INDIAN INSTITUTE OF BANKING & FINANCE

1. INDIAN INSTITUTE OF BANKING & FINANCE RISK MANAGEMENT MODULE C & D BY M.Ravindran ravindran@iibf.org.in

2. 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.

3. 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

4. RISK MANAGEMENTModule C-Treasury Management • Treasury Products • Treasury Risk Management • Derivative Products

5. 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

6. Treasury

7. Dealing settlement MIS

8. Treasury

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

10. 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

11. 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 Features of CD

12. 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)

13. 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.

14. 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

15. 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.

16. 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).

17. 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

18. 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).

19. 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.

20. 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%

21. 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".

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 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

28. 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.

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

30. 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 = (10%*100)/90 X 100 , That is 11.11% p.a.

31. 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

32. 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

33. 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,

34. 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

35. 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

36. 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 11.00[London time] each day.

37. 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.

38. 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. )

39. 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.

40. 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).

41. 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 (30*5% ) . 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.

42. 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.

43. 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.

44. 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.

45. 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

46. 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.

47. 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.

48. 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 ?

49. 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

50. 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.