What Is Aggregate Risk?
Aggregate risk is often defined as the total amount of an institution's exposure to foreign exchange counterparty risk deriving from a single client.
Foreign exchange contracts—both spot and forward—involve a counterparty who is responsible for holding up their side of an agreement. If an institution has made too many agreements with a single client, it may suffer significant losses if the client is unable to pay their side of all their agreements.
Aggregate risk that is too high because too many contracts are held with a single counterparty is an easily avoidable problem. An institution would need to diversify its sources of counterparty risk by holding agreements with a wide number of clients.
Aggregate risk in forex may also be defined as the total exposure of an entity to changes or fluctuations in currency rates.
Understanding Aggregate Risk
Banks and financial institutions closely monitor aggregate risk in order to minimize their exposure to adverse financial developments—such as a credit crunch or even insolvency—arising at a counterparty or client. This is achieved through position limits that stipulate the maximum dollar amount of open transactions that can be entered into for spot and forward currency contracts at any point in time.
Aggregate risk limits will generally be larger for long-standing counterparties and clients with sound credit ratings, and will be lower for clients who are either new or have lower credit ratings.
Example of Aggregate Risk
XYZ Corporation has several outstanding forex contracts with ABC Company. ABC Company has reached a position limit and can no longer enter into additional contracts with XYZ Corporation until it closes out some of its current positions.
These limits are in place to protect XYZ Corporation from taking on too much counterparty risk, or aggregate risk, with ABC Company. If ABC Company were unable to pay its side of the contracts, XYZ Corporation would want to limit its exposure to that loss.