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Ans:- Asset Liability Management (ALM)
Asset liability management refers to the strategic balance involving risk caused due to the changes in interest rate, exchange rates and liquidity position in the organisation. The credit risk and contingency risk are the roots of ALM. During the post liberalisation period, India witnessed rapid industrial growth which has further inspired the growth of fund raising activities. The changes in the sources and features of funds were remarkable due to rise in demand for funds. Hence this reflected in the organisation’s profile and exposure limits in interest rate structure for deposits and advances etc. Significance The changing environment in assets and liabilities has brought the following significances of ALM in recent years: 1. Volatility – The globalization scenario has led to increase in number of economies. This has paved way for market driven economies due to the changing dynamics of the financial markets. These changes are reflected in interest rate structures, money supply, and credit position of the market, exchange rates and price levels. Hence the organisation experiences low market value, net interest income etc. 2. Product innovation – The innovation in financial products has grown rapidly. Some of the innovations are repacked with existing products with slight modifications. These have major impact on the risk profile in the organization enhancing the need for ALM. 3. Regulatory environment – The integration of domestic and international market has enabled the regulatory bodies of financial markets to initiate number of measures. These measures prevent major losses that occur due to market impulses. 4. Management recognition – The top management in the organisation realised that asset liability is neither a franchise for credit disbursement nor it’s a place for retail deposit base. It must be considered to relate and link the asset with liability. Hence the need for efficient asset liability management came into existence. Objectives The objective of ALM is to achieve perfect match in assets and liabilities. The match is related to the changes in the present value of assets and liabilities. The importance of ALM has led to the change in the functional environment. The ALM objectives are divided into micro and macro levels. The macro level objectives deal with formulation of critical business policies, efficient allocation of capital and designing of products with suitable pricing strategies. At macro level, the ALM aims at obtaining profits through price matching while ensuring liquidity by maturity matching. The process of price matching ensures deployment of liabilities which are greater than costs.
Q2 What are the features of a capital market?
Ans:- Capital Market A financial market is an organization which permits the employees to trade financial securities like stocks, bonds, commodities and so on to raise its net capital in economy. A financial market includes parties like brokers, dealers, investment bankers and financial mediators. A capital market is an organization where securities like debt and equity are traded to raise longterm funds in the economy. The capital market is fragmented into stock market which trade equity securities and the bond market which trade debt securities. Various financial instruments like equity, insurance, derivative instruments and so on are traded in capital market to enhance liquidity. The regulation of an organization is essential for its perfect functioning. In Indian capital market the protection of investor's activity is carried out by Features of capital market are as follows: 1. 2. 3. 4. Capital markets deal with primary securities like equities, bonds and so on. Trading in capital market occurs without intervention of financial intermediary. The information structure is complex. The security prices are volatile in nature.
Q3. Describe the approaches of CAC.
Ans:- Approaches to Capital Account Convertibility (CAC)
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 liberalized 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 liberalization 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 liberalized it had been since late 1950’s. The different ways of implementing CAC are as follows: 1. Open the capital account for residents and non-residents. 2. Initially open the inflow account and later liberalise the outflow account. 3. Approach to simultaneously liberalise control of inflow and outflow account. Liberalization of current account transactions Current account transaction refers to converting domestic currencies freely into foreign currency and vice versa. The domestic currency is said to be convertible on the current account. This is known as current account convertibility. The benefits of current account transaction are as follows: Current account convertibility enhances the increase of capital inflow in to the country. The confidence of a country will be enhanced when the country will manage its affairs without exchange restrictions which enhance the international confidence in the countries policies. Relaxing the exchange restrictions has improved the Balance of Payment (BOP) in the country. The exclusion of exchange restrictions tends to increase the capital inflows and thus promote efficient allocation of inflows to the growth of the country’s economy.
RBI has introduced more relaxations in current account transactions. The authorized dealers (ADs) have been permitted to provide exchange facilities to their customers up to specified limit without prior approval of the RBI. The liberalization rules regarding current account transaction of RBI under FEMA 1999 are as follows: Authorized Dealers of Category - I banks permits withdrawal of foreign exchange payments below USD 2million by the individuals and approval of Ministry of Commerce and Industry, GOI is not mandatory. As per the Rule 4 of FEMA (current account transactions), it is mandatory to get approval of Ministry of Commerce and Industries for drawing foreign exchange remittances ,when the payment exceeds 5% on local sales and 8% increase on exports.
Liberalized remittance scheme is a facility extended to the residents of India. Under this scheme; the residents can remit in any current or capital account up to USD 2 million per financial year. This facility is only for resident individuals. The resident individuals can purchase and hold immovable property or shares or debt instrument outside India, without the prior approval of RBI. Residents can open, maintain and hold foreign currency accounts with banks outside India. The liberalized remittance scheme is not applicable for the following: Any purpose under Schedule I and any item under Schedule II are prohibited for remittance under Foreign Exchange Management Rules 2000. The resident individual cannot remit directly to Nepal, Bhutan and Pakistan. There can be no remittances made directly or indirectly towards countries identified as non-cooperative countries and territories by the Financial Action Task Force (FATF). The individuals and organizations identified and advised by the RBI as significant risk of committing terrorism are not eligible for any remittances directly or indirectly.
· Liberalization of Exchange Earner’s Foreign Currency (EEFC) account - EEFC account is a foreign currency account maintained by a resident individual with an authorized dealer in India. These accounts are non-interest bearing and they are used for hedging against foreign currency fluctuations by the business organizations which have exports and imports in foreign currency payments. Some of the liberalized measures in EEFC account are: RBI has permitted to earn interests on EEFC account if the outstanding balance is USD 1 million. Due to liberalization, all categories of foreign exchange earners can avail credit in this account based on their foreign exchange earnings. RBI decides on credit and debit limits. If the reimbursement for an international credit card is provided in foreign exchange, it may be considered as a remittance through normal banking and the earnings can be credited to EEFC account.
Other measures The other measure taken towards CAC is fuller capital account convertibility which is explained as follows: Fuller Capital Account Convertibility (FCAC) India’s cautious approach towards capital account and assessing it as a liberalisation process based on certain pre conditions has held India in good state. But with the changes that have taken place over the last two decades, India felt the need to revisit the CAC and suggested a new map towards FCAC based on current situations. RBI, in consultation with the Government of India (GOI) appointed a committee on FCAC. S.S Tarapore was the chairman of committee. The committee suggested several recommendations for the development of financial market in addition to addressing issues related to interaction of monetary policy and exchange rate management, regulation and supervision of banks, and the timing and sequencing of capital account liberalization measures. The objectives of FCAC are as follows: Economic growth - It facilitates economic growth through higher capital investment .This will lead to growth in employment opportunities, infrastructure development and other areas. Improvement in financial sector - Huge capital flow into the system will lead to the improvement of financial sector which will enhance performance of the companies. This will enhance the liquidity in the system. Diversify the investment – The diversification of investment will help ordinary people, to invest in foreign countries without restriction. This will help them to diversify their portfolio.
Q4. Explain the IRR hedging techniques. Ans:- Bank uses a number of derivative instruments like interest rate futures, interest rate options, interest rate caps, collars and interest rate swaps to hedge against interest rate risk. The following are the IRR hedging techniques: Interest rate swaps – Interest rate swap is the contractual understanding between two banks under which one bank pays periodically to the other for a contracted time period based upon an estimated principal amount. Swaps transform cash flows through a bank to closely match the cash flows pattern as desired by the management. From 1995, Reserve Bank of India (RBI) started allowing the usage of swaps by counterparties in India from 1995 on a sequential case basis. Each transaction needs to have an explicit RBI approval. However, RBI started to relax the rules from 1999 and allowed banks to enter into swap contracts and report such deals to it on a quarterly basis. Since 2005, swap related transactions have been legalized by a special approval from the parliament. The most common type of swap is the plain vanilla interest rate swap. In this swap, a company agrees to pay cash flows equal to interest at a predetermined fixed rate on an estimated principal for a number of years. In return, it receives interest at a floating rate on the same estimated principal for the same time period. The floating rate in most interest rate swap agreements is the London Interbank Offered Rate (LIBOR). LIBOR is the rate of interest at which a bank is prepared to deposit money with other banks in the Eurocurrency market and is a reference rate of interest for floating rate loans in international financial markets. Interest rate futures – Interest rate future is an agreement between a buyer and a seller that calls for the delivery of a particular security in exchange for cash at some future date. It is a financial derivative with an interest bearing instrument as the underlying asset. Interest rate futures are used to hedge against the possible movement of interest rates in the adverse direction. Buying an interest rate futures contract allows the buyer of the contract to lock in a future investment rate. Interest rate caps – An interest cap is an Over the Counter (OTC) derivative that protects the holder from rise in short term interest rates by making a payment to the holder when an underlying interest rate exceeds a specified strike rate. Interest rate caps protect an individual holder from the increase in market interest rates. Borrowers are assured that the organisations which lend them money cannot increase their loan rate above the level of the cap. When conditions of loss arise, the banks buy interest rate caps. Interest rate floors - A bank holds on establishing an interest rate floor under its loans so that during certain situations like dropping of loan rates, it is guaranteed some minimum rate of return. Bank uses interest rate floors when their liabilities have longer maturities than their assets or when they are funding floating rate assets with fixed rate debt. Interest rate collars - This instrument combines an interest rate cap and an interest rate floor in one agreement. The collars' purchaser pays a payment for the rate cap while receiving a premium for accepting the rate floor. The net premium paid for the collar can be positive or negative, depending upon the interest rate view. Banks can use collars to protect their earnings when interest rates appear to be volatile and there is considerable uncertainty about the movement of market interest rates.
Q5. Define VaR and illustrate its components Ans:- VaR is the most popularly used and powerful tool to calculate, tackle and control market risk. VaR
gained so much of importance only because it is easily and spontaneously understood in simple terms. It is used to communicate easily within the company, and between the company and its investors. The biggest advantage of VaR lies in the implementation of a structured methodology for analytical thinking about risk. With the growing importance of VaR, firms need to compulsorily tackle their exposure to financial risk and set up independent risk management departments supervising the financial fluctuations. VaR estimations should not be considered as an accurate number since it does not produce accurate information. However, it indicates the amount of risk involved. It also helps in identifying the developments in the behaviour of individuals, companies or markets. There is no other risk management tool that addresses most of the aspects of risk measurement in a single framework. Therefore VaR has been proved as a very successful tool. Multiple organizations acknowledged the importance of VaR in handling various risks faced by financial institutions irrespective of its shortcomings. Components of VaR VaR can be defined as the maximum amount of loss a portfolio of securities can face from uncertain events over a specified time period with a specified level of probability. For example, a trading security has a VaR of Rs. 20 lakhs for one day at a probability of 10%. It means that the firm can expect a loss of Rs. 20 lakhs in one day with a probability of 10%. This indicates that there is a probability of 90% that the firm cannot lose more than Rs. 20 lakhs in one day. The components of VaR are market factors, factor sensitivity, market volatility and defeasance period. Market factors Any external factor that brings changes in the price of an instrument is a market factor. VaR methodologies differ with respect to the simulation and changes in transformation of market rates. Large institutions require simulation of thousands of general and specific market factors to compute VaR. Factor sensitivity It is the impact of movements of portfolio of assets in the relying risk parameter of an individual asset. To estimate the component VaR of factor, its marginal VaR should be multiplied with the evaluated factor sensitivity. Market volatility The factors or events which cannot be predicted are market volatility. It illustrates the investment opportunities in the future. Previous studies regularly and strongly support the relationship between the stock market volatility and the priced factors. Defeasance period It is the time consumed to liquidate the position on the basis of liquidity in the secondary market. This period increases VaR. Defeasance period is vibrant and fluctuating. It also experiences changes on account of product-specific or general market conditions
Q6. What are the functions and benefits of integrated treasury?
Ans:- Let us first understand the concepts and benefits of integrated treasury management. Treasury function was restricted to fund or liquid management. Fund management includes maintaining adequate cash balances to meet the daily requirements, implementing the surplus funds in other operations, sourcing the funds to even the gaps in cash flow. The treasury departments in banks are responsible to meet the Cash Reserve Requirement (CRR) and invest the funds in securities under Statutory Liquid Ratio (SLR). Treasury basically deals with shortterm cash flows(less than one year), but investment in some securities exceeds more than one year. Integrated treasury came into existence as a result of financial reforms, the most important being the deregulation of rupee and partial convertibility of rupee. Rupee is freely convertible on current account. Due to the relaxations of RBI in Foreign Direct Investment (FDI), rupee is now partially convertible on capital account. Banks are permitted a larger limit in terms of their net worth, and overseas borrowing and lending. The functions of integrated treasury are not restricted to traditional functions. The major functions of integrated treasury are as follows: Performing reserve management, which involves meeting CRR and SLR obligations. Deploying surplus funds in securities which have low risk and earn profits. Performing global cash management. Providing effective and efficient merchant services. Improving the profit by exploring market opportunities in money market, securities market and forex market. Assisting the banks in Asset-Liability Management (ALM). Managing market risk for the entire bank.
Treasury is the back bone of the financial institutions and banks. Integrated treasury helps banks and financial institutions to effectively manage the resources and comply with the regulatory requirements. The benefits of integrated treasury are as follows: Improves cash planning and monitors the cash position of the organisation. Prepares the financial statement and other financial reports for analysis, financial control and budgeting. Allows greater financial control by integrating budget and budget execution data. Enhances the quality of data for budget execution.