Professional Documents
Culture Documents
Bank
Financial Management
( For CAIIB Examination)
Sure Success Series- CAIIB- Bank Financial Management -4th Edition-Vaibhav Awasthi Page 1
The content of this book has been developed keeping in view courseware for the
Second paper of Bank Financial Management of CAIIB.
An attempt has been made to cover fully the syllabus prescribed for each
module/subject and the presentation of topics may not always be in the same
sequence as given in the syllabus. Candidates are also expected to take note of
all the latest developments relating to the subjects covered in the syllabus by
referring to RBI circulars, financial papers, economic journals, latest books and
publications in the subjects concerned.
Although due care has been taken in publishing this study material, yet the
possibility of errors, omissions and/or discrepancies cannot be ruled out.
We welcome suggestion for improving the book and its contents. You may write
back to us at jaiibcaiibadmission@gmail.com
He has been mentoring students for JAIIB/CAIIB since last 10 years and
presently works as Senior Manager with a leading Public Sector Bank. He
can be reached at Vaibhav.awasthi16@gmail.com
All rights reserved. No part of this publication may be reproduced or transmitted, in any form or by
any means, without permission. Any person who does any unauthorized act in relation to this
publication may be liable to criminal proceedings and civil claim for damages.
This book is meant for educational and learning purpose. The author of this book has taken all reasonable care to ensure that the contents
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Sure Success Series- CAIIB- Bank Financial Management -4th Edition-Vaibhav Awasthi Page 2
To the thought
Sure Success Series- CAIIB- Bank Financial Management -4th Edition-Vaibhav Awasthi Page 3
Preface
Dear Students,
At the outset I would like to express my thanks to thousands of students who have chosen Sure
Success Series for preparing for CAIIB.
Our last 3rd edition of BFM was a runaway hit and response received by our students was more
than overwhelming and humbling.
We have always understood and believed that Banking students are very bright and
hardworking, so what is causing such high failure rates in CAIIB?
The answer was lack of good material and lack of time students faced due to taxing banking
hours and responsibilities.
So while we wrote Sure Success Series- BFM, we had focus on two things (i) The material
should be concise (ii) Material should be precise.
The result was phenomenal as our concise book helped student clear the dreaded exam of
BFM sometime in time as less than a week. There were many who were skeptical when they
received the concise book thinking whether such thin book can help them clear the gigantic
BFM and they were in for a big surprise when they cleared the exam with great numbers.
Your expectation from us increases our responsibility. The exam of Dec 15 and June 16 had
Basel III, and we received many requests from our students to incorporate Basel III in our book.
The task of incorporating Basel III was a tough exercise as the whole concept is huge and
complex and incorporating it in our book in an easy manner would require increase in length of
our book something which we as a policy avoid. Also the number of questions and types of
question which will be asked was also not clear as official Macmillan book does not contain
Basel III.
However our team at Sure Success Series took up the challenge and in our this edition we
have brought Basel III along with Numericals and simplified understanding
We have also doubled the case studies/numerical from existing 100 to 200. Also many printing
error, outdated information of the previous edition have been done away with.
We are more than hopeful that this edition will prove to be extremely beneficial to the CAIIB
aspirant and will prove to be the Easiest and Surest way to crack the exam in a single attempt.
We have also launched our revamp website www.jaiibcaiib.co.in and mobile app SURE
SUCCESS SERIES in google play store. We request all of you to download the app and very
shortly we are coming up with objective test series for CAIIB subjects on our app and website
which will prove to be the ultimate practice ground and check your preparedness for taking the
final exam.
Sure Success Series- CAIIB- Bank Financial Management -4th Edition-Vaibhav Awasthi Page 4
Foreword
Bank Financial Management is the second paper of CAIIB exam. Typically, this is considered
as the toughest paper amongst all the three paper of CAIIB because of the numerical portion
which often occupy as much as 60% of the question paper.
The subject is divided into four module and questions are evenly asked from all the modules.
Thus while preparing students must not ignore any module.
Having said that, Module B, C & D are inter related and having understanding of one module
is necessary for progressing to another.
Aim of BFM subject is to enable student to have high level of understanding of how banks
operate on Macro level, how funds are managed, how capital is arranged and managed and
how treasury operates and helps the bank in making profits.
When students take up this subject, they are worried about the numerical and how they will
solve it. We assure you that numerical asked in BFM are of very basic nature and little
understanding will make sure that you not only crack but enjoy the numerical part.
The book has been written based on our experience about prior year question papers. We have
tried to keep the book concise and most relevant by explaining all the important points’ chapter
wise along with case studies and numerical.
The aim of our Sure Success Series- is to make sure that students are able to finish the course
in minimum possible time.
To boost their preparation students may stay in touch with us by visiting our website
www.jaiibcaiib.co.in our download our android app SURE SUCCESS SERIES. They can also
join us on facebook for regular updates and questions
Sure Success Series- CAIIB- Bank Financial Management -4th Edition-Vaibhav Awasthi Page 5
Module A
International Banking
What to Focus in this module
Module A is based on Foreign exchange. Students are expected to know various
facilities available to NRIs, various kinds of deposits like NRE, NRO, FCNR along
with details of foreign exchange which can be remitted.
Foreign trade means export and import. Export requires funds which are granted
in the form of pre shipment and post shipment finance. Students should
understand various financial facilities like PCFC, PSFC, etc. which can be given.
Import involves giving away of valuable foreign exchange. There are various
guidelines on release of funds and how to monitor it. Students should be aware
of it.
Finally Forex numerical. They essentially require calculation of correct rate to be
quoted to export and import customer for various kind of transactions-
spot/forward. We have covered various types of numerical calculation to give
student a clear picture of how to calculate the various rates.
Sure Success Series- CAIIB- Bank Financial Management -Vaibhav Awasthi Page 6
Unit-1 Exchange Rates and Forex Business
Foreign Exchange Management Act (FEMA), 1999, (Section 2) defines foreign
exchange as: "Foreign Exchange means foreign currency, and includes:
(i) All deposits, credits and balances payable in foreign currency, and any drafts,
traveler’s cheques, letters of credit and bills of exchange, expressed or drawn in Indian
currency and payable in any foreign currency,
(ii) Any instrument payable at the option of the drawee or holder, thereof or any other
party thereto, either in Indian currency or in foreign currency, or partly in one and partly
in the other." Thus, broadly speaking, foreign exchange is all claims payable abroad,
whether consisting funds held in foreign currency with banks abroad or bills, checks
payable abroad.
Exchange rate mechanism: The delivery of FX deals can be settled in one or more of
the following ways:
Ready or Cash: Settlement of funds takes place on the same day (date of deal),
Tom: Settlement of funds takes place on the next working day of the date of deal
Spot: Settlement of funds takes place on the second working day after/following the
date of
Contract/deal.
Forward Delivery of funds takes place on any day after Spot date.
Forward rate = Spot rate + Premium (or - Discount).
Sure Success Series- CAIIB- Bank Financial Management -Vaibhav Awasthi Page 7
If the value of the currency is more than that being quoted for Spot, then it is said to be
at a Premium, while if the currency is cheaper at a later date than spot, than it is called
at a Discount
The forward price of a currency against another can be worked out with the following
factors:
(i) Spot price of the currencies involved.
(ii) The interest rate differentials for the currencies.
(iii) The term, i.e., the future period for which the price is worked out
Sure Success Series- CAIIB- Bank Financial Management -Vaibhav Awasthi Page 8
Unit 2 Basics of Forex Derivatives
Types of Risks in foreign business are given as under:
(1) Exchange Risk: Exchange risk means risk on account of adverse movement in
prices which affects your position. There can be two position overbought and oversold.
Understand through an example. A merchant buys 100 dollars @ Rs 50 but is able to
sell only 60 at the end of the day. He has 40 dollars which he has not been able to sell.
This is overbought position. Now let’s say price of dollar next day is Rs 49 only. This
means he faces loss of Rs 1 on each 40 dollar. This is exchange risk
Another case can be a deal buys 100 dollars but enters into a contract to sell 120 dollars.
Here his position is oversold.
Foreign exchange exposure has been classified into:
(i) Transaction Exposure: Arising due to normal business operations consequent to
which the value of transactions will be affected. This is affected by the transactions
undertaken which may expose the company/firm to currency risk, when compared to
the value in home currency.
(ii) Translation Exposure: This arises when firms have to revalue their assets and
liabilities or receivables and payables in home currency, at the end of each accounting
period. Also arises due to consolidating the accounts of all foreign operations. These
are not actual costs or gains, but notional, as the actual loss or gain is booked at the
time of actual translation of the exposure.
(iii) Operating Exposure: This affects the bottom-line of the firm /company, not directly
due to any foreign exchange exposure of the firm /company, but due to other external
factors in the market/ economy, like changes in competition, reduction in import duty
increasing competition from imported goods, reduction in prices by other country
exporters- effecting exports, increase in import duty by other country -trade tariff, etc.-
causing reduction in exports, etc.
(2) Settlement Risk: When one party of trade fails to performs its part due to difference in
time is called settlement risk
(3) Liquidity Risk: when one party is unable to meet its funding requirement or not able to
exit or or offset positions quickly at reasonable prices.
(4) Country Risk /Sovereign Risk: is a situation when the foreign counter party is
unwilling or unable to fulfill its obligations for reasons other than usual risks. One recent
example of the same is crisis of Greek. Greece during times of boom borrowed more and
now faces the problem of repaying. All the Eurozone countries which had lent to Greece
now faces the country or sovereign risk.
(5) Interest Rate Risk: Interest rate affects the value of currencies. Generally, higher
interest rates increase the value of a given country's currency. The higher interest rates
that can be earned tend to attract foreign investment, increasing the demand for and value
Sure Success Series- CAIIB- Bank Financial Management -Vaibhav Awasthi Page 9
of the home country's currency. Conversely, lower interest rates tend to be unattractive for
foreign investment and decrease the currency's relative value. Understand it like this.
Suppose present rate is 1USD = Rs 45.00. Now interest rate in USA rises. This means
higher return can be earned in USA and thus there will be more demand for the dollars.
This higher demand means value of USD will rise and thus new exchange rate is let’s say
after 3 month is 1USD= Rs 50. Suppose in the above example only, a bank has entered
into a forward agreement to buy 1000 USD at Rs 48 after 3 months, the bank will stand to
gain Rs 2 per dollar as actual market rate is 1USD= Rs 50 while bank can buy the same at
Rs 48 by virtue of its forward agreement. Same way if the rate of interests have declined
in USA dollar would have depreciated and bank would stood to lose.
(6) Operational Risk: The risk arising on account or deficiencies in information system or
internal control or human errors or other infrastructure problems
(7) Legal Risk: When the counter party with whom transaction has been undertaken
doesn’t have the legal authority to enter into the transaction arises legal risk.
Sure Success Series- CAIIB- Bank Financial Management -Vaibhav Awasthi Page 10
Unit 4- Documentary Letter of Credit
It is an instrument by which a bank undertakes to make payment to a seller on
production of documents stipulated in the credit (Refer to article 2 of UCPDC)..
Parties to LCs
a: Applicant: - The Buyer or importer of the goods.
b: Issuing bank: - Importer’s or buyer’s bank who lends its name or credit.
d: Beneficiary :- The Party to whom the credit is addressed i.e. seller or supplier or
exporter.
e: Negotiating bank: - The Bank to whom the beneficiary presents his documents
for negotiation or acceptance under the credit.
f: Reimbursing bank: - Third bank which repays, settles or funds the negotiating
bank at the request of its principal, the issuing bank.
g: Confirming bank: - The bank adding confirmation to the credit. Which under
takes the responsibility of payment by the issuing bank and on his failure to pay.
4. After receiving LC, the beneficiary manufactures the goods and makes
shipments and prepares documents as mentioned in LC.
Sure Success Series- CAIIB- Bank Financial Management -Vaibhav Awasthi Page 11
5. Documents are Presented by beneficiary to nominated bank for negotiation.
Negotiating Bank makes payment against these documents and claims payment
on due date from opening bank.
6. Opening bank makes payment to negotiating bank and recovers the payment
from applicant.
ARTICLES OF UCPDC-600
Article-1: UCPDC-600 applies to any LC when its text expressly indicates that it is
subject to these rules. The rules are binding on all parties thereto unless expressly
modified or excluded by the credit.
Article-2: It contains important Definitions such as: Advising bank, Applicant,
Banking day, Beneficiary, Complying presentation, Confirmation, Confirming bank,
Credit, Honour, Issuing bank, Negotiation, Nominated, Presentation and Presenter.
Sure Success Series- CAIIB- Bank Financial Management -Vaibhav Awasthi Page 12
Unit 5- Facilities for Exporters and Importers
EXPORTS FROM INDIA
Importer-exporter code number: All persons engaged in export-import trade are
required to
obtain IEC number from DGFT. It is a registration number and is to be quoted in all
declarations etc.
General Guidelines for exports are given as under
1.Realisation and Repatriation of export proceeds:
It is obligatory on the part of the exporter to realise and repatriate the full value of goods
/ software / services to India within a stipulated period from the date of export, as under:
(i) It has been decided in consultation with the Government of India that the period of
realization and repatriation of export proceeds shall be nine months from the date of
export for all exporters including Units in SEZs, Status Holder Exporters, EOUs, Units
in EHTPs, STPs & BTPs until further notice.
(i) Under the scheme of Government of India, firms and companies dealing in purchase
/ sale of rough or cut and polished diamonds / precious metal jewellery plain, with a track
record of at least 2 years in import / export of and having an average annual turnover of
Rs. 3 crores or above during the preceding three licensing years (licensing year is from
April to March) are permitted to transact their business through Diamond Dollar
Accounts.
(ii) They may be allowed to open not more than five Diamond Dollar Accounts with their
banks.
(i) A person resident in India may open with, an AD Category – I bank in India, an
account in foreign currency called the Exchange Earners’ Foreign Currency (EEFC)
Account,
(ii) Resident individuals are permitted to include resident close relative(s) as defined in
the Companies Act 1956 as a joint holder(s) in their EEFC bank accounts on former or
survivor basis. However, such resident Indian close relative, being made eligible to
become joint account holder, shall not be eligible to operate the account during the life
time of the resident account holder
Sure Success Series- CAIIB- Bank Financial Management -Vaibhav Awasthi Page 13
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Supplier's Credit
Under supplier credit contracts the exporter supplier extends a credit to the buyer
importer of capital goods. The terms can be down payment with the balance payable in
instalments. The interest on such deferred payments will have to be paid on the rates
determined at the time of entering into such arrangement. The deferred payments are
supported by the promissory notes or bills of exchange often carrying the guarantee of
importer's bank.
Buyer Credit
In a buyer credit transaction, the buyer importer raises a loan from a bank in the
exporter's country under the export credit scheme in force on the terms conforming to
the OECD consensus. The loan is drawn to pay the exporter in full and thus for the
exporter, the transaction is a cash sale. Another form of the buyer credit arrangement
is, for a bank in the exporter's country, to establish a line of credit in favour of a bank or
financial institutions, in the importing country. The later makes available, loans under
the line of credit to its importer clients for the purchase of capital goods from the credit
giving country. In India EXIM Bank makes available supplier/buyer credits and also
extends line of credit toforeign financial institutions to promote exports of capital goods
from India.
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Unit 6- Risk in Foreign Trade &Role of ECGC
Export Credit Guarantee Corporation of India Limited (ECGC)- Role
and Products
ECGC Ltd. (Formerly Export Credit Guarantee Corporation of India Ltd.), wholly
owned by Government of India, was set up in 1957 with the objective of promoting
exports from the country by providing Credit Risk Insurance and related services for
exports. It functions under the administrative control of Ministry of Commerce &
Industry, and is managed by a Board of Directors comprising representatives of the
Government, Reserve Bank of India, banking, and insurance and exporting
community.
o Provides a range of credit risk insurance covers to exporters against loss in export
of goods and services
o Offers Export Credit Insurance covers to banks and financial institutions to enable
exporters to obtain better facilities from them
Sure Success Series- CAIIB- Bank Financial Management -Vaibhav Awasthi Page 15
o Buyer's failure to accept the goods (subject to certain conditions).
Political risks:
o Imposition of restrictions by the Government of the buyer's country or any
Government action which may block or delay the transfer of payment made by the
buyer;
o War, civil war, revolution or civil disturbances in the buyer's country;
o New import restrictions or cancellation of a valid import license;
o Interruption of voyage outside India resulting in payment of additional freight or
insurance charges which cannot be recovered from the buyer.
Percentage of Cover: 90%
Minimum Premium: Rs. 10,000/- shall be adjusted towards premiums falling due
on the shipments effected under the policy and is non-refundable.
2. Small Exporters Policy
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Unit 7- RBI & EXCHANGE CONTROL, EXIM
Bank, FEDAI
FOREIGN EXCHANGE DEALERS' ASSOCIATION OF INDIA (FEDAI)
FEDAI, a non-profit making body was established during 1958 to take over the functions
of the then Exchange Banks Association.
Functions of FEDAI: Major functions include (1) to frame uniform rules for a level
playing field (b) granting accreditation to forex brokers.
All ADs are required to mandatorily abide by the FEDAI rules. FEDAI rules relate to
operations in foreign exchange for having uniformity in dealings. Important rules are
provided asunder:
Rules 1 Hours of 1.1 The exchange trading hours for Inter-bank forex market in
business India would be from 9.00 a.m. to 5.00 p.m. No customer
transaction should be undertaken by the Authorised Dealers after
4.30 p.m. on all working days.
1.2 Cut-off time limit of 05.00 p.m. is not applicable for cross
currency transactions. In terms of paragraph 7.1 of Internal
Control Guidelines over Foreign Exchange Business of Reserve
Bank of India (February 2011), Authorised Dealers are permitted
to undertake cross currency transactions during extended hours,
provided the Managements lay down the extended dealing hours.
1.3 For the purpose of Foreign Exchange business, Saturday will
not be treated as a working day. 1.4 “Known holiday” is one which
is known at least 4 working days before the date. A holiday that is
not a “known holiday” is defined as a “suddenly declared holiday”..
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Normal transit period - Normal Transit Period Concepts of
normal transit period and notional due date are linked to
concessional interest rate on export bills. Normal transit period
comprises of the average period normally involved from the date
of negotiation/purchase/discount till the receipt of bill proceeds. It
is not to be confused with the time taken for the arrival of the
goods at the destination.
Normal transit period for different categories of export business
are laid down as below
a) Fixed Due Date In the case of export usance bills, where due
dates are fixed or are reckoned from date of shipment or date of
bill of exchange etc, the actual due date is known. Therefore in
such cases, normal transit period is not applicable.
b) Bills in Foreign Currencies – 25 days
c) Exports to Iraq under United Nations Guidelines – Max. 120
days
d) Bills drawn in Rupees under Letters of Credit (L/C) i)
Reimbursement provided at centre of negotiation - 3 days ii)
Reimbursement provided in India at centre different from centre
of negotiation - 7 days iii) Reimbursement provided by banks
outside India - 20 days iv) Exports to Russia under L/C where
reimbursement is provided by RBI - 20 days.
e) Bills in Rupees not under Letter of Credit - 20 days
Payment of interest - AD to pay interest to exporter for delay in
payment on export bill sent for collection and realized if the delay
is more than the prescribed period.
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Numerical on Foreign exchange
Direct quote is when a unit of foreign currency is expressed in terms of home currency
e.g. SD/INR 45.00. Indirect quotes is when a unit of home currency is expressed in
terms of a foreign currency e.g. 1 unit of euro is equal to USD 1.40 – only a few
currencieslike GBP/Euro, Euro/USD and AUD/USD are quoted in this manner.
In cross currency quotes where home currency (say, INR) is not involved, the currency to
the right side of the quote is known as terms currency and the currency to the left side is
base currency. The usage applies to direct as well as indirect quotes.
TOD (or cash) is delivery on the same day (today) and TOM is delivery next day (tomorrow)
All the rates quoted by banks are interbank rates i.e. these rates are applicable between
banks. For a customer margin is added or deducted When a customer wishes to buy
currency
Base currency is the currency which is being bought and sold and the other currency is
incidental.
Forwards are quoted as follows
• Spot/1 month 17/18
• Spot/ 2 months 35/37
• Spot/ 3 months 53/56
If forward differentials are in the ascending order (1st figure is lower than the 2nd) the
base currency is at premium.
Fedai prescribed types of rates of merchant transactions:
• TT (buying)- clean inward remittances
• Bill (buying)- purchase/discount of export bills
• TT (selling) clean outward remittances
• Bill (selling) remittance for import bills
Numericals
1. Based on the data given below answer the questions from (i) to (iii)
Following are interbank quotes on certain date Spot USD/INR 45.70/75
1 month 5/7
2 month 8/10
3 month 12/15
Spot GBP/USD 1.8000/8010
1 month 30/25
2 month 50/45
3 month 60/65
Margin of the bank is 3 paise
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(i) An exporter presents a sight bill. What rate will be quoted to the exporter.
Ans. Spot USD/INR is 45.70/75. This means bank is willing to buy USD at 45.70 and sell
at 45.75. When an export customer goes to bank he will be selling currency to bank thus
bank will be buying currency from the customer. The basic principle followed by bank
is buy low sell high. Whenever bank buys currency it deducts margin from the spot
so that it has to pay lower to the customer. In this case bank will buy at Spot –
Margin ie. 45.70 -0.05 = 45.65. Thus rate quoted to the customer will be 45.65
(ii) Another exporter submitted 3 month usance bill. What rate will be quoted to the
customer.
Ans: Usance bills mean payment will be made after a specified period. 3 month export
usance bill means foreign exchange will be received by the bank 3 months from now. To
arrive at this forward rate add premium to the spot rate ie 45.70+0.12 = 45.82 from this
deduct margin hence rate given to customer will be 45.79
Another factor which determines exchange rate between two countries is the interest
rate between two countries. Remember one rule a country with high interest rates has
weak currency and country with low interest rate has strong currency. A country like
India which has interest rate of 8-9% has weak currency while a country like US has
interest rate of around 0.25 %
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So suppose you want to buy one dollar now you can buy it a spot Rate lets say that
rate is 1$= Rs 62. But what if you want to know what would be rate of this dollar 3
months from now? This will depend upon premium or discount. If a country has lower
interest rate it will be at premium, if currency has higher rate of interest it will be at
discount.
We add premium to the spot rate and deduct discount from spot rate to arrive at the
future rate known as forward rate.
Calculation of Rates:
Illustration 1: Spot USD is Rs 44.80/85. If forward premium is given as under
1M – 0234/0239
2M-0303/0307
3M – 0323/0327
What rate will be quoted to an export customer who books 1 month forward contract .
Ans 1: Spot rate is given as 44.80/85 here 44.80 is the bid rate and 44.85 is the ask
rate. Now always remember that questions here are to be solved from the point of view
of bank and not of customer. 44.80 which is bid rate means bank is willing to buy one
dollar for Rs 44.80 from a customer but will sell one dollar for Rs 44.85 to a customer.
Now always remember export customer means a customer who has made exports and
receives foreign exchange. He will go to bank to sell this foreign exchange to the bank
which in other language means bank will buy foreign exchange from the exporter.
So when quoting rates to an exporter buy rate of bank is to be considered which Rs
44.80 in this case. However forward contract for 1month to be booked which means
bank will buy this exchange one month from now and hence one month rate is to be
arrived.
The premium for one month is 0234.
We will add this premium to the spot rate to arrive at one month forward rate, thus one
month forward rate at which contract is to be booked is
Spot rate --- ------------ 44.8000
Add- 1M Premium----- 0.0234
-------------
44.8234
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Module B
Risk Management
What to Focus in this module
Module B is based on Risk in banking sector. It tracks the evolution of Basel and
various risks defined as per Basel accord and how they are to be handled by
Banks.
The most important pillar of Basel accord is keeping of minimum capital. Students
must get themselves fully acquainted with various components of capital and how
to calculate eligible capital as numerical are asked from it.
There are three major risks faced by banks (i) Credit risk (ii) Market risk & (iii)
Operational risk. This unit dwells in detail upon all these risks and how they are
calculated.
Numerical from this portion are based on calculation of capital, calculation of Risk
weights, calculating capital charge for market and operational risk.
At the end of this unit student must be fully aware about Basel II accord and how
it affects the banking Industry in terms of risk management. Remember this unit
is precursor to module D so students should be fully conversant with this unit
before they move ahead.
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Unit-8 Risk and Basic Risk Management
Framework
What is risk? To understand it in financial terms, a business is done keeping in mind
certain expected cash flows. These cash flows represent money which will be generated
by doing that business. The money generated should cover all costs incurred and
estimated profits. Now let’s say a business is expecting the following net flows which will
cover all its costs and give required profits for survival and expansion:
Year I II III IV
Expected net 1000 2000 3000 4000
flow
Actual net flow 1100 1900 3100 3500
Variance 100 (100) 100 (500)
As can be seen cash flows in Year I & III is more than expected but cash flow in Year II
& IV is lower than expected. Why cash flows are different from as projected? Because
of various uncertainties, these uncertainties can either be favourable or unfavorable,
only the unfavourable variance in cash flow is known as risk.
Few points need to be understood in this regard:
1. Risk is not bad.
2. Risk cannot be completely eliminated
3. Risk needs to be managed.
4. Higher the risk, higher the return and thus higher is the capital.
First to understand that risk is not bad. Risk also returns in higher reward and often
results in better and unique methods to do a business. Secondly risk cannot be
completely eliminated while doing a business, risk will always be there, it is for a firm to
decide its goal and risk appetite. Why risk needs to be managed? Reckless risk taking
can result into losses which cannot be afforded and business has to shut down. How
risk and capital are related? Capital
“represents that amount of fund in the business which is necessary to start and grow
the business and which is assumed to be in the business as long as the business is run.
Capital is necessary to absorb losses. If a business involves high risk, losses could be
high and thus capital needed would be high to cover those losses.
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3. Risk measurement
4. Risk pricing
5. Risk Monitoring and control
6. Risk Mitigation.
1. Banking book: Includes advances, deposits of the banks. They also represents fixed
assets of the banks and any borrowings made by them .The banking book is exposed
to credit risk, operational risk, liquidity risk and interest rate risk. They are normally held
till maturity and accrual system of accounting is applied.
2. Trading Book: These generally consists assets which are exposed to markets. For e.g.
Treasury Department of the Bank invests in various government bonds, stock, foreign
currency and corporate bonds. Trading book apart from credit, operational, market and
liquidity is also exposed to market risk. They are normally not held until maturity
and positions are liquidated in the market after holding it for a period and mark to
market system is followed.
3. Off Balance Sheet exposure: These are exposures which may convert into asset or
liability based upon the happening of a certain event. These do not appear in Balance
sheet but are shown as notes to Balance sheet. For example, Bank issues guarantees
on behalf of their customers, in case that guarantee is invoked by the beneficiary, bank
will have to immediately make payment to beneficiary then it will become liability of the
bank and reflect in Balance sheet.
Can off balance sheet exposures be asset too? Yes, suppose a Bank is involved in
litigation and judgment comes in favor of Bank and Court directs the other party to pay
some amount as compensation to Bank then that will result as asset. Off balance sheet
exposures may convert into exposure of banking book or trading book depending upon
the nature of off balance sheet exposure.
Before we go any further and understand various risks faced by Bank, we need to
understand certain concepts which are related with valuation of assets and liabilities.
1. Mark to Market: Mark to market simply means that assets and liabilities should be
shown at their market value.
Mark to market relates to trading book in banks. Banks hold government securities,
bonds, stocks their prices changes daily, Suppose a Bank holds a government bond
valued at Rs 1000 on 01.01.2014, on 01.02.2014 it is valued at Rs 1200, now this Rs
200 is profit and must be recognized as profit and bond must now be shown in books at
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Rs 1200.This procedure of showing the securities at their market price is known as mark
to market.
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Category Risk weight assigned
Sovereigns 0%
Banks 20%
Public sector enterprises 50%
Others 100
What does this risk weight mean? Understand this, suppose a bank ABC Ltd in India
which has capital (Tier I + Tier II) of Rs 40 lakh and has given loans of Rs 100 lakh to
Government of India (GOI), Rs 200 lakh to State Bank of India and Rs 300 lakh to
Reliance company. What would be risk weighted assets (RWA) of ABC ltd ?
1996 Amendment to include market risk. In 1996 amendments were made to 1988
basel accord and market risk was also recognized and methods to measure it were
prescribed. Salient features are given as below:
(i) Banks to identify a trading book and hold capital for market risk under trading book and
organization wide foreign exchange exposures.
(ii) Capital charge to be measured based on 10-day 95 percent VaR metric. Market
requirements were equal to the greater of either the previous day’s VaR, or the average
VaR over the previous 6 days multiplied by 3.
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Numerical & Case Studies - Calculation of Capital:
Case 1. Bank of Indians had paid up capital of Rs 500 crore, Reserves of Rs 250 cr, ,
Revaluation reserve of Rs 100 cr, Perpetual non-cumulative preference shares
(PNCPS) of Rs 50 cr and subordinated debts of Rs 200 cr. Calculate Tier I and Tier II
capital of Bank of Indians and total capital fund of the Bank.
Tier I capital of the Bank = Paid up capital + Reserves+ PNCPS
= 500 + 250+ 50 = 800 cr
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Case Studies and Numerical Problems- Module B
1. Position of The Western Bank of India as on 31.03.2013 is given as under:
Paid up capital of Rs 300 crore, Statutory reserves of Rs 400 crore, Tier I Capital as
on 31.03.11 and 31.03.12 is Rs 800 crore and 900 crore. IPDI as on 31.03.13 is Rs 300
crore. PNCPS is Rs 200 crore. Revaluation reserve of Rs 250 crore and Subordinated
debt of Rs 400 crore.
Calculate (i) Tier I capital of the Bank (ii) Tier II capital of the Bank (iii) Total capital of the
Bank
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Module C
Treasury Management
What to Focus in this module
Module C is based on Treasury Management. As ordinary bankers working as
desk officers, assistant, we fail to see what role treasury plays in the growth of
Banks.
So did you ever wonder, how profitability of your bank is decided? What happens
to the deposits you have mobilized? How banks never fall short of cash? How
CRR & SLR are maintained?
This module gives a glimpse of that to student. Structure of CAIIB exams is such
that it tends to give sufficient knowledge to students on various topics without
delving much into the deeper nuances.
Treasury is one area of banking business where risk can be so great that it can
cause collapse of whole banking systems. Students should take out some time
and read about derivative trader Nick Leeson. Nick Leeson, a derivative trader
caused loss of £827 million ($1.3 billion) to 233 year old Barings banks forcing it
to be sold for £ 1 to ING in 1995
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Unit 14 Introduction to Treasury
Management
Suppose a bank receives Rs 100 in the form of FD for 3 years and bank pays 10 % RoI
on it. Bank must lend this money in the form of loan to some borrower. However it is not
always possible to lend the money received instantly, however Bank cannot keep this
money idle, so traditionally bank would invest it in money market instruments for short
term till it finds suitable opportunity to lend it. This function of deploying surplus fund is
performed by treasury department. Now suppose bank finds a borrower and lends this
Rs 100 to that borrower for 3 years. But after 1 year the depositor comes into the Bank
and asks for premature withdrawal of FD. Bank must pay Rs 100 to borrower, but bank
has given that money as loan. In this condition treasury must borrow the money from
money market and pay back the borrower.
So traditionally treasury was involved in managing liquidity aspect of the bank. Also
treasury was required to comply with the requirement of maintenance of CRR & SLR.
Even today managing liquidity is the important function of the treasury, however due to
availability of various investment avenue treasury has moved from being a cost center
to a profit center.
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Conventional sources of profit generation:
(i) Forex Business: Banks buy currencies and sell. Principle is buy low and sell high.
Difference between buy rate and sell rate is known as spread and is profit. For example
Bank can buy US dollar at Rs 65 from an exporter and sell the same at Rs 66 to an
importer. Rs 1 will be the profit of the bank. Now Suppose Bank has bought 10 USD
and could sell only 8 dollars, the 2 dollar which will be left with the Bank is known as
open position. In this case Bank will be in the position known as overbought, similarly if
Bank had bought inly 10 USD and entered into a contract to sell 12 USD bank would
be in a position called oversold. Banks generally try to square off their position by buying
equal and selling equal amount of currency so that at the end of the day it is not left with
any open position so as to avoid exchange risk.
(a) Spot Trades: Spot means settlement takes place two working days from the trade
date i.e. on the third day. Currency can also be bought and sold, with settlement on the
same day i.e. today (TOD) or, on the next day i.e. tomorrow (TOM). All the rates printed
are for spot trade unless otherwise mentioned.
(b) Forward rates: While spot refers to current transaction, forwards refer to purchase
and sale of currency on future date. Forward exchange rates are arrived at on the basis
of interest rate differentials of two currencies, added or deducted from spot exchange
rate. The interest rate differential is added to the spot rate for low interest yielding
currency (representing forward premium) and deducted from the spot rate for high
interest yielding currency (representing forward discount).
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(c) Investment of foreign exchange surpluses: Forex surplus arise out (i) profits from
treasury operations(ii) profits from overseas branches (iii) forex borrowings from
domestic/overseas markets (iv) Foreign currency and deposits from customers (v)
Balances in Nostro accounst, EEFC acs. These surpluses can be lent to domestic and
global banks for a period not exceeding 1 year or can be invested in overseas market
in short term instrument or can be deposited in Nostro Accounts.
(d) Loans and advances: Banks can give loans in foreign currency in form of FCNR
loans, PCFC and discount of foreign currency bills.
(a) Call money, notice money and term money: The market is for raising and
deploying short term resources not exceeding one year. Call money is for placement of
funds for 1 day. Rate used for this is Overnight Mumbai Interbank offered rate (O/N
MIBOR). Notice money is for period not exceeding 14 days and term money is for period
more than 14 days but not exceeding one year.
(b) Treasury bills: They are short term money market instruments issued by GOI
through RBI for maturity of 91-day, 182 day and 364-day. There are no treasury bills
issued by state governments. Minimum amount is Rs 25,00 and in multiples of Rs
25,000. T Bills are issued at discount and redeemed at par. For example T Bill of 91
day will be available for purchase at 99.26 yielding interest at 5.16% p.a. and after 91
days it can be redeemed for Rs 100. They are held in SGL account which is maintained
with RBI by each banks. Secondary market of t bills takes place through Clearing
Corporation of India Ltd (CCIL).
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Unit 16 Funding and Regulatory aspects
Cash Reserve Ratio (CRR) is the amount of funds that all Scheduled Commercial
Banks (SCB) excluding Regional Rural Banks (RRB) are required to maintain without
any floor or ceiling rate with RBI with reference to their total net Demand and Time
Liabilities (DTL) to ensure the liquidity and solvency of Banks (Section 42 (1) of RBI
Act 1934).
Computation of DTL
Demand Liabilities are liabilities which are payable on demand and Time Liabilities are
those which are payable otherwise than on demand. The components for computation
of DTL include Demand Liabilities, Time Liabilities and Other Demand & Time Liabilities
(ODTL) as under:-
a)Demand Liabilities:-
Current Deposits, Savings bank deposits, Margins held against letters of
credit/guarantees, Balances in overdue fixed deposits, Outstanding TTs, MTs, DDs,
Unclaimed deposits, Credit balances in the Cash Credit account and deposits held as
security for advances which are payable on demand, & Money at Call and Short Notice
from outside the Banking System (Liability to others).
b)Time Liabilities:-
Fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities
portion of savings bank deposits, staff security deposits, margin held against letters of
credit, if not payable on demand, & deposits held as securities for advances which are
not payable on demand and Gold deposits.
Paid up capital, reserves, credit balance in the Profit & Loss Account, loan taken from
the RBI, refinance taken from Exim Bank, NHB, NABARD, SIDBI;
Net income tax provision;
Amount received from DICGC towards claims pending adjustments thereof;
Amount received from ECGC
Amount received from insurance company on ad-hoc settlement of claims pending
judgment of the Court;
Amount received from the Court Receiver;
The liabilities arising on account of utilization of limits under Bankers Acceptance
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Facility (BAF);
District Rural Development Agency (DRDA) subsidy of Rs.10, 000/- kept in Subsidy
Reserve Fund account in the name of Self Help Groups.
Subsidy released by NABARD under Investment Subsidy Scheme for
Construction/Renovation/Expansion of Rural Godowns;
Net unrealized gain/loss arising from derivatives transaction under trading portfolio;
(ii) Internal controls: Internal controls mean internal control imposed by the Bank on
position limits and stop loss limits. What are positions?
Case I: Suppose a Bank for the sake of trading profits enter into a deal to buy 1 million
USD, 1 month from now at Rs 60. Now if after 1 month USD is valued at Rs 65 bank
will make profit of Rs 50 lakh since it can buy USD at Rs 60 while their market value is
Rs 65. However, if after 1 month USD is valued at Rs 55, Bank will lose Rs 50 lakh.
Here the deal to buy 1 million USD is known as position of the Bank. When the deal is
to buy it is called long position, when the deal is to sell it is called short position.
As already stated earlier the deals are made by single dealer and that too quickly based
on his assessment and judgment, if a dealer is allowed to make any size of deal he can
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even make a deal of 1 billion USD in which case bank in scenario 2 of dollar at Rs 55
will suffer loss of Rs 500 crore. Thus there is a need to put restrictions on the deal size
which a dealer can make.
Case II : Suppose a bank enters into a deal to buy 100 dollars at Rs 60, and at the
same time enter into a contract to sell 100 dollars at Rs 61. The position here is called
covered position as bank has matched the buy and sells position and at the end of day
Bank will make profit of Rs 100. However, if bank has bought 100 dollars and at the end
of day there is no customer to whom it can sell, bank faces risk. First it has blocked its
money in buying the dollars and secondly value of dollar may fall from Rs 60, resulting
into loss to the bank. This position here where buy and sell orders are not matched is
known as open position. Bank imposes limits on these open positions.
Derivatives can either be over the counter (OTC) products designed between two
parties. For exam A wants to purchase 100 shares of Company ABC after 3 months at
Rs 100 per share. He can enter into a contract with another person B who is willing to
offer this deal. This is an example of derivative contract which is OTC. Derivatives can
also be exchange traded where A can go to stock exchange and purchase the required
contract. However there are differences between OTC products and exchange traded
products.
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Counter-party risk (bank risk is present.) No counter-party risk, as Exchange is
the counter part - who manages the risk
by margining system
Settlement is mostly by physical delivery Mostly net settlement by cash (physical
(net settlement only in trading delivery may be insisted upon in
positions/cancellations) commodity futures)
Mostly used for hedging Mostly used for trading and speculation.
Derivatives are basically of three kinds (i) Forward contracts (ii) Options (iii)
swaps.
(i) Forward contracts: it’s a contract to deliver foreign currency on a future date at a
pre agreed rate. For e.g. Rajesh, an importer is purchasing machinery from USA for1
million dollar and payment is to be made 3 months from now. Current rate is Rs 60. So
from current rate Rajesh would have to make Rs 6 crore (1millionusd* 60). But payment
is to be made 3 months from now, let’s say dollar is appreciating and is expected at Rs
70 three months from then Rajesh would have to pay Rs 7 crore. So for saving himself
from this risk he can enter into a forward contract with bank, where by paying a premium
he will get a contract where he can purchase 1million USD at 60/ dollar after three
months.
(ii) Options: Options means a contract where buyer of an option gets a right though no
obligation to exercise the contract. Options are of two types; first option to buy known
as call option and secondly option to sell is known as put option.
How options differ from forwards? Here buyer of an option is not obliged to exercise the
contract. For eg Rajesh buys a call option to purchase 100 shares of Reliance at Rs 60,
3 months from now. This price at which it is agreed to be purchased is called strike
price. Suppose 3 months from now, price of Reliance is Rs 70. Now Rajesh can buy the
stock at Rs 60 when price is Rs 70. This Rs 10 will be his profit. The price on that date
will be known as spot price. Now suppose 3 months from now price of Reliance is Rs
50, but he has agreed to buy at Rs 60, here he gets the advantage, now he is not
obliged to buy it at Rs 60. He can simply not exercise the contract and let the option
expire. Call option is an option to buy and put option is an option to sell.
Now understand some concept. When you will buy call option? When you expect price
to rise and when you will buy put option when you expect prices to fall. Here comes
three terms
(i) At the money option: Suppose you have bought a call option to buy a stock at Rs
60 (strike price) after 3 months . 3 months later stock price (known as spot price for
that day) is Rs 60 only. This is called at the money option cause there is no loss no gain
in exercising this option
(ii) In the money option: Suppose you have bought a call option to buy a stock at Rs
60 after 3 months. 3 months later stock price (known as spot price for that day) is Rs
70. Now you earn Rs 10. Your option will earn you money this is called in the money
option. However note if it was a put option it will earn money if spot price is less than
strike price i.e. spot price to be less than 60 then put will be in the money.
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(iii) Out of money option. In case of call option if spot price is less than strike price,
option will be out of money. For e.g. a call option to buy a stock at Rs 60 after 3 months.
3 months later stock price (known as spot price for that day) is Rs 50. Here there is no
use in exercising this option as stock is available at Rs 50 so there is no rational in
buying it at Rs 60.
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Unit 19 Treasury and Asset Liability
Management
In ALM, assets yield income, hence are shown as cash inflows, while liabilities need to
be repaid, hence are shown as cash outflows. Asset-liability mismatch is therefore, a
cash flow mismatch, with excess inflow or outflow of funds. If part of inflow or outflow is
denominated in foreign currency, there is also currency mismatch which needs to be
managed by the Treasury.
Liquidity : The difference between sources and uses of funds in specific time bands is
known as liquidity gap which may be positive or negative. The liquidity gap arises out
of mismatch of assets and liabilities of the bank. RBI has prescribed 11 time buckets in
which assets and liability are placed . An example of maturity bucket is given as below.
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Case studies and Numerical Module C
A. Q1. Major Bank has following assets and liabilities in its balance sheet as on
31.03.2010.
Capital Rs 4000 cr, Reserves- Rs 8200 cr, demand deposits Rs 22000 cr , Saving
Bank Deposit- Rs 30,000, Fixed Deposit Rs 50,000. Borrowings from Financial
Institutions- Rs 700 cr, NABARD Refinace – Rs 800 cr, Bills Payable-Rs 300 cr,
Interest accrued – Rs 50 cr, Subordinated Debt- Rs 900 cr and Suspense account
– Rs 200 cr. Total liability of the Bank is 1,20,000. Calculate the following
a) What is the amount that will not be included in NDTL for calculation of CRR
d) What is the minimum balance in CRR account with RBI, in the above situation which
should be available.
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Wherein;
P-Purchase Price
D – Days to maturity
Day Count: For Treasury Bills, D = [actual number of days to maturity/365]
Illustration
Assuming that the price of a 91 day Treasury bill at issue is Rs.98.20, the yield on the
same would be
After say, 41 days, if the same Treasury bill is trading at a price of Rs. 99, the yield
would then be
Note that the remaining maturity of the treasury bill is 50 days (91-41).
i) Coupon Yield
This is a sample preview. All pages of the book
not available
The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive
Liabilities (RSL) for each time bucket. The positive Gap indicates that it has more RSAs
than RSLs whereas the negative Gap indicates that it has more RSLs. The Gap reports
indicate whether the institution is in a position to benefit from rising interest rates by
having a positive Gap (RSA > RSL) or whether it is in a position to benefit from declining
interest rates by a negative Gap (RSL > RSA). The Gap can, therefore, be used as a
measure of interest rate sensitivity.
What are RSA- Which will be affected by a change in interest rate. For example, Cash
Credit, Term Loans, If interest rate on term loan increases bank will gain by Interest
income
What are RSL- which will be affected by a change in interest rate. For example Saving
Bank accounts, Fixed Deposit accounts.
Cash in Hand, Current accounts etc are not affected by changes in interest Rate. If a
bank has lend in call money it is an asset and will be affected by change in interest rate.
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Given below is the GAP statement of Paradise Bank ( Amt in Crores of Rupees.)
Calculate the GAP
b) if the spot price of USD on the date of expiry is Rs 45, the option is :
(i) ITM (ii) ATM (iii) OTM
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Module-D
Balance Sheet
Management
What to Focus in this module
Module D is based Balance sheet management of the Bank with reference to
Basel norms, Asset Liability Management, Asset classification, NPA norms
This module is very important as we have covered Basel III under this. Basel III
has become very important in recent times and students can expect 10-15 marks
from Basel itself.
Another important portion is ALM, Gap Management, NIM effect. Students can
expect 5 marks numerical easily from this part.
Thus all in all students can expect 20 marks numerical from this module and also
theoretical portion.
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Unit- 20. Components of Assets and Liabilities in Bank's Balance Sheet
and their Management
Sources of Funds
Capital Reserves Deposits Borrowings
Other Liabilities and provisions
Application of Funds
Cash In Hand and Balance with RBI
Balances with Banks and Money at Call and Short Notice
Investments
Advance
Fixed Assets
Other Assets
The parameters that are selected for the purpose of stabilizing Asset Liability
Management of banks re:
• Net Interest Income (NiI)
• Net Interest Margin (NIM)
• Economic Equity Ratio
Net Interest Income (NII) The impact of volatility on the short-term profit is measured
by Net Interest Income.
Net Interest Income = Interest Income - Interest Expenses. In order to stabilise short-
term profits; banks have to minimise fluctuation in the NII
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Unit 21& 22 Banking Regulation and Capital and
Capital Adequacy
Tier I capital
It includes:-
a. Paid-up equity capital, statutory reserves, and other disclosed free reserves, if any;
b. Capital reserves representing surplus arising out of sale proceeds of assets;
c. Innovative perpetual debt instruments (IPDI) eligible for inclusion in Tier I capital,
d. Perpetual Non-Cumulative Preference Shares (PNCPS),
e. Any other type of instrument generally notified by RBI from time to time for inclusion
in Tier I capital.
Limits on eligible Tier I Capital
a. IPDIs upto 15% of Tier I capital as on March 31of previous financial year;
b. The outstanding amount of Tier I preference shares i.e. Perpetual Non-Cumulative
Preference Shares (PNCPS) along with Innovative Tier I instruments shall not exceed
40 per cent of total Tier I capital at any point of time.
c. Innovative instruments/PNCPS, in excess of the limit shall be eligible for inclusion
under Tier II, subject to limits prescribed for Tier II capital.
Tier II Capital
a. Revaluation Reserve;
b. General Provisions and Loss Reserves;
c. Hybrid debt capital instruments;
d. Subordinated debts;
e. IPDI in excess of 15% of Tier I capital and PNCPS in excess of overall ceiling of
40% of Tier I capital;
f. Any other type of instrument generally notified by the Reserve Bank from time to
time for inclusion in Tier II capital.
a) It shall not exceed 100% of Tier I capital net of goodwill, Deferred Tax Assets (DTA),
and other intangible assets but before deduction of investments;
b) Subordinated debt instruments are limited to 50% of Tier I capital after all
deductions.
Revised capital norms are applicable to all commercial banks except ( Local area banks
and regional rural banks) both at the solo level ( global position) i.e bank as an entity as
well as on consolidated level. A consolidated bank will include all group entities under
its control, except the exempted entities. A consolidated bank may exclude group
companies which are engaged in insurance business and business not pertaining to
financial services.
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Unit 25 Asset Classification & Provisioning norms
RBI started implementation of the prudential guidelines on asset classification, income
recognition and provisioning on loan assets based on the recommendations of the
Narsimham committee, commencing with the accounting year beginning 01.04.1992.
Out of order status
An out of order account is one in which the outstanding balance remains continuously
in excess of the sanctioned limit/drawing power or the outstanding balance is less than
the sanctioned limit/drawing power, but there are no credits continuously for 90 days as
on the date of Balance Sheet or credits are not enough to cover the interest debited
during the same period.
‘Overdue’
Overdue is the unpaid amount due to the bank under any credit facility on due date.
Non-performing Assets
An asset (including a leased asset) ceases to generate income is treated as non
performing asset (NPA). A Loan or an advance is classified as NPA as under:-
Banks are required to classify an account as NPA wherein the interest due and charged
during any quarter is not serviced fully within 90 days from the end of the quarter.
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PROVISIONING NORMS
In conformity with the prudential norms, and on the basis of classification of assets,
taking into account the time lag between an account becoming doubtful of recovery, its
recognition as such, the realization of the security, as also the erosion over time in the
value of security charged to the bank, banks are required to make provisions on funded
outstanding on global loan portfolio basis. as under:-
Standard:
General Advances 0.40%
Direct Agriculture & SME 0.25%
Commercial Real estate 1.00%
Restructured loans classified as 2.75%
standard (for 2 years)
Restructured loans classified as NPA ( 2.75%
for one years after upgradation as
standard)
Sub standard
secured 15%
unsecured 25%
Doubtful Secured Unsecured
Upto 12 months 25% 100%
More than 12 months upto 3 years 40% 100%
More than 3 years 100% 100%
Loss 100%
Gross NPAs: Gross NPA is the principal dues of the NPA plus funded interest term loan
where the corresponding contra credit is parked in sundries account
= 8% - 2% NPA Numerical
01. If there is an assets of Rs 200 only in the doubtful-I category and the
realization value of security is Rs 90 only , what will be the provision
requirement.
a. 132.50 b. 22.50
c. 110 d. none of the above
02. If the above asset is in Doubtful category II, what will be the provision requirement?
a. Rs 200 b. Rs 110
c. Rs 36 d. Rs 146
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03. If the above asset is in Doubtful category III what would be the provision
requirement
a. Rs 200 b. Rs 110
c. Rs 36 d. Rs 146
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(i) Stock Approach (to Measuring and Managing Liquidity) :Stock approach is based on
the level of assets and liabilities as well as off-balance sheet exposures on a particular
date.
The following ratios are calculated to assess the liquidity position of a bank.
(a) Ratio of Core Deposit toTotal Assets - Core Deposit/Total Assets: More the ratio,
better it is because core deposits are treated to be the stable source of liquidity. Core
deposit will
constitute deposits from the public in the normal course of business.
(b) Net Loans to Totals Deposits Ratio - Net Loans/Total Deposits: It reflects the ratio
of loans to public deposits or core deposits. Total loans in this ratio represent net
advances after
deduction of provision for loan losses and interest suspense account. Loan is treated to
be
less liquid asset and therefore lower the ratio, better it is.
(c) Ratio of Time Deposits to Total Deposits - Time Deposits/Total Deposits: Time
deposits
provide stable level of liquidity and negligible volatility. Therefore, higher the ratio better
it
is.
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Unit 27- Interest rate risk management
Sources of interest rate risk
1. Gap or Mismatch Risk :A gap or mismatch risk arises from holding assets and
liabilities with different principal amounts, maturity dates or repricing dates, thereby
creating exposure to changes in the level of interest rate.
2. Basis Risk In a perfectly matched gap position there is no timing difference between
the repricing dates; the magnitude of change in the deposit rates would be exactly
matched by the magnitude of change in the loan rate. However, interest rate of two
different instmments will seldom change by the same degree during the same period of
time. The risk that the interest rate of different assets and liabilities may change in
different magnitudes is called basis risk.
3. Embedded Option Risk: The risk arising out of use of embedded options like
premature withdrawal etc.
4. Yield Curve Risk An yield curve is a line on a graph plotting the yield of all maturities
of a particular instmment. Yield curve changes its slope and shape from time to time
depending upon repricing and various other factors.
5. Reinvestment Risk Uncertainty with regard to interest rate at which the future cash
flows can be reinvested is called reinvestment risk.
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Mock Questions –I
01. One of the following is not a function of dealing room of treasury
a. Taking a proprietary position in derivatives
b. Booking a forward contract for a customer
c. managing nostro accounts
d. issuing foreign currency draft
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Mock Questions- II
A bank raises a floating rate corporate deposit of Rs 50 crs for 2 years at a rate 50BPS
over 91 days T bill rates that gets re priced at every calendar quarter. The proceeds of
deposits is used to finance
(a) a project of loan of Rs 25 crs for a period of 5 years having moratorium of 2 years.
Interest rate is set at 300 BPS over 5 years GOI bond with reset date at the end of each
calendar year
(b) the balance of Rs 25 crs is invested in 5 years GOI bond with remaining period of 2
years.
These transactions stood in the books of the bank as on 01.01.2010
1. The bank may see variation in its net interest income over 1 year in respect of asset
‘a’ because the transaction is associated with
a. gap risk b. yield curve risk
c. basis risk d. market risk
2. a bank has disbursed 6 months loan at a fixed rate of 12 % and raised the funds
through 6 months CDs of same amount. Bank is exposed to
3. a bank funds its loans through composite liabilities. In a scenario where interest rate
changes across the board the bank stands exposed to
a. yield curve risk b. basis risk
c. both a& b d. neither a nor b
6. a 5 year 9 % semi annual bond @ market yield of 7.65 has a price of Rs 108.20
which rises to 109.00 when yield falls to 7.35. What is the BPV of the bond
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Questions no 17-21 are based on the data compiled by ABM bank for computing its
CRAR as on 31.03.2014
( Figures in Rs crore)
Tier I Capital 8000
Tier II capital 7000
RWA for credit risk other than retail assets (including Rs 3000 cr for 80,000
commercial real estate)
Exposure on retail assets 17000
Total eligible financial collaterals available for retail assets 3300
Capital charge for general market risk (net position) 550
Capital charge for specific risk 390
Vertical adjustment 80
Horizontal adjustment 40
Total capital charge for equities 200
Total capital charge for options 240
Gross income for previous year 20000
Gross income for the year before the previous year 23000
nd
Gross income for the 2 year before the previous year 25000
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BASEL – III
Introduction:
This topic has almost haunted all the CAIIB BFM students. Exam of December 2015
was entirely based on BFM and caused a huge number of students to fail miserably.
The June 2016 exam also covered around 10 questions of Basel III 5 of which included
theory and 5 of practical problems.
Basel III is a very comprehensive topic and very complex. The master circular issued by
RBI in itself is so complex that it becomes impossible for a common student to
understand anything from it.
Add to the woes, the official Macmillan books do not contain anything about Basel III
thus it becomes extremely difficult for students to know what to study.
In our book, based on the questions asked in previous papers and considering things
which are important in reference to computation of capital requirement for BASEL III we
have tried to explain the Basel III in the easiest possible way.
Before we begin, we again retreat that all topics are easy and logical, what is important
is that they should be presented in an understandable manner.
Basel III
In our previous topics we have covered in details about Basel I & Basel II and why they
were introduced. We would like to bring here the similarities between all the accords of
Basel.
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2. Supervisory 2. Supervisory review
Review process process
3. Market Discipline 3. Market discipline
New Introduction of capital
conservation buffer
and Leverage ratio
By going through the above charts we can see that there is not much difference between
Basel II & Basel III accords as they carry calculation of same percentage of risk weights
for same 3 risks – Credit, Market and Operational. Even the methodology of calculation
of risks etc is same.
So how it is different from Basel II? It is different in the manner focus has been given on
newly introduced concept of Common equity which means the capital in the form of
equity and reserves and surplus. Also items included in additional tier I and Tier II like
IPDI, PNCPS have been modified in terms of limits upto which they are admissible. Also
introduction of capital conservation buffer of 2.5% means banks now need to have
capital of 11.5% rather than the previous 9% which causes additional capital to be kept
by the banks to meet basel III norms
The Basel III norms were issued after subprime crisis and the main objective of the
Basel III framework issued by the Basel Committee on Banking Supervision (BCBS) in
Dec. 2010 was to improve the banking sector’s ability to absorb shocks arising from
financial and economic stress. The macro prudential aspects of Basel III are largely
enshrined in the capital buffers. Both the buffers i.e. the capital conservation buffer
and the countercyclical buffer are intended to protect the banking sector from periods
of excess credit growth.
So let’s see step by step method to calculate CRAR under Basel III
Under Pillar 1, the Basel III framework will continue to offer the three distinct options for
computing capital requirement for credit risk and three other options for computing
capital requirement for operational risk, albeit with certain modifications / enhancements.
The options available for computing capital for credit risk are:-
a) Standardised Approach,
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So regulatory capital i.e. Pillar I capital needs to be like this by March 31, 2019
However this capital structure has to be achieved in stages upto March 31, 2019
and a transitional arrangement has been provided by RBI. The transitional
arrangement is as follows:
As can be seen from the table that capital conservation buffer of 0.625 needs to be
maintained from 31/0/2016 and would gradually increase to 2.5 % by 31/03/2019.
Banks are required to comply with the capital adequacy ratio at two levels viz.
consolidated (Group) and standalone (Solo) level.
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How to start understanding it?
As told above, three pillars of Basel II continue to be the key theme in Basel III also.
However these pillars have been modified suitably.
The first pillar as you are aware is Minimum Capital Requirement, which simply
means Banks should have sufficient capitals in terms of their risk weighted asset.
This capital is known as regulatory capital. Under Basel II, the capital was known as
tier I & Tier II which continues here also, however with certain modification.
While in the Basel II framework, the total regulatory capital comprised of Tier I (core
capital) and Tier 2 capital (supplementary capital). It has been termed as Common
Equity under Basel III. Non-equity Tier 1 and Tier 2 capital would continue to form
part of regulatory capital subject to eligibility criteria as laid down in Basel III.
The total regulatory capital fund will consist of the sum of the following
categories: -
(*From regulatory capital perspective, going-concern capital is the capital which can
absorb losses without triggering bankruptcy of the bank. Gone-concern capital is the
capital which will absorb losses only in a situation of liquidation of the bank).
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While complying with minimum Tier 1 of 7% of risk weighted assets, a bank cannot admit,
Perpetual Non-Cumulative Preference Shares (PNCPS) together with Perpetual Debt
Instruments (PDI) in Additional Tier 1 Capital, more than 1.5% of risk weighted assets.
However, once this minimum total Tier 1 capital has been complied with, any additional
PNCPS and PDI issued by the bank can be included in Total Tier 1 capital reported. Excess
PNCPS and PDI can be reckoned to comply with Tier 2 capital if the latter is less than 2% of
RWAs. PNCPS shall not be issued with a 'put option'. ( We will see more about this while solving
numericals)
Example 1 :
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(v) Total capital eligible for CRAR calculation
(vi) CRAR of the bank
(i) As per guidelines, while complying with minimum Tier 1 of 7% of risk weighted
assets, a bank cannot admit, Perpetual Non-Cumulative Preference Shares
(PNCPS) together with Perpetual Debt Instruments (PDI) in Additional Tier 1
Capital, more than 1.5% of risk weighted assets.
This means if CET-I is 5.5 than PNCPS/PDI which can be taken is 1.5 thus overall
making Tier I at 7%
(iii) Guidelines for inclusion in Tier II capital for PNCPS/PDI Excess PNCPS and PDI
i.e. above Tier I can be reckoned to comply with Tier 2 capital if the latter is less than
2% of RWAs.
We must understand here that required Tier I capital is 7(when CET is 5.5%) and
required Tier capital is 9%. Thus eligible Tier II capital is 2 %
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Example 2 : Following is the position of Himalya bank as on 31.03.2015. Calculate CET-
I , Tier I and Tier II capital of the bank
Borrowings
Solution:
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I) Credit Risk:-
Credit risk is most simply defined as the potential that a bank’s borrower or counterparty
may fail to meet its obligations in accordance with agreed terms. It is the possibility of
losses associated with diminution in the credit quality of borrowers or counterparties.
Under the Standardised Approach, the rating assigned by the eligible external credit
rating agencies will largely support the measure of credit risk. The Reserve Bank has
identified the external credit rating agencies that meet the eligibility criteria specified
under the revised Framework. Banks may rely upon the ratings assigned by the
external credit rating agencies chosen by the Reserve Bank for assigning risk weights
for capital adequacy purposes as per the mapping furnished in these guidelines.
*The above risk weights for both direct claims and guarantee claims
will be
applicable as long as they are classified as ‘standard’/ performing assets
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Category of Loan LTV Ratio Risk Weight
(a) Individual Housing Loans
(i) Up to Rs. 30 lakh
a. Less than or equal to 80% 35
Above 80% to less than or
b. equal 50
to 90%
(ii) Above Rs. 30 lakh and up to 75
lakh 50
a. Less than or equal to 75% 35
Above 75% to less than or
b. equal 50%
to 80%
(iii) Above Rs. 75 lakh Less than or equal to 75% 75
(b) Commercial Real Estate –
Residential NA 75
Housing (CRE-RH)
(c) Commercial Real Estate (CRE) NA 100
Note:
i) Restructured housing loans should be risk weighted with an additional risk weight of 25 per
cent to the risk weights prescribed above.
ii) The LTV ratio should not exceed the prescribed ceiling in all fresh cases of sanction. In case
the LTV ratio is currently above the ceiling prescribed for any reasons, efforts shall be
made to bring it within limits.
iii) CRE-RH means integrated housing projects comprising of some commercial space (e.g.
shopping complex, school, etc.) can also be classified under CRE-RH, provided that the
commercial area in the residential housing project does not exceed 10% of the total Floor
Space Index (FSI) of the project. In case the FSI of the commercial area in the
predominantly residential housing complex exceeds the ceiling of 10%, the project loans
should be classified as CRE and not CRE-RH.
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Credit Risk Mitigation Techniques
Banks use a number of techniques to mitigate the credit risks to which they are exposed. For
example, exposures may be collateralised in whole or in part by cash or securities, deposits from
the same counterparty, guarantee of a third party, etc. In order for banks to obtain capital relief
for any use of CRM techniques, certain minimum standards for legal documentation must be
met. All documentation used in collateralised transactions and guarantees must be binding on
all parties and legally enforceable in all relevant jurisdictions. Banks must have conducted
sufficient legal review, which should be well documented, to verify this requirement. Such
verification should have a well-founded legal basis for reaching the conclusion about the binding
nature and enforceability of the documents
a) Collateralized transactions –
Hair Cut
In the comprehensive approach, Banks are required to adjust both the amount of the exposure
to the counterparty and the value of any collateral received in support of that counterparty to take
account of possible future fluctuations in the value of either, occasioned by market movements.
These adjustments are referred to as ‘haircuts’. The application of haircuts will produce volatility
adjusted amounts for both exposure and collateral. The volatility adjusted amount for the
exposure will be higher than the exposure and the volatility adjusted amount for the collateral
will be lower than the collateral, unless either side of the transaction is cash. In other words, the
‘haircut’ for the exposure will be a premium factor and the ‘haircut’ for the collateral will be a
discount factor.
It may be noted that the purpose underlying the application of haircut is to capture the market-
related volatility inherent in the value of exposures as well as of the eligible financial collaterals.
Where the volatility-adjusted exposure amount is greater than the volatility-adjusted collateral
amount (including any further adjustment for foreign exchange risk), banks shall calculate their
risk-weighted assets as the difference between the two multiplied by the risk weight of the
counterparty.
Banks have two ways of calculating the haircuts viz. (i) Standard supervisory haircuts; using
parameters set by the Basel Committee, and (ii) Own estimate haircuts, using banks’ own internal
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estimates of market price volatility. Banks in India shall use only the standard supervisory
haircuts for both the exposure as well as the collateral.
Cash, Gold, Securities issued by Central & State Governments, KVP, NSC (no lock in period is
operational), LIC policies, Debt securities (rated by a chosen rating agency), Debt Securities
( not rated by a chosen Credit Rating Agency in respect of which
banks should be sufficiently confident about the market liquidity), Units of Mutual Funds, etc. are
eligible financial instruments for recognition in the Comprehensive Approach.
Where:
E* = the exposure value after risk mitigation
E = current value of the exposure for which the collateral qualifies as a risk mitigant
He = haircut appropriate to the exposure
C = the current value of the collateral received Hc =
haircut appropriate to the collateral
Hfx = haircut appropriate for currency mismatch between the collateral and exposure
The exposure amount after risk mitigation (i.e., E*) will be multiplied by the risk weight of the
counterparty to obtain the risk-weighted asset amount for the collateralised transaction.
(Illustrative examples calculating the effect of Credit Risk Mitigation is furnished in the RBI
Circular).
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Case Studies
Most important Part of BFM
1. Mr. Amit purchases a call option for 100 shares of Deliance
Remains the Numerical. Company with strike price of Rs. 100 having maturity after 03 months
Throughout the book we at a premium of Rs. 40. On maturity, shares of A were priced at Rs.
have incorporate the 160. Taking interest cost @ 12% p.a. What is the profit/loss for the
numerical module wise so individual on the transaction?
that students understand
what is expected of them.
a. Gain of Rs. 2000 b. Gain of Rs. 4000
Based on feedback of c. Gain of Rs. 680 d. Gain of Rs. 1880
students and demand for
more and more case studies, Ans - d
we have decided to add
Explanation. We need to understand that call option or put option is
more than 200 solved case
simply a financial product which can be purchased by paying its price.
studies to enable students to
The price in this case is known as premium.
understand the numerical
part and solve any type of
In the above case Amit has purchased 100 call option. Price of each
numerical with ease
option is Rs 40. Thus total price paid by Amit for buying these 100 call
We have also covered options is 100* 40 = Rs 4000.
numerical and questions
asked in last examination. This amount he has taken on a loan of 12%. Thus total interest which
Hope it serves your purpose needs to be paid back is 4000*3/12 * 12/100 = Rs 120 after 3 months.
and enables you to crack all
kind of numerical. On maturity the stock is priced at Rs 160. Thus gain on each call option
is Rs 60. However since premium of Rs 40 is paid on each option net
gain is Rs 20. Thus Gain of Rs 20 on each option so gain of Rs 2000
on total transaction.However, he needs to return back interest of Rs
120 thus his net gain would be Rs 1880.
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Q2. LIC of India buys a specified no of futures at NSE on a stock at strike price of Rs 100 each
when spot price of the stocks is Rs 110. At the maturity of the contract the FI takes delivery of
the shares. During the period, the spot price of the stock decreases by Rs 3. What is the
acquisition cost to the FI per share?
Explanation: LIC has closed the deal at Rs 100. Now at the time of delivery market price i.e.
spot price is Rs 107 (fall of Rs 3 from current price) but since the strike price is Rs 100, LIC will
take the delivery at Rs 100.
Q3. Ms Neha purchases a put option for 200 shares of Star Company with strike price of Rs. 220
having maturity after 02 months for Rs. 50 each. On maturity, shares of A were priced at Rs.
230. What is the profit/loss for the individual on the transaction (without taking the interest cost
and exchange commission into calculation)?
Ans - c
Explanation. Total amount spent by Neha on buying this put option is Rs 10,000. Ie. Rs 50 *
200. Now on the maturity date Price of the stock is Rs 230. Neha has an option to sell the stock
Rs 220, however market price is Rs 230 which means if she does not uses this option she can
sell this stock at the price of Rs 230. Thus Neha will let this option expire and thus total loss on
this transaction would be the loss of the premium amount which is Rs 10,000.
Ans - c
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Explanation: Since the asset is in DF- I, provision is 25 % on secured portion and 100% on
unsecured portion which will work out to 25000 on secured and 2,00,000 on unsecured thus total
provision would be Rs 2,25,000
Q27. Two stocks A and B have negative correlation of 70% between them. The portfolio consists
of 100 units of stock A (market price Rs 50) and 100 units of stock B (market price Rs 80). If
price of stock A moves up by 15 % what would be the gain/loss on the portfolio?
Ans - b
Explanation – Negative correlation means if one stock moves up another comes down. So if
stock A moves up by 15%, stock B will come down by 10.5 % (70% of 15, as negative correlation
is of 70 %)
Now if there is 15% increase in stock A its new price is 5000 * 115% = 5750
Subsequently New price of Stock B after 10.5% decline would be = 8000 * 89.5% = 7160
Thus there is gain of Rs 750 on stock A while there is loss of Rs 840 on stock B thus there is net
loss of Rs 90.
Before we proceed any further, we would again like to explain what is bond and how its valuation
is arrived. Bonds are simply a debt instrument which have a face value ie the amount of debt
which has been taken by the issuer) and carry a fixed rate of interest called coupon to be paid
by the issuer to the holder of the bond. Let’s understand it through an example
Eg: ABC limited issued one bond of Rs 1000 to Rahul with 8% coupon and maturity of 3 years .
This means ABC company (issuer) has taken debt of Rs 1000 (face value) from Rahul ( holder)
on which it will pay interest of 8% each year to Rahul and repay back the amount after 3 years.
Thus in first year ABC will pay Rs 80 to Rahul, second year also Rs 80 to Rahul and in Third
year RS 1000 ( Principal amt)+ Rs 80 to Rahul. Thus Rahul will earn a total of Rs 240 on this
bond and get back his principal amount in 3 years.
Now how value of bond will be arrived at? Value of bond or for that matter any financial instrument
is simply the discounted value of its cash flow. In the question above we saw, Rahul earned Rs
80 each year. So his cash flow for 1s year was Rs 80, his cash flow second year was Rs 80 and
his cash flow during third year was Rs 1080. This cash flow is discounted by the rate known as
market yield or
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Now these bonds are just like shares and they are traded in market. Just like share price changes
every day, bond prices also change every day. The important factor which is responsible for the
change in the prices of bond is the general interest rate in the market known as market yield or
simply yield or also YTM.
Students must remember here that bonds prices are nothing but simply discounting of cash flows
of bond by this yield. Let’s see various types of questions on bond to make sure that you master
this topic
Q37. A bond with coupon of 7 % is with 3 years to maturity is available for you to purchase. If
yield is 8%, what price you should pay for the bond.
a. 95.53 b.103.14
c. 97.42 d. 101.20
Ans: C
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Q71-75 : Aam Aadmi Bank has Rs 38000 crore to invest which can be done under given 4
options. Answer the questions given below based on the information given in table
Particular I II III IV
Q 94-97Export bill for USD 5mio drawn 120 days from the date of shipment, Shipment date
is 3rd october2014. Due date is1st feb2015. Exchange margin 0.15% Spot rupees :63.15/20
Premium spot-january55/60 paise . Rate to be quoted to nearest 0.25 paise& rupee amount
is to be rounded off. Rate of interest on post shipment export up to 180 days is 9%p.a
Commission on bills purchased is 0.075% Interest &commission to be charged up front
( Questions asked in June 15 exam)
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116-120 are based on the given information.
Following information is available with respect to Bandan bank as on 31.03.2016.
Based on this answer the following
146-150 Following information has been presented to the CEO of Ratnakar Tata Bank
Ltd. Assuming VAR @ 95% level, answer the following
Particular Estimated profit Capital Volatility
Option A 5 million $ 80 million$ 7%
Option B 8 million $ 140 million $ 9%
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186-189 On 02.01.2016, you had purchased a demand bill for USD 10,000 @ Rs 52.03
and the exporter was paid in rupees immediately. The bill when presented on
10.01.2016 at New York was not honoured. The advice of non-payment was received
and conveyed to the exporter on 13.01.2016. The exporter requested that
a. the bill amount plus charges ( Rs 250) be recovered from him
b. The bill be treated on collection basis and represented for payment
c. 5 % rebate be allowed to overseas importer
on 03.02.2016 the bank in New York telexed having recovered and credited the
proceeds less their charges USD20 with value date 03.02.2016. Meanwhile the market
has moved and TT selling rate on 13.01.2016 was Rs 52.07 and TT buying rate on
03.02.2016 was Rs 51.81
194-197 Bank of Hindustan earned a net profit after tax and provision of Rs 5000cr
and Bank of India Rs 6000 cr. CET ratio of Bank of Hindustan is 6.50% after including
the current period retained profits. The ratio of Bank of India is 7%. Both the banks
are in need of fresh capital.
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198-200 Given below is the information of Jan dhan Bank
198. What income would be recognised for term loan portfolio of the bank
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