CAIIB banking financial management module C- Treasury Management

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CAIIB Paper II Module III Treasury Management

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Presentation Transcript Presentation Transcript

Welcome Participants : Welcome Participants Presentation on Treasury Management

An Overview of Financial Markets : Capital Market : It is a market wherein long-term loans and equity capital are raised and traded. This market consist of Stock market and Bond market. Derivative Market : It is a market which could be either OTC or exchange driven. Derivatives are instruments developed on the price movement and volatility of an underlying. Money Market : In general terms for the markets in which bank lend to or borrow money. The market normally trades in maturities up to one year. An Overview of Financial Markets

An Overview of Financial Markets (Contd.) : Foreign Exchange Market : It is a market where currencies of various counties are traded. Insurance Market : Insurance companies are allowed as lenders in the inter-bank money market to maintain funds. Mutual Funds : Mutual funds offer platform to the individual to access the stock and bond market. Mutual funds invest the funds in the market as per investment plan in the scheme. An Overview of Financial Markets (Contd.)

Roles & Functions of Participants in Financial Market : Banks : Banks participate in the capital and money market and also function as clearing houses. Primary Dealers : These are the firms established for the purpose of market making in government securities. Financial Institutions : They provide/ lend long-term funds for industry and agriculture. Stock Exchange : It is a place where securities are traded. It also proved clearing house facility and guarantee all payments and deliveries. Roles & Functions of Participants in Financial Market

Roles & Functions of Participants in Financial Market (Contd.) : Brokers : Brokers perform the job of intermediating between buyers and sellers of securities and concluding deal in foreign exchange market. Investment Bankers : These are agencies who arrange raising funds through equity and debt route for company. Foreign Institutional Investors : These are foreign based funds to invest in country ’ s equity and debt market through stock exchanges. Custodians / Depositories : Custodians are allowed to hold securities on behalf of customers and carry-out operations on their behalf., and Depositories hold securities in D-mat (electronic) form and operate on behalf of customers. Roles & Functions of Participants in Financial Market (Contd.)

Introduction to Treasury Management : Introduction : Treasury of bank is considered to be a service centre that takes care of funds management. However with the liberalization of financial markets, the scope of treasury functions has been expended and it has now become a profit centre having trading activities. Basic Role of Treasury : i) Liquidity management : Management of short-term funds, CRR, SLR. ii) Proprietary positions : Trading in securities / currencies and other financial instruments. iii) Risk Management : Bridging asset – liability mismatch. Introduction to Treasury Management

Evolving Role of Treasury as Profit Centre : Features of Treasury operations : i) It is free from credit risk. ii) It is highly leveraged as return on capital is high. iii )Cost of operation is low. iv) It operates in narrow spreads but with huge volumes. Sources of Treasury profit : a) Conventional : Foreign exchange business, Money market deals, Investment activities b) Contemporary : Interest and currency arbitrage, Trading, Evolving Role of Treasury as Profit Centre

Integrated Treasury : Introduction : It refers to integration of money market, security market and foreign exchange market operations of the bank. The integration is the result of opportunities available to the bank due to liberalization of financial markets. Integrated Treasury and customers : Due to integration of market activities, the treasury undertakes the treasury operations of customers in addition to banks ’ own treasury operations. These operation relates to ( a) hedging export/import receivable/payable (b) raising foreign currency loans (c) making overseas investments. Integrated Treasury

Organization of Treasury : Front office : Dealing room where sale and purchase transactions takes place. Middle office : It provides information to management and implement risk management system through monitoring of various limits. Back office : They undertake the verification and settlement of various sale purchase deals concluded at dealing room, besides maintaining of Nostro accounts, reconciliation and book keeping, submission of return etc. Organization of Treasury

Treasury Products : Money Market : It is a market for short term funds ranging from one day to one year. Products in Money Market : Call money : It is lending and borrowing for one day i.e. overnight. Interest rare relates to MIBOR. Notice money : It is lending and borrowing for a period of more than one day but upto 14 days. Term money : It is lending and borrowing for a period of 15 days or above upto one year. Treasury Products

Products in Money Market (Contd.) : Commercial papers : It is an unsecured negotiable instrument issued by companies, PDs and FIs with a maturity period of 7 days to one year. The minimum amount is Rs.5 lac and multiples thereof and it is issued at a discount to face value. The issuer company credit rating should not be less than A3. It is regulated by RBI and FIMMDA. Certificate of deposit : It is an unsecured negotiable instrument issued by SCBs and FIs with a maturity period of 7 days to one year. The minimum amount is 1 lac and multiple thereof and it is issued at a discount to face value. Products in Money Market (Contd.)

Products in Money Market (Contd.) : Treasury Bills : These are issued by Govt. of India through RBI for maturity of 91 days, 182 days and 364 days. The interest is allowed by way of discount which is called implicit yield. Repo/ Reverse repo : It is a sale of security with a commitment to repurchase. It is a lending and borrowing transaction at an agreed rate of interest known as Repo rate. RBI/banks makes use of Repo/Reverse repo as an instrument to control liquidity. Bills Re-discounting : This is a process, where the already discounted bills for a maturity period generally 3 to 6 months are rediscounted at near market prevailing rate to maintain liquidity as well as to reduce its capital requirement for credit adequacy purpose as these bills are removed from credit portfolio and added to interbank liability. Products in Money Market (Contd.)

Products in Security Market : Govt. securities : These are issued in the form of Bonds by Public Debt Office of RBI on behalf of central and state govt. The interest paid is called coupon and maturity of bonds may range from 1 to 30 years. Corporate securities : These are issued by companies as secured instruments by creating charge on their assets. It is issued in the form of debentures. Convertible securities : These bonds are a mix of debt and equity. Products in Security Market

Products in Forex Market : Spot : The spot is refer to a situation where settlement takes place to T+2 i.e. on 3rd day. Forward : It refers to situation where the settlement takes place in future i.e. after T+2 on a pre-fixed rate and pre-fixed date, which are decided on the date of contract. Swap : Swap represent a combination of spot and forward transaction i.e. simultaneous buy/sell or sell/ buy of foreign currency of equv. amount for different maturities at pre-fixed rate on the date of contract. Re-discounting of Bills : It is source of refinancing of already discounted foreign currency bills by other banks for short term nature. Products in Forex Market

Treasury Products (Contd.) : Products in Forex Market : i) Interbank transactions : Spot Forward Swap Foreign currency placements ii) Merchant transactions : Import / export Pre and post shipment credit in foreign currency Foreign currency loans Treasury Products (Contd.)

Treasury Products (Contd.) : Product in Derivative Market : Interest rate swaps Forward rate agreement Interest rate future Interest rate option Currency options Treasury Products (Contd.)

Funding & Regulatory Aspects : Cash Reserve Ratio (CRR) : It is a ratio of bank ’ s cash reserve balances with RBI with reference to bank ’ s net demand and time liabilities to ensure the liquidity and solvency of the scheduled bank. Important features : i) Present, it is 4% of NDTL. Min. /Max. RBI discretion. ii) It is maintained at fortnightly average basis( Saturday to following Friday). iii) On a daily basis, it should be minimum 70% of average balance iv) No interest is being paid by RBI on CRR balances. v) Failure to maintain prescribed CRR on daily / average basis during fortnight, bank is liable to pay penalties. 3% over bank rate for the day of default. Next day 5%. Funding & Regulatory Aspects

Funding & Regulatory Aspects : Statutory Liquidity Ratio (SLR) : It is a ratio of bank ’ s cash/ govt. securities reserve balances with RBI with reference to bank ’ s demand and time liabilities to ensure the liquidity and solvency of the scheduled bank. Important features : i) Present, it is 21.5% of DTL, however the max. limit is 40%. ii) It is maintained at close of business on every day based on DTL as obtaining on the last Friday of the 2 nd preceding fortnight. iii) Interest is being paid by RBI as per investment made in different securities. iv) Failure to maintain prescribed CRR on daily basis ,bank is liable to pay penalties. At present 3% above bank rate for the day of default, next day 5%. Funding & Regulatory Aspects

Liquidity Adjustment Facility : Introduction : LAF is lending of funds by RBI to banks, banks to RBI through Repo/Reverse repo to meet their liquidity needs. Tenor : Reverse repo and Repo auctions are conducted on daily basis (except Saturday). Minimum Bid size : Rs.5 cr. and in multiple of Rs.5 cr. Eligible securities : Central govt. dated securities and treasury bills. Rate of interest : As on date Repo rate is 6.75% and Reverse Repo is 5.75%. Overnight LAF of (NDTL) 0.25% and 14 days term Repo of (NDTL) 0.75%.Repo rate is upper band and Reverse Repo rate is floor rate under LAF. Liquidity Adjustment Facility

Payment & Settlement System : Clearing Corporation of India (CCIL) : It is a clearing house to settle the trades on a guaranteed basis. It handles domestic and forex trades. By clearing the trades on netting basis, it reduce the counterparty exposure. Negotiated Dealing System (NDS) : It provides an electronic dealing platform for trading in approved money market instruments. It is also used as reporting system to RBI. Members must have SGL and current account with RBI. FX Clear : It is a forex dealing system and presently it is providing STP for USD/INR trades. Structured Financial Messaging System (SFMS) : It is on the pattern of SWIFT. Interbank transfers are sorted out and cleared by National Clearing Cell of RBI. Payment & Settlement System

Treasury Risk : Credit Risk : It arises on account of default by the counter-party to honour payment obligations. Market Risk : It arises on account of movement in prices/ exchange rates in such a way that affects the value of asset/ liability. It has three main components : a) Liquidity risk : b) Interest rate risk : c) Currency risk or Exchange risk Treasury Risk

Treasury Risk Management : Organizational control : It refers to internal checks and balances. Exposure ceiling limits : It refers to limits put for transactions with counter-party to protect the bank from credit risk i.e. default or settlement risk. Internal controls : It refers to position limits to protect from Market risk. a) Open position limit : (Day-light and overnight limit) b) Stop loss limits : c) Aggregate gap limit Treasury Risk Management

Risk Measures : Value at Risk (VaR) : VaR is used to make assessment of possible loss during the period due to volatility, when the position is held by treasury. It is expressed in %age (say 98% confidence level, means a 2% probability of incurring loss). Calculation of VaR : It is derived from the statistical formula that are based on volatility of the market. Volatility is the standard deviation from the mean observed over a period. a) Parametric approach b) Monte carlo approach c) Historical data approach Risk Measures

Duration/Modified Duration & YTM : Duration : It is used in all asset and liability positions where interest rate risk is prevalent. Duration is weighted average measure of life of bond, where time of receipt of cash flow is weighted by the present value of the cash flow. Duration is expressed in the no. of years. For a longer duration, the sensitivity of price change is greater to change in interest change. Modified Duration : It is arrived by dividing the duration with the interest rate. Yield to Maturity (YTM) : The effective return on bond is called yield. The rate, at which the present value of bond equals the market price of bond is called YTM. The yield and price of bond move in opposite direction. Duration/Modified Duration & YTM

Derivative Products : Introduction : Treasury makes use of derivative products for the purpose of : Management of risk including risk related to ALM Catering to requirement of corporate customers Taking trade positions in derivative products What is Derivative : It is a financial contract that derives its value from another financial product/commodity (underlying). Objective of Derivative : The derivatives are being used as hedging risk. The derivative products are over the counter (OTC) as well as exchange traded contracts. Derivative Products

Forward Contract : Definition : A Forward Contract is an agreement between Bank and Customer where Bank agrees to buy/sell foreign exchange at a future date at a rate fixed on the date of contract. It is obligatory on the part of the customer to fulfill the contract. Features : The contract is negotiated directly by the buyer and seller. It is an over the counter (OTC) agreement. Terms of the contract can be tailored to suit the needs of the each party. No money is changes hands when a contract is first negotiated and it is settled at maturity. Early delivery under the contract is accepted. Extension of contract is only by cancellation and rebooking at current rates. Contracts may be booked for fixed date as well as for option period ranging between one month. If the contract is not used, it will be automatically cancelled on 3 rd business day of the maturity date. Forward Contract

Options : Definition : An option is a contract, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). Types of Options : i) European option : Where the holder can exercise his right on the expiry date. ii) American option: Where the right can be exercised anytime before maturity date. Options

Features of Option Contracts : Parties : Option buyer Option seller Components of options : Call option : Buyer has right to purchase Put option : Buyer has right to sell Premium : Consideration for the seller to offer the right for the buyer Strike price : Exchange rate Maturity & expiration date : The last day on which option can be exercised In the money : Where exercising the option, results gain to buyer At the money : Where exercising the option, results no gain or no loss to buyer Out of money : Where exercising the option, results loss to buyer Embedded option : Where the buyer is given option to repay before maturity Features of Option Contracts

Futures : Definition : It is an agreement to buy and sell an asset for a certain price at a certain time in future. Features of Futures : Traded through an exchanges. The size and maturities are standardized. Participants needs to maintain margins. The future exchange guarantee the settlement. Marking to market of outstanding position at the end of each trading day. Futures

Financial Futures : Currency Futures : These are standardized contracts and can be traded for major currencies through exchange. There is a commitment to deliver the currency at agreed exchange rate by both the parties. Interest Rate Futures : These are the contracts made on the basis of fixed income securities (Bonds/ T- bills) of specified size. Contract based on bonds deal in medium and long term interest rates and contracts based on Treasury bills trade in short term interest. Financial Futures

Swap : Definition : A swap in a contract that binds two counterparties to exchange the different streams of payment over the specified period at specified rate. Foreign Exchange Swap : Simultaneous purchase or sale of foreign currency on spot against forward. Interest Rate Swap : It is exchange of different streams of interest structures i.e fixed to floating or vice versa. Currency Swap : It is contract where pre-determined streams of payments in different currencies are exchanged on a prefixed period at pre fixed rate. Swap

Development in Indian Market (Permissible Derivative Instruments) : Rupee Interest Rate Derivatives : i) Interest Rate Swap ii) Forward Rate Agreement iii) Interest Rate Future Foreign Currency Derivatives : i) Foreign Exchange Forward ii) Currency Swap ii) Currency option iv) Interest Rate Caps and Floors Development in Indian Market (Permissible Derivative Instruments)

Treasury & Asset-Liability Management : Liquidity Risk : It arises out of mismatch of assets and liabilities in a given time range. The RBI has prescribed 11 maturity time bucket beginning from next day to more than 5 years for measuring and monitoring the liquidity risk. Interest Rat Risk : It arises when the value of assets and liabilities changes in the reverse direction corresponding to a change in market rate interest in a given time band. Treasury & Asset-Liability Management

Role of Treasury in ALM : Treasury maintain the pool of funds of the bank and its core function is funds management, hence its activities expose the bank to liquidity and interest rate risk. The Treasury is an important member of Asset Liability Committee (ALCO), (who manage the liquidity and interest rate risk for the bank) due to following reasons : i) Treasury operate financial market directly, hence market risk is identified and monitored through treasury. ii)Treasury makes use of derivative instruments to manage the liquidity and interest rate risk which arises due to mismatch in the residual maturity of various assets and liabilities in different time buckets. Role of Treasury in ALM

Use of Derivatives in ALM : Derivative instruments are used to reduce the liquidity and interest rate risk or in structuring new products to mitigate market risk. These are used due to following reasons: i) It replicate the market movements and can be used to counter the risks inherent in regular transactions. ii) It require small capital as there is no fund deployment, except margin requirement. iii) It can be used to hedge high value individual transactions or aggregate risks as reflected in the asset liability mismatch. iv) It can protect the foreign currency obligation from exchange risk. v) It helps the bank in structuring new products to reduce to mismatch in balance sheet, such as floating rate deposits and loans, where the interest rate is linked to a bench mark rate . Use of Derivatives in ALM

Credit Derivatives : Definition : It is OTC financial contracts, and usually defined as “ off-balance sheet financial instruments that permit one party (Beneficiary) to transfer credit risk of a reference asset, which it owns, to another party (guarantor) without actually selling the asset ” . Types of Credit Derivatives : a) transactions where credit protection is bought and sold : It is bilateral derivative contract in which the protection buyer pays a fee through the life of the contract in return for a contingent payment by the protection seller following a credit event. The instrument is called ‘ Credit Default Swap ’ . ‘ Credit Default Option ’ ‘ Credit Linked Notes ’ . b) Total Return Swap : It is bilateral financial designed to synthetically replicate the economic returns of an underlying asset for a pre-specified time. Credit Derivatives

Benefits from Credit Derivatives : Credit derivatives allow banks to transfer credit risk and hence free up capital. Banks can conduct business on existing client relationship in excess of exposure norms and transfer away the risk. Banks can construct and manage a credit risk portfolio of their own choice and risk appetite unconstrained by funds, distribution and sales efforts. Credit risk would be diversified from Bank/DFIs alone to another players in the financial markets and leads to financial stability. Banks would stand to benefit due to efficient utilisation of capital and flexibility in developing/ managing a target risk portfolio. Benefits from Credit Derivatives

Treasury and Transfer Pricing : Transfer pricing refers to fixing the cost of resources and return on assets of the bank in a rational manner. Treasury buy and sell the deposits and loans of the bank, notionally, at a price which becomes the basis of assessing the profitability of the banking activity. The price is fixed by treasury on the basis of : i) Market interest rates ii) Cost of hedging market risk iii) Cost of maintaining the reserve assets Treasury and Transfer Pricing

Fixed Income Securities : Introduction : These are instruments wherein the total return to the investor is fixed for entire tenor of the instrument. However during the life of security, the return may fluctuate in case the investor wishes to sell the security before its redemption or values the security at the market price at any point of time. Since the income on the face value is constant over the tenor of the bond, the bond will trade at premium or discount if the market rate of interest is lower or higher than the fixed interest. Thus the price of fixed income security goes down when the prevailing interest rates go up and vice versa. Such securities are called as ‘ bonds ’ Fixed Income Securities

Terminology : Face Value : It is minimum denomination at which it is issues. Coupon Rate : It is the rate of interest payable on the bond. Dated security : It is security with a specific repayment date. Redemption Amount : It is the amount payable to the investor holding the bond on redemption date. Bullet v/s Staggered or Amortised Redemption : When bond is payable on one particular date, it is termed as ‘ buller redumption ’ and if it is payment on more than one date, these are said to have ‘ staggered or amortised redumption. Tenor : it is the time period from the date of issue to the redemption date. Clean Price : It is price payable for the face value of bond. Dirty Price : It is price payable, clean price plus accrued interest from the last interest date till the date of settlement. Trade Date : It is date on which bond transaction concluded. Settlement Date : It is the date on which buyer and seller exchange the bond for funds. Terminology

Types of Bonds : SLR Securities : Govt. of India securities : State Development Loans Other approved Securities Non-SLR Securities : PSU Bonds Corporate Debentures Central government is the issuer of the govt. securities raising money through bond issuances for budgetary funding requirement. RBI act as investment banker and raises funds through Bonds (G-sec) and Treasury bills auctions. Types of Bonds

Slide 42 : Case studies on Exchange Rate Mechanism and Treasury Instruments

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