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Ma 0042

Ma 0042

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  • Q.1 Explain any two major risks associated with banking organization
  • Q.2 What is liquidity gap and detail the assumptions of it?
  • Q.3 Explain loanable fund theory and liquidity preference theory
  • Q.4 Explain various sources of interest rate risk
  • Q.5 Detail Foreign exchange risk management and control procedure
  • Q.6 Describe the three approaches to determine VaR

Reg no # 511017114

Sikkim Manipal University – Distant Education

Name: Registration Number: Learning Center:

Manik Pant 511017114 Chandigarh 03038

Learning Center Code: Course: Subject: Semester:

Masters of Business Administration (MBA)

MA0042 Treasury Management


Directorate of Distance Education Sikkim Manipal University II Floor, Syndicate House Manipal – 576104



Reg no # 511017114

Signature of Coordinator Signature of Center Evaluator Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 1

Signature of

Q.1 Explain how organization structure of commercial bank treasury facilitates in handling various treasury operations. Ans: Treasury Organisation 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 depicts the structure of treasury organisation which is divided into five groups.

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.

Reg no # 511017114

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. Corporate services: This group deals with overall management of the treasury organisation. It includes financial and facilities division, human resource division, business solutions and information management division. Treasury as a profit centre The implementation of treasury in the organisation gains profits in several aspects rather than considering it as a cost centre. It helps in providing market rates to the individual business units for the services provided and thereby making operating costs more realistic. The treasurer is motivated to ensure that more services are provided to make profits in market rate. Organisations also experiences the following disadvantages when considering treasury as a profit centre: Profit is a tempting factor to speculate as it sometimes encourages the organisation to invest in wrong direction that brings depreciation in economy as well growth of organisation. Most of the time is duly spent in arguing with business units with respect to charges over services. There may be excessive additional administrative costs. Centralised and decentralised treasury management Most of the multinational organisations face huge challenges in managing transactions globally. As the organisation expands geographically, it is difficult to access and track accurate and timely cash flow information. As the technology has been adversely developed, the need for centralising treasury has evolved; theoretically centralisation allows the treasurers to exercise greater control over operating organisations. The process of centralisation consists of: Providing centralised foreign exchange and interest rate risk management Dealing with cash management Providing fully centralised treasury including incoming and outgoing payments Centralising business treasury functions enhances the organisation to build economies of scale and rationalise costs during acquisition. Centralisation helps

Reg no # 511017114

to achieve low cost debts, increase investment returns, reduce financial risks and ensure liquidity across the organisation. Decentralisation refers to the challenges of producing overall view of cash position and exposure to risk on a timely basis. Since the organisation contains various recording and reporting information methods, it will be difficult to construct a global risk position while combining information from different sources. In such cases it is impossible to make strategic decisions without access to timely and accurate information during the periods of economic volatility. In a decentralised environment, the company allows its subsidiaries to manage their own payables and payment processes. A lack of standardisation across subsidiaries and automation can lead to risks in transactions like incorrect payments and data redundancy. Treasury management in banks In recent days, most of the Indian banks have classified their business into two primary business segments like treasury operations (investments) and banking operations (excluding treasury). The treasury operations in banks are divided into: Rupee treasury: The rupee treasury carries out various rupee based treasury functions like asset liability management, investments and trading. It helps in managing the banks position in terms of statutory requirements like cash reserve ratio, statutory liquidity ratio according to the norms of the Reserve Bank of India (RBI). The various products in rupee treasury are: = Money market instruments Call, term, and notice money, commercial papers, treasury bonds, repo, reverse repo and interbank participation etc. = Bonds Government securities, debentures etc = Equities Foreign exchange treasury: The banks provide trading of currencies across the globe. It deals with buying and selling currencies. Derivatives The banks make foundation for Over the Counter (OTC). It helps in developing new products, trading in order to lay off risks and form apparatus for much of the industrys self-regulation. The role of policies in strategic management was described in this section. The next section deals with inter-dependency between policy and strategy.


maturitydated obligations of banks. CDs are known as negotiable instruments and they are also known as Negotiable Certificates of Deposit. hence they are riskless in terms of payments and principal amount. Basically they are a part of banks deposit.Reg no # 511017114 Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 1 Q. Ans: Certificate of deposit (CDs) is a short-term instrument issued by commercial banks and financial institutions. This contributes to 5/43 . CDs are interest-bearing. It is a document issued for the amount deposited in a bank for a specified period at a specified rate of interest. The bankers need not encash the deposit before the maturity and the investor can sell the CDs in the secondary market before the maturity. The concerned bank issues a receipt which is both marketable and transferable in the market.2 Bring out in a table format the features of certificate of deposits and commercial papers. The receipts are in bearer or registered form. CDs benefit both the banker and the investor.

1 crore.Reg no # 511017114 the liquidity and ready marketability for the instrument. CDs can be issued only by the schedule banks. It is purchased mostly by the commercial banks. Sometimes they are issued directly to the investors. The maturity period ranges from 30 days to one year. As per the scheme.5 lakh. The introduction of CDs in Indian market was assessed in 1980. endorsement and delivery. There is no restriction on the discount rate by the RBI. they are known as Euro-commercial paper. CDs are subjected Statutory Liquidity requirements to CRR and The ceiling amount of CPs should not Ratio (SLR) exceed the working capital of the issuing company. It is issued at discount to face value. It issued by the corporations to raise funds for a shortterm. CDs are issued in the multiples of Rs. They are highly liquid as they have buy-back facility. the corporate units registered in India and incorporated units. dealers or brokers. Generally CPs is issued through banks. Commercial Papers (CPs) is a type of instrument in money market and it was introduced in Jan 1990. CDs can be issued only by the scheduled banks at a discount rate to face value. business organisations and no lock-in period. Non-Banking Finance Companies (NBFCs) and business organisations. They have individuals. They are issued in bearer forms on a discount to face value. CPs is issued in domestic as well as international financial markets. The discount rate depends on the market conditions. Features of CDs in Indian market Features of CPs Schedule banks are eligible to issue CPs is an unsecured promissory note. Based on the suggestions of Vaghul committee. They are freely transferable by The investors in CPs market are banks. 25 lakh. Commercial paper is a short-term unsecured promissory note issued by large corporations. RBI appointed the Vaghul Working Group to study the Indian market for five years. months to one year CPs is issued in the denomination of Banks are not permitted to buy back Rs. The CPs is issued in denominations of Rs. The minimum size of the their CDs before the maturity issue is Rs. CPs is negotiable by endorsement and delivery. CDs CPs can be issued for a maturity period Maturity period varies from three of 15 days to less than one year. CDs have to bear stamp duty at the prevailing rate in the markets The interest rate of CPs depends on 6/43 . 5 lakh or multiples of Rs. 25 lakh and the minimum size of the issue is Rs. RBI formulated a scheme for the issue of CDs. In international financial markets. 5 lakh. The maturity period ranges from three months to one year.

4. Master of Business Administration – MBA Semester 4 7/43 . The attractive rate of interest in any of these markets.The issuing company has to be listed on stock exchange. affects the demand of CPs.The current ratio of the issuing company should be 1. . forex market and call money market.33:1.5 Crores. (ICRA) respectively .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. The eligibility criteria for the companies to issue CPs are as follows: . .Reg no # 511017114 The NRIs can subscribe to CDs on the prevailing interest rate on CPs repatriation basis market.The tangible worth of the issuing company should not be less than Rs.

The Committee is. Any dividends or capital gains collected from the primary securities are returned back to the investors. whereas all FIIs have to register compulsorily. These PNs are freely transferable and trading of these instruments makes it all the more difficult to know the identity of the owner. both the non-resident foreigner and Non-resident Indian pay a hefty premium to a firm which has managed to get the license to operate in the Indian stock market i. In the case of Participatory Notes (PNs). PNs are basically contract notes. Detail the regulatory aspects on it. Investors use PNs to enter Indian market and shift to fully fledged FII structure when they are established. Non-resident investments in India and use of Participatory Notes (PNotes) All things considered. Indian traders buy securities and then issue PNs to foreign investors. which enables large funds to carry out their operations without revealing their identity. It is also not possible to prevent trading in PNs as the entities subscribing to the PNs cannot be restrained from issuing securities on the strength of the PNs held by them. of the view that FIIs should be prohibited from investing fresh money raised through PNs.e. The market has found a way to avoid the limitation by creating an instrument called Participatory Notes (PNs).3 Critically evaluate participatory notes. Existing PNholders may be provided an exit route and phased out completely within one year. Ans: Participatory notes International entrance to Indian capital market is limited to Foreign Institutional Investors (FIIs). an FII. It provides a high degree of secrecy. Instead of moving towards decreasing 8/43 . Any entity investing in PNs may not register with SEBI. The benefits of PNs are as follows: Entities route their investment through PNs to extract advantage of the tax laws system. the nature of the beneficial ownership or the identity is not known unlike in the case of FIIs.Reg no # 511017114 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 1 Q. therefore.

incidentally. and second by recommending a ban on Participatory notes or P-notes. That this might be a “politically correct” conclusion. Regrettably. is recommending a significant move backwards. the Committee. (India has a 10 % tax on short-term gains and a 33 percent tax rate on short-term gains made via futures markets. the Report did not deem it appropriate to discuss the influence of such differential tax rates on human and investment behavior). without any documentation or evidence. It is the bans and controls on investment by foreign based individuals and corporates that has created the off-shore P-notes market in Indian securities. at least in some institutions in India. by recommending a ban on P-notes. the Committee recommends two actions that will further increase these costs: first. P-notes primarily exist because of the large transaction costs that the Indian system imposes on foreign residents and corporates. suggests an ideological bureaucratic predisposition. with immediate implementation. it reached the opposite conclusion on P-Notes than that reached by the FCAC Committee. My only issue is that the Report is inconsistent in its recommendations. Most important. is irrelevant. The recommendation on industrial houses does not come with any strings attached – somewhat surprising. of industrial houses owning commercial banks – a policy. Instead of reforming this “license raj”. 9/43 . by delaying entry of individuals into the Indian market until 2008/9. So as water finds its way. The Committee’s haste towards an immediate ban of P-Notes. P-Notes (an appropriate response to controls) is considered by the Committee to be of such an undesirable nature that it is recommended that they be banned immediately. with the Reports endorsement of a new policy. Unfortunately. and perhaps out of character. This GOI report was published in November 2005. comparator emerging markets have zero short and long term capital gains taxes. given the extreme “caution” with which the report proceeds on other matters. and immediate reversal of existing GoI policy. I support. The license raj has shifted from the industrial sector to the financial sector.Reg no # 511017114 these transaction costs. of stock market transactions. Like the FCAC committee. And is in complete contrast. and because of higher capital gains taxes in India than in other emerging markets. the government of India had also constituted an expert group to look at the issue of “Encouraging FII Flows and checking the vulnerability of capital markets to speculative flows”. and reality. so do investors. The report reveals a lack of understanding of the underlying fundamentals.

Reg no # 511017114 Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 1 Q. CAC enhances growth and welfare of country. human cost and even extensive presence of capital controls creates distortions. Most of the countries have liberalised their capital account by having an open account. These developments have led to considerable caution being exercised by EMEs in opening up capital account. Crisis such as economic. but they do retain some regulations for influencing inward and outward capital flow. Due to global integration. both in trade and finance. social. which went through currency and banking crises in 1990s. The Committee 10/43 .4 What is capital account convertibility? What are the implications on implementing CAC? Ans: Capital Account Convertibility (CAC) Capital Account Convertibility (CAC) refers to relaxing controls on capital account transactions. The perception of CAC has undergone some changes following the events of emerging market economies (EMEs) in Asia and Latin America. The cost and benefits from capital account liberalisation is still being debated among academics and policy makers. It means freedom of currency conversion in terms of inflow and outflows with respect to capital account transaction. A few counties backtracked and re-imposed capital controls as part of crisis resolution. making CAC either ineffective or unsustainable.

11/43 . This is known as current account convertibility.S. The domestic currency is said to be convertible on the current account. Initially open the inflow account and later liberalise the outflow account. Approach to simultaneously liberalise control of inflow and outflow account. S.when the payment exceeds 5% on local sales and 8% increase on exports. GOI is not mandatory.Reg no # 511017114 on Capital Account Convertibility (Chairman: Shri. The liberalisation rules regarding current account transaction of RBI under FEMA 1999 are as follows: Authorised Dealers of Category . Liberalisation of current account transactions Current account transaction refers to converting domestic currencies freely into foreign currency and vice versa. RBI has introduced more relaxations in current account transactions. 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.I banks permits withdrawal of foreign exchange payments below USD 2million by the individuals and approval of Ministry of Commerce and Industry. The confidence of a country will be enhanced when the country will manage its affairs without exchange restrictions which enhance the international confidence in the countries policies. Relaxing the exchange restrictions has improved the Balance of Payment (BOP) in the country. it is mandatory to get approval of Ministry of Commerce and Industries for drawing foreign exchange remittances . The authorised dealers (ADs) have been permitted to provide exchange facilities to their customers up to specified limit without prior approval of the RBI. The exclusion of exchange restrictions tends to increase the capital inflows and thus promote efficient allocation of inflows to the growth of the countrys economy. The different ways of implementing CAC are as follows: • • • Open the capital account for residents and non-residents. The benefits of current account transaction are as follows: Current account convertibility enhances the increase of capital inflow in to the country. As per the Rule 4 of FEMA (current account transactions).

But with the changes that have taken place over the last two decades. all categories of foreign exchange earners can avail credit in this account based on their foreign exchange earnings. . . Under this scheme.There can be no remittances made directly or indirectly towards countries identified as non-co-operative countries and territories by the Financial Action Task Force (FATF).Reg no # 511017114 Liberalised remittance scheme is a facility extended to the residents of India. 12/43 . maintain and hold foreign currency accounts with banks outside India.The individuals and organisations identified and advised by the RBI as significant risk of committing terrorism are not eligible for any remittances directly or indirectly.The resident individual cannot remit directly to Nepal. . The liberalised remittance scheme is not applicable for the following: . Residents can open. Some of the liberalised measures in EEFC account are: . without the prior approval of RBI.RBI has permitted to earn interests on EEFC account if the outstanding balance is USD 1 million.If the reimbursement for an international credit card is provided in foreign exchange. These accounts are non-interest bearing and they are used for hedging against foreign currency fluctuations by the business organisations which have exports and imports in foreign currency payments. the residents can remit in any current or capital account up to USD 2 million per financial year. This facility is only for resident individuals. The resident individuals can purchase and hold immovable property or shares or debt instrument outside India.EEFC account is a foreign currency account maintained by a resident individual with an authorised dealer in India.Due to liberalisation. . . Bhutan and Pakistan.Any purpose under Schedule I and any item under Schedule II are prohibited for remittance under Foreign Exchange Management Rules 2000. it may be considered as a remittance through normal banking and the earnings can be credited to EEFC account. Liberalisation of Exchange Earners Foreign Currency (EEFC) account . Other measures The other measure taken towards CAC is fuller capital account convertibility which is explained as follows: Fuller Capital Account Convertibility (FCAC) Indias cautious approach towards capital account and assessing it as a liberalisation process based on certain pre conditions has held India in good state. RBI decides on credit and debit limits.

It facilitates economic growth through higher capital investment . Likewise. A transparent financial consolidation is necessary to reduce risk of the currency crisis. affects the banks interest rate and liabilities. Improvement in financial sector . regulation and supervision of banks. For example. RBI.This will lead to growth in employment opportunities. 13/43 .Markets risks like interest rate and foreign exchange risks become more complicated when financial institutions have access to new markets or securities.S Tarapore was the chairman of committee. the risk associated with economic. This will enhance the liquidity in the system. infrastructure development and other areas. social. Large flow of funds in different currencies will expose the banks to greater variations in their liquidity position and complicate their asset-liability management. S. Credit risk: It includes a new dimension with cross border transaction.It includes both market and credit risk.Huge capital flow into the system will lead to the improvement of financial sector which will enhance performance of the companies. and the timing and sequencing of capital account liberalisation measures. Risks involved in FCAC FCAC risk arises from inadequate preparedness before liberalisation in domestic and external sector of policy consolidation. Liquidity risk: It includes risk in foreign currencies denominated assets and liabilities. and political environment of the borrowers country. Cross border transactions introduces country risks to domestic market participants. The objectives of FCAC are as follows: Economic growth . Diversify the investment: The diversification of investment will help ordinary people. banks have to quote rates and take open positions in new and more volatile currencies. the change in foreign interest rate.Reg no # 511017114 India felt the need to revisit the CAC and suggested a new map towards FCAC based on current situations. to invest in foreign countries without restriction. Risk in derivatives transaction It is very important with FCAC as derivatives transaction are main tools used in hedging risks . in consultation with the Government of India (GOI) appointed a committee on FCAC. strengthening of regulation and development of financials markets. Participation of foreign investors in domestic market changes the working of the domestic market. The risks are as follows: Market risks . This will help them to diversify their portfolio. The committee suggested several recommendations for the development of financial market in addition to addressing issues related to interaction of monetary policy and exchange rate management.

Reg no # 511017114 Operational risk: The difference between domestic and foreign legal rights and obligations and their enforcements is important with FCAC. 14/43 . Consequences of FCAC India might face the following consequences if it implements full convertibility without adequate reform measures: It will have to face the danger of becoming vulnerable to free movement of foreign capital. Inadequate technology for industrial economy. Operational risk may increase with FCAC. Inflationary pressure on the economy. Lack of emphasis on the quality of labour and management practices. The limitations are as follows: • • • • • • • Indian industries lack competitive strength. which may further worsen the macro-economic imbalances. Inadequate attention on tariff reduction and the rationalisation of tax structure in the adjustment scheme. This will result in rupee appreciation which will affect Indian exporters. Lack of resilient exchange rate mechanism at work. they are not fully prepared to handle the intricacies of the fuller convertibility. Absence of prudent fiscal management. Hence it is desirable to further strengthen their financial base. Limitations of FCAC The effort of making the Indian rupee fully convertible has a number of difficulties involved in it. Though the banks and financial institutions are fully capitalized. The prevailing high interest rates in the economy will attract capital inflow.

depositing cash into a lock box to ensure its protection. control payments to trade creditors and efficiently manage the liquidity margin. HCL is a recognised leader in multi-service delivery engagement services.5 Detail domestic and international cash management system.Reg no # 511017114 Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 1 Q. Ans: Cash Management System Maintaining the channels of collections and accounting information efficiently has become essential with growth in business transaction sections. CMS involves hiring a debt collection service to recover the borrowed property by a customer. Problems in cash management system are as follows: • • • Controlling the cash level. A Cash Management System (CMS) is a companys strategy which includes sustainable investment practices to enhance the collection of receivables. Optimum investment of surplus cash. This includes enabling greater connectivity to internal corporate systems and providing better IT solutions and services in cash management. The objectives of cash management system are to bring the companys cash resources within control in an efficient manner and to achieve the optimum conservation and utilisation of the funds. Keeping in view of the clients special needs. Controlling inflows and outflows of cash. proposition of CMS by HCL in order to enhance its liquidity level. HCL has set up its cash 15/43 . For example.

the regulatory body ensures that the exchange rate is at levels that do not affect domestic money supply in 16/43 . liquid asset ratio. Application re-engineering. HCL has an enthusiastic domain practice team for cash management activities which includes bankers and IT professionals from various global banks and techno functionalists who have worked on cash management systems for global banks. In this way the available savings are allocated and investments are directed in significant directions. The central bank reduces the supply of reserves by selling the securities and increased the supply of reserves by purchasing securities to the deposit money banks and thus affecting the supply of money. Prudential guidelines Regulatory bodies require the deposit money banks to exercise particular care in their operations to fulfil the specified outcomes.Reg no # 511017114 management system. Vital elements of prudential guidelines remove some choices from bank management and replace it with certain decision making rules. Direct credit control Regulatory bodies direct banks on maximum percentage or amount of loans to different economic sectors. Exchange rate By trading foreign exchange. Consulting services to select a suitable platform. The domain practice team supports the product development and delivery teams by continuous training and builds the required competency across the organisation. Domestic Cash Management System Reserve requirement The regulatory bodies like RBI instructs the banks to hold the deposit reserves of the public as cash and deposit. Open market operations The regulatory body trades securities like treasury bills to the banking and non-banking public. Few features of HCLs cash management system are as follows: • • • • • • Application designing and development. System integration services. Infrastructure management. It affects the reserve levels and hence the monetary base. Lending by the central bank The regulatory body sometimes provide credit to deposit money banks. Business process outsourcing. The reserves requirement limits the amount of loan that banks can lend to the domestic economy and thus limit the supply of money.

Language and cultural differences. The payments between the branches and the parent company are managed through the 17/43 . Multinational Cash Management 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. Expanding its business.Reg no # 511017114 undesired direction. import duties. During multinational cash management system payments by customers to companys branches are basically handled through a local bank. 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. Political risk and other risk. Difference in tax rates. Role of governments. The principle objective of multinational cash management programme is to maximise a companys financial resources by taking benefits from all liability provisions. payable periods. Multinational companies are those that operate in two or more countries. Economic and legal complications. The main goal of multinational cash management is the utilisation of local banking and cash management services. 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-house banking and by relocating funds for tax and foreign exchange management through repricing and invoicing. Decision making within the corporation is centralised in the home country or decentralised across the countries where the organisation does its business. Retaining customers and protecting its processes. Several factors which distinguish multinational cash management from domestic cash management are as follows: • • • • • • Different currency denominations. through the balance of payments and the real exchange rate. Preventing the regulatory obstacles.

6 Distinguish between CRR and SLR. crediting to the retail company's account. Wincors focus was on the entire process chain which started from head office to stores. correspondents or associates of the parent company. Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 1 Q. It occurs due to the change in exchange rates. Ans: Cash Reserve Ratio 18/43 .Reg no # 511017114 branches. negotiated value range. head office to branches and so on. Multinational cash management programme specifically evaluate its techniques by timing of billing. Through the use of electronic reporting systems a parent company observes cash balances in its foreign local banks. use of lockboxes or intercept points. IT services to side operations and consulting services to develop custom optimised solutions. For example. Wincor Nixdorf played an innovative role in enhancing cash handling between various countries. The exchange rates are determined by a structure which is called the international monetary system. Wincor Nixdorf's served several countries with its innovative hardware and software elements. 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.

RBI practices this method. The nonpayer bank pays an interest as penalty which is above the actual bank rate. Increase in SLR also limits the banks leverage position to drive more money into the economy. CRR is also called liquidity ratio as it controls money supply in the economy. It means the percentage of demand and time maturities that banks need to have in forms of cash. An organisation that holds reserves in excess amount is said to hold excess reserves. 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 any Indian bank fails to maintain the required level of SLR.Reg no # 511017114 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. There are some statutory requirements for placing the money in the government bonds. After following the requirements. These reserves are considered to meet the withdrawal demands of the customers. If RBI decides to increase CRR. the RBI arranges the level of SLR. that is. then the banks available cash drops. In India. The maximum limit of SLR is 40 percent and minimum limit of SLR is 25 percent. then it is penalised by RBI. gold and securities like Government Securities (G-Secs). increases CRR rate to drain out excessive money from banks. The RBI increases the SLR to control inflation. The CRR in the economy as declared by RBI in September 2010 is 6 percent. RBI determines the percentage of SLR. The reserves are in the form of authorised currency stored in a bank treasury (vault cash) or with the central bank. CRR is occasionally used as a tool in monetary policies that influence the countrys economy. The main objectives for maintaining SLR are the following: 19/43 . As gold and government securities are highly liquid and safe assets they are included along with cash. 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. extract liquidity in the market and protects customers money.

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 20/43 .Reg no # 511017114 • • • By changing the SLR level.

quantity. It is often associated with corporate bonds. Currency exposure: It deals with future cash flows arising from domestic and foreign currencies that involve assets and liabilities and generating revenues which are susceptible to variations in foreign currency exchange rates. It analyses the price and risk profile of financial dealings on a pre-dealing basis. Event exposure: This happens due to a sudden change in the financial market during an investment (an event) that has a detrimental effect on the value of that investment. financial instruments or any physical substances. hence hedging towards these risks by integrating business exposures and treasury transactions helps an organisation to manage financial risk and stay profitable. Hence the identification of existing potential currency relationship that arises from business activities includes hedging and other risk management activities. Hence treasury management is liable to deal with various risks like price. cost that are associated with commodities. Foreign exchange exposure: This occurs due to the low profits and adverse fluctuations in foreign exchange rates. Many organisations suffer from foreign exchange risk by making purchases or sales in foreign currency or by owning assets or liabilities in foreign countries.Reg no # 511017114 Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 2 Q. The exposure in foreign exchange market is intense. The commodities depend on any production including foreign currencies. Following are the few treasury exposures in an organisation: Financial exposure: The treasury management in the organisation are disclosed to the powerful analytics that enable to measure the global treasury operations and control financial market risks. Ans: Treasury exposure allows treasury management to various risks in the organisation. Need for risk management 21/43 . Commodity exposure: This happens due to variations in the prices of commodities which change the future and magnitude of market values.1 Explain any two major risks associated with banking organization. Hence a relevant course of action must be implemented to reduce exposures in business operations.

The corporate risk varies for different organisations based on factors like size. natural disaster etc. It is the responsibility of the organisation to manage risk effectively and overcome hindrances affecting the overall growth of the organisation. It helps to control the negative political. The organisation faces market risk with respect to commodity price risk and foreign exchange risk. It helps in increasing the ability to deliver products to the customers within the stipulated time and reduce the production cost. and commodity prices. Corporate risk is further divided into market. credit and operational risks. Hidden risks are also concerned with financial accounting. The value of an organisation depends on the changes in exchange and interest rates. Hence the manager is responsible to identify the risk and implement relevant actions to eliminate it. According to the assumptions of Modiglani and Miller (1958). Corporate risks Corporate risks include non-financial organisational risks that arise during challenging times in the economy. To improve the efficiency of strategic and business plans. social or safety issues or regulatory and licensing conditions available in most of the organisations. . Corporate risk is a redundant activity. It is mainly concerned with progressive tax rate and expecting costs from financial distress. Financial risk is the 22/43 . Hidden risks Hidden risks are related to cash and financial risk in an organisation. The operational risk occur due to certain factors like back office errors. economic.Reg no # 511017114 Risk management helps in minimising the failure of business activities which are based on finance or performance in the organisation. and effective use of resources among the stakeholders in the organisation. To overcome sensitive internal environment. Credit risk experiences less challenges compared to operational and market risks. fraud. and financial factors which may harm an organisations growth. diversity in business activities and sources of capital etc. To focus on internal audit process and robust contingency planning. A complete and accurate exposure calculation can eliminate the hidden risks. Hence risk management is required in the organisation for the following purposes: • • • • • • To identify the risk in business activities and establish a plan to manage risk and minimise the negative effects. These risks might harm the growth of an organisation. Hence the corporate risk manager quantifies the exposures occurring in the organisation to reduce risks that hamper the financial sector.

At any point of time. Alternative scenarios Alternative scenario method is used to calculate the adequate liquidity in banks. Depending on the behaviour of cash flow the alternative scenario calculates a banks liquidity in different conditions. The marginal gap refers to the difference between the changes of assets and liabilities over time. a positive gap between assets and liabilities is equivalent to shortage of cash.2 What is liquidity gap and detail the assumptions of it? Ans: A liquidity gap is the difference between the due balances of assets and liabilities over time. Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 2 Q. 23/43 . A positive marginal gap means that the change in the values of assets exceeds that of liabilities. They are the uncertainties in business leading to variations in expected profits and losses. Uncertainties related to several risks affect the net cash flow of any business organisation. Lower uncertainties have lower variations in net cash flow.Reg no # 511017114 probability when an actual return on an investment is lower than the expected return. and vice versa. The gap profile changes as and when new assets and liabilities are added. All the assets and liabilities are accounted in liquidity gap report and it is dependent on the dates of maturity and the actual date. The gap profile is represented either in the form of tables or charts.

then the bank can survive any kind of small problems. Banks use general market conditions to handle the deposit and other debts. The banks must pay the liabilities at the time of maturity. Going concern/general market conditions The going concern/general market conditions scenario is helpful for banks in establishing a standard for the normal business behaviour. General market crisis The general market crises are the ones under which liquidity affects every bank in more than one market. They are: • • • Going concern Bank specific crisis General market crisis A bank should try to account for any major liquidity changes (positive or negative) that could occur in these scenarios. Some banks might think that the nations Central bank would ensure that the key markets would continue to function in some form. liabilities and off balance sheet items 24/43 . the Central bank might find this scenario to be of particular interest. the banks never face a very large need of cash to be paid on any given day. Assumptions in preparation of gap report in terms of assets. Bank specific crisis The bank specific crises are liquidity crises for individual banks. the scenario represents a second type of "worstcase". The main idea in bank specific crisis is that. The decision about the exact time and size of cash flows is an essential part of the construction of the maturity ladder under every situation. The result also suggests the likely distribution of liquidity problems among large institutions. If a bank can survive these types of worst-cases. The crises remain restricted to the banks and provide a sort of worst-case benchmark. Due to this concern. With the help of general market conditions the banks avoid the impact of temporary constraints and manage their NFRs. For bank management. The combined results will suggest the size of the total liquidity buffer in the banking system.Reg no # 511017114 There are three scenarios for a bank that provides useful benchmarks. While surveying the liquidity profile of entire banking sector. A bank needs to assign the time for cash flow for each category of asset. the banks liabilities cannot be replaced or rolled over.

cash and securities. Assumptions regarding a banks 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. bank premises and investments in subsidiaries. Therefore a bank may classify the assets according to the type of scenario it is forecasting. might be viewed as unsaleable within the time frame of the liquidity analysis. The assignment here is to develop assumptions about a reasonable plan for the clearance of a bank's assets. To determine the marketability of an asset. the normal growth in new deposit accounts. 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. This would include forming: The level of roll-overs of deposits and other liabilities remain normal. They are assets. different banks can allot the same assets to different groups on maturity ladder. But the number of assumptions to be made should be limited. assumptions play an important role in determining the continuing due to the rapidly changing banking markets. such as interbank loans might lose liquidity in a common crisis. 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. 25/43 . The actual maturity of deposits with non-contractual maturities. Because of the difference in the banks internal asset-liability management. While categorising the assets. Some assets. there may be assets which are much liquid then during a time of crisis. and off-balance sheet assets. a bank should first examine the behaviour of its liabilities under normal business situations. while marketable. Assets Assets are nothing but any item of economic value owned by an individual or corporation. liabilities. A less liquid group of assets consists of bank's saleable loan portfolio. Under normal conditions.Reg no # 511017114 Since the future liquidity position of a firm cannot always be predicted based on the factors. banks should take care of the effects on the assets liquidity under the various conditions. Some of the assets might instantaneously be converted into cash at existing market values under almost any situation whereas others. Liabilities To check the cash flows occurring due to a bank's liabilities.

And help in creating a time table.Reg no # 511017114 While examining the cash flow arising from a bank's liabilities during the two crisis scenario. Liabilities. a bank's capital and term liabilities that are not maturing within the prospect of the liquidity analysis provide a liquidity buffer. The first two questions represent the proceedings in the flow of cash that tend to reduce the cash outflows planned directly from contractual maturities. Under each case. What are the sources of funding that can be estimated to run off gradually if problems occur. The total liabilities identified in the first category may be assumed to stay with the bank even when its a worst scenario. 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. 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. especially for some business services that include transactions accounts. 26/43 . in a general market crisis. a bank would look at four basic questions. especially when there is high crisis. 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. Nevertheless. even though there are no cash inflows existing for other firms in the market. includes core deposits that are not already included in the first category. including some without contractual maturities. sometimes high scale firms may find that they receive larger than the usually got wholesale deposit inflows. and can the count of these sources be increased? Other than the liabilities identified from this step. 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. other than core deposits.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. 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. In some countries. is unaffordable in the very short term. such as wholesale deposits. or because the cost of changing banks. some of the interbank deposits and government funding remains with the bank even though they are considered volatile . as such money may flow to government securities and other safe refuges. The four questions are as follows: What are the different sources of funding that are likely to stay with a bank under any situation.

since certain types of crises sometimes arouse an increase in early exercises or requests that the banks should buy the offer back. if hedges can neither be quickly liquidated to generate cash nor provide insufficient cash. small banks in local areas may also have credit lines that they can bring down to offset cash discharges. there might be some of the factors that might have a major impact on the cash flows. and whether or not the total net pay-out is significant. it would then want to study the circumstances under which it could become a net payer. Consider another situation wherein a bank acts as a swap market-maker. The banks too need excess funds to support extra operations. The need for liquidity arises from business activities. especially in a bank specific crisis. represent potentially significant cash outflow for a bank. For instance. These activities could result in an unexpected cash loss. A bank may be able to create a "normal" level of out flow of cash on a regulatory basis. These facilities are rarely found in larger banks but however it depends on the assumptions made on the banks liabilities. even if they are not a portion of the banks recent liquidity analysis. In addition. and forward foreign exchange rate contracts. customers with inthe-money swaps (or a net in-the-money swap position) would try to reduce their credit exposure to the bank by requesting the bank to buy the swaps back. such as letters of credit and financial guarantees. written Over-The-Counter (OTC) options. with a possibility that in a bank-specific or general market crisis. but are usually not dependent on a bank's condition. However. Such facilities usually need to undergo many changes but only to a limit.Reg no # 511017114 Does the bank have a reliable back-up facility? For example. a bank would like to review its written OTC options book and any warrants that are due. Other assumptions Until now the discussion was centered on the assumption about the behaviour of the specific instrument under different scenarios. 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. consider that a bank has a large swap book. Similarly. At the time of looking the components exclusively. 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). and then estimate the possibility a raise in these flows during periods of stress. along with hedges if any against these positions. Other possible sources of cash outflows are swaps. 27/43 . the Contingent liabilities.

compound interest. The other expenses such as rent and salary however are not given much importance in the analysis of the banks liquidity. Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 2 Q. time preference theory. the impact of interest rates on the economy is very significant. each type of debt instruments in the market considers factors like inflation. We will discuss few of the interest theories in the succeeding section. cumulative interest or return. The rate of interest in the global investment market is determined according to the existing conditions of the retail economic organisations like banks. opportunity cost. bond market and financial market. 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 banks funds to a large extent. and interest rate risk. fixed and floating rates of interest. Different types of interest terms exist in todays global economic environment which has its own identical meanings like simple interest.3 Explain loanable fund theory and liquidity preference theory. classical theory of interest. Investment being a function of interest rates. the majority of the banks provide clearing services to financial institutions and correspondent banks.Reg no # 511017114 For example. Before calculating the rate of interest. mathematical theory. There are various interest rate theories given by several economists like loanable funds theory. In every case the rate of interest is charged on the total asset values. Ans: Here we will discuss about the theories on interest rate whose main focus is on the charged amount to be paid against the borrowed money. Loanable funds theory 28/43 .

the risks related to the maturity of debt instruments are directly proportional to the length of the maturity period. Keynes. The liquidity preference theory does not deal with liquidity. explains the relation between the generation of a debt instrument and its maturity period. M. Also an increase in the supply of loanable funds results in the fall of interest rate. Banks offer interest to investors to compensate for their liquidity losses which ultimately promote long-term investments. In case of loanable funds theory the determination of the interest rates depends on the availability of the loan amount. 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. It was widely accepted before the work of the English economist John Maynard Keynes (1883-1946). The short-term interest rates are assessed on the basis of the financial conditions of an economy. proposed by J. 29/43 . An increase in the demand of loanable funds leads to an increase in the interest rate and vice versa. If both the demand and supply of the loanable funds changes. The availability of loan amount is based on certain factors like net increase in currency deposits. According to the liquidity preference theory. Liquidity preference theory The liquidity preference theory or liquidity preference hypothesis. This premium is known as the liquidity premium. amount of savings made. the resultant interest rate depends on the level and route of the movement of the loanable funds. Liquidity premium stabilises the financial risks that the investors have suffered due to the investment in debt instruments that had longer term periods. and willingness to enhance cash balances. Liquidity preference is a potentiality or functional tendency. which arranges the quantity of money which the public will hold when the rate of interest is given. The liquidity preference theory states that investors maintain their funds in liquid form like cash rather than less liquid assets like stocks. As a result of the premium. the generation of the debt instrument that has a longer periodic term is higher compared to debt instruments having shorter term periods. The loanable funds theory encourages that both savings and investments are responsible for the determination of the rates of interest. The concept was created by Knut Wicksell (1851-1926). According to this theory.Reg no # 511017114 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. but deals with the risks associated with maturity. bonds and commodities.

Therefore.Reg no # 511017114 so if r is the rate of interest. we can define M = L(r). The liquidity preference theory recognises this problem. Speculative motive It is the object of securing profit from knowing better than the market what the future will bring forth. The liquidity preference theory also proposes the concept of risks and liquidity premium to predict the future rates. The following are the three divisions of liquidity preference: • • • Transactions motive It is the need of cash for the current transaction of personal and business exchanges. It provides a suitable analytical framework to investigate the role of monetary policy and the financial system. The added risk prevents some investors from investing in long-term bonds. we cannot be sure whether this is the result of investors expecting interest rates to rise in the future.4 Explain various sources of interest rate risk. the prices of long-term bonds fluctuate more than the prices of short-term bonds. The liquidity preference theory is a short-run model of interest rate determination. To attract investors. when the yield curve rises up. the long-term bonds must offer a return that exceeds the expected return on a series of short-term bonds. Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 2 Q. Investors have a preference for investing in short-term securities. It describes economic fluctuations around the long-run drift. when the market interest rates change. Ans: 30/43 . But. Precautionary motive It is the desire for security as to the future cash equivalent of a certain proportion of total resources. Cause of liquidity preference Liquidity preference theory is preferred among most of the theories. M the quantity of money and L the function of liquidity preference. It depicts that the yield curve slope is influenced by the expected interest rate changes and the liquidity premium that investors require on long-term bonds.

It is called as flat curve. Figure 1 depicts the normal yield curve Figure 1: Normal Yield Curve 31/43 .Reg no # 511017114 The interest rate risk adversely affects the organisations financial situation. 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. We shall discuss some of the sources of interest rate risk in the following subsections. The yield curve flattens when the short term interest rates increases across the long term interest rates. The inverted yield curve refers to the economic recession period. The variations in movements of interest rates changes when the yield curve of a market flattens or steepens in the interest rate cycle. This yield curve is known as normal yield curve. It poses significant threat to the incomes and capital investments of the organisation. The effects of recession impose negative impacts to the organisation hence they must concentrate on diversifying the investment portfolio. The changes occurring in interest rate affects the value of underlying assets of the organisation. Yield curve risk The yield refers to the relationship between short term and 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. The yield curve risk occurs due to the yield curve fluctuations which affect the organisations income and economic values of underlying assets. This occurs during the transition of the normal yield curve to an inverted curve. The yield curve slopes upwards when the short term interest rates are lower than the long term interest rates. It changes the price values of interest bearing asset and liability based on the magnitude level of fluctuations in interest 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.Reg no # 511017114 Figure 2 depicts the inverted yield curve Figure 2: Inverted Yield Curve The yield curve has major impacts on the consumers. 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. Optionality risk 32/43 . The fixed income investors are benefited with better returns with short term investments due to the elimination of risk premium for long term investments. The different market rates of financial instruments differ with time and amounts. Basis risk Basis risk occurs due to the changes in relationship between the various financial markets or financial instruments. For example . 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 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. This reduces the liquidity risk but increases the basis risk due to the differences between the selling and stock index prices. The changes of interest rates can give rise to unexpected changes of asset and liability cash flows and earnings. 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.an organisation holds large untraded stocks.

exchange traded options. Inversely. The callable embedded option bond consists of hold (option free bond) option and embedded call option. during the favourable movements. It is measured by comparing the liability volume with asset volume that reprice within specified period of time. liabilities and off balance sheets. Since the banks focus on short term repricing imbalances are initiated to implement increase interest rate risk by extending maturities to improve profits. The value of the bond 33/43 . The income of the liability sensitive bank increases during the fall of interest rates and declines when the interest rate increases. The option holder experiences limited downside risk (paid amount) and unlimited upside reward whereas the option seller has unlimited risk and limited upside reward. there are chances of bank experiencing variations in interest rate movements of future earnings. financial instruments. bond loans and so on. Repricing risk affects the banks earnings performance. 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). Most of the banking organisations allow prepayment option of commercial loans which includes the prepayment process without any penalties. Embedded option risk The embedded option refers to other option securities such as bonds. The bank faces losses during the sold position option to its customers.Reg no # 511017114 Optionality risk arises with various option instruments of banks like assets. The embedded option is a part of another instrument which cannot be separated. The option allows the option holder to buy or sell financial instruments. It usually results in a risk or rewards to the bank. the asset sensitive bank benefits from rise in rates and detriments with fall in rates. 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. The banking organisations must consider long term imbalances during the repricing risk evaluation. If the gauging of long term repricing is improper. 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. 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. The stand-alone instruments are explicitly priced and are not linked with other bank products. It occurs during the process of altering the banks instruments levels of cash flows by banks customers or by bank itself. liabilities. 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 price of callable bond is equal to the price of hold option bond minus price of call option bond. The exceeding 34/43 . Figure 3: Value of Embedded Call Option The embedded putable bond consists of option free bond and embedded put option. Figure 4 depicts the value of embedded put option which is obtained by the changes in interest rates. 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 decline in interest rates increases the callable option price bond. Figure 3 depicts the value of embedded call option varying with respect to changes in interest rates.Reg no # 511017114 changes according to the changes occurring in interest rates of embedded options values. Figure 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. The price of putable bond is equal to price of option bond plus price of embedded put option.

Reg no # 511017114 number of options can implicate leverage magnifying the positive or negative influences of financial options positions in the organisation. Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 2 Q. . Even though it is impossible to eradicate all risks. To reduce the variability of the cash flows of business. investments and loans. Although the foreign exchange risk management is different for various banks based on the nature and complexity of their foreign exchange activities. effective foreign exchange risk Objectives of foreign exchange risk management Foreign exchange risk management in a bank requires well defined objectives which must reflect the organisations attitude towards foreign exchange risk. negative exchange outcomes can be predicted and managed effectively by individuals and corporate entities. a foreign exchange risk management plan requires: Establishing and executing comprehensive and prudent foreign exchange risk management policies. the objectives of foreign exchange risk management must be in line with the corporate objectives set by the bank.5 Detail Foreign exchange risk management and control procedure. Primarily. Ans: Foreign Exchange Risk Management Foreign exchange risk management is intended to preserve the value of currency inflows. The objectives of foreign exchange risk management are as follows: • • 35/43 To minimise the possible currency losses. Evolving and applying suitable and management and control procedures. while enabling international banks to compete abroad.

The level of foreign currency exposure that the bank is willing to assume. .Clearly defined levels of delegated authority helps in ensuring that a banks foreign exchange positions does not surpass the limits established under the foreign exchange risk management policies. Therefore. Foreign exchange risk management tools and techniques 36/43 . To outline enhanced procedural guidelines for ongoing control and management of foreign exchange risk.The units. The delegation of authority needs to be clearly recognised. and must include the following: .Before setting up the foreign exchange risk limits and management controls it is necessary for banks to decide the goals of foreign exchange risk management plan and in particular. readiness of the bank to assume risk. positions or committees to whom authority is being delegated.Risk limits are established according to the relationship between the foreign exchange position and the capital.The ability of receivers to further delegate authority. or according to the foreign exchange volume which includes total cash and the number of transactions. the objective of foreign exchange risk management is to manage the influence of exchange rate changes within self-imposed limits after considering a wide range of possible foreign exchange rate scenarios. Foreign exchange risk management policies Well defined policies. .The absolute and/or incremental authority to be delegated. The foreign exchange risk limits cover the following: .The restrictions placed on the use of delegated authority. set forth the objectives of the banks foreign exchange risk management strategy and its parameters.The currencies in which the institution is permitted to experience risk exposure. . To develop possible solutions to avoid the negative influence of adverse currency movements in foreign exchange.Reg no # 511017114 • • • To assist individuals involved in foreign exchange management in the implementation of updated procedures of foreign exchange risk. Delegation of authority . entities. . Limits of forex risks . The foreign exchange risk management policies include the following: A statement of forex risk principles and objectives .

The major currency futures market is the EUR futures market. For such a right the holder pays a price called the option premium. CAD . A foreign exchange option is an agreement for future supply of a currency interchanged with another. The most popular currency futures are provided by the Chicago Mercantile Exchange group.It is the Euro to US Dollar futures market. where the owner of the option has the right to buy (or sell) the currency at a settled price.It is the British Pound (Sterling) to US Dollar futures market. Some of the foreign exchange management tools used are as follows: • • • • Forward contracts Currency futures Currency options Currency swaps Forward contracts Foreign exchange forward contracts are the most common resources for hedging transactions in foreign currencies. counter party risk as prevalent in Forward contracts is prevented. As futures contracts are traded on exchange with appropriate controls. Currency futures Currency futures are forward contracts in which two parties agree between them to exchange something in the future. and include the following futures markets: EUR . the right to sell is called as put. This gives rise to counterparty risk or default risk arising out of failure of the other party to honour its commitment. based upon the Euro to US Dollar exchange rate. Currency options A currency option is an alternative tool for managing forex risk.Reg no # 511017114 Various tools and techniques are used for measuring foreign exchange risk management. The 37/43 . A forward contract is an agreement to buy or sell foreign exchange for an amount determined in advance.It is the Canadian Dollar to US Dollar futures market.It is the Swiss Franc to US Dollar futures market. GBP . CHF . Forward contracts are privately exchanged and are not standardized. at a specified exchange rate at a designated date in future. The specified rate is called the forward rate. For such situations currency futures are more suitable. the designated date the settlement date or delivery date. The difference between forward contract and other sales contracts is that the delivery and payment of the commodity occurs at a specified future date in case of forward contracts. The right to buy is a call.

Therefore. the competitors stance and most importantly regulatory requirements. Control of foreign exchange activities: Though the controls of foreign activities vary widely among the banks depending upon the nature and extent of their foreign exchange activities. they are promptly and correctly settled and to identify unauthorised dealing instantly and reported to the management. general attitude towards risk management. 38/43 . 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. .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. the main elements of any foreign exchange control plan are well-defined procedures governing: . In devising a firms FERM policy. Currency swaps Currency swaps deal with the exchange of payments in different currencies between two trading partners. riskindifferent or risk-seeking. applying and supervising procedures to manage and control foreign exchange risk based on the risk management policies. Foreign Exchange Risk Management (FERM) and control procedures Each of the banks engaged in foreign exchange activities is responsible for evolving. in which the winning party obtains payment at the end of the swap term.Reg no # 511017114 option seller receives the premium and is indebted to make (or take) delivery at the agreed-upon price if the buyer exercises his option. whether its risk-averse. adequate information must be readily available to permit suitable action to be taken within the acceptable time period. 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: . In order to make these determinations.The risk exposures related to foreign exchange trading. the firms ability to alter exposed positions i.The impact of potential exchange rate changes on the bank. certain factors have to be taken into account the firms exposure. For productivity currency swaps feature netting.e. the maximum exchange loss it can absorb without much impact. .Procedural controls: To ensure that the transactions are completely recorded in the accounts of the banks.

counterparty and other limits and those excesses are reported to the management. Banks must use them to ensure compliance with.Ensure adherence to the foreign exchange management policies and procedures. Independent inspections/audits should examine the banks foreign exchange risk management activities in order to: . the foreign exchange policies and procedures. Independent inspections/audits Independent inspections/audits are an important factor for managing and controlling a banks foreign exchange risk management plan.Ensure operative management controls over foreign exchange positions. Master of Business Administration – MBA Semester 4 MA0042 Treasury Management 39/43 . and the integrity of. . risk limits and positions.Verify the capability and accurateness of the management information reports regarding the institutions foreign exchange risk management activities.Reg no # 511017114 .Other controls: To make sure that the foreign exchange activities are supervised frequently against the banks foreign exchange risk. .Ensure that employees involved in foreign exchange risk management are given accurate and complete information about the institutions foreign exchange risk policies. .Ensure that the foreign exchange hedging activities are consistent with the banks foreign exchange risk management policies and procedures. .

the risk manager should try to analyse whether to change methodology. Multiple approaches are used to compute VaR and they have numerous variations.Reg no # 511017114 (Book ID: B1311) Assignment Set – 2 Q. a method which is discussed later in this unit indicates that VaR estimations are not accurate. or implement both. it should be moderately simple to calculate if we can derive a probability distribution of potential values.6 Describe the three approaches to determine VaR. The method of mapping equity positions through beta is often used in this approach as it is a very crucial stage in computing VaR. The following 40/43 . But it is simplistic as it neglects the following factors while calculating VaR for nonlinear positions: The relationship between the underlying asset price and the potential value of the component of a portfolio is nonlinear. They are making variance and covariance method freely available to everyone. VaR has become an established risk exposure measurement tool. and the variances across these risks. If back testing. improve the mapping process. and providing easy access to compute the VaR logically for a portfolio. As VaR measures the probability of loss going beyond a specific amount in a particular time period. The measure of VaR can be calculated analytically through assumptions about return distributions in market risks. The price of the components is also exposed to risk factors like delay in time and the expected volatility of the underlying assets returns. Ans: Approaches to Compute VaR In most of the organisations including financial and non-financial sectors. the three basic approaches used to calculate VaR are: • • • Variance covariance method Simulation approaches Extreme value theory Variance covariance method Variance covariance method is an approach that has the advantage of simplicity but it is limited by the difficulties related with derived probability distributions. Risk metrics contribution Risks metrics contribution has two major basic contributions. In spite of the variations in different approaches to compute VaR.

The shock effects on the variance of stock market returns.Effects of increase in the variance of excess returns of bonds on risk premiums. suggested the following two variants which provide better forecasts of variance and better estimations of VaR: Autoregressive Conditional Heteroskedasticity (ARCH) model The basic idea of ARCH is that the error terms conditional variance at time (t) depends on the squared error term (t-1). an American economist. ARCH is crucially applied in the following areas: . Here. Others suggested that arithmetical innovations in existing data can bring better accuracy. ARCH and GARCH model To generate more accurate variance covariance values in VaR estimations. This approach 41/43 . Generalised Autoregressive Conditional Heteroskedasticity (GARCH) model This model was introduced by Taylor (1986) and Schwert (1989). The focus on normal standardised returns attains more exposure of VaR estimation to the frequent outliers risks than that could be assumed with a normal distribution. It is assumed that the return divided by the forecasted standard deviation is normally distributed. It represents the simplest way to evaluate VaR for many portfolios. The risk metrics approach also covers standard normal and normal mixture distributions. the revaluation of VaR of each asset is computed as per the value of each set of risk factors. Analysing the assumptions based on marginal distributions and dependence structure among various benchmark assets is relevant. P. The attention on the standardised returns indicates that we should focus on the size relative to the standard deviation rather than the size of the return. It is described by a symmetric response of current volatility to positive and negative lagged errors. we estimate VaR by assuming the distribution of basic risk factors or targeting asset returns. extracting a sample from the joint distribution and then recalculating the portfolio of assets.Reg no # 511017114 assumptions underlying the computations of VaR are described by publications by J. R F Engle. Simulation approaches In this approach. Morgan in 1996: Returns may not distribute themselves normally and the outliers are very common. . The three methods of simulation approaches are as follows: Historical simulation It is the most popular among simulation approaches. They recalculate the portfolio with a simple approach that is based on partial derivatives. few recommended improving the sampling methods and data innovations.

Reg no # 511017114 estimates VaR by creating imaginary returns of that portfolio based on time series. VaR is detected by the value for which the total weight would be equal to the aspired confidence level. Hybrid model In this method. It concentrates only on the samples of returns data carrying information about extreme behaviour. portfolio returns are categorised based on historical stimulation in decreasing order. Then. This approach has both the advantages of risk metrics contribution and historical simulation. A series of maxima and minima are generated by extracting the respective largest rise and fall in returns from each block. Extreme value theory generates methods for quantifying events and their 42/43 . . Extreme value theory Extreme value theory is used for measuring extreme risks. . . The probability of occurrence of an extreme event is estimated from the VaR value for a given probability when the tail index is available. It also delivers a scientific language for translating management guidelines on the boundaries into actual numbers. The samples of non-overlapping returns is categorised into n blocks in each block.Crude Monte Carlo This method concludes the confidence intervals of your method and the accuracy of the answer. A Generalised Extreme Value (GEV) or Generalised Pareto (GP) distributions is used to one of these series through method of moments to evaluate the tail index parameter. the manager would evaluate the gathered weights of portfolio returns.Acceptance Rejection Monte Carlo: This evaluation provides a less accurate approximation when compared to Crude Monte Carlo method. These returns are gained by applying historical data on the portfolio and evaluating the changes occurred in each period. It achieves good approximation on the important functional areas which has greater impact on the overall approximation value and reduces variance. Monte Carlo simulation: This method is based on using random data and probability to gain an approximate solution to an issue in lesser time when compared to the formal techniques. Various Monte Carlo methods are introduced as an attempt to minimise the approximation error. This parameter illustrates the way in which the extreme events in the data can occur. Extreme value theory provides a significant set of techniques to quantify the boundaries between different loss classes.Importance sampling: This method uses more samples on more important functional areas. The four methods of Monte Carlo simulation are as follows: . It depends on the assumption that more simulations provide higher level of accuracy.Stratified sampling: This technique divides the interval into subintervals and then performs Crude Monte Carlo method on each interval.

It also helps in the patterning of default probabilities and the evaluation of divergence factors in the management of bond portfolios. It has developed as one of the most important statistical fields for applied sciences and is widely used in many other subjects.Reg no # 511017114 consequences in a statistically optimal way. 43/43 . This modeling is applied in the fields of management strategy. thermodynamics of earthquakes. memory cell failure and bio-medical data processing.

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