Name :-
Roll Number :-
Programme :- MASTER OF BUSINESS ADMINISTRATION (MBA)
Subject :- TREASURY MANAGEMENT
Course Code :- DFIN402
Answer 1 :- Repo Market vs. Tri-Party Repo Market
Both the Repo (Repurchase Agreement) Market and the Tri-Party Repo Market are crucial
for short-term funding in financial markets. They involve the exchange of securities for cash
with an agreement to reverse the transaction at a later date. However, they differ significantly
in their structure and operation.
Repo Market
Structure: A simple two-party transaction where a borrower sells securities to a lender and
agrees to repurchase them at a slightly higher price. This effectively functions as a
collateralized loan.
Participants: Primarily involves two parties: the borrower and the lender.
Collateral Management: The borrower typically manages the collateral.
Risk: Relatively lower risk due to the collateralization of the loan.
Tri-Party Repo Market
Structure: Involves three parties: the borrower, the lender, and a third-party custodian
(usually a clearing bank or securities depository).
Role of Custodian: The custodian acts as an intermediary, managing the collateral, handling
the settlement of the transaction, and ensuring the safekeeping of assets.
Collateral Management: The custodian oversees the collateral, ensuring it meets margin
requirements and reducing operational risks for both parties.
Efficiency: Streamlines the process, reducing operational burdens on the borrower and
lender.
Risk Mitigation: The involvement of the custodian enhances risk mitigation by providing a
layer of oversight and ensuring the proper handling of collateral.
Key Differences Summarized:
Participants: Two parties in Repo vs. Three parties in Tri-Party Repo.
Collateral Management: Borrower-managed in Repo vs. Custodian-managed in Tri-Party
Repo.
Complexity: Repo is simpler; Tri-Party Repo involves more complex operational processes
due to the custodian's role.
In essence:
The Repo Market is a basic framework for short-term borrowing.
The Tri-Party Repo Market adds a layer of operational efficiency and risk mitigation by
incorporating a third-party custodian, making it more suitable for larger and more complex
transactions.
Answer 2 :- Major Functions of Financial Markets Financial markets are vital components of
the economic system that facilitate the flow of funds between savers and borrowers. They
play a crucial role in the allocation of resources, risk management, and the establishment of
fair asset prices.
Below are the key functions of financial markets:
a. Facilitating Capital Formation One of the primary functions of financial markets is
facilitating capital formation. Through financial markets, businesses and governments can
raise funds by issuing equity (stocks) and debt (bonds) securities. Investors purchase these
securities, providing funds that allow businesses to expand, innovate, and create jobs, which
in turn promotes overall economic growth. These markets allow savers to invest their money
in a variety of instruments, effectively channeling resources into productive uses.
b. Liquidity Provision Liquidity refers to the ability to buy or sell an asset without causing
significant price changes. Financial markets provide liquidity by ensuring that buyers and
sellers can easily transact in securities. The more liquid a market, the easier it is for
investors to convert assets into cash. This reduces the risk associated with holding assets
and ensures investors that they can exit investments when needed without incurring
substantial losses due to illiquidity.
c. Price Discovery Financial markets enable the process of price discovery. The interaction
between buyers and sellers in the market determines the fair value of securities. Various
factors such as economic indicators, supply and demand, interest rates, and market
sentiment influence these prices. Through continuous trading and market analysis, financial
markets provide real-time price signals, which reflect the overall health and outlook of the
economy.
d. Risk Sharing and Diversification Financial markets provide investors with a platform to
diversify their investments and manage risk. By investing in a variety of financial instruments
such as stocks, bonds, and derivatives, investors can reduce the impact of adverse
outcomes from any single investment. This spread of risk is beneficial for both individuals
and institutions. For instance, a diversified portfolio reduces the likelihood of major financial
losses and helps stabilize returns over time.
e. Efficient Allocation of Resources Financial markets play a crucial role in ensuring that
resources are directe towards their most productive uses.. They match those who need
funds (borrowers) with those who have surplus funds (investors). Capital is allocated to the
most productive projects and investments through the pricing mechanisms of financial
markets. This is critical for sustaining economic growth, as the funds flow to the best
opportunities that yield higher returns, benefiting both the investors and the economy.
f. Providing Investment Opportunities Financial markets offer a wide range of investment
opportunities, allowing individuals and institutions to participate in the growth of companies,
governments, and industries. For instance, stock markets provide opportunities for
individuals to invest in companies, while bond markets enable investors to buy debt issued
by governments and corporations. These investment opportunities allow for wealth creation
and encourage savings, which are essential for long-term economic stability.
g. Economic Indicator for Decision-Making Financial markets act as important economic
indicators. The performance of financial markets often reflects the overall state of the
economy. For instance, a rising stock market may indicate investor optimism and economic
growth, while falling bond prices may signal concerns over inflation or default risks.
Policymakers and investors use these indicators to make informed decisions about interest
rates, fiscal policy, and investment strategies.
h. Enhancing Transparency and Governance Public financial markets, such as stock
exchanges, are regulated by governing bodies that enforce strict rules regarding disclosure
and transparency. Companies listed on these exchanges are required to provide regular
financial reports and updates on their operations, helping investors assess the value and risk
of their investments. This regulatory framework enhances governance, promotes trust, and
ensures the orderly functioning of the market.
In conclusion, the functions of financial markets are vital for economic stability and growth.
By providing liquidity, facilitating capital formation, and enabling price discovery, they help
ensure that funds are allocated efficiently, risks are managed, and investors have access to
a variety of investment opportunities.
Answer 3 :- Call Option on ABC Ltd. Stock
A call option is a financial contract that gives the buyer the right, but not the obligation, to
purchase a stock at a specific price (the strike price) within a specified period. In this
scenario, the common stock of ABC Ltd. is trading at ₹140 per share. The buyer of the
option has the right to purchase 100 shares of ABC Ltd. at ₹140 each over the next three
months. In exchange for granting this option, the seller charges a premium of ₹8 per share.
a. The Call Option Contract
A call option allows the buyer to purchase shares at a fixed price (₹140) within a given
period (three months in this case). The seller of the option is obligated to deliver the shares
at the agreed strike price if the buyer decides to exercise the option. The buyer pays a
premium of ₹8 per share to secure this right. This premium is paid upfront and is
non-refundable, whether or not the option is exercised.
b. Profit and Loss Scenarios for the Buyer
● Scenario 1: Stock Price Rises to ₹165
If the stock price rises to ₹165 after two months, the buyer will exercise the option to
purchase the shares at ₹140, well below the market price. The profit per share would
be:
Profit per Share=165−140−8=17\text{Profit per Share} = 165 - 140 - 8 = 17Profit per
Share=165−140−8=17
Since the buyer owns 100 shares, the total profit would be:
Total Profit=17×100=₹1700\text{Total Profit} = 17 \times 100 = ₹1700Total
Profit=17×100=₹1700
Therefore, in this case, the buyer would earn a profit of ₹1700.
● Scenario 2: Stock Price Declines to ₹130
If the stock price falls to ₹130, the buyer would not exercise the option because they
can buy the stock cheaper in the open market. In this scenario, the buyer’s loss is
limited to the premium paid, which is ₹8 per share. Therefore, the total loss for 100
shares would be:
Total Loss=8×100=₹800\text{Total Loss} = 8 \times 100 = ₹800Total
Loss=8×100=₹800
In this case, the buyer’s loss would be ₹800, as the option expires worthless.
c. Seller’s Perspective
The seller of the call option receives the premium upfront, ₹8 per share, as compensation for
agreeing to potentially sell the shares at the strike price. If the stock price rises above ₹140,
the seller must deliver the shares at ₹140, which could result in a loss if the market price is
significantly higher. However, if the stock price stays below ₹140, the seller retains the
premium as profit, and the option expires worthless.
Answer 4 :- Risk Mitigation Tools for Liquidity Risk Management
Liquidity risk refers to the risk that an organization will be unable to meet its short-term
financial obligations due to an imbalance between its liquid assets and liabilities. Different
organizations, depending on their nature, have distinct strategies for managing liquidity risk.
a. Liquidity Risk in Non-Financial Organizations (e.g., Garment Trader)
For a non-financial organization like a garment trader, liquidity risk often arises from
slow-moving inventory, delayed payments from customers, or seasonal fluctuations in sales.
The trader may struggle to cover short-term expenses like rent, wages, or supplier payments
if cash inflows are delayed.
Risk Mitigation Tools for Non-Financial Organizations
Cash Flow Forecasting: By forecasting future cash inflows and outflows, the organization
can better plan for liquidity shortages and ensure that funds are available when needed.
Inventory Management: Efficiently managing inventory ensures that products are not tied up
in stock for too long. Slow-moving items should be discounted or cleared quickly to release
cash.
Short-Term Financing: Garment traders can also use short-term loans or lines of credit from
financial institutions to bridge temporary liquidity gaps.
Receivables Management: Speeding up the collection process for outstanding invoices can
help reduce liquidity risk. Offering discounts for early payments or using factoring services
can be effective.
b. Liquidity Risk in Financial Institutions (e.g., Banks)
Financial institutions like banks face liquidity risk primarily because they borrow short-term
(via customer deposits) and lend long-term (via loans and mortgages). If there’s a sudden
demand for withdrawals, or if loan defaults increase, banks may struggle to meet their
obligations.
Risk Mitigation Tools for Financial Institutions
Liquidity Coverage Ratio (LCR): The LCR requires banks to hold a sufficient amount of
high-quality liquid assets that can cover net cash outflows for 30 days.
Access to Central Bank Funding: In case of a liquidity crisis, banks can access emergency
funding from the central bank through discount windows or other mechanisms.
Diversified Funding Sources: By using a mix of short-term deposits, long-term debt, and
equity, banks reduce their reliance on any single funding source.
Stress Testing: Banks conduct stress tests to assess their ability to handle liquidity shocks
under various scenarios, ensuring they are prepared for adverse market conditions.
Reasons for Liquidity Risk
Liquidity risk arises from several factors, including mismatches between short-term liabilities
and long-term assets, sudden changes in market conditions, and unexpected withdrawals or
defaults. In non-financial organizations, poor cash management, high inventory costs, or
weak receivables management can lead to liquidity challenges. For financial institutions,
changes in interest rates, large-scale deposit withdrawals, or an economic downturn can
exacerbate liquidity risks.
Answer 5:- Interest Rate Risk Mitigation Tools
Interest rate risk refers to the risk of changes in interest rates affecting an organization’s
financial performance, particularly its cost of borrowing or investment returns. Below are
common tools used to manage interest rate risk:
a. Caps, Floors, and Collars
● Caps: A cap is an agreement that sets an upper limit on the interest rate that a
borrower will pay on a floating-rate loan. It protects borrowers from rising interest
rates by capping the maximum rate they will pay.
● Floors: A floor is the opposite of a cap, setting a lower limit on the interest rate. It is
often used by investors to protect the return on floating-rate investments in a
declining interest rate environment.
● Collars: A collar is a combination of both a cap and a floor. This limits the interest
rate range within which the borrower or investor operates, providing protection
against both rising and falling rates.
These tools allow businesses and investors to hedge against the uncertainty of interest rate
fluctuations, ensuring more predictable financial outcomes.
Answer 6:- Interest Rate Parity and Forward Rates
a. Interest Rate Parity (IRP)
Interest Rate Parity is a fundamental concept in foreign exchange markets that links the spot
rate and forward rate of two currencies to the interest rates in their respective countries. The
formula for IRP is:
Where:
F = Forward exchange rate
S = Spot exchange rate
𝑖domestic= Domestic interest rate
𝑖foreign= Foreign interest rate
t = Time period in years
b. Calculation of Forward Rate
Given:
● Interest rate in India = 8% per annum
● Interest rate in the United States = 6% per annum
● Spot rate = USD/INR 84.1000
● Time horizon = 3 months (0.25 years)
The forward rate can be calculated as:
So, the 3-month forward rate is USD/INR 84.4719.
c. Forward Margin
The forward margin is the percentage difference between the forward rate and the spot rate:
Thus, the forward margin for three months is 0.44%.
Option Scenarios
Scenario 1: Stock Price Rises to ₹165
The buyer will exercise the option and purchase the stock at ₹140. The profit per share
would be:
Profit per Share=165−140−8=₹17
For 100 shares, the total profit would be:
Total Profit = 1700
Scenario 2: Stock Price Falls to ₹130
The buyer will not exercise the option. The loss will be limited to the premium paid:
Total Loss=₹800
