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1 Explain how organization structure of commercial bank treasury facilitates in handling various treasury operations.
Ans:- The treasury organisation deals with analysing, planning, and implementing treasury functions. It deals with issues of profit centre, cost centre etc. The organisations managing interfaces with treasury functions include intragroup communications, taxation, recharging, measurement and cultural aspects. Structure of treasury organisation Figure 1.2 depicts the structure of treasury organisation which is divided into five groups.
Figure 1.2: Treasury Organisations • • • • Fiscal – This group includes budget policy planning division, industrial and environmental division, common wealth state relationships, and social policy division. Macroeconomic – This group deals with economic sector of the organisation. It includes domestic and international economic divisions, macroeconomic policy and modeling division. Revenue – This group is concerned with the taxes in an organisation. It includes business tax division, indirect tax, international and treaties division, personal and income division, tax analysis and tax design division. Markets – This group mainly deals with selling of products in the competitive market. It includes competition and consumer policy, corporations and financial services policy, foreign investments and trade policy division.
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Ans:Features of commercial papers CPs is an unsecured promissory note. Treasury management in banks In recent days. The various products in rupee treasury are: 1. commercial papers. It includes financial and facilities division. treasury bonds. human resource division. It helps in developing new products. reverse repo and interbank participation etc. It helps in managing the bank’s position in terms of statutory requirements like cash reserve ratio. most of the Indian banks have classified their business into two primary business segments like treasury operations (investments) and banking operations (excluding treasury). Bonds – Government securities. Derivatives – The banks make foundation for Over the Counter (OTC). Equities • • Foreign exchange treasury – The banks provide trading of currencies across the globe. The treasury operations in banks are divided into: • Rupee treasury – The rupee treasury carries out various rupee based treasury functions like asset liability management.• Corporate services – This group deals with overall management of the treasury organisation. Q. Money market instruments – Call. 2. investments and trading. It deals with buying and selling currencies. The role of policies in strategic management was described in this section. debentures etc 3. repo. and notice money. term. business solutions and information management division. trading in order to lay off risks and form apparatus for much of the industry’s self-regulation. The next section deals with inter-dependency between policy and strategy. Features of CDs in Indian market Schedule banks are eligible to issue With Lots of Luck: Ali 2 . statutory liquidity ratio according to the norms of the Reserve Bank of India (RBI).2 Bring out in a table format the features of certificate of deposits and commercial papers.
The minimum size of the issu e is Rs. They have no lock-in period.5 lakh. affects the deman d of CPs. CDs have to bear stamp duty at the prevailing rate in the markets The NRIs can subscribe to CDs on repatriation basis With Lots of Luck: Ali 3 .CPs can be issued for a maturity period of 15 days to less than one year. The interest rate of CPs depends on the prevailing interest rate on CPs market. The investors in CPs market are banks. The issuing company has to be listed on stock exchange. forex market and call money market. CPs is issued in the denomination of Rs. 25 lakh. The company should have a minimum credit rating of P2 and A2 obtained from Credit Rating Information Service of India (CRISIL) and Investment Information and Credit Ratin g Agency of India Limited.33:1. 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. 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 .5 Crores. The ceiling amount of CPs should not exceed the working capital of th e issuing company. The attractive rate of interest In any of these markets. 4. business organisations and the corporate units registered in India an d incorporated units. individuals. (ICRA) respectively The current ratio of the issuing company should be 1.
• • • The other participants include RBI and its authorised dealers.4 What is capital account convertibility? What are the implications on implementing CAC? Ans:. Crisis such as economic. exporters. social. Banks provide opportunities to brokers in order to increase or decrease the rate of buying or selling foreign currencies. It means freedom of currency conversion in terms of inflow and outflows with respect to capital account transaction.Q. A few counties backtracked and re-imposed capital controls as part of crisis resolution. Exchange brokers have a tendency to specialise in unusual currencies but also manage major currencies. exporters. companies and individuals.3 Critically evaluate participatory notes. both in trade and finance. Exchange brokers – They ensure the most favourable quotations between the banks at a low cost in terms of time and money. The cost and benefits from capital account liberalisation is still being debated among academics and policy makers. importers. Detail the regulatory aspects on it. Central banks get involved in forex market to regain price stability of exchange rate.The participants in forex market are the RBI at the apex. Ans:. Due to global integration. authorised dealers (ADs) licensed by forex market. Commercial banks – They play an important role in forex market. They operate in market by trading currencies for their clients. They operate in market by buying or selling currencies within the framework of exchange control regulations. The major participants of foreign exchange market are: • Corporates – They mainly include business houses. Central bank – It plays a vital role in the country’s economy by controlling money supply. 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. which went through currency and banking crises in 1990’s. companies and individuals. It deals with banks and their clients to form retail segment of forex market. importers.Capital Account Convertibility (CAC) refers to relaxing controls on capital account transactions. Q. international investors. In India. and multinational corporations. These developments have led to considerable caution being exercised by EMEs in With Lots of Luck: Ali 4 . making CAC either ineffective or unsustainable. human cost and even extensive presence of capital controls creates distortions. The perception of CAC has undergone some changes following the events of emerging market economies (EMEs) in Asia and Latin America. many banks deal through recognised exchange brokers or may deal directly among themselves. CAC enhances growth and welfare of country. Large volume of transactions consists of banks dealing directly among themselves and smaller transactions usually consists of intermediary foreign exchange brokers. and support economic goals like inflation and growth. protect certain levels of price in exchange rate.
Initially open the inflow account and later liberalise the outflow account. Several factors which distinguish multinational cash management from domestic cash management are as follows: • • • • • • Different currency denominations Political risk and other risk.. The Committee on Capital Account Convertibility (Chairman: Shri. import duties. The different ways of implementing CAC are as follows: • • • Open the capital account for residents and non-residents. S. The reasons for which the firms expand into other countries are as follows: • • • • • Seeking new markets and raw materials Seeking new technology and product efficiency. 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. Economic and legal complications. The multinational cash management programme effectively achieve its goals by using excess cash flow from some units across the globe to extend cash needs in other units which is called in- With Lots of Luck: Ali 5 . Decision making within the corporation is centralised in the home country or decentralised across the countries where the organisation does its business. Approach to simultaneously liberalise control of inflow and outflow account. Preventing the regulatory obstacles. The principle objective of multinational cash management programme is to maximise a company’s financial resources by taking benefits from all liability provisions. Difference in tax rates.S.5 Detail domestic and international cash management system Ans.opening up capital account.The strategy of a company which has its businesses in many nations and efficiently manages its cash and liquidity is called multinational cash management programme. Retaining customers and protecting its processes Expanding its business. 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 1950’s. Multinational companies are those that operate in two or more countries. The main goal of multinational cash management is the utilisation of local banking and cash management services. Q. Role of governments Language and cultural differences. payable periods.
that is. head office to branches and so on. The reserves are in the form of authorised currency stored in a bank treasury (vault cash) or with the central bank. 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. These reserves are considered to meet the withdrawal demands of the customers. For example. It occurs due to the change in exchange rates. The multinational cash management system involves exchange rate risk which occurs when the cash flow of one currency during transformation to another currency the cash value gets declined. increases CRR rate to drain out excessive money from banks. CRR is also called liquidity ratio as it controls money supply in the economy. negotiated value range. The payments between the branches and the parent company are managed through the branches. Through the use of electronic reporting systems a parent company observes cash balances in its foreign local banks. use of lockboxes or intercept points. If RBI decides to increase CRR. RBI practices this method. IT services to side operations and consulting services to develop custom optimised solutions. During multinational cash management system payments by customers to company’s branches are basically handled through a local bank. 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 economy’s money supply by effecting the potential of banks CRR influences inflation in an organization With Lots of Luck: Ali 6 . Wincor’s focus was on the entire process chain which started from head office to stores.Cash Reserve Ratio Cash Reserve Ratio (CRR) is a country’s central bank regulation that sets the minimum reserves for banks to hold for their customer deposits and notes. The CRR in the economy as declared by RBI in September 2010 is 6 percent. crediting to the retail company’s account. Q.house banking and by relocating funds for tax and foreign exchange management through repricing and invoicing. Wincor Nixdorf’s served several countries with its innovative hardware and software elements. Wincor Nixdorf played an innovative role in enhancing cash handling between various countries. Multinational cash management programme specifically evaluate its techniques by timing of billing. then the banks’ available cash drops.6 Distinguish between CRR and SLR Ans:. CRR is occasionally used as a tool in monetary policies that influence the country’s economy. The exchange rates are determined by a structure which is called the international monetary system. correspondents or associates of the parent company.
If any Indian bank fails to maintain the required level of SLR. In India. After following the requirements. The RBI increases the SLR to control inflation. There are some statutory requirements for placing the money in the government bonds. It means the percentage of demand and time maturities that banks need to have in forms of cash. The nonpayer bank pays an interest as penalty which is above the actual bank rate. The maximum limit of SLR is 40 percent and minimum limit of SLR is 25 percent. As gold and government securities are highly liquid and safe assets they are included along with cash. RBI determines the percentage of SLR.• 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. gold and securities like Government Securities (G-Secs). 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 With Lots of Luck: Ali 7 . Increase in SLR also limits the bank’s leverage position to drive more money into the economy. the RBI arranges the level of SLR. then it is penalised by RBI. extract liquidity in the market and protects customers’ money. The main objectives for maintaining SLR are the following: • • • By changing the SLR level.
Master of Business Administration .The major risks are associated with banking organisations.1 Explain any two major risks associated with banking organization. it becomes important to manage risks carefully. mutual funds or money market instruments and can be reduced by diversifying or hedging techniques. The various types of risks are: • • • • • • • • • • Interest rate risk Foreign exchange risk Liquidity risk Default risk Financial risk Market risk Credit risk Personnel risk Environmental risk Production risk Interest rate risk Interest rate risk occurs due to the change in absolute level of interest rates causing variations in the value of investments. Such changes usually affect the securities like shares. bonds. They are classified into the following: With Lots of Luck: Ali 8 .2 Q. The evaluation of interest rate risk should consider illiquid hedging products or strategies.MBA Semester 4 MF0016 – Treasury Management Assignment Set. Since banks use a large amount of leverage. and potential impact on fee income which are sensitive to changes in interest rates. Ans:.
. The option seller faces unlimited downside risk (option exercised during the time of disadvantage) and limited upside reward (retaining premium). It refers to the probability of loss occurring due to an adverse movement in foreign exchange rates. The changes in relationships occur when the shape of yield curve for a market flattens.• • • Term structure risk (yield curve risk) – It arises from the variations in the movement of interest rates across maturity spectrum. Basis risk – It occurs due to the changes in relationship between interest rates for different market sectors. By this the investor experiences decline in rate of return at which the Yen exchanges for dollars. It is also known as accounting exposure. Foreign exchange risk Foreign exchange risk occurs during the change of investments value occurring due to the changes in currency exchange rates. Q. The gap profile is represented either in the form of tables or charts.2 What is liquidity gap and detail the assumptions of it? Ans. The gap profile changes as and when new assets and liabilities are added. But the option holder faces limited downside risks (amount paid for option) and unlimited upside reward. a positive gap between assets and liabilities is equivalent to shortage of cash. At any point of time. Economic risk – It measures the impact of changes in exchange rate risk on the organisation’s cash flows and earnings. Options risk – It arises when bank or bank customer gains privileges to alter the level and timing of cash flows of asset. With Lots of Luck: Ali 9 . steepens. The marginal gap refers to the difference between the changes of assets and liabilities over time. The three types of foreign exchange risk or exposure are: • • • Transaction risk – It is the possibility of affecting future transactions of the organisation due to the changes in currency exchange rates. The yield curve variations can emphasise a bank’s risk position by increasing the effect of maturity mismatches. For example – Consider an investor residing in United States purchases a bond denominated in Japanese Yen. It consists of changes in relationship between interest rates of various maturities of similar market. The option holder has the rights to buy or sell the financial instruments over a specified period of time. Translation risk – It measures the impact of changes in exchange rate of organisation’s financial statements. or becomes inverted during interest rate cycle. All the assets and liabilities are accounted in liquidity gap report and it is dependent on the dates of maturity and the actual date.Liquidity Gap Report A liquidity gap is the difference between the due balances of assets and liabilities over time. liability or off balance sheet instruments. A positive marginal gap means that the change in the values of assets exceeds that of liabilities.
and off-balance sheet assets. Under normal conditions. a bank would look at four basic questions. different banks can allot the same assets to different groups on maturity ladder. A less liquid group of assets consists of bank’s saleable loan portfolio. Assumptions regarding a bank’s future stock of assets include their possible marketability and use an asset as a guarantee of existing assets which could increase flow of cash and others. The assignment here is to develop assumptions about a reasonable plan for the clearance of a bank’s assets. the normal growth in new deposit accounts. Some of the assets might instantaneously be converted into cash at existing market values under almost any situation whereas others. there may be assets which are much liquid then during a time of crisis. To determine the marketability of an asset. such as interbank loans might lose liquidity in a common crisis. The first two questions represent the proceedings in the With Lots of Luck: Ali 10 . This would include forming: • • The level of roll-overs of deposits and other liabilities remain normal. liabilities and off balance sheet items Since the future liquidity position of a firm cannot always be predicted based on the factors. But the number of assumptions to be made should be limited. such as demand deposits and others. the method segregates the assets into three categories according to their degree of relative liquidity: • The highly liquid group of assets consists of components such as interbank loans. The least liquid group of assets consist of basically unmarketable assets such as loans that are not capable of being readily sold. The assumptions can be made based on three aspects. While examining the cash flow arising from a bank’s liabilities during the two crisis scenario. They are assets. banks should take care of the effects on the asset’s liquidity under the various conditions.Assumptions in preparation of gap report in terms of assets. while marketable. While categorising the assets. bank premises and investments in subsidiaries. Therefore a bank may classify the assets according to the type of scenario it is forecasting. • • Because of the difference in the banks internal asset-liability management. Liabilities To check the cash flows occurring due to a bank’s liabilities. liabilities. might be viewed as unsaleable within the time frame of the liquidity analysis. The actual maturity of deposits with non-contractual maturities. Assets Assets are nothing but any item of economic value owned by an individual or corporation. Some assets. a bank should first examine the behaviour of its liabilities under normal business situations. cash and securities. assumptions play an important role in determining the continuing due to the rapidly changing banking markets.
flow of cash that tend to reduce the cash outflows planned directly from contractual maturities. includes core deposits that are not already included in the first category. Nevertheless. especially when there is high crisis. And help in creating a time table. These facilities are rarely found in larger banks but With Lots of Luck: Ali 11 . this approach adopts a conservative stand and assumes that these remaining liabilities will be paid back at as early as possible before the maturity date.for these kinds of cash flows a bank’s very own past experience related to liabilities and the experiences of other such firms with similar problems may come handy. as such money may flow to government securities and other safe refuges. • Does the bank have a reliable back-up facility? For example. such as wholesale deposits. some of the interbank deposits and government funding remains with the bank even though they are considered volatile . is unaffordable in the very short term. sometimes high scale firms may find that they receive larger than the usually got wholesale deposit inflows. especially for some business services that include transactions accounts. Some core deposits generally remain with a bank because retail and small scale industry depositors may rely on the public-sector security net to shield them from occurring loss. Liabilities. and can the count of these sources be increased? Other than the liabilities identified from this step. in a general market crisis. even though there are no cash inflows existing for other firms in the market. The total liabilities identified in the first category may be assumed to stay with the bank even when it’s a worst scenario. Factors such as diversification and relationship building are considered important during the evaluation of the degree of the outflow of funds and a bank’s capacity to replace funds. In some countries. Under each case. including some without contractual maturities. The four questions are as follows: • What are the different sources of funding that are likely to stay with a bank under any situation. and at what rate? Is deposit pricing a way for controlling the rate of runoff? The second category consists of liabilities that have chances of staying back with the bank during the period of slight difficulties and can be used during crisis. • What are the sources of funding that can be estimated to run off gradually if problems occur. or because the cost of changing banks. a bank’s capital and term liabilities that are not maturing within the prospect of the liquidity analysis provide a liquidity buffer. small banks in local areas may also have credit lines that they can bring down to offset cash discharges. • Which maturing liabilities can be estimated to run off instantly at the first warning of trouble? The third category consists of the maturing liabilities that remained. other than core deposits.
customers with in-the-money swaps (or a net in-themoney swap position) would try to reduce their credit exposure to the bank by requesting the bank to buy the swaps back. A bank may be able to create a "normal" level of out flow of cash on a regulatory basis. especially in a bank specific crisis. Other assumptions Until now the discussion was centered on the assumption about the behaviour of the specific instrument under different scenarios. the Contingent liabilities. and forward foreign exchange rate contracts. but are usually not dependent on a bank’s condition. a general market crisis may generate a considerable increase in the total invocation of letters of credit because of an increase in defaults and liquidations in the market. a bank would like to review its written OTC options book and any warrants that are due. At the time of looking the components exclusively. since certain types of crises sometimes arouse an increase in early exercises or requests that the banks should buy the offer back. For instance. These activities could result in an unexpected cash loss. Similarly. In addition. Consider another situation wherein a bank acts as a swap market-maker. However. and then estimate the possibility a raise in these flows during periods of stress. Other possible sources of cash outflows are swaps. written Over-The-Counter (OTC) options. along with hedges if any against these positions. even if they are not a portion of the bank’s recent liquidity analysis. such as letters of credit and financial guarantees. With Lots of Luck: Ali 12 . the majority of the banks provide clearing services to financial institutions and correspondent banks. and whether or not the total net pay-out is significant. there might be some of the factors that might have a major impact on the cash flows. Such facilities usually need to undergo many changes but only to a limit. But they can be sources of cash outflows in some cases. These institutions generate a major sum of cash inflow and cash outflows and unpredicted variations in these services can reduce a bank’s funds to a large extent. Off balance sheet item A bank should also examine the availability of sufficient cash flows from its off balance sheet activities (other than the loan commitments already considered). represent potentially significant cash outflow for a bank. if hedges can neither be quickly liquidated to generate cash nor provide insufficient cash. The need for liquidity arises from business activities. The banks too need excess funds to support extra operations. consider that a bank has a large swap book. with a possibility that in a bank-specific or general market crisis. For example. The other expenses such as rent and salary however are not given much importance in the analysis of the bank’s liquidity. it would then want to study the circumstances under which it could become a net payer.however it depends on the assumptions made on the bank’s liabilities.
who was a well-known Swedish economist. if the investors possess debt instruments that have longer term periods then they will receive a premium of the rates of interest over a long-term period.. With Lots of Luck: Ali 13 . Liquidity premium stabilises the financial risks that the investors have suffered due to the investment in debt instruments that had longer term periods. so if ‘r’ is the rate of interest. An increase in the demand of loanable funds leads to an increase in the interest rate and vice versa. Also an increase in the supply of loanable funds results in the fall of interest rate. the generation of the debt instrument that has a longer periodic term is higher compared to debt instruments having shorter term periods. Keynes. the resultant interest rate depends on the level and route of the movement of the loanable funds.Loanable funds theory Loanable funds theory explains that the calculation of the rate of interest is on the basis of demand and supply of loanable funds which are available in the capital market. which arranges the quantity of money which the public will hold when the rate of interest is given. The liquidity preference theory does not deal with liquidity.Q. the risks related to the maturity of debt instruments are directly proportional to the length of the maturity period. M. bonds and commodities. The loanable funds theory encourages that both savings and investments are responsible for the determination of the rates of interest. but deals with the risks associated with maturity. According to the liquidity preference theory. Liquidity preference theory The liquidity preference theory or liquidity preference hypothesis. explains the relation between the generation of a debt instrument and its maturity period. The availability of loan amount is based on certain factors like net increase in currency deposits. The liquidity preference theory states that investors maintain their funds in liquid form like cash rather than less liquid assets like stocks. The concept was created by Knut Wicksell (1851-1926). If both the demand and supply of the loanable funds changes. and willingness to enhance cash balances. Liquidity preference is a potentiality or functional tendency. According to this theory. amount of savings made. Banks offer interest to investors to compensate for their liquidity losses which ultimately promote long-term investments. ‘M’ the quantity of money and ‘L’ the function of liquidity preference.3 Explain loanable fund theory and liquidity preference theory Ans. As a result of the premium. The short-term interest rates are assessed on the basis of the financial conditions of an economy. In case of loanable funds theory the determination of the interest rates depends on the availability of the loan amount. we can define M = L(r). This premium is known as the liquidity premium. It was widely accepted before the work of the English economist John Maynard Keynes (1883-1946). proposed by J.
google. We shall discuss some of the sources of interest rate risk in the following subsections. This yield curve is known as normal yield curve.1: Normal Yield Curve Source: http://www.in/imgres?imgurl=http://livingeconomics. The yield curve risk occurs due to the yield curve fluctuations which affect the organisation’s income and economic values of underlying assets. The changes occurring in interest rate affects the value of underlying assets of the organisation.Q.org/images/glossary/yield_curve. It is called as flat curve.asp&usg=__73JVTBBWNvKyxZj2AVoLIU dx3GM=&h=289&w=480&sz=29&hl=en&start=1&zoom=1&um=1&itbs=1&tbnid=MIK7LKa With Lots of Luck: Ali 14 . It changes the price values of interest bearing asset and liability based on the magnitude level of fluctuations in interest rates.org/glossary.co. The variations in movements of interest rates changes when the yield curve of a market flattens or steepens in the interest rate cycle. The effects of recession impose negative impacts to the organisation hence they must concentrate on diversifying the investment portfolio. 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. It poses significant threat to the incomes and capital investments of the organisation. The yield curve flattens when the short term interest rates increases across the long term interest rates. Figure 10. gif&imgrefurl=http://livingeconomics. This occurs during the transition of the normal yield curve to an inverted curve.1 depicts the normal yield curve Figure 10.4 Explain various sources of interest rate risk Ans:. The inverted yield curve refers to the economic recession period.The interest rate risk adversely affects the organisation’s financial situation. The yield curve slopes upwards when the short term interest rates are lower than the long term interest rates. Therefore the market status overviews the yield curve of long term interest rate as decline in the long term fixed income of the organisation. Yield curve risk The yield refers to the relationship between short term and long term interest rates.
it experiences liquidity risk because the selling prices may be depressed in the market. With Lots of Luck: Ali 15 . The fixed rate loans will be encouraged when the short term rates exceeds the long term rates. 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. equity and fixed income investors.an organisation holds large untraded stocks. For example .XJ7cLjM:&tbnh=78&tbnw=129&prev=/images%3Fq%3Dnormal%2Byield%2Bcurve%2Bdiagr am%26um%3D1%26hl%3Den%26sa%3DN%26tbs%3Disch:1 Figure 10.co. The changes of interest rates can give rise to unexpected changes of asset and liability cash flows and earnings.2: Inverted Yield Curve Source: http://books. Basis risk Basis risk occurs due to the changes in relationship between the various financial markets or financial instruments. The fixed income investors are benefited with better returns with short term investments due to the elimination of risk premium for long term investments. This reduces the liquidity risk but increases the basis risk due to the differences between the selling and stock index prices. Hence the consumers who invest in financing properties experience higher mortgage payments.2 depicts the inverted yield curve Figure 10.in/books?id=F7OenmM8jiwC&pg=PA199&dq=inverted+yield+curve+ris k+diagram&hl=en&ei=sGG1TNjuD5DUvQOd66iOCg&sa=X&oi=book_result&ct=result&resn um=3&ved=0CD0Q6AEwAg#v=onepage&q&f=false The yield curve has major impacts on the consumers. If the company tries to sell those stocks in wholesale.google. The different market rates of financial instruments differ with time and amounts. the company enters into futures contract with stock index. Hence to overcome this issue. In the banking organisation basis risk occurs due to the differences in the prime rate and offering rates on money market deposits. saving accounts.
Embedded option risk The embedded option refers to other option securities such as bonds. The stand-alone instruments are explicitly priced and are not linked with other bank products. exchange traded options. there are chances of bank experiencing variations in interest rate movements of future earnings. It usually results in a risk or rewards to the bank. The income of the liability sensitive bank increases during the fall of interest rates and declines when the interest rate increases. The callable embedded option bond consists of hold (option free bond) option and embedded call option. There are chances of losses in bank’s capital value due to unfavourable interest rate movements such that it exceeds the profits that a bank gains. The repricing risk increases the earnings of the banks. The option allows the option holder to buy or sell financial instruments. Hence during the decline of rates the customers will perform prepaying loan process which shortens the bank’s asset maturities while the bank desires to extend it. bond loans and so on. liabilities. Therefor it has more downside exposure than upside reward. The banking organisations must consider long term imbalances during the repricing risk evaluation. Most of the banking organisations allow prepayment option of commercial loans which includes the prepayment process without any penalties. It occurs during the process of altering the bank’s instruments’ levels of cash flows by bank’s customers or by bank itself. The embedded option is a part of another instrument which cannot be separated.The basis risk affects the profits of an organisation by striking the cash positions. Inversely. Repricing risk affects the bank’s earnings performance. If the gauging of long term repricing is improper. The bank faces losses during the sold position option to its customers. The basis risk changes the storable commodities based on the changes of the storage costs over a period of time. the asset sensitive bank benefits from rise in rates and detriments with fall in rates. Optionality risk Optionality risk arises with various option instruments of banks like assets. liabilities and off balance sheets. Liability sensitivity occurs in banking organisations since repricing asset maturities are longer than the repricing liability maturities. Since the banks focus on short term repricing imbalances are initiated to implement increase interest rate risk by extending maturities to improve profits. financial instruments. The options are traded in banks with stand-alone instruments such as over the counter (OTC). Repricing risk Repricing risk arises due to the differences between the timing of rate changes and cash flows occurring in pricing and maturity of bank’s instruments such as assets. It is measured by comparing the liability volume with asset volume that reprice within specified period of time. The option holder experiences limited downside risk (paid amount) and unlimited upside reward whereas the option seller has unlimited risk and limited upside reward. during the favourable movements. The With Lots of Luck: Ali 16 .
3: Value of Embedded Call Option The embedded putable bond consists of option free bond and embedded put option. The price of callable bond is equal to the price of hold option bond minus price of call option bond. 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. The decline in interest rates increases the callable option price bond. Figure 10.value of the bond changes according to the changes occurring in interest rates of embedded options values.analystnotes.4: Value of Embedded Put Option Source: http://www.3 depicts the value of embedded call option varying with respect to changes in interest rates. The With Lots of Luck: Ali 17 .com/browse_los.php?id=13868 The organisations must handle the options effectively such that the various types of bonds under embedded option are exposed to low level of risks. Figure 10. 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.
Organisational controls – To guarantee that there exists a clear and effective isolation of duties between those persons who initiate the foreign exchange transactions and are responsible for operational functions of foreign exchange activities. • Control of foreign exchange activities – Though the control of foreign activities vary widely among the banks depending upon the nature and extent of their foreign exchange activities. applying and supervising procedures to manage and control foreign exchange risk based on the risk management policies. In devising a firm’s FERM policy. certain factors have to be taken into account – the firm’s exposure. counterparty and other limits and those excesses are reported to the management.e. risk-indifferent or risk-seeking. the maximum exchange loss it can absorb without much impact.5 Detail Foreign exchange risk management and control procedure Ans. the main elements of any foreign exchange control plan are well-defined procedures governing: 1. • Independent inspections/audits – Independent inspections/audits are an important factor for managing and controlling a bank’s foreign exchange risk management plan. and the integrity of. Q. Therefore. Procedural controls – To ensure that the transactions are completely recorded in the accounts of the banks.exceeding number of options can implicate leverage magnifying the positive or negative influences of financial options positions in the organisation.Foreign Exchange Risk Management (FERM) and control procedures Each of the banks engaged in foreign exchange activities is responsible for evolving.. Other controls – To make sure that the foreign exchange activities are supervised frequently against the bank’s foreign exchange risk. 2. 3. the firm’s ability to alter exposed positions i. general attitude towards risk management. 2. The impact of potential exchange rate changes on the bank. the foreign exchange With Lots of Luck: Ali 18 . adequate information must be readily available to permit suitable action to be taken within the acceptable time period. Foreign exchange risk management procedures include the following: • Systems to measure and monitor foreign exchange risk – Management of foreign exchange risk involves a clear understanding of the amount of risk and the influence of exchange rate changes on the foreign currency exposure. Banks must use them to ensure compliance with. each of the banking organisations engaged in foreign exchange activities must have an operative accounting and management information system in place that records and measures the following accurately: 1. The risk exposures related to foreign exchange trading. the competitor’s stance and most importantly regulatory requirements. they are promptly and correctly settled and to identify unauthorised dealing instantly and reported to the management. In order to make these determinations. whether its risk-averse.
VaR acts as a versatile tool for forex risk measurement. 4. Independent inspections/audits should examine the bank’s foreign exchange risk management activities in order to: 1. • The VaR of a specific market position is not always the same for the VaR of the overall portfolio of the bank. 2. Ensure adherence to the foreign exchange management policies and procedures. where traders have a natural tendency to take on extra risk. Ensure operative management controls over foreign exchange positions. Q. 5. • VaR may miscalculate the worst-case outcomes for a bank. thus permitting rapid comparison among different countries and the analysis of the evolution over time for a country.policies and procedures. Ensure that employees involved in foreign exchange risk management are given accurate and complete information about the institution’s foreign exchange risk policies. VaR allow creation of a common denominator to compare risky activities in varied markets. Performance assessment of risk is vital in banks. value at risk approach possesses certain limitations too. risk limits and positions. Value at risk method is used to set market position limits for traders and to decide how to allocate minimum capital resources. • VaR fails to incorporate positive results. The VaR approach has a number of practical advantages and disadvantages. VaR approach is approved by various regulatory bodies concerned with the risks faced by banks such as RBI (Reserve Bank of India) and SEBI (Securities and Exchange Board of India). Ensure that the foreign exchange hedging activities are consistent with the bank’s foreign exchange risk management policies and procedures. 3. With Lots of Luck: Ali 19 . Risk capital charges based on VaR approach provides corrected incentives to the traders.The Value at Risk (VaR) approach is a comprehensive indicator for measuring foreign exchange risks. VaR approach incorporates all the assets and liabilities of the national financial system. The limitations of VaR are as follows: • VaR faces some difficulties in risk estimation and is sensitive to the estimation methods used. VaR can be used to regulate the performance of risk.6 Describe the three approaches to determine VaR Ans:. The advantages of VaR are as follows: • • • The potential losses are computed in simple terms. thus painting an incomplete picture of the situation. The total risk of the banks can also be decomposed into incremental VaR to reveal positions that increases total risk. Verify the capability and accurateness of the management information reports regarding the institution’s foreign exchange risk management activities. along with the contingent liabilities. On the other hand. On the other hand. • VaR approach may create a false sense of security.
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