INDIAN INSTITUTE OF INDIAN INSTITUTE OF BANKING & FINANCEBANKING & FINANCE

Risk Management –Module CRisk Management –Module C24-10-2007 6-7.30 pm24-10-2007 6-7.30 pm

ByByM.RavindranM.Ravindran

ravindran@iibf.org.inravindran@iibf.org.in

SyllabusSyllabusModule C: Treasury ManagementModule C: Treasury Management: :

Treasury managementTreasury management; concepts and functions; instruments in the; concepts and functions; instruments in thetreasury market; development of new financial products; controltreasury market; development of new financial products; controland supervision of Treasury management; linkage of domesticand supervision of Treasury management; linkage of domesticoperations with foreign operations.operations with foreign operations.Asset-liability managementAsset-liability management; Interest rate risk; interest rate futures;; Interest rate risk; interest rate futures;stock options; debt instruments; bond portfolio strategy; riskstock options; debt instruments; bond portfolio strategy; riskcontrol and hedging instruments.control and hedging instruments.Investments –Investments – Treasury bills – Money markets instruments such Treasury bills – Money markets instruments suchas CDs, CPs, IBPs; Securitisation and Forfaiting; Refinance andas CDs, CPs, IBPs; Securitisation and Forfaiting; Refinance andrediscounting facilities. rediscounting facilities.

ExampleExample

Which of the following about a callable bond is true?a. Callable bonds always trade at a discount to non-callable bonds.b. Callable bonds expose issuers to the risk of reduced re-investment return.c. Callable bonds are actually variable tenor bonds.d. Callable bonds are not as liquid as non-callable bonds.

Ans: c.

ABC Bank enters into an Interest Rate Swap with XYZ Ltd on the following terms

Principal Amount Principal Amount Rs. 100crores Rs. 100crores

Corporate to Pay Corporate to Pay 6.50% Fixed6.50% Fixed

Corporate to ReceiveCorporate to Receive 3 month NSE MIBOR3 month NSE MIBOR

Start dateStart date 25-4-0725-4-07

TenorTenor 6 months6 months

Termination dateTermination date 25-10-0725-10-07

Interest Payment Dates Interest Payment Dates 2525thth July & 25 July & 25thth Oct Oct

First Fixing First Fixing 6.10%6.10%

In the above case, which of the following is correct in respect of net interest amount payable/receivable on 25th July 2007? a) XYZ Ltd to pay Rs.986301********b) XYZ Ltd to receive Rs.986301 1000000000*90*.4 -------------------------c)XYZ Ltd to pay Rs. 1972602 36500d) XYZh Ltd to receive Rs.1972602

General Ledger Balance of ABC Bank as on 12-10-2007Rs. In 000’s

Liabilities Rs Assets Rs

Paid up capital 10,000 Building 10000

Current Account 180,000 Car 20000

SB 450,000 Cash Credit 1000000

Fixed Deposit 600,000 Term Loan 800000

Interest accrued 10000

Margin on LCs 2,000 Suspense Account 10000

TT Payable 1,000 Branch Adjustment Account

20000

CBLO(Colaterised Borrowing & Lending Obligations)

600,000

ECGC Claims 7,000

18 60 000 1860000

1)Demand Liabilities in the above cae works out to ……………

a) 631000******b) 638000c) 1238000d) None of the above

2)Time Liabilities is equal to ………………………..a) 600000********b) 120000c) 127000d) None of the above

3)Other demand and time

Liabilities amounts to ……………………

a) 10000b) 17000c) 18000d) None of the

above

4)Which of the following is not an exempted category for the purpose of CRR calculation?

a) Credit Balances in ACU Dollar Accounts

b)CBLOc) DTL in respect of OBUsd)Staff Security Deposits ********

Which of the following can be included for DTL/NDTL

computationa. Amount received from

DICGC Claimsb. Amount received from

Insurance company on ad hoc settlement of claims

c. Amount received from the court receiver

d. Amount held as margin against LC*********

ABC IS A CORPORATE, WHOSE BANKER IS XYZ.ABC WILL IMPORT RAW MATERIAL WORTH USD.500000.00 IN THE MONTH OF JANUARY & PAYMENT IS TO BE MADE ON 31ST JANUARY,2008 ABC WANTS TO BOOK A FORWARD CONTRACT FOR THIS TRANSACTION :SPOT RATE OF USD : 39.32/33PREMIUM UPTO 31ST JANUARY,2008 :RS.0.15 PAISEBANK WILL KEEP A MARGIN OF RS.0.03 PAISEBASED ON THE ABOVE, WHAT WILL BE THE RATE TO BE QUOTED TO ABC, BY XYZ :(A) RS. 39.50(B) RS. 39.51(C) RS.39.44 Answer : B(D) RS.39.48

The credit portfolio of ABC Bank has undergone a uniform downgrade as on 31-3- 2007 after an economic downturn. The position prior to the downgrade is given below:.The minimum capital required after downgrade is …………..

Rating Scale Risk Weight (%) ExposureRs. In crores

Extent of downgrade

AAA 20 200 20 %

AA 50 200 20 %

A 50 100 20 %

BBB 100 200 20 %

BB& Below 150 100  

    800  

Minimum capital under Basel II

Rs.48.60 crores    

a)57.6 crores***********b)58.6 croresc)60.6 croresd)52.6 crores

WorkingRating Scale

Risk Weight

Exposure

RWABefore down grade

Exposure after Downgrade

RWAAFTER DOWNGRADE

AAA 20% 200 40 160 80

AA 50% 200 100 200 100

A 50% 100 50 120 60

BBB 100% 200 200 180 180

BB & below

150% 100 150 140 210

540 630

Integrated TreasuryIntegrated Treasury

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

FRONT OFFICE

BACK OFFICEMID OFFICE

Dealing

MIS

settlement

TreasuryTreasury

Money MarketMoney Market

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

Certificate of DepositCertificate of Deposit

CDs are short-term borrowings BY BANKS in CDs are short-term borrowings BY BANKS in the form of Usance Promissory Notes having a the form of Usance Promissory Notes having a maturity of not less than 7 days up to a maturity of not less than 7 days up to a maximum of one year.maximum of one year.

CD is subject to payment of Stamp Duty under CD is subject to payment of Stamp Duty under Indian Stamp Act, 1899 (Central Act) Indian Stamp Act, 1899 (Central Act)

Features of CDFeatures of CD

Issued by all scheduled commercial banks Issued by all scheduled commercial banks except RRBsexcept RRBs

Minimum period 7 daysMinimum period 7 days Maximum period upto 1 yearMaximum period upto 1 year Minimum Amount Rs 1 lac and in multiples of Minimum Amount Rs 1 lac and in multiples of

Rs. 1 lacRs. 1 lac CDs are transferable by endorsementCDs are transferable by endorsement CRR & SLR are to be maintainedCRR & SLR are to be maintained CDs are to be stampedCDs are to be stamped

Commercial PaperCommercial Paper Commercial Paper (CP) is an unsecured Commercial Paper (CP) is an unsecured

money market instrument issued in the money market instrument issued in the form of a promissory note by form of a promissory note by corporates/PDs/FIscorporates/PDs/FIs

Who can issue Commercial Paper (CP) Who can issue Commercial Paper (CP) Highly rated corporate borrowers, primary Highly rated corporate borrowers, primary dealers (PDs) and all-India financial dealers (PDs) and all-India financial institutions (FIs) institutions (FIs)

Eligibility for issue of CP Eligibility for issue of CP

a)a) The tangible net worth of the company, as The tangible net worth of the company, as per the latest audited balance sheet, is not per the latest audited balance sheet, is not less than Rs. 4 crore;less than Rs. 4 crore;

b)b) The borrowal account of the company is The borrowal account of the company is classified as a Standard Asset by the classified as a Standard Asset by the financing bank/s. financing bank/s.

Rating RequirementRating Requirement All eligible participants should obtain the credit rating for All eligible participants should obtain the credit rating for

issuance of Commercial Paperissuance of Commercial Paper Credit Rating Information Services of India Ltd. (CRISIL) Credit Rating Information Services of India Ltd. (CRISIL) Investment Information and Credit Rating Agency of India Investment Information and Credit Rating Agency of India

Ltd. (ICRA) Ltd. (ICRA) Credit Analysis and Research Ltd. (CARE) Credit Analysis and Research Ltd. (CARE) Duff & Phelps Credit Rating India Pvt. Ltd. (DCR India)Duff & Phelps Credit Rating India Pvt. Ltd. (DCR India) The minimum credit rating shall be P-2 of The minimum credit rating shall be P-2 of

CRISIL or such equivalent rating by other CRISIL or such equivalent rating by other agenciesagencies

To whom issuedTo whom issued

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

MaturityMaturity

CP can be issued for maturities between a CP can be issued for maturities between a minimum of 7 days and a maximum upto one minimum of 7 days and a maximum upto one year from the date of issue.year from the date of issue.

If the maturity date is a holiday, the company If the maturity date is a holiday, the company would be liable to make payment on the would be liable to make payment on the immediate preceding working day. immediate preceding working day.

Meaning of RepoMeaning of Repo

It is a transaction in which two parties agree to sell It is a transaction in which two parties agree to sell and repurchase the same security. Under such an and repurchase the same security. Under such an agreement the seller sells specified securities with an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually agreement to repurchase the same at a mutually decided future date and a price decided future date and a price

The Repo/Reverse Repo transaction can only be done The Repo/Reverse Repo transaction can only be done at Mumbai between parties approved by RBI and in at Mumbai between parties approved by RBI and in securities as approved by RBI (Treasury Bills, securities as approved by RBI (Treasury Bills, Central/State Govt securities). Central/State Govt securities).

RepoRepo

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

Coupon rate and YieldCoupon rate and Yield

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

Example Example

10% Aug 2015 10 year Govt Bond 10% Aug 2015 10 year Govt Bond Face Value RS.1000Face Value RS.1000 Market Value Rs.1200Market Value Rs.1200 In this case Coupon rate is 10%In this case Coupon rate is 10% Yield is 8.33%Yield is 8.33% 1000*101000*10 ----------= 8.33%----------= 8.33% 12001200

Call Money MarketCall Money Market

The call money market is an integral part of the The call money market is an integral part of the Indian Money Market, where the day-to-day Indian Money Market, where the day-to-day surplus funds (mostly of banks) are traded. surplus funds (mostly of banks) are traded.

The money that is lent for one day in this The money that is lent for one day in this market is known as "market is known as "Call MoneyCall Money", ",

if it exceeds one day (but less than 15 days) it if it exceeds one day (but less than 15 days) it is referred to as "is referred to as "Notice MoneyNotice Money". ".

Call Money MarketCall Money Market

Banks borrow in this market for the following Banks borrow in this market for the following purposepurpose

To fill the gaps or temporary mismatches in To fill the gaps or temporary mismatches in funds funds

To meet the CRR & SLR mandatory To meet the CRR & SLR mandatory requirements as stipulated by the Central bank requirements as stipulated by the Central bank

To meet sudden demand for funds arising out To meet sudden demand for funds arising out of large outflows.of large outflows.

Factors influencing interest ratesFactors influencing interest rates

The factors which govern the interest rates are mostly The factors which govern the interest rates are mostly economy related and are commonly referred to as economy related and are commonly referred to as macroeconomic factorsmacroeconomic factors. Some of these factors are:. Some of these factors are:

1) 1) Demand for money Demand for money 2) 2) Government borrowingsGovernment borrowings3) 3) Supply of money Supply of money 4) 4) Inflation rateInflation rate5) 5) The Reserve Bank of India and the Government The Reserve Bank of India and the Government

policies determine some of the variables mentioned policies determine some of the variables mentioned above.above.

Gilt edged securitiesGilt edged securities

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

Treasury BillsTreasury Bills

Treasury bills, commonly referred to as T-Treasury bills, commonly referred to as T-Bills are issued by Government of India Bills are issued by Government of India against their short term borrowing against their short term borrowing requirements with maturities ranging between requirements with maturities ranging between 14 to 364 days. 14 to 364 days.

All these are issued at a discount-to-face value. All these are issued at a discount-to-face value. For example a Treasury bill of Rs. 100.00 face For example a Treasury bill of Rs. 100.00 face value issued for Rs. 91.50 gets redeemed at the value issued for Rs. 91.50 gets redeemed at the end of it's tenure at Rs. 100.00. end of it's tenure at Rs. 100.00.

Who can invest in T-BillWho can invest in T-Bill

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

What is auction of SecuritiesWhat is auction of Securities

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

Yield of Treasury BillYield of Treasury Bill

Y= (100-P)*365*100Y= (100-P)*365*100 ---------------------------------------------- P*DP*D Y = YieldY = Yield P= PriceP= Price D =Days to maturityD =Days to maturity

ExampleExample

91 days treasury bills maturing on 6-12-91 days treasury bills maturing on 6-12-20072007

Purchased on 12-10-2007 Rate quoted is Purchased on 12-10-2007 Rate quoted is Rs.99.1489 per Rs100Rs.99.1489 per Rs100

(100-99.1489)*365*100= 31065.15(100-99.1489)*365*100= 31065.15-------------------------------------------------------- (99.1489*55 days) =5453.18(99.1489*55 days) =5453.18=5.70%=5.70%

DebentureDebenture

A Debenture is a debt security issued by a A Debenture is a debt security issued by a company (called the Issuer), which offers to company (called the Issuer), which offers to pay interest in lieu of the money borrowed for pay interest in lieu of the money borrowed for a certain period. a certain period.

These are long-term debt instruments issued These are long-term debt instruments issued by private sector companies. These are issued by private sector companies. These are issued in denominations as low as Rs 1000 and have in denominations as low as Rs 1000 and have maturities ranging between one and ten years. maturities ranging between one and ten years.

Difference between debenture Difference between debenture and bondand bond

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

Current yieldCurrent yield

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

Primary Dealers Primary Dealers

Primary Dealers can be referred to as Primary Dealers can be referred to as Merchant Bankers to Government of Merchant Bankers to Government of India, comprising the first tier of the India, comprising the first tier of the government securities market. These government securities market. These were formed during the year 1994-96 to were formed during the year 1994-96 to strengthen the market infrastructure strengthen the market infrastructure

What role do Primary Dealers play?What role do Primary Dealers play?

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

OMOOMO

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

YIELD CURVEYIELD CURVE

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

SHAPE OF YIELD CURVESHAPE OF YIELD CURVEA A yieldyield curve can be positive, neutral or flat. A positive curve can be positive, neutral or flat. A positive yield curve, which is most natural, is when the slope of yield curve, which is most natural, is when the slope of the curve is positive, i.e. the yield at the longer end is 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 higher than that at the shorter end of the time axis. This results, as people demand higher compensation for parting results, as people demand higher compensation for parting their money for a longer time into the future. their money for a longer time into the future.

A neutral yield curve is that which has a zero slope, i.e. is 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 flat across time. T his occurs when people are willing to accept more or less the same returns across maturities. accept more or less the same returns across maturities.

The negative yield curve (also called an inverted yield The negative yield curve (also called an inverted yield curve) is one of which the slope is negative, i.e. the long curve) is one of which the slope is negative, i.e. the long term yield is lower than the short term yield term yield is lower than the short term yield

Shape of Yield curveShape of Yield curve

LIBORLIBOR

LIBOR stands for the London Interbank Offered LIBOR stands for the London Interbank Offered Rate and is the rate of interest at which banks Rate and is the rate of interest at which banks borrow funds from other banks, in marketable borrow funds from other banks, in marketable size, in the London interbank market. size, in the London interbank market.

LIBOR is the most widely used "benchmark" or LIBOR is the most widely used "benchmark" or reference rate for short term interest rates. It is reference rate for short term interest rates. It is compiled by the British Bankers Association as a compiled by the British Bankers Association as a free service and released to the market at about free service and released to the market at about 11.00[London time] each day.11.00[London time] each day.

CRR & SLRCRR & SLR

CRR is at present prescribed at 7% of demand CRR is at present prescribed at 7% of demand and term liabilities (DTL) of the bank, and term liabilities (DTL) of the bank, respectively, under Reserve Bank of India Act of respectively, under Reserve Bank of India Act of 1934. 1934.

The minimum and maximum SLR are prescribed The minimum and maximum SLR are prescribed at 25% and 40% of DTL respectively, under at 25% and 40% of DTL respectively, under Banking Regulation Act of 1949.Banking Regulation Act of 1949.

The CRR and SLR are to be maintained on The CRR and SLR are to be maintained on fortnightly basis. fortnightly basis.

Demand and Time LiabilitiesDemand and Time Liabilities

Main components of DTL are:Main components of DTL are: Demand deposits (held in current and savings Demand deposits (held in current and savings

accounts, margin money for LCs, overdue fixed accounts, margin money for LCs, overdue fixed deposits etc.)deposits etc.)

Time deposits (in fixed deposits, recurring deposits, Time deposits (in fixed deposits, recurring deposits, reinvestment deposits etc.)reinvestment deposits etc.)

Overseas borrowingsOverseas borrowings Foreign outward remittances in transit (FC liabilities Foreign outward remittances in transit (FC liabilities

net of FC assets)net of FC assets) Other demand and time liabilities (accrued interest, Other demand and time liabilities (accrued interest,

credit balances in suspense account etc. )credit balances in suspense account etc. )

SLRSLR

SLR is to be maintained in the form of the SLR is to be maintained in the form of the following assets:following assets:

Cash balances (excluding balances maintained Cash balances (excluding balances maintained for CRR)for CRR)

Gold (valued at price not exceeding current Gold (valued at price not exceeding current market price)market price)

Approved securities valued as per norms Approved securities valued as per norms prescribed by RBI.prescribed by RBI.

VaRVaR

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

VaRVaR

A VaR of Rs. 100,000 at 99% confidence A VaR of Rs. 100,000 at 99% confidence level for one week for a investment portfolio level for one week for a investment portfolio of Rs. 10,000,000 similarly means that the of Rs. 10,000,000 similarly means that the market value of the portfolio is most likely market value of the portfolio is most likely to drop by maximum Rs. 100,000 with 1% to drop by maximum Rs. 100,000 with 1% probability over one week.probability over one week.

Exchange Rate QuotationExchange Rate Quotation

Exchange Quotations :Exchange Quotations :There are two methodsThere are two methods Exchange rate is expressed as the price per unit of foreign Exchange rate is expressed as the price per unit of foreign

currency in terms of the home currency is known as the currency in terms of the home currency is known as the “Home currency quotation” or “Direct Quotation“Home currency quotation” or “Direct Quotation””

Exchange rate is expressed as the price per unit of home Exchange rate is expressed as the price per unit of home currency in terms of the foreign currency is known as the currency in terms of the foreign currency is known as the “Foreign Currency Quotation” or “Indirect Quotation“Foreign Currency Quotation” or “Indirect Quotation” ”

Direct Quotation is used in New York and other foreign Direct Quotation is used in New York and other foreign exchange markets and Indirect Quotation is used in London exchange markets and Indirect Quotation is used in London foreign exchange market.foreign exchange market.

PrinciplesPrinciples Direct Quotation: Buy Low, Sell High:Direct Quotation: Buy Low, Sell High: The prime motive of any trader is to make profit. By The prime motive of any trader is to make profit. By

purchasing the commodity at lower price and selling purchasing the commodity at lower price and selling it at a higher price a trader earns the profit. In foreign it at a higher price a trader earns the profit. In foreign exchange, the banker buys the foreign currency at a exchange, the banker buys the foreign currency at a lesser price and sells it at a higher price.lesser price and sells it at a higher price.

Indirect Quotation: Buy High, Sell Low:Indirect Quotation: Buy High, Sell Low: A trader for a fixed amount of investment would A trader for a fixed amount of investment would

acquire more units of the commodity when he acquire more units of the commodity when he purchases and for the same amount he would part purchases and for the same amount he would part with lesser units of the commodity when he sells.with lesser units of the commodity when he sells.

Spot and Forward TransactionsSpot and Forward Transactions

‘‘A’ Bank agrees to buy from ‘B’ Bank USD A’ Bank agrees to buy from ‘B’ Bank USD 100000. The actual exchange of currencies 100000. The actual exchange of currencies i.e. payment of rupees and receipt of US i.e. payment of rupees and receipt of US Dollars, under the contract may take place :Dollars, under the contract may take place :

on the same day oron the same day or two days later ortwo days later or some day later, say after a month.some day later, say after a month.

Interpretation of QuotationInterpretation of Quotation

The market quotation for a currency consists The market quotation for a currency consists of the spot rate and the forward margin. The of the spot rate and the forward margin. The outright forward rate has to be calculated by outright forward rate has to be calculated by loading the forward margin into the spot rate. loading the forward margin into the spot rate. For example US Dollar is quoted as under in For example US Dollar is quoted as under in the inter-bank market on a given day as under :the inter-bank market on a given day as under :

Spot 1 USD = Rs.44.1000/1300Spot 1 USD = Rs.44.1000/1300 Spot/November 0200/0500Spot/November 0200/0500 Spot/December 1500/1800Spot/December 1500/1800

TT Buying Rate TT Buying Rate

TT Buying Rate (TT stands for Telegraphic TT Buying Rate (TT stands for Telegraphic Transfer)Transfer)

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

Bills Buying Rate Bills Buying Rate

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

ProblemProblem

You would like to import machinery from USA worth USD You would like to import machinery from USA worth USD 100000100000

to be payable to the overseas supplier on 31st Octto be payable to the overseas supplier on 31st Oct[a] Spot Rate USD = Rs.45.8500/8600[a] Spot Rate USD = Rs.45.8500/8600Forward Premium Forward Premium September 0.2950/3000September 0.2950/3000October 0.5400/5450October 0.5400/5450November 0.7600/7650November 0.7600/7650[b] exchange margin 0.125%[b] exchange margin 0.125%[c] Last two digits in multiples of nearest 25 paise[c] Last two digits in multiples of nearest 25 paise Calculate the rate to be quoted by the bank ?Calculate the rate to be quoted by the bank ?

Find out the CROSS rate for GBP/AUD 5

Currency pair Bid Ask

GBP/USD 0.9891 0.9894AUD/USD 1.2287 1.2289

Ans : GBP/AUD 0.8049/0.8052

SolutionSolution

This is an example Forward Sale Contract .This is an example Forward Sale Contract .Inter Bank Spot Selling Rate Rs. 45.8600Inter Bank Spot Selling Rate Rs. 45.8600Add Forward Margin .5450Add Forward Margin .5450 ---------------------------- 46.405046.4050Add Exchange Margin .0580Add Exchange Margin .0580 ------------------------------Forward Rate 46.4630Forward Rate 46.4630Rounded Off to multiple of 25 paise Rs.46.4625Rounded Off to multiple of 25 paise Rs.46.4625Amount Payable to the bank Rs.46,46,250 Amount Payable to the bank Rs.46,46,250

SwapSwap

A swap agreement between two parties A swap agreement between two parties commits each counterparty to exchange an commits each counterparty to exchange an amount of funds, determined by a formula, at amount of funds, determined by a formula, at regular intervals, until the swap expires.regular intervals, until the swap expires.

In the case of a currency swap, there is an In the case of a currency swap, there is an initial exchange of currency and a reverse initial exchange of currency and a reverse exchange at maturity.exchange at maturity.

MechanicsMechanics

Firm A needs fixed rate loan –AAA ratedFirm A needs fixed rate loan –AAA rated Firm B needs floating rate -A ratedFirm B needs floating rate -A rated Firm A enjoys an Firm A enjoys an absolute advantageabsolute advantage in both in both

credit markets.credit markets.

11%9%

LIBOR+0.0%

LIBOR+1%

Firm A Firm B

Fixed-rate

finance

Floating-rate

finance

MechanicsMechanics

STEP !STEP !Firm A will borrow at Fixed rate 9% Firm A will borrow at Fixed rate 9% Firm B will borrow at floating rate (LIBOR +1)%Firm B will borrow at floating rate (LIBOR +1)%STEP 2STEP 2Firm A will pay Floating rate [LIBOR] to Firm BFirm A will pay Floating rate [LIBOR] to Firm BFirm B will Pay Fixed rate [9.5%] onlyFirm B will Pay Fixed rate [9.5%] only

GainGainNet interest cost LIBOR- .5%Net interest cost LIBOR- .5%Net Interest cost 9+[ 1%+0.5%]=10.5%Net Interest cost 9+[ 1%+0.5%]=10.5%

MechanicsMechanics

Gain Gain

A B

Borrows at9.0%fixed

for 7 years

Borrows atLIBOR + 1%

floatingfor 7 years

9.5%

LIBOR

Interest payments to each other in years t 1 to t 7.

Which set of the following statements is true in respect of Commercial Paper (CP): 1, Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note 2. CP can be issued by Corporate, primary dealers (PDs) and the all-India financial institutions (FIs) 3. A corporate would be eligible to issue CP provided the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs.4 crore; 4.. The minimum credit rating shall be P-1 of CRISIL or such equivalent rating by other agencies. 5. CP can be issued for maturities between a minimum of 7 days and a maximum up to six months from the date of issue. 6. Amount invested by a single investor should not be less than Rs.15 lakh .A.1,2 & 4B.1,2 & 3*****C.1,4 & 5D.1,4 & 6

Which of the following is/are true in respect of Certificate of Deposit?1. CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions .2.. Minimum amount of a CD should be Rs.5 lakh i.e., the minimum deposit that could be accepted from a single subscriber should not be less than Rs. 5 lakh and in the multiples of Rs. 1 lakh thereafter. 3. CDs can be issued to individuals, corporations, companies, trusts, funds, associations, etc. 4.. The maturity period of CDs issued by banks should be not less than 7 days and not more than three years.A . 1 & 2B. 1 & 3*******C 1 & 4D 2 & 3

Credit Risk Mitigation

Borrower- A Ltd Borrower- A Ltd Borrower- B LtdBorrower- B Ltd

ExposureExposure Rs.100 croreRs.100 crore Rs.100 croreRs.100 crore

Maturity of Maturity of exposure(years)exposure(years)

66 22

Nature of exposureNature of exposure CorporateCorporate CorporateCorporate

CurrencyCurrency USDUSD INRINR

Rating of ExposureRating of Exposure BBBBBB UNRATEDUNRATED

Haircut for exposureHaircut for exposure 12%12% 25%25%

Value of collateral Value of collateral after haircutafter haircut

Rs.88croreRs.88crore Rs75 croreRs75 crore

Risk weightRisk weight 100%100% 100%100%

In the above case, the RWA for the net exposures of A & B under Basel II are …..………………A)Rs.28 crore and Rs 50 crore respectively********B)Rs.172.50 crore and Rs.53 crore respectivelyC)Rs.18 crore and Rs.12 crore respectivelyD)Rs.150 crore and Rs.75 crore respectively

A dealer has a $200 million open position. He finds that his VaR for a one day period with a one percent probability is $1000,000.Which of the following is true?a) This means that the dealer can expect to lose at least $1000,000in any given day about one percent of the time, or in other words, 2.5 times in a year (assuming 250 trading days).**** b)This means that the dealer can expect to lose at least $1000,000in any given day about 99 percent of the time, or in other words, 247.5 times in a year (assuming 250 trading days).c) This means that the dealer can expect to lose at least $2,000,000in any given day about one percent of the time, or in other words, 2.5 times in a year (assuming 250 trading days). d)This means that the dealer can expect to lose at least $ 4000,000in any given day about one percent of the time, or in other words, 2.5 times in a year (assuming 250 trading days).

Bank A enters into a Overnight Indexed Swap (OIS) with XYZ Ltd whereby Bank agrees to pay 7 days OIS at 6.25% for Rs.25 crores and receive MIBOR Overnight Rate.Actual MIBOR rates for 7 days are given below:

Day 1Day 1 6.15%6.15%

Day 2Day 2 6.05%6.05%

Day 3Day 3 6.10%6.10%

Day 4Day 4 6.15%6.15%

Day 5Day 5 6.05%6.05%

Day 6Day 6 6.05%6.05%

Day 7Day 7 6.10%6.10%

In the above case. the difference to be settled between the bank and the XYZ Ltd amounts to…………….. a)Rs.7671*********b)Rs.7692c)Rs.8035d)Rs.8074

The following is the NPA status of XYZ Exporters Ltd account in Bank A

Asset Classification Asset Classification Status Status

Doubtful -more than 3 Doubtful -more than 3 years as on 31-3-2007years as on 31-3-2007

ECGC Cover ECGC Cover 50%50%

Realizable Value of Realizable Value of SecuritySecurity

Rs.1.50 lakhsRs.1.50 lakhs

Balance Outstanding Balance Outstanding Rs.4 lakhsRs.4 lakhsThe total provision required in the above case is ………………….a)Rs.1.25 lakh*****b)Rs.2.50 lakhc)Rs.0.50 lakhd)Rs.2.00 Lakh

ExampleExample

Coupon of a floating rate bond isa. modified whenever there is a change in the benchmark rate.b. modified at pre-set intervals with reference to a benchmark rate.c. modified for changes in benchmark rate beyond agreed levels.d. modified within a range, for changes in the benchmark rate.

Ans: b.

ExampleExample

Which of the following is true about a uniform price auction?

a. a.       An auction in which all successful bids are made for the same price.

b. b.       An auction in which all bidders have bid a uniform price.

c. c.       An auction in which all successful bidders are allotted bonds at the same price.

d. d.       An auction in which the cut-off price is derived as the weighted average of all successful bids.

Answer: c

ExampleExample

A treasury bill maturing on 28-Jun-2008 is trading in the market on 3-Jul-2007 at a price of Rs. 92.8918. What is the discount rate in this price?Answer: The yield is computed as:= ((100-price)*365)/(Price * No of days to maturity)= ((100-92.8918)*365)/(92.8918*360)) =

7.7624% 

ExampleExample

What is the price at which a treasury bill maturing on 23rd March 2008 would be valued on July 13, 2007 at a yield of 6.8204%?Answer: The price can be computed as = 100/(1+(yield% * (No of days to maturity/365))= 100/(1+(6.8204%*(253/365)) =

Rs. 95.4858

ExampleExample

What is the day count convention in the treasury bill markets?a. 30/360b. Actual/Actualc. Actual/360d. Actual/365

Answer: d

ExampleExample

Which of the following participants in the call markets are allowed to lend as well as borrow?a. Mutual Fundsb. Banks and Primary Dealersc. Corporatesd. Financial Institutions

Answer: b

RepoRepo A 3-day repo is entered into on July 10, 2007, on an 11.99% 2009 security, maturing on April 7, 2009. The face value of the transaction is Rs. 3, 00, 00, 000. The price of the security is Rs. 116.42. If the repo rate is 7%, what is the settlement amount on July 10, 2007?Answer: Settlement amount on July 10, 2007 is the transaction value for the securities plus accrued interest. Transaction Value:3, 00, 00, 000 * 116.42/100 =Rs. 3, 49, 26, 000Accrued Interest:The number of days is 93.Accrued interest = 3, 00, 00, 000 * 11.99%* 93/360 = Rs. 9, 29, 225.00 Therefore, the settlement amount is: Rs. 3,49,26,000 + Rs. 9, 29, 225.00 = Rs. 3, 58, 55, 225.00

ExampleExampleCompute the Rupee value of an SGL transaction, with the following data:Coupon Rate: 11.68%Maturity date: August 6, 2008Settlement Date: July 11, 2007Price: Rs. 105.4025Transaction amount: Rs. 50000000

Answer:Value of the transaction = number of securities * trade price= (50000000/100) * 105.4025= Rs. 5,27,01,250Accrued Interest for the period since the last coupon is = days since the last coupon/360 * coupon rate * face value= (155/360) * 0.1168 * 50000000= Rs. 25,14,444Settlement amount = Value of transaction + Accrued Interest= Rs. 5,27,01,250 + 25,14,444= Rs. 5,52,15,694

1A GOI security with coupon of 11.68%, maturing on 6-Aug-2008, is to be settled on 1-Feb-07. What are the number of days from the previous coupon date?a.       179b.       176c.       178d.       175Answer: d.

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