You are on page 1of 92

BAS-BN202 Treasury Operations Basics

Treasury Operations Basics

Table of Contents
Basic Treasury Operations.................................................................................................. 4
1. 1.1 1.2 1.3 1.4 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3. 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 Introduction to Treasury Operations .................................................................................. 4 Understanding Treasury Operations .................................................................................. 4 Structure and Functions of Treasury Management ........................................................... 8 Role and Functions of Front, Mid and Back Office of Integrated Treasury Department . 9 Treasury Control Framework ........................................................................................... 12 Macroeconomic Policy ...................................................................................................... 17 GDP / GNP ......................................................................................................................... 17 Inflation ............................................................................................................................. 18 Interest Rates .................................................................................................................... 19 Exchange Rate: .................................................................................................................. 20 Macroeconomic Policies Monetary and Fiscal Policies ................................................ 20 Monetary and Fiscal Policies ............................................................................................ 22 Monetary policy and interest rates.................................................................................. 24 Treasury markets and instruments ................................................................................... 26 Money Market Instruments ............................................................................................. 26 Coupon Bearing Instruments............................................................................................ 27 Discount Instruments ....................................................................................................... 27 Fixed income instruments ................................................................................................ 28 Participants in fixed income markets .............................................................................. 29 Government Securities ..................................................................................................... 30 Corporate Debt Markets................................................................................................... 31 Credit Rating and its importance ..................................................................................... 31 Trading in fixed income securities ................................................................................... 33

3.10 Bond Mathematics Yield, Duration, Convexity, Bond Prices and Interest Rates ........ 33 3.11 Cost of Funds..................................................................................................................... 48 3.12 Managing Investment Portfolio and Trading Portfolio ................................................... 49 3.13 Derivatives in Fixed Income Markets Forwards, Futures, Options and Swaps ........... 50 4. 4.1 4.2 Foreign Exchange Markets Introduction ........................................................................ 59 Overview of Global Forex Markets .................................................................................. 59 Products and Participants in Foreign Exchange Markets ................................................ 60

Treasury Operations Basics

4.3 4.4 4.5 5. 5.1 5.2 6. 6.1 6.2 6.3 6.4 6.5

Spot and forward markets................................................................................................ 61 Foreign Exchange Arithmetic Rate Computations ........................................................ 65 Factors affecting Foreign Exchange Market..................................................................... 69 Asset Liability Management Overview ........................................................................... 71 Product Pricing and Performance Management, Interest Rate Risk for Asset Liability Management ..................................................................................................................... 71 Liquidity Risk in Asset Liability Management, Transfer Pricing ...................................... 73 Cash Management............................................................................................................. 84 Cash Flow Dynamics, Forecasting and Valuation ............................................................ 85 Short-Term Funding Investments..................................................................................... 87 Cash Management Techniques ........................................................................................ 88 Sales Cash Conversion Cycle (SCCC) ................................................................................. 89 Cash Budget ...................................................................................................................... 89

Treasury Operations Basics

Basic Treasury Operations

1. Introduction to Treasury Operations


Chapter objectives: 1. To introduce the concept of treasury operations 2. To understand the structure and functions of treasury management 3. To comprehend the role and functions of front, mid and back office of integrated treasury department 4. To understand the framework of treasury control

Treasury operations refer to all activities related to management of cash inflows and outflows of all organizations. Treasury is a special term within a compass of the broader term finance. The basis of treasury operations is money and near-money assets such as money market instruments, derivatives, bonds and securities. The money in terms of foreign currencies is traded in the forex or foreign exchange market.

1.1 Understanding Treasury Operations Treasury operations include management of an organizations investible surpluses, which in turn include trading in bonds, currencies, derivatives and associated risk management. Treasury operations are prevalent across all types of organizations, e.g., corporations, banks, financial institutions, insurance companies, asset management companies, etc. Typically, in a bank or financial institutions, the person in charge of the treasury is called Treasurer and in a non-financial organization or corporations, the Chief Financial Officer or Director Finance is typically in charge of the treasury and he/she also manages the finance department.

Treasury Operations Basics

In a bank, treasury operations typically comprise the following business lines: Proprietary Trading Proprietary trading comprises trading in financial instruments such as equities, bonds, currencies and the derivatives thereof for the banks own portfolio within regulatory restrictions.

Balance Sheet Management Balance sheet management comprises trading and investments in financial instruments keeping in mind the objective of asset liability management for the bank, i.e., managing the interest rate and liquidity risks.

Corporate Sales Corporate sales, as the name suggests, comprises all the treasury financial transactions, e.g., buying and selling of currencies, bonds and derivatives with the banks institutional clients (typically corporations), based on their specific trade, commerce and treasury requirements.

Inter-Bank dealings Inter-Bank dealings are typically dealings with banks and financial institutions with the main objective of trading or hedging corporate sales transactions either back-to-back or otherwise.

Treasury Operations Basics

In a corporation, treasury operations would typically comprise the following business lines: Banking and Cash Management Banking and cash management includes management of bank accounts including account administration and user authorization, negotiation of contracts for various products and services based on the corporations industry and ongoing monitoring of activity to ensure optimal pricing and consistent service levels. It also includes review and validation of daily bank transactions, initiation of wire transfers and transactions as necessary and long-term and daily cash forecasting, including daily evaluation of cash positions to ensure appropriate investment of funds.

Investments Managing and monitoring investments of surplus investible funds based on working capital requirement or operating funds based on short-term, medium-term and long-term objectives. Investments to comply with all policies adopted by the board and all other regulatory compliances. They also need to adhere to all generally accepted accounting principles.

Debt servicing Debt servicing includes managing or monitoring servicing of all existing or future debts of the corporation including managing or monitoring all registration, payment and transfer activities.

Treasury Operations Basics

The various functions in a treasury operation are as follows:

Treasury Functions

Control & Reporting

Policy & Objectives

Technology & Systems

Treasury Organization

Control and Reporting Control and reporting refers to treasury payments and dealing room security, procedures and controls and it incorporates treasury reporting and key performance indicators. This function also deals with managing the relationship between treasury and internal / external auditors, combating money laundering, fraud and financial crime.

Policy and Objectives Policy and objectives refers to preparation and approval of a treasury policy, making sure it is appropriate for the business and the business objectives and incorporates performance measurement and benchmarking for the treasury function, treasury authority limits and detailed procedures

Technology and Systems Technology and Systems incorporates market developments in treasury management systems, dealing and information systems, internet and technologies including the selection and implementation of treasury management systems. It also deals with specific technology security, identity and risk related issues.

Treasury Operations Basics

Treasury Organization Treasury organization deals with the overall set-up of treasury. It addresses issues such as decentralized or centralized treasury, and treasury as profit center etc.

1.2 Structure and Functions of Treasury Management As far as the asset classes are considered, bank treasuries would typically comprise the following desks:

Equity desk The Equities desk would typically deal in listed stocks in the market and derivatives thereof to the extent permissible by regulators.

Interest rate desk Interest rate desk deals with all interest rate products in money (short-term) and bond (long-term) markets.

Foreign exchange desk Foreign exchange desk deals with buying and selling currencies.

Derivatives and Structured Products desk Derivatives and structured products desk deals with trading in derivatives in interest rates, currencies, credit and the combination of them.

Treasury Operations Basics

Treasury Desks

Equity

Interest Rates

Foreign Exchange

Derivatives & Structured Products

1.3 Role and Functions of Front, Mid and Back Office of Integrated Treasury Department Front Office Front office department in an integrated treasury function is essentially the group that initiates a financial transaction. Front office undertakes hedging and financing, which includes investments, position management, trading and arbitrage.

Some of the important functions of the front office are: Sales and trading The primary function of the front office is buying and selling products on behalf of the organization or its clients. Traders buy and sell financial products in the market with the goal of earning profit on each trade. The salespersons job is to suggest trading ideas to the clients and take orders on their behalf.

Corporate finance This function involves helping customers raise funds in capital markets. This division is generally divided into industry coverage and product coverage groups. Industry coverage groups focus on a specific industry whereas product coverage groups focus on various types of financial products.

Treasury Operations Basics

Research This function involves reviewing companies and writing reports about their prospects with recommendations. This group has also been involved in research for specific financial markets like equity, interest rates, forex, and credit. It assists the traders in trading, the sales force in suggesting ideas to customers and helps the corporate finance people by covering their clients.

Front Office

Sales & Trading

Corporate Finance

Research

Mid Office Mid office department in an integrated treasury function is essentially the group that is responsible for control, compliance and risk management for the treasury. The functions involve valuations and collateral management of the treasury portfolio of the organization. Mid office also ensures compliance of the organizations treasury and risk policies. It essentially ensures control and processing of transactions.

Some of the important functions of the mid office are: Financial control This function tracks and analyzes the capital flows of the firm, acting as the principal adviser to senior management on areas like controlling the firms global risk exposure and profitability of the various lines of business. Valuation and collateral management, including margining, is a sub-function of financial control.

Treasury Operations Basics

10

Compliance and Asset Liability Management This function is responsible for the organizations daily operations compliance with regulations, both external and internal and is also responsible for monitoring asset liability management for the organization.

Risk Management This function involves analyzing market, credit and operational risks that sales and trading are taking onto the balance sheet, setting limits on the amount of capital that they are able to trade and ensuring that all economic risks are captured accurately, correctly and on time.

Mid Office

Financial Control

Compliance and Asset Liability Management

Risk Management

Back Office The back office department in an integrated treasury function is essentially the group that monitors post-trade processing of transactions. It is responsible for confirmation, payment, settlement and accounting of all treasury transactions of the organization, whether banking or corporate. It also ensures the treasury regulatory compliance required by regulators. Further, it is responsible for managing all ancillary functions such as reconciliations and documentations for the treasury function.

Treasury Operations Basics

11

Some of the important functions of the back office are: Operations This function involves validating trades that have been executed, ensuring that they are not erroneous and transacting the required transfers. Operations include various sub-functions like reconciliations, confirmation, payment, settlement, documentation and accounting.

Technology This function manages all the information technology requirements of the treasury, including management of in-house software with technical support.

Back Office

Operations

Technology

1.4 Treasury Control Framework The treasury front office executives take large positions across asset classes, including leveraged products such as derivatives. Hence, managements are highly sensitive to treasury risks as they make significant impact on the organization. The risk of losing capital is much higher than in the credit business. The conventional control and supervisory measures, mostly in the nature of preventive steps, may be divided into the following parts:

Treasury Operations Basics

12

Organization Controls Organizational controls refer to the checks and balances within the system. Treasury is predominantly divided into three parts front office, mid office and back office as mentioned earlier. The front office generates deals, mid office monitors valuation, risk management and back office settles trades only after verifying compliance with the internal controls.

Exposure limits Exposure limits deal with caps put in place to protect the bank from credit risk, which, in treasury, may be of defaulters and counterparty.

Internal controls The most important of the internal controls is the position and stop-loss limits. Trading limits are of the following types: Deal size Open positions Stop loss

Treasury faces market risks such as those related to liquidity, interest rate, exchange rate, price, credit, and operational risks.

Treasury Controls

Organization Controls

Exposure Limits

Internal Controls

Treasury Operations Basics

13

Salient features of the treasury control framework are: Risk Appetite An organizations risk appetite needs to be decided before designing an efficient treasury control framework. A tighter control framework is expected to be around a business that runs a profit centre treasury to make returns rather than a simpler transaction-based treasury. Differentiation needs to be also made for a treasury that runs a more manual process compared with a greater level of straightthrough processing.

Governance The ultimate responsibility for ensuring that an adequate system of internal controls is established and maintained lies with the board of directors. The risks the business is facing needs to be understood by senior management. Policies and procedures need to be developed that reflect that position, articulating the risk appetite. A policy covering identification, measurement, management, monitoring and control of financial risk should be approved by the board.

Operating Controls Following are some of the operating controls that are ideal for an efficient treasury control function: o Segregation of duties - Segregation of duties pertaining to front, mid, and back office is a key element for proper treasury controls. Some of the key duties that should be properly segregated in a treasury are: Identification of opportunities and trades Deal authorization Confirmations Settlement authorization Settlement release Accounting

Treasury Operations Basics

14

Dealing - Competitive quotes should be sought in a dealing function. Records of banks contacted and rates quoted need to be maintained. No one bank or broker is favored over another and it needs to be ensured that the best returns are being achieved. The dealer should immediately input deal details into the treasury management system as soon a deal is struck.

Access to the front office - Physical access to the dealing room within a treasury environment is debatable. In a banking environment, it is common to have staff from the front and back offices physically separated.

System security - Regular checking of passwords for systems and locking of computers of unattended personnel is essential. Time-out locks should be installed, which flag alerts if a machine is not touched for a period of time.

Confirmations - Back office has the responsibility of confirming details of all treasury transactions before the settlement is made, to minimize the risk of error or fraud. An exception report should ideally generate, to show transactions not being confirmed.

Treasury Operations Basics

15

Straight Through Processing

Pricing

Market Data

Risk Monitoring Pre-trade Position Keeping Trading Portfolios

Trading

Validation Execution Back Office Routing

Trade Enrichment

Reference Data

Confirmation Post-trade Settlement

Accounting

Treasury Operations Basics

16

2. Macroeconomic Policy

Chapter Objective: 1. To understand macroeconomic aggregates 2. To identify the various monetary and fiscal policies 3. To comprehend the macroeconomics and treasury operations

2.1 GDP / GNP Gross Domestic Product (GDP) is the money value of all final goods and services produced in a country during a given time period, generally during a year. In estimating the GDP, we do not differentiate between production carried out by nationals of a given economy and those of foreign nationals/ firms having manufacturing facilities and service organizations operating in a country.

Nominal and Real GDP: GDP measured in current market prices is called Nominal GDP. Real GDP refers to nominal GDP minus inflation rate. In other words, the real GDP measure provides the quantity of goods and services produced and valued at prices in the base year rather than current market prices. Real GDP measures actual physical volume of production.

Gross National Product (GNP) measures the value of output that can be attributed to the nationals of an economy. It is estimated by deducting the value of the output produced by foreign firms in that country from the GDP. To this, we add the value of the output the local firms produced during the same time period in the rest of the world. Such

Treasury Operations Basics

17

information is continuously obtained by the government departments from major countries of the world.

2.2 Inflation Inflation basically refers to a rise in general price level. In other words, if the price of one of the items we are purchasing goes up sharply, we cannot say that there is inflation present in the economy. We need to, therefore, differentiate between price rise in individual good and rise in price level of an identified basket of important goods. There could also be some goods whose prices may be on the decline.

Inflation is sensitive to day-to-day changes that take place in the economy. All changes would invariably have to be classified into factors that either affect cost of production or influence demand. The part of inflation resulting from changes that influence cost of production is known as cost-push inflation. Examples include: Rise in fuel cost Increase in input tax rate Upward revision in duties Rise in wages/ salaries Increase in lending rates charged by banks Increase in transportation costs Increase in power tariffs and, rentals for office premises etc.

Demand pull inflation is due to the following factors: Rise in money supply Spurt in spending on infrastructure Increase in Foreign Direct Investment

Treasury Operations Basics

18

Rise in income levels of individuals Panic buying Artificial supply bottlenecks Anticipated shortage of essential goods Deflation: Deflation is a situation in which prices of most goods and services fall over time so that inflation is negative.

2.3 Interest Rates Interest rates decide the level of investment activity in the country. Nominal interest rate is the contractual rate of interest when a business firm/ individual borrows money from a bank or financial institution. Real interest rate is the inflation adjusted interest rate (real interest rate = nominal interest rate - inflation). As the Indian firms are made to compete with the global players as part of our globalization exercise, interest rates in India need to be lowered in line with cost of funds for firms abroad.

Investment is of two types: autonomous and induced. Autonomous investment is interest-independent and income-independent. This type of investment takes places largely as public investment. Induced investment, on the other hand, is interest-sensitive investment that rises when there is a decline in interest rate (lending rate) and vice versa.

Treasury Operations Basics

19

2.4 Exchange Rate: Price of one currency expressed in terms of another currency. It depends on the trade and investment flows between countries.

Balance of Payments Balance of payments is a systematic record of transactions made by one country with the rest of the world during a given time period, normally a year. This record helps us understand the value of merchandise exports and imports and the services transacted as well as the long-term capital-related transactions taking place.

The balance of payments has two accounts: the current account and the capital account. When we talk about the position of the balance of payments, we are taking into account the cumulative value of the two accounts. It may give us a negative or positive value as the overall value. It has to be offset by an equivalent amount to have neither a surplus nor a deficit. In other words, balance of payments should always remain balanced.

2.5 Macroeconomic Policies Monetary and Fiscal Policies The goal of macroeconomic policy is to achieve high and stable growth rate of the economy with low and stable inflation. It is to be noted that monetary, fiscal and external trade policies play a critical role in the management of an economy. Monetary policy aims at influencing the performance of an economy in terms of price stability, output growth, and employment. Depending on the phase of the business cycle an economy is undergoing, it tries to affect consumption and, spending decisions of firms and individuals. Monetary policy is a much better stabilization tool. Using monetary policy,

Treasury Operations Basics

20

unlike most government actions (tax and expenditure policies), interest rates can be changed literally overnight. Fiscal policy focuses on building solid foundations for longterm growth. Stabilizing prices requires estimates of sustainable or potential growth rate of the economy. The potential output depends on three factors: growth in labor force, capital investment and technological progress. External policy focuses on exchange rate movements and their impact on capital inflows and outflows, tariffs to be imposed on imports, and issues relating to the countrys balance of payments situation.

Fluctuations in real economic growth measured by real GDP over a long period can be analyzed in terms of business cycle. Business cycle has four phases. These phases are: Expansion or boom Recession Depression Recovery

The business cycle is the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real GDP and other macroeconomic variables. A business cycle is not a regular, predictable, or repeating phenomenon like the swing of the pendulum of a clock. Its timing is random and, to a large extent, unpredictable.

Currently, policymakers worldwide are seriously involved in formulating and fine-tuning macroeconomic policies to address issues relating to the recent 2008 financial crisis. If we look keenly into their efforts, we can see that all these policy makers are trying to revive economic growth rate, stabilize inflation, and handle large scale unemployment that had resulted due to the financial crisis. By inducing liquidity into the system and

Treasury Operations Basics

21

reducing interest rates, policy makers are trying for the recovery in their respective economies.

2.6 Monetary and Fiscal Policies

Monetary Policy Monetary Policy is formulated by the respective central banks of the countries. Its objective is to determine money supply and assess its impact on output, inflation, unemployment. It has various policy tools like quantitative and qualitative measures that help fine-tune policy making as per the situation warranted.

In the US context, the Federal Reserve is the central bank that formulates US monetary policies and is the authority to affect changes in policy interest rates. It uses open market operations, changes in reserve requirements, and Fed fund rate as policy instruments to affect money supply, credit availability and liquidity in the system.

Money Supply measures In the US, the following two money supply measures are used:

M1 - Currency, demand deposits, other checkable deposits and travelers checks M2 - M1 plus savings deposits, small denominated time deposits and money market mutual funds

Treasury Operations Basics

22

Monetary policy and business cycles During the boom time a contractionary monetary policy is used to cool down the economy from overheating. During recessions, an expansionary monetary policy is used to bring back the economy on to the growth path.

To tighten or ease credit availability, central banks generally influence short-term interest rates. These changes are gradually transmitted to longer-term rates. Central banks influence rates largely by buying and selling government securities in the market, an activity referred to as open market operations. Buying and selling activity influences bank reserves and lending power. For example, monetary ease is achieved by buying government securities and expanding bank reserves. Monetary restraint is achieved through sale of government securities. To a large extent, the central banks can affect interest rates by adjusting the level of reserves required to back bank deposits (reserve requirements) and adjusting the rate at which it will lend money to banks (discount rate).

Monetary policy and inflation In the long run, rate of growth of money supply and rate of growth of inflation are closely related. A larger money supply in circulation will cause people to increase prices of existing goods and services. Velocity of money supply refers to the relation between money supply prices and output.

Monetary Policy and exchange rates: In a flexible exchange rate regime, monetary policy (by raising real interest rate) increases demand for currency and causes it to appreciate. The stronger currency reinforces the effects of tight monetary policy on aggregate demand by reducing net exports. Easy monetary policy, on the other hand, lowers real interest rates and weakens the currency, which stimulates exports.

Treasury Operations Basics

23

2.7 Monetary policy and interest rates

A central bank operates Monetary Policy by controlling money supply, media and financial markets focus on the central banks announcements on interest rates. The central banks ability to control money supply is the source of its ability to control interest rates. Nominal money supply is determined by demand and supply forces. Demand for money is determined by comparison of costs and benefits of holding money. The nominal interest rate measures the opportunity cost of holding money. Increases in GDP, price level, and volume of transactions, result in increased demand for money. The central bank determines supply of money through use of open market operations, changes in reserve ratios, and changes in short-term policy rates.

Fiscal Policies Levying and collection of various types of taxes, purchase of goods and services, and spending on transfer payments, constitute major functions of the government. The policies that govern these aspects are termed Fiscal Policies. The government uses different tools to influence economic activity.

Taxes and expenditure are the two major components of fiscal policies. Charges of public goods/services are other aspect of public finance. Taxes are levied on incomes (personal, corporate) and goods and services (customs, excise). These taxes provide resources to the government to carry out its functions of national security and public expenditure. It reduces the disposable incomes of individuals and companies by levying taxes on their earned income. The tax system is also used to give a direction to economic activities. For instance, tax incentives encourage investments into certain

Treasury Operations Basics

24

productive activities (housing loan incentives) and high level of taxes discourages certain activities like smoking of cigarettes.

Expenditure is made on public goods such as roads, education, public protection along with the social security (pensions, public healthcare subsidies, unemployment doles, relief and ex-gratia payments are termed as transfer payments) by the government to individuals. These help in building infrastructure of a country and in improving quality of life of individuals.

The concept of fiscal deficit refers to the overall borrowing requirement of the government; it is the gap between aggregate expenditure (revenue and capital) and aggregate receipts (net of non-debt receipts).

The higher the fiscal deficit, the greater is the pressure on interest rates to rise. This is because the government is now raising loans from the market. Thus, given limited availability of funds at the disposal of institutions, a rise in demand for credit would make interest rates rise, discouraging the private sector from borrowing at rising interest rates.

Government policies have a strong effect on the performance of industries and other sectors of the economy. Business firms can represent their concerns to the appropriate department/ ministry to influence public policies in their favor, although public policies are considered to be exogenous or something beyond the control of firms. Removal of restrictions on the movement of some goods between states or regions, fix prices (e.g. statutory minimum price), retrenchment of workers, tax-related policies and subsidies, etc., go a long way in deciding the overall performance of firms.

Treasury Operations Basics

25

3. Treasury markets and instruments

Chapter objectives: 1. To understand the various money market and fixed income market instruments 2. To identify the participants of fixed income markets 3. To understand the role of credit rating 4. To comprehend various concepts of bond mathematics 5. To identify the derivatives instruments used in fixed income markets 6. To analyze the cost of funds and manage investment and trading portfolio

The entire treasury desk is basically divided into two groups: Forex market desk, and home currency desk and ALM. Details about forex market desk and ALM are taken in chapter 4 and 5 and this chapter deals with home currency desk operations.

Treasury markets on the home currency desk can be classified into money market and bond market, depending on the maturity of instruments that are traded in these markets. The money market is where short-term instruments for borrowing and lending (less than one year of original maturity) are traded. The bond market, on the other hand, is the financial market where participants buy and sell long-term debt securities.

3.1 Money Market Instruments Inter Bank Markets It is a market where banks borrow and lend to each other for short-term purposes such as meeting reserve requirements. Term Money It is an inter-bank borrowing and lending money for short period of

Treasury Operations Basics

26

time, usually up to one year. Repo Repo or repurchase agreement is a transaction where one party buys securities from another party, only to sell it back to the same party after a short period of time. Repo is used by central banks as a liquidity management tool. Bankers Acceptance Bankers acceptance is a short-term money market instrument where a bank guarantees payment to a counterparty if the buyer defaults on a trade transaction. Euro Deposits Dollar Euro dollars are short-term (up to one year) USD denominated institutional deposits held with banks outside the US

3.2 Coupon Bearing Instruments Treasury notes and bonds Treasury notes and bonds are issued by various governments. These instruments have longer maturities (greater than one year) and they pay coupon periodically. Corporate bonds Corporate bonds are long-term instruments used to borrow funds by corporations.

3.3 Discount Instruments Treasury bills Treasury bills are short-term (up to one year) discount papers issued by governments to meet short-term borrowing requirements. They are issued at less than face value and redeemed at face value on maturity. Treasury Bills are usually issued at regular intervals for a particular issue size and may have multiple maturities, e.g., fortnight, month, 3-month, 6-month, and 1 year. These bills are liquid instruments and banks, financial institutions and investment funds are the major traders, investors in these instruments. They are

Treasury Operations Basics

27

considered risk free securities since they are issued by governments and hence are believed to have no default risk. Commercial papers Commercial papers are short-term (up to one year) discount papers issued by corporations to meet their short-term financing requirements. They are issued at less than face value and redeemed at face value on maturity.

Treasury markets and instruments and fixed income markets

3.4 Fixed income instruments Capital can be raised in two forms: equity and debt. Equity capital is contributed by owners (i.e., shareholders) of the company and represents owned funds. Debt capital is raised from outside lenders such as banks and hence constitutes borrowed funds. Financial market instruments that are used to raise borrowed funds are typically called debt or fixed income instruments. As already mentioned, the debt market is divided into money market and bond market. Some of the bond market instruments are government securities and corporate bonds.

Bonds can also be differentiated based on: Taxability : Taxable and tax-free bonds Issuers: Banks, Financial Institutions, Agencies, Corporates, Special Purpose Entities Convertibility: Fully, partially, and non-convertible

Apart from debt instruments that are cash market instruments, we also have fixed income derivative instruments. Some of the interest rate derivative instruments are

Treasury Operations Basics

28

forward rate agreements, interest rate futures, interest rate swaps, currency swaps, and interest rate options and swaptions.

3.5 Participants in fixed income markets Some of the participants in the fixed income markets are: Governments Governments are typically the largest players in the fixed income markets since they borrow large quantum of funds in a year to meet their budgetary requirements. Short-term borrowings of the government are through treasury bills while long-term borrowings by governments are through government securities.

Regulators The central bank of a country is the banker to the government and typically regulates the banking industry and as a result, it predominantly regulates the fixed income markets. Apart from central banks, other regulators (regulating the capital markets or insurance sector etc.) may regulate certain aspects of fixed income markets.

Banks . Banks participate in various capacities such as issuers, dealers, investors and brokers.

Financial Institutions Apart from banks, financial institutions are also important players in fixed income markets. These institutions raise substantial capital in the form of debt. Many of these are active investors in debt instruments.

Primary dealers Primary Dealers are a special type of fixed income market participants who act as underwriters for government security issuances by

Treasury Operations Basics

29

accepting underwriting commission from the government. They have a responsibility towards development of this market by readily providing two-way quotes for securities being traded in the market. As a result, they provide the required liquidity to the market.

Corporations Corporations take part in the fixed income market as issuers or investors. Large amount of funds are raised in the form of debt and corporates also invest surplus funds in debt instruments.

Asset Management Companies Asset Management Companies manage mutual funds which pool investors money. These mutual funds invest the proceeds in debt and fixed income markets.

Insurance companies Insurance companies, both life and non-life, invest in the fixed income markets to provide returns to the policy holders. Maturity profiles of insurance companies are typically much longer than other investors.

Broker dealers Broker dealers predominantly act as intermediaries in the fixed income markets and as facilitators to major players in the market. They do so by acting as a bridge between the buyer and seller. Many a times, however, they invest or trade for their own proprietary portfolio positions in the market.

3.6 Government Securities As mentioned earlier, government securities are instruments through which governments raise funds for longer tenors to meet their budgetary requirements. A government pays periodic coupon payments, usually semi-annually, to the holder of the bonds until

Treasury Operations Basics

30

maturity of the bonds. Maturity of the bonds can be as long as 50 years. Rather than paying regular fixed coupons, government may even pay floating rate coupons to bond holders and link it to any industry approved benchmarks, which would be reset at regular intervals, typically during periodic cash flow dates.

3.7 Corporate Debt Markets As mentioned earlier, corporate debt markets are the market for corporations to raise funds, both short-term and long-term. Commercial papers are short-term money market instruments with maturity of up to one year are used by corporations to raise short-term funds to meet their working capital requirements. Corporate bonds are long-term bond market instruments for maturity beyond a year and are used by corporations to raise funds to meet their demands for long-term capital for business, expansions, infrastructure funding etc.

3.8 Credit Rating and its importance Credit rating is a mechanism by which issuers and issuances with different creditworthiness are differentiated from each other both for short-term and long-term. There are specialized global credit rating agencies such as Moodys, S&P and Fitch, which provide credit ratings to organizations, issuances and even countries, based on their past performance and projected cash flows. Most credit worthy organizations and issuances are awarded the highest credit rating, viz., Aaa from Moodys, AAA from S&P and Fitch and D is generally a default rating. Investment grade ratings are typically higher than and up to Baa3 from Moodys and BBB from S&P and Fitch.

Treasury Operations Basics

31

Credit Ratings Moody's Long Short term Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 P-3 P-2 P-1 term S&P - Long term AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ B A-3 A-2 A-1 A-1+ - Short term Fitch - Long Short term AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BB Highly Speculative Substantial Risks Extremely Caa2 Caa3 Sub prime - CCC CCCC CCC C Speculative In Default with Non-Investment Grade Speculative F3 F2 Lower Grade Medium F1 Upper Grade Medium F1+ High Grade term Prime -

Treasury Operations Basics

32

CC Ca C / / D / C DDD DD D /

little prospect for recovery

In Default

3.9 Trading in fixed income securities Trading in fixed income securities is a specialized field and requires the right kind of skill sets, training and attitude. Trading in fixed income securities typically requires forming a view on interest rates and buying / selling fixed income cash securities or derivatives.

Treasury markets and instruments - fixed income mathematics

3.10 Bond Mathematics Yield, Duration, Convexity, Bond Prices and Interest Rates Important terminologies: Face Value Face value or par value of a bond represents bonds nominal value on which interest is paid and at which the bond is redeemed.

Maturity Maturity of a bond is the date when the bond is redeemed or when the holder of the bonds receives the principal back.

Redemption Price Redemption Price is the price at which the bond is redeemed and is generally equal to par value.

Treasury Operations Basics

33

Coupon frequency Coupon Frequency refers to the number of times in a year coupon is received by the holder of the bond.

Coupon on bond It is the rate at which interest is paid to bond holders.

Price of a bond If a bond is trading in the market, the price of a bond refers to market price of the bond. However, if the bond is not traded, we can arrive at a theoretical price. Depending on the pricing model used, a theoretical bonds price is the sum of all present values (PV) of the bonds future cash flows discounted using either one discount rate or multiple discount rates.
Principal

Coupon PV PV PV PV PV PV

Coupon

Coupon

Coupon

Coupon

All coupon and principal PVs are calculated using the yield of the bond Price

Clean Price Clean price is the quoted price of a bond in the market (excluding accrued interest).

Treasury Operations Basics

34

Accrued Interest Accrued interest is the interest due on a bond since the last coupon payment.

Yield Yield of a bond is the effective return from the bond; Yield to Maturity (YTM) is the return provided by a bond when it is purchased at a particular price and expected to be held till maturity, assuming that all the cash flows from the bond are reinvested at a rate equal to YTM of the bond until maturity.

Dirty Price Dirty Price is the sum of clean price and accrued interest.

Price Yield Example

Issuer: Settlement: Coupon: Issue Date: 1st Interest: Maturity: Market Price: Market YTM: Accrued Interest: Dirty Price:

US Treasury 09-Jan-2006 4.5% 15-Nov-2005 15-May-2006 15-Nov-2015 101 1/64% 4.37133% 0.6837% 101.6993%

Number of days for first coupon, e.g., is 126 09-Jan-2006 to 15-May-2006: 126 days 15-Nov-2005 to 15-May-2006: 181 days

Treasury Operations Basics

35

Expressing in periods: 126/181 = 0.696133

Present value of the first coupon is calculated as follows: Period (N) 0.696133 4.37133 2

Semi-Annual YTM (I%YR)

Semi-annual Coupon (4.5 2)% of 100 Present Value (PV) 2.2164

Dirty Price and Clean Price

Dirty Price is 101.6993% Accrued Interest is 0.6837% Clean Price is 101.0156%

Cash Flows

Dates 15-Nov-2005 09 Jan-006 15-May-2006 15-Nov-2006 15-May-2007 15-Nov-2007 15-May-2008 15-Nov-2008

A/A / D ys

Pe

ods

Cas

Flow

CF PV

55 126 0 6133 2.2500% 2.2500% 2.2500% 2.2500% 2.2500% 2.2500%

101.6993% 2.1 4% 2.1690% 2.1226% 2.0772% 2.0328% 1.9893%

1.696133 2.696133 3.696133 4.696133 5.696133

Treasury Operations Basics

36

15-May-2009 15-Nov-2009 15-May-2010 15-Nov-2010 15-May-2011 15-Nov-2011 15-May-2012 15-Nov-2012 15-May-2013 15-Nov-2013 15-May-2014 15-Nov-2014 15-May-2015 15-Nov-2015

6.696133 7.696133 8.696133 9.696133 10.696133 11.696133 12.696133 13.696133 14.696133 15.696133 16.696133 17.696133 18.696133 19.696133

2.2500% 2.2500% 2.2500% 2.2500% 2.2500% 2.2500% 2.2500% 2.2500% 2.2500% 2.2500% 2.2500% 2.2500% 2.2500% 102.2500%

1.9467% 1.9051% 1.8643% 1.8245% 1.7854% 1.7473% 1.7099% 1.6733% 1.6375% 1.6025% 1.5682% 1.5347% 1.5018% 66.7909%

Treasury Operations Basics

37

YTM and Reinvestment Risk

7%

7%

7%

7%

95%

100.0000% 7.0000% 7.5783% 8.2043% 8.8820% 9.6158% 141.2804%

All coupons received are reinvested through maturity at a rate equal to the yield of the bond 8.2609% in this example. The IRR reinvestment assumption requires the investor have 141.2804% at maturity, if he/she invests 95% up front to earn the stated YTM.

Internal Rate of Return (IRR) considers that bondholder may reinvest all the coupons, until the maturity date at a particular rate, which is equal to the yield to maturity. Reinvestment assumption says that all coupons received until the maturity of the bond is reinvested at a rate equal to the yield. If the bondholder is able to reinvest at the yield to maturity, return for the five years to maturity is 8.2609%.

(141.2804% / 95%) (1/5) 1 = 8.2609%

Treasury Operations Basics

38

Reinvestment risk arises when the bondholder cannot reinvest at the yield to maturity and hence the return for the period in comparison is not equal to the stated yield.

Zero coupon bonds and reinvestment risk Zero coupon bonds do not pay any coupons and hence carry no reinvestment risk

100%

67.2422%

The return on this zero coupon bond is 8.2609%

Yield = (100% / 67.2422%) (1/5) - 1 = 8.2609%

Day count convention Different day count conventions are used to calculate accrued interest. Some of the commonly used conventions are Actual/Actual, Actual/360, Actual/365, US 30/360, European 30/360.

Treasury Operations Basics

39

Valuation of bonds using Zero Coupon Yield Curve As explained earlier, bonds can be valued using YTM as the discounting factor. However, YTM suffers from reinvestment rate assumption. Hence bonds can be valued using alternate methodology i.e. by deriving zero coupon yield curve. A zero coupon yield applicable to particular maturity is called a spot rate.

Determining Spot Rates Spot rates are used to discount a single cash flow to be received at some specific date in the future.

Hence all cash flows received at t=1 must be discounted at the same rate, assuming that the issuer for all bonds is same.

The one-year zero coupon bond has only one cash flow, we can use its YTM as the discount factor for other t=1 cash flows (again assuming same issuer or same credit quality of issuer), i.e. use the YTM as the one-year spot rate Z1.

The approach that we are employing to create a theoretical spot rate curve is called bootstrapping.

Zero Coupon Cash Flow Approach To avoid the problems of comparability caused by differing cash flow patterns among onthe-run Treasuries, we can realize that each coupon bond is really a package of single payment bonds.

Treasury Operations Basics

40

For example, a 2-year 10% coupon bond is really a package of five single-payment bonds: four for the semi-annual coupon payments and one for the repayment of the corpus

Zeroes A single-payment bond is called a zero

A coupon bond can be thought of as a package of zeroes, one for each of the coupon payments and one for the principal

In principle, any coupon bond can be stripped or unbundled into its constituent zeroes. STRIPS are unbundled coupon bonds.

Spot Yields A spot yield is the current YTM on a zero coupon bond. For example, the one-year spot yield is the yield to maturity on a one-year zero. The price of an n-year zero is related to the n-year spot rate by the formula:

0Pn

= 1 / (1 + in/2)2n

0Pn

= Price of n-year zero

in = n-year spot rate

Treasury Operations Basics

41

Forward Rates These are used for valuing, borrowing, or lending, which can happen at some future date. The spot rate for a six-month tenor, one-year from now is known as the six-month forward rate one-year from now. This rate will be applicable on a sum of money borrowed for a period between 1-year and 1.5 years from now. This rate can be derived from the zero-coupon spot rate curve as follows. A spot bond is issued at $ 100 on date 0 and gets repaid on date t2 (say after 2 years). In a forward contract, one agrees on date 0 to lend $ 100 on date t1 (say after 1 year) and gets repaid on date t2. As with all forward contracts, there is no optionality, and it is a locked-in contract. The interest rate rt2 (contracted at time 0 for a period between t1 to t2) is known as a forward interest rate. The spot yield curve directly shows all the rt values. Case 1: When one buys a bond for $100, it yields 100(1+r02)2 after two years. Case 2: When one buys a oneyear bond and enters into a following oneyear forward contract, we get the following: 100 (1+r0 )
2 2 2

= 100(1+r01)(1+r12)
2 2

(1+r1 ) = (1+r0 )

(1+r0 )

Measuring bond price sensitivity An investor in fixed income is worried about bond price fluctuations. Since bond prices fluctuate mainly in response to change in interest rates an interesting question to be answered is how sensitive are bond prices to changes in interest rates? The concept of duration helps us to arrive at approximate changes in bond prices due to changes in interest rates as follows.

Treasury Operations Basics

42

Duration Duration is the weighted average maturity of a bond, where the present values of cash flows are used as weights.

In computing duration, we consider both the timing and magnitude of all cash flows associated with the security.

Duration is a measure of the price volatility of a bond.

The concept of duration is used for a single asset, a portfolio of assets, or the entire balance sheet.

(Macaulay) Duration Formula D = (t x PV(t)) / PV(t)

D = Duration t = Period PV (t) = Present Value of Cash Flow in Period t

Modified duration: It is a price sensitivity measure. It measures the change in market value of a bond resulting from a small change in interest rates.

Modified duration = Duration / (1 + YTM)

YTM = Yield to Maturity

Treasury Operations Basics

43

Percent change in bond price = - Modified duration x Change in yield

Steps in Computing Duration 1. Calculate the timing and magnitude of cash flows associated with the instrument.

2. Find the present value of each cash flow.

3. Find the total of all PVs.

4. Find the time-weighted PV of each cash flow.

5. Find the total of all time-weighted PVs.

6. Duration: Divide the total in Step 5 by the total in Step 3.

7. Find the modified duration as Duration / (1 + Yield).

Duration and modified duration Problem 1: 5-year 12% Coupon Bond selling at Rs.100 par

Problem 2: 5-year 10% Coupon Bond selling at Rs.100 par

Problem 3: 5-year 6% Coupon Bond selling at Rs.100 par

Problem 4: 10-year 10% Coupon Bond selling at Rs.100 par

Treasury Operations Basics

44

Problem 5: 5 Year 8% Coupon 10% Yield

Problem 6: 5 Year 13% Coupon 10% Yield

Problem 7: 5 Year Zero Coupon 10% Yield

Yield vs. Duration Problem Bond 1 2 3 Duration

5 Year 12% Coupon 12% Yield Par 4.0373 5 Year 10% Coupon 10% Yield Par 4.1699 5 Year 6% Coupon 6% Yield Par 4.4651

Conclusion: Other things remaining the same, the lower the yield, the greater the duration

Maturity vs. Duration Problem Bond 2 4 5 Year 10% Coupon 10% Yield Par Duration 4.1699

10 Year 10% Coupon 10% Yield Par 6.7590

Conclusion: Other things remaining the same, the greater the maturity, the greater the duration

Treasury Operations Basics

45

Coupon vs. Duration Problem Bond 6 2 5 7 5 Year 13% Coupon 10% Yield Duration 4.0310

5 Year 10% Coupon 10% Yield Par 4.1699 5 Year 8% Coupon 10% Yield 5 Year Zero Coupon 10% Yield 4.2814 5.0000

Conclusion: Other things remaining the same, the lower the coupon, the greater the duration

Using Modified Duration o o % change in bond price = -MD * % change in yields If modified duration is 3.84, 1% increase in yields brings approx. -3.84*1% =3.84% change (decline) in bond price.

Portfolio Duration Portfolio Duration = DixWi (i = 1 to N) Where Di = Duration of Security i Wi = Market Value weight of Security i = Sum Wi = 1 Modified Duration = Duration / (1+Portfolio Yield) = Bond Modified DurationixWi (i = 1 to N)

Treasury Operations Basics

46

Properties of Duration Duration of a zero coupon bond equals its maturity. Duration of a coupon paying bond is less than its maturity. Duration of a floating rate bond selling at par equals its repricing maturity. Greater the coupon, lower the duration Greater the yield, lower the duration Greater the maturity, greater the duration Greater the frequency of coupon payments, lower the duration Duration of a coupon paying bond decreases slower than time Duration works well for small changes in yield, for large changes in yields we have to use duration as well as convexity to judge the change in bond price

Convexity Convexity is the rate of change of duration.

Duration is the first derivative (of bond price with respect to interest rates).

Convexity is the second derivative (of bond price with respect to interest rates).

Convexity can be positive, negative or zero.

A non-callable bond has positive convexity.

Treasury Operations Basics

47

Coupon vs. Convexity Higher convexity implies greater price volatility.

Security with lower coupon has higher convexity.

Option embedded debt contract / security has negative convexity, e.g., callable bond, home mortgage / mortgage backed security. This happens because when interest rates fall, bond may be called and mortgage may be repaid. Thus, the rate of increase in the bonds price (due to fall in interest rates) will be less compared with a non-callable bond.

Using Convexity % change in price as indicated by Convexity is as follows:

= C* * %change in yields 2 Thus, total % change in bonds price is approximately equal to i) % change indicated by modified duration (=-MD * % change in yields)

ii) % change indicated by convexity (= C* * %change in yields2)

3.11 Cost of Funds The interest rate paid on an outstanding loan is referred to as cost of funds. Thus, it is the cost of borrowing money by any entity, either the government, a bank, financial institution or a corporation. Cost of funds is low during a benign interest rate regime whereas it is quite steep in a hardened interest rate regime.

Treasury Operations Basics

48

3.12 Managing Investment Portfolio and Trading Portfolio Portfolios are of different types. Typically, a portfolio in a bank is classified as a trading portfolio, an available-for-sale portfolio, and a held-to-maturity portfolio. The trading portfolio is the portfolio where securities are traded very frequently to make profits; an availablefor-sale portfolio is one where securities are bought and sold for a comparatively longer period of time and a held-to-maturity portfolio is one where securities are bought to be held until maturity of the security.

Different strategies are used for management of trading portfolio and investment portfolios. Bullet, barbell and ladder strategies (mentioned below) are some of the strategies used for trading portfolios. Investment strategies include immunization, cash flow matching, horizon matching, yield curve strategies and yield spread strategies.

Bond Portfolio Management (Trading) Strategies Bullet Strategy the portfolio is constructed so that maturity of securities in the portfolio is highly concentrated at one point on the yield curve. Barbell Strategy the maturity of securities included in portfolio is concentrated at two extreme maturities. Ladder Strategy the portfolio is constructed to have approximately equal amounts of each maturity.

Bond Portfolio Management (Investment) Strategies Immunization This strategy involves matching the duration of assets with the investment horizon of the institution. This immunizes the portfolio from interest rate risks.

Treasury Operations Basics

49

Cash flow matching This strategy involves matching of cash flow arising from bond investment to liabilities. For example, if a liability is maturing after five years, we can match the cash outflow (since the liability is to be repaid) with cash inflow from a bond that matures after five years. Horizon matching This is a combination of the above two strategies. In this case, cash flow matching is done for next few years and duration matching is done for rest of the years. Yield curve strategies These are based on interest rate anticipation. For example, if interest rates are expected to fall, portfolio duration can be increased and vice versa. Yield spread analysis In this case, portfolio management strategies are designed by taking into account expected yield curve changes.

3.13 Derivatives in Fixed Income Markets Forwards, Futures, Options and Swaps The meaning of the word derivative according to Chambers dictionary is derived from something else, not original. In the financial world also, derivatives are instruments, which derive value from an underlying asset. Derivatives are used for trading, arbitrage and hedging. The underlying assets from which derivatives derive their value are equity prices, equity indices, interest rates, currencies, and commodities, etc.

Characteristics Options, forwards, futures and swaps are derivative instruments. Forwards and swaps are over-the-counter (OTC) instruments whereas futures are exchange-traded ones. Options can both be exchange traded and OTC. OTC instruments refer to those

Treasury Operations Basics

50

instruments that are tailor-made as per the requirements of the parties to the contract. These are not standardized products like exchange-traded instruments.

Applications of derivatives Risk Transfer Derivatives are used for hedging risks. For example, an investor who is worried about fall in value of his investment portfolio may use derivatives for risk management. He/she will be able to hedge the risk since the value of derivatives fluctuates directly or inversely with the underlying and hence a suitable position in derivatives will ensure price risk is hedged.

Leverage Effect A position in the derivative instrument can be created at nil or fraction of cost of the asset. For example, in case of forwards and swaps, no upfront cost needs to be incurred while in case of options there is a premium to be paid, which generally is a fraction of the asset cost. Hence, with the same amount of capital, a trader can take a large position in derivatives compared with outright trading of an underlying asset. This creates a leverage effect, magnifying the traders gains as well as losses.

Liquidity The tradability of derivatives raises the interest and number of market participants, which in turn improves their liquidity. This means, large volumes can be traded at any time, without influencing the prices.

Treasury Operations Basics

51

Derivative products Forward Rate Agreements A Forward Rate Agreement (FRA) is an agreement whereby the seller of the FRA agrees to pay to the buyer the value of the difference between a pre-agreed interest rate and the final settlement rate, based on an agreed Notional principal for a notional period. It is basically to hedge the interest rate risk. The seller of the FRA will not take deposit or make an advance to the Buyer of the FRA. The buyer of the FRA will either place a deposit in the market or borrow from the market. If market rate is adverse in comparison to the FRA rate, then the seller of the FRA will have to compensate the buyer of the FRA. The difference of interest is calculated at the FRA contract rate and the market rate and is payable at the start of the period at discounted interest rate i.e. at market rate. On the other hand, if the market rate is favourable than the FRA contract rate, then the buyer will have to pay the seller of the FRA the difference of interest calculated @ FRA rate and the market rate. This is also payable at the start of the period and hence discounted @ market rate of interest.

The settlement rate is determined by an agreed reference rate. Settlement is discounted to the start of the period.

Example: On 11 Jan 2006, a customer asks for a quote from bank for USD 10mn for 3x6 months.The banks quote will be: USD 10mn 3x6 5.90/6.00, which means bank is ready to lend @ 6% or take deposit @ 5.90% , USD 10mn on 11-Apr-2006 for a period of 3 months effectively 91 days period. The buyer of FRA will continue to place deposit/ borrow from the market only. The difference of interest for notional period (in the preset example it is for 91 days) for a notional principal (in the present example it is USD 10mn)

Treasury Operations Basics

52

will be exchanged between the buyer of the FRA and the seller of the FRA on the fixing date normally 2 days earlier to the settlement date (in the present case on 09-Apr-2006). Let us assume that the buyer of the FRA wants to hedge the interest rate risk for his/her borrowing and hence bought FRA @ 6%. So the total interest payable by the buyer of FRA is now fixed. It is USD 149,589 only. Situation 1-If the market rate of interest is 8% on 09 Apr 2006. In this case the seller of the FRA, has to USD 49,863 pay interest calculated @ 2% for USD 10mn for 91 days Since this is payable on the settlement date USD 48,888 i.e. on 11 Apr 2006, it will be discounted @ market rate of interest @ 8% So the Buyer of FRA will borrow in market, USD 9,951,112(USD 10mn less USD

48,888 received from the seller) @ 8% for 91 days The interest payable on this loan will be The interest received from seller of FRA Net interest cost to FRA Buyer USD 198,477 USD 48,888 USD 149,589

Treasury Operations Basics

53

Situation 2 The market rate of interest is 4% as on 09-Apr-2006. In this case the buyer of FRA has to pay to USD 49,863 the seller of FRA, the interest calculated @ 2% on USD10mn for a period of 91 days. It is: Since the same is payable at the start of USD 49,371 the period i.e. on 11_Apr-2006, the same is discounted @ 4% So the buyer of FRA has to effectively USD 100,218 borrow 10,049,371 in market @ 4%. The interest payable to the lender comes to: Add: the interest paid to seller of FRA: Net interest cost to FRA Buyer USD 49,371 USD 149,589

Interest Rate Futures - Interest Rate Futures (IRF) are financial derivative (a futures contract) with interest-bearing instrument as the underlying asset. IRFs are traded on derivatives exchanges in the US and other markets. In the US, IRFs are available on short maturity as well as long maturity fixed income securities. For example, LIBOR futures and T Bill futures are available on short maturity products and T Bond futures are available on Treasury Bonds, which have longer-term maturity.

Interest Rate Swap - An Interest Rate Swap (IRS) is a financial contract between two parties exchanging or swapping a stream of interest payments for a notional principal amount on multiple occasions during a specified period. Such contracts generally involve an exchange of a fixed-to-floating or floating-to-floating rate of interests. Accordingly, on

Treasury Operations Basics

54

each payment date that occurs during the swap period, parties make cash payments to one another based on fixed/floating and floating rates. Features of IRS An IRS involves exchange of interest obligations between two parties at regular intervals over the life of IRS. Debt is denominated in the same currency. There is no transfer of principal. It is only notional. Typically floating/fixed swaps are done.

Suppose Company A and Company B wants to borrow $ 10mn for five years and have been offered the following rates. Fixed Company A Company B Spread 10% Floating 6 m Libor + 0.3%

11.20% 6 m Libor + 1% 1.2% 0.7%

Difference in Spread 1.2% - 0.7% = 0.5% Let us also assume that Company A wants to borrow on a floating basis and Company B wants to borrow on a fixed basis. The following table summarizes their borrowing obligations and comparative advantage in borrowing.

Desired obligation Company A Floating Company B Fixed

borrowing Comparative borrowing Fixed Floating

advantage

in

Treasury Operations Basics

55

The spread of 1.2% - 0.7% = 0.5% can be shared between Company A and B to lower their costs of borrowing.

Generally this arrangement is worked out by a bank, which may find two counterparties or enter into a transaction as a counterparty.

Let us assume in this case, the spread of 0.5% is shared by Company A 0.2%, Company B 0.2% and bank 0.1%.

Companies A and B borrow in the respective markets (fixed / floating) where they have comparative advantage and enter into IRS. Ultimately, both the companies are able to reduce their cost of funds as shown below: Interest Rate Swaps Cash Flows As cash flows i) Borrows at fixed Bs cash flows rate, Borrows at floating rate, pays Libor +1% to lenders Receives Libor 0.10% from Bank Pays 9.90% to Bank Net Cost = 11%

pays 10% to lenders ii) Receives 9.85% from Bank iii) Pays Libor 0.05% to Bank Net Cost = Libor + 0.10%

The following diagram shows how Party A converts from floating to fixed, and Party B converts from fixed to floating.

Treasury Operations Basics

56

Another form of interest rate swap is the Basis Swap or floating-to-floating swap. Here, two floating rate obligations are exchanged where the two obligations are based on different benchmark rates. For example, the benchmark rate can be LIBOR or T-Bill rate.

Interest Rate Options Interest rate options represent the right to make a fixed interest payment and receive a floating interest payment or to make a floating interest payment and receive a fixed interest payment. These interest rate options will have exercise rate or strike rate. They are available for both European and American versions. Interest rate options are widely used to hedge an interest rate exposure on a specific date.

Interest Rate Cap An interest rate cap is defined as a combination of interest rate calls designed to protect a borrower in a floating rate loan against increases in interest rates. Each component call is referred to as a caplet. A combination of interest rate puts designed to protect a lender in a floating rate loan against decreases in interest rate is known as interest rate floor. Each component put is referred to as a floorlet. A combination of long cap and short floor is known as an interest rate collar. This is most often used by a borrower and consists of a long position in a cap, financed by selling a short position in a floor.

An interest rate cap, also known as a ceiling, is a call option on interest rates. It is a contract that guarantees a maximum level of a floating rate benchmark. A Cap can serve as a guarantee for one particular period, known as a Caplet. A series of Caplets or Caps can extend for many years. The maximum loss on a Cap transaction is the premium paid by the buyer.

Treasury Operations Basics

57

Interest Rate Floor This is a put option on interest rates. Floors guarantee a maximum level of the fixed rate benchmark, and they comprise a series of floorlets, each of which is a put option at a given future date.

Interest Rate Floors are used typically by lenders in a floating rate loan when they wish to counter falling rates. A floor contains a series of interest rate put options, each of which is known as a floorlet.

An Interest Rate Collar A collar is a combination of buying a cap and simultaneously selling a floor. The strike levels are generally decided such that the net premia outflow is zero. Collar = Cap - Floor

Swaptions Swaptions are options on Interest Rate Swaps. The payer of a Swaption has an option to enter into a payer swap (pay a Fixed Rate and receive a Floating Rate). The receiver of a Swaption has the Option to enter into a receiver swap (receive a Fixed Rate and pay a Floating Rate).

Treasury Operations Basics

58

4. Foreign Exchange Markets Introduction


Chapter objectives: 1. To identify the products and participants of foreign exchange markets 2. To understand the important terminologies and mechanism of spot and derivative markets 3. To recognize the factors that affect foreign exchange markets

4.1 Overview of Global Forex Markets The market that facilitates exchange of currencies is the Foreign Exchange Market. The world is emerging as a global economy because of flow of goods, services and capital. For each transaction of goods and services, there is a corresponding currency transaction, which forms a part of international network of payments. The foreign exchange market is that in which currencies are bought and sold against each other.

The foreign exchange market is largely an OTC market. This means that there is no single market place or an organized exchange, electronic or physical (like stock exchange) where all trades are executed between exchange members. The traders sit in the offices (foreign exchange dealing rooms) of major commercial banks around the world and communicate with each other through telephones, telexes and other electronic means of communication.

The market spans all time zones of the world and functions virtually round-the-clock, enabling a trader to offset a position created in one market using another market. The major market centers are London, New York and Tokyo. Other important centers are Zurich, Frankfurt, Hong Kong and Singapore.

Treasury Operations Basics

59

4.2 Products and Participants in Foreign Exchange Markets The participants in the foreign market can be classified under three broad categories: Non-bank Entities who wish to exchange currencies to meet or hedge contractual commitments (arising out of, for e.g., import or export contracts in foreign currencies). Many multinational firms engage themselves in forward contracts to protect the home currency values of foreign currency denominated assets and liabilities on their balance sheet. These companies also hedge receivables and payables. Banks that exchange currencies to meet client requirements. Central banks participate in foreign exchange markets whenever there is a need to stabilize exchange rates.

These participants can assume the following roles while transacting in foreign exchange markets. Hedging: Participants who have foreign exchange exposures due to various transactions that they undertake, such as exports or imports, may like to hedge themselves from currency fluctuations. Hence they participate in foreign currency derivatives markets and take positions in currency forwards, futures, swaps and options to minimize the risk. Trading: Traders / dealers buy or sell currencies in the hope of profiting from price movements. In fact, speculative transactions are by far the largest proportion of the total activity in the market. The big speculators in currencies include large commercial and investments banks, multinational, and so-called hedge funds.

Profiting from arbitrage: Participants who take advantage of price disparities on a fully hedged basis are called arbitragers. They have a limited role to play in the

Treasury Operations Basics

60

currency market since communication systems have made the market too efficient to allow any arbitrage opportunities.

4.3 Spot and forward markets Quotations in the Foreign Exchange Market A quotation is the amount of one currency to buy or sell a unit of another currency. When it is expressed in currency terms it is called an outright rate. For example, 1 EUR = 1.3810 USD is an outright rate. The quotes are usually made in the form of buy and sell or bid and ask rates. The buy quotes are the price at which the exchange dealer is ready to buy the currency and the sell quotes indicate the price at which the dealer is ready to sell the currency. Bid and ask are alternative terms for the above two quotes. Sometimes ask is also referred as offer price.

Direct Quotations While quoting the exchange rate for a currency, if the unit of foreign currency is kept constant and its value is expressed in terms of variable home currency, the method of quoting the exchange rate is direct quotation. In this case, the unit of home currency will vary for every unit of foreign currency. e.g., USD 1 = Rs.45.80 (USD is base currency and INR is offered currency)

Indirect Quotations When the unit of home currency is kept constant and the unit of home currency is expressed in terms of variable units of foreign currency, this method of quoting exchange rate is called indirect quotation. E.g., Rs.100 = USD 2.18

Treasury Operations Basics

61

Also, the point to be noted is, in market parlance except for EUR, GBP, NZD and AUD all other currencies are quoted with USD as base currency. Example: 1 USD=x CHF, or 1 USD = y CAD But, 1 EUR= xyz USD or 1 NZD = abc USD

Relationship between bid and ask prices of currencies One important thing to know about bid and offer rates is that when a bank quotes for a currency, it simultaneously offers another currency in lieu i.e., when it buys euros for dollars, it is simultaneously offering dollars for euros. Thus there are two sides of all quotes.

Two-way quotes In other commercial transactions, whenever we enquire the price of the commodity, the seller immediately quotes his/her selling price. But in a foreign exchange market, exchange rates are quoted for buying and selling i.e., one rate for buying and another rate for selling. For example, if Bank X calls for the rate from Bank Y for GBP / USD Bank Y will quote: GBP 1 = USD 1.6150 / 60 This way banks act as market makers.

It means that Bank Y is prepared to buy GBP at USD 1.6150 and sell at 1.6160. This method of quoting both buying and selling rates is known as a two-way quotation. For all practical purposes, if we treat foreign exchange as a commodity, the logic and application of a two-way quotation can be understood easily i.e., a trader will always be willing to buy a commodity at a lesser price and sell at a higher price. This is called a bidask spread.

Treasury Operations Basics

62

As there is no specific exchange for dealing in FX, only those participants have access to market rates who are dealing directly and act as market makers. There are quotes (bid /ask) available at all the time by authorized dealers (market makers) through e-trading screens etc.

In a spot two way price Right Hand Side is always greater than Left Hand Side Spread / Cost of Transaction Ask and Bid differential is called the spread. The spread is always in favour of the party making the price and against the party facing the price. The maker of price will take more (and give less) of variable currency for each unit currency. The facer of price will take less (and give more) of variable currency for each unit currency.

The main determinants of spread are: If the currency is fairly traded, (i.e. trading volumes are high and are traded against number of currencies in a free environment), the spread will be smaller than the currency that is rarely traded. For dollar, the spread is smaller than that for Danish Krone. If the volume of the currency traded is large, the authorized dealer (market maker) tends to quote lower spreads. This is because the cost of the service required per unit of the currency traded falls. The spread of the quote also depends on the nature of the organization making the quotation. If a bank is making a quote, spread will be smaller compared with a money changer who has obtained a license to deal in foreign exchange.

Treasury Operations Basics

63

If the forex dealer perceives larger fluctuations in the economic conditions in the near future and thinks that risk is going to increase, the dealer starts expanding spread. However, if the opposite perception prevails, the usual spreads continue.

Value Dates Because of technicalities involved in expressing the time when a cash flow is to take place, we will discuss the concept of value dates. As we know, there are two major time dimensions in the foreign exchange markets: 1. Spot transactions are for a value date, usually two business days following the day when the transaction is closed.

2. Forward transactions are for value dates in future, usually computed as a number of months from the spot value date at the time of transaction.

Value dates as of today (called Cash) and one business day following the transaction (called Tom), are also possible. However, these will not be genuine spot transactions and the spot rate will not apply despite its resemblance to spot transactions. If we deal with value date today or tomorrow, an adjustment of the spot rate may be necessary to reflect interest rates of the two days between today and the value date of the spot transaction.

Eligible value dates To be an eligible value date, a value date must be a business day in the home country of the currency involved in the transaction.

Treasury Operations Basics

64

4.4 Foreign Exchange Arithmetic Rate Computations Foreign exchange rate computations involve a number of calculations which can be best understood by examples. The following example explains the calculations required to arrive at specific foreign exchange rates. Example 1: Understanding two way quotes Suppose a quotation is given as USD/CHF 0.9340 / 42: a) The two currencies involved are: US dollars and Swiss Franc. In the above case, USD is the base currency and CHF is variable currency. Concept of base currency is very important in foreign exchange market since all quotes are for base currency. b) The rate is being stated as CHF per USD or CHF price of 1 USD. c) A bank will buy 1 USD for 0.9340 CHF. d) A bank will sell 1 USD for 0.9342 CHF. e) The bid-offer spread is 2 points or .0002 CHF.

Example 2: Arriving at two way cross currency rates The market quotes: GBP/USD Spot: 1.6180 / 90 USD/JPY Spot: 81.45 / 50 USD/INR Spot: 45.80 / 85

Please calculate two-way, cross currency Spot rates for the following pairs. a. JPY / INR b. GBP / INR

a) JPY / INR: This quote is derived from USD/JPY and USD/INR quotes. In both

Treasury Operations Basics

65

these cases, the base currency is USD. Hence, the rule is to divide one quote by another while arriving at a cross currency rate. We assume JPY / INR, JPY is the base currency in a cross currency quote. Hence, USD/JPY becomes the denominator and USD / INR the numerator. b) Cross currency bid rate = USD/INR bid / USD/JPY ask = 45.80/81.50 = 0.5620 c) Cross currency ask rate = USD/INR ask / USD/JPY bid = 45.85 / 81.45 = 0.5629 d) GBP / INR: This quote is derived from GBP/USD (base currency GBP) and USD/INR quotes (base currency USD). Since base currencies are different, cross currency calculations are straightforward. Multiply both bid rates and ask rates to arrive at cross currency bid and ask rates respectively.

Cross currency bid rate = GBP/USD bid * USD/INR bid = 1.6180 * 45.80 = 74.10

Cross currency ask rate = GBP/USD ask * USD/INR ask = 1.6190 * 45.85 = 74.23

Forward Market This segment of the market is an important part, which makes the foreign exchange market vibrant. In this market, contracts are bought and sold at forward exchange rates and hence cash flow happens at a future date (agreed on the date of entering the transaction). Hedging and speculation are main activities, which pertain to forward markets. For example, an exporter who is expecting USD 1mn after 3 months can book a three-month forward ( sell expected USD , where actual cash flow will happen after three months ,once the dollars are received) and know the exchange rate of his/her receivables well in advance and mitigate exchange risks.

Treasury Operations Basics

66

Swap Margins and Quotations While banks quote and do outright forward deals with their non-bank customers, in the interbank market, forwards are done in the form of swaps. Thus, suppose a bank buys pounds one-month forward against dollars from a customer, it has created a long position in pounds (short in dollars) for one-month forward. If it wants to square this in the interbank market, it will do so as follows: A swap in which it buys pounds spot and sells one month forward, thus creating an offsetting short pound position one month forward. Coupled with a spot sale of pounds to offset the long pound position in spot created in the above swap.

This is because it is difficult to find counterparties with matching opposite needs to cover the original position by an opposite outright forward whereas accumulation of various customer transactions in a banks books can be easily managed by squaring the spot and swap positions separately or can be easily offset by dealing in the euro deposit markets.

FX Swap can be structured in two ways. If a currency is bought in the spot and simultaneously sold in a forward market, it is called BuySell swap. In the reverse case it will be a SellBuy swap.

Receipt and Payment of Swap Points If the currency is in Discount in Future then a swap where the currency is bought is spot and sold in forward will result in gain of the swap points. This is simply because the currency is being sold costly and bought cheap. Further, in a currency pair, the currency

Treasury Operations Basics

67

with a lesser interest rate is at premium and hence the currency having higher interest rate is at discount. We can summarize the rule as given below: 1. A Sell / Buy Swap in Discount currency results in Gain of Swap Points. And it logically follows that. 2. A Buy / Sell swap in Discount currency results in Loss of Swap Points. 3. A Buy / Sell swap in Premium currency results in Gain of Swap Points. 4. A Sell / Buy swap in Premium currency results in Loss of Swap Points.

Some Applications of Swaps Banks use swaps among themselves to offset positions created in outright forwards done with customers. You may have noticed that swap deals alter the timings of cash flows.

For instance, suppose a firm bought CHF against dollar three-month forward on August 30.The delivery date is December 1. By late November, it realizes that it does not need the CHF on December 1 but on December 14. On November 29, it can do a swap, selling CHF spot and buying it for delivery on December 14. The CHF received from the original forward contract is used to deliver against the spot leg of the swap.

Another variant of swaps is in so called Roll-over Forward contracts. Forward quotes may not exist or lack liquidity beyond certain maturities. Consider the case of a firm in India that has contracted a foreign currency loan of $1,000,000. The principal has to be repaid in 10 six-monthly installments starting six months from today. Ignoring the interest payments (which can be easily figured into the calculation), the firm has definite outflows of $10,000 every six months for the next five years. The firm would like to know the

Treasury Operations Basics

68

rupee value of its entire liability at all times. Assume that forward markets are not liquid beyond six months. The firm can use swaps as follows: Buy USD 1,000,000 six-month forward at a rate known today. Six months later, take delivery, use USD 100,000 to repay the first installment. For the remaining USD 900,000 do a six-month swap i.e., sell in the spot market, and buy six months forward. Rupee outflow six months later is again known with certainty. Repeat this operation every six months until till the loan is repaid.

4.5 Factors affecting Foreign Exchange Market Short-term factors Short-term factors that affect the foreign exchange market are those that have an immediate effect on exchange rates between a pair of currencies. Some of them are liquidity, interest rates, inflation, money supply, capital market performance, etc. Tight liquidity for a particular currency results in an adverse movement in exchange rate pertaining to that currency. Typically, high interest rates in a particular currency results in more fund inflows into that currency, thereby making that currency dearer. Similarly, high inflation rates and excess money supply in a particular currency regime pushes exchange rates adversely for the currency. Buoyancy in capital markets also attracts foreign institutional investors into the market, making the exchange rate appreciate for the currency.

Long-term factors Long-term factors that affect the foreign exchange market are those that have long lasting effect on the exchange rates between a pair of currencies. Some of them are government policies, central bank regulations, political scenario, structural market reforms, long-term economic growth, etc. Rigid government policies and central

Treasury Operations Basics

69

bank regulations have a depreciating effect on the exchange rate of a currency. An unstable political scenario and lack of structural market reforms also have an adverse long-term effect on exchange rates. Countries boasting of substantial long-term economic growth attract foreign investments, causing exchange rates to appreciate on a longer-term horizon.

Economic factors Economic factors play a vital role in affecting the foreign exchange market. Currencies of countries with upbeat economies usually appreciate compared with countries with distressed economies. Countries with burgeoning economies attract more foreign investments, both direct and indirect, thereby increasing the value of the currency and the foreign exchange market.

Political factors Political factors influence the foreign exchange markets in a major way. An unstable political scenario in a country has a negative effect on its currency and hence depreciates the currency compared with other currencies. Investors put their trust in economies where the political scenario is stable and conducive to business and industrial growth, thereby making the currency of the country valuable.

Treasury Operations Basics

70

5. Asset Liability Management Overview


Chapter objectives: 1. To understand the concept of asset liability management 2. To comprehend product pricing and performance management and risk management

5.1 Product Pricing and Performance Management, Interest Rate Risk for Asset Liability Management As we appreciate, for a bank, a disbursing loan is an asset and accepting deposits is a liability. The Asset Liability Management (ALM) desk manages these basic

asset/liabilities, along with investments and other on-balance sheet and off-balance sheet items.

The ALM function involves planning, directing and controlling the flow, level, mix, cost and yield of the consolidated funds of the bank. These responsibilities are interwoven with the overall objectives of achieving the banks financial goals (of achieving risk adjusted return for shareholders)

ALM is concerned with strategic management of the banks balance sheet by giving due weightings to liquidity risk, interest rate risk and currency risk. It is the process of making decisions of the composition of banks assets and liabilities.

Interest Rate Risk Interest rate risk is the exposure of the banks earnings and capital to adverse changes in interest rates. For all practical purposes, we are aware that interest rates keep

Treasury Operations Basics

71

changing; hence banks run risks on their assets, liabilities, capital, income and / or expense at different times or in different amounts.

Components of Interest Rate Risk

Risk of adverse consequences from a Repricing Risk change in interest rates that arises because of differences in the timing of interest rate changes of the banks assets and liabilities Risk of adverse consequences resulting from unequal change in the spread Interest Rate Risk between two or more rates for different Basis Risk instruments with the same maturity. This risk will occur when the rates paid on liabilities are determined differently from the rates received from the assets Risk of adverse consequences resulting Yield Curve Risk from unequal changes in spreads between two or more rates for different maturities in the same yield curve, i.e., short term interest rates changing by more or less than the change in long term interest rates

Risk that rate changes prompt changes in Options Risk the amount and / or maturity of the instruments. Options risk arises whenever the bank products give customer the right but not the obligation to alter the quality or the timing of cash flows

Treasury Operations Basics

72

5.2 Liquidity Risk in Asset Liability Management, Transfer Pricing A funding crisis does not arise in vacuum and is triggered by endogenous and exogenous factors. Endogenous problems are most often credit risks (credit risks arise due to deterioration of borrowers capacity to pay, which increases chances of default) deterioration or operational risk events.

Exogenous problems are triggered by: Market disruptions Payment system events Country risk flare ups

Liquidity risk is defined as the risk of loss to earnings and capital arising from a banks inability to meet its obligations when they become due, without incurring an unacceptable loss.

This risk arises on the bank when it is perceived as not having sufficient cash at one or more future periods of time to meet its requirements.

Treasury Operations Basics

73

Funding Liquidity Risk

It is defined as the risk that an institution will be unable to meet its obligations as they become due because of inability to liquidate funding. assets or obtain adequate

Liquidity Risk

Market Liquidity Risk

It is the risk that an institution will be unable to meet its obligations as they become due because it cannot easily unwind or offset specific exposures without significantly lowering market prices due to lack of market depth or market disruptions.

Contingency Liquidity Risk

It is the risk that future events may require significantly larger amount of cash than projected owing to sudden and unexpected short-term obligations.

Treasury Operations Basics

74

Sources of Liquidity Risk

Event Driven

Rating downgrades and other negative news about the firm can lead to:

Reduced market access to unsecured borrowing Reduction or cancellation of Inter-bank credit lines Reduction of deposits

Off balance sheet exposures with / without embedded optionality due to unanticipated market movements leading to unanticipated:

Margin / Collateral calls from exchanges Margin / Collateral calls from OTC transactions Liability mismatches arising from settlement systems requiring effective hedging or increased collateralization

Transaction and Product driven

Short positions in options which require cash delivery

Market Trends

Technological advancement in the banking sectors like: Depositors ability to transfer funds among accounts electronically

Treasury Operations Basics

75

Objective of Liquidity Risk Management Liquidity Risk Management needs to be prospective. Historical levels of liquidity are far less important than ensuring that the bank has enough liquidity to ensure future cash flow needs.

Liquidity Risk Management must include provision of prudent cushion for unanticipated cash flow needs. Maintaining a prudent cushion is the single most critical aspect of liquidity management.

Liquidity Risk Management must strive to achieve the best possible cost / benefit balance. Too little liquidity can kill the bank and too much liquidity can kill the bank slowly.

Liquidity Statement Structural Liquidity Statement Dynamic Liquidity Statement

Structural liquidity approach analyses Dynamic liquidity statement assesses the liquidity profile of the bank at selected the liquidity profile of the bank based on maturity bands under static scenario certain business growth assumptions of the bank.

without reckoning future business growth. Structural liquidity approach assesses

liquidity profile under As Is condition of the Assessment is conducted over a 90 bank. day period and hence is popularly called

Outcome of this approach is to provide as short term dynamic liquidity statement. a long term view of the liquidity profile of the bank.

Treasury Operations Basics

76

Liquidity Ratios as indicators Liquidity ratios are used by banks to measure their liquidity needs under going concern concept and stress market conditions

Liquidity ratios also act as a basis for setting up limits for liquidity risk.

Ratios

Description

Usage the ratio more the

Loan-to-deposit ratio Measure of the extent to which a Higher

bank is funding its illiquid assets dependence of funding loans on with stable liabilities Medium Funding ratio other sources of funds

Term Ratio of liabilities to assets with a The higher the ratio, the more are contractual maturity of a year. The the liabilities maturing in a yr. ratio focuses on the medium term liquidity profile of the bank

Liquid

Assets*

/ This ratio gives a view on the level The higher the ratio, the more the

Anticipated requirement**

funding of liquid asset available for the availability of liquid assets for the funding requirements of the bank. bank.

Cash-inflow-to-cash- Ratio of cash inflow during the Gives an idea to the bank on the % outflow ratio month to cash outflow during the of inflows for the month to the month Ratio of outflows.

long-term This ratio gives a view of how much The higher the ratio, the better for

debt and equity to of the illiquid assets are supported the bank, indicating the bank is not Illiquid assets*** by Long term debt and equity of the depending on short-term debt to bank fund illiquid assets

* - Liquid Assets: Liquid assets are cash or assets which can be quickly converted into cash

Treasury Operations Basics

77

** - Anticipated funding requirement: Future requirements of cash resources for business expansion and other tactical and strategic planning, mostly strategic *** - Illiquid assets Illiquid assets are those assets that cannot be readily converted into cash by selling them in the market like illiquid corporate bonds or junk bonds, private equity investments or venture capital investments that cannot be easily exited.

Fund Transfer Pricing FTP is a management accounting technique used to calculate the true net interest component of profitability of business units, products, portfolios and customers.

FTP helps build income statement for each of these views by calculating the cost of funding assets and the credit for funds provided in the form of deposits.

FTP rates are asset and liability rates generated by the funding centre (or treasury) of a bank to charge deploying units and to credit the sourcing units in accordance with repricing, maturity and optionality associated with asset and liability. This is done in such a way that: Financial revenue and expense are allocated to business units that are involved in funding and sourcing.

Interest rate risk and liquidity risk are removed from funding and deploying units to be mapped at bank level.

Treasury Operations Basics

78

Market Yield curve


Banks Position Details
Rate

Asset Loan 100mn @ 8% for 10 yrs

Liability Term Deposit 100mn @ 2% for 2 yrs

s
7.0% 4.0% 2.0%
Term

2 year

10 years

Allocation of FTP rates to Assets and Liabilities

Tenor 2 year 10 years

Asset Rate

FTP Rate

Liability Rate 2%

FTP Rate 4%

8%

7%

Explanation: For example the deposit mobilization team of the bank mobilizes term deposits of USD 100mn from depositors paying them interest @ 2% for 2 years. This USD 100mn thus becomes a liability for the bank. The deposit mobilization team in turn transfers the funds to the Asset Liability Management team within the bank and thereby getting paid say @ 4% for two years, thereby the deposit mobilization team earns an income of 2% on the deposits since 4% is the funds transfer pricing rate being provided to them by the Asset Liability Management team of the bank. Deposit mobilization team needs to roll over the two-year deposits, which in turn are provided as 10=-year loan by the loan disbursement team in the bank.

Treasury Operations Basics

79

Asset Liability Management team in turn passes on the funds to the loan disbursement team say @ 7%, which extends loans to the tune of USD 100 @ 8% for a 10-year tenor. The Asset Liability Management team in turn hedges the rates with the outside market thus acting as a central focus group managing both the assets and the liabilities of the bank, thereby managing a 3% spread between assets and liabilities.

Objectives of FTP Allocate funds within the bank Transfer Liquidity and interest rate risk to the ALM unit to make the performance of business lines independent of market movements that are beyond the control of business units Bifurcate the total interest earned into various components attributable to various businesses within the bank in such as way that contributions to bank-level margins are explained properly Define economic benchmarks for pricing and performance measurement Drive pricing policies of business units in line with the market practices Provide incentives or penalties to trigger expected performance from business units to bring them in line with commercial policy

FTP System Treasury or a designated unit within treasury brings out rates for assets and liabilities for various tenor periodically through yield curves for various currencies. These rates serve as transfer rates for sourcing and deploying units at which they lend and borrow respectively: Gross margin for a lending unit = Customer rate Transfer Rate of FTP Gross margin for a sourcing unit = Transfer rate of FTP Customer rate

Treasury Operations Basics

80

In case of units having both sourcing and deployment of funds, gross funds sourced and gross funds deployed must flow through the FTP system. Use of net of funds sourced and deployed would defeat the very purpose of FTP system.

Liquidity adjustment is necessary for items that have behavioral maturity different from contractual maturity. For e.g., term deposits with renewal possibilities may have a shorter contractual maturity but they have a longer behavioral maturity.

For products with embedded options (loans that can be prepaid), special adjustments are necessary

Transfer Pricing Mechanism

Deposit Customers

2% 2 yr Fixed Rate

Bank

8% 10 yr Fixed Rate

Loan Customers

Sourcing Unit Deposit Customer


2% 2 yr Fixed Rate

Deploying Unit
4% 2 yr Fixed Rate

Deposit Business Unit of the Bank

Funding Center

7% 10 yr Fixed Rate

Lending Business Unit of the Bank

8% 10 yr Fixed Rate

Loan Customer

Rates 7.0% 4.0% 2.0% 2 year 10 years Ter m

Inter Bank Market

Rates 7.0% 4.0% 2.0% 2 year 10 years Term

Treasury Operations Basics

81

FTP Outcome

Customer Credit Rate 8%

Commercial Margin 1% Financial Margin 3% Commercial Margin 2%


Customer Deposit Rate

10 yrs. FTP Rate 7%

Total Interest Margin 6%

2 yr. FTP Rate 4%

2%

Asset
Commercial Department Responsibility

Liability

Customer Credit Rate 8%

Commercial Margin 1% Financial Margin 3% Commercial Margin 2%

10 yrs. FTP Rate 7%

Total Interest Margin 6%

2 yr. FTP Rate 4%

Customer Deposit Rate

2%

Asset
Commercial Department Responsibility

Interest Rate Risk Management


ALM Responsibility

Liability
Commercial Department Responsibility

Treasury Operations Basics

82

Outcome of an Effective FTP Enables the Asset Liability Management unit to have a powerful leverage on business Decision making process, customer pricing and commercial policy are based on the FTP system Helps increase the bottom line Enables true performance of business units to be reflected in the P&L

Applications of FTP FTP is a tool for: Implementing ALCOs decisions Pricing Decisions Comparative evaluation of business lines Views of profitability Product Profitability Business line Profitability Customer Profitability Market Segment Profitability Branch Profitability Region Profitability Delivery Channel Profitability FTP Basic Components for Computation Gross Balance of Asset (to be funded) or Liability (to be sourced) FTP Balance Rate applicable on the balance amount FTP rate Time period for which the charge needs to be calculated FTP Period FTP Charge = FTP Balance * FTP Rate * FTP Period

Treasury Operations Basics

83

6. Cash Management

Chapter objectives: 1. To understand the dynamics, forecasting and valuation of cash flow 2. To identify short term funding investments 3. To comprehend sales cash conversion cycle 4. To prepare the cash budget

The expression cash is king has taken on a new meaning in banks these days. Leveraging balance sheets with complex structured investments turned out to be a losing bet during financial crisis witnessed recently. But cash management departments at multinational banks continued to bring in income. Similarly, corporations that had their cash management procedures well thought out were better placed to weather the storm.

Cash Management: Banking perspective Cash management from the banking perspective is a low margin, high-volume business with a low risk factor. Cash management in the banking sector is generally considered as a value added service provided to clients. But the income generated from float money in the process is substantial as volume of transaction increases, which make the business a profitable proposition for banks.

Corporate perspective Cash management from a corporation perspective is a vital and essential component in the entire financial management activities of the corporation. It goes a long way in streamlining working capital funds flow for a business by utilizing the potential of surplus cash and limiting the time between receivables and payables, by trying to bridge the two functions.

Treasury Operations Basics

84

6.1 Cash Flow Dynamics, Forecasting and Valuation Corporate Cash Management Objectives An efficient process for collections and remittances Enhance velocity of money, which calls for speed, accuracy and efficiency of high order in the banking system Manage cash flows, boost liquidity, and ensure reduction in costs

Clearing Clearing is the process by which obligations of banks to pay (or receive) with the central bank are arrived at. Clearing is also required to be done for arriving at obligations of market participants with a designated clearing bank on the exchange of instruments such as equities, bonds etc. Thus, clearing makes transactions ready for settlement, which actually involves transfer of funds and or securities.

Types of clearing High value clearing Normal check clearing Interbank clearing Return clearing Non instrument based clearing

Treasury Operations Basics

85

Cash Management System Cash management system is a system of collections and remittances that addresses the limitations of clearing through technology and provides client liquidity and enables efficient funds planning.

Cash management services addresses three basic components: Receivables management Payables management Liquidity management

Trade cycle of an organization

Raw Materials

Payables

Payables

Cash
Receivables

Cash Management System

Work in Progress

Finished Goods

Treasury Operations Basics

86

Conventional banking channels Locks up funds in transit, strains liquidity

As a result the consequences are as follows. Borrowing to bridge funds gap Reduce profitability due to interest outgo Adversely affects return on investment Lowers returns to shareholders

Importance of cash management system Optimal usage of available funds Minimization of idle balances Minimization of borrowings to save costs Increase in investment opportunities available Control over funds Lower administrative burden and cost of monitoring cash transmission Effective oversight and management of counterparty risks Assured liquidity

6.2 Short-Term Funding Investments Short-term funding investments preferred by cash management clients include: Money market mutual funds Money market mutual funds are mutual funds that invest in short-term or money market instruments like Treasury bills, commercial paper, certificate of deposit, repo, and the like. Characteristics of such investments are low risk and low returns but greater liquidity.

Treasury Operations Basics

87

Direct investments in money market Many banks provide their cash management clients an option to directly invest in money markets through the bank rather than through a mutual fund. This saves the client on distributorship and investment management fees, although it misses out on specific fund management expertise which the fund house might possess.

6.3 Cash Management Techniques Accounts Receivables Tracking Accounts receivables tracking goes a long way in helping build an efficient cash management technique, since it helps a corporation to efficiently manage receivables. Expense Tracking Expense tracking helps an organization to have control on its expenses and in analyzing expense patterns. Establishment of Credit Lines Establishment of credit lines with banks goes a long way in doing away with short-term funding mismatches and requirements. Cash Pooling the cash pooling concept connects all accounts of a corporation with a particular bank into a single repository, to effectively manage funds and any requirement from any divisions of the corporation can be centrally managed. Netting Netting refers to adjustment of cash receivables and cash payables between parties, leaving only incremental cash payments to be effected from one party to another. Electronic Data Interchange Electronic Data Interchange here refers to electronic transfer of funds, and messages and instructions to reduce delivery time of physical movement of instruments.

Treasury Operations Basics

88

6.4 Sales Cash Conversion Cycle (SCCC) Sales Cash Conversion Cycle is considered as the total time taken since when a corporation purchases raw material, converts into finished goods, sells goods and realizes cash.

Intuitively, Sales Cash Conversion Cycle (in days) = Inventory Conversion Period + Receivables Conversion Period - Payables Conversion Period Explanation of the ratios are as follows: Inventory conversion period Where inventory turnover ratio Receivables conversion period Where debtors turnover ratio 365/inventory turnover ratio Cost of goods sold/average inventory 365/debtors turnover ratio Credit sales/average debtors + average bills receivables Payables conversion period Where creditors turnover ratio 365/creditors turnover ratio Credit purchases/average creditors +

average bills payables

6.5 Cash Budget Cash budget signifies estimation of short-term cash inflows and cash outflows in an organization to plan out its working capital requirements. It includes cash receipts and cash disbursements for that specific period of time.

Cash Receipts Cash Disbursements = Change in Cash

Change in Cash + Beginning Cash + Borrowings Repayments = Ending Cash Balance

Treasury Operations Basics

89

Example: XYZ Inc. needs a cash budget for December 2010. The following information is available: Cash balance on 1st December 2010 is $6,000. November 2010 sales are $80,000 and December 2010 sales are $60,000. Cash collections on sales are 30% in the month of sale, 65% in the following month, and 5% are uncollectable. December 2010 General expenses (budgeted) are $25,000 (depreciation $2,000) November 2010 and December 2010 Inventory purchases are $30,000 and $40,000 respectively. Half of the inventory purchases are always paid for in the month of purchase and the balance is paid in the following month. December 2010 Office furniture cash purchase is $4,000. December 2010 Sales Commission (budgeted) is $12,000. Minimum ending cash balance is $4,000. Bank borrowings are in multiples of $100. Loans are repaid after 60 days.

Cash budget for XYZ Inc. for December 2010 XYZ Inc. Cash Budget December 2010 (figures in USD) Cash receipts (30% of December 2010 Sales) (65% of November 2010 Sales) Total Cash Receipts Cash Payments: General Expenses (25,000 2,000) Purchases (Nov 2010 15,000 + Dec 2010 20,000) Office Furniture 23,000 35,000 4,000 18,000 52,000 70,000

Treasury Operations Basics

90

Sales Commissions Total Cash Payments Change in Cash Beginning Cash Borrowing Repayments Ending Cash

12,000 74,000 (4,000) 6,000 2,000 4,000

Treasury Operations Basics

91

End of Document

Treasury Operations Basics

92