Treasury Division & its functions

1. Treasury Division & its functions

2. TREASURY ACTIVITIES • Treasury Division – Heart of the bank • Managing Asset & Liabilities of the bank – ‘The Balance Sheet Management’. Thereby enhancing the risk-adjusted return on equity.

3. Assets: • i. Cash • ii. Running Finance & ERF • iii. Advances linked with • KIBOR, T Bills – Short Term • iv. Advances linked with PIBs • Long Term Fixed • v. Advances linked with PIBs • Long Term Floating • vi. Investments – Advances • converted into Bonds • vii. Others Liabilities: i. Current Deposits ii. Savings Deposits iii. Term Deposits (TDRs) iv. Interest Payables v. Others Objectives: Maximizing Risk Weighted Returns • Risk Weighted Returns take into account liquidity and interest rate gap risk associated with certain asset or liability instead of applying same interest rate to assess the cost/return of liability/asset e.g.: Branch ‘A’

7. MONEY MARKETMECHANISM, MARKET & INSTRUMENTS

8. Statutory Liquidity Requirement Statutory Cash Reserve Requirement Average 5% of Total Time & Demand Liabilities for Week & Minimum Daily 4% of TDL 15% of TDL in Eligible Liquid Assets 1. Treasury Bills 2. FIBs/PIBs Not More Than 5% of TDL 3. Reverse Repos - Repos 4. Other Approved Assets i.e. NIT, Cash in Vault, Foreign Currency Held, Excess in SCR etc. A/C with SBP Rate of Return = 0% Opportunity Cost = Av. Weekly O/N Rate Functions of Money Market Desk • The need for financial institutions to indulge in money market transactions arises primarily from the statutory reserve and liquidity requirements imposed by the State Bank.

9. MARKET TYPES • Primary Market This constitutes all securities issued for the first time. • Secondary Market The securities issued in the primary market are then traded in the secondary market among banks, investors etc.

10. MARKET PARTICIPANTS • Commercial Banks /NBFIs. • State Bank of Pakistan. • Corporate Treasuries. • Public Sector/Government. • Inter-Bank Brokerage Houses-Playing the role of facilitators. • Exchange Companies

11. PRIMARY DEALER SYSTEM • The PDs are Price makers, quoting two-way prices reflective of market sentiment and actively participating in trading of all marketable securities. • PD must be a Band/ DFI/ Investment Bank/ Listed Brokerage House. • The PD status is assigned by the SBP.

12. Money Market Activities • Money Market Transactions Call/Term lending/borrowing • Clean lending/borrowing among banks. • Providing KIBOR as a benchmark for term lending to the corporate sector. • Less developed as compared to other countries because of the presence of more developed REPO/Reverse REPO market.

13. Money Market Activities • Money Market Transactions Cont’d. • REPO/Reverse REPO • Repurchase of securities. Introduced in early 80s. Akin to Collateralized lending borrowing andGoverned by Master REPO Agreement. • Securities usually repurchased are T Bills, FIBs, PIBs etc.

14. Money Market Activities • Money Market Transactions Cont’d. • Outright Purchase/Sale of Securities • Purchase of government securities i.e. Treasury Bills and Pakistan Investment Bonds (PIBs) for portfolio management. • Purchase/Sale of securities is based on the portfolio strategy and market conditions.

15. Money Market Activities • Major Money Markets instruments. • Market Treasury Bills. • 3, 6 and 12 months maturity, zero coupon instruments priced at discount. • Issued by Govt. to finance current expenditure. • Sold by SBP through auctions. • Risk free, highly liquid and reserve eligible.

16. Money Market Activities • Federal Investment Bonds. • Half yearly coupon bonds. 3,5 & 10 years maturity. • Discontinued in the Primary Market • Issued by GoP, these bonds are only traded in the secondary market. • Are SLR eligible security.

17. Money Market Activities • Pakistan Investment Bonds. • Launched in the year 2000 to replace FIBs as a long term investment. • Half yearly coupon bonds. 3, 5, 10, 15 & 20 years maturity. Are sold to Primary Dealers through auction. • Active secondary market catering to banks and institutional investors etc. • Are SLR eligible securities up to 5% of DTL.

18. Money Market Activities Outstanding Stock

19. MARKET YIELDS T-Bills

20. MARKET YIELDS PIBs

21. BENCHMARK RATES • Discount Rate • The SBP discount window facility offer funds to banks as the lender of last resort. • Current rate is 7.5%. • Karachi Inter-bank Offer Rate (KIBOR): • Lending rate for 1, 2 weeks and 1, 3, 6, 9 and 12 months. • Recently established as a benchmark rate for all corporate term lending.

22. BONDS • Investments for period of more than 1 year. • Currently, PIBs are auctioned by SBP (traded in Primary Market). • FIBs are no more auctioned and are traded in the secondary market. • Riskier than T-Bills because of longer maturity and presence of coupons.

23. Bonds’ Pricing • A Bond’s price is simply the present value of its: • Coupons to be received during life of the bond, and • Principal repayment at the maturity. Price = C1 + C2 + .…………………+Cn + FV 1+ i (1+ i)2 (1+ i)n (1+ i)n

24. Bonds’ Pricing • Issued / traded at Premium or Discount depending upon the coupon rate and the market yield for the tenors. • Bond trades at Premium when: Coupon Rate > Market Yield and vice versa.

25. Bonds’ Pricing • Bonds’ price (whether at premium or at discount) converges to its par value as the bond reaches its maturity. Premium Bond Maturity Par Value Discount Bond

26. Sensitivity Measures for Bonds • Duration • Price Value of a Basis Point (PVBP or PV01) • Convexity

27. Duration • Measures the Interest Rate Risk or Price Risk. • Measures the change in price of the bond w.r.t change in the yield. Price Change in Price as the yield drops by 1% Yield 3% 4%

28. Duration • Higher for papers with longer maturity. • Lower for bonds with higher coupon rate. • For a zero coupon bond, duration is approx. equal to life of the bond. • However, duration of a zero coupon security is higher compared to that of coupon bonds.

29. PVBP • Calculates the change in price as a result of 1 basis point (0.01%) change in yield. • As Duration measures the change in price for 100 basis point change in yield, PVBP is: PVBP = Duration (for 1%) / 100

30. Convexity • The change in duration for a change in yield. • Convexity adjusts the flaw in the price estimated by duration, especially for larger changes in the yield. Convexity Adjustment Price Price estimated through Duration Yield 1% 4%

31. Convexity • Duration underestimates the increase in Bond’s price and overestimates the decline. • Therefore, Convexity adjustment is to be added to the duration estimate in both the cases of price increase or decrease.

32. Interest Rate Derivatives • Interest Rate Swap (IRS) • Forward Rate Agreement (FRA)

33. The Derivatives Market • A Derivative transaction is a contract whose value depends on (or derives from) the value of an underlying asset, reference rate or index. (Group of Thirty, Global Derivatives Study 1993). • Underlying asset may refer to: • Currency • Interest Rate • Stock Price • Commodity • Derivatives are sometimes referred to as ‘contingent claims’. • Derivatives contracts are of two types: • Exchange traded contracts. • OTC (Over the Counter) Contracts.

34. Forward Rate Agreement (FRA) • An agreement to fix interest rate for a future transaction based on a certain benchmark. • Agreement to borrow/lend an amount of money (nominal principal)… • At a specified future date (‘settlement date’) • For a specified tenor • For a specified interest rate (‘forward rate’) • FRA buyer hedges against rising interest rates. • Buy a 6-over-9M FRA for PKR10 Million at 9% • Agreement to…... • Borrow PKR 10 Million for 3M • At a date 6M from today • At 9% cost

35. FRAs – A Practical Example A bank needs to fund a six month fixed rate Dollar Loan. Two choices are available: • Borrow for six months at KIBOR, 8 3/8%. • Fund the first three months using its own funds at a cost of 8 1/16%. In choosing option 2 the runs the risk that interest rates will rise within three months and that overall funding cost will be above 8 3/8% To guard against this risk, the bank could buy a three against six FRA which is being quoted at 8 ¼ - 8 ½ .. By buying a 3/6 FRA at 8 ½ % the bank locks in a borrowing cost of 8 ½ % from the third to the sixth month. The overall cost of borrowing in this fashion is 8.36% almost exactly the same as borrowing for six months at 8 3/8 %.

36. Forward Rate Agreements - Settlement Suppose after three months, three month KIBOR has risen to 10 ½ %. The bank receives the difference between the current KIBOR and the agreed FRA rate (10 ½ - 8 ½ = 2%). Suppose FRA bought had been for a notional principal of PKR 10 M. Settlement would be as under: The buyer of the FRA would gain 2% on PKR 10 M for three months, discounted to take account of the fact that it is being paid at the start rather than the end of the three month period. This comes to : PKR 10,000,000 * 2 * 0.25 = PKR 48,721.07 1+ (10.5*0.25)

37. Interest Rate Swaps • An Interest Rate Swap is an agreement between counter parties in which each party agrees to make a series of payments to the other on agreed future dates until maturity of the agreement. Each party’s interest payments are calculated using different benchmarks by applying the agreement terms to the notional principal amount of the swap. • An agreement to exchange: • Floating rate payments for fixed rate payments (or vice-versa) • At regular intervals over a pre-specified period • On a certain principal amount Typical features: • Payments denominated in the same currency • Payments are netted • Principal in not exchanged • Tailor made • Off Balance Sheet

38. IRS Floating to Fixed Swap Fixed 3.8% Bank ABC Ltd 6m KIBOR Current 2.25% 5 year Floating rate Loan

39. IRS - Applications • If the borrower’s view is that PKR interest rates will go higher an IRS synthetically converts a floating rate loan into a fixed rate loan (or vice versa). • Users may be able to better match assets and liabilities using an interest rate swap; matching dates, floating or fixed interest rates. • Exchange certainly for uncertainty • Synthetically convert a fixed rate liability into a floating rate liability if the borrower’s view is that PKR interest rates will move lower.