a ratio of 20%. The board decides that is too high and asks treasury to hedge half of it with forward contracts.
Example
A foreign exchange dealer is told by the regulator to keep its net open position under a stated percentage of capital. The dealer sets a tighter internal limit so there is a buffer before the regulatory limit is reached.
Formula
Calculation
Open position ratio = net open position / capital
Under the shorthand method, net open position = the larger of (sum of net long positions) and (sum of net short positions)
A bank has a net long position of $3,000,000 in one currency and a net short position of $1,000,000 in another. The larger of the two totals is $3,000,000, so the net open position = $3,000,000. With capital of $50,000,000, the open position ratio = 3,000,000 / 50,000,000 = 0.06, which is 6%. If the internal limit is 10%, the bank is within its limit with room for $2,000,000 more exposure, because 10% of $50,000,000 is $5,000,000. Applying the ratio daily shows quickly when exposure drifts toward the limit.Case study
Seen in the real world.
Northgate Capital is a fictional trading house with $80,000,000 of capital and a policy that its net open position must stay below 8%. The risk officer noticed during a busy month that the ratio had crept up to 9.5%.
The excess was 9.5% less 8%, or 1.5% of $80,000,000, which is $1,200,000. The trading desk closed out enough positions to bring the ratio back within the limit by the end of the day.
The illustrative lesson is that a ratio only protects the firm if it is calculated frequently and the limit is enforced when it is breached. The risk officer also recommended a review of how positions were being reported intraday, because the breach had been spotted late in the afternoon rather than when it first occurred.
Watch out
Common mistakes.
- Assuming there is one universal definition of the ratio, when regulators and firms use different methods and the details matter.
- Netting positions in different currencies as if they always offset each other, when currencies can move in different directions.
- Treating a low ratio as proof of low risk, since it ignores how volatile the currencies involved are.
Questions
People also ask.
Why is capital used as the denominator?
Because capital is the cushion that absorbs losses, so exposure is judged against what the firm can afford to lose.
Does the ratio apply only to banks?
No, it is most common in banking but any business with foreign currency balances can use it to monitor its exposure.
How can a firm reduce a high ratio?
By hedging with forwards, options or swaps, or by closing the underlying positions.
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