Master of Business Administration - MBA Semester 4 Subject Code – MF0016 Subject Name – Treasury Management 4 Credits

(Book ID: B1311) Assignment Set- 1 (60 Marks)

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 •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 modelling 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: 1. Money market instruments – Call, term, and notice money, commercial papers, treasury bonds, repo, reverse repo and interbank participation etc. 2. Bonds – Government securities, debentures etc. 3. 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 interdependency between policy and strategy. Q.2 Bring out in a table format the features of certificate of deposits and commercial papers? Ans :- commercial papers is a type of instrument in money market and it was introduced in Jan 1990. Commercial paper is a short term unsecured promissory note issued by large corporations. They are issued in bearer forms in a discount to face value. It is issued by the corporations to raise funds for a short term. The salient features of commercial papers are as follows: 1. They are negotiable by endorsement and delivery and hence they are flexible as well as liquid instruments. Commercial paper can be issued with varying maturities as required by the issuing company. 2. They are unsecured instruments as they are not backed by any assets of the company which is issuing the commercial paper. 3. They can be sold either directly by the issuing company to the investors or else issuer can sell it to the dealer who in turn will sell it into the market. 4. It helps the highly rated company in the sense they can get cheaper funds from commercial paper rather than borrowing from the banks. However use of commercial paper is limited to only blue chip companies and from the point of view of investors though commercial paper provides higher returns for him they are unsecured and hence investor should invest in commercial paper according to his risk -return profile.


o CPs is an unsecured for a maturity period of 15 days to less than one year. o CPs is issued in the denomination of Rs 5 lakhs. The minimum size of the issue is Rs25 lakhs. o The ceiling amount of CPs should not exceed the working capital of the issuing company. o The investors in CPs market are banks, individuals, business organizations and the corporate units registered in India and incorporated units. o The interest rate of CPs depends on the prevailing interest rate on CPs market, fore market and call money market. The attractive rate of interest in any of this markets, affects the demand of CPs. o The eligibility criteria for the companies to issue CPs are as follows: The tangible worth of the issuing company should not be less than Rs 4.5 crores. The company should have a minimum credit rating of P2 and A2 obtained from credit rating information services of India(CRISIL) and investment information and credit rating agency of India limited(ICRA) respectively. The current ratio of the issuing company should be .The issuing company has to be listed on stock exchange.

Features of certificate of deposits in Indian market the characteristics features of CDs in Indian money market are as follows:

Deal in Money Market Only There are two main markets for getting fund for company. One is money market and other is capital market. In capital market, we issue the shares and stocks. People come and buy the same. When they need money they also sell these shares. But in money market, short term money needs are fulfilled. Bank can issue a certificate of deposits and get money from public. It is just like one or two years FD. But in the FD, people request. But in a certificate of deposits, bank has to request through advertising in news or online way. Using of Ladders Facility in CDs We can use ladders facility in CDs. It is useful from investor point of view. In this ladders facility, investor does not invest his all money in one type of CDs, he invests step by step. First of all he invests in very short period CDs. After this, he collects its money from it and invests in the CDs who have good rate of interest. By taking ladders facility, you can easily reinvest your received interest in previous CDs. Schedule banks are eligible to issue CDs

Maturity period stands varies from three months to one year. Banks are not permitted to buy back their CDs before the maturity. CD 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 RNIs can subscribe to CDs on repatriation basis. Certificate of deposits is considered as risk-less because default risk in them is almost negligible and hence its safe bet for investors. Certificate of deposits is highly liquid and marketable and hence investors can buy or sell it whenever they desire to do so. They are transferable from one party to another which cannot be done with term deposits and hence it is an added advantage for investors who are willing to invest init. It is a time deposit that restricts holders from withdrawing funds on demand, however if an investor wants to withdraw the money, this action will often incur a penalty. A certificate of deposits may be payable to the bearer or registered in the name of the investor. Most certificates of deposits are issued in bearer form because investors can resell bearer CD„s more easily than registered CD„s. Hence from the above one can see that certificate of deposits can be one of the alternatives for an investor if he or she does not want to invest in term deposits. Q3 Critically evaluate participatory notes. Detail the regulatory aspects on it. Ans :International entrance to Indian capital market is limited to foreign institutional investors(FIIs) the market has found a way to avoid the limitation by creating an instrument called participatory notes(PNs).PNs are basically contract notes. Indian traders by securities and then issue PN to foreign investors. Any dividends or capital gains collected from the primary securities are returned back to the investors. Any entity investing in PNs may not register with SEBI whereas all FIIs have to register compulsorily. Since international access to the Indian capital market is limited to FIIs. The market has found a way to circumvent this by creating the device called participatory notes, which are said to account for half the $80billion that stands to the credit of FIIs. Investing through P-Notes is very

simple and hence very popular-Notes are issued to the real investors on the basis of stocks purchased by the FII. The registered FII looks after all the transactions, which appear as proprietary trades in its books. It is not obligatory for the FIIs to disclose their client details to the Sebi, unless asked specifically FIIs who issue/renew/cancel/redeem P-Notes are required to report on a monthly basis. The report should reach the Sebi by the 7th day of the following month. The FII merely investing/subscribing in/to the Participatory Notes -- or any such type of instruments/securities -- with underlying Indian market securities are required to report on quarterly basis (Jan-Mar, Apr-Jun, Jul-Sep and OctDec).FIIs who do not issue PNs but have trades/holds Indian securities during the reporting quarter(Jan-Mar, Apr-Jun, Jul-Sep and Oct-Dec) require to submit 'Nil' undertaking on a quarterly basis.FIIs who do not issue PNs and do not have trades/ holdings in Indian securities during the reporting quarter. (Jan-Mar, AprJun, Jul-Sep and Oct-Dec): No reports required for that reporting quarter. a) Any entity incorporated in a jurisdiction that requires filing of constitutional and/or other documents with a registrar of companies or comparable regulatory agency or body under the applicable companies legislation in that jurisdiction; b) Any entity that is regulated, authorised or supervised by a central bank, such as the Bank of England, the Federal Reserve, the Hong Kong Monetary Authority, the Monetary Authority of Singapore or any other similar body provided that the entity must not only be authorised but also be regulated by the aforesaid regulatory bodies; c) Any entity that is regulated, authorised or supervised by a securities or futures commission, such as the Financial Services Authority (UK), the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Securities and Futures Commission (Hong Kong or Taiwan), Australia Securities and Investments Commission (Australia) or other securities or futures authority or commission in any country , state or territory‟s) Any entity that is a member of securities or futures exchanges such as the New York Stock Exchange (Subaccount), London Stock Exchange (UK), Tokyo Stock Exchange (Japan ),NASD (Sub-account) or other similar self-regulatory securities or futures authority or commission within any country, state or territory provided that the aforesaid organizations which are in the nature of self-regulatory organizations are ultimately accountable to the respective securities / financial market regulators. e) Any individual or entity (such as fund, trust, collective investment scheme, Investment Company or limited partnership) whose investment advisory function is managed by an entity satisfying the criteria of (a), (b), (c) or (d) above However, Indian regulators are not very happy about participatory notes because they have no way to know who owns the underlying securities. Regulators fear that hedge funds acting through participatory notes will cause economic volatility in India's exchanges. Hedge funds were largely blamed for the sudden sharp falls in indices. Unlike FIIs, hedge funds are not directly registered with Sebi, but they

can operate through sub-accounts with FIIs. These funds are also said to operate through the issuance of participatory notes. 30% FII money in stocks thru P-Notes According to one estimate, more than 30 per cent of foreign institutional money coming into India is from hedge funds. This has led Sebi to keep a close watch on FII transactions, and especially hedge funds. Hedge funds, which thrive on arbitrage opportunities, rarely hold a stock for a long time. With a view to monitoring investments through participatory notes, Sebi had decided that FIIs must report details of these instruments along with the names of their holders.t the proposals were against PNs but not against FIIs. The procedures for registering FIIs were in fact being simplified; he said. Sebi has also proposed a ban on all PN issuances by sub-accounts of FIIs with immediate effect. They also will be required to wind up the current position over 18 months, during which period the capital markets regulator will review the position from time to time.t the amount of foreign investment coming in through participatory notes keeps changing and is somewhere between 25-30 per cent. "Recent indications are that it has gone up a little but again after the sub-prime crisis, there have been some exits. But it's a fairly significant percentage; it's not something you can ignore. “When asked if he was comfortable with almost one-fourth of the market being held by P-Notes, he said that he wasn't 'entirely uncomfortable.” A column by Niranjan Rajadhyaksha that deals with the issues relating to regulation of complex financial instruments such as participatory notes that are held by investors like hedge funds. Referring to the classic debate between public regulation and market regulation, he states: “Regulators have two options: to demand more clarity on what is going on or to clamp down on financial innovation. The former is quite clearly the more sensible option. Bans never help, although there are the inevitable calls for them whenever there are problems in the financial markets. Usually, crises in the real economy bring with them calls for further deregulation while crises in the financial economy come with calls for tighter regulation: That„s a big paradox in the annals of contemporary policy debate. All this is of relevance to India. The domestic financial markets are still repressed. Local investors have access to a limited range of securities to buy and sell. But the same cannot be said of offshore investors who are taking positions on the Indian economy either directly or indirectly. Many of them are hedge funds use a range of trading strategies. They buy in to the India story through participatory notes (PNs), which are offshore instruments backed by Indian equities and derivatives and whose proliferation has kept troubling the Reserve Bank of India and the Securities And Exchange Board of India (Sebi) He also cites an IMF Working Paper by Manmohan Singh that traces the use of participatory notes in the Indian financial markets, and concludes with the impact


of the regulatory pronouncements issued by SEBI in October 2007. The abstract of the paper runs as follows: This paper focuses on the use of participatory notes (PNs) by foreign investors, as a conduit for portfolio flows into Indian equity markets for more than a decade. The broadening of India's foreign investor base, in recent years, has a bias towards hedge funds/unregistered foreign investors who invest primarily via PNs. While tax arbitrage via capital gains tax has almost disappeared since July 2004, it is intriguing to note that since then the demand for PNs has actually increased. The paper suggests some reasons for the continuation of a buoyant market in PNs, and explains the possible impact from the recent regulatory changes. SEBI„s October 2007 pronouncements can be found here and here .Essentially, they bar foreign institutional investors (FIIs) from issuing PNs on derivatives and require them to wind-down their existing positions within 18 months. As far as PNs for cash are concerned, they are permitted up to a maximum of 40% of the assets under custody (AUC) of the FIIs .Manmohan Singh concludes as follows: SEBI„s ban on the issuance of PNs on derivatives will reshuffle the investor base on portfolio inflows. Its proposal may increase the inflows onshore by the apparent interest from real money accounts to register onshore (including pension, endowments, charitable trusts etc.); however, inflows from margin accounts (i.e., from investors who use PNs on derivatives) are likely to disappear along with some investors from the PN cash market .Inflows from PNs on derivatives will not be replaced since this route allowed transactions that cannot be mimicked onshore. The near-term impact depends on how staggered the unwinding is likely to be. Once the reshuffling of the investor base in favour of the real money account takes place over the next 18 months, capital flows are likely to be more stable. Although SEBI„s pronouncements are likely to cause churn in FII investments during the 18-month period and possibly disrupt investment flows, the regulator„s is a unique step toward investor regulation and enhanced transparency. While economies like the US are still grappling with the issue of whether to regulate hedge funds and other similar investors, India has taken the step of imposing stringent regulations by requiring hedge funds and other PN holders to register directly with SEBI rather than use conduits such as PNs to avoid registration requirements. The benefits of PNs are as follows: Entities route their investment through PN to extract advantage of the tax laws system. It provide a high degree of secrecy, which enables large funds to carry out their operations without revealing their identity. Investors used PNs to enter Indian market and shift to fully fledged FII structure when they are established.

Q4 what is capital account convertibility? What are the implications on implementing CAC? Ans: capital accounts convertibility refers to relaxing controls on capital account transactions. It means freedom of currency conversion in terms of inflow and outflow with respect to capital account transaction. Most the countries have liberalised their capital account by having an open account but they do retain some operations for influencing inward and outward capital flow. Due to global integration, both in trade and finance, CAC enhances growth and welfare of country. It refers to the abolition of all limitations with respect to the movement of capital from India to different countries across the globe. In fact, the authorities officially involved with CAC (Capital Account Convertibility) for Indian Economy encourage all companies, commercial entities and individual countrymen for investments, divestments, and real estate transactions in India as well as abroad. It also allows the people and companies not only to convert one currency to the other, but also free cross-border movement of those currencies, without the interventions of the law of the country concerned. 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 crisis in 1990. A few countries backtracked and re imposed capital controls as part of crisis resolution. Crisis such as economics, social, human cost and even extensive presence of capital controls creates distortions, making CAC either ineffective or unsustainable. The cost and benefits from capital accounts 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 accounts. The committee on capital accounts convertibility which submitted its report in 1997 highlighted the benefits of a more open capital accounts but at the same time cautioned that CAC could post tremendous pressures on the financial systems. India has cautiously opened its capital accounts 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. Initial open the inflow account and later liberalise the outflow account. Approach to simultaneous liberalise control of inflow and outflow account. ON the inaugural function of the 16th Asian Corporate Conference (March 18, 2006), the prime minister Dr Manmohan Singh, stated that there is merit in India„s moving forward towards fuller Capital Account Convertibility. In an immediate response, the RBI set up a committee under the Chairmanship of Mr S Tarapore to pave the way for the Capital Account Convertibility. This article provides a basic analysis of the problems involved with the issue of Capital Account Convertibility in India. In India, the foreign exchange transactions (transactions in dollars, pounds, or any other currency) are broadly classified into two accounts:

Current account transactions and capital account transactions. If an Indian citizen needs foreign exchange of smaller amounts, say$3,000, for travelling abroad or for educational purposes, she/he can obtain the same from a bank or a money-changer. This is a“current account transaction”. But, if someone wants to import plant and machinery or invest abroad, and needs a large amount of foreign exchange, say $1 million, the importer will have to first obtain the permission of the Reserve Bank of India (RBI). If approved, this becomes a “capital account transaction”. This means that any domestic or foreign investor has to seek the permission from a regulatory authority, like the RBI, before carrying out any financial transactions or change of ownership of assets that comes under the capital account. Of course there are a whole range of financial transactions on the capital account that may be freed form such restrictions, as is the case in India today .But this is still not the same as full capital account convertibility .By Capital Account Convertibility ‖ (or CAC in short), we mean “the freedom to convert the local financial assets into foreign financial assets and vice-versa at market determined rates of exchange. It is associated with the changes of ownership in foreign/domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by the rest of the world. …” (Report of the Committee on Capital Account Convertibility, RBI, 1997) Thus, in simpler terms, it means that irrespective of whether one is a resident or nonresident of India one„s assets and liabilities can be freely (i.e. without permission of any regulatory authority) denominated (or cashed) in any currency and easily interchanged between that currency and the Rupee. PROBLEMS WITH CAC Several economists are of the view that the full Capital Account Convertibility (and allowing the exchange rate to be market determined) has serious consequences on the wellbeing of the country, and this may even lead to extreme sufferings of the common masses. Some of the reasons are highlighted below. During the good years of the economy, it might experience huge inflows of foreign capital, but during the bad times there will be an enormous outflow of capital under “herd behaviour” (refers to a phenomenon where investors acts as herds, i.e. if one moves out, others follow immediately). For example, the South East Asian countries received US$ 94 billion in 1996and another US$ 70 billion in the first half of 1997. However, under the threat of the crisis, US$ 102 billion flowed out from the region in the second half of 1997, thereby accentuating the crisis. This has serious impact on the economy as a whole, and can even lead to an economic crisis as in South-East Asia. There arises the possibility of misallocation of capital inflows. Such capital inflows may fund low-quality domestic investments, like investments in the stock markets or real estates, and desist from investing in building up industries and factories, which leads to more capacity creation and utilisation, and increased level of employment. This also

reduces the potential of the country to increase exports and thus creates external imbalances. An open capital account can lead to “the export of domestic savings” (the rich can convert their savings into dollars or pounds in foreign banks or even assets in foreign countries), which for capital scarce developing countries would curb domestic investment. Moreover, under the threat of a crisis, the domestic savings too might leave the country along with the foreign ‗investments„, thereby rendering the government helpless to counter the threat n Entry of foreign banks can create an unequal playing field, whereby foreign banks cherry pick the most creditworthy borrowers and depositors. This aggravates the problem of the farmers and the small-scale industrialists, who are not considered to be creditworthy by these banks. In order to remain competitive, the domestic banks too refuse to lend to these sectors, or demand to raise interest rates to more competitive levels from the subsidised „rates usually Followed. International finance capital today is “highly volatile”, i.e. it shifts from country to country in search of higher speculative returns. In this process, it has led to economic crisis in numerous developing countries. Such finance capital is referred to as” hot money in today„s context. Full capital account convertibility exposes an economy to extreme volatility on account of “Hot money” flows. The class which benefits from the CAC primarily compromises the big business houses and the finance capitalists, who invest in the stock market for speculations. The policies like CA Care pursued mainly to gain the confidence of the speculators and punters in the Stock Markets, and do not have any beneficial effects on the real sector of the economy, like increasing the employment level, eliminating poverty and decreasing the inequality gap. However, the irony is that under a crisis, the burden is borne primarily by the common masses. This may come in the form of a sharper reduction in subsidies, less investment for social welfare projects by the government and an increase in the privatisation process. The foreign speculators and the domestic players may walk out of the market (by converting their assets to foreign currency) and insulate themselves from any damage. Q5.Detailed domestics and international cash management systems? Ans: Maintaining the channels of collections and accounting information efficiently has become essential with growth in business transaction sections. This includes enabling greater connectivity to internal corporate systems and providing better IT solutions and services in cash management. A cash management systems is a company„s strategy which includes sustainable investment practices to enhance the collection of receivables, control payments to trade creditors and efficiently manage the liquidity margin. CMS involves hiring a debt collection service to recover the borrowed property by a customer, depositing cash into a lock box to ensure its protection. The objectives of cash management system are to bring the company„s cash resources within control in an efficient manner and to achieve the optimum conservation and utilisation of the funds. 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. The main goal of

multinational cash management is the utilisation of local banking and cash management services. Multinational companies are those that operates 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 firm expand into other countries are as follows: Seeking new raw markets and raw materials. Seeking new technology and products 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 principal objectives 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 flows 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 re pricing and invoicing. During multinational cash management system payments by customers to company„s branches are basically handled through a local bank. The payment between the branches and the parent company are managed through the branches, correspondents or associates of the parent company The multinational cash management 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.


Q6. Distinguished between CRR and SLR. Ans: cash reserve ratio 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 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 CRR decides to increase CRR, then the banks available cash drops. RBI practices this method this is increase CRR to drain out excessive money from banks. Statutory liquidity ratio: it 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 needs to have in forms of cash, gold and securities like government securities. 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, extra liquidity in the market and protects customer‟s money. Increase the 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 non-payer bank pays an interest as penalty which is above the actual bank rate. The main objectives for maintaining SLR are the following: By exchanging 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. CRR CRR stands for Cash Reserve Ratio, and specifies in percentage the money commercial banks need to keep with themselves in the form of cash. In reality, banks deposit this amount with RBI instead of keeping this money with them. This ratio is calculated by RBI, and it is in the jurisdiction of the apex bank to keep it high or low depending upon the cash flow in the economy. RBI makes judicious use of this amazing tool to either drain excess liquidity from the economy or pump in money if so required. When RBI lowers CRR, it allows banks to have surplus money that they can lend to invest anywhere they want. On the other hand, a higher CRR means banks have lesser amount of money at

their disposal to distribute. This serves as a measure to control inflationary forces in economy. Present rate of CRR is 5%. SLR It stands for Statutory Liquidity Ratio and is prescribed by RBI as a ratio of cash deposits that banks have to maintain in the form of gold, cash, and other securities approved by RBI. This is done by RBI to regulate growth of credit in India. These are un-encumbered securities that a bank has to purchase with its cash reserves. The present SLR is 24%, but RBI has the power to increase it up to 40%, if it so deems fit in the interest of the economy. •Both CRR and SLR are instruments in the hands of RBI to regulate money supply in the hands of banks that they can pump in economy • CRR is cash reserve ratio that stipulates the percentage of money or cash that banks are required to keep with RBI • SLR is statutory liquidity ratio and specifies the percentage of money a bank has to maintain in the form of cash, gold, and other approved securities • CRR controls liquidity in economy while SLR regulates credit growth in the country • While banks themselves maintain SLR in liquid form, CRR is with RBI maintained as cash.


Master of Business Administration - MBA Semester 4 Subject Code – MF0016 Subject Name – Treasury Management 4 Credits
(Book ID: B1311) Assignment Set- 2 (60 Marks)

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 are 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 ReportA 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 overtime. 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 assumption scan is 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 UN saleable within the timeframe 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 assetliability 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 timetable. •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 marketmaker, with a possibility that in a bank-specific or general market crisis, customers with in-the-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. 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 centred 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 concentration diversifying the investment portfolio. Figure 10.1 depicts the normal yield curve

Figure 10.1: Normal Yield Curve


Figure 10.2: Inverted Yield Curve

Figure 10.2: Inverted Yield Curve

The yield curve has major impacts on the consumers, equity and fixed income investors. The fixed rate loans will be encouraged when the short term rates exceeds the long term rates. Hence the consumers who invest in financing properties experience higher mortgage payments. The fixed income investors are benefited with better returns with short term investments due to the elimination of risk premium for long term investments. During the phase of inverted yield curve the margins of the profits decline such that the organisation at short term rates borrow cash and lend it at long term rates to gain profits. 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 reprise 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 there pricing liability maturities. The income of the liability sensitive bank increases during the fall off 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 affect the bank‟s earnings performance. Since the banks focus on short term Repricing imbalances is initiated to implement increase interest rate risk by extending maturities to improve profits. The banking organisations must consider long term imbalances during their pricing 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 put able bond consists of option free bond and embedded put option. The price of put able bond is equal to price of option bond plus price of embedded put option.


Figure 10.4 depicts the value of embedded put option which is obtained by the changes in interest rates.

Figure 10.4: Value of Embedded Put Option

The organisations must handle the options effectively such that the various types of bonds under embedded option are exposed to low level of risks. During the selling process of financial instruments there are chances of exposure to significant risks since the holding options are explicit and embedded which provides advantage to holder and disadvantage to seller. The exceeding number of options can implicate leverage magnifying the positive or negative influences of financial options positions in the organisation.

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: 1. The risk exposures related to foreign exchange trading. 2. 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: 1.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. 2. 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. 3. 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.