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Master of Business Administration - MBA Semester 4

MF0016 – Treasury Management
Assignment Set- 1

Q.1 Explain how organization structure of commercial bank treasury facilitates in
handling various treasury operations.

Ans:- The treasury organisation deals with analysing, planning, and implementing treasury
functions. It deals with issues of profit centre, cost centre etc. The organisations managing
interfaces with treasury functions include intragroup communications, taxation, recharging,
measurement and cultural aspects.

Structure of treasury organisation

Figure 1.2 depicts the structure of treasury organisation which is divided into five groups.

Figure 1.2: Treasury Organisations

• Fiscal – This group includes budget policy planning division, industrial and
environmental division, common wealth state relationships, and social policy division.
• Macroeconomic – This group deals with economic sector of the organisation. It includes
domestic and international economic divisions, macroeconomic policy and modeling
division.
• Revenue – This group is concerned with the taxes in an organisation. It includes business
tax division, indirect tax, international and treaties division, personal and income
division, tax analysis and tax design division.
• Markets – This group mainly deals with selling of products in the competitive market. It
includes competition and consumer policy, corporations and financial services policy,
foreign investments and trade policy division.

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• Corporate services – This group deals with overall management of the treasury
organisation. It includes financial and facilities division, human resource division,
business solutions and information management division.

Treasury management in banks

In recent days, most of the Indian banks have classified their business into two primary business
segments like treasury operations (investments) and banking operations (excluding treasury).

The treasury operations in banks are divided into:

• Rupee treasury – The rupee treasury carries out various rupee based treasury functions
like asset liability management, investments and trading. It helps in managing the bank’s
position in terms of statutory requirements like cash reserve ratio, statutory liquidity ratio
according to the norms of the Reserve Bank of India (RBI). The various products in rupee
treasury are:

1. Money market instruments – Call, term, and notice money, commercial papers,
treasury bonds, repo, reverse repo and interbank participation etc.
2. Bonds – Government securities, debentures etc
3. Equities

• Foreign exchange treasury – The banks provide trading of currencies across the globe. It
deals with buying and selling currencies.
• Derivatives – The banks make foundation for Over the Counter (OTC). It helps in
developing new products, trading in order to lay off risks and form apparatus for much of
the industry’s self-regulation.

The role of policies in strategic management was described in this section. The next section deals
with inter-dependency between policy and strategy.

Q.2 Bring out in a table format the features of certificate of deposits and commercial
papers.

Ans:-

Features of commercial papers Features of CDs in Indian market
CPs is an unsecured promissory note. Schedule banks are eligible to issue

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CDs
CPs can be issued for a maturity Maturity period varies from three
period months
of 15 days to less than one year. to one year
CPs is issued in the denomination of
Rs.5 lakh. The minimum size of the Banks are not permitted to buy back
issu their CDs before the maturity
e is Rs. 25 lakh.
The ceiling amount of CPs should CDs are subjected to CRR and
not exceed the working capital of th Statutory
e issuing company. Liquidity Ratio (SLR) requirements
The investors in CPs market are
banks,
individuals, business organisations They are freely transferable by
and endorsement and delivery.
the corporate units registered in India They have no lock-in period.
an
d incorporated units.
The interest rate of CPs depends on
the prevailing interest rate on CPs
market, forex market and call money
CDs have to bear stamp duty at the
market. The attractive rate of interest
prevailing rate in the markets
In any of these markets, affects the
deman
d of CPs.
The eligibility criteria for the
The NRIs can subscribe to CDs on
companies
repatriation basis
to issue CPs are as follows:
The tangible worth of the issuing
company should not be less than Rs
. 4.5 Crores.
The company should have a
minimum credit rating of P2 and
A2 obtained from Credit Rating
Information Service of India
(CRISIL) and
Investment Information and Credit
Ratin
g Agency of India Limited. (ICRA)
respectively
The current ratio of the issuing
company should be 1.33:1.
The issuing company has to be
listed on stock exchange.

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Q.3 Critically evaluate participatory notes. Detail the regulatory aspects on it.

Ans:- The participants in forex market are the RBI at the apex, authorised dealers (ADs) licensed
by forex market, exporters, importers, companies and individuals. The major participants of
foreign exchange market are:

• Corporates – They mainly include business houses, international investors, and
multinational corporations. They operate in market by buying or selling currencies within
the framework of exchange control regulations. It deals with banks and their clients to
form retail segment of forex market.
• Commercial banks – They play an important role in forex market. They operate in market
by trading currencies for their clients. Large volume of transactions consists of banks
dealing directly among themselves and smaller transactions usually consists of
intermediary foreign exchange brokers.
• Central bank – It plays a vital role in the country’s economy by controlling money
supply. Central banks get involved in forex market to regain price stability of exchange
rate, protect certain levels of price in exchange rate, and support economic goals like
inflation and growth.
• Exchange brokers – They ensure the most favourable quotations between the banks at a
low cost in terms of time and money. Banks provide opportunities to brokers in order to
increase or decrease the rate of buying or selling foreign currencies. Exchange brokers
have a tendency to specialise in unusual currencies but also manage major currencies. In
India, many banks deal through recognised exchange brokers or may deal directly among
themselves.

The other participants include RBI and its authorised dealers, exporters, importers, companies
and individuals.

Q.4 What is capital account convertibility? What are the implications on implementing
CAC?

Ans:- Capital Account Convertibility (CAC) refers to relaxing controls on capital account
transactions. It means freedom of currency conversion in terms of inflow and outflows with
respect to capital account transaction. Most of the countries have liberalised their capital account
by having an open account, but they do retain some regulations for influencing inward and
outward capital flow. Due to global integration, both in trade and finance, CAC enhances growth
and welfare of country.

The perception of CAC has undergone some changes following the events of emerging market
economies (EMEs) in Asia and Latin America, which went through currency and banking crises
in 1990’s. A few counties backtracked and re-imposed capital controls as part of crisis
resolution. Crisis such as economic, social, human cost and even extensive presence of capital
controls creates distortions, making CAC either ineffective or unsustainable. The cost and
benefits from capital account liberalisation is still being debated among academics and policy
makers. These developments have led to considerable caution being exercised by EMEs in

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opening up capital account. The Committee on Capital Account Convertibility (Chairman: Shri.
S.S. Tarapore) which submitted its report in 1997 highlighted the benefits of a more open capital
account but at the same time cautioned that CAC could pose tremendous pressures on the
financial system. India has cautiously opened its capital account and the state of capital control in
India is considered as the most liberalised it had been since late 1950’s. The different ways of
implementing CAC are as follows:

• Open the capital account for residents and non-residents.
• Initially open the inflow account and later liberalise the outflow account.
• Approach to simultaneously liberalise control of inflow and outflow account.

Q.5 Detail domestic and international cash management system

Ans;- The strategy of a company which has its businesses in many nations and efficiently
manages its cash and liquidity is called multinational cash management programme. The main
goal of multinational cash management is the utilisation of local banking and cash management
services.

Multinational companies are those that operate in two or more countries. Decision making within
the corporation is centralised in the home country or decentralised across the countries where the
organisation does its business.

The reasons for which the firms expand into other countries are as follows:

• Seeking new markets and raw materials
• Seeking new technology and product efficiency.
• Preventing the regulatory obstacles.
• Retaining customers and protecting its processes
• Expanding its business.

Several factors which distinguish multinational cash management from domestic cash
management are as follows:

• Different currency denominations
• Political risk and other risk.
• Economic and legal complications.
• Role of governments
• Language and cultural differences.
• Difference in tax rates, import duties.

The principle objective of multinational cash management programme is to maximise a
company’s financial resources by taking benefits from all liability provisions, payable periods.
The multinational cash management programme effectively achieve its goals by using excess
cash flow from some units across the globe to extend cash needs in other units which is called in-

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house banking and by relocating funds for tax and foreign exchange management through
repricing and invoicing.

During multinational cash management system payments by customers to company’s branches
are basically handled through a local bank. The payments between the branches and the parent
company are managed through the branches, correspondents or associates of the parent company.
Through the use of electronic reporting systems a parent company observes cash balances in its
foreign local banks.

Multinational cash management programme specifically evaluate its techniques by timing of
billing, use of lockboxes or intercept points, negotiated value range.

The multinational cash management system involves exchange rate risk which occurs when the
cash flow of one currency during transformation to another currency the cash value gets
declined. It occurs due to the change in exchange rates. The exchange rates are determined by a
structure which is called the international monetary system.

For example, Wincor Nixdorf played an innovative role in enhancing cash handling between
various countries. Wincor’s focus was on the entire process chain which started from head office
to stores, crediting to the retail company’s account, head office to branches and so on. Wincor
Nixdorf’s served several countries with its innovative hardware and software elements, IT
services to side operations and consulting services to develop custom optimised solutions.

Q.6 Distinguish between CRR and SLR

Ans:- Cash Reserve Ratio

Cash Reserve Ratio (CRR) is a country’s central bank regulation that sets the minimum reserves
for banks to hold for their customer deposits and notes. These reserves are considered to meet the
withdrawal demands of the customers. The reserves are in the form of authorised currency stored
in a bank treasury (vault cash) or with the central bank. CRR is also called liquidity ratio as it
controls money supply in the economy. CRR is occasionally used as a tool in monetary policies
that influence the country’s economy.

CRR in India is the amount of funds that a bank has to keep with the RBI which is the central
bank of the country. If RBI decides to increase CRR, then the banks’ available cash drops. RBI
practices this method, that is, increases CRR rate to drain out excessive money from banks. The
CRR in the economy as declared by RBI in September 2010 is 6 percent.

An organisation that holds reserves in excess amount is said to hold excess reserves.

The following are the effects of CRR on economy:

• CRR influences an economy’s money supply by effecting the potential of banks
• CRR influences inflation in an organization

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• CRR stimulates higher economic activity by influencing the liquidity

Statutory Liquidity Ratio

Statutory Liquidity Ratio (SLR) is the percentage of total deposits that banks have to invest in
government bonds and other approved securities. It means the percentage of demand and time
maturities that banks need to have in forms of cash, gold and securities like Government
Securities (G-Secs). As gold and government securities are highly liquid and safe assets they are
included along with cash.

In India, RBI determines the percentage of SLR. There are some statutory requirements for
placing the money in the government bonds. After following the requirements, the RBI arranges
the level of SLR. The maximum limit of SLR is 40 percent and minimum limit of SLR is 25
percent.

The RBI increases the SLR to control inflation, extract liquidity in the market and protects
customers’ money. Increase in SLR also limits the bank’s leverage position to drive more money
into the economy.

If any Indian bank fails to maintain the required level of SLR, then it is penalised by RBI. The
nonpayer bank pays an interest as penalty which is above the actual bank rate.

The main objectives for maintaining SLR are the following:

• By changing the SLR level, the RBI increases or decreases banks’ credit expansion
• Ensures the comfort of commercial banks
• Forces the commercial banks to invest in government securities like government bonds

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Master of Business Administration - MBA Semester 4
MF0016 – Treasury Management
Assignment Set- 2

Q.1 Explain any two major risks associated with banking organization.

Ans:- The major risks are associated with banking organisations. Since banks use a large amount
of leverage, it becomes important to manage risks carefully. The various types of risks are:

• Interest rate risk
• Foreign exchange risk
• Liquidity risk
• Default risk
• Financial risk
• Market risk
• Credit risk
• Personnel risk
• Environmental risk
• Production risk

Interest rate risk

Interest rate risk occurs due to the change in absolute level of interest rates causing variations in
the value of investments. Such changes usually affect the securities like shares, bonds, mutual
funds or money market instruments and can be reduced by diversifying or hedging techniques.
The evaluation of interest rate risk should consider illiquid hedging products or strategies, and
potential impact on fee income which are sensitive to changes in interest rates. They are
classified into the following:

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• Term structure risk (yield curve risk) – It arises from the variations in the movement
of interest rates across maturity spectrum. It consists of changes in relationship between
interest rates of various maturities of similar market. The changes in relationships occur
when the shape of yield curve for a market flattens, steepens, or becomes inverted during
interest rate cycle. The yield curve variations can emphasise a bank’s risk position by
increasing the effect of maturity mismatches.
• Basis risk – It occurs due to the changes in relationship between interest rates for
different market sectors.
• Options risk – It arises when bank or bank customer gains privileges to alter the level
and timing of cash flows of asset, liability or off balance sheet instruments. The option
holder has the rights to buy or sell the financial instruments over a specified period of
time. But the option holder faces limited downside risks (amount paid for option) and
unlimited upside reward. The option seller faces unlimited downside risk (option
exercised during the time of disadvantage) and limited upside reward (retaining
premium).

Foreign exchange risk

Foreign exchange risk occurs during the change of investments value occurring due to the
changes in currency exchange rates. It refers to the probability of loss occurring due to an
adverse movement in foreign exchange rates. For example – Consider an investor residing in
United States purchases a bond denominated in Japanese Yen. By this the investor experiences
decline in rate of return at which the Yen exchanges for dollars. The three types of foreign
exchange risk or exposure are:

• Transaction risk – It is the possibility of affecting future transactions of the organisation
due to the changes in currency exchange rates.
• Economic risk – It measures the impact of changes in exchange rate risk on the
organisation’s cash flows and earnings.
• Translation risk – It measures the impact of changes in exchange rate of organisation’s
financial statements. It is also known as accounting exposure.

Q.2 What is liquidity gap and detail the assumptions of it?

Ans;- Liquidity Gap Report

A liquidity gap is the difference between the due balances of assets and liabilities over time.

At any point of time, a positive gap between assets and liabilities is equivalent to shortage of
cash. The marginal gap refers to the difference between the changes of assets and liabilities over
time. A positive marginal gap means that the change in the values of assets exceeds that of
liabilities. The gap profile changes as and when new assets and liabilities are added. The gap
profile is represented either in the form of tables or charts. All the assets and liabilities are
accounted in liquidity gap report and it is dependent on the dates of maturity and the actual date.

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Assumptions in preparation of gap report in terms of assets, liabilities and off balance sheet
items

Since the future liquidity position of a firm cannot always be predicted based on the factors,
assumptions play an important role in determining the continuing due to the rapidly changing
banking markets. But the number of assumptions to be made should be limited. The assumptions
can be made based on three aspects. They are assets, liabilities, and off-balance sheet assets.

Assets

Assets are nothing but any item of economic value owned by an individual or corporation.
Assumptions regarding a bank’s future stock of assets include their possible marketability and
use an asset as a guarantee of existing assets which could increase flow of cash and others.

To determine the marketability of an asset, the method segregates the assets into three categories
according to their degree of relative liquidity:

• The highly liquid group of assets consists of components such as interbank loans, cash
and securities. Some of the assets might instantaneously be converted into cash at
existing market values under almost any situation whereas others, such as interbank loans
might lose liquidity in a common crisis.
• A less liquid group of assets consists of bank’s saleable loan portfolio. The assignment
here is to develop assumptions about a reasonable plan for the clearance of a bank’s
assets. Some assets, while marketable, might be viewed as unsaleable within the time
frame of the liquidity analysis.
• The least liquid group of assets consist of basically unmarketable assets such as loans that
are not capable of being readily sold, bank premises and investments in subsidiaries.

Because of the difference in the banks internal asset-liability management, different banks can
allot the same assets to different groups on maturity ladder.

While categorising the assets, banks should take care of the effects on the asset’s liquidity under
the various conditions. Under normal conditions, there may be assets which are much liquid then
during a time of crisis. Therefore a bank may classify the assets according to the type of scenario
it is forecasting.

Liabilities

To check the cash flows occurring due to a bank’s liabilities, a bank should first examine the
behaviour of its liabilities under normal business situations. This would include forming:

• The level of roll-overs of deposits and other liabilities remain normal.
• The actual maturity of deposits with non-contractual maturities, such as demand deposits
and others; the normal growth in new deposit accounts.

While examining the cash flow arising from a bank’s liabilities during the two crisis scenario, a
bank would look at four basic questions. The first two questions represent the proceedings in the

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flow of cash that tend to reduce the cash outflows planned directly from contractual maturities.
The four questions are as follows:

• What are the different sources of funding that are likely to stay with a bank under any
situation, and can the count of these sources be increased?

Other than the liabilities identified from this step, a bank’s capital and term liabilities that
are not maturing within the prospect of the liquidity analysis provide a liquidity buffer.

The total liabilities identified in the first category may be assumed to stay with the bank
even when it’s a worst scenario. Some core deposits generally remain with a bank
because retail and small scale industry depositors may rely on the public-sector security
net to shield them from occurring loss, or because the cost of changing banks, especially
for some business services that include transactions accounts, is unaffordable in the very
short term.

• What are the sources of funding that can be estimated to run off gradually if problems
occur, and at what rate? Is deposit pricing a way for controlling the rate of runoff?

The second category consists of liabilities that have chances of staying back with the
bank during the period of slight difficulties and can be used during crisis. Liabilities,
includes core deposits that are not already included in the first category. In some
countries, other than core deposits, some of the interbank deposits and government
funding remains with the bank even though they are considered volatile .for these kinds
of cash flows a bank’s very own past experience related to liabilities and the experiences
of other such firms with similar problems may come handy. And help in creating a time
table.

• Which maturing liabilities can be estimated to run off instantly at the first warning of
trouble?

The third category consists of the maturing liabilities that remained, including some
without contractual maturities, such as wholesale deposits. Under each case, this
approach adopts a conservative stand and assumes that these remaining liabilities will be
paid back at as early as possible before the maturity date, especially when there is high
crisis, as such money may flow to government securities and other safe refuges.

Factors such as diversification and relationship building are considered important during
the evaluation of the degree of the outflow of funds and a bank’s capacity to replace
funds. Nevertheless, in a general market crisis, sometimes high scale firms may find that
they receive larger than the usually got wholesale deposit inflows, even though there are
no cash inflows existing for other firms in the market.

• Does the bank have a reliable back-up facility?

For example, small banks in local areas may also have credit lines that they can bring
down to offset cash discharges. These facilities are rarely found in larger banks but

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however it depends on the assumptions made on the bank’s liabilities. Such facilities
usually need to undergo many changes but only to a limit, especially in a bank specific
crisis.

Off balance sheet item

A bank should also examine the availability of sufficient cash flows from its off balance sheet
activities (other than the loan commitments already considered), even if they are not a portion of
the bank’s recent liquidity analysis.

In addition, the Contingent liabilities, such as letters of credit and financial guarantees, represent
potentially significant cash outflow for a bank, but are usually not dependent on a bank’s
condition. A bank may be able to create a "normal" level of out flow of cash on a regulatory
basis, and then estimate the possibility a raise in these flows during periods of stress. However, a
general market crisis may generate a considerable increase in the total invocation of letters of
credit because of an increase in defaults and liquidations in the market.

Other possible sources of cash outflows are swaps, written Over-The-Counter (OTC) options,
and forward foreign exchange rate contracts. For instance, consider that a bank has a large swap
book; it would then want to study the circumstances under which it could become a net payer,
and whether or not the total net pay-out is significant.

Consider another situation wherein a bank acts as a swap market-maker, with a possibility that in
a bank-specific or general market crisis, customers with in-the-money swaps (or a net in-the-
money swap position) would try to reduce their credit exposure to the bank by requesting the
bank to buy the swaps back. Similarly, a bank would like to review its written OTC options book
and any warrants that are due, along with hedges if any against these positions, since certain
types of crises sometimes arouse an increase in early exercises or requests that the banks should
buy the offer back. These activities could result in an unexpected cash loss, if hedges can neither
be quickly liquidated to generate cash nor provide insufficient cash.

Other assumptions

Until now the discussion was centered on the assumption about the behaviour of the specific
instrument under different scenarios. At the time of looking the components exclusively, there
might be some of the factors that might have a major impact on the cash flows.

The need for liquidity arises from business activities. The banks too need excess funds to support
extra operations.

For example, the majority of the banks provide clearing services to financial institutions and
correspondent banks. These institutions generate a major sum of cash inflow and cash outflows
and unpredicted variations in these services can reduce a bank’s funds to a large extent.

The other expenses such as rent and salary however are not given much importance in the
analysis of the bank’s liquidity. But they can be sources of cash outflows in some cases.

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Q.3 Explain loanable fund theory and liquidity preference theory

Ans;- Loanable funds theory

Loanable funds theory explains that the calculation of the rate of interest is on the basis of
demand and supply of loanable funds which are available in the capital market. The concept was
created by Knut Wicksell (1851-1926), who was a well-known Swedish economist. It was
widely accepted before the work of the English economist John Maynard Keynes (1883-1946).

An increase in the demand of loanable funds leads to an increase in the interest rate and vice
versa. Also an increase in the supply of loanable funds results in the fall of interest rate. If both
the demand and supply of the loanable funds changes, the resultant interest rate depends on the
level and route of the movement of the loanable funds.

The loanable funds theory encourages that both savings and investments are responsible for the
determination of the rates of interest. The short-term interest rates are assessed on the basis of the
financial conditions of an economy.

In case of loanable funds theory the determination of the interest rates depends on the availability
of the loan amount. The availability of loan amount is based on certain factors like net increase
in currency deposits, amount of savings made, and willingness to enhance cash balances.

Liquidity preference theory

The liquidity preference theory or liquidity preference hypothesis, proposed by J. M. Keynes,
explains the relation between the generation of a debt instrument and its maturity period.

The liquidity preference theory states that investors maintain their funds in liquid form like cash
rather than less liquid assets like stocks, bonds and commodities. Banks offer interest to investors
to compensate for their liquidity losses which ultimately promote long-term investments.

The liquidity preference theory does not deal with liquidity, but deals with the risks associated
with maturity. According to this theory, the risks related to the maturity of debt instruments are
directly proportional to the length of the maturity period.

According to the liquidity preference theory, if the investors possess debt instruments that have
longer term periods then they will receive a premium of the rates of interest over a long-term
period. This premium is known as the liquidity premium. Liquidity premium stabilises the
financial risks that the investors have suffered due to the investment in debt instruments that had
longer term periods. As a result of the premium, the generation of the debt instrument that has a
longer periodic term is higher compared to debt instruments having shorter term periods.

Liquidity preference is a potentiality or functional tendency, which arranges the quantity of
money which the public will hold when the rate of interest is given; so if ‘r’ is the rate of interest,
‘M’ the quantity of money and ‘L’ the function of liquidity preference, we can define M = L(r).

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Q.4 Explain various sources of interest rate risk

Ans:- The interest rate risk adversely affects the organisation’s financial situation. It poses
significant threat to the incomes and capital investments of the organisation. The changes
occurring in interest rate affects the value of underlying assets of the organisation. It changes the
price values of interest bearing asset and liability based on the magnitude level of fluctuations in
interest rates. We shall discuss some of the sources of interest rate risk in the following
subsections.

Yield curve risk

The yield refers to the relationship between short term and long term interest rates. The yield
curve risk occurs due to the yield curve fluctuations which affect the organisation’s income and
economic values of underlying assets. The short term interest rates are lower than long term
interest rates and hence the occurring fluctuation exposes the organisation to maturity gap of
interest rate risk. The variations in movements of interest rates changes when the yield curve of a
market flattens or steepens in the interest rate cycle.

The yield curve slopes upwards when the short term interest rates are lower than the long term
interest rates. This yield curve is known as normal yield curve. The yield curve flattens when the
short term interest rates increases across the long term interest rates. This occurs during the
transition of the normal yield curve to an inverted curve. It is called as flat curve. The inverted
yield curve refers to the economic recession period. Therefore the market status overviews the
yield curve of long term interest rate as decline in the long term fixed income of the organisation.
The effects of recession impose negative impacts to the organisation hence they must concentrate
on diversifying the investment portfolio.

Figure 10.1 depicts the normal yield curve

Figure 10.1: Normal Yield Curve

Source:

http://www.google.co.in/imgres?imgurl=http://livingeconomics.org/images/glossary/yield_curve.
gif&imgrefurl=http://livingeconomics.org/glossary.asp&usg=__73JVTBBWNvKyxZj2AVoLIU
dx3GM=&h=289&w=480&sz=29&hl=en&start=1&zoom=1&um=1&itbs=1&tbnid=MIK7LKa

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XJ7cLjM:&tbnh=78&tbnw=129&prev=/images%3Fq%3Dnormal%2Byield%2Bcurve%2Bdiagr
am%26um%3D1%26hl%3Den%26sa%3DN%26tbs%3Disch:1

Figure 10.2 depicts the inverted yield curve

Figure 10.2: Inverted Yield Curve

Source:

http://books.google.co.in/books?id=F7OenmM8jiwC&pg=PA199&dq=inverted+yield+curve+ris
k+diagram&hl=en&ei=sGG1TNjuD5DUvQOd66iOCg&sa=X&oi=book_result&ct=result&resn
um=3&ved=0CD0Q6AEwAg#v=onepage&q&f=false

The yield curve has major impacts on the consumers, equity and fixed income investors. The
fixed rate loans will be encouraged when the short term rates exceeds the long term rates. Hence
the consumers who invest in financing properties experience higher mortgage payments. The
fixed income investors are benefited with better returns with short term investments due to the
elimination of risk premium for long term investments. During the phase of inverted yield curve
the margins of the profits decline such that the organisation at short term rates borrow cash and
lend it at long term rates to gain profits.

Basis risk

Basis risk occurs due to the changes in relationship between the various financial markets or
financial instruments. The different market rates of financial instruments differ with time and
amounts. In the banking organisation basis risk occurs due to the differences in the prime rate
and offering rates on money market deposits, saving accounts. The changes of interest rates can
give rise to unexpected changes of asset and liability cash flows and earnings. For example - an
organisation holds large untraded stocks. If the company tries to sell those stocks in wholesale, it
experiences liquidity risk because the selling prices may be depressed in the market. Hence to
overcome this issue, the company enters into futures contract with stock index. This reduces the
liquidity risk but increases the basis risk due to the differences between the selling and stock
index prices.

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The basis risk affects the profits of an organisation by striking the cash positions. The basis risk
changes the storable commodities based on the changes of the storage costs over a period of
time.

Optionality risk

Optionality risk arises with various option instruments of banks like assets, liabilities. It occurs
during the process of altering the bank’s instruments’ levels of cash flows by bank’s customers
or by bank itself. The option allows the option holder to buy or sell financial instruments. It
usually results in a risk or rewards to the bank. The option holder experiences limited downside
risk (paid amount) and unlimited upside reward whereas the option seller has unlimited risk and
limited upside reward.

The bank faces losses during the sold position option to its customers. There are chances of
losses in bank’s capital value due to unfavourable interest rate movements such that it exceeds
the profits that a bank gains, during the favourable movements. Therefor it has more downside
exposure than upside reward.

The options are traded in banks with stand-alone instruments such as over the counter (OTC),
exchange traded options, bond loans and so on. The stand-alone instruments are explicitly priced
and are not linked with other bank products. Most of the banking organisations allow
prepayment option of commercial loans which includes the prepayment process without any
penalties. Hence during the decline of rates the customers will perform prepaying loan process
which shortens the bank’s asset maturities while the bank desires to extend it.

Repricing risk

Repricing risk arises due to the differences between the timing of rate changes and cash flows
occurring in pricing and maturity of bank’s instruments such as assets, liabilities and off balance
sheets. It is measured by comparing the liability volume with asset volume that reprice within
specified period of time. The repricing risk increases the earnings of the banks. Liability
sensitivity occurs in banking organisations since repricing asset maturities are longer than the
repricing liability maturities. The income of the liability sensitive bank increases during the fall
of interest rates and declines when the interest rate increases. Inversely, the asset sensitive bank
benefits from rise in rates and detriments with fall in rates.

Repricing risk affects the bank’s earnings performance. Since the banks focus on short term
repricing imbalances are initiated to implement increase interest rate risk by extending maturities
to improve profits. The banking organisations must consider long term imbalances during the
repricing risk evaluation. If the gauging of long term repricing is improper, there are chances of
bank experiencing variations in interest rate movements of future earnings.

Embedded option risk

The embedded option refers to other option securities such as bonds, financial instruments. The
embedded option is a part of another instrument which cannot be separated. The callable
embedded option bond consists of hold (option free bond) option and embedded call option. The

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value of the bond changes according to the changes occurring in interest rates of embedded
options values. The price of callable bond is equal to the price of hold option bond minus price
of call option bond. The decline in interest rates increases the callable option price bond.

Figure 10.3 depicts the value of embedded call option varying with respect to changes in interest
rates.

Figure 10.3: Value of Embedded Call Option

The embedded putable bond consists of option free bond and embedded put option. The price of
putable bond is equal to price of option bond plus price of embedded put option.

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

Figure 10.4: Value of Embedded Put Option

Source: http://www.analystnotes.com/browse_los.php?id=13868

The organisations must handle the options effectively such that the various types of bonds under
embedded option are exposed to low level of risks. During the selling process of financial
instruments there are chances of exposure to significant risks since the holding options are
explicit and embedded which provides advantage to holder and disadvantage to seller. The

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exceeding number of options can implicate leverage magnifying the positive or negative
influences of financial options positions in the organisation.

Q.5 Detail Foreign exchange risk management and control procedure

Ans;- Foreign Exchange Risk Management (FERM) and control procedures

Each of the banks engaged in foreign exchange activities is responsible for evolving, applying
and supervising procedures to manage and control foreign exchange risk based on the risk
management policies. In devising a firm’s FERM policy, certain factors have to be taken into
account – the firm’s exposure, general attitude towards risk management, whether its risk-averse,
risk-indifferent or risk-seeking, the firm’s ability to alter exposed positions i.e. the maximum
exchange loss it can absorb without much impact, the competitor’s stance and most importantly
regulatory requirements. Foreign exchange risk management procedures include the following:

• Systems to measure and monitor foreign exchange risk – Management of foreign
exchange risk involves a clear understanding of the amount of risk and the influence of
exchange rate changes on the foreign currency exposure. In order to make these
determinations, adequate information must be readily available to permit suitable action
to be taken within the acceptable time period. Therefore, each of the banking
organisations engaged in foreign exchange activities must have an operative accounting
and management information system in place that records and measures the following
accurately:

1. The risk exposures related to foreign exchange trading.
2. The impact of potential exchange rate changes on the bank.

• Control of foreign exchange activities – Though the control of foreign activities vary
widely among the banks depending upon the nature and extent of their foreign exchange
activities, the main elements of any foreign exchange control plan are well-defined
procedures governing:

1. Organisational controls – To guarantee that there exists a clear and effective
isolation of duties between those persons who initiate the foreign exchange
transactions and are responsible for operational functions of foreign exchange
activities.
2. Procedural controls – To ensure that the transactions are completely recorded in
the accounts of the banks, they are promptly and correctly settled and to identify
unauthorised dealing instantly and reported to the management.
3. Other controls – To make sure that the foreign exchange activities are supervised
frequently against the bank’s foreign exchange risk, counterparty and other limits
and those excesses are reported to the management.

• Independent inspections/audits – Independent inspections/audits are an important factor
for managing and controlling a bank’s foreign exchange risk management plan. Banks
must use them to ensure compliance with, and the integrity of, the foreign exchange

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policies and procedures. Independent inspections/audits should examine the bank’s
foreign exchange risk management activities in order to:

1. Ensure adherence to the foreign exchange management policies and procedures.
2. Ensure operative management controls over foreign exchange positions.
3. Verify the capability and accurateness of the management information reports
regarding the institution’s foreign exchange risk management activities.
4. Ensure that the foreign exchange hedging activities are consistent with the bank’s
foreign exchange risk management policies and procedures.
5. Ensure that employees involved in foreign exchange risk management are given
accurate and complete information about the institution’s foreign exchange risk
policies, risk limits and positions.

Q.6 Describe the three approaches to determine VaR

Ans:- The Value at Risk (VaR) approach is a comprehensive indicator for measuring foreign
exchange risks. VaR approach incorporates all the assets and liabilities of the national financial
system, along with the contingent liabilities, thus permitting rapid comparison among different
countries and the analysis of the evolution over time for a country.

Value at risk method is used to set market position limits for traders and to decide how to
allocate minimum capital resources. VaR allow creation of a common denominator to compare
risky activities in varied markets. The total risk of the banks can also be decomposed into
incremental VaR to reveal positions that increases total risk. On the other hand, VaR can be used
to regulate the performance of risk. Performance assessment of risk is vital in banks, where
traders have a natural tendency to take on extra risk. Risk capital charges based on VaR approach
provides corrected incentives to the traders.

The VaR approach has a number of practical advantages and disadvantages. The advantages of
VaR are as follows:

• The potential losses are computed in simple terms.
• VaR approach is approved by various regulatory bodies concerned with the risks faced by
banks such as RBI (Reserve Bank of India) and SEBI (Securities and Exchange Board of
India).
• VaR acts as a versatile tool for forex risk measurement.

On the other hand, value at risk approach possesses certain limitations too. The limitations of
VaR are as follows:
• VaR faces some difficulties in risk estimation and is sensitive to the estimation methods
used.
• VaR approach may create a false sense of security.
• VaR may miscalculate the worst-case outcomes for a bank.
• The VaR of a specific market position is not always the same for the VaR of the overall
portfolio of the bank.
• VaR fails to incorporate positive results, thus painting an incomplete picture of the
situation.

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