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Understanding Treasury Management

XIMB’ August’2010

Understanding Treasury
Rishi Rakesh
Dynamics 1
Contents
Session –I (Overview):
o Role of Treasury in an organization
o Balance Sheet Dynamics
o Benchmark\Transfer Pricing

Session –II (Treasury Risk)


o Managing Interest Rate Risk
o Managing Liquidity Risk
o Managing Foreign Exchange Risk

Session- III (Money Market)


 Govt Bonds, Yield Curve
 Interest Rate Swaps, Forwards, Options
 Foreign Exchange Swaps & Forwards

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Session- I
Treasury Overview

3
Course Objectives
o Understand basic concepts of Treasury
management
o Understand Treasury function and its
role in business management process

Course Outcome
o Be able to better consider treasury
issues as part of the business
management process
o Be able to understand Treasury’s
different risk exposures and the
methods used to manage these risks
o Be able to interpret treasury data and
treasury language
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The Evolution

Building Blocks of the Banking Business:

 Credit/Lending

 Marketing

 Operations

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Treasury Management

THE MISSING LINK

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The Missing Link
Building Blocks of Banking Business:
 Credit
 Marketing
 Operations

AND Treasury

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The Finance Industry
Role of Financial Market:
1. Interaction of buyers and sellers of risks
2. Determination of price of risks
3. Reduction of transaction costs

Purposes of Financial Assets:


1. Transfer of funds from surplus-holders to deficit-holders
2. Redistribute unavoidable risks from risk-providers to seekers

B
A
Risk Providers / N Risk Investors /
Sellers Buyers
K
S

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Role of Treasury
Customer Business Proposition

Market Strategy

Credit Op. Capacity

Product Planning Process

Funding / Investment

Treasury Cycle
• Transaction initiation Credit Cycle
• Revenue / Expense • Credit Initiation
Stream management • Account Maintenance
Marketing / Sales
- Interest rate • Collection - write offs
- FX rate
• Liquidity / Cash flow
management.
MIS: Portfolio Management

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Role of Treasury
o “Central bank” for all internal customers
o Determine price of money
o Bridge funding/lending needs
o Identify/quantify market risk
o Interest rate risk
o Liquidity risk
o Foreign exchange risk
o Manage risk where necessary
o Managing the company's relationships
with credit rating agencies

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Summary

Treasury Actions
 Hedging

 Investments

 Funding

 Asset / Liability Management

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The Treasury Balance Sheet
Unit Outline
 Treasury components of a balance sheet

 Why have treasury assets & liabilities?

 Treasury assets

 Treasury liabilities

 Example balance sheets

 Summary

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Components of a Typical Bank Treasury Balance Sheet

ASSETS LIABILITIES
 Our accounts  Their accounts

 Bank placements  Bank borrowings

 Intercompany (pool) assets  Intercompany (pool) liabilities

 Mandatory reserves  Commercial paper

 Available for sale (AFS)  Capital market borrowings

 Trading account securities (bond issues)

 Swap assets
 Swap liabilities

 TP assets
 Capital
 TP Liabilities

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Why Have Treasury Assets & Liabilities?
 For management of the structural position

 For liquidity management

 For interest rate risk management

 For FCY portfolio management

 For regulatory compliance

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Liquidity Management
 Treasury Assets  Treasury Liabilities

 Funding consumer assets


 Normal liquidity buffer
 Opportunistic Gapping
 Contingency liquidity
buffer
 Investment of excess
liquidity from
consumer deposits

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Rate Risk Management
 Developed markets have derivative (off balance sheet)
instruments to manage interest rate risk

 Less sophisticated markets use treasury instruments to


hedge interest rate risk

 Limited by
 Available instruments
 Available liquidity to make the investment

 Volume and maturity of customer assets may be equal


to those of customer liabilities, while having different
interest rate repricing profiles

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FCY Portfolio Management

 Manage Exchange Risk

 FCY deposits are used to fund LCY balance sheets in certain markets (e.g. India FX
swaps)

 Generally unwilling to use FCY deposits to fund LCY balance sheet (high MTM
volatility, corporate limitations)

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Regulatory Compliance

 Reserve requirements

 Deposits with central bank

 Government securities

 Other securities acceptable to central bank

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Treasury Assets

o Bank placements

o Available for sale (AFS)

o Trading account securities

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Summary
Treasury Responsibilities for
Balance Sheet Management
 Define the liquidity characteristics of each balance
sheet item; use treasury assets and liabilities to
structure a liquidity plan to manage the risks

 Anticipate future balance sheet growth and articulate


funding strategies and contingency plans to manage
the liquidity risk

 Define the rate sensitivity of different customer assets


and liabilities and structure a plan to manage the
interest rate risk

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Balance Sheet Dynamics

Unit Outline
 Key concepts
 Re-pricing and Repayment Models
 Treasury’s Response
 Summary

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Key Concepts
The three variables that Treasury is most interested in are:
 Re-pricing characteristic
 Repayment characteristic
 Foreign exchange risk

These characteristics are the core of:


 Interest rate risk management
 Liquidity management
 Foreign exchange risk management

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Key Concepts
 Every product has certain characteristics important to
Treasury

 The goal is to understand the profile of each asset and


liability category

 Detailed analyses provides actual re-pricing/maturity


profile of each asset and liability category

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Key Concepts

 The actual re-pricing/maturity of assets vs. liabilities


determines the inherent amount of interest rate risk and
liquidity risk

 “Matched” or “square” indicates that re-pricing/maturity


of assets matches liabilities; there is no position

 A “Gap” indicates a mismatch of repricing/maturing


assets and liabilities

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Repricing & Repayment Models

A Simplified Balance Sheet


Assets Liabilities
Fixed Rate Loan $150MM Consumer Time $100MM
Deposit
Floating Rate $50MM Floating Rate $50MM
Loan Deposit
Mortgage Loan $100MM Professional CD $150MM
$300MM $300MM

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Repricing & Repayment Models
Product Characteristics
Product Tenor Behaviour

Loan 3 years Fixed rate

Floating Rate Loans 4 years Repriceable Yearly

Mortgage Loan 10 years Amortizing

Professional CD 3 years Fixed rate

Floating Rate Deposit 4 years Repriceable Yearly

Time Deposit 5 years Fixed rate but 25% matures in Year 1


Fixed rate but 25% matures in Year 2
Fixed rate but 50% matures in Year 5

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A Simplified Repricing Model
1 YR 2 YR 3 YR 4 YR 5 YR > 5 YR TOTAL
Fixed Rate Loans 150 150

Floating Rate Loans 50 50 50 50 50

Mortgages 4 4 5 7 10 70 100

Total 54 54 205 57 10 70 300

Prof CD 150 150

Floating Rate Deposit 50 50 50 50 50

Time Deposit 25 25 50 100

Total 75 75 200 50 50 0 300

Gap (21) (21) 5 7 (40) 70

Cum (21) (42) (37) (30) (70) 0

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A Simplified Repricing Model
Conclusions
 In general, the re-pricing of liabilities in a bank
takes place earlier than the re-pricing of
assets.
 If the yield curve was positively sloped (i.e. if
longer maturities have higher rates), a
negative gap is profitable.
 If interest rates rise and gap is negative,
profitability will be squeezed since a higher
rates will be paid to raise liabilities whereas
the interest being paid on assets are already
locked.

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A Simplified Repayment Model
1 YR 2 YR 3 YR 4 YR 5 YR > 5 YR TOTAL
Fixed Rate Loans 150 150

Floating Rate Loans 50 50

Mortgages 4 4 5 7 10 70 100

Total 4 4 155 57 10 70 300

Prof CD 150 150

Floating Rate Deposit 50 50

Time Deposit 25 25 50 100

Total 25 25 150 50 50 0 300

Gap (21) (21) 5 7 (40) 70

Cum (21) (42) (37) (30) (70) 0

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A Simplified Repayment Model
Conclusions
 In general, the repayment of liabilities for a
bank takes place faster than the repayment of
assets.
 Treasury should ensure that existing funding
can be rolled over upon maturity or new
funding can be sourced to support assets.
 There is liquidity risk if cash inflows from asset
repayments do not coincide with the cash
outflows from liability maturities.

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Repricing & Repayment Model
Benefits
 A good model provides insights into profit dynamics
and liquidity position of the business.
 Once the risk is identified, it can be managed.
 Needs highlighted by the model can help us evolve
new product offerings.
 Elimination of risk may not be a goal; as a financial
intermediary, we take some interest rate risk.
 The key is to determine an acceptable amount of risk
given a certain set of forecast events.

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Product Dynamics
Product Pricing Liquidity

Product Behavior often Product Agreement Behavior often


Agreement observed observed

Term deposit Agreed upon rate Market lagging / Contractual for 3 Roll-over /
(e.g. 3 month fixed Pricing pressure months Pre-termination
rate TD) (competition)

Current a/c Savings On demand (short- Sticky pricing On demand (short- Portfolio Dynamics:
a/c term) term) Core (LT) vs Non-
Core (ST)

15 year Fixed-Rate Agreed upon rate Refinancing with the Contractual for 15 Refinancing with
Mortgages same bank years another bank

Credit cards Can be re-priced Limited repricing ability Minimum payment by Portfolio Dynamics:
upon notice due to competitive due date Transactor vs.
pressure or statutory Revolver
max.

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Savings Example
REPAYMENT ANALYSIS
 With a large enough population, we can perform statistical behavioral
analysis.
 This analysis will identify a certain core percentage of deposits that can
be said to have an indefinite maturity.

 A portfolio dynamic occurs when:


 The core portion of the book remains long term.

 As the book grows, the amount of this core segment will also grow.

 As the book grows, the percentage which this core segment


represents usually does not grow.

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Savings Example
REPRICING ANALYSIS
 Movements of product price vs. market rates generally show a weak
but notable relationship.
 Although the entire portfolio could (in theory) be re-priced tomorrow, it
clearly will NOT be.
 However, once the portfolio does re-price:
 The amount of the change in basis points will be less than
movements in the market rates.
 Regardless of market movements, there will be a considerable
interval before the next repricing.

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Savings Example
Assigning
 We said that even though Savings is
a Tenor to contractually “on demand”, the core
Savings is portion of the book remains long
term.
a
CHALLENG  But how long is long enough for core?
E!
 It all depends…

 Core: Generally 2 years ~ 5 years

 Non-Core: Generally overnight ~ 1


month.

 Assumptions should be reviewed


periodically.

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Treasury’s Response
 Statistically Determine Actual Behavior
 Take a portfolio approach (providing that a large
enough population exists for statistical validation).
 Do a redemption analysis (examining the actual
payment history of a product set).
 Adjust for seasonalities.
 Take into account other variables, such as:
 Ceilings / Floors
 Advertising / promotion campaigns
 Innovation

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Treasury’s Response
 Use re-pricing models to predict profitability
 The actual re-pricing structure determine future
profitability.
 A re-pricing model should be able to forecast earnings
volatility.
 A re-pricing schedule of all assets vs. all liabilities and
capital gives us our current interest rate position and
exposure to future events.

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Summary
 Consumer products have certain repayment
and re-pricing characteristics that need to be
managed.
 A model needs to be built that shows the
liquidity and interest rate risks inherent in the
balance sheet.
 Effective management of repricing and
repayment risk results in enhanced and more
consistent earnings.

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Treasury Role of Benchmarking
Unit Outline
 Benchmarking: the concept
 Benchmark determination

 Benchmark pricing examples

 Benchmark pricing in practice

 Summary

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Benchmarking : The Concept
 What is a Benchmark?
 Benchmarking is a framework that divides the bank into separate
product lines & transfers risk to a central unit

 A benchmark is the rate of interest charged (to assets) or paid (to


liabilities) by Treasury

 Benchmarks are matched to the cash flows of each product

 Benchmark assumptions operate like a service level agreement


between Treasury and Products (reviewed and agreed at least
annually)

 Benchmarks serve several purposes


 Product pricing signal
 Essential to the calculation of product profitability
 Transfer of interest rate risk from Products to Treasury

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Benchmarking : The Concept
 Why is Benchmarking Necessary?
 Benchmarks are designed to transfer market risk exposure from the individual product
managers to treasury, where all risk is centrally located and professionally managed on
a portfolio basis

 Fundamental to the overall concept of market risk neutrality and stable Net Interest
Margin (NIM)

 Provides acute focus upon product profitability, customer pricing, positioning and
product development

 Promotes management accountability

 Without benchmark, the impact of market risk is buried in the results of the product
manager

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Measurement of Margin Components
 Simplified Yield Curve Example
 – one asset, one liability, booked today

Asset Spread
(Loans)
5% Yield Curve
Risk Management
Gap (tenor
mismatch)
4%

Liability Spread (Deposits)

Time
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Measurement of Margin Components

Line Unit Assets Liabs Spread


Customer Rate8.0% 3.0% 5.0%
Transfer Price 5.0% 4.0%
Matched Spread 3.0% 1.0%
Risk Totally
Treasury Mgt Matched
Transfer Price Income 5.0% 5.0%
Transfer Price Expense 4.0% 5.0%
Treasury Risk Mgt Revenue 1.0% 0.0%

Adding the matched spreads (3%+1%) and the treasury spread (1.0%)
equates to the total business spread of 5.0%. The 1% treasury spread is
the net impact arising from the bank’s market risk. Generally the spread
is positive when the asset tenors are longer than liabilities.

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Features of Good Benchmarks
 Benchmark is a transfer pricing mechanism that aims to reflect
the true economics of the product

 Ideally it should be based upon:


 External markets (as a pricing signal)
 Market risk neutrality (matched tenors)

 It is a representation of a product’s price risk (interest rate)


and liquidity risk summarized into a single concept - the
benchmark price

 The assignment of a benchmark should be driven by the


characteristics of cash flow, date of origination, repricing,
maturity (with adjustments for liquidity and embedded
options)

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Session- II
Managing Treasury Risk

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Managing Interest Rate Risk
UNIT OUTLINE

 Identifying the Risk

 Measuring the Risk

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I. Identifying the Risk
 Determine the re-pricing profiles of assets and
liabilities in the balance sheet

 Distinguish between the actual and contractual


profiles (Can we re-price, Do we, How often?
How much?)

 Portfolio vs. Single Account

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I. Identifying the Risk
INTEREST RATE EXPOSURE DUE TO
 Gaps in an existing portfolio
 Basis Mismatch
 Volume Risk
 Sticky rates on new originations
 Embedded options

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I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
A GAP….
 Difference in repricing tenor (periods) of assets and
liabilities and/or
 Difference in the amount of assets and liabilities
maturing / re-pricing within a time period.
 Can be represented as run-off gaps or as remaining gaps
(cumulative gaps).
 Can be “Positive” or “Negative”.
 Can be Structural or Intentional

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I. Identifying the Risk

SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO

Re-pricing Mismatch: A gap occurs when assets are re-


priced at different periods from liabilities

Q1 Q2 Q3 Q4
ASSET
REPRICING

LIABILITY
REPRICING

Asset : A one-year quarterly floating rate loan

Liability : A one-year time deposit

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I. Identifying the Risk

SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO


RUN-OFF GAPS (Maturing amounts)

At the beginning of Mth 1 Mth 2 Mth 3 Mth 4 Mth 5 Mth 6 Mth 7


Asset
$100MM 1-mth placement w/CMB 100
Liability
$100MM 3-mth deposit (100)
(Repriceable in 3 mths time)

Run-off Gap 0 100 0 (100) 0 0 0


Cumulative Gap 0 100 100 0 0 0 0

Cumulative gaps (Remaining Amount)


Mth 1 Mth 2 Mth 3 Mth 4 Mth 5 Mth 6 Mth 7
Asset (100)
Liability 100 100 100
Cumulative Gap 0 100 100

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I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO

TYPE DEFINITION / IMPLICATIONS IF RATES IF RATES


MOVE UP MOVE DOWN

Positive • Assets repricing faster than Profits rise Profits fall


Gap liabilities
• More liabilities to be placed
• Lend short Borrow long
• Over-Borrowed
• COF (Depos Rates) locked-
in

Negative • Liabilities repricing faster Profits fall Profits rise


Gap than assets
• More assets to be funded
• Borrow short Lend long
• Over-Lent
• Revenue (Lending rates)
locked-in 52
I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO

STRUCTURAL GAP
 Result of the mismatch in the inherent re-pricing
characteristics of assets and liabilities
 Influenced by product features and determined by
customer behavior

INTENTIONAL GAP
 Due to Treasury Actions
 Dependent on view of interest rates

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I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
INTENTIONAL GAPPING : NEGATIVE GAP

You believe rates will fall


 Lend long term to lock in current high rates
 Borrow short term and roll it over at future lower rates

This results in a Negative Gap…

Year 1 Year 2 Year 3


L e n d (lo n g ) 10% 10% 10%
B o rro w (s h o rt) 10% 9% 8%
S p re a d 1% 2%

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I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
INTENTIONAL GAPPING : POSITIVE GAP

You believe rates will rise


 Borrow long term at today’s cheap rates and lend money
short term so when rates rise, you can reinvest it at the
higher rates
 This results in a Positive Gap

Year 1 Year 2 Year 3


L e n d (s h o rt) 10% 11% 12%
B o rro w (lo n g ) 10% 10% 10%
S p re a d 1% 2%

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I. Identifying the Risk
SOURCE OF RISK - BASIS MISMATCH

When two products (which may have the same re-pricing


or maturity) in the same market, have different degrees of
rate sensitivity
PRODUCT 1st QUARTER 2nd QUARTER

Asset 7.25% 7.25%


(90 days Eurodollar)
Liability 7.00% 7.50%
(90 days Bank CD)

To manage the basis mismatch risk, change pricing nature


of assets to match pricing nature of liabilities or vice versa

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I. Identifying the Risk
 Source of Risk – Volume Risk
FYF Actual B/(W)
BAU/Status Quo 100 100 -

If rates increase after FYF


and customer behavior changes
100 120 (20)

If rates fall after FYF and customer


behavior changes
100 80 20
 Changing rate levels could significantly impact
forecasted volume of asset/liability originations as well
as affect run-off rates of existing portfolio

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I. Identifying the Risk

SOURCE OF RISK - STICKY RATES ON ORIGINATION

If interest rates rise 2%


 Current portfolio - no rate risk

 New portfolio - may be unable to price new loans


upwards while we might have to re-price deposits
upwards by close to 2%

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I. Identifying the Risk
SOURCE OF RISK - EMBEDDED OPTIONS

EXAMPLES:
 Cap/Floor on Floating Rate Products
 Pre-termination without penalty for Fixed Rate Products
 Borrow-back at pre-determined rate on Deposit Products

These options add a new dimension to rate risk that is


difficult to manage

Introduces element of “convexity”

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II. Measuring the Risk

KEY CONCEPTS

 DV01
 (Earnings At Risk)

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II. Measuring the Risk

 To be more meaningful, the re-pricing gap must be translated


into how much earnings risk it represents.

DV01
 Management Tool to evaluate risk and define economic loss
parameter

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II. Measuring the Risk
DV 01 (A Methodology)
 Dollar value for 1 basis point move
 Captures the potential earnings impact of one basis point
movement in interest rates
 Calculated by : Repricing Gap * 0.01% * Tenor
 Total DV01 are the sum of individually derived Dv01
(deal by deal calculated)
 Total DV01 categorized into Rolling 12 mths and Full
Tenor discounted

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II. Dv01

An Example:

Executed Placement deal of USD 100 mio for


Tenor 6 mths

Dv01 = 0.01% * 100 mio * 6/12


= 5,000

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Liquidity Risk

Overview

 Introduction – What is Liquidity Risk?


 How Liquidity Risk Arises
 Liquidity Management
 Product Liquidity Characteristics
 Summary – Liquidity Risk

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Liquidity Problem?
 How much water should you bring if you are going to a 7-day trip across the
Sahara?

 Carrying enough water for 1-day only assuming there will be wells or
suppliers along the way… taking a risk of not being able to find the well
(source of liquidity) before dying of thirst.

 Carrying additional water as a safety buffer… enough for 10-days incurring


extra carrying costs (another camel to carry the load)

 Carrying just enough water for 7-days… perfectly matched strategy

 The art of balancing liquidity risk vs. return

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What Is Liquidity Risk?
 The risk that funds will not be
available to meet a financial
commitment to a counterparty in any
location or any currency at any time.
This is our key franchise risk
(customer confidence).

 Liquidity risk-taking is
 Fundamental to banking
 An important source of revenue

66
Businesses Need Liquidity

 For survival:
 Having funds available at all times to meet fully and
promptly all contracted liabilities, including demand
deposits and off-balance sheet commitments

 For growth:
 Having funds available to take advantage of future
business opportunities

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How Liquidity Risk Arises
Liquidity risk may come from:
 Operating environment:

 Exposure arises from daily funding and trading


activities in normal markets

 Contingency situations:

 Exposure arises from external events


 Market

 Name

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Contingency Situations
 Market Disruption

 Displacement of market arising from “abnormal”


events (often economic crisis, political turmoil, or
central bank policy change) affecting market liquidity
and ability of most participants to transact at normal
volumes, rates, or tenors.

 Name Problem

 Denial of market access to specific counterparty due


to concern over its creditworthiness

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Liquidity Management
Objectives
o To ensure sufficient liquidity to meet all financial
commitments and obligations when they fall due

o To be able to access liquidity in global markets at


“reasonable” terms

o To plan, quantify, and monitor what kinds and levels


of risk that is prudent for the company

o To balance the cost of maintaining liquidity, with the


appropriate level of returns

70
Roles & Responsibility
 Managing liquidity risk is the joint
responsibilities of Business, Treasury, and
Risk Management; oversight by Asset and
Liability Committee (ALCO).

 Country Treasurer
 Has primary responsibility for liquidity
management
 Develops funding plan & process for each legal
vehicle

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Summary
 Effective liquidity management is critical to:
 Business survival, growth and expansion
 Maintaining market confidence

 Liquidity mismanagement can result in severe


repercussions including loss of market confidence and
erosion of capital base

 Liquidity risk management is a joint responsibility of


business, treasury and ALCO.

 Prudent liquidity management requires:


 Stable and diversified funding structure
 Limited reliance on single counterparty and/or market
 Proactive management of asset and liability maturity profiles
 Disciplined planning for contingency situations

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Session- III
Money Market Instruments

73
Concept of a Yield Curve
Positive Yield Curve

 Positive Yield Curve


 Aka “normal yield curve”

Rates
 Slopes upward to the right
 No specific trend
 Premium for longer period Maturities
(credit risk, liquidity risk, compounding)
 Opportunity cost of inflation
 Cost of insulating against rate moves
 With a positive yield curve, all things being equal, a
negative gap is generally the profitable position

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Gapping: Examples of Different Yield Curve

Positive Yield Curve Parallel Shift Change Shape

Rates
Rates
Rates

Maturities Maturities Maturities

75
Gapping: Current Yield Curve - USD

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Gapping: Yield Curve Shifts – USD Yr 2003 vs
2004

May 2004

June 2003

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Gapping: Yield Curve Shifts – USD Yr 2004 vs 2005

June 2005

May 2004

78
Gapping: Yield Curve Changes – UST Yr 2005 vs 2006

August 2006

June 2005

79
Gapping: Yield Curve Changes – USD Yr 2006 vs 2007

May 2006

May 2007

80
Gapping: Yield Curve Changes – USD Yr 2007 vs 2008

May 2007

May 2008

81
Gapping: Fed Funds Target

First pause in 2 years

Total 425 bps Rate Hikes

225 bps Rate Cut

82
Gapping: Yield Curve Comparison

Beginning of rate cut cycle (Yr 2001)

beginning of rate rise cycle (Yr 1993)

83
Instrument to Manage Risk

 Interest Rate Swap

 Forward Rate Agreement

 Interest Rate Options (Caps / Floors)

84
Interest Rate Swap
 Definition
 Agreement between two parties to exchange interest rate
payments on a notional principal sum which is not
exchanged

 Purpose:
 Manage interest rate risk
 Permit large volume transactions
 Change the interest rate profiles of liabilities or assets
 Most common swap is fixed-for-floating which one counter-
party agrees to pay a fixed rate over the term of the swap
in exchange for a floating rate payment payable by the
other counter-party (aka “coupon” swap)

85
Interest Rate Swap Example

 Bank ABC’s fixed rate mortgage portfolio is funded by 6-month


interbank borrowing

Assets Liabilities
$50MM mortgages $50MM TDs
Avg. Life: 10 yrs Avg. Life: 6 mths
Avg. Rate: 11% Avg. Rate: 8%
(fixed for 10 yrs)

 Concern: ABC expects interest rates to rise; higher rates will


narrow their spread

 Solution: ABC decides to enter a SWAP to “pay fixed, receive


float” with bank XYZ

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Interest Rate Swap Example
 Swap Agreement:

 ABC will “pay” fixed rate at 9% for 5 years on notional


principal of $50MM (less than full life)

 ABC will “receive” the inter-bank rate reset every 6mths


for the next 5 years on notional principal of $50MM

 No principal is exchanged, only net coupon interest


payments

87
Interest Rate Swap Example

MORTGAGE FIXED RATE


PORTFOLIO Asset

11%
FIXED RATE = (9%)

XYZ SWAP ABC


FLOATING RATE = 8% (8%)

FUNDING FLOATING RATE


SOURCE Liability

• No liquidity forfeiture due to notional principal


• Only exchange of interest differential

88
Interest Rate Swap Example

 Results for ABC: The first 6 months

 Borrows 6mth interbank (8%)


 Receives from XYZ 8%
 Net Spread 0%

 Receives from Mortgage 11%


 Pays fixed to XYZ 9%
 Net Spread 2%

89
Interest Rate Swap Example
 Results for ABC: The Next Six Months
 (Assume interest rates increase 2%)

 With SWAP       
Without SWAP
Borrows 6-month libor (10%) (10%)
Receives from XYZ, 6-month libor 10%
Net spread 0%
Receives from mortgage portfolio 11% 11%
Pays Bank XYZ 9% --
Net spread 2% 1%

Without an interest rate swap, ABC’s net revenues from


the mortgage portfolio are reduced by half as a result of
rising interest rate environment impacting short term
funding

90
Interest Rate Swap Example

 Assume rates continued to rise by 1.0% at each of the


next 2 resets (1 year), then begin to fall by 2% for each
of the next 2 resets (1 year)

14
12 12
11
10 10
Fixed
Interest Rates

8 8 Rate Paid
to XYZ
6
4
2
0
R1 R2 R3 R4

Resets

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Interest Rate Swap Example
R1 R2 R3 R4
a. Borrows Inter-bank (11%) (12%) (10%) (8%)
b. Receives from Mortgages 11% 11% 11% 11%
c. Net Spread 0% (1%) 1% 3%

d. Receives from XYZ 11% 12% 10% 8%


e. Pay XYZ (9%) (9%) (9%) (9%)
f. Swap Spread 2% 3% 1% (1%)

Net Spread (c+f) 2% 2% 2% 2%

 Without the interest rate swap, ABC has interest rate risk based on the
changing cost of 6 month borrowings

 The Swap with XYZ will lock-in a guaranteed earnings spread of 2% on the
fixed rate mortgages, regardless of how interest rates change

92
Forward Rate Agreement
Agreement with a counter-party to pay or receive the
difference in interest on a notional principal amount
between an agreed future interest rate and a reference
interest rate for a specified period

Only the difference in interest between the agreed


contract rate and the reference rate at the start of the
period to which the rate refers is paid to or received
from the counterparty

93
Forward Rate Agreement

 Jargon

 Quoting of desired periods is done by


calendar months. Thus, a deal for a 3-
month tenor in 3 months time is a 3x6.
Similarly, the following are:
 6x12 : 6-month rate in 6 months time
 2x5 : 3-month rate in 2 months time

94
Forward Rate Agreement Example

 ABC has a $50MM, 1 year fixed rate auto loan portfolio,


funded via 3-month interbank borrowings

 ASSETS LIABILITIES
$50MM auto loans $50MM TDs
Tenor: 1year Tenor: 3mths
Fixed Rate: 10% Rate: 7.5%

 Concern: ABC expects rates to rise in the future; higher


rates will narrow spreads
 Solution: ABC decides to enter a series of FRA “strips” to
lock-in rollover rates with Bank XYZ to ensure a predictable
spread is maintained

95
Forward Rate Agreement Example

o ABC will buy FRA strips to match rollover dates of 3-


month borrowings:

$50MM 3 x 6 mths @ 7.75%


$50MM 6 x 9 mths @ 8.00%
$50MM 9 x 12 mths @ 8.25%

o On maturity of the 3-month interbank cash


borrowing at 7.5%, ABC will rollover the US$50MM
at the prevailing interbank market rate

96
Forward Rate Agreement Example

 Assume rates continued to increase by 0.5% at the next


rollover, then another 0.5% and then fall -1.0% by the
last quarter:
9
8.5
 R1 + 0.5% 8
7.5 8.0
 R2 + 0.5% 7
7.0

Interest Rates
6
 R3 - 1.0%
5
4
3
2
1
0
R0 R1 R2 R3
Resets

97
Forward Rate Agreements Example
Results for ABC rollovers

R0 R1 R2 R3
Auto Loan 10% 10% 10% 10%
3mth interbank 7.5% 8.0% 8.5% 7.0%
Spread before FRA 2.5% 2.0% 1.5% 3.0%

FRA - 7.75% 8.00% 8.25%


FRA Gain/(Loss) - 0.25 0.50 (1.25%)

Effective Rate 7.5% 7.75% 8.0% 8.25%


Net Spread 2.5% 2.25% 2.0% 1.75%

98
Interest Rate Options
 Definition:
 A contract that gives the options buyer the right, but
not the obligation, to lend/borrow funds at a specific
rate over a specified time frame
 In return, the options buyer pays a fee called a
premium at the time of option purchase (Buying
insurance)

 Purpose:
 Manage interest rate risk
 Permit large volume transactions
 Allow flexibility of rate cover, but still receive benefit
of favorable moves

99
Introduction to Foreign Exchange
Unit Outline
 Foreign Exchange Fundamentals
 Types of Foreign Exchange Exposure
 Managing FX Exposure - considerations
 Factors affecting the market

100
Foreign Exchange Fundamentals
What is Foreign Exchange?
 A foreign exchange transaction involves one currency
being bought or sold against another currency
Rate Quotation:
a. Cross Rates:
 A foreign exchange rate between two
currencies derived via a third currency
 Example: GBP/HKD via USD (GBP/USD and
USD/HKD)
b. Price Quotation:
 Bid and Offer

101
Foreign Exchange Fundamentals
Time element in FX market:

Spot Transaction:
 Settlement within two business days from deal date

Forward Transaction:
 Settlement at a specified future date (>two business
days)
 Common tenors are 1, 2, 3, 6, 9 and 12 months

102
Foreign Exchange Fundamentals
Why is there a FX market?

 International trade
 Capital movements
 Financial transactions
 Exchange of services
 Tourism

103
Foreign Exchange Fundamentals
Players in the FX market?

 Commercial banks
 Speculators
 Fund Managers
 Non financial businesses
 Central banks
 Investment houses

104
Foreign Exchange Fundamentals
Factors affecting FX rate movement
 Demand and supply
 Sovereign policy
 Exchange control/regulations

 Economic performance
 Money supply
 Inflation
 Interest rates

 Speculation

105
Types of FX Exposure
Transaction Exposure
(daily Mark-to-Market):

 Exposures arising from buying and selling foreign


currencies
 for customer’s account
 for Banks’s own account

106
Types of FX Exposure
Translation Exposure

 Exposure arises from translating a local currency balance


sheet into Bank’s native country accounting/reporting
purposes.

107
FX Treasury Products
We will briefly discuss the 3 basic forms of
derivative products:

1. Forwards
2. FX Swaps
3. Options

108