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Q.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. • 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 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 bank’s 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 industry’s 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.
Q.2 Bring out in a table format the features of certificate of deposits and commercial papers. Ans:-
Features of commercial papers CPs is an unsecured promissory note.
Features of CDs in Indian market Schedule banks are eligible to issue
Features of commercial papers CPs is an unsecured promissory note. CPs can be issued for a maturity period of 15 days to less than one year. CPs is issued in the denomination of Rs.5 lakh. The minimum size of the issu e is Rs. 25 lakh. The ceiling amount of CPs should not exceed the working capital of th e issuing company. The investors in CPs market are banks, individuals, business organisations and the corporate units registered in India an d incorporated units. The interest rate of CPs depends on the prevailing interest rate on CPs market, forex market and call money market. The attractive rate of interest In any of these markets, affects the deman d of CPs. The eligibility criteria for the companies to issue CPs are as follows: The tangible worth of the issuing company should not be less than Rs . 4.5 Crores. The company should have a minimum credit rating of P2 and A2 obtained from Credit Rating Information Service of India (CRISIL) and Investment Information and Credit Ratin g Agency of India Limited. (ICRA) respectively The current ratio of the issuing company should be 1.33:1. The issuing company has to be listed on stock exchange.
Features of CDs in Indian market Schedule banks are eligible to issue CDs Maturity period varies from three months to one year Banks are not permitted to buy back their CDs before the maturity CDs are subjected to CRR and Statutory Liquidity Ratio (SLR) requirements They are freely transferable by endorsement and delivery. They have no lock-in period.
CDs have to bear stamp duty at the prevailing rate in the markets
The NRIs can subscribe to CDs on repatriation basis
Q.3 Critically evaluate participatory notes. Detail the regulatory aspects on it. Ans:-The participants in forex market are the RBI at the apex, authorised dealers (ADs) licensed by forex market, exporters, importers, companies and individuals. The major participants of foreign exchange market are: • Corporates – They mainly include business houses, international investors, and multinational corporations. They operate in market by buying or selling currencies within the framework of exchange control regulations. It deals with banks and their clients to form retail segment of forex market. • Commercial banks – They play an important role in forex market. They operate in market by trading currencies for their clients. Large volume of transactions consists of banks dealing directly among themselves and smaller transactions usually consists of intermediary foreign exchange brokers. • Central bank – It plays a vital role in the country’s economy by controlling money supply. Central banks get involved in forex market to regain price stability of exchange rate, protect certain levels of price in exchange rate, and support economic goals like inflation and growth. • Exchange brokers – They ensure the most favourable quotations between the banks at a low cost in terms of time and money. Banks provide opportunities to brokers in order to increase or decrease the rate of buying or selling foreign currencies. Exchange brokers have a tendency to specialise in unusual currencies but also manage major currencies. In India, many banks deal through recognised exchange brokers or may deal directly among themselves. The other participants include RBI and its authorised dealers, exporters, importers, companies and individuals.
Q.4 What is capital account convertibility? What are the implications on implementing CAC? Ans:- Capital Account Convertibility (CAC) refers to relaxing controls on capital account transactions. It means freedom of currency conversion in terms of inflow and outflows with respect to capital account transaction. Most of the countries have liberalised their capital account by having an open account, but they do retain some regulations for influencing inward and outward capital flow. Due to global integration, both in trade and finance, CAC enhances growth and welfare of country. The perception of CAC has undergone some changes following the events of emerging market economies (EMEs) in Asia and Latin America, which went through currency and banking crises in 1990’s. A few counties backtracked and re-imposed capital controls as part of crisis resolution. Crisis such as economic, social, human cost and even extensive presence of capital controls creates distortions, making CAC either ineffective or unsustainable. The cost and benefits from capital account liberalisation is still being debated among academics and policy makers. These developments have led to considerable caution being exercised by EMEs in opening up capital account. The Committee on Capital Account Convertibility (Chairman: Shri. S.S. Tarapore) which submitted its report in 1997 highlighted the benefits of a more open capital account but at the same time cautioned that CAC could pose tremendous pressures on the financial system. India has cautiously opened its capital account and the state of capital control in India is considered as the most liberalised it had been since late 1950’s. The different ways of implementing CAC are as follows: • Open the capital account for residents and non-residents. • Initially open the inflow account and later liberalise the outflow account. • Approach to simultaneously liberalise control of inflow and outflow account.
Q.5 Detail domestic and international cash management system Ans;-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. The main goal of multinational cash management is the utilisation of local banking and cash management services. Multinational companies are those that operate in two or more countries. Decision making within the corporation is centralised in the home country or decentralised across the countries where the organisation does its business. 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. Preventing the regulatory obstacles. Retaining customers and protecting its processes Expanding its business.
Several factors which distinguish multinational cash management from domestic cash management are as follows: • • • • • • Different currency denominations Political risk and other risk. Economic and legal complications. Role of governments Language and cultural differences. Difference in tax rates, import duties.
The principle objective of multinational cash management programme is to maximise a company’s financial resources by taking benefits from all liability provisions, payable periods. 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. During multinational cash management system payments by customers to company’s branches are basically handled through a local bank. The payments between the branches and the parent company are managed through the branches, correspondents or associates of the parent company. Through the use of electronic reporting systems a parent company observes cash balances in its foreign local banks. Multinational cash management programme specifically evaluate its techniques by timing of billing, use of lockboxes or intercept points, negotiated value range. 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. It occurs due to the change in exchange rates. The exchange rates are determined by a structure which is called the international monetary system. For example, Wincor Nixdorf played an innovative role in enhancing cash handling between various countries. Wincor’s focus was on the entire process chain which started from head office to stores, crediting to the retail company’s account, head office to branches and so on. Wincor Nixdorf’s served several countries with its innovative hardware and software elements, IT services to side operations and consulting services to develop custom optimised solutions.
Q.6 Distinguish between CRR and SLR
Ans:- 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. These reserves are considered to meet the withdrawal demands of the customers. The reserves are in the form of authorised currency stored in a bank treasury (vault cash) or with the central bank. CRR is also called liquidity ratio as it controls money supply in the economy. CRR is occasionally used as a tool in monetary policies that influence the country’s economy. CRR in India is the amount of funds that a bank has to keep with the RBI which is the central bank of the country. If RBI decides to increase CRR, then the banks’ available cash drops. RBI practices this method, that is, increases CRR rate to drain out excessive money from banks. The CRR in the economy as declared by RBI in September 2010 is 6 percent. An organisation that holds reserves in excess amount is said to hold excess reserves.
The following are the effects of CRR on economy: • • • CRR influences an economy’s money supply by effecting the potential of banks CRR influences inflation in an organization CRR stimulates higher economic activity by influencing the liquidity
Statutory Liquidity Ratio Statutory Liquidity Ratio (SLR) is the percentage of total deposits that banks have to invest in government bonds and other approved securities. It means the percentage of demand and time maturities that banks need to have in forms of cash, gold and securities like Government Securities (G-Secs). As gold and government securities are highly liquid and safe assets they are included along with cash. In India, RBI determines the percentage of SLR. There are some statutory requirements for placing the money in the government bonds. After following the requirements, the RBI arranges the level of SLR. The maximum limit of SLR is 40 percent and minimum limit of SLR is 25 percent. The RBI increases the SLR to control inflation, extract liquidity in the market and protects customers’ money. Increase in SLR also limits the bank’s leverage position to drive more money into the economy. If any Indian bank fails to maintain the required level of SLR, then it is penalised by RBI. The nonpayer bank pays an interest as penalty which is above the actual bank rate.
The main objectives for maintaining SLR are the following: • • • By changing the SLR level, the RBI increases or decreases banks’ credit expansion Ensures the comfort of commercial banks Forces the commercial banks to invest in government securities like government bonds
Master of Business Administration -MBA Semester 4 MF0016 – Treasury Management Assignment Set- 2
Q.1 Explain any two major risks associated with banking organization. Ans:-The major risks are associated with banking organisations. Since banks use a large amount of leverage, it becomes important to manage risks carefully. 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, mutual funds or money market instruments and can be reduced by diversifying or hedging techniques. The evaluation of interest rate risk should consider illiquid hedging products or strategies, and potential impact on fee income which are sensitive to changes in interest rates. They are classified into the following: • Term structure risk (yield curve risk) – It arises from the variations in the movement of interest rates across maturity spectrum. It consists of changes in relationship between interest rates of various maturities of similar market. The changes in relationships occur when the shape of yield curve for a market flattens, steepens, or becomes inverted during interest rate cycle. The yield curve variations can emphasise a bank’s risk position by increasing the effect of maturity mismatches. • Basis risk – It occurs due to the changes in relationship between interest rates for different market sectors. • Options risk – It arises when bank or bank customer gains privileges to alter the level and timing of cash flows of asset, liability or off balance sheet instruments. The option holder has the rights to buy or sell the financial instruments over a specified period of time. But the option holder faces limited downside risks (amount paid for option) and unlimited upside reward. The option seller faces unlimited downside risk (option exercised during the time of disadvantage) and limited upside reward (retaining premium).
Foreign exchange risk Foreign exchange risk occurs during the change of investments value occurring due to the changes in currency exchange rates. It refers to the probability of loss occurring due to an adverse movement in foreign exchange rates. For example – Consider an investor residing in United States purchases a bond denominated in Japanese Yen. By this the investor experiences decline in rate of return at which the Yen exchanges for dollars. 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.
• Economic risk – It measures the impact of changes in exchange rate risk on the organisation’s cash flows and earnings. • Translation risk – It measures the impact of changes in exchange rate of organisation’s financial statements. It is also known as accounting exposure.
Q.2 What is liquidity gap and detail the assumptions of it? Ans;- Liquidity Gap Report A liquidity gap is the difference between the due balances of assets and liabilities over time. At any point of time, a positive gap between assets and liabilities is equivalent to shortage of cash. The marginal gap refers to the difference between the changes of assets and liabilities over time. A positive marginal gap means that the change in the values of assets exceeds that of liabilities. The gap profile changes as and when new assets and liabilities are added. The gap profile is represented either in the form of tables or charts. All the assets and liabilities are accounted in liquidity gap report and it is dependent on the dates of maturity and the actual date. Assumptions in preparation of gap report in terms of assets, liabilities and off balance sheet items Since the future liquidity position of a firm cannot always be predicted based on the factors, assumptions play an important role in determining the continuing due to the rapidly changing banking markets. But the number of assumptions to be made should be limited. The assumptions can be made based on three aspects. They are assets, liabilities, and off-balance sheet assets.
Assets Assets are nothing but any item of economic value owned by an individual or corporation. 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. To determine the marketability of an asset, 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, cash and securities. Some of the assets might instantaneously be converted into cash at existing market values under almost any situation whereas others, such as interbank loans might lose liquidity in a common crisis. • A less liquid group of assets consists of bank’s saleable loan portfolio. The assignment here is to develop assumptions about a reasonable plan for the clearance of a bank’s assets. Some assets, while marketable, might be viewed as unsaleable within the time frame of the liquidity analysis. • The least liquid group of assets consist of basically unmarketable assets such as loans that are not capable of being readily sold, bank premises and investments in subsidiaries. Because of the difference in the banks internal asset-liability management, different banks can allot the same assets to different groups on maturity ladder. While categorising the assets, banks should take care of the effects on the asset’s liquidity under the various conditions. Under normal conditions, there may be assets which are much liquid then during a time of crisis. Therefore a bank may classify the assets according to the type of scenario it is forecasting.
Liabilities To check the cash flows occurring due to a bank’s liabilities, a bank should first examine the behaviour of its
liabilities under normal business situations. This would include forming: • The level of roll-overs of deposits and other liabilities remain normal. • The actual maturity of deposits with non-contractual maturities, such as demand deposits and others; the normal growth in new deposit accounts. While examining the cash flow arising from a bank’s liabilities during the two crisis scenario, a bank would look at four basic questions. The first two questions represent the proceedings in the flow of cash that tend to reduce the cash outflows planned directly from 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 can the count of these sources be increased? Other than the liabilities identified from this step, a bank’s capital and term liabilities that are not maturing within the prospect of the liquidity analysis provide a liquidity buffer. The total liabilities identified in the first category may be assumed to stay with the bank even when it’s a worst scenario. 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, or because the cost of changing banks, especially for some business services that include transactions accounts, is unaffordable in the very short term. What are the sources of funding that can be estimated to run off gradually if problems occur, 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. Liabilities, includes core deposits that are not already included in the first category. In some countries, other than core deposits, some of the interbank deposits and government funding remains with the bank even though they are considered volatile .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 help in creating a time table. • 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, including some without contractual maturities, such as wholesale deposits. Under each case, 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, especially when there is high crisis, as such money may flow to government securities and other safe refuges. 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. Nevertheless, in a general market crisis, sometimes high scale firms may find that they receive larger than the usually got wholesale deposit inflows, even though there are no cash inflows existing for other firms in the market. Does the bank have a reliable back-up facility? For example, small banks in local areas may also have credit lines that they can bring down to offset cash discharges. These facilities are rarely found in larger banks but however it depends on the assumptions made on the bank’s liabilities. Such facilities usually need to undergo many changes but only to a limit, especially in a bank specific crisis.
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), even if they are not a portion of the bank’s recent liquidity analysis. In addition, the Contingent liabilities, such as letters of credit and financial guarantees, represent potentially significant cash outflow for a bank, but are usually not dependent on a bank’s condition. A bank may be able to create a "normal" level of out flow of cash on a regulatory basis, and then estimate the possibility a raise in these flows during periods of stress. However, 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. Other possible sources of cash outflows are swaps, written Over-The-Counter (OTC) options, and forward foreign exchange rate contracts. For instance, consider that a bank has a large swap book; it would then want to study the circumstances under which it could become a net payer, and whether or not the total net pay-out is significant. Consider another situation wherein a bank acts as a swap market-maker, with a possibility that in a bank-specific or general market crisis, 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. Similarly, a bank would like to review its written OTC options book and any warrants that are due, along with hedges if any against these positions, since certain types of crises sometimes arouse an increase in early exercises or requests that the banks should buy the offer back. These activities could result in an unexpected cash loss, if hedges can neither be quickly liquidated to generate cash nor provide insufficient cash.
Other assumptions Until now the discussion was centered on the assumption about the behaviour of the specific instrument under different scenarios. At the time of looking the components exclusively, there might be some of the factors that might have a major impact on the cash flows. The need for liquidity arises from business activities. The banks too need excess funds to support extra operations. For example, the majority of the banks provide clearing services to financial institutions and correspondent banks. 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. The other expenses such as rent and salary however are not given much importance in the analysis of the bank’s liquidity. But they can be sources of cash outflows in some cases.
Q.3 Explain loanable fund theory and liquidity preference theory Ans;- 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. The concept was created by Knut Wicksell (1851-1926), who was a well-known Swedish economist. It was widely accepted before the work of the English economist John Maynard Keynes (1883-1946). 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. If both the demand and supply of the loanable funds changes, the resultant interest rate depends on the level and route of the movement of the loanable funds. The loanable funds theory encourages that both savings and investments are responsible for the determination of the rates of interest. 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. The availability of loan amount is based on certain factors like net increase in currency deposits, amount of savings made, and willingness to enhance cash balances.
Liquidity preference theory The liquidity preference theory or liquidity preference hypothesis, proposed by J. M. Keynes, explains the relation between the generation of a debt instrument and its maturity period. The liquidity preference theory states that investors maintain their funds in liquid form like cash rather than less liquid assets like stocks, bonds and commodities. Banks offer interest to investors to compensate for their liquidity losses which ultimately promote long-term investments. The liquidity preference theory does not deal with liquidity, but deals with the risks associated with maturity. According to this theory, the risks related to the maturity of debt instruments are directly proportional to the length of the maturity period. According to the liquidity preference theory, 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. This premium is known as the liquidity premium. Liquidity premium stabilises the financial risks that the investors have suffered due to the investment in debt instruments that had longer term periods. 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. 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; so if ‘r’ is the rate of interest, ‘M’ the quantity of money and ‘L’ the function of liquidity preference, we can define M = L(r).
Q.4 Explain various sources of interest rate risk Ans:-The interest rate risk adversely affects the organisation’s financial situation. It poses significant threat to the incomes and capital investments of the organisation. The changes occurring in interest rate affects the value of underlying assets of the organisation. It changes the price values of interest bearing asset and liability based on the magnitude level of fluctuations in interest rates. We shall discuss some of the sources of interest rate risk in the following subsections.
Yield curve risk The yield refers to the relationship between short term and long term interest rates. The yield curve risk occurs due to the yield curve fluctuations which affect the organisation’s income and economic values of underlying assets. The short term interest rates are lower than long term interest rates and hence the occurring fluctuation exposes the organisation to maturity gap of interest rate risk. The variations in movements of interest rates changes when the yield curve of a market flattens or steepens in the interest rate cycle. The yield curve slopes upwards when the short term interest rates are lower than the long term interest rates. This yield curve is known as normal yield curve. The yield curve flattens when the short term interest rates increases across the long term interest rates. This occurs during the transition of the normal yield curve to an inverted curve. It is called as flat curve. The inverted yield curve refers to the economic recession period. Therefore the market status overviews the yield curve of long term interest rate as decline in the long term fixed income of the organisation. The effects of recession impose negative impacts to the organisation hence they must concentrate on diversifying the investment portfolio. Figure 10.1 depicts the normal yield curve
Figure 10.1: Normal Yield Curve Source: http://www.google.co.in/imgres?imgurl=http://livingeconomics.org/images/glossary/yield_curve. gif&imgrefurl=http://livingeconomics.org/glossary.asp&usg=__73JVTBBWNvKyxZj2AVoLIU dx3GM=&h=289&w=480&sz=29&hl=en&start=1&zoom=1&um=1&itbs=1&tbnid=MIK7LKa XJ7cLjM:&tbnh=78&tbnw=129&prev=/images%3Fq%3Dnormal%2Byield%2Bcurve%2Bdiagr am%26um%3D1%26hl%3Den%26sa%3DN%26tbs%3Disch:1
Figure 10.2 depicts the inverted yield curve
Figure 10.2: Inverted Yield Curve Source: http://books.google.co.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, equity and fixed income investors. The fixed rate loans will be encouraged when the short term rates exceeds the long term rates. Hence the consumers who invest in financing properties experience higher mortgage payments. The fixed income investors are benefited with better returns with short term investments due to the elimination of risk premium for long term investments. During the phase of inverted yield curve the margins of the profits decline such that the organisation at short term rates borrow cash and lend it at long term rates to gain profits.
Basis risk Basis risk occurs due to the changes in relationship between the various financial markets or financial instruments. The different market rates of financial instruments differ with time and amounts. In the banking organisation basis risk occurs due to the differences in the prime rate and offering rates on money market deposits, saving accounts. The changes of interest rates can give rise to unexpected changes of asset and liability cash flows and earnings. For example - an organisation holds large untraded stocks. If the company tries to sell those stocks in wholesale, it experiences liquidity risk because the selling prices may be depressed in the market. Hence to overcome this issue, the company enters into futures contract with stock index. This reduces the liquidity risk but increases the basis risk due to the differences between the selling and stock index prices.
The basis risk affects the profits of an organisation by striking the cash positions. The basis risk changes the storable commodities based on the changes of the storage costs over a period of time.
Optionality risk Optionality risk arises with various option instruments of banks like assets, liabilities. It occurs during the process of altering the bank’s instruments’ levels of cash flows by bank’s customers or by bank itself. The option allows the option holder to buy or sell financial instruments. It usually results in a risk or rewards to the bank. The option holder experiences limited downside risk (paid amount) and unlimited upside reward whereas the option seller has unlimited risk and limited upside reward. The bank faces losses during the sold position option to its customers. There are chances of losses in bank’s capital value due to unfavourable interest rate movements such that it exceeds the profits that a bank gains, during the favourable movements. Therefor it has more downside exposure than upside reward. The options are traded in banks with stand-alone instruments such as over the counter (OTC), exchange traded options, bond loans and so on. The stand-alone instruments are explicitly priced and are not linked with other bank products. Most of the banking organisations allow prepayment option of commercial loans which includes the prepayment process without any penalties. Hence during the decline of rates the customers will perform prepaying loan process which shortens the bank’s asset maturities while the bank desires to extend it.
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, liabilities and off balance sheets. It is measured by comparing the liability volume with asset volume that reprice within specified period of time. The repricing risk increases the earnings of the banks. Liability sensitivity occurs in banking organisations since repricing asset maturities are longer than the repricing liability maturities. The income of the liability sensitive bank increases during the fall of interest rates and declines when the interest rate increases. Inversely, the asset sensitive bank benefits from rise in rates and detriments with fall in rates. Repricing risk affects the bank’s earnings performance. Since the banks focus on short term repricing imbalances are initiated to implement increase interest rate risk by extending maturities to improve profits. The banking organisations must consider long term imbalances during the repricing risk evaluation. If the gauging of long term repricing is improper, there are chances of bank experiencing variations in interest rate movements of future earnings.
Embedded option risk The embedded option refers to other option securities such as bonds, financial instruments. The embedded option is a part of another instrument which cannot be separated. The callable embedded option bond consists of hold (option free bond) option and embedded call option. The value of the bond changes according to the changes occurring in interest rates of embedded options values. The price of callable bond is equal to the price of hold option bond minus price of call option bond. The decline in interest rates increases the callable option price bond.
Figure 10.3 depicts the value of embedded call option varying with respect to changes in interest rates. Figure 10.3: Value of Embedded Call Option
The embedded putable bond consists of option free bond and embedded put option. The price of putable bond is equal to price of option bond plus price of embedded put option. Figure 10.4 depicts the value of embedded put option which is obtained by the changes in interest rates. Figure 10.4: Value of Embedded Put Option
Source: http://www.analystnotes.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. During the selling process of financial instruments there are chances of exposure to significant risks since the holding options are explicit and embedded which provides advantage to holder and disadvantage to seller. The exceeding number of options can implicate leverage magnifying the positive or negative influences of financial options positions in the organisation.
Q.5 Detail Foreign exchange risk management and control procedure Ans;- Foreign Exchange Risk Management (FERM) and control procedures Each of the banks engaged in foreign exchange activities is responsible for evolving, 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, general attitude towards risk management, whether its risk-averse, risk-indifferent or risk-seeking, the firm’s ability to alter exposed positions i.e. the maximum exchange loss it can absorb without much impact, the competitor’s stance and most importantly regulatory requirements. 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. In order to make these determinations, adequate information must be readily available to permit suitable action to be taken within the acceptable time period. Therefore, 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: The risk exposures related to foreign exchange trading. The impact of potential exchange rate changes on the bank. 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, the main elements of any foreign exchange control plan are well-defined procedures governing: 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. Procedural controls – To ensure that the transactions are completely recorded in the accounts of the banks, they are promptly and correctly settled and to identify unauthorised dealing instantly and reported to the management. Other controls – To make sure that the foreign exchange activities are supervised frequently against the bank’s foreign exchange risk, counterparty and other limits and those excesses are reported to the management. • Independent inspections/audits – Independent inspections/audits are an important factor for managing and controlling a bank’s foreign exchange risk management plan. Banks must use them to ensure compliance with, and the integrity of, the foreign exchange
policies and procedures. Independent inspections/audits should examine the bank’s foreign exchange risk management activities in order to: 1 Ensure adherence to the foreign exchange management policies and procedures. 2 Ensure operative management controls over foreign exchange positions. 3 Verify the capability and accurateness of the management information reports regarding the institution’s foreign exchange risk management activities. 4 Ensure that the foreign exchange hedging activities are consistent with the bank’s foreign exchange risk management policies and procedures. 5 Ensure that employees involved in foreign exchange risk management are given accurate and complete information about the institution’s foreign exchange risk policies, risk limits and positions.
Q.6 Describe the three approaches to determine VaR Ans:-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, along with the contingent liabilities, thus permitting rapid comparison among different countries and the analysis of the evolution over time for a country. Value at risk method is used to set market position limits for traders and to decide how to allocate minimum capital resources. VaR allow creation of a common denominator to compare risky activities in varied markets. The total risk of the banks can also be decomposed into incremental VaR to reveal positions that increases total risk. On the other hand, VaR can be used to regulate the performance of risk. Performance assessment of risk is vital in banks, where traders have a natural tendency to take on extra risk. Risk capital charges based on VaR approach provides corrected incentives to the traders. The VaR approach has a number of practical advantages and disadvantages. The advantages of VaR are as follows: • The potential losses are computed in simple terms. • 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). • VaR acts as a versatile tool for forex risk measurement. On the other hand, value at risk approach possesses certain limitations too. The limitations of VaR are as follows: • VaR faces some difficulties in risk estimation and is sensitive to the estimation methods used. • VaR approach may create a false sense of security. • VaR may miscalculate the worst-case outcomes for a bank. • The VaR of a specific market position is not always the same for the VaR of the overall portfolio of the bank. • VaR fails to incorporate positive results, thus painting an incomplete picture of the situation.