This action might not be possible to undo. Are you sure you want to continue?
Sikkim Manipal University – Distant Education
Name: Registration Number: Learning Center:
Manik Pant 511017114 Chandigarh 03038
Learning Center Code: Course: Subject: Semester:
Masters of Business Administration (MBA)
MA0042 Treasury Management
Directorate of Distance Education Sikkim Manipal University II Floor, Syndicate House Manipal – 576104
Reg no # 511017114
Signature of Coordinator Signature of Center Evaluator Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 1
Q.1 Explain how organization structure of commercial bank treasury facilitates in handling various treasury operations. Ans: Treasury Organisation The treasury organisation deals with analysing, planning, and implementing treasury functions. It deals with issues of profit centre, cost centre etc. The organisations managing interfaces with treasury functions include intragroup communications, taxation, recharging, measurement and cultural aspects. Structure of treasury organisation Figure depicts the structure of treasury organisation which is divided into five groups.
Fiscal: This group includes budget policy planning division, industrial and environmental division, common wealth state relationships, and social policy division. Macroeconomic: This group deals with economic sector of the organisation. It includes domestic and international economic divisions, macroeconomic policy and modeling division.
Reg no # 511017114
Revenue: This group is concerned with the taxes in an organisation. It includes business tax division, indirect tax, international and treaties division, personal and income division, tax analysis and tax design division. Markets: This group mainly deals with selling of products in the competitive market. It includes competition and consumer policy, corporations and financial services policy, foreign investments and trade policy division. Corporate services: This group deals with overall management of the treasury organisation. It includes financial and facilities division, human resource division, business solutions and information management division. Treasury as a profit centre The implementation of treasury in the organisation gains profits in several aspects rather than considering it as a cost centre. It helps in providing market rates to the individual business units for the services provided and thereby making operating costs more realistic. The treasurer is motivated to ensure that more services are provided to make profits in market rate. Organisations also experiences the following disadvantages when considering treasury as a profit centre: Profit is a tempting factor to speculate as it sometimes encourages the organisation to invest in wrong direction that brings depreciation in economy as well growth of organisation. Most of the time is duly spent in arguing with business units with respect to charges over services. There may be excessive additional administrative costs. Centralised and decentralised treasury management Most of the multinational organisations face huge challenges in managing transactions globally. As the organisation expands geographically, it is difficult to access and track accurate and timely cash flow information. As the technology has been adversely developed, the need for centralising treasury has evolved; theoretically centralisation allows the treasurers to exercise greater control over operating organisations. The process of centralisation consists of: Providing centralised foreign exchange and interest rate risk management Dealing with cash management Providing fully centralised treasury including incoming and outgoing payments Centralising business treasury functions enhances the organisation to build economies of scale and rationalise costs during acquisition. Centralisation helps
Reg no # 511017114
to achieve low cost debts, increase investment returns, reduce financial risks and ensure liquidity across the organisation. Decentralisation refers to the challenges of producing overall view of cash position and exposure to risk on a timely basis. Since the organisation contains various recording and reporting information methods, it will be difficult to construct a global risk position while combining information from different sources. In such cases it is impossible to make strategic decisions without access to timely and accurate information during the periods of economic volatility. In a decentralised environment, the company allows its subsidiaries to manage their own payables and payment processes. A lack of standardisation across subsidiaries and automation can lead to risks in transactions like incorrect payments and data redundancy. Treasury management in banks In recent days, most of the Indian banks have classified their business into two primary business segments like treasury operations (investments) and banking operations (excluding treasury). The treasury operations in banks are divided into: Rupee treasury: The rupee treasury carries out various rupee based treasury functions like asset liability management, investments and trading. It helps in managing the banks position in terms of statutory requirements like cash reserve ratio, statutory liquidity ratio according to the norms of the Reserve Bank of India (RBI). The various products in rupee treasury are: = Money market instruments Call, term, and notice money, commercial papers, treasury bonds, repo, reverse repo and interbank participation etc. = Bonds Government securities, debentures etc = Equities Foreign exchange treasury: The banks provide trading of currencies across the globe. It deals with buying and selling currencies. Derivatives The banks make foundation for Over the Counter (OTC). It helps in developing new products, trading in order to lay off risks and form apparatus for much of the industrys self-regulation. The role of policies in strategic management was described in this section. The next section deals with inter-dependency between policy and strategy.
The receipts are in bearer or registered form.2 Bring out in a table format the features of certificate of deposits and commercial papers. The concerned bank issues a receipt which is both marketable and transferable in the market. hence they are riskless in terms of payments and principal amount. Basically they are a part of banks deposit.Reg no # 511017114 Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 1 Q. maturitydated obligations of banks. This contributes to 5/43 . CDs benefit both the banker and the investor. The bankers need not encash the deposit before the maturity and the investor can sell the CDs in the secondary market before the maturity. Ans: Certificate of deposit (CDs) is a short-term instrument issued by commercial banks and financial institutions. It is a document issued for the amount deposited in a bank for a specified period at a specified rate of interest. CDs are interest-bearing. CDs are known as negotiable instruments and they are also known as Negotiable Certificates of Deposit.
CDs can be issued only by the schedule banks. CPs is issued in domestic as well as international financial markets. they are known as Euro-commercial paper. Generally CPs is issued through banks.1 crore. There is no restriction on the discount rate by the RBI.Reg no # 511017114 the liquidity and ready marketability for the instrument. business organisations and no lock-in period. 25 lakh. In international financial markets. The maturity period ranges from three months to one year. It is issued at discount to face value. They are issued in bearer forms on a discount to face value. 5 lakh.5 lakh. RBI formulated a scheme for the issue of CDs. CDs can be issued only by the scheduled banks at a discount rate to face value. The minimum size of the their CDs before the maturity issue is Rs. The maturity period ranges from 30 days to one year. RBI appointed the Vaghul Working Group to study the Indian market for five years. CDs are subjected Statutory Liquidity requirements to CRR and The ceiling amount of CPs should not Ratio (SLR) exceed the working capital of the issuing company. The introduction of CDs in Indian market was assessed in 1980. Commercial paper is a short-term unsecured promissory note issued by large corporations. It is purchased mostly by the commercial banks. It issued by the corporations to raise funds for a shortterm. They are freely transferable by The investors in CPs market are banks. endorsement and delivery. the corporate units registered in India and incorporated units. Non-Banking Finance Companies (NBFCs) and business organisations. dealers or brokers. They are highly liquid as they have buy-back facility. CDs are issued in the multiples of Rs. months to one year CPs is issued in the denomination of Banks are not permitted to buy back Rs. The discount rate depends on the market conditions. They have individuals. 5 lakh or multiples of Rs. Features of CDs in Indian market Features of CPs Schedule banks are eligible to issue CPs is an unsecured promissory note. Commercial Papers (CPs) is a type of instrument in money market and it was introduced in Jan 1990. The CPs is issued in denominations of Rs. Based on the suggestions of Vaghul committee. 25 lakh and the minimum size of the issue is Rs. CPs is negotiable by endorsement and delivery. Sometimes they are issued directly to the investors. CDs have to bear stamp duty at the prevailing rate in the markets The interest rate of CPs depends on 6/43 . CDs CPs can be issued for a maturity period Maturity period varies from three of 15 days to less than one year. As per the scheme.
Master of Business Administration – MBA Semester 4 7/43 .The tangible worth of the issuing company should not be less than Rs.33:1. . The attractive rate of interest in any of these markets. forex market and call money market.The issuing company has to be listed on stock exchange. (ICRA) respectively .5 Crores.Reg no # 511017114 The NRIs can subscribe to CDs on the prevailing interest rate on CPs repatriation basis market.The company should have a minimum credit rating of P2 and A2 obtained from Credit Rating Information Services of India (CRISIL) and Investment Information and Credit Rating Agency of India Limited. 4. affects the demand of CPs. .The current ratio of the issuing company should be 1. The eligibility criteria for the companies to issue CPs are as follows: .
Indian traders buy securities and then issue PNs to foreign investors. It is also not possible to prevent trading in PNs as the entities subscribing to the PNs cannot be restrained from issuing securities on the strength of the PNs held by them. which enables large funds to carry out their operations without revealing their identity. Investors use PNs to enter Indian market and shift to fully fledged FII structure when they are established. whereas all FIIs have to register compulsorily. of the view that FIIs should be prohibited from investing fresh money raised through PNs. These PNs are freely transferable and trading of these instruments makes it all the more difficult to know the identity of the owner. It provides a high degree of secrecy. Detail the regulatory aspects on it. In the case of Participatory Notes (PNs). Existing PNholders may be provided an exit route and phased out completely within one year. The market has found a way to avoid the limitation by creating an instrument called Participatory Notes (PNs). an FII. Any dividends or capital gains collected from the primary securities are returned back to the investors. The Committee is.3 Critically evaluate participatory notes. Instead of moving towards decreasing 8/43 . both the non-resident foreigner and Non-resident Indian pay a hefty premium to a firm which has managed to get the license to operate in the Indian stock market i. PNs are basically contract notes.e. Any entity investing in PNs may not register with SEBI.Reg no # 511017114 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 1 Q. Ans: Participatory notes International entrance to Indian capital market is limited to Foreign Institutional Investors (FIIs). the nature of the beneficial ownership or the identity is not known unlike in the case of FIIs. Non-resident investments in India and use of Participatory Notes (PNotes) All things considered. therefore. The benefits of PNs are as follows: Entities route their investment through PNs to extract advantage of the tax laws system.
and because of higher capital gains taxes in India than in other emerging markets. by delaying entry of individuals into the Indian market until 2008/9. P-notes primarily exist because of the large transaction costs that the Indian system imposes on foreign residents and corporates. Most important. of stock market transactions. (India has a 10 % tax on short-term gains and a 33 percent tax rate on short-term gains made via futures markets. and immediate reversal of existing GoI policy. And is in complete contrast. The Committee’s haste towards an immediate ban of P-Notes. It is the bans and controls on investment by foreign based individuals and corporates that has created the off-shore P-notes market in Indian securities. of industrial houses owning commercial banks – a policy. suggests an ideological bureaucratic predisposition. without any documentation or evidence. and perhaps out of character. So as water finds its way. comparator emerging markets have zero short and long term capital gains taxes. My only issue is that the Report is inconsistent in its recommendations. with immediate implementation.Reg no # 511017114 these transaction costs. incidentally. I support. and reality. by recommending a ban on P-notes. with the Reports endorsement of a new policy. is irrelevant. This GOI report was published in November 2005. is recommending a significant move backwards. Instead of reforming this “license raj”. at least in some institutions in India. given the extreme “caution” with which the report proceeds on other matters. so do investors. the Committee recommends two actions that will further increase these costs: first. Unfortunately. 9/43 . The report reveals a lack of understanding of the underlying fundamentals. The recommendation on industrial houses does not come with any strings attached – somewhat surprising. it reached the opposite conclusion on P-Notes than that reached by the FCAC Committee. That this might be a “politically correct” conclusion. Regrettably. the government of India had also constituted an expert group to look at the issue of “Encouraging FII Flows and checking the vulnerability of capital markets to speculative flows”. and second by recommending a ban on Participatory notes or P-notes. the Committee. Like the FCAC committee. the Report did not deem it appropriate to discuss the influence of such differential tax rates on human and investment behavior). P-Notes (an appropriate response to controls) is considered by the Committee to be of such an undesirable nature that it is recommended that they be banned immediately. The license raj has shifted from the industrial sector to the financial sector.
Most of the countries have liberalised their capital account by having an open account. These developments have led to considerable caution being exercised by EMEs in opening up capital account. making CAC either ineffective or unsustainable. It means freedom of currency conversion in terms of inflow and outflows with respect to capital account transaction. CAC enhances growth and welfare of country. human cost and even extensive presence of capital controls creates distortions. social. The perception of CAC has undergone some changes following the events of emerging market economies (EMEs) in Asia and Latin America. which went through currency and banking crises in 1990s.4 What is capital account convertibility? What are the implications on implementing CAC? Ans: Capital Account Convertibility (CAC) Capital Account Convertibility (CAC) refers to relaxing controls on capital account transactions. both in trade and finance. but they do retain some regulations for influencing inward and outward capital flow. A few counties backtracked and re-imposed capital controls as part of crisis resolution. Due to global integration.Reg no # 511017114 Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 1 Q. The cost and benefits from capital account liberalisation is still being debated among academics and policy makers. Crisis such as economic. The Committee 10/43 .
RBI has introduced more relaxations in current account transactions. India has cautiously opened its capital account and the state of capital control in India is considered as the most liberalised it had been since late 1950s. Relaxing the exchange restrictions has improved the Balance of Payment (BOP) in the country. This is known as current account convertibility.Reg no # 511017114 on Capital Account Convertibility (Chairman: Shri.S. The different ways of implementing CAC are as follows: • • • Open the capital account for residents and non-residents.when the payment exceeds 5% on local sales and 8% increase on exports. The domestic currency is said to be convertible on the current account. The liberalisation rules regarding current account transaction of RBI under FEMA 1999 are as follows: Authorised Dealers of Category . As per the Rule 4 of FEMA (current account transactions). Liberalisation of current account transactions Current account transaction refers to converting domestic currencies freely into foreign currency and vice versa. The benefits of current account transaction are as follows: Current account convertibility enhances the increase of capital inflow in to the country.I banks permits withdrawal of foreign exchange payments below USD 2million by the individuals and approval of Ministry of Commerce and Industry. The authorised dealers (ADs) have been permitted to provide exchange facilities to their customers up to specified limit without prior approval of the RBI. 11/43 . The confidence of a country will be enhanced when the country will manage its affairs without exchange restrictions which enhance the international confidence in the countries policies. it is mandatory to get approval of Ministry of Commerce and Industries for drawing foreign exchange remittances . Approach to simultaneously liberalise control of inflow and outflow account. Tarapore) which submitted its report in 1997 highlighted the benefits of a more open capital account but at the same time cautioned that CAC could pose tremendous pressures on the financial system. The exclusion of exchange restrictions tends to increase the capital inflows and thus promote efficient allocation of inflows to the growth of the countrys economy. S. GOI is not mandatory. Initially open the inflow account and later liberalise the outflow account.
. Liberalisation of Exchange Earners Foreign Currency (EEFC) account . .There can be no remittances made directly or indirectly towards countries identified as non-co-operative countries and territories by the Financial Action Task Force (FATF). . . Under this scheme. Bhutan and Pakistan.The individuals and organisations identified and advised by the RBI as significant risk of committing terrorism are not eligible for any remittances directly or indirectly. But with the changes that have taken place over the last two decades. the residents can remit in any current or capital account up to USD 2 million per financial year. without the prior approval of RBI.Due to liberalisation. These accounts are non-interest bearing and they are used for hedging against foreign currency fluctuations by the business organisations which have exports and imports in foreign currency payments.Reg no # 511017114 Liberalised remittance scheme is a facility extended to the residents of India.RBI has permitted to earn interests on EEFC account if the outstanding balance is USD 1 million. This facility is only for resident individuals.The resident individual cannot remit directly to Nepal. The resident individuals can purchase and hold immovable property or shares or debt instrument outside India. RBI decides on credit and debit limits. it may be considered as a remittance through normal banking and the earnings can be credited to EEFC account. 12/43 .If the reimbursement for an international credit card is provided in foreign exchange. maintain and hold foreign currency accounts with banks outside India. Residents can open. Some of the liberalised measures in EEFC account are: . Other measures The other measure taken towards CAC is fuller capital account convertibility which is explained as follows: Fuller Capital Account Convertibility (FCAC) Indias cautious approach towards capital account and assessing it as a liberalisation process based on certain pre conditions has held India in good state. The liberalised remittance scheme is not applicable for the following: . .EEFC account is a foreign currency account maintained by a resident individual with an authorised dealer in India. all categories of foreign exchange earners can avail credit in this account based on their foreign exchange earnings.Any purpose under Schedule I and any item under Schedule II are prohibited for remittance under Foreign Exchange Management Rules 2000.
Participation of foreign investors in domestic market changes the working of the domestic market. For example. banks have to quote rates and take open positions in new and more volatile currencies. and the timing and sequencing of capital account liberalisation measures. Liquidity risk: It includes risk in foreign currencies denominated assets and liabilities. Cross border transactions introduces country risks to domestic market participants. strengthening of regulation and development of financials markets. The objectives of FCAC are as follows: Economic growth .S Tarapore was the chairman of committee. the change in foreign interest rate.It facilitates economic growth through higher capital investment . S. Likewise. This will help them to diversify their portfolio. infrastructure development and other areas. and political environment of the borrowers country. Diversify the investment: The diversification of investment will help ordinary people. RBI.Huge capital flow into the system will lead to the improvement of financial sector which will enhance performance of the companies. Improvement in financial sector .Markets risks like interest rate and foreign exchange risks become more complicated when financial institutions have access to new markets or securities. affects the banks interest rate and liabilities. to invest in foreign countries without restriction.Reg no # 511017114 India felt the need to revisit the CAC and suggested a new map towards FCAC based on current situations. the risk associated with economic. A transparent financial consolidation is necessary to reduce risk of the currency crisis. The committee suggested several recommendations for the development of financial market in addition to addressing issues related to interaction of monetary policy and exchange rate management. Risk in derivatives transaction It is very important with FCAC as derivatives transaction are main tools used in hedging risks . Large flow of funds in different currencies will expose the banks to greater variations in their liquidity position and complicate their asset-liability management. social. This will enhance the liquidity in the system. in consultation with the Government of India (GOI) appointed a committee on FCAC. Credit risk: It includes a new dimension with cross border transaction.It includes both market and credit risk. regulation and supervision of banks. The risks are as follows: Market risks . 13/43 .This will lead to growth in employment opportunities. Risks involved in FCAC FCAC risk arises from inadequate preparedness before liberalisation in domestic and external sector of policy consolidation.
Inadequate attention on tariff reduction and the rationalisation of tax structure in the adjustment scheme. The limitations are as follows: • • • • • • • Indian industries lack competitive strength. Hence it is desirable to further strengthen their financial base. Limitations of FCAC The effort of making the Indian rupee fully convertible has a number of difficulties involved in it. Inadequate technology for industrial economy. This will result in rupee appreciation which will affect Indian exporters. Consequences of FCAC India might face the following consequences if it implements full convertibility without adequate reform measures: It will have to face the danger of becoming vulnerable to free movement of foreign capital. Though the banks and financial institutions are fully capitalized. they are not fully prepared to handle the intricacies of the fuller convertibility. which may further worsen the macro-economic imbalances. Lack of emphasis on the quality of labour and management practices. The prevailing high interest rates in the economy will attract capital inflow. Absence of prudent fiscal management. Operational risk may increase with FCAC. Lack of resilient exchange rate mechanism at work. Inflationary pressure on the economy.Reg no # 511017114 Operational risk: The difference between domestic and foreign legal rights and obligations and their enforcements is important with FCAC. 14/43 .
depositing cash into a lock box to ensure its protection. This includes enabling greater connectivity to internal corporate systems and providing better IT solutions and services in cash management. The objectives of cash management system are to bring the companys cash resources within control in an efficient manner and to achieve the optimum conservation and utilisation of the funds. control payments to trade creditors and efficiently manage the liquidity margin. Problems in cash management system are as follows: • • • Controlling the cash level. proposition of CMS by HCL in order to enhance its liquidity level. A Cash Management System (CMS) is a companys strategy which includes sustainable investment practices to enhance the collection of receivables. Optimum investment of surplus cash.Reg no # 511017114 Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 1 Q. HCL has set up its cash 15/43 . Ans: Cash Management System Maintaining the channels of collections and accounting information efficiently has become essential with growth in business transaction sections. Keeping in view of the clients special needs.5 Detail domestic and international cash management system. HCL is a recognised leader in multi-service delivery engagement services. CMS involves hiring a debt collection service to recover the borrowed property by a customer. For example. Controlling inflows and outflows of cash.
Business process outsourcing. It affects the reserve levels and hence the monetary base. Prudential guidelines Regulatory bodies require the deposit money banks to exercise particular care in their operations to fulfil the specified outcomes. Open market operations The regulatory body trades securities like treasury bills to the banking and non-banking public. Lending by the central bank The regulatory body sometimes provide credit to deposit money banks. Exchange rate By trading foreign exchange. Domestic Cash Management System Reserve requirement The regulatory bodies like RBI instructs the banks to hold the deposit reserves of the public as cash and deposit. the regulatory body ensures that the exchange rate is at levels that do not affect domestic money supply in 16/43 . Few features of HCLs cash management system are as follows: • • • • • • Application designing and development. The reserves requirement limits the amount of loan that banks can lend to the domestic economy and thus limit the supply of money. HCL has an enthusiastic domain practice team for cash management activities which includes bankers and IT professionals from various global banks and techno functionalists who have worked on cash management systems for global banks.Reg no # 511017114 management system. Vital elements of prudential guidelines remove some choices from bank management and replace it with certain decision making rules. Consulting services to select a suitable platform. Direct credit control Regulatory bodies direct banks on maximum percentage or amount of loans to different economic sectors. System integration services. Application re-engineering. In this way the available savings are allocated and investments are directed in significant directions. The domain practice team supports the product development and delivery teams by continuous training and builds the required competency across the organisation. The central bank reduces the supply of reserves by selling the securities and increased the supply of reserves by purchasing securities to the deposit money banks and thus affecting the supply of money. liquid asset ratio. Infrastructure management.
Difference in tax rates. Political risk and other risk. through the balance of payments and the real exchange rate. Several factors which distinguish multinational cash management from domestic cash management are as follows: • • • • • • Different currency denominations. The reasons for which the firms expand into other countries are as follows: • • • • • Seeking new markets and raw materials Seeking new technology and product efficiency. payable periods.Reg no # 511017114 undesired direction. import duties. Expanding its business. The payments between the branches and the parent company are managed through the 17/43 . The multinational cash management programme effectively achieve its goals by using excess cash flow from some units across the globe to extend cash needs in other units which is called in-house banking and by relocating funds for tax and foreign exchange management through repricing and invoicing. Preventing the regulatory obstacles. Decision making within the corporation is centralised in the home country or decentralised across the countries where the organisation does its business. Economic and legal complications. Multinational Cash Management The strategy of a company which has its businesses in many nations and efficiently manages its cash and liquidity is called multinational cash management programme. During multinational cash management system payments by customers to companys branches are basically handled through a local bank. Language and cultural differences. Role of governments. Multinational companies are those that operate in two or more countries. The principle objective of multinational cash management programme is to maximise a companys financial resources by taking benefits from all liability provisions. The main goal of multinational cash management is the utilisation of local banking and cash management services. Retaining customers and protecting its processes.
Multinational cash management programme specifically evaluate its techniques by timing of billing.6 Distinguish between CRR and SLR. head office to branches and so on. Wincor Nixdorf played an innovative role in enhancing cash handling between various countries. crediting to the retail company's account. negotiated value range. Wincors focus was on the entire process chain which started from head office to stores. For example. Through the use of electronic reporting systems a parent company observes cash balances in its foreign local banks. The exchange rates are determined by a structure which is called the international monetary system. The multinational cash management system involves exchange rate risk which occurs when the cash flow of one currency during transformation to another currency the cash value gets declined. Ans: Cash Reserve Ratio 18/43 .Reg no # 511017114 branches. IT services to side operations and consulting services to develop custom optimised solutions. Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 1 Q. Wincor Nixdorf's served several countries with its innovative hardware and software elements. It occurs due to the change in exchange rates. use of lockboxes or intercept points. correspondents or associates of the parent company.
Reg no # 511017114 Cash Reserve Ratio (CRR) is a countrys central bank regulation that sets the minimum reserves for banks to hold for their customer deposits and notes. The reserves are in the form of authorised currency stored in a bank treasury (vault cash) or with the central bank. The CRR in the economy as declared by RBI in September 2010 is 6 percent. The nonpayer bank pays an interest as penalty which is above the actual bank rate. CRR is also called liquidity ratio as it controls money supply in the economy. As gold and government securities are highly liquid and safe assets they are included along with cash. It means the percentage of demand and time maturities that banks need to have in forms of cash. then the banks available cash drops. After following the requirements. Increase in SLR also limits the banks leverage position to drive more money into the economy. CRR is occasionally used as a tool in monetary policies that influence the countrys economy. RBI practices this method. There are some statutory requirements for placing the money in the government bonds. increases CRR rate to drain out excessive money from banks. that is. CRR in India is the amount of funds that a bank has to keep with the RBI which is the central bank of the country. If RBI decides to increase CRR. The RBI increases the SLR to control inflation. extract liquidity in the market and protects customers money. The maximum limit of SLR is 40 percent and minimum limit of SLR is 25 percent. If any Indian bank fails to maintain the required level of SLR. The main objectives for maintaining SLR are the following: 19/43 . The following are the effects of CRR on economy: • • • CRR influences an economys money supply by effecting the potential of banks CRR influences inflation in an organisation CRR stimulates higher economic activity by influencing the liquidity Statutory Liquidity Ratio Statutory Liquidity Ratio (SLR) is the percentage of total deposits that banks have to invest in government bonds and other approved securities. These reserves are considered to meet the withdrawal demands of the customers. An organisation that holds reserves in excess amount is said to hold excess reserves. the RBI arranges the level of SLR. gold and securities like Government Securities (G-Secs). In India. RBI determines the percentage of SLR. then it is penalised by RBI.
Reg no # 511017114 • • • By changing the SLR level. the RBI increases or decreases banks credit expansion Ensures the comfort of commercial banks Forces the commercial banks to invest in government securities like government bonds 20/43 .
It analyses the price and risk profile of financial dealings on a pre-dealing basis. Many organisations suffer from foreign exchange risk by making purchases or sales in foreign currency or by owning assets or liabilities in foreign countries. Hence a relevant course of action must be implemented to reduce exposures in business operations.Reg no # 511017114 Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 2 Q. Commodity exposure: This happens due to variations in the prices of commodities which change the future and magnitude of market values.1 Explain any two major risks associated with banking organization. Hence the identification of existing potential currency relationship that arises from business activities includes hedging and other risk management activities. The exposure in foreign exchange market is intense. Currency exposure: It deals with future cash flows arising from domestic and foreign currencies that involve assets and liabilities and generating revenues which are susceptible to variations in foreign currency exchange rates. quantity. Ans: Treasury exposure allows treasury management to various risks in the organisation. Hence treasury management is liable to deal with various risks like price. Event exposure: This happens due to a sudden change in the financial market during an investment (an event) that has a detrimental effect on the value of that investment. Need for risk management 21/43 . Foreign exchange exposure: This occurs due to the low profits and adverse fluctuations in foreign exchange rates. hence hedging towards these risks by integrating business exposures and treasury transactions helps an organisation to manage financial risk and stay profitable. The commodities depend on any production including foreign currencies. cost that are associated with commodities. financial instruments or any physical substances. It is often associated with corporate bonds. Following are the few treasury exposures in an organisation: Financial exposure: The treasury management in the organisation are disclosed to the powerful analytics that enable to measure the global treasury operations and control financial market risks.
It is the responsibility of the organisation to manage risk effectively and overcome hindrances affecting the overall growth of the organisation. credit and operational risks. The operational risk occur due to certain factors like back office errors. diversity in business activities and sources of capital etc. fraud. . Hence the corporate risk manager quantifies the exposures occurring in the organisation to reduce risks that hamper the financial sector. It helps to control the negative political.Reg no # 511017114 Risk management helps in minimising the failure of business activities which are based on finance or performance in the organisation. Hence the manager is responsible to identify the risk and implement relevant actions to eliminate it. and commodity prices. economic. The value of an organisation depends on the changes in exchange and interest rates. It helps in increasing the ability to deliver products to the customers within the stipulated time and reduce the production cost. Corporate risk is a redundant activity. social or safety issues or regulatory and licensing conditions available in most of the organisations. A complete and accurate exposure calculation can eliminate the hidden risks. Corporate risks Corporate risks include non-financial organisational risks that arise during challenging times in the economy. and effective use of resources among the stakeholders in the organisation. Hidden risks Hidden risks are related to cash and financial risk in an organisation. Financial risk is the 22/43 . These risks might harm the growth of an organisation. Hence risk management is required in the organisation for the following purposes: • • • • • • To identify the risk in business activities and establish a plan to manage risk and minimise the negative effects. According to the assumptions of Modiglani and Miller (1958). and financial factors which may harm an organisations growth. To focus on internal audit process and robust contingency planning. It is mainly concerned with progressive tax rate and expecting costs from financial distress. natural disaster etc. To overcome sensitive internal environment. Corporate risk is further divided into market. To improve the efficiency of strategic and business plans. The organisation faces market risk with respect to commodity price risk and foreign exchange risk. The corporate risk varies for different organisations based on factors like size. Hidden risks are also concerned with financial accounting. Credit risk experiences less challenges compared to operational and market risks.
The marginal gap refers to the difference between the changes of assets and liabilities over time. 23/43 .Reg no # 511017114 probability when an actual return on an investment is lower than the expected return. At any point of time. a positive gap between assets and liabilities is equivalent to shortage of cash. The gap profile changes as and when new assets and liabilities are added. Lower uncertainties have lower variations in net cash flow. Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 2 Q. Uncertainties related to several risks affect the net cash flow of any business organisation. A positive marginal gap means that the change in the values of assets exceeds that of liabilities. and vice versa.2 What is liquidity gap and detail the assumptions of it? Ans: A liquidity gap is the difference between the due balances of assets and liabilities over time. They are the uncertainties in business leading to variations in expected profits and losses. Depending on the behaviour of cash flow the alternative scenario calculates a banks liquidity in different conditions. The gap profile is represented either in the form of tables or charts. Alternative scenarios Alternative scenario method is used to calculate the adequate liquidity in banks. All the assets and liabilities are accounted in liquidity gap report and it is dependent on the dates of maturity and the actual date.
Reg no # 511017114 There are three scenarios for a bank that provides useful benchmarks. The main idea in bank specific crisis is that. The combined results will suggest the size of the total liquidity buffer in the banking system. Assumptions in preparation of gap report in terms of assets. the Central bank might find this scenario to be of particular interest. If a bank can survive these types of worst-cases. The crises remain restricted to the banks and provide a sort of worst-case benchmark. The result also suggests the likely distribution of liquidity problems among large institutions. Some banks might think that the nations Central bank would ensure that the key markets would continue to function in some form. Banks use general market conditions to handle the deposit and other debts. then the bank can survive any kind of small problems. The banks must pay the liabilities at the time of maturity. liabilities and off balance sheet items 24/43 . While surveying the liquidity profile of entire banking sector. Going concern/general market conditions The going concern/general market conditions scenario is helpful for banks in establishing a standard for the normal business behaviour. With the help of general market conditions the banks avoid the impact of temporary constraints and manage their NFRs. Due to this concern. General market crisis The general market crises are the ones under which liquidity affects every bank in more than one market. For bank management. A bank needs to assign the time for cash flow for each category of asset. The decision about the exact time and size of cash flows is an essential part of the construction of the maturity ladder under every situation. the banks liabilities cannot be replaced or rolled over. the scenario represents a second type of "worstcase". They are: • • • Going concern Bank specific crisis General market crisis A bank should try to account for any major liquidity changes (positive or negative) that could occur in these scenarios. the banks never face a very large need of cash to be paid on any given day. Bank specific crisis The bank specific crises are liquidity crises for individual banks.
A less liquid group of assets consists of bank's saleable loan portfolio. assumptions play an important role in determining the continuing due to the rapidly changing banking markets. Some of the assets might instantaneously be converted into cash at existing market values under almost any situation whereas others. 25/43 . The least liquid group of assets consist of basically unmarketable assets such as loans that are not capable of being readily sold. bank premises and investments in subsidiaries. and off-balance sheet assets. This would include forming: The level of roll-overs of deposits and other liabilities remain normal. To determine the marketability of an asset. such as interbank loans might lose liquidity in a common crisis. a bank should first examine the behaviour of its liabilities under normal business situations. liabilities. different banks can allot the same assets to different groups on maturity ladder. might be viewed as unsaleable within the time frame of the liquidity analysis. Liabilities To check the cash flows occurring due to a bank's liabilities. there may be assets which are much liquid then during a time of crisis. the normal growth in new deposit accounts.Reg no # 511017114 Since the future liquidity position of a firm cannot always be predicted based on the factors. banks should take care of the effects on the assets liquidity under the various conditions. Under normal conditions. They are assets. the method segregates the assets into three categories according to their degree of relative liquidity: The highly liquid group of assets consists of components such as interbank loans. cash and securities. While categorising the assets. The assignment here is to develop assumptions about a reasonable plan for the clearance of a bank's assets. such as demand deposits and others. Therefore a bank may classify the assets according to the type of scenario it is forecasting. The actual maturity of deposits with non-contractual maturities. Assets Assets are nothing but any item of economic value owned by an individual or corporation. The assumptions can be made based on three aspects. Some assets. Because of the difference in the banks internal asset-liability management. Assumptions regarding a banks future stock of assets include their possible marketability and use an asset as a guarantee of existing assets which could increase flow of cash and others. while marketable. But the number of assumptions to be made should be limited.
includes core deposits that are not already included in the first category. Factors such as diversification and relationship building are considered important during the evaluation of the degree of the outflow of funds and a bank's capacity to replace funds.Reg no # 511017114 While examining the cash flow arising from a bank's liabilities during the two crisis scenario. as such money may flow to government securities and other safe refuges. is unaffordable in the very short term. including some without contractual maturities. Which maturing liabilities can be estimated to run off instantly at the first warning of trouble? The third category consists of the maturing liabilities that remained. such as wholesale deposits. And help in creating a time table. The four questions are as follows: What are the different sources of funding that are likely to stay with a bank under any situation. or because the cost of changing banks. some of the interbank deposits and government funding remains with the bank even though they are considered volatile . Nevertheless. Liabilities. Some core deposits generally remain with a bank because retail and small scale industry depositors may rely on the public-sector security net to shield them from occurring loss. a bank's capital and term liabilities that are not maturing within the prospect of the liquidity analysis provide a liquidity buffer. The first two questions represent the proceedings in the flow of cash that tend to reduce the cash outflows planned directly from contractual maturities. In some countries. Under each case. other than core deposits. The total liabilities identified in the first category may be assumed to stay with the bank even when its a worst scenario.for these kinds of cash flows a bank's very own past experience related to liabilities and the experiences of other such firms with similar problems may come handy. in a general market crisis. sometimes high scale firms may find that they receive larger than the usually got wholesale deposit inflows. What are the sources of funding that can be estimated to run off gradually if problems occur. this approach adopts a conservative stand and assumes that these remaining liabilities will be paid back at as early as possible before the maturity date. and at what rate? Is deposit pricing a way for controlling the rate of runoff? The second category consists of liabilities that have chances of staying back with the bank during the period of slight difficulties and can be used during crisis. especially when there is high crisis. even though there are no cash inflows existing for other firms in the market. and can the count of these sources be increased? Other than the liabilities identified from this step. a bank would look at four basic questions. especially for some business services that include transactions accounts. 26/43 .
and whether or not the total net pay-out is significant. and forward foreign exchange rate contracts. These activities could result in an unexpected cash loss. Such facilities usually need to undergo many changes but only to a limit. and then estimate the possibility a raise in these flows during periods of stress. These facilities are rarely found in larger banks but however it depends on the assumptions made on the banks liabilities. A bank may be able to create a "normal" level of out flow of cash on a regulatory basis. The banks too need excess funds to support extra operations. Other possible sources of cash outflows are swaps. especially in a bank specific crisis. but are usually not dependent on a bank's condition. Off balance sheet item A bank should also examine the availability of sufficient cash flows from its off balance sheet activities (other than the loan commitments already considered). even if they are not a portion of the banks recent liquidity analysis.Reg no # 511017114 Does the bank have a reliable back-up facility? For example. with a possibility that in a bank-specific or general market crisis. there might be some of the factors that might have a major impact on the cash flows. Other assumptions Until now the discussion was centered on the assumption about the behaviour of the specific instrument under different scenarios. customers with inthe-money swaps (or a net in-the-money swap position) would try to reduce their credit exposure to the bank by requesting the bank to buy the swaps back. In addition. along with hedges if any against these positions. it would then want to study the circumstances under which it could become a net payer. represent potentially significant cash outflow for a bank. The need for liquidity arises from business activities. At the time of looking the components exclusively. Similarly. 27/43 . such as letters of credit and financial guarantees. the Contingent liabilities. a bank would like to review its written OTC options book and any warrants that are due. since certain types of crises sometimes arouse an increase in early exercises or requests that the banks should buy the offer back. small banks in local areas may also have credit lines that they can bring down to offset cash discharges. However. Consider another situation wherein a bank acts as a swap market-maker. a general market crisis may generate a considerable increase in the total invocation of letters of credit because of an increase in defaults and liquidations in the market. written Over-The-Counter (OTC) options. consider that a bank has a large swap book. if hedges can neither be quickly liquidated to generate cash nor provide insufficient cash. For instance.
Loanable funds theory 28/43 . In every case the rate of interest is charged on the total asset values. the majority of the banks provide clearing services to financial institutions and correspondent banks. These institutions generate a major sum of cash inflow and cash outflows and unpredicted variations in these services can reduce a banks funds to a large extent. time preference theory. Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 2 Q.3 Explain loanable fund theory and liquidity preference theory. each type of debt instruments in the market considers factors like inflation. We will discuss few of the interest theories in the succeeding section. compound interest.Reg no # 511017114 For example. cumulative interest or return. classical theory of interest. Different types of interest terms exist in todays global economic environment which has its own identical meanings like simple interest. bond market and financial market. opportunity cost. Before calculating the rate of interest. the impact of interest rates on the economy is very significant. mathematical theory. There are various interest rate theories given by several economists like loanable funds theory. But they can be sources of cash outflows in some cases. Ans: Here we will discuss about the theories on interest rate whose main focus is on the charged amount to be paid against the borrowed money. fixed and floating rates of interest. The rate of interest in the global investment market is determined according to the existing conditions of the retail economic organisations like banks. and interest rate risk. Investment being a function of interest rates. The other expenses such as rent and salary however are not given much importance in the analysis of the banks liquidity.
According to this theory. and willingness to enhance cash balances. Banks offer interest to investors to compensate for their liquidity losses which ultimately promote long-term investments. amount of savings made. M. Also an increase in the supply of loanable funds results in the fall of interest rate. explains the relation between the generation of a debt instrument and its maturity period. the generation of the debt instrument that has a longer periodic term is higher compared to debt instruments having shorter term periods. but deals with the risks associated with maturity. The loanable funds theory encourages that both savings and investments are responsible for the determination of the rates of interest. which arranges the quantity of money which the public will hold when the rate of interest is given. The liquidity preference theory does not deal with liquidity. proposed by J. if the investors possess debt instruments that have longer term periods then they will receive a premium of the rates of interest over a long-term period. the risks related to the maturity of debt instruments are directly proportional to the length of the maturity period. The short-term interest rates are assessed on the basis of the financial conditions of an economy. who was a well-known Swedish economist. The liquidity preference theory states that investors maintain their funds in liquid form like cash rather than less liquid assets like stocks. bonds and commodities. As a result of the premium. In case of loanable funds theory the determination of the interest rates depends on the availability of the loan amount. Liquidity preference is a potentiality or functional tendency. The concept was created by Knut Wicksell (1851-1926). It was widely accepted before the work of the English economist John Maynard Keynes (1883-1946). Liquidity premium stabilises the financial risks that the investors have suffered due to the investment in debt instruments that had longer term periods. The availability of loan amount is based on certain factors like net increase in currency deposits. Keynes. This premium is known as the liquidity premium.Reg no # 511017114 Loanable funds theory explains that the calculation of the rate of interest is on the basis of demand and supply of loanable funds which are available in the capital market. An increase in the demand of loanable funds leads to an increase in the interest rate and vice versa. 29/43 . Liquidity preference theory The liquidity preference theory or liquidity preference hypothesis. If both the demand and supply of the loanable funds changes. According to the liquidity preference theory. the resultant interest rate depends on the level and route of the movement of the loanable funds.
Speculative motive It is the object of securing profit from knowing better than the market what the future will bring forth. The liquidity preference theory also proposes the concept of risks and liquidity premium to predict the future rates. The following are the three divisions of liquidity preference: • • • Transactions motive It is the need of cash for the current transaction of personal and business exchanges. Cause of liquidity preference Liquidity preference theory is preferred among most of the theories. Precautionary motive It is the desire for security as to the future cash equivalent of a certain proportion of total resources. we cannot be sure whether this is the result of investors expecting interest rates to rise in the future.4 Explain various sources of interest rate risk. when the yield curve rises up. M the quantity of money and L the function of liquidity preference. Investors have a preference for investing in short-term securities. It depicts that the yield curve slope is influenced by the expected interest rate changes and the liquidity premium that investors require on long-term bonds. when the market interest rates change. The liquidity preference theory is a short-run model of interest rate determination. Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 2 Q. the long-term bonds must offer a return that exceeds the expected return on a series of short-term bonds. Therefore. we can define M = L(r).Reg no # 511017114 so if r is the rate of interest. It describes economic fluctuations around the long-run drift. Ans: 30/43 . The added risk prevents some investors from investing in long-term bonds. the prices of long-term bonds fluctuate more than the prices of short-term bonds. To attract investors. The liquidity preference theory recognises this problem. But. It provides a suitable analytical framework to investigate the role of monetary policy and the financial system.
The inverted yield curve refers to the economic recession period. The variations in movements of interest rates changes when the yield curve of a market flattens or steepens in the interest rate cycle. The short term interest rates are lower than long term interest rates and hence the occurring fluctuation exposes the organisation to maturity gap of interest rate risk. It is called as flat curve. The yield curve flattens when the short term interest rates increases across the long term interest rates. This yield curve is known as normal yield curve. It poses significant threat to the incomes and capital investments of the organisation. This occurs during the transition of the normal yield curve to an inverted curve. The effects of recession impose negative impacts to the organisation hence they must concentrate on diversifying the investment portfolio. Yield curve risk The yield refers to the relationship between short term and long term interest rates. The yield curve slopes upwards when the short term interest rates are lower than the long term interest rates. The changes occurring in interest rate affects the value of underlying assets of the organisation. Therefore the market status overviews the yield curve of long term interest rate as decline in the long term fixed income of the organisation. It changes the price values of interest bearing asset and liability based on the magnitude level of fluctuations in interest rates.Reg no # 511017114 The interest rate risk adversely affects the organisations financial situation. Figure 1 depicts the normal yield curve Figure 1: Normal Yield Curve 31/43 . The yield curve risk occurs due to the yield curve fluctuations which affect the organisations income and economic values of underlying assets. We shall discuss some of the sources of interest rate risk in the following subsections.
an organisation holds large untraded stocks.Reg no # 511017114 Figure 2 depicts the inverted yield curve Figure 2: Inverted Yield Curve The yield curve has major impacts on the consumers. Hence to overcome this issue. Basis risk Basis risk occurs due to the changes in relationship between the various financial markets or financial instruments. In the banking organisation basis risk occurs due to the differences in the prime rate and offering rates on money market deposits. The changes of interest rates can give rise to unexpected changes of asset and liability cash flows and earnings. Hence the consumers who invest in financing properties experience higher mortgage payments. the company enters into futures contract with stock index. The basis risk changes the storable commodities based on the changes of the storage costs over a period of time. saving accounts. The fixed rate loans will be encouraged when the short term rates exceeds the long term rates. The basis risk affects the profits of an organisation by striking the cash positions. The fixed income investors are benefited with better returns with short term investments due to the elimination of risk premium for long term investments. During the phase of inverted yield curve the margins of the profits decline such that the organisation at short term rates borrow cash and lend it at long term rates to gain profits. If the company tries to sell those stocks in wholesale. For example . Optionality risk 32/43 . This reduces the liquidity risk but increases the basis risk due to the differences between the selling and stock index prices. it experiences liquidity risk because the selling prices may be depressed in the market. equity and fixed income investors. The different market rates of financial instruments differ with time and amounts.
Embedded option risk The embedded option refers to other option securities such as bonds. The option holder experiences limited downside risk (paid amount) and unlimited upside reward whereas the option seller has unlimited risk and limited upside reward. Therefor it has more downside exposure than upside reward. The bank faces losses during the sold position option to its customers. Hence during the decline of rates the customers will perform prepaying loan process which shortens the banks asset maturities while the bank desires to extend it. Most of the banking organisations allow prepayment option of commercial loans which includes the prepayment process without any penalties. liabilities. financial instruments. The value of the bond 33/43 . Repricing risk affects the banks earnings performance. There are chances of losses in banks capital value due to unfavourable interest rate movements such that it exceeds the profits that a bank gains. It occurs during the process of altering the banks instruments levels of cash flows by banks customers or by bank itself. The option allows the option holder to buy or sell financial instruments. The income of the liability sensitive bank increases during the fall of interest rates and declines when the interest rate increases. The banking organisations must consider long term imbalances during the repricing risk evaluation. If the gauging of long term repricing is improper. It is measured by comparing the liability volume with asset volume that reprice within specified period of time. The embedded option is a part of another instrument which cannot be separated. during the favourable movements. The callable embedded option bond consists of hold (option free bond) option and embedded call option. there are chances of bank experiencing variations in interest rate movements of future earnings. Repricing risk Repricing risk arises due to the differences between the timing of rate changes and cash flows occurring in pricing and maturity of banks instruments such as assets. bond loans and so on. exchange traded options. liabilities and off balance sheets. It usually results in a risk or rewards to the bank. the asset sensitive bank benefits from rise in rates and detriments with fall in rates. The stand-alone instruments are explicitly priced and are not linked with other bank products.Reg no # 511017114 Optionality risk arises with various option instruments of banks like assets. Since the banks focus on short term repricing imbalances are initiated to implement increase interest rate risk by extending maturities to improve profits. The repricing risk increases the earnings of the banks. The options are traded in banks with stand-alone instruments such as over the counter (OTC). Inversely. Liability sensitivity occurs in banking organisations since repricing asset maturities are longer than the repricing liability maturities.
The decline in interest rates increases the callable option price bond. The exceeding 34/43 . The price of callable bond is equal to the price of hold option bond minus price of call option bond. Figure 3: Value of Embedded Call Option The embedded putable bond consists of option free bond and embedded put option. Figure 3 depicts the value of embedded call option varying with respect to changes in interest rates. Figure 4: Value of Embedded Put Option The organisations must handle the options effectively such that the various types of bonds under embedded option are exposed to low level of risks.Reg no # 511017114 changes according to the changes occurring in interest rates of embedded options values. During the selling process of financial instruments there are chances of exposure to significant risks since the holding options are explicit and embedded which provides advantage to holder and disadvantage to seller. The price of putable bond is equal to price of option bond plus price of embedded put option. Figure 4 depicts the value of embedded put option which is obtained by the changes in interest rates.
Primarily. investments and loans. Even though it is impossible to eradicate all risks. To reduce the variability of the cash flows of business. effective foreign exchange risk Objectives of foreign exchange risk management Foreign exchange risk management in a bank requires well defined objectives which must reflect the organisations attitude towards foreign exchange risk. while enabling international banks to compete abroad.Reg no # 511017114 number of options can implicate leverage magnifying the positive or negative influences of financial options positions in the organisation. The objectives of foreign exchange risk management are as follows: • • 35/43 To minimise the possible currency losses. negative exchange outcomes can be predicted and managed effectively by individuals and corporate entities. Evolving and applying suitable and management and control procedures.5 Detail Foreign exchange risk management and control procedure. . Master of Business Administration – MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set – 2 Q. Ans: Foreign Exchange Risk Management Foreign exchange risk management is intended to preserve the value of currency inflows. a foreign exchange risk management plan requires: Establishing and executing comprehensive and prudent foreign exchange risk management policies. the objectives of foreign exchange risk management must be in line with the corporate objectives set by the bank. Although the foreign exchange risk management is different for various banks based on the nature and complexity of their foreign exchange activities.
To develop possible solutions to avoid the negative influence of adverse currency movements in foreign exchange. Limits of forex risks . entities.Risk limits are established according to the relationship between the foreign exchange position and the capital. and must include the following: . . To outline enhanced procedural guidelines for ongoing control and management of foreign exchange risk. The foreign exchange risk limits cover the following: . .Before setting up the foreign exchange risk limits and management controls it is necessary for banks to decide the goals of foreign exchange risk management plan and in particular.The restrictions placed on the use of delegated authority. . Delegation of authority . Foreign exchange risk management tools and techniques 36/43 . Foreign exchange risk management policies Well defined policies. the objective of foreign exchange risk management is to manage the influence of exchange rate changes within self-imposed limits after considering a wide range of possible foreign exchange rate scenarios. The delegation of authority needs to be clearly recognised. positions or committees to whom authority is being delegated.The ability of receivers to further delegate authority.The absolute and/or incremental authority to be delegated.The currencies in which the institution is permitted to experience risk exposure.Clearly defined levels of delegated authority helps in ensuring that a banks foreign exchange positions does not surpass the limits established under the foreign exchange risk management policies. The foreign exchange risk management policies include the following: A statement of forex risk principles and objectives . . set forth the objectives of the banks foreign exchange risk management strategy and its parameters.Reg no # 511017114 • • • To assist individuals involved in foreign exchange management in the implementation of updated procedures of foreign exchange risk.The units. readiness of the bank to assume risk. or according to the foreign exchange volume which includes total cash and the number of transactions.The level of foreign currency exposure that the bank is willing to assume. Therefore.
CHF . The right to buy is a call.It is the British Pound (Sterling) to US Dollar futures market. Currency options A currency option is an alternative tool for managing forex risk. The specified rate is called the forward rate.It is the Swiss Franc to US Dollar futures market. The difference between forward contract and other sales contracts is that the delivery and payment of the commodity occurs at a specified future date in case of forward contracts.Reg no # 511017114 Various tools and techniques are used for measuring foreign exchange risk management. the right to sell is called as put. counter party risk as prevalent in Forward contracts is prevented. A foreign exchange option is an agreement for future supply of a currency interchanged with another. where the owner of the option has the right to buy (or sell) the currency at a settled price. A forward contract is an agreement to buy or sell foreign exchange for an amount determined in advance. The major currency futures market is the EUR futures market. the designated date the settlement date or delivery date. For such situations currency futures are more suitable. based upon the Euro to US Dollar exchange rate. Currency futures Currency futures are forward contracts in which two parties agree between them to exchange something in the future. and include the following futures markets: EUR . For such a right the holder pays a price called the option premium.It is the Canadian Dollar to US Dollar futures market. Forward contracts are privately exchanged and are not standardized. As futures contracts are traded on exchange with appropriate controls. CAD . at a specified exchange rate at a designated date in future. Some of the foreign exchange management tools used are as follows: • • • • Forward contracts Currency futures Currency options Currency swaps Forward contracts Foreign exchange forward contracts are the most common resources for hedging transactions in foreign currencies. The 37/43 . The most popular currency futures are provided by the Chicago Mercantile Exchange group. This gives rise to counterparty risk or default risk arising out of failure of the other party to honour its commitment.It is the Euro to US Dollar futures market. GBP .
whether its risk-averse.Procedural controls: To ensure that the transactions are completely recorded in the accounts of the banks. Currency swaps Currency swaps deal with the exchange of payments in different currencies between two trading partners. 38/43 .Reg no # 511017114 option seller receives the premium and is indebted to make (or take) delivery at the agreed-upon price if the buyer exercises his option. Foreign Exchange Risk Management (FERM) and control procedures Each of the banks engaged in foreign exchange activities is responsible for evolving.The impact of potential exchange rate changes on the bank. the main elements of any foreign exchange control plan are well-defined procedures governing: . . Control of foreign exchange activities: Though the controls of foreign activities vary widely among the banks depending upon the nature and extent of their foreign exchange activities. Foreign exchange risk management procedures include the following: Systems to measure and monitor foreign exchange risk Management of foreign exchange risk involves a clear understanding of the amount of risk and the influence of exchange rate changes on the foreign currency exposure. In devising a firms FERM policy. Therefore. . adequate information must be readily available to permit suitable action to be taken within the acceptable time period.e. the firms ability to alter exposed positions i. applying and supervising procedures to manage and control foreign exchange risk based on the risk management policies.The risk exposures related to foreign exchange trading. in which the winning party obtains payment at the end of the swap term. each of the banking organisations engaged in foreign exchange activities must have an operative accounting and management information system in place that records and measures the following accurately: . the competitors stance and most importantly regulatory requirements. they are promptly and correctly settled and to identify unauthorised dealing instantly and reported to the management. certain factors have to be taken into account the firms exposure. riskindifferent or risk-seeking. In order to make these determinations. general attitude towards risk management. the maximum exchange loss it can absorb without much impact.Organisational controls: To guarantee that there exists a clear and effective isolation of duties between those persons who initiate the foreign exchange transactions and are responsible for operational functions of foreign exchange activities. For productivity currency swaps feature netting.
Ensure that employees involved in foreign exchange risk management are given accurate and complete information about the institutions foreign exchange risk policies. .Reg no # 511017114 . Banks must use them to ensure compliance with.Ensure operative management controls over foreign exchange positions. risk limits and positions. Independent inspections/audits Independent inspections/audits are an important factor for managing and controlling a banks foreign exchange risk management plan. . the foreign exchange policies and procedures.Ensure adherence to the foreign exchange management policies and procedures. . counterparty and other limits and those excesses are reported to the management. Independent inspections/audits should examine the banks foreign exchange risk management activities in order to: .Other controls: To make sure that the foreign exchange activities are supervised frequently against the banks foreign exchange risk.Ensure that the foreign exchange hedging activities are consistent with the banks foreign exchange risk management policies and procedures. Master of Business Administration – MBA Semester 4 MA0042 Treasury Management 39/43 . and the integrity of.Verify the capability and accurateness of the management information reports regarding the institutions foreign exchange risk management activities. .
VaR has become an established risk exposure measurement tool. it should be moderately simple to calculate if we can derive a probability distribution of potential values. the three basic approaches used to calculate VaR are: • • • Variance covariance method Simulation approaches Extreme value theory Variance covariance method Variance covariance method is an approach that has the advantage of simplicity but it is limited by the difficulties related with derived probability distributions. In spite of the variations in different approaches to compute VaR. or implement both. Risk metrics contribution Risks metrics contribution has two major basic contributions. The price of the components is also exposed to risk factors like delay in time and the expected volatility of the underlying assets returns. They are making variance and covariance method freely available to everyone. If back testing. Ans: Approaches to Compute VaR In most of the organisations including financial and non-financial sectors.6 Describe the three approaches to determine VaR. The method of mapping equity positions through beta is often used in this approach as it is a very crucial stage in computing VaR. improve the mapping process. and providing easy access to compute the VaR logically for a portfolio. The measure of VaR can be calculated analytically through assumptions about return distributions in market risks.Reg no # 511017114 (Book ID: B1311) Assignment Set – 2 Q. Multiple approaches are used to compute VaR and they have numerous variations. the risk manager should try to analyse whether to change methodology. The following 40/43 . and the variances across these risks. a method which is discussed later in this unit indicates that VaR estimations are not accurate. As VaR measures the probability of loss going beyond a specific amount in a particular time period. But it is simplistic as it neglects the following factors while calculating VaR for nonlinear positions: The relationship between the underlying asset price and the potential value of the component of a portfolio is nonlinear.
It is assumed that the return divided by the forecasted standard deviation is normally distributed.Reg no # 511017114 assumptions underlying the computations of VaR are described by publications by J. This approach 41/43 . few recommended improving the sampling methods and data innovations. The focus on normal standardised returns attains more exposure of VaR estimation to the frequent outliers risks than that could be assumed with a normal distribution. extracting a sample from the joint distribution and then recalculating the portfolio of assets. we estimate VaR by assuming the distribution of basic risk factors or targeting asset returns. R F Engle.The shock effects on the variance of stock market returns. . Others suggested that arithmetical innovations in existing data can bring better accuracy. an American economist. It is described by a symmetric response of current volatility to positive and negative lagged errors. Morgan in 1996: Returns may not distribute themselves normally and the outliers are very common. It represents the simplest way to evaluate VaR for many portfolios. the revaluation of VaR of each asset is computed as per the value of each set of risk factors. Generalised Autoregressive Conditional Heteroskedasticity (GARCH) model This model was introduced by Taylor (1986) and Schwert (1989). They recalculate the portfolio with a simple approach that is based on partial derivatives.Effects of increase in the variance of excess returns of bonds on risk premiums. ARCH is crucially applied in the following areas: . The risk metrics approach also covers standard normal and normal mixture distributions. Simulation approaches In this approach. The three methods of simulation approaches are as follows: Historical simulation It is the most popular among simulation approaches. Analysing the assumptions based on marginal distributions and dependence structure among various benchmark assets is relevant. suggested the following two variants which provide better forecasts of variance and better estimations of VaR: Autoregressive Conditional Heteroskedasticity (ARCH) model The basic idea of ARCH is that the error terms conditional variance at time (t) depends on the squared error term (t-1). ARCH and GARCH model To generate more accurate variance covariance values in VaR estimations. The attention on the standardised returns indicates that we should focus on the size relative to the standard deviation rather than the size of the return. Here. P.
. The samples of non-overlapping returns is categorised into n blocks in each block. Extreme value theory provides a significant set of techniques to quantify the boundaries between different loss classes. the manager would evaluate the gathered weights of portfolio returns.Stratified sampling: This technique divides the interval into subintervals and then performs Crude Monte Carlo method on each interval. The four methods of Monte Carlo simulation are as follows: . Extreme value theory generates methods for quantifying events and their 42/43 . . Hybrid model In this method. Monte Carlo simulation: This method is based on using random data and probability to gain an approximate solution to an issue in lesser time when compared to the formal techniques. It concentrates only on the samples of returns data carrying information about extreme behaviour. A series of maxima and minima are generated by extracting the respective largest rise and fall in returns from each block. It achieves good approximation on the important functional areas which has greater impact on the overall approximation value and reduces variance. These returns are gained by applying historical data on the portfolio and evaluating the changes occurred in each period. Then. VaR is detected by the value for which the total weight would be equal to the aspired confidence level. The probability of occurrence of an extreme event is estimated from the VaR value for a given probability when the tail index is available.Reg no # 511017114 estimates VaR by creating imaginary returns of that portfolio based on time series. It also delivers a scientific language for translating management guidelines on the boundaries into actual numbers. portfolio returns are categorised based on historical stimulation in decreasing order. Extreme value theory Extreme value theory is used for measuring extreme risks.Importance sampling: This method uses more samples on more important functional areas. Various Monte Carlo methods are introduced as an attempt to minimise the approximation error. .Acceptance Rejection Monte Carlo: This evaluation provides a less accurate approximation when compared to Crude Monte Carlo method. This approach has both the advantages of risk metrics contribution and historical simulation. It depends on the assumption that more simulations provide higher level of accuracy.Crude Monte Carlo This method concludes the confidence intervals of your method and the accuracy of the answer. This parameter illustrates the way in which the extreme events in the data can occur. A Generalised Extreme Value (GEV) or Generalised Pareto (GP) distributions is used to one of these series through method of moments to evaluate the tail index parameter.
memory cell failure and bio-medical data processing. It has developed as one of the most important statistical fields for applied sciences and is widely used in many other subjects. 43/43 . thermodynamics of earthquakes. This modeling is applied in the fields of management strategy. It also helps in the patterning of default probabilities and the evaluation of divergence factors in the management of bond portfolios.Reg no # 511017114 consequences in a statistically optimal way.