INDIAN INSTITUTE OF BANKING

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INDIAN INSTITUTE OF BANKING FINANCE

• RISK MANAGEMENT
• MODULE C D
• BY
• M.Ravindran
• ravindran_at_iibf.org.in

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Syllabus

• Module C Treasury Management
• Treasury management concepts and functions
  instruments in the
• treasury market development of new financial
  products control
• and supervision of Treasury management linkage
  of domestic
• operations with foreign operations.
• Asset-liability management Interest rate risk
  interest rate futures
• stock options debt instruments bond portfolio
  strategy risk
• control and hedging instruments.
• Investments Treasury bills Money markets
  instruments such
• as CDs, CPs, IBPs Securitisation and Forfaiting
  Refinance and
• rediscounting facilities.

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Syllabus

• Module D Capital Management and Profit Planning
  
• Prudential Norms- Capital Adequacy-Basel II-Asset
  Classification-provisioning
• Profit and Profitability-Historical Perspective
  of the Approach of Banks to profitability-Effects
  of NPA on profitability-A profitability
  Model-Share holders value Maximization
  EVA-Profit Planning-Measures to improve
  profitability

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RISK MANAGEMENTModule C-Treasury Management

• Treasury Products
• Treasury Risk Management
• Derivative Products

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Integrated Treasury

• Integrated Treasury refers to integration of
  money market, securities market and foreign
  exchange operations.
• -Meeting reserve requirements
• -Efficient merchant services
• -Global cash management
• -Optimizing profit by exploiting market
  opportunities in forex market, money market and
  securities market
• -Risk management
• -Assisting bank management in ALM

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Treasury
Function Responsible for
Front office Dealing
Mid-Office Risk management, accounting and management information
Back office Confirmations, settlement and reconciliation
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Dealing
settlement
MIS
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Treasury
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Money Market

• Certificate of Deposit (CD)
• Commercial Paper (C.P)
• Inter Bank Participation Certificates
• Inter Bank term Money
• Treasury Bills
• Call Money

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Certificate of Deposit

• CDs are short-term borrowings in the form of
  Usance Promissory Notes having a maturity of not
  less than 15 days up to a maximum of one year.
• CD is subject to payment of Stamp Duty under
  Indian Stamp Act, 1899 (Central Act)
• They are like bank term deposits accounts. Unlike
  traditional time deposits these are freely
  negotiable instruments and are often referred to
  as Negotiable Certificate of Deposits

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Features of CD

• CDs can be issued by all scheduled commercial
  banks except RRBs
• Minimum period 15 days
• Maximum period 1 year
• Minimum Amount Rs 1 lac and in multiples of Rs. 1
  lac
• CDs are transferable by endorsement
• CRR SLR are to be maintained
• CDs are to be stamped

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Commercial Paper

• Commercial Paper (CP) is an unsecured money
  market instrument issued in the form of a
  promissory note.
• Who can issue Commercial Paper (CP) Highly
  rated corporate borrowers, primary dealers (PDs)
  and satellite dealers (SDs) and all-India
  financial institutions (FIs)

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Eligibility for issue of CP

• the tangible net worth of the company, as per the
  latest audited balance sheet, is not less than
  Rs. 4 crore
• (b) the working capital (fund-based) limit of
  the company from the banking system is not less
  than Rs.4 crore
• and the borrowal account of the company is
  classified as a Standard Asset by the financing
  bank/s.

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Rating Requirement

• All eligible participants should obtain the
  credit rating for issuance of Commercial Paper
• Credit Rating Information Services of India Ltd.
  (CRISIL)
• Investment Information and Credit Rating Agency
  of India Ltd. (ICRA)
• Credit Analysis and Research Ltd. (CARE)
• Duff Phelps Credit Rating India Pvt. Ltd. (DCR
  India)
• The minimum credit rating shall be P-2 of CRISIL
  or such equivalent rating by other agencies

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Maturity

• CP can be issued for maturities between a minimum
  of 15 days and a maximum upto one year from the
  date of issue.
• If the maturity date is a holiday, the company
  would be liable to make payment on the immediate
  preceding working day.

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To whom issued

• CP is issued to and held by individuals, banking
  companies, other corporate bodies registered or
  incorporated in India and unincorporated bodies,
  Non-Resident Indians (NRIs) and Foreign
  Institutional Investors (FIIs).

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Repo

• Uses of RepoIt helps banks to invest surplus
  cashIt helps investor achieve money market
  returns with sovereign risk. It helps borrower
  to raise funds at better ratesAn SLR surplus and
  CRR deficit bank can use the Repo deals as a
  convenient way of adjusting SLR/CRR positions
  simultaneously. RBI uses Repo and Reverse repo
  as instruments for liquidity adjustment in the
  system

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Meaning of Repo

• It is a transaction in which two parties agree to
  sell and repurchase the same security. Under such
  an agreement the seller sells specified
  securities with an agreement to repurchase the
  same at a mutually decided future date and a
  price
• The Repo/Reverse Repo transaction can only be
  done at Mumbai between parties approved by RBI
  and in securities as approved by RBI (Treasury
  Bills, Central/State Govt securities).

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Coupon rate and Yield

• The difference between coupon rate and yield
  arises because the market price of a security
  might be different from the face value of the
  security. Since coupon payments are calculated on
  the face value, the coupon rate is different from
  the implied yield.

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Example

• 10 Aug 2015 10 year Govt Bond
• Face Value RS.1000
• Market Value Rs.1200
• In this case Coupon rate is 10
• Yield is 8.33

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Call Money Market

• The call money market is an integral part of the
  Indian Money Market, where the day-to-day surplus
  funds (mostly of banks) are traded. The loans are
  of short-term duration varying from 1 to 14 days.
• The money that is lent for one day in this
  market is known as "Call Money", and if it
  exceeds one day (but less than 15 days) it is
  referred to as "Notice Money".

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Call Money Market

• Banks borrow in this market for the following
  purpose
• To fill the gaps or temporary mismatches in funds
  
• To meet the CRR SLR mandatory requirements as
  stipulated by the Central bank
• To meet sudden demand for funds arising out of
  large outflows.

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Factors influencing interest rates

• The factors which govern the interest rates are
  mostly economy related and are commonly referred
  to as macroeconomic factors. Some of these
  factors are
• 1) Demand for money
• 2) Government borrowings
• 3) Supply of money
• 4) Inflation rate
• 5) The Reserve Bank of India and the Government
  policies which determine some of the variables
  mentioned above.

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Gilt edged securities

• The term government securities encompass all
  Bonds T-bills issued by the Central Government,
  and state governments. These securities are
  normally referred to, as "gilt-edged" as
  repayments of principal as well as interest are
  totally secured by sovereign guarantee.

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Treasury Bills

• Treasury bills, commonly referred to as T-Bills
  are issued by Government of India against their
  short term borrowing requirements with maturities
  ranging between 14 to 364 days.
• All these are issued at a discount-to-face
  value. For example a Treasury bill of Rs. 100.00
  face value issued for Rs. 91.50 gets redeemed at
  the end of it's tenure at Rs. 100.00.

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Who can invest in T-Bill

• Banks, Primary Dealers, State Governments,
  Provident Funds, Financial Institutions,
  Insurance Companies, NBFCs, FIIs (as per
  prescribed norms), NRIs OCBs can invest in
  T-Bills.

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What is auction of Securities

• Auction is a process of calling of bids with an
  objective of arriving at the market price. It is
  basically a price discovery mechanism

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Debenture

• A Debenture is a debt security issued by a
  company (called the Issuer), which offers to pay
  interest in lieu of the money borrowed for a
  certain period.
• These are long-term debt instruments issued by
  private sector companies. These are issued in
  denominations as low as Rs 1000 and have
  maturities ranging between one and ten years.

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Difference between debenture and bond

• Long-term debt securities issued by the
  Government of India or any of the State
  Governments or undertakings owned by them or by
  development financial institutions are called as
  bonds. Instruments issued by other entities are
  called debentures.

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Current yield

• This is the yield or return derived by the
  investor on purchase of the instrument (yield
  related to purchase price) It is calculated by
  dividing the coupon rate by the purchase price of
  the debenture. For e. g If an investor buys a
  10 Rs 100 debenture of ABC company at Rs 90, his
  current Yield on the instrument would be computed
  as Current Yield (10100)/90 X 100 , That is
  11.11 p.a.

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Primary Dealers Satellite Dealers

• Primary Dealers can be referred to as Merchant
  Bankers to Government of India, comprising the
  first tier of the government securities market.
  Satellite Dealers work in tandem with the Primary
  Dealers forming the second tier of the market to
  cater to the retail requirements of the market.
• These were formed during the year 1994-96 to
  strengthen the market infrastructure

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What role do Primary Dealers play?

• The role of Primary Dealers is to (i) commit
  participation as Principals in Government of
  India issues through bidding in auctions (ii)
  provide underwriting services (iii) offer firm
  buy - sell / bid ask quotes for T-Bills dated
  securities (v) Development of Secondary Debt
  Market

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OMO

• OMO or Open Market Operations is a market
  regulating mechanism often resorted to by Reserve
  Bank of India. Under OMO Operations Reserve Bank
  of India as a market regulator keeps buying
  or/and selling securities through it's open
  market window. It's decision to sell or/and buy
  securities is influenced by factors such as
  overall liquidity in the system,

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YIELD CURVE

• The relationship between time and yield on a
  homogenous risk class of securities is called the
  Yield Curve. The relationship represents the time
  value of money - showing that people would demand
  a positive rate of return on the money they are
  willing to part today for a payback into the
  future

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SHAPE OF YIELD CURVE

• A yield curve can be positive, neutral or flat.
  A positive yield curve, which is most natural, is
  when the slope of the curve is positive, i.e. the
  yield at the longer end is higher than that at
  the shorter end of the time axis. This results,
  as people demand higher compensation for parting
  their money for a longer time into the future. A
  neutral yield curve is that which has a zero
  slope, i.e. is flat across time. T his occurs
  when people are willing to accept more or less
  the same returns across maturities. The negative
  yield curve (also called an inverted yield curve)
  is one of which the slope is negative, i.e. the
  long term yield is lower than the short term
  yield

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LIBOR

• LIBOR stands for the London Interbank Offered
  Rate and is the rate of interest at which banks
  borrow funds from other banks, in marketable
  size, in the London interbank market.
• LIBOR is the most widely used "benchmark" or
  reference rate for short term interest rates. It
  is compiled by the British Bankers Association
  as a free service and released to the market at
  about 11.00London time each day.

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CRR SLR

• The minimum and maximum levels of CRR are
  prescribed at 3 and 20 of demand and term
  liabilities (DTL) of the bank, respectively,
  under Reserve Bank of India Act of 1934. The
  minimum and maximum SLR are prescribed at 25 and
  40 of DTL respectively, under Banking Regulation
  Act of 1949. The CRR and SLR are to be maintained
  on fortnightly basis. The RBI is authorized to
  increase or decrease the CRR and SLR at its
  discretion.

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Demand and Time Liabilities

• Main components of DTL are
• Demand deposits (held in current and savings
  accounts, margin money for LCs, overdue fixed
  deposits etc.)
• Time deposits (in fixed deposits, recurring
  deposits, reinvestment deposits etc.)
• Overseas borrowings
• Foreign outward remittances in transit (FC
  liabilities net of FC assets)
• Other demand and time liabilities (accrued
  interest, credit balances in suspense account
  etc. )

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SLR

• SLR is to be maintained in the form of the
  following assets
• Cash balances (excluding balances maintained for
  CRR)
• Gold (valued at price not exceeding current
  market price)
• Approved securities valued as per norms
  prescribed by RBI.

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VaR

• Value at Risk (VaR) is the most probable loss
  that we may incur in normal market conditions
  over a given period due to the volatility of a
  factor, exchange rates, interest rates or
  commodity prices. The probability of loss is
  expressed as a percentage VaR at 95 confidence
  level, implies a 5 probability of incurring the
  loss at 99 confidence level the VaR implies 1
  probability of the stated loss. The loss is
  generally stated in absolute amounts for a given
  transaction value (or value of a investment
  portfolio).

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VaR

• The VaR is an estimate of potential loss, always
  for a given period, at a given confidence level..
  A VaR of 5p in USD / INR rate for a 30- day
  period at 95 confidence level means that Rupee
  is likely to lose 5p in exchange value with 5
  probability, or in other words, Rupee is likely
  to depreciate by maximum 5p on 1.5 days of the
  period (305 ) . A VaR of Rs. 100,000 at 99
  confidence level for one week for a investment
  portfolio of Rs. 10,000,000 similarly means that
  the market value of the portfolio is most likely
  to drop by maximum Rs. 100,000 with 1
  probability over one week, or , 99 of the time
  the portfolio will stand at or above its current
  value.

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Exchange Rate Quotation

• Exchange Quotations
• There are two methods
• Exchange rate is expressed as the price per unit
  of foreign currency in terms of the home currency
  is known as the Home currency quotation or
  Direct Quotation
• Exchange rate is expressed as the price per unit
  of home currency in terms of the foreign currency
  is known as the Foreign Currency Quotation or
  Indirect Quotation
• Direct Quotation is used in New York and other
  foreign exchange markets and Indirect Quotation
  is used in London foreign exchange market.

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Principles

• Direct Quotation Buy Low, Sell High
• The prime motive of any trader is to make profit.
  By purchasing the commodity at lower price and
  selling it at a higher price a trader earns the
  profit. In foreign exchange, the banker buys the
  foreign currency at a lesser price and sells it
  at a higher price.
• Indirect Quotation Buy High, Sell Low
• A trader for a fixed amount of investment would
  acquire more units of the commodity when he
  purchases and for the same amount he would part
  with lesser units of the commodity when he sells.

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Spot and Forward Transactions

• A Bank agrees to buy from B Bank USD 100000.
  The actual exchange of currencies i.e. payment of
  rupees and receipt of US Dollars, under the
  contract may take place
• on the same day or
• two days later or
• some day later, say after a month.

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Interpretation of Quotation

• The market quotation for a currency consists of
  the spot rate and the forward margin. The
  outright forward rate has to be calculated by
  loading the forward margin into the spot rate.
  For example US Dollar is quoted as under in the
  inter-bank market on a given day as under
• Spot 1 USD Rs.44.1000/1300
• Spot/November 0200/0500
• Spot/December 1500/1800

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TT Buying Rate

• TT Buying Rate (TT stands for Telegraphic
  Transfer)
• This is the rate applied when the transaction
  does not involve any delay in realization of the
  foreign exchange by the bank. In other words,
  the nostro account of the bank would already have
  been credited. The rate is calculated by
  deducting from the inter-bank buying rate the
  exchange margin as determined by the Bank.

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Bills Buying Rate

• This is the rate to be applied when a foreign
  bill is purchased. When a bill is purchased, the
  proceeds will be realized by the Bank after the
  bill is presented to the drawee at the overseas
  center. In the case of a usance bill the
  proceeds will be realized on the due date of the
  bill which includes the transit period and the
  usance period of the bill.

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Problem

• You would like to import machinery from USA
  worth USD 100000
• to be payable to the overseas supplier on 31st
  Oct
• a Spot Rate USD
  Rs.45.8500/8600
• Forward Premium
• September 0.2950/3000
• October 0.5400/5450
• November 0.7600/7650
• b exchange margin 0.125
• c Last two digits in multiples of nearest 25
  paise
• Calculate the rate to be quoted by the bank ?

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Solution

• This is an example Forward Sale Contract .
• Inter Bank Spot Selling Rate Rs. 45.8600
• Add Forward Margin .5450
• 
  --------------
• 
  46.4050
• Add Exchange Margin .0580
• 
  ---------------
• Forward Rate
  46.4630
• Rounded Off to multiple of 25 paise
  Rs.46.4625
• Amount Payable to the bank
  Rs.46,46,250

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Swap

• A swap agreement between two parties commits each
  counterparty to exchange an amount of funds,
  determined by a formula, at regular intervals,
  until the swap expires.
• In the case of a currency swap, there is an
  initial exchange of currency and a reverse
  exchange at maturity.

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Mechanics

• Firm A needs fixed rate loan AAA rated
• Firm B needs floating rate -A rated
• Firm A enjoys an absolute advantage in both
  credit markets.

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Mechanics

• STEP !
• Firm A will borrow at Fixed rate 9
• Firm B will borrow at floating rate (LIBOR 1)
• STEP 2
• Firm A will pay Floating rate LIBOR to Firm B
• Firm B will Pay Fixed rate 9.5 only
• Gain
• Net interest cost LIBOR- .5
• Net Interest cost 9 10.510.5

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Mechanics

• Gain