Understanding Treasury Management

XIMB’ August’2010

Rishi Rakesh Understanding Treasury Dynamics


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Session –I (Overview): Role of Treasury in an organization Balance Sheet Dynamics Benchmark\Transfer Pricing

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Session –II (Treasury Risk) Managing Interest Rate Risk Managing Liquidity Risk Managing Foreign Exchange Risk Session- III (Money Market)

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


Session- I
Treasury Overview


Course Objectives o o Understand basic concepts of Treasury management 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 Be able to understand Treasury’s different risk exposures and the methods used to manage these risks Be able to interpret treasury data and treasury language o o 4 .

The Evolution Building Blocks of the Banking Business:    Credit/Lending Marketing Operations 5 .

Treasury Management THE MISSING LINK 6 .

The Missing Link Building Blocks of Banking Business:    Credit Marketing Operations AND Treasury 7 .

2. 3.The Finance Industry Role of Financial Market: 1. 2. Transfer of funds from surplus-holders to deficit-holders Redistribute unavoidable risks from risk-providers to seekers Risk Providers / Sellers B A N K S Risk Investors / Buyers 8 . Interaction of buyers and sellers of risks Determination of price of risks Reduction of transaction costs Purposes of Financial Assets: 1.

write offs Op.Interest rate .Role of Treasury Customer Business Proposition Market Strategy Credit Product Planning Process Funding / Investment Treasury Cycle • Transaction initiation • Revenue / Expense Stream management . Credit Cycle • Credit Initiation • Account Maintenance • Collection . Capacity Marketing / Sales MIS: Portfolio Management 9 .FX rate • Liquidity / Cash flow management.

Role of Treasury o o o o “Central bank” for all internal customers Determine price of money Bridge funding/lending needs Identify/quantify market risk o o o Interest rate risk Liquidity risk Foreign exchange risk o o Manage risk where necessary Managing the company's relationships with credit rating agencies 10 .

Summary Treasury Actions  Hedging  Investments  Funding  Asset / Liability Management 11 .

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 12 .

Components of a Typical Bank Treasury Balance Sheet ASSETS         LIABILITIES      Our accounts Bank placements Intercompany (pool) assets Mandatory reserves Available for sale (AFS) Trading account securities Swap assets TP assets Their accounts Bank borrowings Intercompany (pool) liabilities Commercial paper Capital market borrowings (bond issues)    Swap liabilities Capital TP Liabilities 13 .

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     14 .

Liquidity Management  Treasury Assets   Treasury Liabilities   Normal liquidity buffer Contingency liquidity buffer Investment of excess liquidity from consumer deposits Funding consumer assets Opportunistic Gapping   15 .

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 16 .

FCY Portfolio Management  Manage Exchange Risk FCY deposits are used to fund LCY balance sheets in certain markets (e.g. corporate limitations)   17 . India FX swaps) Generally unwilling to use FCY deposits to fund LCY balance sheet (high MTM volatility.

Regulatory Compliance  Reserve requirements  Deposits with central bank Government securities Other securities acceptable to central bank   18 .

Treasury Assets o Bank placements Available for sale (AFS) Trading account securities o o 19 .

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   20 .Summary Treasury Responsibilities for Balance Sheet Management  Define the liquidity characteristics of each balance sheet item.

Balance Sheet Dynamics Unit Outline     Key concepts Re-pricing and Repayment Models Treasury’s Response Summary 21 .

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 22 .

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   23 .

liabilities determines the inherent amount of interest rate risk and liquidity risk “Matched” or “square” indicates that re-pricing/maturity of assets matches liabilities.Key Concepts  The actual re-pricing/maturity of assets vs. there is no position A “Gap” indicates a mismatch of repricing/maturing assets and liabilities   24 .

Repricing & Repayment Models A Simplified Balance Sheet Assets Fixed Rate Loan Floating Rate Loan Mortgage Loan $150MM $50MM $100MM $300MM Liabilities Consumer Time Deposit Floating Rate Deposit Professional CD $100MM $50MM $150MM $300MM 25 .

Repricing & Repayment Models Product Characteristics Product Loan Floating Rate Loans Mortgage Loan Professional CD Tenor 3 years 4 years 10 years 3 years Behaviour Fixed rate Repriceable Yearly Amortizing Fixed rate Repriceable Yearly Fixed rate but 25% matures in Year 1 Fixed rate but 25% matures in Year 2 Fixed rate but 50% matures in Year 5 Floating Rate Deposit 4 years Time Deposit 5 years 26 .

A Simplified Repricing Model
1 YR Fixed Rate Loans Floating Rate Loans Mortgages Total Prof CD Floating Rate Deposit Time Deposit Total Gap Cum 50 25 75 (21) (21) 50 25 75 (21) (42) 200 5 (37) 50 7 (30) 50 4 54 50 4 54 2 YR 3 YR 150 50 5 205 150 50 50 50 50 (40) (70) 0 70 0

4 YR

5 YR

> 5 YR

TOTAL 150 50

50 7 57 10 10 70 70

100 300 150 50 100 300

A Simplified Repricing Model

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.

A Simplified Repayment Model
1 YR Fixed Rate Loans Floating Rate Loans Mortgages Total Prof CD Floating Rate Deposit Time Deposit Total Gap Cum 25 25 (21) (21) 25 25 (21) (42) 150 5 (37) 50 7 (30) 4 4 4 4 5 155 150 50 50 50 (40) (70) 0 70 0 2 YR 3 YR 150 4 YR 5 YR > 5 YR TOTAL 150 50 10 10 70 70 100 300 150 50 100 300 50 7 57


  30 . 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.A Simplified Repayment Model Conclusions  In general. There is liquidity risk if cash inflows from asset repayments do not coincide with the cash outflows from liability maturities.

The key is to determine an acceptable amount of risk given a certain set of forecast events. it can be managed.     31 . we take some interest rate risk. Elimination of risk may not be a goal. Needs highlighted by the model can help us evolve new product offerings.Repricing & Repayment Model Benefits  A good model provides insights into profit dynamics and liquidity position of the business. Once the risk is identified. as a financial intermediary.

Product Dynamics Product Product Agreement Pricing Behavior often observed Liquidity Product Agreement Behavior often observed Contractual for 3 months Roll-over / Pre-termination Portfolio Dynamics: Core (LT) vs NonCore (ST) Term deposit Agreed upon rate Market lagging / Pricing pressure (e. pressure or statutory Revolver max. 32 .Sticky pricing a/c term) On demand (shortterm) 15 year Fixed-Rate Agreed upon rate Refinancing with the Mortgages same bank Credit cards Can be re-priced upon notice Contractual for 15 years Refinancing with another bank Limited repricing ability Minimum payment by Portfolio Dynamics: due to competitive due date Transactor vs. 3 month fixed (competition) rate TD) Current a/c Savings On demand (short.g.

 As the book grows. 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. we can perform statistical behavioral analysis. the amount of this core segment will also grow.   33 .Savings Example REPAYMENT ANALYSIS  With a large enough population.  As the book grows. the percentage which this core segment represents usually does not grow.

there will be a considerable interval before the next repricing. it clearly will NOT be.Savings Example REPRICING ANALYSIS  Movements of product price vs. Although the entire portfolio could (in theory) be re-priced tomorrow. market rates generally show a weak but notable relationship.  34 . 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. However.

the core portion of the book remains long term. But how long is long enough for core? It all depends… Core: Generally 2 years ~ 5 years Non-Core: Generally overnight ~ 1 month. 35      . Assumptions should be reviewed periodically.Savings Example Assigning a Tenor to Savings is a CHALLENG E!  We said that even though Savings is contractually “on demand”.

such as:       Ceilings / Floors Advertising / promotion campaigns Innovation 36 . Adjust for seasonalities. Take into account other variables. Do a redemption analysis (examining the actual payment history of a product set).Treasury’s Response   Statistically Determine Actual Behavior Take a portfolio approach (providing that a large enough population exists for statistical validation).

Treasury’s Response   Use re-pricing models to predict profitability The actual re-pricing structure determine future profitability. all liabilities and capital gives us our current interest rate position and exposure to future events. A re-pricing schedule of all assets vs. A re-pricing model should be able to forecast earnings volatility.   37 .

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.Summary  Consumer products have certain repayment and re-pricing characteristics that need to be managed.   38 .

Treasury Role of Benchmarking Unit Outline  Benchmarking: the concept  Benchmark determination  Benchmark pricing examples  Benchmark pricing in practice  Summary 39 .

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 40 .

Benchmarking : The Concept  Why is Benchmarking Necessary?  Benchmarks are designed to transfer market risk exposure from the individual product managers to treasury. customer pricing. the impact of market risk is buried in the results of the product manager     41 . positioning and product development Promotes management accountability Without benchmark. 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.

booked today Asset Spread (Loans) 5% Yield Curve Risk Management Gap (tenor mismatch) 4% Liability Spread (Deposits) Time 42 . one liability.Measurement of Margin Components   Simplified Yield Curve Example – one asset.

43 .0% Matched Spread Liabs 3.0% Adding the matched spreads (3%+1%) and the treasury spread (1.0% Spread 5.0% Treasury Risk Mgt Revenue 1.0% 5.0% 4.0% Transfer Price 5. The 1% treasury spread is the net impact arising from the bank’s market risk.0% 1.0% Transfer Price Expense 4.0% 5.Measurement of Margin Components Line Unit Assets Customer Rate8.0%) equates to the total business spread of 5. Generally the spread is positive when the asset tenors are longer than liabilities.0% 3.0% Risk Totally Treasury Mgt Matched Transfer Price Income 5.0% 0.0%.

repricing. date of origination.the benchmark price The assignment of a benchmark should be driven by the characteristics of cash flow.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 . maturity (with adjustments for liquidity and embedded options)  44 .

Session.II Managing Treasury Risk 45 .

Managing Interest Rate Risk UNIT OUTLINE  Identifying the Risk Measuring the Risk  46 .

How often? How much?) Portfolio vs.I. Do we. 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. Single Account   47 .

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 48 .

 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 Structural or Intentional     49 .I. Identifying the Risk SOURCE OF RISK . Can be “Positive” or “Negative”. Can be represented as run-off gaps or as remaining gaps (cumulative gaps).GAPS IN AN EXISTING PORTFOLIO A GAP….

I. Identifying the Risk SOURCE OF RISK .GAPS IN AN EXISTING PORTFOLIO Re-pricing Mismatch: A gap occurs when assets are repriced at different periods from liabilities ASSET REPRICING LIABILITY REPRICING Asset Liability : A one-year quarterly floating rate loan : A one-year time deposit Q1 Q2 Q3 Q4 50 .

GAPS IN AN EXISTING PORTFOLIO RUN-OFF GAPS (Maturing amounts) At the beginning of Asset $100MM 1-mth placement w/CMB Liability $100MM 3-mth deposit (Repriceable in 3 mths time) Run-off Gap Cumulative Gap Mth 1 Mth 2 Mth 3 Mth 4 Mth 5 Mth 6 Mth 7 100 (100) 0 0 100 100 0 100 (100) 0 0 0 0 0 0 0 Cumulative gaps (Remaining Amount) Asset Liability Cumulative Gap Mth 1 Mth 2 Mth 3 Mth 4 Mth 5 Mth 6 Mth 7 (100) 100 100 100 0 100 100 51 .I. Identifying the Risk SOURCE OF RISK .

Identifying the Risk SOURCE OF RISK .GAPS IN AN EXISTING PORTFOLIO TYPE DEFINITION / IMPLICATIONS IF RATES MOVE UP Profits rise IF RATES MOVE DOWN Profits fall Positive Gap • Assets repricing faster than liabilities • More liabilities to be placed • Lend short Borrow long • Over-Borrowed • COF (Depos Rates) lockedin • Liabilities repricing faster than assets • More assets to be funded • Borrow short Lend long • Over-Lent • Revenue (Lending rates) locked-in Negative Gap Profits fall Profits rise 52 .I.

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 53 .

Identifying the Risk SOURCE OF RISK .I.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… L e n d (lo n g ) B o rro w (s h o rt) S p re a d Year 1 10% 10% Year 2 10% 9% 1% Year 3 10% 8% 2% 54 .

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. Identifying the Risk SOURCE OF RISK .I. you can reinvest it at the higher rates  This results in a Positive Gap L e n d (s h o rt) B o rro w (lo n g ) S p re a d Year 1 10% 10% Year 2 11% 10% 1% Year 3 12% 10% 2% 55 .

00% 7. change pricing nature of assets to match pricing nature of liabilities or vice versa 56 .50% To manage the basis mismatch risk.25% 7.25% 7. have different degrees of rate sensitivity PRODUCT Asset (90 days Eurodollar) Liability (90 days Bank CD) 1st QUARTER 2nd QUARTER 7.I.BASIS MISMATCH When two products (which may have the same re-pricing or maturity) in the same market. Identifying the Risk SOURCE OF RISK .

I. Identifying the Risk  Source of Risk – Volume Risk BAU/Status Quo FYF 100 Actual 100 B/(W) - 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 57 .

Identifying the Risk SOURCE OF RISK .may be unable to price new loans upwards while we might have to re-price deposits upwards by close to 2% 58 .no rate risk  New portfolio .I.STICKY RATES ON ORIGINATION If interest rates rise 2%  Current portfolio .

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” 59 . Identifying the Risk SOURCE OF RISK .I.

Measuring the Risk KEY CONCEPTS   DV01 (Earnings At Risk) 60 .II.

DV01  Management Tool to evaluate risk and define economic loss parameter 61 .II. the re-pricing gap must be translated into how much earnings risk it represents. Measuring the Risk  To be more meaningful.

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    62 . 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.II.

000 63 .01% * 100 mio * 6/12 = 5.II. Dv01 An Example: Executed Placement deal of USD 100 mio for Tenor 6 mths Dv01 = 0.

Liquidity Risk Overview      Introduction – What is Liquidity Risk? How Liquidity Risk Arises Liquidity Management Product Liquidity Characteristics Summary – Liquidity Risk 64 .

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     65 .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.

This is our key franchise risk (customer confidence).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. 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 67 .

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 68 .

or central bank policy change) affecting market liquidity and ability of most participants to transact at normal volumes.  Name Problem  Denial of market access to specific counterparty due to concern over its creditworthiness 69 . rates. or tenors. political turmoil.Contingency Situations  Market Disruption  Displacement of market arising from “abnormal” events (often economic crisis.

Liquidity Management Objectives o To ensure sufficient liquidity to meet all financial commitments and obligations when they fall due To be able to access liquidity in global markets at “reasonable” terms To plan. quantify. and monitor what kinds and levels of risk that is prudent for the company To balance the cost of maintaining liquidity. with the appropriate level of returns o o o 70 .

oversight by Asset and Liability Committee (ALCO). Treasury. and Risk Management. Country Treasurer    Has primary responsibility for liquidity management Develops funding plan & process for each legal vehicle 71 .Roles & Responsibility  Managing liquidity risk is the joint responsibilities of Business.

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.Summary  Effective liquidity management is critical to:   Business survival. 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 72 .

Session.III Money Market Instruments 73 .

all things being equal. liquidity risk. compounding)    Opportunity cost of inflation Cost of insulating against rate moves With a positive yield curve.Concept of a Yield Curve Positive Yield Curve  Positive Yield Curve    Slopes upward to the right No specific trend Premium for longer period Rates  Aka “normal yield curve” Maturities (credit risk. a negative gap is generally the profitable position 74 .

Gapping: Examples of Different Yield Curve Positive Yield Curve Parallel Shift Change Shape Rates Rates Rates Maturities Maturities Maturities 75 .

USD 76 .Gapping: Current Yield Curve .

Gapping: Yield Curve Shifts – USD Yr 2003 vs 2004 May 2004 June 2003 77 .

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 counterparty 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 .

Life: 6 mths Avg. higher rates will narrow their spread Solution: ABC decides to enter a SWAP to “pay fixed. receive float” with bank XYZ 86  . Life: 10 yrs Avg. Rate: 11% (fixed for 10 yrs)  Concern: ABC expects interest rates to rise.Interest Rate Swap Example  Bank ABC’s fixed rate mortgage portfolio is funded by 6-month interbank borrowing Liabilities $50MM TDs Avg. Rate: 8% Assets $50MM mortgages Avg.

only net coupon interest payments   87 .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.

Interest Rate Swap Example MORTGAGE FIXED RATE PORTFOLIO Asset FIXED RATE = (9%) 11% XYZ SWAP FLOATING RATE = 8% ABC (8%) FUNDING SOURCE FLOATING RATE 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 Receives from XYZ Net Spread Receives from Mortgage Pays fixed to XYZ Net Spread (8%) 8% 0% 11% 9% 2%       89 .

6-month libor Net spread Receives from mortgage portfolio Pays Bank XYZ Net spread 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   Results for ABC: The Next Six Months (Assume interest rates increase 2%) Without SWAP  With SWAP        (10%) (10%) 10% 0% 11% 11% -9% 1% 2% Borrows 6-month libor Receives from XYZ.

0% at each of the next 2 resets (1 year).Interest Rate Swap Example  Assume rates continued to rise by 1. then begin to fall by 2% for each of the next 2 resets (1 year) 14 12 Interest Rates 12 11 10 8 10 8 6 4 2 0 R1 R2 Fixed Rate Paid to XYZ R3 Resets R4 91 .

Swap Spread Net Spread (c+f)  R2 R3 (11%) (12%) 11% 11% 0% (1%) 11% (9%) 2% 2% 12% (9%) 3% 2% R4 (10%) 11% 1% 10% (9%) 1% 2% (8%) 11% 3% 8% (9%) (1%) 2% Without the interest rate swap. regardless of how interest rates change  92 . Receives from Mortgages c. 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. Net Spread d.Interest Rate Swap Example R1 a. Pay XYZ f. Receives from XYZ e. Borrows Inter-bank b.

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. Similarly. the following are:   6x12 : 6-month rate in 6 months time 2x5 : 3-month rate in 2 months time 94 . a deal for a 3month tenor in 3 months time is a 3x6.

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 . funded via 3-month interbank borrowings ASSETS $50MM auto loans Tenor: 1year Fixed Rate: 10% LIABILITIES $50MM TDs Tenor: 3mths Rate: 7.Forward Rate Agreement Example  ABC has a $50MM.5%    Concern: ABC expects rates to rise in the future. 1 year fixed rate auto loan portfolio.

5%.25% o On maturity of the 3-month interbank cash borrowing at 7.75% $50MM 6 x 9 mths @ 8.00% $50MM 9 x 12 mths @ 8.Forward Rate Agreement Example o ABC will buy FRA strips to match rollover dates of 3month borrowings: $50MM 3 x 6 mths @ 7. ABC will rollover the US$50MM at the prevailing interbank market rate 96 .

1.Forward Rate Agreement Example  Assume rates continued to increase by 0. then another 0.0 7.0% 9 8 7 6 5 4 3 2 1 0 R0 8.5% R2 + 0.5% at the next rollover.0% by the last quarter:    Interest Rates R1 + 0.5% R3 .0 R1 Resets R2 R3 97 .5 7.5% and then fall -1.5 8.

75% 8.5% 3.25 0.00% 8.5% 2.0% 1.0% 1.0% Auto Loan 3mth interbank Spread before FRA FRA FRA Gain/(Loss) Effective Rate Net Spread 7.25%) 7.0% 2.25% 2.Forward Rate Agreements Example Results for ABC rollovers R0 R1 10% 10% 7.5% 2.75% 98 .5% 7.0% 8.75% 8.0% R2 R3 10% 10% 8.50 (1.25% 2.25% 0.5% 7.5% 8.

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.Interest Rate Options  Definition:   A contract that gives the options buyer the right. but still receive benefit of favorable moves 99 . but not the obligation.

Introduction to Foreign Exchange Unit Outline     Foreign Exchange Fundamentals Types of Foreign Exchange Exposure Managing FX Exposure .considerations Factors affecting the market 100 .

Price Quotation:  Bid and Offer  101 . 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.Foreign Exchange Fundamentals What is Foreign Exchange?  A foreign exchange transaction involves one currency being bought or sold against another currency Rate Quotation: a.

2. 9 and 12 months 102 . 3. 6.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.

Foreign Exchange Fundamentals
Why is there a FX market?
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International trade Capital movements Financial transactions Exchange of services Tourism


Foreign Exchange Fundamentals
Players in the FX market?
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Commercial banks Speculators Fund Managers Non financial businesses Central banks Investment houses


Foreign Exchange Fundamentals
Factors affecting FX rate movement
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Demand and supply Sovereign policy  Exchange control/regulations Economic performance  Money supply  Inflation  Interest rates Speculation


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 .

Options 108 . Forwards 2. FX Swaps 3.FX Treasury Products We will briefly discuss the 3 basic forms of derivative products: 1.

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