Master of Business Administration- MBA Semester 4 MF0016 Treasury Management - 4 Credits Assignment Set- 1 (60 Marks) Q1.

. Bring out in a table format the features of certificate of deposits and commercial papers. Answer :- Certificate of Deposits (CDs) : -Certificate of deposit (CDs) is a short-term instrument issued by commercial banks and financial institutions. It is a document issued for the amount deposited in a bank for a specified period at a specified rate of interest. The concerned bank issues a receipt which is both marketable and transferable in the market. The receipts are in bearer or registered form. CDs are known as negotiable instruments and they are also known as Negotiable Certificates of Deposit. Basically they are a part of banks deposit; hence they are riskless in terms of payments and principal amount. CDs are interest-bearing, maturity-dated obligations of banks. CDs benefit both the banker and the investor. The bankers need not encash the deposit before the maturity and the investor can sell the CDs in the secondary market before the maturity. This contributes to the liquidity and ready marketability for the instrument. CDs can be issued only by the schedule banks. It is issued at discount to face value. The discount rate depends on the market conditions. CDs are issued in the multiples of Rs. 25 lakh and the minimum size of the issue is Rs.1 crore. The maturity period ranges from three months to one year. The introduction of CDs in Indian market was assessed in 1980. RBI appointed the Vaghul Working Group to study the Indian market for five years. Based on the suggestions of Vaghul committee; RBI formulated a scheme for the issue of CDs. As per the scheme, CDs can be issued only by the scheduled banks at a discount rate to face value. There is no restriction on the discount rate by the RBI. Features of CDs in Indian market The characteristic features of CDs in Indian money market are as follows: Schedule banks are eligible to issue CDs Maturity period varies from three months to one year Banks are not permitted to buy back their CDs before the maturity CDs are subjected to CRR and Statutory Liquidity Ratio (SLR) requirements They are freely transferable by endorsement and delivery. They have no lock-in period. CDs have to bear stamp duty at the prevailing rate in the markets The NRIs can subscribe to CDs on repatriation basis Commercial Papers (CPs) : - Commercial Papers (CPs) is a type of instrument in money market and it was introduced in Jan 1990. Commercial paper is a short-term unsecured promissory note issued by large corporations. They are issued in bearer forms on a discount to face value. It issued by the corporations to raise funds for a shortterm. The maturity period ranges from 30 days to one year. CPs is negotiable by endorsement and delivery. They are highly liquid as they have buy-back facility. The CPs is issued in denominations of Rs. 5 lakh or multiples of Rs. 5 lakh. Generally CPs is issued through banks, dealers or brokers. Sometimes they are issued directly to the investors. It is purchased mostly by the commercial banks, Non-Banking Finance Companies (NBFCs) and business organisations. CPs is issued in domestic as well as international financial markets. In international financial markets, they are known as Euro commercial paper. Features of commercial papers The salient features of CPs are as follows: CPs is an unsecured promissory note. CPs can be issued for a maturity period of 15 days to less than one year. CPs is issued in the denomination of Rs.5 lakh. The minimum size of the issue is Rs. 25 lakh. The ceiling amount of CPs should not exceed the working capital of the issuing company. The investors in CPs market are banks, individuals, business organisations and the corporate units registered in India and incorporated units. The interest rate of CPs depends on the prevailing interest rate on CPs market, forex market and call money market. The attractive rate of interest in any of these markets, affects the demand of CPs. The eligibility criteria for the companies to issue CPs are as follows: The tangible worth of the issuing company should not be less than Rs. 4.5 Crores. The company should have a minimum credit rating of P2 and A2 obtained from Credit Rating Information Services of India (CRISIL) and Investment Information and Credit Rating Agency of India Limited. (ICRA) respectively The current ratio of the issuing company should be 1:33:1. The issuing company has to be listed on stock exchange. Q2. What is capital account convertibility? What are the implications on implementing CAC? Answer: -Capital Account Convertibility (CAC) refers to relaxing controls on capital account transactions. It means freedom of currency conversion in terms of inflow and outflows with respect to capital account transaction. Most of the countries have liberalised their capital account by having an open account, but they do retain some regulations for influencing inward and outward capital flow. Due to global integration, both in trade and finance, CAC enhances growth and welfare of country. The perception of CAC has undergone some changes following the events of emerging market economies (EMEs) in Asia and Latin America, which went through currency and banking crises in 1990s. A few counties backtracked and re-imposed capital controls as part of crisis resolution.

Crisis such as economic, social, human cost and even extensive presence of capital controls creates distortions, making CAC either ineffective or unsustainable. The cost and benefits from capital account liberalisation is still being debated among academics and policy makers. These developments have led to considerable caution being exercised by EMEs in opening up capital account. The Committee on Capital Account Convertibility (Chairman: Shri. S.S. Tarapore) which submitted its report in 1997 highlighted the benefits of a more open capital account but at the same time cautioned that CAC could pose tremendous pressures on the financial system. India has cautiously opened its capital account and the state of capital control in India is considered as the most liberalised it had been since late 1950s. The different ways of implementing CAC are as follows: Open the capital account for residents and non-residents. Initially open the inflow account and later liberalise the outflow account. Approach to simultaneously liberalise control of inflow and outflow account. Q3. Distinguish between CRR and SLR. Answer : -Treasury function was restricted to fund or liquid management. Fund management includes maintaining adequate cash balances to meet the daily requirements, implementing the surplus funds in other operations, sourcing the funds to even the gaps in cash flow. The treasury departments in banks are responsible to meet the Cash Reserve Requirement (CRR) and invest the funds in securities under Statutory Liquid Ratio (SLR). Treasury basically deals with short-term cash flows(less than one year), but investment in some securities exceeds more than one year. Cash Reserve Ratio : - Cash Reserve Ratio (CRR) is a countrys central bank regulation that sets the minimum reserves for banks to hold for their customer deposits and notes. These reserves are considered to meet the withdrawal demands of the customers. The reserves are in the form of authorised currency stored in a bank treasury (vault cash) or with the central bank. CRR is also called liquidity ratio as it controls money supply in the economy. CRR is occasionally used as a tool in monetary policies that influence the countrys economy. CRR in India is the amount of funds that a bank has to keep with the RBI which is the central bank of the country. If RBI decides to increase CRR, then the banks available cash drops. RBI practices this method, that is, increases CRR rate to drain out excessive money from banks. The CRR in the economy as declared by RBI in September 2010 is 6 percent. An organisation that holds reserves in excess amount is said to hold excess reserves. The following are the effects of CRR on economy: CRR influences an economys money supply by effecting the potential of banks CRR influences inflation in an organisation CRR stimulates higher economic activity by influencing the liquidity Statutory Liquidity Ratio: -Statutory Liquidity Ratio (SLR) is the percentage of total deposits that banks have to invest in government bonds and other approved securities. It means the percentage of demand and time maturities that banks need to have in forms of cash, gold and securities like Government Securities (G-Secs). As gold and government securities are highly liquid and safe assets they are included along with cash. In India, RBI determines the percentage of SLR. There are some statutory requirements for placing the money in the government bonds. After following the requirements, the RBI arranges the level of SLR. The maximum limit of SLR is 40 percent and minimum limit of SLR is 25 percent. The RBI increases the SLR to control inflation, extract liquidity in the market and protects customers money. Increase in SLR also limits the banks leverage position to drive more money into the economy. If any Indian bank fails to maintain the required level of SLR, then it is penalised by RBI. The nonpayer bank pays an interest as penalty which is above the actual bank rate. The main objectives for maintaining SLR are the following: By changing the SLR level, the RBI increases or decreases banks credit expansion Ensures the comfort of commercial banks Forces the commercial banks to invest in government securities like government bonds Q4. Explain various sources of interest rate risk. Answer: - The interest rate risk adversely affects the organisations financial situation. It poses significant threat to the incomes and capital investments of the organisation. The changes occurring in interest rate affects the value of underlying assets of the organisation. It changes the price values of interest bearing asset and liability based on the magnitude level of fluctuations in interest rates. We shall discuss some of the sources of interest rate risk in the following subsections. 1 Yield curve risk: - The yield refers to the relationship between short term and long term interest rates. The yield curve risk occurs due to the yield curve fluctuations which affect the organisations income and economic values of underlying assets. The short term interest rates are lower than long term interest rates and hence the occurring fluctuation exposes the organisation to maturity gap of interest rate risk. The variations in movements of interest rates changes when the yield curve of a market flattens or steepens in the interest rate cycle. The yield curve slopes upwards when the short term interest rates are lower than the long term interest rates. This yield curve is known as normal yield curve. The yield curve flattens when the short term interest rates increases across the long term interest rates. This occurs during the transition of the normal yield curve to an inverted curve. It is called as flat curve. The inverted yield curve refers to the economic recession period. Therefore the market status overviews the yield curve of long term interest rate as decline in the long term fixed income of the

organisation. The effects of recession impose negative impacts to the organisation hence they must concentrate on diversifying the investment portfolio. Figure 10.1 depicts the normal yield curve

Figure 10.1: Normal Yield Curve Figure 10.2 depicts the inverted yield curve

Figure 10.2: Inverted Yield Curve The yield curve has major impacts on the consumers, equity and fixed income investors. The fixed rate loans will be encouraged when the short term rates exceeds the long term rates. Hence the consumers who invest in financing properties experience higher mortgage payments. The fixed income investors are benefited with better returns with short term investments due to the elimination of risk premium for long term investments. During the phase of inverted yield curve the margins of the profits decline such that the organisation at short term rates borrow cash and lend it at long term rates to gain profits. 2Basis risk: -Basis risk occurs due to the changes in relationship between the various financial markets or financial instruments. The different market rates of financial instruments differ with time and amounts. In the banking organisation basis risk occurs due to the differences in the prime rate and offering rates on money market deposits, saving accounts. The changes of interest rates can give rise to unexpected changes of asset and liability cash flows and earnings. For example - an organisation holds large untraded stocks. If the company tries to sell those stocks in wholesale, it experiences liquidity risk because the selling prices may be depressed in the market. Hence to overcome this issue, the company enters into futures contract with stock index. This reduces the liquidity risk but increases the basis risk due to the differences between the selling and stock index prices. The basis risk affects the profits of an organisation by striking the cash positions. The basis risk changes the storable commodities based on the changes of the storage costs over a period of time. 3Optionality risk: -Optionality risk arises with various option instruments of banks like assets, liabilities. It occurs during the process of altering the banks instruments levels of cash flows by banks customers or by bank itself. The option allows the option holder to buy or sell financial instruments. It usually results in a risk or rewards to the bank. The option holder experiences limited downside risk (paid amount) and unlimited upside reward whereas the option seller has unlimited risk and limited upside reward. The bank faces losses during the sold position option to its customers. There are chances of losses in banks capital value due to unfavourable interest rate movements

such that it exceeds the profits that a bank gains, during the favourable movements. Therefor it has more downside exposure than upside reward. The options are traded in banks with stand-alone instruments such as over the counter (OTC), exchange traded options, bond loans and so on. The stand-alone instruments are explicitly priced and are not linked with other bank products. Most of the banking organisations allow prepayment option of commercial loans which includes the prepayment process without any penalties. Hence during the decline of rates the customers will perform prepaying loan process which shortens the banks asset maturities while the bank desires to extend it. 4. Repricing risk : -Repricing risk arises due to the differences between the timing of rate changes and cash flows occurring in pricing and maturity of banks instruments such as assets, liabilities and off balance sheets. It is measured by comparing the liability volume with asset volume that reprice within specified period of time. The repricing risk increases the earnings of the banks. Liability sensitivity occurs in banking organisations since repricing asset maturities are longer than the repricing liability maturities. The income of the liability sensitive bank increases during the fall of interest rates and declines when the interest rate increases. Inversely, the asset sensitive bank benefits from rise in rates and detriments with fall in rates. Repricing risk affects the banks earnings performance. Since the banks focus on short term repricing imbalances are initiated to implement increase interest rate risk by extending maturities to improve profits. The banking organisations must consider long term imbalances during the repricing risk evaluation. If the gauging of long term repricing is improper, there are chances of bank experiencing variations in interest rate movements of future earnings. 5. Embedded option risk : -The embedded option refers to other option securities such as bonds, financial instruments. The embedded option is a part of another instrument which cannot be separated. The callable embedded option bond consists of hold (option free bond) option and embedded call option. The value of the bond changes according to the changes occurring in interest rates of embedded options values. The price of callable bond is equal to the price of hold option bond minus price of call option bond. The decline in interest rates increases the callable option price bond. Figure 10.3 depicts the value of embedded call option varying with respect to changes in interest rates.

Figure 10.3: Value of Embedded Call Option The embedded putable bond consists of option free bond and embedded put option. The price of putable bond is equal to price of option bond plus price of embedded put option. Figure 10.4 depicts the value of embedded put option which is obtained by the changes in interest rates.

Figure 10.4 value of embedded put option The organisations must handle the options effectively such that the various types of bonds under embedded option are exposed to low level of risks. During the selling process of financial instruments there are chances of exposure to significant risks since the holding options are explicit and embedded which provides advantage to holder and disadvantage to seller. The exceeding number of options can implicate leverage magnifying the positive or negative influences of financial options positions in the organisation. Assignment Set- 2 (60 Marks) Q1. What are the features of ADRs and GDRs? Answer: -ADRs and GDRs A Depository Receipt (DR) is a versatile financial security that is traded on a local stock exchange but it represents a security that is issued by a foreign publicly listed company. Two of the most common types of DRs are the American Depository Receipt (ADR) and Global Depository Receipt (GDR). ADR is a security issued by a non-U.S. company and is traded on U.S. stock exchanges. ADRs are issued to offer investment methods that avoid the unwieldy laws applied to the non-citizens who buy shares on local exchanges. ADRs are listed on NYSE, AMEX or NASDAQ. Few advantages of ADRs are: ADRs are easy and cost efficient methods to buy shares in foreign companies. ADRs save money by reducing administration costs and avoiding foreign taxes on the transaction. GDRs were developed on the basis of ADRs and are listed on stock exchanges outside US. GDRs are traded globally instead of the original shares on exchanges. The objective of GDR is to enable investors to gain economic exposure to a planned company in developed markets. Features of GDRs are as follows: GDR holders do not have a voting right. It has less exchange risk as compared to foreign currency loan. GDR investors may cancel his receipt by advising the depository. ADRs and GDRs are excellent means of investment for NRIs and foreign nationals who want to invest in India. By buying these, they can invest directly in Indian companies without going through the harassment of understanding the rules in Indian financial market. Q2. Explain FEMA and highlight the effect of FEMA on liberalisation. Answer: -Foreign Exchange Management Act (FEMA), 1999: -The foreign exchange activities in India are governed by Foreign Exchange Management Act (FEMA), 1999. FEMA came into effect in JUNE 2000 and its provisions are available on RBIs website. FEMA replaced Foreign Exchange Regulation Act (FERA) which has outlived the objective. It was originally enacted for the conservation of the precious foreign exchange. The objectives of FEMA are: To promote external trade through foreign exchange Orderly development and maintenance of foreign exchange market in India Effect of liberalization: -The liberalisation of Indian investments in global financial market has increased the access to commercial borrowings by Indian corporates and participation of foreign investors in the stock market. The aim of FEMA is to simplify, consolidate and amend the law related to foreign exchange and facilitate external trade and payments. FEMA seeks to establish a more liberal and orderly regulatory framework for economic growth. Some liberalisation measures of FEMA are:

Current account transaction such as foreign trade, current business, short-term banking services, remittances for living expenses of parents, spouse and children residing abroad ,expenses in education, foreign travel and medical care of parents ,spouse and children has been liberalised. Capital account transaction alters the assets or liabilities of persons resident in India, assets or liabilities in India of persons residing outside India. Exports of goods and services. Certain cases are exempted from realisation and repatriation cases and they are as follows: Possession of foreign currencies or coins up to a limit specified by RBI. Foreign currency account held and operated by person or group of persons up to a limit specified by RBI. Foreign exchange acquired or received, or any income arising which is held outside India by any person in pursuance of a general or special permission granted by the RBI FEMA is more liberal but conformed to postulates of justice and fairness. Itis prerequisite for promoting further economic liberalisation and growth.

Q4. Explain the framework for measuring and managing the liquidity risks. Answer: 1. Measuring Liquidity Risk: - The framework for measuring and managing the liquidity risk can be divided into three dimensions. They are: Measuring and managing net funding requirements. Managing market access. Contingency planning. A banks future cash inflows are compared with the future cash outflows over a series of definite time periods via a maturity ladder. These cash flows arise due to assets that have already crossed their maturity dates, other nonmaturing saleable assets and tapped credit lines that are well established. The cash outflow consists of contingent liabilities and liabilities falling due, especially devoted lines of credit that can be drawn down. The maturity ladder is represented by comparing sources and sum of currency inflows and sources and sum of currency outflows. The two simple ways to measure liquidity are: Stock approach Flow approach Stock approach: -The stock approach is the first step in the evaluation of liquidity. Under this method, liquidity is treated as stock. By comparing items on the balance sheet this method aims at determining the banks ability to use its short term debts as a measure of liquid assets that can be used for other purposes. Under this method certain ratios, like liquid assets, short term liabilities, purchased funds to total assets and others are calculated and compared to the targets that a bank has set for itself. Though the stock approach is useful in determining the liquidity from one aspect, it does not reveal the essential liquidity profile of a bank. Flow approach: -The flow approach predicts liquidity at different points of time. It looks at the liquidity requirements for a minimum of 15 days. Next it consults the maturity ladder and tracks the cash flow mismatches over a series of specified time periods. It aims at safe-guarding the ability of the firm in meeting its repayment commitments (like funding risk), calculating and limiting the liquidity maturity transformation risk based on figures obtained from measured liquidity risk. 2. Managing market access: -Some liquidity management techniques are important not because of influence on the assumptions used during construction of the maturity ladders, but due to their direct involvement to increase the bank's liquidity. To check the sufficient changes in liabilities banks need to inspect the level of confidence on individual funding sources. In addition a bank should understand and evaluate the use of intercompany financing for its individual business offices. To build a strong relation with providers of funding, banks can offer a line of defence in a liquidity problem. The addition of loan-sale clauses in loan documentation and the rate of using the asset-sales markets are two possible indicators of the bank's ability to perform asset sales under unfavorable scenarios. 3. Contingency planning:- An effective contingency plan should address the following major issues: Have a strategy to handle crisis. Have back up facilities to access cash in emergency. The degree to which these issues have been solved determines the approach of the bank and how well it can perform during the time of crisis. A banks ability to face NFR also helps in determining the status of the bank and its previous contingency plans. Strategy: -Several strategies should be used in contingency planning to deal with crisis. The most important are those that involve the coordination and control at the managerial level. A contingency plan must have procedures to ensure that the flow of information is stable and uninterrupted, and they prove handy to the senior management in taking important decisions. Responsibilities must be divided equally to all personnel and they must understand their duties and stand by the expectations. There should be no scope for confusion that could lead to adverse effects. Another major aspect to be taken care while planning is the strategy to alter the behaviour of assets and liabilities. There are possibilities that the behaviour at different scenarios may be predicted and decisions be taken to change the characteristics. For example, a bank may evaluate if it will suffer a liquidity dearth in the event of a crisis on the following factors based on its assumptions: Amount of saleable assets cash inflows in future. Cash outflows from deposit overflows.

During such a crisis, a bank may be able to sell its assets that were not sold even in normal conditions and enlarge its cash inflows from asset sales. Contrary to that, they may raise the deposit rates to retain deposits that might otherwise have moved elsewhere and reduce cash outflows. Other components of strategy involve maintaining good relationships with the customers, trading and off-balance-sheet counterparties, and liability holders. As the impact of the crisis is higher, banks must often discuss with some customers for liquidity in order to be in pace with other counter parts. An additional, rational element that may be vital is how a bank deals with the press and broadcast media. A smart public relations management can aid a bank by avoiding the spread of public stories that can result in substantial overflows through retail depositors and institutional investors. Back-up liquidity: -Contingency plans should also include a facility to make a shortage of cash flow at the time of emergencies. Banks have a number of sources available to them, like unused credit facilities from the past including previously unused credit facilities and the local banks. A bank can make use of these funds whenever there is huge crisis. So the plan must have clear description of when and how much of the funds from these sources are available for the banks to use. Q5. Discuss the interest rate management using FRAs and swaps and the role of financial intermediaries. Answer: -Interest Rate Risk Management Using FRA and Swaps: -The Forward Rate Agreement (FRA) aims to guard the interest charges or interest yield for future period. It is an agreement to settle the difference between an agreed and actual future level of interest between the two parties. The agreement begins at the start of agreed period where interest is fixed. The interest rate swap is a combination of FRAs which involves agreement between parties to exchange sets of future cash flows. FRA and its features: -It refers to the agreement made by the two parties setting the interest rate with notional principal amount for an agreed future time period. The FRA buyer receives money if the interest rate increases more than the other party in the contract. Similarly the FRA seller receives money from the buyer if the interest rate decreases with other party in the contract. Figure 10.5 depicts the process of forward rate agreement.

Figure 10.5: Forward Rate Agreement Swaps and its features: -The interest rate swap is a derivative instrument present in the currency market exchanging interest rate floating payments for fixed payments between the two counterparties. It is used by hedging funds of investors expecting changes in interest rates. Plain vanilla interest rate swap: -The plain vanilla swap deals with swapping fixed rate interest payments with floating rate interest payments based on London Interbank Offered Rate (LIBOR). The LIBOR is an interest rate that the banks with high credit ratings, obtained from various rating agencies, charge for short term financing. The payer in the vanilla swap agrees to receive floating interest rate in exchange with fixed interest rate. The receiver agrees to receive fixed interest rate in exchange with floating interest rate. The swap dealer acts as intermediary in the plain vanilla interest rate swap. The plain vanilla interest rate swap pays LIBOR through pay floating party at each period in return for fixed rate payment.

Figure 10.6: Plain Vanilla Swap Process The swap dealer receives floating LIBOR from party B and pays it to party A. The dealer has no cash during this transaction. After the transactions between parties A and B, the swap dealer experiences residual risk which are evident in the net cash flows. Later over a period of time, the dealer receives cash from party A depending on the future interest rate by paying LIBOR. The mortgagor repays the loan as soon the rates decrease. Role of Financial Intermediaries: - The financial intermediaries offer lenders interest, and simultaneously charge higher interest rate to their borrowers. They facilitate the transfer of surplus willing to borrow. The financial intermediaries comprise of nonbanking (NBFIs) and banking organisation. The banks include central bank, commercial bank and various specific purpose banks. The NBFIs consists of credit unions, finance companies, superannuation funds and securities. Figure 10.7 depicts the various types of financial intermediaries

Figure 10.7: Types of Financial Intermediaries The financial intermediaries provide liquidity to the savers. Liquidity refers to the ability of converting assets into quick money. They reduce risk by making large amount of loans and can predict the repayment of the borrowed money. The various functions of financial intermediaries include: It provides financial assistance to organisations and individuals. Hence the household resources are used for issuing loans to organisations or investing in equities. It helps in smooth functioning of the economy. The financial intermediaries issues cash to various businesses by using the standalone savings. It has key role in restructuring and liquidation of firms. Financial intermediaries act as market for firms assets. It helps in raising small amount of funds from individual households. Q6. Illustrate few issues that need to be considered while developing market risk management policies. Answer: -Market Risk Management Policy: -Market risk is the risk which arises from unfavourable conditions and fluctuations in market prices. These risks could be price fluctuations in fixed income instruments, equity instruments, commodities. It also arises from general foreign exchange and banking books. The major elements of market risk are interest rate risk, equity risk, commodities risk and currency risk. The growth and establishment of market risk management is very significant for the reliability and correctness of the companys financial institution. Developing a policy is one of the main checklists for market risk management. Marking to market It refers to the (re)pricing of the portfolio of a bank in order to reflect changes in asset prices. It is considered sensible for a bank to analyse and (re)price positions related to a stable liquidity investment portfolio on a monthly basis. Since trading portfolio assets are traded on a daily basis, price positions of a banks trading portfolio should be analysed and marked to market on a daily basis. These reports should be submitted to and reviewed by the senior bank managers who are responsible for investment, asset-liability and risk management of the bank. Marking to market policy should also address the pricing responsibility and the method used in a bank to determine the new market price of an asset. The policy of risk management should specify the determined prices and the officers who are independent of the respective dealers and managers should execute the marking to market. Position limits A market risk management policy must provide limits and monitor the positions in markets and products with constant consideration of liquidity risk that could arise from implementation of unrealised transactions. These transactions may include open contracts or commitments to trade securities. Such position limits should control market risk by relating to the available capital. Banks with large stable liquidity investment and/or trading portfolios should set limits on the range of risk taken by individual dealers and traders. These limits are related to factors like investment/trading functions organisation and the level of technical skill of individual dealers and traders.