Tutorial 2 - TREASURY MANAGEMENT QUESTIONS

Question 1: List the main components of the balance sheet and give examples for each type.
Which is the most important component on the asset side and which one on the liability side?
Explain why.
- Asset:
1) Cash & Bank Balances with State Bank of Vietnam
2) Balances with banks and money at call & short notice (Money at call and short notice
represents short-term investment of surplus funds in the money market. Money lent for one
day is money at 'call' or 'call money' means deals in overnight funds, while money lent for a
period of more than one day and up to fourteen days is money at 'short notice')
3) Investments ( Gov securities, shares, debenture, bonds, subsidiaries and sponsored
institutions…)
4) Advances (Secured by tangible assets, Covered by Bank/ Government Guarantees,
Unsecured) – The most important
5) Fixed Assets (infrastructure/facilities)
6) Other Assets
- Liabilities and Equity:
1) Capital (cash, government securities, and interest-earning loans (e.g., mortgages, letters of
credit, and inter-bank loans) - Capital is needed to allow a bank to cover any losses with its
own funds. A bank can keep its liabilities fully covered by assets as long as its aggre- gate losses
do not deplete its capital.
2) Reserve & Surplus ( all the cumulative amount of retained earnings recorded as a part of
the Shareholders Equity and are earmarked by the company for specific purposes like buying
of fixed assets, payment for legal settlements, debts repayments or payment of dividends etc.)
3) Deposits ( savings accounts, checking accounts, and money market accounts.) – The most
important
4) Borrowings (mortgage products, personal loans, auto loans, construction loans, and other
financing products. They also offer opportunities for those looking to refinance an existing loan
at a more favorable rate.)
5) Other Liabilities & Provisions (Bill payable, not covered specifically in other areas of the
supervisory activity. Often they may be quite insignificant to the overall financial condition of a
bank.)
Question 2: It is said that ALM in Banking is a Liability driven process. Discuss the reasons
Asset/liability management is the process of managing the use of assets and cash flows to reduce
the firm's risk of loss from not paying a liability on time. Well-managed assets and liabilities
increase business profits.
Question 3: Why is capital reserve important? Under the Basel Accord, explain the difference
between Tier I capital and Tier II capital. Give examples for each type
- The purpose for which a capital reserve is created is for preparing the company for sudden
events like inflation, business expansion, funds for a new project. A capital reserve is created
from capital profit earned through sales of capital assets such as the sale of fixed assets, profit on
the sale of shares.
- A capital reserve is a line item in the equity section of a company's balance sheet that indicates
the cash on hand that can be used for future expenses or to offset any capital losses. It is
derived from the accumulated capital surplus of a company and is created out of its profit.
 Tier 1 capital is a bank's core capital and includes disclosed reserves that appears on the
bank's financial statements and equity capital. This money is the funds a bank uses to
function on a regular basis and forms the basis of a financial institution's strength.
(shareholders' equity and retained earnings)
 Tier 2 capital is a bank's supplementary capital. Undisclosed reserves, subordinated
term debts, hybrid financial products, and other items make up these funds.

Question 4: List the 7 sources of Interest rate risk and give example on each of them.

• Gap Risk (Suppose that a stock's price closes at $50. It opens the following trading day at $40
even though no intervening trades have happened between these two times. Gaps can also occur
to the upside. Imagine you are a short-seller in XYZ stock. It closes the day at $50. Due to a
positive earnings surprise, the stock opens at $55 the next day.)
• Basis Risk (if the price of oil is $55 per barrel and the future contract being used to hedge this
position is priced at $54.98, the basis is $0.02. When large quantities of shares or contracts are
involved in a trade, the total dollar amount, in gains or losses, from basis risk can have a
significant impact.)
• Net Interest Position Risk (The size of nonpaying liabilities is one of the significant factors
contributing towards profitability of banks. When banks have more earning assets than paying
liabilities, interest rate risk arises when the market interest rates adjust downwards.)
• Embedded Option Risk (The inclusion of an embedded option can materially impact the value
of that financial security. Embedded options make investors vulnerable to reinvestment risk and
expose them to the possibility of limited price appreciation. Examples of embedded options
include callable, putable, and convertible securities.)
• Yield Curve Risk (A steepening curve typically indicates stronger economic activity and rising
inflation expectations, and thus, higher interest rates. When the yield curve is steep, banks are
able to borrow money at lower interest rates and lend at higher interest rates. An example of a
steepening yield curve can be seen in a 2-year note with a 1.5% yield and a 20-year bond with a
3.5% yield. If after a month, both Treasury yields increase to 1.55% and 3.65%, respectively, the
spread increases to 210 basis points, from 200 basis points.)
• Price Risk (an investor owns stock in two competing restaurant chains. The price of one chain's
stock plummets because of an outbreak of foodborne illness. As a result, the competitor realizes
a surge in business and its stock price.)
• Reinvestment Risk (an investor buys a 10-year $100,000 Treasury note (T-note) with an
interest rate of 6%. The investor expects to earn $6,000 per year from the security. However, at
the end of the first year, interest rates fall to 4%. If the investor buys another bond with the
$6,000 received, they would receive only $240 annually rather than $360. Moreover, if interest
rates subsequently increase and they sell the note before its maturity date, they stand to lose part
of the principal.)

Question 5
A bank makes a $10,000 four2year car loan to a customer at fixed rate of 8.5%. The bank
initially funds the car loan with a one2year $10,000 CD at a cost of 4.5%. The bank’s initial
spread is 4%.
a. What is the bank’s one year gap?
b. What would happen the bank’s balance sheet when the interest rate rises/falls in one year?