ReCh

Management Centre

Auditing the Treasury

department

ALL CONTENTS COPYRIGHT © 2004-2008 H&H ASSOCIATES WEDNESDAY, 05 NOVEMBER 2008

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Contents
Contents..................................................................................................................................................................2

The role of Treasury.................................................................................................................................................1

The role of Treasury...........................................................................................................................................1

Auditing ..................................................................................................................................................................2

External and Internal audit..................................................................................................................................2

Detailed Audit checklist......................................................................................................................................5

Departmental role and responsibilities...............................................................................................................11

Reporting Structure of Internal Audit Function....................................................................................................11

Preparing for the Treasury Audit.............................................................................................................................12

The audit process............................................................................................................................................12

The audit report...............................................................................................................................................15

Introduction to Financial markets............................................................................................................................15

Introduction......................................................................................................................................................15

Markets in the financial system.........................................................................................................................16

The development of financial markets and instruments.....................................................................................17

Classification of Financial Markets....................................................................................................................20

Risks of Financial Transactions.........................................................................................................................21

Institutions in the markets.................................................................................................................................22

The role of the government and the South African Reserve Bank.......................................................................23

Trading in the markets.....................................................................................................................................24

Factors influencing the financial markets...........................................................................................................26

Conclusion......................................................................................................................................................28

Bank and business unit structures.....................................................................................................................29

Treasury objectives..........................................................................................................................................29

Corporate perspectives....................................................................................................................................30

Asset & Liability Management.................................................................................................................................31

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The ALM function............................................................................................................................................. 31
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Advantages..................................................................................................................................................... 32

Disadvantages.................................................................................................................................................32

Action Checklist...............................................................................................................................................32

Dos and Don’ts................................................................................................................................................33

Interest rate risk identification............................................................................................................................33

Interpretation and management........................................................................................................................38

Price Sensitive Gap..........................................................................................................................................38

Liquidity Gap....................................................................................................................................................39

Net Interest Income (NII) at Risk.......................................................................................................................39

Duration Gap Analysis......................................................................................................................................39

Balance sheet constraints.................................................................................................................................40

Return on equity..............................................................................................................................................44

Interest rate and market pointers.......................................................................................................................47

Matching and mismatching...............................................................................................................................58

Management information reporting....................................................................................................................59

Covering and hedging......................................................................................................................................59

Money Market........................................................................................................................................................61

Markets and interest rates................................................................................................................................61

Cash and cash settled financial instruments -Common money market instruments.............................................62

Funding and cash flow control..........................................................................................................................65

Accounting considerations................................................................................................................................68

Accounting practice..........................................................................................................................................68

Accounting practice and fraud...........................................................................................................................69

Accounting standards.......................................................................................................................................70

Warning signals and what to look for.................................................................................................................78

Defining risk.....................................................................................................................................................78

Market risk.......................................................................................................................................................78

Measuring the potential loss amount due to market risk.....................................................................................78

Liquidity risk.....................................................................................................................................................79

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Credit risk........................................................................................................................................................ 84
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Operational risk................................................................................................................................................ 86

Risk management and reporting.......................................................................................................................87

Risk Mitigation ................................................................................................................................................89

Defining and setting limit structures...................................................................................................................89

Operational issues...........................................................................................................................................95

The audit of treasury........................................................................................................................................95

See handout....................................................................................................................................................95

Discussion.............................................................................................................................................................95

Warning signals and what to look for.................................................................................................................95

Appendix – Definitions & Resources.....................................................................................................................102

Resources.....................................................................................................................................................102

Definitions......................................................................................................................................................102

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 The role of Treasury

The role of Treasury

In government the treasury is:

• the part of a government which manages all money and

revenue.

• the funds of a government or institution or individual

• the government department responsible for collecting and

managing and spending public revenues .

• depository (a room or building) where wealth and precious

objects can be kept.

• The centre of financial operations within a company.

In the corporate world
It does Banking Admin and Cash Management. It invests the company’s cash in
order to earn a return and pays down debt. It moves money around to the
departments and field offices that need it, usually in the form of wires and ACH.
Engages in the financial risk management of corporations, helping to manage
corporate debt and maintain cost-effective financing for corporate improvements;
and manages corporate investing activities.
The size of the treasury department depends on the corporation's size; very large
corporations may have regional treasury departments located in regional
accounting offices.
The main treasury department is usually led by a director, who reports directly to
the company's chief financial officer (CFO). The director has accounting
managers or controllers that oversee each specific division in the treasury
department; beneath this management level are the senior and staff accountants
responsible for the daily accounting entries.
The size and scope of employee experience and license requirements depend
on the activities of the treasury department. Corporations that engage in several
investing activities may require accountants who are licensed stockbrokers.
Corporate Cash Flow
Corporate cash flow is the most important part of the treasury department.
Making sure cash is available to pay current liabilities and cover payroll are daily
activities managed by treasury. Large corporations may have several dozen bank
accounts that need to be reconciled daily to ensure no fraud has occurred.
Another important part of cash flow is the preparation of the cash flow statement
for each division or subsidiary of the corporation. The cash flow statement helps
the treasury director find areas struggling to generate cash each month and
correct the business operations appropriately.
Corporate Debt
All corporations use debt in their financing activities; the management of this debt
is usually relegated to the treasury department. Monthly repayments, balloon
payments and interest payments are managed by treasury. Loan agreements
and other related paperwork is also found in the treasury department.
As other financing needs arise in a corporation the treasury director is relied on
to help determine the best options for debt financing. Maintaining strong
relationships with bankers is an integral part of the director's responsibilities.
Corporate Investments
Corporations have various investment strategies for their cash retained from
business operations. Money markets, bonds, securities and special long-term
investments are all part of a corporation's investment portfolio. The treasury
director and CFO will usually have percentages of cash that are required to
remain in cash and short-term investments, which are highly liquid. All other cash
is held in higher-interest investments to gain the maximum interest.

Auditing

External and Internal audit

The treasury organisation:

• Review of the effectiveness of the current organization.

• Adequacy of Treasury policy and procedures documentation,

• Evaluation of procedures, and practices for effectiveness,

appropriateness, and security.

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 • review and assess that adequate segregation of duties in
the Treasury function exists;

• review and assess reporting of Treasury positions in terms of detail and

frequency;

• Reviewing the adequacy of safeguarding of the company’s cash assets;

• review and assess reconciliation, recording, monitoring processes;

• review and assess authorisation levels within the Treasury function; and
• review and assess the systems utilized to undertake
the Treasury function.
Bank services:

• Review of bank services currently for appropriateness to stated needs, as

defined by the treasury staff.
Bank service charges:
• Review of the organisation's bank charges, as detailed on bank account
analysis statements and other bank information for appropriateness for the
services offered.

• Compensation methods and levels are evaluated and compared with

standard benchmarks (where possible).

• Cash flow forecasting activities:

• Review of the effectiveness of the organization's cash flow forecasting

activities is measured against plan, trended over time,

• Evaluation of its impact on investing and/or borrowing activities.

• Investment activities:

• Review of investment strategies and activities,

• Review of organization's investment policy and guidelines for reasonability

and effectiveness.

• Comparison of yields on investments with appropriate standard

benchmarks to measure performance.

• Whether the organisation has established procedures for

- Reviewing and assessing the performance benchmarks
- Reviewing and assessing the credit structure

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 - Reviewing and assessing product management
- Reviewing and assessing liquidity management
Borrowing activities:

• Review of various aspects of current credit lines,

• Comparison of actual vs. planned credit line usage,

• effectiveness of the organization's borrowing policy, and levels of

compensation.

• Average loan price will be compared with appropriate standard rates to

measure performance.

• Whether the organisation has established procedures for

o Reviewing and assessing the borrowings strategy;

o Reviewing and assessing the borrowing limits;

o Reviewing and assessing interest rate risk management;

o Reviewing and assessing the company’s debt to equity ratio; and

o Reviewing and assessing the composition of borrowings.

Financial risk management activities:

• Evaluation of the steps and strategies of the organization's financial risk

management activities

• Comparison of risk management activities with appropriate standard

benchmarks

Foreign exchange risk management activities

• assessment of the foreign exchange policies in relation to the

effectiveness in reducing the impact of exchange rate variances on the
reported annual earnings and operating cash flow;

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Detailed Audit checklist

A. Functions
B. Activities

Checklist for various functions

1. Physical controls:

a. Observe that entry into the dealing room (in case there is one) is restricted to
authorised personnel only
b. Examine in case of physical securities
 Movement of securities is recorded and updated
 Securities are verified before signing the security movement form
c. Verify whether there are procedures for safekeeping of valuables and they
are working effectively.

2. Authorisation
a. For entities having dealing rooms and dealing for others:
i. Check that all sampled deals are authorised at the proper levels of
authority against the deal slip (Chief Dealer or Treasury Manager)
ii. Ensure that alterations and cancellations on deal slips are authorised
iii. Ensure that acknowledged copy is taken from the client
iv. Observe that a copy deal slip is sent for second authorisation to the
Back Office Manager.
b. For other entities:
i. Ensure that proper authorization levels are set for treasury operations.
ii. Observe and verify whether the above procedure is followed.
iii. Verify whether authority limits have been set.

3. Recording Control
a. Control over documents
i. Verify that all money market deals are timely and accurately recorded at
the correct monetary value.
ii. Inspect and ensure that filed copies are pre-numbered and continuous
for ease of reference and continuity in document filing.
iii. Verify that all the documents and statements have been received from
concerned parties (brokers, bankers, lenders etc.) and properly filed in a
logical sequence.

b. Control over Accounting Procedures

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 i. Verify that adequate systems are in place to track all matured investments.
ii. Check for accurate recording and accounting of positions.
iii. Verify that an independent person checks the recording of postings
iv. Trace all deals to the General Ledger and re-compute interest
calculations.
v. Check that account reconciliation is done and time frame is set for
clearing all outstanding items.
vi. Inspect source documents for accuracy of information on source
documents and ascertain that they are initialled as evidence of checking.

4. Segregation of Duties

a. Check and ascertain that segregation of duties is in place. Under no

circumstances staff involved in initiating deals staff be involved in checking or
receiving the related documents.
b. Check that there is segregation between functions of authorisation, execution and
recording of transactions.
c. Do an overall assessment and ensure that management supervision is practiced
where segregation of duty is not possible
d. In cases where management override has taken place , ensure that satisfactory
reasons for doing so were recorded

5. Limits
a. Check counter-party exposure limit for all brokers, lenders etc.
b. Check deal limits- Maximum amount a person can transact without seeking
higher-level approval.
c. Check product limits- Maximum exposure the entity should have in a particular
instrument or product
d. Check sector limits – Maximum investment in a particular sector

6. Reconciliations

a. Check that all printed reconciliations are filed in sequential order.

b. Select a sample for verification
i. Trace each individual item to the recon
ii. Follow up each item and note when it is cleared off the reconciliation.
Establish that proper procedure on clearing the outstanding item are set
and followed
iii. Establish that only outstanding items are carried on reconciliation.
iv. Trace items from the recon to the General Ledger and get an
assertion that they are included in the management accounts.
c. Trace monthly figures to the Management Accounts and compare the figures for
accuracy in compilation
d. Check opening balances in General Ledger and establish continuity of balances
at close periods.

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 7. Processing
a. Examine deals from the front office and establish that they are confirmed by the
Back Office Manager
b. Trace the selected deals to the filing system and establish that a systematic filing
is in place.
c. Examine third party payment and establish that a letter of instruction to that effect
is filed.
d. Establish that outward confirmations are recorded in a Register.

8. Bank Cheques
a. Verify whether unused bank cheques are kept under lock at all times.
b. Ensure that bank cheques for outward payments are accompanied by full
documentation. (Two Confirmation Letters)
c. Observe that a limited number of personnel have access to Bank Cheque
pad currently in use.
d. Inquire the check signing limits and ensure they are adhered to.

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Detailed checklist for activities

Description Remarks
1. General requirements

a. Whether the entity has a policy for

all treasury activities.
Whether the policy is commensurate
with the nature of operations and
adequately covers all the activities?
Interview
selected treasury personnel &
accounting personnel
Review internal control report and
prior audit reports
Verify whether follow up activities
have been undertaken and issues in
past reports have been satisfactorily
resolved
Review management reports
Review reconciliation of cash and
investments
Are their policies for interest rate
risk management?

2 Specific Areas
Foreign Exchange risk
management
Whether there are policies and
procedures for foreign exchange risk
management?
Review whether the policy is
effective in controlling and
monitoring risk
Are there predefined limits for
different types of instruments?
Are their policies establishing
authority levels for approval of
transactions?
Has the entity identified the

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counterparty to conduct foreign
exchange transactions?
Who is authorised to approve
hedging strategies, and the amount
to be hedged
Is there adequate segregation of
duties?
Review the method adopted by
entity to account for foreign
exchange transactions
Are the counterparty banks informed
of the names of employees
authorised to execute foreign
exchange transactions
Is there a system to track exposure
in foreign exchange .Are timely
reports from the system available to
the decision makers?
Analyse the gains and losses from
foreign exchange transactions

Investments
Review the investment strategy .Is
the strategy followed in letter and
spirit?
Are authority level set for
investment in different instruments
monetary limits
Obtain the list of investments
Analyse the investment portfolio
statements
Are all investments in name of the
entity .If not, review whether entity
has valid reasons for not doing so.
Verify the entity has al the
documents with regard to ownership
of investments

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Cash management
Obtain Bank statements
Review the Statement of
investments
Review the liquidity position
Who is/are responsible for cash
management?
Does the entity follow specific
technique for borrowing /investing
short term funds ?
Who is authorised to devise a
strategy for deployment of surplus
funds ?
Does the entity utilise third party
investment managers? Are reasons
for selection recorded in writing?
How does the entity control the
investment managers’ activities?
Are the investment mangers
appraised of the investment policies
of the entity? How does the entity
ensure compliance with them?
How is the performance of
internal/external investment
managers evaluated?
Whether there is adequate
segregation of duties?
Review accounting treatment to
various transactions
Whether monthly statement
reconciled?
Is there an effective procedure of
following up with the un-reconciled
items?

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Departmental role and responsibilities

At a corporate level "Internal auditing is an independent, objective assurance and

consulting activity designed to add value and improve an organisation's
operations. It helps an organisation accomplish its objectives by bringing a
systematic, disciplined approach to evaluate and improve the effectiveness of
risk management, control, and governance processes."
Major roles and responsibilities of internal audit function are summarised as
below:
• evaluates and provides reasonable assurance that risk management,
control, and governance systems are functioning as intended and will
enable the organisation's objectives and goals to be met
• reports risk management issues and internal controls deficiencies
identified directly to the audit committee and provides recommendations
for improving the organisation's operations, in terms of both efficient and
effective performance.
• evaluates information security and associated risk exposures
• evaluates regulatory compliance program with consultation from legal
counsel
• evaluates the organisation's readiness in case of business interruption
• maintains open communication with management and the audit committee
• teams with other internal and external resources as appropriate
• engages in continuous education and staff development; and
• provides support to the company's anti-fraud programs.

Reporting Structure of Internal Audit Function

Existing corporate governance regulations do not address the interaction

between the audit committee and the internal audit function, or the
responsibilities of the function.
In most companies, the internal auditor traditionally reported to either the Chief
Financial Officer or the Chief Risk Officer, though other may have existed in
some companies. Today, the internal auditor may either report directly to the
Audit Committee, or the Audit Committee will have a role in hiring, firing,
evaluating and compensating the Chief Audit Officer. The Audit Committee’s
increasing role with regard to the internal audit is being undertaken to help
ensure the internal auditor’s "independence" and objectivity.
The relationship between the Audit Committee and the internal audit funct.ion
should be clearly defined and addressed in the Audit Committee’s charter

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Preparing for the Treasury Audit

The audit process

The three stages in the treasury audit process

Any internal audit process should have three distinct phases.
Preparation for the actual investigation is the first stage.
Secondly the auditors need to visit the treasury. Finally the auditors need to
report their findings and follow up any recommendations.
We will examine these stages in turn.
1. Preparation
Without adequate preparation, any activity will be of limited value. This is true of
a treasury audit. The preparation process can be broken down into two stages.
Selecting the team
Before much of the preparation work can be done, the head of the audit
department needs to select the team that is going to perform the treasury audit.
The size of the team will depend upon the scale of the audit that needs to be
performed. This team needs to include at least one person with knowledge of
treasury instruments. Unless the auditors understand the instruments used by
the treasury, they will not be able to assess whether any use of such instruments
is appropriate in the context of the role of treasury. This could be a problem as
such skills may not exist within the audit department. As a result, a specialist
could be appointed from outside the audit department. The training of one or two
members of the audit department is a longer-term solution to this problem.
Understanding the treasury
Before the more formal internal audit process can start, the team needs to
familiarise itself with the role of the treasury within the organisation. This role,
whether for example it should act as a cost centre or as a profit centre, has to be
communicated within the annual report. In addition, the overall structure of the
business will also impact on how the treasury conducts its activities. For
example, a highly centralised group treasury will operate in a different way to the
treasury function in a decentralised group.

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Obtaining permanent file data and deep background data
The team should study previous audit reports in combination with the treasury
policy. This will give the team the context within which their audit process needs
to take place. Furthermore, any substantial changes in activities should also be
identified. These changes might involve the operation of the group - for example,
if the group has made an overseas acquisition. In addition, since the last audit,
there may have been a change to the structure of the treasury itself. All of this
work is important in determining the team's approach to the audit process.
2. The audit process itself
Once the preparation work has been carried out, the treasury audit team needs
to conduct its audit. Whilst there are many different ways of conducting an audit,
the preparatory work should form the basis of at least the initial stages.
Have any changes taken place?
In the preparation, the audit team will have identified whether or not any
substantial changes have taken place since the last review process. If such
changes have taken place, these need to be examined. Key questions here
should include:-
·What changes have taken place and have they been managed effectively?
·How have these changes affected the risks within the treasury? With the
increasing focus on risk management, many treasurers will have approached the
internal audit department for help in managing any changes. If this has been the
case, did the treasury follow internal audit's advice?
·Are the systems of control and the segregation of duties still appropriate after
the changes?
Regular review
Although many treasuries will have seen changes between audits, it is also
important to conduct regular reviews of the work that the treasury does. This
reflects the reality that no treasury stands still.
Even if personnel within the treasury are the same after a year, their skills and
experience will be different. At the same time, new products and new ways of
working are being developed all the time.
In practice, this means that, contrary to initial perception, there are in fact
continual, but less obvious, changes within treasury. Within this regular review, a
number of areas should be examined.
a. The treasury policy and the treasury's activities.

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There should be a board-approved treasury policy in place. Some of the detail of
this policy should be published in the annual report, including whether the
treasury is viewed as a profit centre or a cost centre. In addition, it must set down
the company's view on what is acceptable risk.
The team needs to discover whether the treasury is performing the roles it should
be and whether it is operating within the parameters set by the policy.
The position of the treasury within the company should be understood, not only
by the treasury itself, but also within the other parts of the business.

b. Segregation of duties.
The auditors need to make sure that all the activities of the treasury are
sufficiently segregated, particularly those between the initiation and the
confirmation of deals. Given the changing skills and experience of staff members,
auditors need to establish whether the limits and authorities are still relevant. Is
there too much reliance on certain individuals within treasury?
The team should study previous audit reports in combination with the treasury
policy. This will give the team the context within which their audit process needs
to take place. Furthermore, any substantial changes in activities should also be
identified. These changes might involve the operation of the group - for example,
if the group has made an overseas acquisition. In addition, since the last audit,
there may have been a change to the structure of the treasury itself. All of this
work is important in determining the team's approach to the audit process.
c. Documentation.
Is all the relevant documentation in place and is it fully up to date? This refers
both to documentation with service providers, such as banks and systems
providers, and also to documentation issued to subsidiaries and other parts of
the business. Covenants with banks should also be checked.
d. Systems security and use.
The security of the systems - particularly the electronic banking and treasury
management systems - needs to have sufficient controls. With the increased use
of web-based technology, the examination of controls for this is important as well.
You should also identify whether the procedures for the use of these systems are
sufficiently detailed and whether the staff follow them. Finally are the systems
adequate for the tasks they are required to perform? Or should the treasury be
looking to upgrade their system?
e. Contingency planning.
Are there fully tested contingency plans in place should something go wrong?

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f. Performance management.
How well is the treasury performing its various roles?

The audit report

3. The report back

Once the team has finished its work within the treasury itself, the work is not
done. The final report back stage is a crucial part of the process. Firstly, the
report itself will form the basis of the next audit process, as discussed above.
But, more importantly, it is a key formal document in the overall control process
for the treasury.
The report will provide both the board and the treasury with an independent view
of the work of the treasury. As long as both the preparation and the investigation
work was carried out with sufficient rigour, the audit report will be able to answer
the questions about the treasury's activities that we asked above.
The report should identify any problems with the work of the treasury. If any
problems are identified, the internal auditors should be encouraged to make
recommendations for improvements. If any such recommendations are made,
the auditors should conduct a further check on whether these improvements
have been made after a reasonable time.
The process can be less formal. In these notes, we have outlined a formal
internal audit process for a treasury. In smaller treasuries, in particular, it might
be more appropriate to have a less formal process of audit. For example, the
internal audit department could be consulted on a more regular process. The
critical point is that the work of the treasury should be examined by a third party
on a regular basis to give the treasurer the benefit of a more detached view.
Figure 1 illustrates the relationship between an authority’s strategic objectives
and the role of procurement.

Introduction to Financial markets

Introduction

“Life in abundance” is probably one of the greatest desires of mankind. In

business, people strive to manage their assets (and liabilities for that matter) to
obtain maximum advantage, which they believe would eventually lead to true

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joy. Even the astronomers look toward the heavens to try and find explanations
that would enhance our life on earth. The business world can almost be
described with the same philosophy with which Arno A. Penzias, Novel prize
winner in physics, described the universe: “Astronomy leads us to a unique
event, a universe which was created out of nothing, and delicately balanced to
provide exactly the conditions required to support life.”
The business world of today is also delicately balanced with numerous
determinants playing a part in trying to enhance human life.

Markets in the financial system

People have different needs, and in trying to fulfil these needs, opposite needs
are matched. Where needs are matched on a large scale, markets for those
needs develop. Market forces are thus:

• the supply of an item or service where there is

• a demand for that item or service.
Trading of that item or service is created through a price mechanism. The price
is based on the value of the item or service to the traders (buyers and sellers),
depending on certain market factors.

There are different markets in a system, such as

• the services market

• the products market
• the financial markets.
A market is not necessarily a physical and geographically identifiable place, and
goods traded are not necessarily physical goods. Trading might take place over
the telephone, and goods traded might be knowledge, etc. Goods traded in
markets are traded through a price mechanism which expresses the interaction
of demand for and supply of these goods as a value. So, for instance, the
trading of apples uses the price mechanism of a monetary amount, for example
R1,20 per apple.

The different markets in the financial system of a country are not isolated
markets, but they interact with each other. With electronic communication and

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the revolution in computers and computer networks, the markets of the world are
busy interacting on a large scale. In a small country like South Africa, one could
sometimes feel lost in this “universe” of supplies and demands. As astronomer
Bernard de Fontenelle (1657-1757) put it: “Behold a universe so immense, I am
lost in it. I no longer know where I am.”

The effect of different markets on each other can, however, clearly be seen in the
South African context. The money supply in South Africa is, inter alia,
influenced by the gold price, because South Africa is a net exporter (seller) of
gold. If the gold price should increase, the supply of money in the markets will
increase due to more money flowing into the country. This could lead to a
higher demand for products in the product markets because of the availability of
money. A higher demand for products could result in prices of products going
up (resulting in inflation), which would dampen the demand for products and
money. This interactive circle of changes is an ongoing process in markets.

The development of financial markets and instruments

The basic needs in the financial world, are the following:

the need to invest excess money (supply)

the need to borrow money (demand) where there is a shortage of money.

The government of a country might, for instance, need money for certain
projects, while certain private sector companies or individuals might have excess
money to invest in profitable investments. The “price” paid for money is interest
paid on the amount borrowed, and the interest rate is thus the price mechanism
used in financial markets.

To match different financial needs such as the need to borrow and the need to
invest, intermediaries are mostly used, for example:

where an institution wants to invest a certain sum of money, for a certain time,
giving them a certain yield

another institution wants to borrow a certain amount of money for a period at the
lowest cost possible, the lender’s and the borrower’s demands might differ.

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An example would be:

Eskom needs R100 million for a period of at least 10 years to erect new power
lines

SCMB has R50 million it wants to invest for 7 years

Investec has R50 million it wants to invest for 12 years.

An intermediary would seek to merge these different needs and demands of

borrowers and lenders through negotiation and financial instruments. A
certificate would be issued to the lender giving him the right to the interest
payments and the redemption amount at expiry of the loan. These instruments
are called securities.

Large financial transactions involving the lending and borrowing of money (such
as the example above), which are done through intermediaries or as principal by
the lender, are often structured and standardised regarding:

the amount of the loan or investment

the interest paid and received thereon

the term to redemption of the loan.

In order to enhance the marketability and tradability of these securities, these

standards created for transactions are incorporated into financial instruments. A
borrowing certificate from a certain institution, where the institution borrows the
money and gives the lender (investor) a certificate promising to pay the owner or
holder of the certificate R1 million on 1 June 2008 and interest of 11,00% per
annum on R1 million up to 1 June 2008 (similarly to the Eskom 168 certificates),
is an example of a financial instrument. A certificate representing the contract
between the lender and borrower is issued for the duration of the loan. Appendix
1 is an example of a bond (capital market instrument) which is a financial
instrument.

Instruments (certificates) issued by the ultimate borrower are called primary

securities.

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Instruments issued by intermediaries on behalf of the ultimate borrower are
called indirect securities.

The market for instruments (also called securities) issued for the first time, is
called the primary market. Because of the standardisation of these instruments,
different needs in the markets at different times, and different views of economic
factors, these instruments are traded between institutions after they have been
issued for the first time. If a lender needs his money before redemption date of
the loan, the lender could trade the loan by selling the certificate to another
institution. The buyer of the instrument pays the seller an amount (the present
value of the future cash flows of the loan), and the buyer becomes the new
lender. The market where instruments are traded subsequent to the first issue is
called the secondary market.

The secondary market in some of the securities is a very active market.

Activities in the secondary market have a strong determining influence on issues
in the primary market as liquidity, tradability, market rates, scale of demand, etc.
of specific instruments are reflected in the secondary market. The variables of
the economy in these markets are expressed through the interest rate (the price
mechanism) determined in the secondary market (called the market rate), and
this has an influence on the rate and value at which issues can take place in the
primary market. If, for instance, I have R1 million to invest and the market rate is
16% (this means that I can invest my money in the market at 16%); I have the
following two choices:

(This example ignores the nominal amount of R1 million that the investor would
receive at redemption of the loan. The influence of this will be discussed in later
sections and chapters.)

a) Invest in a certificate giving me 11% interest per year indefinitely on R1 million,

b) Invest in an investment in the market giving me 16% (the market rate) interest
per year on R1 million.

The obvious choice is b). I would only invest in a) if I could get a discount on my
investment. The monetary amount of interest that I would receive from the
investment in a) would be 11% on R1 million per year, that is R110 000 per year.

19
For this amount to give me a return of 16%, I would only be willing to invest:

R110 000/16% = R687 500

If I could get a discount of (R1 000 000 – R687 500) R312 500 on the certificate
in a), and only pay R687 500 for the certificate while still receiving 11% interest
on the nominal amount of the certificate (R1 000 000), my yield on the
investment would be:

R110 000/687 500 = 16%,

The same as option b).

Thus, if the market rate in the secondary market is 16%, and an institution wants
to issue certificates in the primary market, the institution has to pay the market
rate on his certificates issued, or issue the certificates at a discount if the rate
paid on the certificate (called the coupon rate) is less than the market rate. Vice
versa, if the rate paid on certificates is higher than the market rate, these
certificates would be issued and traded at a premium.

The secondary market gives the investor the opportunity to manage his portfolio
in terms of risk and return ratios, liquidity, etc. The return that the investor
receives or wants to receive on his investment (called the yield), can be
managed within certain parameters, and by using different strategies of buying
and selling different instruments and investments in the secondary market.

Classification of Financial Markets

Markets can be classified into different categories depending on the

characteristic of the market or instrument used to create categories. Securities
created by institutions in the markets normally pay an interest on the nominal
amount (the amount shown on the certificate or contract). The interest-bearing
securities market is split into the money market and the capital market, based on
the term to maturity (the term left to redemption of the debt) of the securities.

The capital market is the market for the issue and trade of long-term securities.

The money market is that of short-term securities.

20
When goods such as financial instruments are traded in a market, there are
certain differences between transactions done in these markets. The
differences in transactions in the financial markets can be categorised in different
categories, two of which are the following:

The timing difference between the closing of the transaction and the delivering of
the goods or settlement of the transaction

The difference in certainty that the other party will honour the transaction.

In the spot market, the closing of the transaction and the delivery of the goods
take place simultaneously or within a short-term time span prescribed by the
specific market. Uncertainty about delivery from the other party is very limited,
otherwise no transaction would take place.

The forward market is the market where a transaction is closed in the present,
and the settlement of the transaction and the delivery of goods are in the future.
The delivery date and the price are determined at the closing of the transaction.
Because of the time lapse between the closing and the settlement of the
transaction, the risk that one of the parties might not be able to deliver at the
settlement date is higher than in the spot market.

The futures market is similar to the forward market, except that in the futures
market, the risks of settlement and quality of the product are addressed. The
same transaction as in the forward market would be closed, with the addition of
the standardisation of the amount of goods, the quality of the goods and
guarantee (by an exchange) of the payment of the price and delivery of goods or
cash settlement of the difference.

Risks of Financial Transactions

Borrowing and lending of money create certain risks, namely

That the borrower will not be able to repay the money

That the lender is receiving a fixed rate on his investment while market rates
fluctuate in such a way that the yield on his initial investment is now below
current market related rates

21
That the value of the capital invested could decrease due to movements in the
market.

To lower the risk of a financial transaction, the risk can be sold to people or
institutions that are willing to take on that risk without immediately taking over the
effects of the transaction. The institution willing to buy the risk associated with
the transaction would have to be compensated for taking on the risk. In
monetary terms, the compensation for taking on the risk would, however, be less
than the possible maximum loss associated with the risk. The trading of these
risks associated with financial instruments resulted in the development of
derivative products.

To hedge a position means to reduce the risk associated with a financial

transaction or position, by selling the risk or by taking an opposite financial
position, with the effect that a market movement would not result in substantial
financial loss. A financial position which is not hedged, is called an open
position.

The trading of risks created a market for the hedging of risks involved in financial
transactions, which is a market derived from the original financial transaction.
Contracts are drawn up for these kinds of transactions and because these
contracts are derived from the original financial transaction, they are called
derivatives. In a publication by Paul Eloff of the South African Futures
Exchange, the following description of derivatives is given:

“Derivatives such as future contracts and options, are instruments whereby price
risks are reallocated from those not willing to accept the risk and placed with
those who are willing to accept the risk.”

Institutions in the markets

A sophisticated financial services sector consisting of lenders, borrowers,

financial intermediaries, financial instruments and financial markets, has different
institutions participating in these markets.

22
Certain intermediaries in the financial markets take on deposits as principal.
These intermediaries are called deposit-taking intermediaries. Examples of
such intermediaries are:

• South African Reserve Bank (SARB) (deposits from selected clients)

• Private banks
• Land and Agricultural Bank
• SA Post Office Limited.
There are other intermediaries operating in the market, who only manage funds
on behalf of clients as an agent for the client. They do not take on deposits, but
bring together the borrower and lender with similar needs regarding amount, term
and rate of the transaction. Such an intermediary is called a non-deposit-taking
intermediary. Examples of these intermediaries are:

• Unit trusts
• Insurers
• Pension and provident funds
• Finance companies.
Other institutions and interest groups in the market do not participate in the
trading of instruments as principal traders but perform functions such as
supervision of activities, regulation of the markets, provision of trading facilities,
etc. Examples of these institutions and groups are:

• The Johannesburg Stock Exchange

• The South African Futures Exchange
• The Bond Exchange of South Africa
• The Supervision Department of the SARB
• The Financial Services Board.
The role of the government and the South African Reserve Bank

The government of a country, being the ruling body, has to manage and
supervise the economy, resources and people of the country. In order to

23
manage the economy and related resources, economic policies concerning
markets and trade in a country are used. The monetary policy concerning the
money markets and money transactions of a country. This has a strong
influence on imports and exports and the payment system of a country. Fiscal
policy is the policy of the government concerning the collection of money through
taxes, issuing of financial instruments, etc. to fund the level of expenditure they
decide on regarding, for example, education, infrastructure, etc. A guideline of
this policy is given each year in the government’s budget.

One of the functions of the SARB is to co-operate with the Ministry of Finance in
formulating and implementing monetary and exchange rate policy. The SARB
also acts as banker to the government and other banks and thus plays an
important role in the markets as decisions concerning interest rates of the SARB
affect all institutions in the market.

Other important functions of the SARB include:

Issuing of bank notes and coins

Supervising the country’s gold and foreign exchange reserves. In this function it
plays an important role in maintaining a stable exchange rate

Supervising registered banks

Settlement of claims and payments between banks

Lender of last resort for the banks.

Trading in the markets

Trading can take place in a market when information about prices are
exchanged. The mechanism of price measurement in the money markets is the
interest rate, because the interest that the borrower pays is the price that he has
to pay for the privilege of using the money for a certain time.

Financial instruments are quoted at interest rates, from which the transaction
amount or the amount that the buyer which the transaction amount or the amount

24
that the buyer (lender) has to pay to the seller (borrower), also called the
consideration or settlement amount, is then calculated.

Price in monetary values (the consideration paid for an instrument) and interest
rate movements are opposites. Fixed interest rate securities are traded at a
discount on the nominal value if the market interest rate is higher than the
interest rate on the instrument (called the coupon rate). Consider the following
example:

An instrument with a term to maturity of one year, a nominal amount of R1 million

with a coupon rate of 12% will probably trade at the following prices at the
beginning of the year:

If the market rate is 15%, the investor could invest his money at 15% in the
market. He would want to buy the instrument giving only a yield of 12% at a
discount, so that the money he invested would earn an effective yield of at least
15%. The cash flow that he would receive at the end of the year if the interest is
paid at the end of the period, is:
Interest: 12% of R1 000 000 = R 120 000
Capital amount: R1 000 000
Total R1 120 000
The total cash flow discounted at the required yield of 15% for one year gives
R973 913. For the investor to earn 15% on his investment, he would be willing
to pay only R973 913 for the instrument.

If the market rate and yield required by the investor drops to 14% the instrument
(using the same calculation methods) would trade at R982 456. Thus, it is clear
that with a fixed interest and redemption payment, a lower monetary amount
(consideration) would be offered for an instrument if the yield goes up, because
the investor would want to earn more on his investment. The interest rate at
which the instrument is eventually traded, is called the yield and could differ from
the market rate because of differing views, costs, etc.

For trading to take place, a buyer and a seller must get together and negotiate.
This could take place on a specifically allocated floor, or by means of a
communication system using computer networks and telephones, for instance,

25
the South African Futures Exchange and the JSE. Where a transaction takes
place without making use of an organised exchange, the transaction is called an
“over-the-counter” (commonly known as OTC) transaction. The Futures
Exchange and the JSE have in recent years implemented fully automated
electronic trading systems, which eliminate telephone calls between buyers and
sellers or buying and selling agents to a large degree. Although transactions are
closed in numerous ways, the exchange of money and products such as
contracts, certificates, etc. still takes place between the parties of a transaction,
and this is called the settlement of a transaction. Settlement of the transaction
can take place at a later date than the date of the transaction.

Owning a financial instrument is called a long position. A short position is the

selling of a financial instrument without being the owner thereof. Because the
settlement date could be after the transaction date, a seller could sell something
he doesn’t own and buy it before the settlement date, to be able to deliver it to
the buyer.

Factors influencing the financial markets

Each effective market has a supply of a certain commodity, and a demand for
that commodity. Savings (investments) represent the supply side in the money
markets, and financing needs, as the demand side. Because of the interaction
between the various financial commodities, money and service markets in a
country, the simple theory of supply and demand determining prices cannot be
applied in its basic form in these markets.

The theoretical system would determine that the rate (price for money) would
drop if there is a surplus savings (supply) in the market, but if there are savings in
the market which are not utilised to finance income-making activities, the national
income will eventually decline, probably bringing about a decline in the rate of
savings which could work against the fall in interest rates.

Another factor influencing the financial markets is expectations; for instance, if

rates are high, with the expectation that the rates are going to decline in the
future, the demand for securities and thus the supply of money will be high,
pushing interest rates down, and security prices up.

26
Expectations of higher inflation could push up interest rates. Prices of goods are
expected to go up, so consumers tend to buy now rather than later, which
pushes up the demand for cash balances and hikes interest rates. Interest rates
in turn has an effect on inflation. The level of savings and spending is to a
significant extent determined by prevailing interest rates.

Fiscal policy decisions by the government also affect the financial markets. The
decisions by the government also affect the financial markets. The decision on
how to finance the government’s deficits will affect the supply and demand for
cash balances, short and long-term deposits (M3 money supply), and thus
influence interest rates. If the government decides to finance its monetary
needs with the issuing of short-term securities such as treasury bills, the demand
for money in the short-term market increases, exerting upward pressure on
interest rates.

Examples of other factors affecting local financial markets are the following:

The local market seems to overreact on information and expectations. During

1994/95 the expectation of higher inflation was one of the reasons for long-term
interest rates going up by more than 5 percentage points

The level of government spending has an adverse effect on inflation and interest
rate movements

South Africa had a two-tier exchange rate system (the financial and commercial
rand) up to March 1995. Some restraining foreign exchange regulations are still
in place. The exchange rate determines what a country pays for imports, and
what that country gets for exports in terms of its own currency, for example, the
rand proceeds of gold exports. These import and export payments have an
effect on the foreign reserves have an effect on the foreign reserves that South
Africa holds and the amount of money in circulation in the economy. Foreign
trade and the resulting foreign exchange rate affect the local economic
parameters influencing the financial markets.

27
The integrity of the payments system in the financial markets. Trust in the South
African system was affected by the credit rating that South Africa received from
overseas institutions

High labour costs, excessive political violence and significant political

uncertainties in the country have tended to keep away foreign investors.
Because of the local political factors, foreign investors want a premium on their
investment yield to compensate for the risk and uncertainty associated with
investing in South Africa

Liquidity in the markets is low, and pooling of funds needs to be done to improve
liquidity

Domestic funds, such as pension funds, tend to invest in shares rather than
capital market instruments because of risk and return factors and uncertainties
about interest rates and volatility. The demand for capital market instruments is
thus lower, pushing up interest rates. Previously, funds were forced to invest in
certain government capital market instruments as a certain percentage of their
total portfolios

Financial disclosure concerning transactions, positions and risk involving

financial markets is not in line with generally accepted standards world-side.

Capital adequacy and interest rate risk

The general approach is that financial positions, which are exposed to interest
rate fluctuations, should not be more than a certain percentage of the primary
capital of a company. Internationally accepted levels are much lower than the
levels in South Africa.

Conclusion

The financial markets play a very important part in the well-being of every
person. They interact with other markets and have an influence on issues such
as wealth, inflation and stability in a country. The financial markets have their
own characteristics and to operate in them, it is important to comprehend these
characteristics.

28
Bank and business unit structures

It is important that authorities are aware of their image or reputation in the

marketplace. To achieve best value for money and strive for innovation in the
delivery of services, the authority will need to do business with the best suppliers
and providers. If the authority has a poor reputation in the marketplace it may find
it difficult to attract good suppliers, and possible attract others for the wrong
reasons.
If you make it easier for suppliers to tender (i.e. make documentation simple and
have help line), this increases the supply of BIDDERS AND HELPS DRIVE
PRICES DOWN

Treasury objectives

1.1 HM Treasury is the United Kingdom’s finance and economics ministry, and is
responsible for formulating and implementing the UK Government’s financial and
economic policy. Reflecting this role, the Treasury Group has set itself two
Departmental Strategic Objectives (DSOs) for the 2007 Comprehensive
Spending Review (CSR2007) period:
Maintaining sound public finances; and
Ensuring high and sustainable levels of economic growth, well being and
prosperity for all.
1.2 While these are articulated as two separate DSOs, they are strongly linked
and delivery of one DSO cannot be effected in isolation from the other. Each of
these DSOs is underpinned by a series of outcomes. The Delivery and
Measurement section below sets out the full list of these outcomes, and the
indicators the Treasury will use to measure progress against the DSOs over the
CSR2007 period.
1.3 The DSOs cannot be delivered without supporting systems, processes,
resource management and corporate capability: the Treasury is therefore
committed to enhancing the effectiveness and efficiency of its corporate services
over the period.
1.4 In addition, the Treasury Group will be a delivery partner for seven of the
Government’s Public Service Agreements (PSAs) for the CSR2007 period.
Raise the productivity of the UK economy
Deliver the conditions for business success in the UK

29
Improve the economic performance of all English regions and reduce the gap in
economic growth rates between regions
Maximise employment opportunity for all
Halve the number of children in poverty by 2010-11, on the way to eradicating
child poverty by 2020
Lead the global effort to avoid dangerous climate change
Reduce poverty in poorer countries through quicker progress towards the
Millennium Development Goals

Corporate perspectives

Every company operating overseas has some level of FX risk.

A company needs to manage your FX risk – whether it arises from a single
invoice in a foreign currency or a need to source raw materials or components
overseas, to regular import/export activity or a complex series of acquisitions and
disposals around the world.
Hedging solutions
A company also needs to manage currency risks and shape a hedging solution
that concurs with its business objectives, risk appetite and the impact of external
factors on your business, including movements in underlying currencies. From
here a company can develop an effective risk management strategy that will
work now, and will be capable of evolving as the needs of the company evolve
over time.
By understanding of your business activity and your appetite for risk, your
hedging solutions will help provide certainty and peace of mind that you are
protected against volatile currency movements.

30
Asset & Liability Management

The ALM function

In banking, asset and liability management is the practice of managing risks that
arise due to mismatches between the assets and liabilities (debts and assets) of
the bank. This can also be seen in insurance.

Banks face several risks such as the liquidity risk, interest rate risk, credit
risk and operational risk. Asset Liability management (ALM) is a strategic
management tool to manage interest rate risk and liquidity risk faced by banks,
other financial services companies and corporations.

Banks manage the risks of Asset liability mismatch by matching

the assets and liabilities according to the maturity pattern or the matching the
duration, by hedging and by securitization. Much of the techniques
for hedging stem from the delta hedging concepts introduced in the Black-
Scholesmodel and in the work of Robert C. Merton and Robert A. Jarrow. The
early origins of asset and liability management date to the high interest rate
periods of 1975-6 and the late 1970s and early 1980s in the United States. Van
Deventer, Imai and Mesler (2004), chapter 2, outline this history in detail.

Modern risk management now takes place from an integrated approach to

enterprise risk management that reflects the fact that interest rate risk, credit
risk, market risk, and liquidity risk are all interrelated. The Jarrow-Turnbull
model is an example of a risk management methodology that integrates default
and random interest rates. The earliest work in this regard was done by Robert
C. Merton. Increasing integrated risk management is done on a full mark to
market basis rather than the accounting basis that was at the heart of the first
interest rate sensivity gap and duration calculations.

31
Advantages

ALM can help protect a financial institution or corporation against a variety of

financial and nonfinancial risks.
The mere process of identifying risks enables businesses to be better prepared
to deal with these risks in the most cost-effective way.
ALM ensures that a company’s capital and assets are used in the most efficient
way.
It can be used as a strategic and business tool to improve earnings.

Disadvantages

ALM is only as good as the people on the ALM committee and the operational
procedures that they follow.
ALM can prove costly in terms of both the time required of employees and the
investment required in management tools such as IT and techniques such as
hedging.

Action Checklist

Establish an ALM committee to oversee the process.

Ensure the committee has the necessary tools and techniques for measuring
and managing rate, credit, and funding risk. This should include a computer
system that enables the monitoring of funding sources and credit exposures.
Acquire a managerial accounting system that can control the information fed into
the computer system.
Establish a reward and penalty system to manage those employees who are
taking rate, credit, funding and other risks.

Following the experience of equitable and other institutions, financial firms

increasingly focused on ALM, whereby they sought to manage balance sheets in
order to maintain a mix of loans and deposits consistent with the firm’s goals for

32
long-term growth and risk management. They set up ALM committees to oversee
the ALM process. Today, ALM has been adopted by many corporations, as well
as financial institutions. ALM now seeks to ascertain and control three types of
financial risk: Interest rate risk, credit risk (the probability of default), and liquidity
risk, which refers to the danger that a given security or asset cannot be traded
quickly enough in the market to prevent a loss (or make a predetermined profit).

Dos and Don’ts

Do
Talk to one of the many consultancy firms that specialize in ALM, and that can
advise on establishing an ALM committee and improving its performance.
Ensure those appointed to the ALM committee have the necessary knowledge
and experience to perform their tasks.
Constantly monitor the performance of your committee.
Don’t
Don’t seek to cut costs in terms of investing in management tools and personnel.
Don’t forget that risks are constantly changing and developing. Make sure your ALM
committee has the skills to deal with the latest developments.

Interest rate risk identification

Consider a bank that borrows USD 100MM at 3.00% for a year and lends the
same money at 3.20% to a highly-rated borrower for 5 years. For simplicity,
assume interest rates are annually compounded and all interest accumulates to
the maturity of the respective obligations. The net transaction appears profitable
—the bank is earning a 20 basis point spread—but it entails considerable risk. At
the end of a year, the bank will have to find new financing for the loan, which will
have 4 more years before it matures. If interest rates have risen, the bank may
have to pay a higher rate of interest on the new financing than the fixed 3.20 it is
earning on its loan.

33
Suppose, at the end of a year, an applicable 4-year interest rate is 6.00%. The
bank is in serious trouble. It is going to be earning 3.20% on its loan and paying
6.00% on its financing. Accrual accounting does not recognize the problem. The
book value of the loan (the bank's asset) is:
[1
100MM(1.032) = 103.2MM.
]
The book value of the financing (the bank's liability) is:
[2
100MM(1.030) = 103.0MM.
]

Based upon accrual accounting, the bank earned USD 200,000 in the first year.

Market value accounting recognizes the bank's predicament. The respective

market values of the bank's asset and liability are:

[3
]

[4
100MM(1.030) = 103.0MM.
]

From a market-value accounting standpoint, the bank has lost USD 10.28MM.

So which result offers a better portrayal of the bank' situation, the accrual
accounting profit or the market-value accounting loss? The bank is in trouble,
and the market-value loss reflects this. Ultimately, accrual accounting will
recognize a similar loss. The bank will have to secure financing for the loan at the
new higher rate, so it will accrue the as-yet unrecognized loss over the 4
remaining years of the position.

The problem in this example was caused by a mismatch between assets and
liabilities. Prior to the 1970's, such mismatches tended not to be a significant
problem. Interest rates in developed countries experienced only modest
fluctuations, so losses due to asset-liability mismatches were small or trivial.
Many firms intentionally mismatched their balance sheets. Because yield curves
were generally upward sloping, banks could earn a spread by borrowing short
and lending long.

Things started to change in the 1970s, which ushered in a period of volatile

interest rates that continued into the early 1980s. US regulation Q, which had

34
capped the interest rates that banks could pay depositors, was abandoned to
stem a migration overseas of the market for USD deposits. Managers of many
firms, who were accustomed to thinking in terms of accrual accounting, were
slow to recognize the emerging risk. Some firms suffered staggering losses.
Because the firms used accrual accounting, the result was not so much
bankruptcies as crippled balance sheets. Firms gradually accrued the losses
over the subsequent 5 or 10 years.

One example is the US mutual life insurance company the Equitable. During the
early 1980s, the USD yield curve was inverted, with short-term interest rates
spiking into the high teens. The Equitable sold a number of long-term guaranteed
interest contracts (GICs) guaranteeing rates of around 16% for periods up to 10
years. During this period, GICs were routinely for principal of USD 100MM or
more. Equitable invested the assets short-term to earn the high interest rates
guaranteed on the contracts. Short-term interest rates soon came down. When
the Equitable had to reinvest, it couldn't get nearly the interest rates it was paying
on the GICs. The firm was crippled. Eventually, it had to demutualize and was
acquired by the Axa Group.

Increasingly, managers of financial firms focused on asset-liability risk. The

problem was not that the value of assets might fall or that the value of liabilities
might rise. It was that capital might be depleted by narrowing of the difference
between assets and liabilities—that the values of assets and liabilities might fail
to move in tandem. Asset-liability risk is a leveraged form of risk. The capital of
most financial institutions is small relative to the firm's assets or liabilities, so
small percentage changes in assets or liabilities can translate into large
percentage changes in capital.

Exhibit 1 illustrates the evolution over time of a hypothetical company's assets

and liabilities. Over the period shown, the assets and liabilities change only
slightly, but those slight changes dramatically reduce the company's capital
(which, for the purpose of this example, is defined as the difference between
assets and liabilities). In Exhibit 1, the capital falls by over 50%, a development
that would threaten almost any institution.

Example: Asset-Liability Risk

Exhibit 1

35
 Asset-liability risk is leveraged by the fact that the values of
assets and liabilities each tend to be greater than the value of
capital. In this example, modest fluctuations in values of
assets and liabilities result in a 50% reduction in capital.

Accrual accounting could disguise the problem by deferring losses into the future,
but it could not solve the problem. Firms responded by forming asset-liability
management (ALM) departments to assess asset-liability risk. They established
ALM committees comprised of senior managers to address the risk.

Techniques for assessing asset-liability risk came to include gap

analysis and duration analysis. These facilitated techniques of gap management
and duration matching of assets and liabilities. Both approaches worked well if
assets and liabilities comprised fixed cash flows. Options, such as those
embedded in mortgages or callable debt, posed problems that gap analysis could
not address. Duration analysis could address these in theory, but implementing
sufficiently sophisticated duration measures was problematic. Accordingly, banks
and insurance companies also performed scenario analysis.

With scenario analysis, several interest rate scenarios would be specified for the
next 5 or 10 years. These might specify declining rates, rising rate's, a gradual
decrease in rates followed by a sudden rise, etc. Scenarios might specify the
behaviour of the entire yield curve, so there could be scenarios with flattening
yield curves, inverted yield curves, etc. Ten or twenty scenarios might be
specified in all. Next, assumptions would be made about the performance of
assets and liabilities under each scenario. Assumptions might
include prepayment rates on mortgages or surrender rates on insurance
products. Assumptions might also be made about the firm's performance—the
rates at which new business would be acquired for various products. Based upon
these assumptions, the performance of the firm's balance sheet could be

36
projected under each scenario. If projected performance was poor under specific
scenarios, the ALM committee might adjust assets or liabilities to address the
indicated exposure. A shortcoming of scenario analysis is the fact that it is highly
dependent on the choice of scenarios. It also requires that many assumptions be
made about how specific assets or liabilities will perform under specific
scenarios.

In a sense, ALM was a substitute for market-value accounting in a context of

accrual accounting. It was a necessary substitute because many of the assets
and liabilities of financial institutions could not—and still cannot—be marked to
market. This spirit of market-value accounting was not a complete solution. A firm
can earn significant mark-to-market profits but go bankrupt due to inadequate
cash flow. Some techniques of ALM—such as duration analysis—do not
address liquidity issues at all. Others are compatible with cash-flow analysis.
With minimal modification, a gap analysis can be used for cash flow analysis.
Scenario analysis can easily be used to assess liquidity risk.

Firms recognized a potential for liquidity risks to be overlooked in ALM analyses.

They also recognized that many of the tools used by ALM departments could
easily be applied to assess liquidity risk. Accordingly, the assessment and
management of liquidity risk became a second function of ALM departments and
ALM committees. Today, liquidity risk management is generally considered a part
of ALM.

ALM has evolved since the early 1980's. Today, financial firms are increasingly
using market-value accounting for certain business lines. This is true of universal
banks that have trading operations. For trading books, techniques of market risk
management—value-at-risk (VaR), market risk limits, etc.—are more appropriate
than techniques of ALM. In financial firms, ALM is associated with those assets
and liabilities—those business lines—that are accounted for on an accrual basis.
This includes bank lending and deposit taking. It includes essentially all
traditional insurance activities.

Techniques of ALM have also evolved. The growth of OTC derivatives markets
have facilitated a variety of hedging strategies. A significant development has
been securitization, which allows firms to directly address asset-liability risk by

37
removing assets or liabilities from their balance sheets. This not only eliminates
asset-liability risk; it also frees up the balance sheet for new business.

The scope of ALM activities has widened. Today, ALM departments are
addressing (non-trading) foreign exchange risks and other risks. Also, ALM has
extended to non-financial firms. Corporations have adopted techniques of ALM to
address interest-rate exposures, liquidity risk and foreign exchange risk. They
are using related techniques to address commodities risks. For example, airlines'
hedging of fuel prices or manufacturers' hedging of steel prices are often
presented as ALM.

Interpretation and management

Price Sensitive Gap

Under this methodology the impact on the economic value of balances sheet
items are evaluated based on shifts in a given term structure.

Step 1: Slot each asset and liability item of the balance sheet into their respective
maturity bucket.

Step2: Calculate the marked to market value of each item on the revaluation
date. This is will be denoted as the initial market value.

Step3: Recalculate a new marked to market value assuming shifts in the

underlying term structure.

Step4: Calculate the difference between the initial and new market values (and
the % change in the market value) to assess the gain or loss resulting from a
shift in the term structure.

38
Liquidity Gap
This approach evaluates the liquidity gap and assesses the overall concentration
of assets and liabilities across the maturity buckets.

The methodology followed is similar to rate sensitive gap however here the focus
is on liquid assets and liabilities rather than rate sensitive assets and liabilities.

Net Interest Income (NII) at Risk

This report shows the impact of interest rate shocks on cumulative gaps for on-
balance sheet and off-balance sheet items for different maturities as seen in the
Rate Sensitive report.

Duration Gap Analysis

The vulnerability of an institution towards the adverse movements of the interest
rate can be gauged by using the duration GAP analysis. This carried out using
the following procedure:

Step 1: Identify Interest rate sensitive assets and liabilities. Additionally, non –
interest rate bearing items can also be included in calculation.

Step 2: Calculate the MTM value for all the rate sensitive assets.

Step 3: Calculate the MTM value for all the rate sensitive liabilities.

Step 4: Calculate the duration for each asset and liability of the on-balance sheet
portfolio. This is calculated using Macaulay Duration.

Step 5: Calculate the aggregate weighted average duration of assets and

liabilities.

Weighted Average Duration of Assets (DA) = å WaDa

Weighted Average Duration of Liabilities (DL) = å WlDl

Where,

39
W a = market value of the asset ‘a’(MTM) divided by market value of all the
assets (Net MTM)

W l = market value of the liability ‘l’(MTM) divided by the market value of all the
liabilities (Net MTM)

Da = duration of asset ‘a’

Dl = duration of liability ‘l’

Step 6: Calculate the duration GAP using the following formula:

DGAP = DA – DL * MVL/MVA

Where,

DA is the weighted average duration of assets,

DL is the weighted average duration of liabilities,

MVL is the total MTM of liabilities,

MVA is the total MTM of assets.

Step 7: Calculate the change in the market value of equity for a Di % rise in
interest rates. This is approximated using the following formula:

DMVE @ (-DGAP) * Di * MVA / (1 + y)

Where,

Di = The change in the interest rate,

y = The effective yield to maturity of all the assets.

Balance sheet constraints

Asset-Liability Management Decisions in Private Banking

40
This research discusses the sources of added-value in private wealth management,
and argues through a series of illustrations that asset-liability management is the
natural approach for the design of truly client-driven services in private banking
Working from the observation that the contribution of asset-liability management
techniques developed for institutional investors is not yet familiar within private
banking, this study shows the expected benefits of a transposition of that kind.

Asset-liability management represents a genuine means of adding value to private

banking that has not been sufficiently explored to date. Within the framework of
private financial management offerings, personal wealth managers tend to confine
their clients to mandates that are only differentiated through their level of volatility,
without the client’s personal wealth constraints and objectives being genuinely
taken into account in order to determine the overall strategic asset allocation. In
that sense, private wealth management is not sufficiently different from the
management of a diversified or profiled mutual fund.

The private wealth management industry has now become a very significant
industry due to continuing strong economic growth in specific regions of the
world. This increase is currently driving a larger wealth management market
creating greater opportunities for wealth advisors to leverage new technology
with a view to acquiring new clients and boosting profits. As a result, competition
among wealth advisory firms is increasing to find ways to improve existing client
relationships and provide new tools to improve advisor efficiency. Current private
banking tools are typically tax and estate planning geared towards one specific
country and financial simulation software, relying on single period mean-variance
optimization of the asset portfolio. These tools suffer from significant limitations
and cannot satisfy the needs of a sophisticated clientele.

While some industry players have recently developed planning tools that model
assets in a multi-period stochastic framework, asset-liability matching for
individuals remains an area for exploration. This paper adapts Asset-Liability
Management (ALM) techniques developed for institutional investors to the
context of private banking customers. Asset-Liability Management (ALM) denotes
the adaptation of the portfolio management process in order to handle the
presence of various constraints relating to the commitments of an investor’s
liabilities. We argue that portfolio optimization techniques used by institutional
investors, e.g., pension funds, could usefully be transposed to the context of

41
private wealth management because they have been engineered precisely to
allow for the incorporation of an investor’s specific constraints, objectives and
horizon in the portfolio construction process. Taking investors' liability
constraints and specific objectives into account actually has a dramatic impact on
asset allocation decisions. For example, clients who wish to maintain a given
level of expenses for their retirement years will expect the investment process
performed on their current wealth to be able to generate cash-flows sufficient to
meet their consumption needs, which justifies a focus on inflation hedging that is
not typically involved in a standard asset management solution.

As an illustration, we consider the situation of an investor who wishes to invest

fixed annual contributions (€x) for a future expenditure, e.g., the purchase of a
house in 5 years, for which the current value is normalized at €100. We
introduce an explicit model for the dynamics of real estate prices and the exhibit
below shows the impact of real estate price uncertainty on the value of the €100
payment scheduled to be paid in 5 years from now. As we can see, real estate
price risk is significant, with a nominal amount to be secured equal to €156.59
on average and a €27.18 standard deviation.

Distribution of House Prices at final date

House Prices
Distribution of house prices at final date; mean value = 156.59; standard deviation = 27.18.
In practical terms, the goal is to generate a lump sum payment at horizon date
(5 years). It is not possible in general to find a perfect liability-matching
portfolio. The existence of a perfect liability-matching portfolio is actually only
ensured on the following two conditions: the investor must be able to borrow
against future income and invest the present value of the future contributions at
the initial date; and there must be an investment vehicle (e.g., REITS) with a
payoff which is directly related to real estate price uncertainty. We test two
different situations: an opportunity set containing stocks, bonds and TIPS and an
opportunity set containing stocks, bonds, TIPS and real estate (modelled as an
investment that will pay the compounded return on real estate). To generate
comparable portfolios, we looked at the improvement in surplus volatility for a
given level of expected surplus.

42
 ALM Efficient Frontiers without Real Estate (A, B, C, D, E, F) and with Real Estate (A’, B’, C’, D’, E’, F’)

Allocation strategies and risk-return indicators; all values are given as present values at initial date based on a
€20 annual contribution for 5 years, the present value of which amounts to €90.91 given our choice of parameter
values. Expected shortfall is expressed as a percentage of this value. The relative contribution saving
corresponds to the increase (in percentage) in initial investment that should have taken place with a given
strategy so as to generate an expected surplus equal to zero.
The graph shows the efficient frontier in both cases, while risk-return indicators
are reported in the table. As expected, the presence of assets allowing investors
to span real estate price uncertainty proves to be a key element in improving the
efficient frontiers obtained from an ALM perspective. Looking for example at
portfolio D and D’ in the table, we see that for the same level of expected
surplus (12.60 in both cases), the surplus volatility at the optimal level reaches
21.95 when the opportunity set does not contain a real estate asset, while it
merely amounts to 4.25, a dramatic risk reduction, when the real estate asset is
included. Again this signals the relevance of an ALM approach to private wealth

43
management: it is only by trying to fit the client liability constraints that truly
optimal solutions can be proposed.

In the same vein, we also consider a number of other illustrations that are
typical of standard private wealth management problems and show that optimal
solutions are strongly affected by the presence of liability constraints. In
particular, we focus on various pension-related objectives and consider an
individual who is either already retired or still employed, and who seeks to
ensure a stream of inflation-protected fixed payments, based either on a lump-
sum contribution or a series of annual contributions. We also introduce a variety
of bequest-related objectives.

In conclusion, we argue that it is not the performance of a particular fund nor

that of a given asset class (including commodities or hedge funds) that will be
the determining factor in the ability of private wealth management to meet
investors’ expectations. What will prove to be the decisive factor is the private
wealth manager’s ability to design an asset allocation solution that is a function
of the kinds of particular risks to which the investor is exposed, as opposed to
the market as a whole. Hence, an absolute return fund, often perceived as a
natural choice in the context of private wealth management, would not be a
satisfactory response to the needs of a client facing long-term inflation risk,
where the concern is capital preservation in real, as opposed to nominal, terms.
Similarly, a client whose objective would be related to the acquisition of a
property would accept low and even negative returns in situations when real
estate prices significantly decrease, but will not satisfy himself or herself with
relatively high returns if such high returns are not sufficient to meet a dramatic
increase in real estate prices. In such circumstances, a long-term investment in
stocks and bonds with a performance weakly correlated with real estate prices
would not be the right investment solution.

In other words, the success or failure of the satisfaction of the client’s long-term
objectives is fundamentally dependent on an ALM exercise that aims to
determine the proper strategic inter-classes allocation as a function of the
client’s specific objectives and constraints. Asset management should only come
next as a response to the implementation constraints of the ALM decisions. On
the one hand, it is meant to deliver/enhance the risk and return parameters
supporting the ALM analysis for each asset class. On the other hand, it can also
allow for the management of short-term constraints, such as capital preservation
at a given confidence level, which are not necessarily taken into account by an
ALM optimization exercise, which by nature focuses on long-term objectives.

Return on equity

Return on equity (ROE) measures the rate of return on the ownership interest
(shareholders' equity) of the common stock owners. It measures a firm's
efficiency at generating profits from every unit of shareholders' equity (also
known as net assets or assets minus liabilities). ROE shows how well a company
uses investment funds to generate earnings growth.

44
The formula

\mathrm{ROE} = \frac{\mbox{Net Income after tax}}{\mbox{Shareholder

Equity}} [1]

ROE is equal to a fiscal year's net income (after preferred stock dividends but
before common stock dividends) divided by total equity (excluding preferred
shares), expressed as a percentage. As with many financial ratios, ROE is best
used to compare companies in the same industry.

High ROE yields no immediate benefit. Since stock prices are most strongly
determined by earnings per share (EPS), you will be paying twice as much (in
Price/Book terms) for a 20% ROE company as for a 10% ROE company. The
benefit comes from the earnings reinvested in the company at a high ROE rate,
which in turn gives the company a high growth rate.

ROE is presumably irrelevant if the earnings are not reinvested.

* The sustainable growth model shows us that when firms pay dividends,
earnings growth lowers. If the dividend payout is 20%, the growth expected will
be only 80% of the ROE rate.

* The growth rate will be lower if the earnings are used to buy back shares. If
the shares are bought at a multiple of book value (say 3 times book), the
incremental earnings returns will be only 'that fraction' of ROE (ROE/3).

* New investments may not be as profitable as the existing business. Ask

"what is the company doing with its earnings?"

* Remember that ROE is calculated from the company's perspective, on the

company as a whole. Since much financial manipulation is accomplished with
new share issues and buyback, always recalculate on a 'per share' basis, i.e.,
earnings per share/book value per share.

The DuPont formula

The DuPont formula, also known as the strategic profit model, is a common way
to break down ROE into three important components. Essentially, ROE will equal
the net margin multiplied by asset turnover multiplied by financial leverage.
Splitting return on equity into three parts makes it easier to understand changes
in ROE over time. For example, if the net margin increases, every sale brings in

45
more money, resulting in a higher overall ROE. Similarly, if the asset turnover
increases, the firm generates more sales for every unit of assets owned, again
resulting in a higher overall ROE. Finally, increasing financial leverage means
that the firm uses more debt financing relative to equity financing. Interest
payments to creditors are tax deductible, but dividend payments to shareholders
are not. Thus, a higher proportion of debt in the firm's capital structure leads to
higher ROE. Financial leverage benefits diminish as the risk of defaulting on
interest payments increases. So if the firm takes on too much debt, the cost of
debt rises as creditors demand a higher risk premium, and ROE decreases. [2]
Increased debt will make a positive contribution to a firm's ROE only if the
matching Return on assets (ROA) of that debt exceeds the interest rate on the
debt.

A system of analysis has been developed that focuses the attention on all three
critical elements of the financial condition of a company: the operating
management, management of assets and the capital structure. This analysis
technique is called the "DuPont Formula". The DuPont Formula shows the
interrelationship between key financial ratios. It can be presented in several
ways.

The first is:

Formula 7.41
Return on equity (ROE) = net income / total
equity

If we multiply ROE by sales, we get:

Return on equity = (net income / sales) * (sales / total
equity)

Said differently:
ROE = net profit margin * return on equity
The second is:
Formula 7.42
Return on equity (ROE) = net income / total equity

If in a second instance we multiply ROE by assets,

we get:
ROE = (net income / sales) * (sales / assets) * (assets /
equity)

Said differently:
ROE = net profit margin * asset turnover * equity
multiplier

Uses of the DuPont Equation

By using the DuPont equation, an analyst can easily determine what processes
the company does well and what processes can be improved. Furthermore, ROE
represents the profitability of funds invested by the owners of the firm.

All firms should attempt to make ROE as high as possible over the long term.
However, analysts should be aware that ROE can be high for the wrong reasons.
For example, when ROE is high because the equity multiplier is high, this means

46
that high returns are really coming from overuse of debt, which can spell
trouble.

If two companies have the same ROE, but the first is well managed (high net-
profit margin) and managed assets efficiently (high asset turnover) but has a low
equity multiplier compared to the other company, then an investor is better off
investing in the first company, because the capital structure can be changed
easily (increase use of debt), but changing management is difficult.

More Useful Dupont Formula Manipulations

The DuPont formula can be expanded even further, thus giving the analyst more
information.

Formula 7.43
ROE = (net income / sales) * (sales / assets) * (assets / equity)

If in a third instance we substituted net income for EBT * (1-tax rate),

we get:

ROE =(EBT/sales) * (sales / assets) * (assets / equity)* (1-tax rate)

Formula 7.44
ROE = (net income / sales) * (sales / assets) * (assets / equity)

If in a forth instance we substituted EBT for EBIT - interest expense, we

get:

ROE = [EBIT / sales * sales / total assets – interest / total assets] * total
assets / equity * [1 – tax / net before tax]

Said differently:

ROE = operating profit margin * asset turnover – interest expense rate *

equity multiplier * tax retention

Interest rate and market pointers

The credit crisis has intensified during the last few weeks to a new manic stage
as entire countries are put at risk of bankruptcy due to their banking system
rescue attempts exploding liabilities, as the demand goes out for 100%
guarantees of depositors and country after country buckles under the pressure
so as to prevent a collapse of their individual banking systems. However ever
increasing and desperate government bailout cash in the form of escalating
amounts of daily interbank liquidity, capital injections, and mortgage bond buy
back schemes in addition to issuing depositor guarantees increases the liabilities
of ALL countries the immediate consequences of which are being played out in
ever increasing volatility in the currency markets and stock exchanges as record
breaking points swings take place on alternative days. In such a panic stricken
climate there are increasingly deafening calls are for immediate interest rate cuts
across the western world including for an Imminent UK Interest Rate Cut.

47
The effect of the crisis is to make the interest rate forecasting utilising the more
traditional methods of forecasting less relevant in exchange for market trends in
their likely response to government rescue initiatives i.e. this year’s UK interest
rate forecast will seek to focus more on the capital markets, than inflation and
money supply whilst also taking into account that the pace of economic
contraction is escalating far faster than that which is reflected in economic data
released to date. The only economic data that is inline with the current state of
the economy are UK house prices which have been crashing over the summer
months.

My most recent analysis prior to the September 08 Bank of England MPC Interest
rate decision meeting suggested that September would be the last month that
rates will be kept on hold which has been reinforced by subsequent crisis events
as the cry's for an immediate UK interest rate cut reach a crescendo in response
to a banking system collapse panic situation.

Previous UK Interest Rate Forecasts

Interest rate analysis and forecasts for the previous 2 years have proved
remarkably accurate, more so in that at the time they were contrary to the
consensus views.

November and December 2006 - UK Interest rates to peak at 5.75% by

September 2007. - Actual - UK Interest rates peaked at 5.75%.

August and September 2007 - UK Interest rates to fall to 5% by September

2008. UK interest rates fell from a peak of 5.75% and were hold at 5% by the
end September 2008.

Impact of Global Deleveraging

Global deleveraging is taking place as financial intuitions are forced to liquidate

assets such as property, stocks, bonds and commodities to cover losses on huge
derivatives positions that is intensify as evidenced by Iceland's government
instructing their financial institutions to repatriate wealth by liquidating over seas
assets in defence of the Icelandic Krona as the country faced bankruptcy.

The Prime Minster of Iceland, Geir Haarde, on Monday warned: "In the perilous
situation which exists now on the world's financial markets, providing the banks
with a secure life line poses a great risk for the Icelandic nation," Haarde said in
a televised address to the nation. "There is a very real danger, fellow citizens,
that the Icelandic economy, in the worst case, could be sucked with the banks
into the whirlpool and the result could be national bankruptcy."

In my analysis of 2nd October 08, I warned that the natural outcome of the
credit crisis would be that countries would also start to go bankrupt that would
manifest itself along the hyperinflationary bust of the 1920's German Weimar
republic.

48
Meanwhile, the more forced selling takes place the lower asset prices fall which
triggers even more forced selling as derivatives positions both on exchanges and
over the counter which nearly always tend to be on margin of as much as X30
exposure against the capital deployed are hence either being forced to liquidate
positions are meet margin calls. Therefore deleveraging is intensifying as the
only way to finance margin payments is by selling assets as the traditional
avenues for short-term money are frozen.

This also means that the impact of interest rate cuts will be muted as it will not
induce the banks to lend more because they will not have any available funds to
lend, nor are able to borrow money from other banks at as the interbank market
freeze hits a new extreme where the only source for both liquidity and capital is
now from the central banks and governments. Any capital injections will be
utilised to cover losses and not be utilised to provide new mortgages or other
lending as the banks face a wall of defaults on existing loans.

Interest Rate Impact - This will imply deep interest rate cuts due to the relatively
muted impact on the banking sector and UK economy.

Crude Oil Price Collapse

Crude Oil peaked in early July 2008 at $148, at the time my analysis called for a
down trend towards $80 over the next 3 to 6 months as a consequence of
deleveraging of crude oil positions having been used as a vehicle to hedge
against inflation. ( Crude Oil Parabolic Move Driven by Inflation Hedging that
Could Unwind) as the below graph illustrates, so far the trend to date has been
in line with expectations due to deleveraging ahead of a global recession and
economic deflation.

Therefore the the crude oil trend to date is highly deflationary going beyond the
current spike in inflation and supports the view for deep UK interest rate cuts.
That under normal conditions would be pending an actual drop in UK inflation
data but under the current panic situation will be acted on before the fall in oil
prices make themselves apparent in official inflation data.

UK CPI Inflation

The Bank of England's recent inflation report forecast that UK inflation will hit 2%
CPI in two years time, the same as the Bank forecast 2 years ago where UK
inflation would be today, instead UK CPI inflation has Soared to 4.7% for
August . To date the Bank of England has only succeeded in hitting its inflation
target for 5 months out of the 5 years that the BOE has been targeting 2% CPI
inflation, the tendency has been for an average deviation of 0.8% from the
Banks inflation target. Therefore this implies an inflation range expectation for 2
years forward of between 1.2% and 2.8% i.e. for inflation to either be
significantly above the Banks target of 2% or significantly below the banks target
and is indicative of the continuing failure of the Bank of England to actually
control the UK's rate of inflation which contributes to the boom and bust cycle as
clearly the BOE is failing in its duty to set monetary policy to comply with the
Governments target of 2% CPI.

49
The actual inflation trend shows an ongoing spike higher in the CPI to 4.7%,
however inflation data is a lagging the real economy and does not yet reflect the
sharp slowdown of the UK economy over the last 2 months, nor is the impact of
the fall in oil prices from $147 to $90 over the last 2 months. Therefore this
implies inflation data will start to become muted in the coming months in
advance of a similarly sharp drop on par with the spike higher. However inflation
for September given the momentum behind inflation may yet carry the CPI
inflation higher towards 5%. The RPI is already showing signs that the spike
higher is over and that a decline in inflation is on the cards going forward.
Inflation from an imminent peak is targeting a trend back towards 3% by late
2009.

Therefore the conclusion is for UK inflation to target a peak of between 4.9% and
5.1% by October 2008 data, and to start a sharp decline thereafter towards a
August 2009 target of 3%. This would still put CPI inflation at the Bank of
England's upper limit of of 3% and therefore implies government pressure for
the Bank to suspend inflation targeting as I suggested several times over the last
6 months.

Impact on Interest Rates - This suggests that the scope for deep cuts in UK
interest rates is limited despite a fast weakening UK economy.

Stock Market Meltdown

The stock markets are exhibiting extreme short-term volatility which means it is
basically a Reactive traders market than a forward looking forecasters market,
nevertheless the market is oversold on many measures, especially the VIX
volatility indicator which exploded to a new all time high of above 55, this shows
EXTREME FEAR as market participants scrambled to hedge against further
declines and possibly a crash by buying mainly PUT options. This extreme level is
usually associated with imminent significant stock market bottoms. However the
VIX has been elevated at a level of above 40 for several weeks which illustrates
that we are living through historic events the likes of which have not been seen
since the 1987 crash.

Therefore whilst the stocks bear market is a long way from a bottom as
corporate earnings continue to contract in the face of economic recession, the
current stock market panic bottom may be imminent in terms of TIME , which on
a seasonal basis implies a rally into the November US presidential election,
though barring any further screw-ups in disunity amongst European
governments. as we witnessed on Monday.

Stock markets have achieved what can be expected during a normal bear market
of having fallen by as much as 40%, therefore this implies that the downside is
limited. However the damage has been done as fear and panic grips investors in
the face of crashing markets which is economically highly deflationary as
companies seek to cut back on investments both in the face of inability to borrow
and in advance of economic contraction. Therefore corporate earnings will fall for

50
at least the next 12 months which implies a subdued stock market after the
current panic phase has passed.

Impact on Interest Rates - The stock market panic increases the probability for
deep and prolonged series of UK interest rate cuts as there is little fear of
igniting a speculative bubble in equity market.

UK Housing Market Crash 2007 to 2008

The Halifax's latest house price data shows that the housing market crash
continued to accelerate into August, plunging by 1.7% that saw another £3000
wiped off house prices following the £3,300 write off for July to stand at down
12.8% on the year to August (on a non seasonally adjusted basis). UK house
prices have now fallen by more than 8% since April. If a fall of 8% in 4 months
cannot be considered a crash in UK house prices than I do not know what can.
No wonder Chancellor Darling virtually threw in the towel early September in his
famous "I give up, please let me spend more time with my family" speech. The
expectations for the house price crash to have continued during September on
release of data.

The housing market's near 13% plunge in 12 months is having a severe impact
on the whole of the UK economy, as falling house prices are directly impacting
on the Uk economy in a like for like basis, after the Financial Sector those
sectors closest to the housing market contracting the sharpest, followed by
consumer sector and eventually echoing out through the economy. The only
glimmer of hope is for the exporters as the British Pound itself has crashed
during the past 6 weeks.

Britain is facing the the PERFECT STORM of DEFLATION as the housing bear
market erodes home owner equity by several thousands of pounds every month,
and INFLATION in the input and output prices surging to 20 year highs. This has
meant that instead of taking action to save the economy, save the housing
market, the Bank of England has been paralysed since April of this year into
inaction.The fact is the Bank of England did not have a clue of what to do so
sought to do nothing as the situation is far more complex than it appears on face
value given the previously hidden fact that most of the banks are bankrupt,
insolvent !, its just that no one was going to tell the public until they started to
go bust, instead the banks coasted from quarter to quarter announcing ever
larger bad debt provisions and calls for government tax payers cash in exchange
for near worthless mortgage backed illiquid toxic putrid slime that has to
smeared itself right across the whole financial and economic system and brought
the UK financial system to the brink of collapse and therefore pushing Britain
towards a deep dark stagflationary recession.

Where Do House Prices Go From Here?

The current crash in UK house prices has been fore warned by myself several
times during the last 12 months, right from before the housing market peaked in
August 2007 and with the explicit warning in November 07 of a housing market
crash starting in April 08, which was elaborated upon the article at the beginning

51
of April 08 - UK House Prices Plunge Over the Cliff and over the summer months
UK House Price Crash In Progress!

The existing forecast for a minimum fall at the rate of 7.5% per annum as of
August 2007 is now due for imminent update to extrapolate a trend for UK house
prices for at least 2 years forward. Whilst this analysis is yet to be completed
and published , I can give a quick outlook for as the housing market which has to
contend with multiple factors each tugging house prices in both directions for
instance, sterling falling by more than 15% since August is highly inflationary
and would tend to support house prices as your house in dollar terms has not
fallen by 1.7% in August but rather by about 16.7%!. Another positive factor in
terms of nominal house prices is the impact of the panicking Brown governments
interventions into engineering a bottom in nominal house prices. More on these
and other factors in the forthcoming housing market forecast.

Impact on Interest Rates - The continuation crash in UK House prices that is

pulling the whole economy down with it is crying out for imminent deep interest
rate cuts.

UK Economy - GDP Growth Trend

The UK economy is expected to enter into a recession by the end of this year,
this compares against forecasts by many financial institutions including the IMF
and OECD for growth for 2008 of between 2% and 2.5%, at the time (Dec 07) , I
forecast UK growth for 2008 of 1.2%, which appeared overly pessimistic at the
time and now looks very optimistic.

As with the United States entering into economic depression the UK economy will
suffer as a direct consequence of the housing bubble bursting. The UK economy
is only now starting to enter into a recession that will likely last at least 12
months and probably more in the region of 18 months to 2 years. As the only
real recovery will take place once the UK housing market bottoms. The forecast
for 2009 GDP will be published on release of quarter 3 GDP data during
November 2008.

Interest Rate Implications - As bad economic data is revealed there will be

greater pressure on the Bank of England to continue cutting interest rates.

Economy - Retail Sales

The most recent official released monthly retail sales data again demonstrated
the inbuilt trend inaccuracy by reporting a 1.2% rise in August 2008, up 3.4% on
the year and in the face of the UK economy slumping fast into recession. Whilst
the mainstream media mistakenly concentrates on explaining why retail sales
rose, I refer readers to the below two graphs, one of the official retail sales data
and the second of the inflation indexed and trend adjusted retail sales which
more accurately reflects the current true state of distressed retailers than the
wild month to month gyrations of official data that literally switch between boom
and bust statistics on a monthly basis.

52
Even the venerable Financial Times reports puzzlement at the data- Surprise rise
in UK retail sales - " These numbers are still puzzlingly strong compared to the
much gloomier message coming from the retail surveys, consumer confidence
figures and anecdotal evidence,” said Jonathan Loynes, economist at Capital
Economics. “”As such we suspect that the (Bank of England's) Monetary Policy
Committee will treat them with a pinch of slat when considering the overall
strength of the household sector.”

The only thing puzzling is the lack of analysis performed on the data series to
determine the underlying trend which as clearly been bearish for several years
which has been reflected in the relative under performance of the retailers stock
prices.

Whilst official data suggests healthy growing positive retail sales at 3.4% year on
year as though everything is rosy in the high street, the real state of the UK high
street as per trend and inflation adjusted data illustrates a slump in retail sales
activity that is contracting at the rate of -1.9% year on year and reflects the
actual state of the retail sales market. This trend is expected to continue
deteriorating for the duration of the imminent recession as more retailers report
losses and in fact go out of business.

Implication for Interest Rates - The retail sector is experiencing extreme distress
that will become apparent in the coming months, therefore supports a sustained
campaign of interest rate cuts.

British Pound Trend

The US Dollar continues to benefit from scared capital seeking shelter in US

Dollar short-term money market funds and treasury bonds. My analysis of
August 2008 (The US Dollar Bull Market) implied that the US Dollar had now
embarked on a bull market that was destined to reach to USD 90 from a low of
71. However the credit chaos complicates the picture somewhat as we enter into
a new era of less of free markets and more government intervention, therefore
the currency markets are far more at the mercy of ever increasing desperate
government actions to prevent economic depression.

The fall in the British Pound amounting to 18% from a peak of £/$2.11 to the
recent dip to below £/$1.74 is highly inflationary as commodities and much of
international trade is generally priced in US Dollars, therefore over the last 2
months the fall in sterling will trend to feed through into forward inflation.

The next target for the British Pound in the ongoing bear market is for an assault
on the £/$1.70 low. However, the Pound may find temporary support in the near
term above £/$1.7250 given its generally oversold state.

Implications for Interest Rates - The fall in the British Pound is inflationary and
would tend to imply interest rate cuts will be muted. Sterling is in a Bear market
against the Dollar therefore the trend is expected to continue down after a
pause.

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LIBOR Interbank Market Tsunami Waves and Earthquake

The credit crunch tsunami waves that have been crashing into the banking sector
in huge waves over the past year, with each freeze claiming more financial
institutions as evidenced by the lack of confidence amongst interbank market
participants which has meant that the only source of short term financing has
been via the central banks.

Following Lehman's bust the already high LIBOR interbank spread leapt towards
the stratosphere as the worlds financial system edged ever closer to total
collapse. In the UK the key triggers were the attacks on HBOS by hedge fund
short sellers that smelled blood in the wake of Lehman's bankruptcy. US
government indecision over the bailout plan did not help which further escalated
the freeze in the money market which have so far failed to respond to the huge
inflows of liquidity from the worlds central banks. This was followed by the
weekend of 27th Sept news of the nationalisation of Bradford and Bingley as
further evidence that literally ALL banks were at risk of collapse and thus
defaulting on their counter party obligations.

The chaos that ensued following Irelands 100% guarantee of depositors led to
mini-runs across Europe as desperate savers sought safety from collapsing
banks. This pushed the interbank spread to a new credit crisis extreme that was
not helped by the near bankruptcy of the small north atlantic country Iceland
who's banks had leveraged up the countries bad debts to more than six times
the countries annual GDP with implications that 300,000 UK savers could lose
substantial sums of money.

54
Interest Rate Implications - The interbank spread more than anything else is
signaling the need for urgent immediate action to prevent a collapse of the UK
banking system. We are talking of a deep series of cuts in an attempt to
unfreeze the money markets as the current rate of 6.30% is substantially above
base interest rate of 5%, therefore acts as an interest rate hike. The usual
market expectation is for there to be a small difference between the base
interest rate and the interbank rate. In a rate cutting environment the interbank
rate would tend to discount future cuts in base rates but, therefore the interbank
rate should be trading BELOW the base interest rate i.e. at around 4.75%,
instead the 6.30% is shockingly representative of the credit crisis earthquake
that is taking place on the money markets. Interest rate cuts will have the effect
of reducing the headline rate even if the differential remains i.e. a cut to 4.5%
should imply an interbank rate of 5.80% with further government measures
taken with the aim of towards convergence with the base interest rate.

How Can the Banks be Going Bankrupt ?

The question I am most asked is how can banks be going bust due to just a few
US subprime mortgages. Without going deep into the whole history and
sequence of events which led to the current situation which dates back to Japan
entering into an economic depression, deregulation of capital markets during the
1990's in the wake of the collapse of the Soviet Union and the deflation of cheap
Chinese goods coupled with manipulated government inflation statistics.
Followed by the Dot com crash and post Sept 11th deep US interest rate cuts
which ignited the housing bubble, with similar deep rate cuts amongst other
western economies.

The reason why the banks are going bust in simple terms is:

The banks traded in complex derivatives products between themselves, in what

is termed as the over the counter market. The exposure to the Securitized debt
packages was further exaggerated by the use of leverage of in many cases more
than 30X the banks assets against valuations based on complex models that
inflated the packages values during the boom times which allowed huge profits
and bonuses to be banked (Fraud?). However the critical point is in the final link
in a long chain of sliced and diced debt packages was the US housing market.

As US house prices fell, the gap between the real value and the banks inflated
model values to boost profits grew, until the crunch point of August 2007, when
it dawned upon market participants that in actual fact they did not have a clue
as to the real value of these mortgage backed securities and hence the credit
markets froze as no one wanted to buy something they could not value and nor
lend to financial institutions that may default on their obligations. The impact hit
all banks, whether or not they had exposure to the US housing market, as those
banks whose business model relied heavily on the short-term money markets to
finance long-term mortgages were in deep trouble, i.e. Northern Rock and to a
lesser extent ALL of the other UK mortgage banks.

Now many banks are left with assets that are worth LESS than 50% of their
"mark to market" booked value. Now that does not mean a 50% loss for the

55
banks on investments, remember the greedy banks deployed LEVERAGE of as
much as 30 times of assets, so capital of say £100 million is controlling risk of as
much as £3,000 million. Therefore a 50% loss results in a loss of value of £1,500
million, that's 15 TIMES the capital. Hence the banks have been reluctant to
price their debt packages at the real market price as that would mean that the
bank is effectively bankrupt with losses far greater than the banks capital base.
So the market remains frozen until all of the illiquid mortgage backed debt has
been transferred over to the tax payers in exchange for liquid cash, hence
prompting the US Mother of All bailouts plan.

So Basically there are TWO related problems at work driving the Banks Bust:

1. One of collatorised debt that is not being valued at market prices, hence
frozen money markets with banks sitting on over leveraged time bombs that
have started to explode in recent weeks, as the credit markets tighten further.

2. Mortgage banks reliant on short-term money markets to finance long-term

mortgages that threw caution to the wind and loaned far too much money to
people who could not afford to repay the mortgages are now being hit by
increasing defaults as the western housing markets crash from over inflated
'bubble' levels, as their losses mushroom but now find that they are unable to
borrow money to cover day to day operations due to the increased risk of default
and thus hoarding of cash (if they have any left) amongst investment banks in
advance of further asset price mark downs. Therefore the only avenue available
for short-term cash is from either the Bank of England or individual savers,
hence high savings interest rates relative to the base interest rate of 5%.

And there's more .... mortgage backed securities are the tip of the credit crunch
iceberg, the next inline are credit default swaps which are basically investor
insurance to protect themselves against losses on the debt packages. However
as we saw with collapse of and nationalisation of the worlds biggest insurer AIG,
this is another huge part of the derivatives market that is imploding, perhaps in
the region of $60 trillion. Its the reason why ordinary people are going to find
problems with the credit card freeze next as defaults rise and retailers start to
charge a premium on card transaction due to risk of default on the transactions,
or even refuse to accept credit cards, but that has yet to happen.

Government Emergency Action, Bank of England Loss of Control

The government, Bank of England and Regulator are in emergency talks aimed
towards rescuing the British banking system from collapse. The expectation is
that the banks will provide capital injections totaling of as much as £50 billion,
that would mean inflating the countries national debt by 10% busting through
the 40% debt to GDP rule. This IS an emergency move to prevent an imminent
collapse of the UK banking system. This highly inflationary in monetary terms,
but deflationary in economic terms i.e. .your money buys less but at the same
time you have less money to spend! This is in addition to the estimated losses as
a consequence of nationalisation of Northern Rock and Bradford and Bingley of
£40 billion, therefore the UK debt has been inflated by £90 billion, with another
£150 billion loaned out to the banks with perhaps a default rate of 20% implying

56
another loss of £30 billion. That is a total cost to the UK tax payer to date of
some £120 billion with the potential to explode yet higher towards £200 billion
plus. The £200 billion figure is not born out of hindsight for in the analysis of
22nd April 2008, I specifically warned that the costs of bailing out the banks by
means of nationalisation and exchange of cash for illiquid mortgage back
securities would explode to over £200 billion this year . In the analysis of April
08, I voiced the concern that the governments debt ceiling of 40% would soon
be busted through onward sand upwards to 60% of GDP by late 2009. Recent
events put Britain directly on this path to exceed 60% of GDP with all of the
consequences in terms of currency devaluation.

Avoiding the Mistakes of Japan

The key mistake that the government of Japan made was to not allow any banks
to fail. Therefore as we have witnessed with banks being broken up and
liquidated such as Bradford and Bingley and Iceland's Landanski, that bad banks
must be allowed to go bust however without any consequences to depositors.
This will be much better in the long-run than the American $700 billion bailout
which implies that many bad banks will be allowed to survive as the $700 billion
objective is to buy bad debts from the banks at inflated prices. The UK proposal
for capital injections for a share in the banks is a much better proposal. However
the expectation is that all over the world many governments including the UK,
will still follow the US example of buying bad debts rather than the ordinary
dismantling of bankrupt banks.

Bank of England Inflation Remit Changed

Another aspect of the multi-pronged rescue attempt is by liberating the Bank of

England from its primary objective which is to peg inflation between 1% and 3%.
With current inflation on an upward curve to 5%, which effectively means the
Bank of England has been paralysed into a state of inaction. However I have
specifically warned several times over the last 6 month, that as the credit crisis
progresses there will come a time when the Government will force the Bank of
England to abandon inflation targeting and CUT UK interest rates regardless. So
as to support the banking sector and the wider economy from crashing into a
deep dark recession. The spin given on this event will be that the inflation
outlook 2 years forward will be benign and therefore justifies immediate action.
However as I have pointed out earlier that the Bank of England's inflation
forecasts are consistently wrong.

The consequences of abandoning the inflation target will in actual fact prove
highly inflationary beyond the scope of this forecast for the next 12 months I.e.
we will pay the price of the increasing anticipated emergency actions of rate cuts
and money printing for many years in subdued economic activity.

However in the meantime there are far more deflationary forces at work as the
financial markets crash, and house prices crash and the UK economy crashes
than any forward inflationary pressures and therefore there WILL BE DEEP UK
INTEREST RATE CUTS regardless of current inflation statistics.

57
UK Interest Rate Forecast Conclusion

A series of Emergency UK Interest Rate Cuts is imminent to prevent a collapse of

the UK financial system and therefore the UK economy. The government will give
the Bank of England the green light to ignore its inflation target, therefore the
expectation is for a near immediate cut in interest rates by probably as much as
0.5% by this Thursdays (9th October) MPC Meeting to 4.5%, to again be
followed by a similar move next month (November) . This will mark the first of a
series of rate cuts that will trend towards our interest rate target of 3.25% by
September 2009 as the below graph illustrates:

Matching and mismatching

Liquidity management is required for all savings products to ensure cash is

available on demand by clients

Increased demands for credit may also follow disasters or other significant
events, and ensuring available credit to meet demand in emergency situations is
important

Asset-liability matching (ALM) may also be required to optimise assets backing

reserves for insurance business

58
ALM exercises can be useful for this.

Considerations

Savings accounts for dedicated purposes like healthcare savings accounts

require validation that the withdrawal is to meet designated needs

Demand for funds from healthcare savings accounts may be very volatile, and
accounts should be backed with very liquid assets

Savings accounts used to fund future ART may be held for a long period of time
before accessing, and should be appropriately invested into higher yielding
assets if possible.

Management information reporting

Covering and hedging

Institutional Investment - June 16, 2010

EDHEC-Risk Survey of the Asset-Liability Management
Practices of European Pension Funds
Why Pension Funds Should Favour Rule-Based Strategies over Discretionary Ones
EDHEC-Risk Institute took a recent survey of pension funds, their advisers,
regulators, and fund managers. One hundred twenty-nine of these asset/liability
management (ALM) specialists, representing assets under management (AUM) of
around €3 trillion, responded to the survey. Pension funds and their sponsors
account for approximately €0.9 trillion.

ALM involves covering liabilities and generating performance; in addition,

pension funds must respect their minimum funding ratios, or, more broadly,
achieve their goals. In the end, proper ALM requires three forms of risk
management. Covering liabilities requires hedging risks; generating performance
in efficient portfolios requires diversifying risks; ensuring that minimum funding
ratios and other constraints are respected at all times requires insuring risks
away.

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The first challenge for a pension fund involves meeting its liability by fully or
partially hedging it away. The survey suggests that the liability-hedging portfolio
(LHP) is modelled imprecisely at 45% of pension funds. From an academic
perspective, liability-driven investing (LDI) is an example of life-cycle investing
(Viceira 2007).

The second challenge for pension funds is to gain access to performance through
optimal diversification within an asset class and between asset classes. We find
that 66% of respondents use market indices to define the investment
benchmarks of investment funds, even though market indices are weighted by
capitalisation and are known to be highly inefficient. In addition, pension funds
invest relatively little in alternative and potentially illiquid assets, though pension
funds are the longest-term investors and are not subject to liquidity risk. The
average cumulative weights of investments in hedge funds, private equity, and
infrastructure come to less than 15%, and, combined with real estate,
investment in these asset classes is less than 25%.

Last, pension funds must ensure they respect their minimum funding ratios and
other constraints by insuring risks away. To do so, they must define risk budgets
and risk-controlled investing (RCI) strategies that involve forgoing upside
potential in exchange for protection on the downside. The survey suggests that
pension funds generally understand risk-controlled investing more often than
they use it: RCI, which insures against a fall in funding ratios below the required
minimum, is understood by 53% of pension funds but used by only 27%.
Twenty-eight percent of respondents use RCI, whereas 56% use
economic/regulatory capital to manage prudential constraints. Like RCI,
economic capital relies on the measure of a risk budget and of a surplus.
Economic capital, however, involves a discretionary, as opposed to rule-based,
investment strategy, and possible implementation delays. We thus recommend
that pension funds rely more heavily on rule-based strategies in their economic
capital models.

The majority of respondents have a blinkered view of the risks they face:
prudential risk (the risk of underfunding) is managed by only 40% of
respondents, accounting risk (the volatility from the pension fund in the accounts
of the sponsor) by 31% of respondents. More than 50% of respondents ignore
sponsor risk (the risk of a bankrupt sponsor’s leaving a pension fund with
deficits).

Last, pension funds generally do not assess the adequacy of their ALM. Thirty
percent of respondents do not assess the performance of the design of the
performance-seeking portfolio, and more than 50% use crude outperformance
measures. These failings may lead to sub-optimal decisions’ being taken again
and again.

This research was produced as part of the "Regulation and Institutional

Investment" research chair sponsored by AXA Investment Managers.

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Money Market

Markets and interest rates

Whenever a bear market comes along, investors realize (yet again!) that the
stock market is a risky place for their savings. It's a fact we tend to forget while
enjoying the returns of a bull market! Unfortunately, this is part of the risk-
return trade-off. To get higher returns, you have to take on a higher level of risk.
For many investors, a volatile market is too much to stomach - the money
market offers an alternative to these higher-risk investments.

The money market is a component of the financial markets for assets involved in
short-term borrowing and lending with original maturities of one year or shorter
time frames. Trading in the money markets involves Treasury bills, commercial
paper, bankers' acceptances, certificates of deposit, federal funds, and short-
lived mortgage- and asset-backed securities. It provides liquidity funding for the
global financial system.

The money market is a subsection of the fixed income market. We generally

think of the term fixed income as being synonymous to bonds. In reality, a bond
is just one type of fixed income security. The difference between the money
market and the bond market is that the money market specializes in very short-
term debt securities (debt that matures in less than one year). Money market
investments are also called cash investments because of their short maturities.

Money market securities are essentially IOUs issued by governments, financial

institutions and large corporations. These instruments are very liquid and
considered extraordinarily safe. Because they are extremely conservative,
money market securities offer significantly lower returns than most other
securities.

One of the main differences between the money market and the stock market is
that most money market securities trade in very high denominations. This limits
access for the individual investor. Furthermore, the money market is a dealer
market, which means that firms buy and sell securities in their own accounts, at
their own risk. Compare this to the stock market where a broker receives
commission to acts as an agent, while the investor takes the risk of holding the
stock. Another characteristic of a dealer market is the lack of a central trading
floor or exchange. Deals are transacted over the phone or through electronic
systems.

The easiest way for us to gain access to the money market is with a money-
market- mutual fund or sometimes through a money market bank account.
These accounts and funds pool together the assets of thousands of investors in

61
order to buy the money market securities on their behalf. However, some money
market instruments, like Treasury bills, may be purchased directly. Failing that,
they can be acquired through other large financial institutions with direct access
to these markets.

There are several different instruments in the money market, offering different
returns and different risks. In the following sections, we'll take a look at the
major money market instruments.

Cash and cash settled financial instruments -Common money market

instruments

Certificate of deposit - Time deposits, commonly offered to consumers by

banks, thrift institutions, and credit unions.

A certificate of deposit (CD) is a time deposit with a bank. CDs are generally
issued by commercial banks but they can be bought through brokerages. They
bear a specific maturity date (from three months to five years), a specified
interest rate, and can be issued in any denomination, much like bonds. Like all
time deposits, the funds may not be withdrawn on demand like those in a
checking account.

CDs offer a slightly higher yield than T-Bills because of the slightly higher default
risk for a bank but, overall, the likelihood that a large bank will go broke is pretty
slim. Of course, the amount of interest you earn depends on a number of other
factors such as the current interest rate environment, how much money you
invest, the length of time and the particular bank you choose. While nearly every
bank offers CDs, the rates are rarely competitive, so it's important to shop
around.

A fundamental concept to understand when buying a CD is the difference

between annual percentage yield (APY) and annual percentage rate (APR). APY
is the total amount of interest you earn in one year, taking compound interest into
account. APR is simply the stated interest you earn in one year, without taking
compounding into account. (To learn more, read APR vs. APY: How The
Distinction Affects You.)

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The difference results from when interest is paid. The more frequently interest is
calculated, the greater the yield will be. When an investment pays interest
annually, its rate and yield are the same. But when interest is paid more
frequently, the yield gets higher. For example, say you purchase a one-year,
$1,000 CD that pays 5% semi-annually. After six months, you'll receive an
interest payment of $25 ($1,000 x 5 % x .5 years). Here's where the magic of
compounding starts. The $25 payment starts earning interest of its own, which
over the next six months amounts to $ 0.625 ($25 x 5% x .5 years). As a result,
the rate on the CD is 5%, but its yield is 5.06. It may not sound like a lot, but
compounding adds up over time.

The main advantage of CDs is their relative safety and the ability to know your
return ahead of time. You'll generally earn more than in a savings account, and
you won't be at the mercy of the stock market. Plus, in the U.S. the Federal
Deposit Insurance Corporation guarantees your investment up to $100,000.

Despite the benefits, there are two main disadvantages to CDs. First of all, the
returns are paltry compared to many other investments. Furthermore, your
money is tied up for the length of the CD and you won't be able to get it out
without paying a harsh penalty.

Repurchase agreements - Short-term loans—normally for less than two weeks

and frequently for one day—arranged by selling securities to an investor with an
agreement to repurchase them at a fixed price on a fixed date.

Repo is short for repurchase agreement. Those who deal in government

securities use repos as a form of overnight borrowing. A dealer or other holder of
government securities (usually T-bills) sells the securities to a lender and agrees
to repurchase them at an agreed future date at an agreed price. They are usually
very short-term, from overnight to 30 days or more. This short-term maturity and
government backing means repos provide lenders with extremely low risk.

Repos are popular because they can virtually eliminate credit problems.
Unfortunately, a number of significant losses over the years from fraudulent
dealers suggest that lenders in this market have not always checked their
collateralization closely enough.

There are also variations on standard repos:

Reverse Repo - The reverse repo is the complete opposite of a repo. In this
case, a dealer buys government securities from an investor and then sells them
back at a later date for a higher price

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Term Repo - exactly the same as a repo except the term of the loan is greater
than 30 days.

Commercial paper - Unsecured promissory notes with a fixed maturity of one to

270 days; usually sold at a discount from face value.

Commercial paper is an unsecured, short-term loan issued by a corporation,

typically for financing accounts receivable and inventories. It is usually issued at
a discount, reflecting current market interest rates. Maturities on commercial
paper are usually no longer than nine months, with maturities of between one
and two months being the average.

For the most part, commercial paper is a very safe investment because the
financial situation of a company can easily be predicted over a few months.
Furthermore, typically only companies with high credit ratings and credit
worthiness issue commercial paper. Over the past 40 years, there have only
been a handful of cases where corporations have defaulted on their commercial
paper repayment.

Commercial paper is usually issued in denominations of $100,000 or more.

Therefore, smaller investors can only invest in commercial paper indirectly
through money market funds.

Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch

located outside the United States.

Federal agency short-term securities - (in the U.S.). Short-term securities

issued by government sponsored enterprises such as the Farm Credit System,
the Federal Home Loan Banks and the Federal National Mortgage Association.

Federal funds - (in the U.S.). Interest-bearing deposits held by banks and other
depository institutions at the Federal Reserve; these are immediately available
funds that institutions borrow or lend, usually on an overnight basis. They are lent
for the federal funds rate.

Municipal notes - (in the U.S.). Short-term notes issued by municipalities in

anticipation of tax receipts or other revenues.

Treasury bills - Short-term debt obligations of a national government that are

issued to mature in three to twelve months.

Treasury Bills (T-bills) are the most marketable money market security. Their
popularity is mainly due to their simplicity. Essentially, T-bills are a way for the
U.S. government to raise money from the public. In this tutorial, we are referring
to T-bills issued by the U.S. government, but many other governments issue T-
bills in a similar fashion.

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T-bills are short-term securities that mature in one year or less from their issue
date. They are issued with three-month, six-month and one-year maturities. T-
bills are purchased for a price that is less than their par (face) value; when they
mature, the government pays the holder the full par value. Effectively, your
interest is the difference between the purchase price of the security and what you
get at maturity. For example, if you bought a 90-day T-bill at $9,800 and held it
until maturity, you would earn $200 on your investment. This differs from coupon
bonds, which pay interest semi-annually.

Treasury bills (as well as notes and bonds) are issued through a competitive
bidding process at auctions. If you want to buy a T-bill, you submit a bid that is
prepared either non-competitively or competitively. In non-competitive bidding,
you'll receive the full amount of the security you want at the return determined at
the auction. With competitive bidding, you have to specify the return that you
would like to receive. If the return you specify is too high, you might not receive
any securities, or just a portion of what you bid for.

The biggest reasons that T-Bills are so popular are that they are one of the few
money market instruments that are affordable to the individual investors. T-bills
are usually issued in denominations of $1,000, $5,000, $10,000, $25,000,
$50,000, $100,000 and $1 million. Other positives are that T-bills (and all
Treasuries) are considered to be the safest investments in the world because the
U.S. government backs them. In fact, they are considered risk-free. Furthermore,
they are exempt from state and local taxes. (For more on this, see Why do
commercial bills have higher yields than T-bills?)

The only downside to T-bills is that you won't get a great return because
Treasuries are exceptionally safe. Corporate bonds, certificates of deposit and
money market funds will often give higher rates of interest. What's more, you
might not get back all of your investment if you cash out before the maturity date.

Money funds - Pooled short maturity, high quality investments which buy money
market securities on behalf of retail or institutional investors.

Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the
reversal of the exchange of currencies at a predetermined time in the future.

Short-lived mortgage- and asset-backed securities

Funding and cash flow control

Transaction treasury - adding up the benefits of cashflow forecasting

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My colleagues and I have both examined cash flow forecasting from the
perspective of the FD and the Treasurer in previous entries on this blog. Today
I’d like to consider the benefits of this practice in relation to M&A transactions.

Companies prepare forecasts in order to plan ahead and ensure that effective
decisions can be made at the earliest possible time. Cash flow forecasting aims
to identify where, when and in what currency cash flows are expected to occur
allowing management the ability to optimise the use of available cash, identify
and plan how shortfalls will be funded, and how surpluses will be invested.

Being able to forecast cash flow is one of the most important elements of
treasury management. The primary objective is to ensure that the company has
sufficient liquidity (i.e. access to cash) so that it can meet all known obligations
and to allow it to continue to function. This discipline is valid in the deal space,
both in terms of assessing future cash generation capabilities during the deal
process and, especially in terms of existing private equity portfolio companies,
guaranteeing timely and accurate visibility of cashflow is in place to ensure
financial covenants are complied with. Any size of business can quickly find itself
more vulnerable to a lack of cash than to a lack of profit.

Operationally, by predicting shortfalls and surpluses the business can improve

investment returns, negotiate better borrowing terms and conditions and
minimise external borrowing, optimising the use of cash and of borrowing
facilities and avoiding shocks. When assessing potential surpluses and deficits of
cash, it is necessary to assess not only amounts and currencies, but also the
time periods in which the surpluses or shortages will occur.

There can be disadvantages to forecasting as well and these mainly revolve

around the time, and hence cost, spent by the business in preparing them. Often
pushed from every side, further pressures and questions on the forecast
variances to tight deadlines can cause friction. However, in today’s liquidity
environment, can any business afford not to forecast its cash?

Time horizons

For cash management purposes there are generally up to three time horizons for
forecasting, each serving a different purpose and using different forecasting
methods. As the time horizon extends, it becomes more difficult to forecast with
accuracy and the usefulness of the forecast can diminish.

The key to reliability and credibility is to ensure that the operational liquidity and
tactical forecasts, prepared using different methodologies, are comparable
across the common period that they cover (i.e. 0-3 months). By ensuring that the
forecasts align within acceptable tolerance and materiality levels, the business
creates the credibility to encourage decision making on both a short and longer
term basis.

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KPIs, incentivisation and change

It is a key part of any process to ensure that the business creates the right
framework of KPIs and appropriate incentivisation at each level of the process.
This can be a difficult area, and it is important to ensure that there are no
rewards for undercasting cash (thereby creating positive variances, but an
opportunity loss for the business). Equally, being penalised twice (once for P&L
changes, and again for the cash flow impacts) should be avoided.

Longer term forecasts in particular should be subjected to sensitivity analysis, to

quantify any uncertainties in the forecast, and any appropriate “what if”
scenarios. Information should be reported in a way that is useful to those that use
and rely upon it to make decisions. Easy to read dashboards are vital to ensure
that outputs are understood by all levels of management, and to instil
accountability and responsibility.

There is likely to be some organisational change and "pain" involved, and key
steps to a successful implementation include:

* engaging hearts and minds by effective communication;

* ensuring understanding through practical and comprehensible materials;

* embedding disciplines with robust and routine processes; and

* encouraging compliance with appropriate KPI's and incentivisation.

To summarise, a fundamental part of the cash and liquidity management process

is, as for any process, planning ahead. This is particularly relevant in today’s
market of less available and more expensive liquidity. Cash is rarely
instantaneously available; the delay may be as short as a day for a payment, or it
might be a week if the company is chasing an important sales receipt, out to
weeks or months if the company needs to raise equity or to borrow in the capital
markets.

As a reminder, the main actions are:

* Liquidity management – ensuring available funds as and when required;

* Minimise cost of funds – take advantage of opportunities to borrow at lower

rates;

* Maximise earnings – use and invest surpluses optimally;

* Foreign exchange – manage the currency flows to reduce treasury deals;

* Working capital management – identify changes for corrective action;

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 * Financial control – compare forecast to actuals throughout the business;

* Investing and funding strategies – identify structural cash shortages and

surpluses;

* Strategic investment – funding significant capex or M&A activity from

available resources; and

* Strategic objectives – compare longer term variances to influence corporate

strategy and anticipate market, economic and competitive changes.

Accounting considerations

Mark-to-Market Accounting and the Financial Crisis

Mark-to-Market (MtM) Accounting is usually cast as a villain of the piece in most

financial crises. This note aims to rebut this criticism from a “system resilience”
perspective. It also expands on the role that MtM Accounting can play in
mitigating agents’ preference for severely negatively skewed payoffs, a theme I
touched upon briefly in an earlier note.

Mark-to-market or fair value accounting refers to accounting for the value of an

asset or liability based on the current market price of the asset or liability, or for
similar assets and liabilities, or based on another objectively assessed "fair"
value. Fair value accounting has been a part of the U.S. Generally Accepted
Accounting Principles (GAAP) since the early 1990s, and has been used
increasingly since then.

Mark-to-market accounting can make values on the balance sheet change

frequently, as market conditions change. In contrast, book value, based on the
original cost/price of an asset or liability, is more stable but can become outdated
and inaccurate. Mark-to-market accounting can also become inaccurate if market
prices deviate from the "fundamental" values of assets and liabilities because
buyers and sellers are unable to collectively and accurately value the future value
of income from assets and expenses from liabilities, possibly due to incorrect
information or over-optimistic and over-pessimistic expectations.

Accounting practice

The practice of mark to market as an accounting device first developed among

traders on futures exchanges in the 20th century. It was not until the 1980s that
the practice spread to big banks and corporations far from the traditional
exchange trading pits, and beginning in the 1990s, mark-to-market accounting
began to give rise to scandals.

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To understand the original practice, consider that a futures trader, when taking
a position, deposits money with the exchange, called a "margin". This is intended
to protect the exchange against loss. At the end of every trading day, the contract
is marked to its present market value. If the trader is on the winning side of a
deal, his contract has increased in value that day, and the exchange pays this
profit into his account. On the other hand, if the market price of his contract has
declined, the exchange charges his account that holds the deposited margin. If
the balance of his accounts falls below the deposit required to maintain the
position, the trader must immediately pay additional margin into the account to
maintain his position (a "margin call"). As an example, the Chicago Mercantile
Exchange, taking the process one step further, marks positions to market twice a
day, at 10:00 am and 2:00 pm.[1]

Over-the-counter (OTC) derivatives on the other hand are formula-based

financial contracts between buyers and sellers, and are not traded on exchanges,
so their market prices are not established by any active, regulated market
trading. Market values are, therefore, not objectively determined or readily
available (purchasers of derivative contracts are customarily furnished computer
programs which compute market values based upon data input from the active
markets and the provided formulas). During their early development, OTC
derivatives such as interest rate swaps were not marked to market frequently.
Deals were monitored on a quarterly or annual basis, when gains or losses would
be acknowledged or payments exchanged.

Accounting practice and fraud

As the practice of marking to market caught on in corporations and banks, some

of them seem to have discovered that this was a tempting way to commit
accounting fraud, especially when the market price could not be objectively
determined (because there was no real day-to-day market available or the asset
value was derived from other traded commodities, such as crude oil futures), so
assets were being 'marked to model' in a hypothetical or synthetic manner using
estimated valuations derived from financial modelling, and sometimes marked in
a manipulative way to achieve spurious valuations. See Enron and the Enron
scandal.

Internal Revenue Code Section 475 contains the mark to market accounting
method rule for taxation. Section 475 provides that qualified securities dealers
that elect mark to market treatment shall recognize gain or loss as if the property
were sold for its fair market value on the last business day of the year, and any
gain or loss shall be taken into account in that year. The section also provides
that dealers in commodities can elect mark to market treatment for any
commodity (or their derivatives) which is actively traded (i.e., for which there is an
established financial market that provides a reasonable basis to determine fair
market value by disseminating price quotes from broker/dealers or actual prices
from recent transactions).

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Accounting standards

FAS 115

Accounting for Certain Investments in Debt and Equity Securities (Issued May
1993)

This Statement addresses the accounting and reporting for investments in equity
securities that have readily determinable fair values and for all investments in
debt securities. Those investments are to be classified in three categories and
accounted for as follows:

Debt securities that the enterprise has the positive intent and ability to hold to
maturity are classified as held-to-maturity securities and reported at amortized
cost less impairment.

Debt and equity securities that are bought and held principally for the purpose of
selling them in the near term are classified as trading securities and reported at
fair value, with unrealized gains and losses included in earnings.

Debt and equity securities not classified as either held-to-maturity securities or

trading securities are classified as available-for-sale securities and reported at
fair value, with unrealized gains and losses excluded from earnings and reported
in a separate component of shareholders' equity (Other Comprehensive Income).

FAS 157

Statements of Financial Accounting Standards No. 157, Fair Value

Measurements, commonly known as "FAS 157", is an accounting standard
issued in September 2006 by the Financial Accounting Standards Board (FASB)
which became effective for entities with fiscal years beginning after November
15, 2007.[2][3]

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FAS Statement 157 includes the following:

Clarity on the definition of fair value;

A fair value hierarchy used to classify the source of information used in fair value
measurements (i.e. market based or non-market based);

Expanded disclosure requirements for assets and liabilities measured at fair

value; and

A modification of the long-standing accounting presumption that a measurement

date-specific transaction price of an asset or liability equals its same
measurement date-specific fair value.

Clarification that changes in credit risk (both that of the counterparty and the
company's own credit rating) must be included in the valuation.

A FAS 157 defines "fair value" as: “The price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date.”

A FAS 157 only applies when another accounting rule requires or permits a fair
value measure for that item. While FAS 157 does not introduce any new
requirements mandating the use of fair value, the definition as outlined does
introduce certain key differences.

First, it is based on the exit price (for an asset, the price at which it would be sold
(bid price)) rather than an entry price (for an asset, the price at which it would be
bought (ask price)), regardless of whether the entity plans to hold the asset for
investment or resell it later.

Second, FAS 157 emphasizes that fair value is market-based rather than entity-
specific. Thus, the optimism that often characterizes an asset acquirer must be
replaced with the scepticism that typically characterizes a dispassionate, risk-
averse buyer.

FAS 157’s fair value hierarchy underpins the concepts of the standard. The
hierarchy ranks the quality and reliability of information used to determine fair
values, with level 1 inputs being the most reliable and level 3 inputs being the
least reliable. Information based on direct observations of transactions (e.g.,
quoted prices) involving the same assets and liabilities, not assumptions, offers
superior reliability; whereas, inputs based on unobservable data or a reporting
entity’s own assumptions about the assumptions market participants would use
are the least reliable. A typical example of the latter is shares of a privately held
company whose value is based on projected cash flows.

71
Problems can arise when the market-based measurement does not accurately
reflect the underlying asset's true value. This can occur when a company is
forced to calculate the selling price of these assets or liabilities during
unfavourable or volatile times, such as a financial crisis. For example, if the
liquidity is low or investors are fearful, the current selling price of a bank's assets
could be much lower than the value under normal liquidity conditions. The result
would be a lowered shareholders' equity. This issue was seen during the
financial crisis of 2008/09 where many securities held on banks' balance sheets
could not be valued efficiently as the markets had disappeared from them. In
April 2009, however, the Financial Accounting Standards Board (FASB) voted on
and approved new guidelines that would allow for the valuation to be based on a
price that would be received in an orderly market rather than a forced liquidation,
starting in the first quarter of 2009.

Although FAS 157 does not require fair value to be used on any new classes of
assets, it does apply to assets and liabilities that are carried at fair value in
accordance with other applicable rules. The accounting rules for which assets
and liabilities are held at fair value are complex. Mutual funds and securities firms
have carried their assets and some liabilities at fair value for decades in
accordance with securities regulations and other accounting guidance. For
commercial banks and other types of financial services firms, some asset classes
are required to be carried at fair value, such as derivatives and marketable equity
securities. For other types of assets, such as loan receivables and debt
securities, it depends on whether the assets are held for trading (active buying
and selling) or for investment. All trading assets are carried at fair value. Loans
and debt securities that are held for investment or to maturity are carried at
amortized cost, unless they are deemed to be impaired (in which case, a loss is
recognized). However, if they are available for sale or held for sale, they are
required to be carried at fair value or the lower of cost or fair value, respectively.
(FAS 65 and FAS 114 cover the accounting for loans, and FAS 115 covers the
accounting for securities.) Notwithstanding the above, companies are permitted
to account for almost any financial instrument at fair value, which they might elect
to do in lieu of historical cost accounting (see FAS 159, "The Fair Value Option").

Thus, FAS 157 applies in the cases above where a company is required or elects
to carry an asset or liability at fair value.

The rule requires a mark to "market," rather than to some theoretical price
calculated by a computer — a system often criticized as “mark to make-believe.”
(Occasionally, for certain types of assets, the rule allows for using a model)

Sometimes, there is a thin market for assets, which trade relatively infrequently -
often during an economic crisis. In these periods, there are few, if any buyers for
such products. This complicates the marking process. In the absence of market
information, an entity is allowed to use its own assumptions, but the objective is
still the same: what would be the current value in a sale to a willing buyer. In

72
developing its own assumptions, the entity cannot ignore any available market
data, such as interest rates, default rates, prepayment speeds, etc.

FAS 157 makes no distinction between non cash-generating assets, i.e., broken
equipment, which can theoretically have zero value if nobody will buy them in the
market – and cash-generating assets, like securities, which are still worth
something for as long as they earn some income from their underlying assets.
The latter cannot be marked down indefinitely, or at some point, can create
incentives for company insiders to buy them out from the company at the under-
valued prices. Insiders are in the best position to determine the creditworthiness
of such securities going forward. In theory, this price pressure should balance
market prices to accurately reflect the "fair value" of a particular asset.
Purchasers of distressed assets should step in to buy undervalued securities,
thus moving prices higher, allowing other Companies to consequently mark up
their similar holdings.

Also new in FAS 157 is the idea of non performance risk. FAS 157 require that in
valuing a liability, an entity should consider the non performance risk. If FAS 157
simply required that fair value be recorded as an exit price, then non
performance risk would be extinguished upon exit. However, FAS 157 defines
fair value as the price at which you would transfer a liability. In other words, the
non performance that must be valued should incorporate the correct discount
rate for an ongoing contract. An example would be to apply higher discount rate
to the future cash flows to account for the credit risk above the stated interest
rate. The Basis for Conclusions section has an extensive explanation of what
was intended by the original statement with regards to non performance risk
(paragraphs C40-C49).

In response to the rapid developments of the financial crisis of 2007–2008, the

FASB is fast tracking the issuance of the proposed FAS 157-d, Determining the
Fair Value of a Financial Asset in a Market That Is Not Active.

Simple example

Example: If an investor owns 10 shares of a stock purchased for $4 per share,

and that stock now trades at $6, the "mark-to-market" value of the shares is
equal to (10 shares × $6), or $60, whereas the book value might (depending on
the accounting principles used) only equal $40. So it will not be written down to
$40.

Similarly, if the stock falls to $3, the mark-to-market value is $30 and the investor
has lost $10 of the original investment and the stock will be written down to this
value. If the stock was purchased on margin, this might trigger a margin call and
the investor would have to come up with an amount sufficient to meet the margin
requirements for his account.

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Marking-to-market a derivatives position

In marking-to-market a derivatives position, at pre-determined periodic intervals,

each counterparty exchanges the change in the market value of their position in
cash. For OTC derivatives, when one counterparty defaults, the sequence of
events that follows is governed by an ISDA contract. When using models to
calculate the ongoing exposure, FAS 157 requires that the entity consider the
default risk ("non performance risk") of the counterparty and make a necessary
adjustment to its calculations.

For exchange traded derivatives, if one of the counterparties defaults in this

periodic exchange, that counterparty's position is immediately closed by the
exchange and the clearing house is substituted for that counterparty's position.
Marking-to-market virtually eliminates credit risk, but it requires the use of
monitoring systems that usually only large institutions can afford.[5]

Use by brokers

Stock brokers allow their clients to access credit via margin accounts. These
accounts allow clients to borrow funds to buy securities. Therefore, the amount of
funds available is more than the value of cash (or equivalents). The credit is
provided by charging a rate of interest, in a similar way as banks provide loans.
Even though the value of securities (stocks or other financial instruments such as
options) fluctuates in the market, the value of accounts is not calculated in real
time. Marking-to-market is performed typically at the end of the trading day, and if
the account value falls below a given threshold, (typically a predefined ratio by
the broker), the broker issues a margin call that requires the client to deposit
more funds or liquidate his account.

The “Downward Spiral” of Mark-to-Market Accounting(MtM)

If there’s anything that can be predicted with certainty in a financial crisis, it is

that sooner or later banks will plead to their regulators and/or FASB asking for
relaxation of MtM accounting rules. The results are usually favourable. So in the
S&L crisis, we got the infamous “Memorandum R-49″ and in the current crisis, we
got FAS 157-e.

The most credible argument for such a relaxation of MtM rules is the “downward
spiral” theory. Opponents of MtM Accounting argue that it can trigger a
downward spiral in asset prices in the midst of a liquidity crisis. As this IIF

74
memorandum puts it: “often dramatic write-downs of sound assets required
under the current implementation of fair-value accounting adversely affect market
sentiment, in turn leading to further write-downs, margin calls and capital impacts
in a downward spiral that may lead to large-scale fire-sales of assets, and
destabilizing, pro-cyclical feedback effects. These damaging feedback effects
worsen liquidity problems and contribute to the conversion of liquidity problems
into solvency problems.” The initial fall in prices feeds upon itself in a “positive
feedback” process.

I am not going to debate the conditions necessary for this positive feedback
process to hold, not because the case is beyond debate but because MtM is just
one in a long list of positive feedback processes in our financial markets. Laura
Kodres at the IMF has an excellent discussion on “destabilizing” hedge fund
strategies here which identifies some of the most common ones – margin calls
on levered bets, stop-loss orders, dynamic hedging of short-gamma positions
and even just plain vanilla momentum trading strategies.

The crucial assumption necessary for the downward spiral to hold is that the
forces exerting negative feedback on this fall in asset prices are not strong
enough to counter the positive feedback process. The relevant question from a
system resilience perspective is why this is so. Why are there not enough
investors with excess liquidity or banks with capital and liquidity reserves to buy
up the “undervalued” assets and prevent collapse? One answer which I
discussed in my previous note is the role of extended periods of stability in
reducing system resilience. The narrowing of the “Leijonhufvud Corridor” reduces
the margin of error before positive feedback processes kick in. The most obvious
example is reduction in collateral required to execute a leveraged bet. The period
of stability also weeds out negative feedback strategies or forces them to adapt
thereby reducing their influence on the market.

A healthy market is characterised not by the absence of positive feedback

processes but by the presence of a balanced mix of positive and negative
feedback processes. Eliminating every single one of the positive feedback
processes above would mean eliminating a healthy chunk of the market. A better
solution is to ensure the persistence of negative feedback processes.

Mark-to-Market Accounting as a Modest Mitigant to the Moral Hazard Problem

As I mentioned in a previous note, marking to a liquid market significantly

reduces the attractiveness of severely negatively skewed bets for an agent. If the

75
agent is evaluated on the basis of mark-to-market and not just the final payout,
significant losses can be incurred much before the actual event of default on a
super-senior bond.

The impact of true mark-to-market is best illustrated by highlighting the difference

between Andrew Lo’s example of the Capital Decimation Partners and the super-
senior tranches that were the source of losses in the current crisis. In Andrew
Lo’s example, the agent sells out-of-the-money (OTM) options on an equity index
of a very short tenor (less than three months). This means that there is significant
time decay which mitigates the mark-to-market impact of a fall in the underlying.
This rapid time decay due to the short tenor of the bet makes the negatively
skewed bet worthwhile for the hedge fund manager even though he is subject to
constant mark to market. On the other hand, loans/bonds are of a much longer
tenor and if they were liquidly traded, the mark-to-market swings would make the
negative skew of the final payout superfluous for the purposes of the agent who
would be evaluated on the basis of the mark-to-market and not the final payout.

Many of the assets on bank balance sheets however are not subject to mark-to-
market accounting or are only subject to mark-to-model on an irregular basis.
This enables agents to invest in severely negatively skewed bets of long tenor
safe in the knowledge that the low probability of an event of default in the first few
years is extremely low. It’s worth noting that mark-to-model is almost as bad as
not marking to market at all for such negatively skewed bets, especially if the
model is based on parameters drawn from recent historical data during the
“stable” period.

On Whether Money Market Mutual Funds (MMMFs) should Mark to Market

The SEC recently announced a new set of money market reforms aimed at fixing
the flaws highlighted by Reserve Primary Fund’s “breaking the buck” in
September 2008. However, it stopped short of requiring money market funds to
post market NAVs that may fluctuate. One of the arguments for why floating rate
NAVs are a bad idea is that regulations that force money market funds to hold
“safe” assets make mark-to-market superfluous. In fact, exactly the opposite is
true. It is essential that assets with severely negatively skewed payoffs such as
AAA bonds are marked to market precisely so that agents such as money market
fund managers are not tempted to take on uneconomic bets in an attempt to pick
up pennies from in front of the bulldozer.

The S&L Crisis: A Case Study on the impact of avoiding MtM

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Martin Mayer’s excellent book on the S&L crisis has many examples of the
damage that can be done by avoiding MtM accounting especially when the
sector has a liquidity backstop via the implicit or explicit guarantee of the FDIC or
the Fed. In his words, “As S&L accounting was done, winners could be sold at a
profit that the owners could take home as dividends, while the losers could be
buried in the portfolio “at historic cost,” the price that had been paid for them,
even though they were now worth less, and sometimes much less.”

As Mayer notes, this accounting freedom meant that S&L managers were eager
consumers of the myriad varieties of mortgage backed securities that Wall Street
conjured up in the 80s in search of extra yield, immune from the requirement to
mark these securities to market.

Wall Street’s Opposition to the Floating NAV Requirement for MMMFs

Some commentators such as David Reilly and Felix Salmon pointed out the
hypocrisy of investment banks such as Goldman Sachs recommending to the
SEC that money market funds not be required to mark to market while rigorously
enforcing MtM on their own balance sheets. In fact the above analysis of the S&L
crisis shows why their objections are perfectly predictable. Investment banks
prefer that their customers not have to mark to market. This increases the
demand from agents at these customer firms for “safe” highly rated assets that
yield a little extra i.e. the very structured products that Wall Street sells, safe in
the knowledge that they are immune from MtM fluctuations.

Mark-to-Market and the OTC-Exchange Debate

Agents’ preference for avoiding marking to market also explains why apart from
investment banks, even their clients may prefer to invest in illiquid, opaque OTC
products rather than exchange-traded ones. Even if accounting allows one to
mark a bond at par, it may be a lot harder to do so if the bond price were quoted
in the daily newspaper!

Mark-to-Market and Excess Demand for “Safe” Assets

Many commentators have blamed the current crisis on an excess demand for
“safe” assets (See for example Ricardo Caballero). However, a significant
proportion of this demand may arise from agents who do not need to mark to
market and is entirely avoidable. More widespread enforcement of mark to

77
market should significantly decrease the demand from agents for severely
negatively skewed bets i.e. “safe” assets.

Warning signals and what to look for

See below

Defining risk

The manner in which credit exposure is assessed is highly dependent on the

nature of the obligation. If a bank has loaned money to a firm, the bank might
calculate its credit exposure as the outstanding balance on the loan. Suppose
instead that the bank has extended a line of credit to a firm, but none of the line
has yet been drawn down. The immediate credit exposure is zero, but this
doesn't reflect the fact that the firm has the right to draw on the line of credit.
Indeed, if the firm gets into financial distress, it can be expected to draw down on
the credit line prior to any bankruptcy. A simple solution is for the bank to
consider its credit exposure to be equal to the total line of credit. However, this
may over-states the credit exposure. Another approach would be to calculate the
credit exposure as being some fraction of the total line of credit, with the fraction
determined based upon an analysis of prior experience with similar credits.

Market risk

Market risk is the risk that the value of a portfolio, either an investment portfolio
or a trading portfolio, will decrease due to the change in value of the market risk
factors. The four standard market risk factors are stock prices, interest rates,
foreign exchange rates, and commodity prices. The associated market risks are:
Equity risk, the risk that stock prices and/or the implied volatility will change.
Interest rate risk, the risk that interest rates and/or the implied volatility will
change.
Currency risk, the risk that foreign exchange rates and/or the implied volatility will
change.
Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil)
and/or implied volatility will change.
Measuring the potential loss amount due to market risk

As with other forms of risk, the potential loss amount due to market risk may be
measured in a number of ways or conventions. Traditionally, one convention is to

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use Value at Risk. The conventions of using Value at risk is well established and
accepted in the short-term risk management practice.
However, it contains a number of limiting assumptions that constrain its
accuracy. The first assumption is that the composition of the portfolio measured
remains unchanged over the specified period. Over short time horizons, this
limiting assumption is often regarded as reasonable. However, over longer time
horizons, many of the positions in the portfolio may have been changed. The
Value at Risk of the unchanged portfolio is no longer relevant.
The Variance Covariance and Historical Simulation approach to calculating Value
at Risk also assumes that historical correlations are stable and will not change in
the future or breakdown under times of market stress.
In addition, care has to be taken regarding the intervening cash flow, embedded
options, changes in floating rate interest rates of the financial positions in the
portfolio. They cannot be ignored if their impact can be large.
Use in annual reports of U.S. corporations
In the United States, a section on market risk is mandated by the SEC[1] in all
annual reports submitted on Form 10-K. The company must detail how its own
results may depend directly on financial markets. This is designed to show, for
example, an investor who believes he is investing in a normal milk company, that
the company is in fact also carrying out non-dairy activities such as investing in
complex derivatives or foreign exchange futures.

Liquidity risk

This is the risk that arises from the difficulty of selling an asset. An investment
may sometimes need to be sold quickly. Unfortunately, an insufficient secondary
market may prevent the liquidation or limit the funds that can be generated from
the asset. Some assets are highly liquid and have low liquidity risk (such as stock
of a publicly traded company), while other assets are highly illiquid and have high
liquidity risk (such as a house).
There are two kinds of liquidity: market liquidity, and funding liquidity.
A security has good market liquidity if it is “easy” to trade, that is, has a low bid-
ask spread, small price impact, high resilience, easy search (in OTC markets).
A bank or investor has good funding liquidity if it has enough available funding
from its own capital or from (collateralised) loans.

79
With these notions in mind, the meaning of liquidity risk is clear.
Market liquidity risk is the risk that the market liquidity worsens when you need to
trade.
Funding liquidity risk is the risk that a trader cannot fund his position and is
forced to unwind.
For instance, a levered hedge fund may lose its access to borrowing from its
bank and must sell its securities as a result. Or, from the bank's perspective,
depositors may withdraw their funds, the bank may lose its ability to borrow from
other banks, or raise funds via debt issues.
We are experiencing extreme market and funding liquidity risk
Liquidity generally varies over time and across markets, and currently we are
experiencing extreme market liquidity risk. The most extreme form of market
liquidity risk is that dealers are shutting down (no bids!), which is currently
happening in a number of markets such as those for certain asset-backed
securities and convertible bonds. We are also experiencing extreme funding
liquidity risk since banks are short on capital, so they need to scale back their
trading that requires capital, and also scale back the amount of capital they lend
to other traders such as hedge funds, that is, hedge funds now face higher
margins. In short, if banks cannot fund themselves, they cannot fund their clients.
The two forms of liquidity are linked and can reinforce each other in liquidity
spirals where poor funding leads to less trading, this reduces market liquidity,
increasing margins and tightening risk management, thus further worsening
funding, and so on.
Liquidity risk and asset prices
An illiquid security has a higher required return to compensate investors for the
transaction costs. Since market liquidity may deteriorate when you need to sell in
the future, investors face market liquidity risk as discussed above. Investors
naturally want to be compensated for this, so market liquidity risk increases the
required return. Indeed, the liquidity-adjusted capital asset pricing model shows
how liquidity betas complement the standard market beta. The higher required
return in times of higher market liquidity risk leads to a contemporaneous drop in
prices, according to this theory, consistent with what we are seeing in the current
marketplace. An overview of the liquidity literature is available here.
Liquidity risk and the current crisis: downward liquidity spirals
The trigger of the crisis was the bursting of the housing bubble, combined with a
large exposure by the levered financial institutions. This led to significant bank
losses with associated funding liquidity problems. This started the systemic
liquidity spirals. As banks’ balance sheets deteriorated, they had to de-lever. To
do this, they:

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started selling assets;
hoarding cash;
tightening risk management.
This put stress on the interbank funding market (as measured e.g. by the TED
spread, see slides) as everyone was trying to minimise counterparty exposures.
Banks’ funding liquidity problems quickly spread. Other investors, especially
those that rely on leverage such as hedge funds, face funding risk when banks
become less willing to lend, they raise margins, and, in the extreme, when the
banks fail as Lehman did.
When banks such as Bear Stearns and Lehman started to look vulnerable, their
clients risked losing capital or having it frozen during a bankruptcy, and they
started to withdraw capital and unwind positions, leading to a bank run.
This funding liquidity crisis naturally lead to market illiquidity with bid-ask spreads
widening in several markets, and quoted amounts being reduced by dealers with
less available capital. This market illiquidity, and the prospect of further liquidity
risk, scared investors and prices dropped, especially for illiquid assets with high
margins.
This is the downward liquidity spiral as illustrated in the chart.

Sources: Garleanu and Pedersen (2007) and Brunnermeier and Pedersen (2008)

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The crisis spreads to other asset classes

The crisis has been spreading across asset classes and markets globally. There
are as traders unwind carry trades and lose faith in weak currencies. Further, as
an example of the gravity of the liquidity crisis, the “Covered Interest Rate Parity”
– the most basic arbitrage condition in the world’s thickest market (foreign
exchange) – currently fails to hold even for the major currencies. This must mean
that no one can arbitrage because no one can borrow uncollateralised, no one
has spare collateral, and no one is willing to lend – arbitrage involves both
borrowing and lending.

The increased risk and illiquidity has also lead to a spike in volatility, contributing
to the higher margins. Further, correlations across assets have increased as
everything started trading on liquidity.

The crisis spreads to Main Street

Clearly, the crisis is having a significant effect on the real economy as

homeowners see their property value deteriorate, consumers access to
borrowing is reduced, main street companies face higher cost of equity and
especially debt capital and a lower demand for their products, unemployment
goes up, etc.

What can - and what cannot - solve a liquidity crisis?

If the problem is a liquidity spiral, we must improve the funding liquidity of the
main players in the market, namely the banks. Hence, banks must be
recapitalised by raising new capital, diluting old equity, possibly reducing face
value of old debt. This can be done with quick resolution bankruptcy for
institutions with systemic risk, i.e. those causing liquidity spirals.

Further, we must improve funding markets and trust by broadening bank

guarantees, opening the Fed's discount window broadly (giving collateralised
funding with reasonable margins), and ensuring the Commercial Paper market
function. Further, risk management must acknowledge systemic risk due to
liquidity spirals and the regulations must consider the system as a whole, as
opposed to each institution in isolation.

If we have learned one thing from the current crisis, it is that trading through
organised exchanges with centralised clearing is better than trading over-the-
counter derivatives because trading derivatives increases co-dependence,
complexity, counterparty risk, and reduces transparency. Said simply, when you
buy a stock, your ownership does not depend on who you bought it from. If you
buy a “synthetic stock” through a derivative, on the other hand, your ownership
does depends on who you bought it from - and that dependence may prevail
even after you sell the stock (if you sell through another bank). Hence, when
people start losing confidence in the bank with which they trade, they may start to

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unwind their derivatives positions and this hurts the bank’s funding, and a
liquidity spiral unfolds.

Banning short selling is a bad idea

In the debate about how to solve the crisis and prevent the next one, it has been
suggested that policymakers should ban short selling and impose a transaction
tax on stocks. I believe that neither is a good idea. First, short sellers bring new
information to the market, increase liquidity, and reduce bubbles (remember the
housing bubble started this crisis) so preventing this can be very costly and
prohibiting short sales does not solve the general funding problem. While
temporarily banning new short sales of financial institutions can be justified if
there is risk of predatory trading, this is rarely a good idea since short sellers are
often simply scapegoats when bad firms go down fighting. (See here for how
shortselling works.)

Tobin taxes are a bad idea

Second, a transaction tax on stocks is problematic for several reasons, most

importantly because it moves trading away from the official exchanges and into
the derivatives world, thus increasing the systemic risk. One of the main
arguments in favour of such a transaction tax is that it helps to prevent bubbles,
but there is little or no empirical evidence to support this. For instance, in the UK
there is a 0.5% tax on trading stocks and a higher tax on trading real estate (up
to 4%), but the UK arguably had one of the larger housing bubbles. Further, with
a depressed and vulnerable stock market, this does not appear to be the best
time to introduce transactions taxes related to potential stock price bubbles in the
far future.

To see the problem, consider what happened in the UK due to their transaction
tax. The professional investors such as hedge funds found a way around the
regulation by executing their trades using derivatives rather than trading stocks
directly (while individual investors are unable to avoid the tax). Specifically, in the
UK hedge funds typically trade via swaps with counterparties such as investment
banks to avoid the transaction tax. There is little doubt that this would also
happen in the US if such a tax was introduced here. This would increase
counterparty dependencies, systemic risk, and worsen risk management spirals
as discussed above.

Another serious problem with the tax is that it lowers liquidity in the marketplace
as trading activity may move abroad, move into other markets, or disappear. On
top of these distortions to the stability of the financial system, this tax may raise
capital costs for Main Street firms because of higher liquidity risk in US financial
markets. Indeed, buying US stocks will be less attractive to investors –
domestically and internationally – if they must pay a tax to buy and if they
anticipate reduced liquidity in the future when they need to sell.

83
This could make it harder for US corporations to raise capital. And, the
importance of being able to raise capital is what this crisis is all about.

Credit risk

The possibility that a bond issuer will default, by failing to repay principal and
interest in a timely manner. Bonds issued by the federal government, for the
most part, are immune from default (if the government needs money it can just
print more). Bonds issued by corporations are more likely to be defaulted on,
since companies often go bankrupt. Municipalities occasionally default as well,
although it is much less common.

Credit risk is risk due to uncertainty in a counterparty's (also called an obligor's or

credit's) ability to meet its obligations. Because there are many types of
counterparties—from individuals to sovereign governments—and many different
types of obligations—from auto loans to derivatives transactions—credit risk
takes many forms. Institutions manage it in different ways.

In assessing credit risk from a single counterparty, an institution must consider

three issues:

default probability: What is the likelihood that the counterparty will default on its
obligation either over the life of the obligation or over some specified horizon,
such as a year? Calculated for a one-year horizon, this may be called the
expected default frequency.

credit exposure: In the event of a default, how large will the outstanding
obligation be when the default occurs?

recovery rate: In the event of a default, what fraction of the exposure may be
recovered through bankruptcy proceedings or some other form of settlement?

When we speak of the credit quality of an obligation, this refers generally to the
counterparty's ability to perform on that obligation. This encompasses both the
obligation's default probability and anticipated recovery rate.

To place credit exposure and credit quality in perspective, recall that every risk
comprise two elements: exposure and uncertainty. For credit risk, credit
exposure represents the former, and credit quality represents the latter.

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For loans to individuals or small businesses, credit quality is typically assessed
through a process of credit scoring. Prior to extending credit, a bank or other
lender will obtain information about the party requesting a loan. In the case of a
bank issuing credit cards, this might include the party's annual income, existing
debts, whether they rent or own a home, etc. A standard formula is applied to the
information to produce a number, which is called a credit score. Based upon the
credit score, the lending institution will decide whether or not to extend credit.
The process is formulaic and highly standardized.

Many forms of credit risk—especially those associated with larger institutional

counterparties—are complicated, unique or are of such a nature that that it is
worth assessing them in a less formulaic manner. The term credit analysis is
used to describe any process for assessing the credit quality of a counterparty.
While the term can encompass credit scoring, it is more commonly used to refer
to processes that entail human judgment. One or more people, called credit
analysts, will review information about the counterparty. This might include its
balance sheet, income statement, recent trends in its industry, the current
economic environment, etc. They may also assess the exact nature of an
obligation. For example, senior debt generally has higher credit quality than does
subordinated debt of the same issuer. Based upon this analysis, the credit
analysts assign the counterparty (or the specific obligation) a credit rating, which
can be used for making credit decisions.

Many banks, investment managers and insurance companies hire their own
credit analysts who prepare credit ratings for internal use. Other firms—including
Standard & Poor's, Moody's and Fitch—are in the business of developing credit
ratings for use by investors or other third parties. Institutions that have publicly
traded debt hire one or more of them to prepare credit ratings for their debt.
Those credit ratings are then distributed for little or no charge to investors. Some
regulators also develop credit ratings. In the United States, the National
Association of Insurance Commissioners publishes credit ratings that are used
for calculating capital charges for bond portfolios held by insurance companies.

Exhibit 1 indicates the system of credit ratings employed by Standard & Poor's.
Other systems are similar.

Standard & Poor's Credit Ratings

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Exhibit 1

AAA Best credit quality—Extremely reliable with regard to financial obligations.

AA Very good credit quality—Very reliable.

A More susceptible to economic conditions—still good credit quality.

BBB Lowest rating in investment grade.

BB Caution is necessary—Best sub-investment credit quality.

B Vulnerable to changes in economic conditions—Currently showing the

ability to meet its financial obligations.

CCC Currently vulnerable to nonpayment—Dependent on favorable economic

conditions.

CC Highly vulnerable to a payment default.

C Close to or already bankrupt—payment on the obligation currently

continued.

D Payment default on some financial obligation has actually occurred.

This is the system of credit ratings Standard & Poor's applies to bonds. Ratings
can be modified with + or – signs, so a AA– is a higher rating than is an A+
rating. With such modifications, BBB– is the lowest investment grade rating.
Other credit rating systems are similar. Source: Standard & Poor's.

Operational risk

A form of risk that summarizes the risks a company or firm undertakes when it
attempts to operate within a given field or industry. Operational risk is the risk
that is not inherent in financial, systematic or market-wide risk. It is the risk
remaining after determining financing and systematic risk, and includes risks
resulting from breakdowns in internal procedures, people and systems.

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Risk management and reporting

All businesses take risks based on two factors: the probability an adverse
circumstance will come about and the cost of such adverse circumstance.

Credit risk modelling is a concept that broadly encompasses any algorithm-based

methods of assessing credit risk. The term encompasses credit scoring, but it is
more frequently used to describe the use of asset value models and intensity
models in several contexts. These include

supplanting traditional credit analysis;

being used by financial engineers to value credit derivatives; and

being extended as portfolio credit risk measures used to analyze the credit risk of
entire portfolios of obligations to support securitization, risk management or
regulatory purposes.

Derivative instruments represent contingent obligations, so they entail credit risk.

While it is possible to measure the mark-to-market credit exposure of derivatives
based upon their current market values, this metric provides an incomplete
picture. For example, many derivatives, such as forwards or swaps, have a
market value of zero when they are first entered into. Mark-to-market exposure—
which is based only on current market values—does not capture the potential for
market values to increase over time. For that purpose some probabilistic metric
of potential credit exposure must be used.

There are many ways that credit risk can be managed or mitigated. The first line
of defence is the use of credit scoring or credit analysis to avoid extending credit
to parties that entail excessive credit risk. Credit risk limits are widely used.
These generally specify the maximum exposure a firm is willing to take to
counterparty. Industry limits or country limits may also be established to limit the
sum credit exposure a firm is willing to take to counterparties in a particular
industry or country. Calculation of exposure under such limits requires some form
of credit risk modelling. Transactions may be structured to include
collateralization or various credit enhancements. Credit risks can be hedged with
credit derivatives. Finally, firms can hold capital against outstanding credit
exposures.

The credit risk report should also be a matrix with maturity on one axis and the
general rating quality on the other. (see Table 6.) Senior managers could of
course demand a more detailed breakdown of rating classes and duration than
that outlined in Table 6. The top 10 individual counterparty exposures should also
accompany the credit matrix report. More sophisticated institutions may in
addition apply default probabilities to the number in each cell in the matrix to
arrive at an expected loss figure.

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The liquidity risk report must show the funding requirements of the firm so that
senior managers will have information on the maturity structure of the institution’s
liabilities. A tabulation of the debt profile of the firm will enable managers to know
when and how much debt will need to be refinanced.
Credit and liquidity risk reports should be sent to senior managers at least
weekly.

Table 6: CREDIT RISK

Rating Net uncollateralised exposure with a Total (in $

remaining life million)
up to 1 year 1-5 years >5 years

AAA
AA
A
BBB
Non-investment
grade
TOTAL

Table 7: DEBT PROFILE OF A FIRM (in $ million)

Short-term Debt Maturing Within

1 month 2 months 3 months 6 months 9 months 1 year

US dollar
Non-US dollar

Long-term Fixed rate Fixed rate Total fixed Variable Total

Debt obligations obligations rate rate
swapped to not swapped obligations obligations
variable

US dollar
Due 1998
Due 1999
Due 2000
Due 2001
Thereafter
SUB-TOTAL

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 Non-US
dollar
Due 1998
Due 1999
Due 2000
Due 2001
Thereafter
SUB-TOTAL

TOTAL

Risk Mitigation

One growing risk mitigation technique is the use of insurance to cover certain
operational risk exposures. During discussion with the industry, the Committee
found that firms were using, or were considering using, insurance policies to
mitigate operational risk.

These include a number of traditional insurance products, such as bankers’

blanket bonds and professional liability insurance. Specifically, insurance could
be used to externalise the risk of potentially “low frequency, high severity” losses,
such as errors and omissions (including processing losses), physical loss of
securities, and fraud. The Committee agrees that, in principle, such mitigation
should be reflected in the capital requirement for operational risk. However, it is
clear that the market for insurance of operational risk is still developing.
Defining and setting limit structures

Financial risk measurement has advanced significantly in recent years, and

though it has complicated Treasury Management the pay off has been smarter
risk taking. The pressure is on to identify, measure and to manage the multitude
of Treasury-related risks. Some are “new” while others are just separated out or
better appreciated in the light of new valuation models. Still, each addition
requires that policies, practices, limits and limit structures be adapted. But how
does a Treasurer coordinate their risk view into a relevant, logical, coherent and
practical system of limits?

In the academic hurry to publish and developers’ rush to popularize the most
current risk valuation models into software, Treasurers have been left alone with
the task of adapting limit structures. “New” statistical risk measures like liquidity
risk are springing up. Non-market risks are being added. The latest is
operational risk and there is talk of modeling “reputational” risk. Driving this are,
a) Unprecedented “write-offs” due to unexpected FX “translation”
adjustments, funding rate “movements”, and “liquidity” crises; improper hedges or

89
 even ‘three-legged stool’ off-balance sheet financing programs, and “rogue”
traders
b) Product innovations involving contingency assets and liabilities,
c) Detailed “business unit” level profit measures (cost allocation & transfer
pricing regimes for risk management)
d) Valuation methods like RAROC (Risk Adjusted Return on Capital,) and
e) Changing capital adequacy regimes.

Singular, exclusive risk limits on, for example “liquidity”, do not logically follow
from a new risk measurement. We can continue though, to limit activities or
exposures that directly or indirectly affect the new risk measurements. Without a
logical blueprint however, limits have been added on without consideration to the
overall effectiveness of the structure.

The many risks are indeed a function of a Treasurer’s role: funding, cash, interest
rate, Foreign Exchange (FX) and liquidity management and sometimes financing,
capital and balance sheet management. Limits act as guiding parameters and
reflect the faith and confidence Treasury is given in managing certain risks. A
proper limit structure defining process needs to assess the relevance and relative
importance of each risk as well as Treasury’s freedom and flexibility in their
management. It should be kept current via a periodic, systematic and thorough
review of the business, strategies, policies, procedures and practices vis-à-vis
the business environment. Then risk limits, a limited resource like capital, are
assigned out on the basis of risk appetite and ability to handle exposures.

Initial limit structures were simple. As the types of Treasury risks recognized
multiplied, the list of limits has gotten longer. Each industry sector and even
each business has its own risk nuances. But the limit structure has generally
remained flat, wide and simple (Figure 1).

Treasury’s Separate
Limits

Aged
Investment
FX Funding Receivable ALM Gap
Product
Limit Limit s Limits
Limits
Limit

90
Simply adding on a different limit for each type of risk involved has led to illogical
and uncoordinated limit systems. There are still instances where Treasury
groups follow static notional position limits (i.e. $2 million USD/CAD) even though
the potential $ amount risk varies with obviously trending markets or greater
volatilities. VaR is a broadly accepted “holistic” effort to bring together various
market exposures into one Value at Risk number. Most Treasury managers now
speak this “new math”: a statistical language of standard deviations, correlation,
variance and various Greek letters. In Figure 1 VaR summarizes the FX and
ALM Gap limits.

Since the deficiencies of VaR were highlighted in the 1998 Long Term Capital
Management debacle, Stress Testing has been added alongside individual
market type or VaR limits. Stress Testing, a VaR engine outcome of potential
(but highly unlikely) extreme scenarios, can have bankruptcy consequences. A
separate limit for this was created. Jeremy Berkowitz (Federal Reserve Board
March 20, 1999) in a paper “A Coherent Framework for Stress-Testing”
suggested folding Stress Tests into the risk model (VaR), by assigning them
probabilities. He argued this provided a “usable risk metric” -- a singular risk
measure. The modified VaR with redefined extreme events does have a more
realistic “tail”. An even more realistic result could be had by boosting the
probability of the extreme events closer to that of historic occurrences.

Such aggregation, however, ignores the usually different bases of time horizons
between VaR and Stress Testing and it negates the original purpose of the latter.
Stress Tests could separately supply limits to avoid reaching catastrophic
exposure to perhaps 10-year horizon events that come with little forewarning.
Trading VaR limits on the other hand can be based on 1 day horizons (the time it
takes to off-load a futures hedge). Even for similar horizons, one should
seriously question whether Treasury should be allowed to substitute credit or
concentration risk for market exposures. Most firms that do both VaR and Stress
Testing do not “roll” the stress test results into VaR numbers. The two limits
reflect different risks…one the kind of losses that could be sustained but should
be controlled, while the latter relates to disastrous exposure. They should be
used separately. A Stress Testing limit logically should have priority over related
VaR limits. Other attempts to incorporate Liquidity and Credit risks into VaR
(Expected Extremity Associated Risk, EXAR, Rik Sen & N.A. Hariharan 2002)
have not resulted in any generally accepted “best practices” models or limits
either.

91
Just as a simple, singular, exclusive VaR limit does not follow from an
aggregated valuation, a singular Stress Test limit would also be incorrect. It too
would allow Treasury too much freedom over management of specific market &
concentration exposures. Therefore separate, ancillary limits for market, credit
and liquidity risks need to be employed. Here too, each can have their own sub
limits, i.e. controlling for types of market risks depending on appetite or expertise.
Detail and complexity will be limited by system and personnel competencies.

Not everyone has the need or desire to take on the complexity of a correlated
VaR. However, simplistic limit structures should be updated to force relevance,
i.e. by allowing addition (though not necessarily netting) across risks. Simple FX
limits can be expressed in terms of:

a) notional limits (i.e. spot exposure of $2 million USD/CAD) and

b) DaR (i.e. $120,000 Dollars at Risk backed by the application of volatility

figures)

Apart from VaR one can choose risk measures such as Net Interest Income for
accrual accounting management styles or Shortfall exposure for those focused
on targeted earnings. Each has its use and potential ancillary limits, depending
on the type of strategy chosen to run a firm, or the way it is valued. Unfortunately
there are few formal papers written on the subject and no available
benchmarking studies.

Indiscriminately layered “legacy” limits, left or created without regard to a firm’s

changed environment, goals, risk appetite or a Treasury group’s level of
competence will result in poor management. Systematic attempts should be
made to create, to prioritize and to coordinate the limits into a logical limit
structure. Otherwise some limits will confuse and frustrate effective
management. For example maximum DV01 limits and gap limits may seriously
conflict and together may seriously overshoot Stop-loss limits making the former
irrelevant, providing poor guidance. Stress Test limits should not ignore the VaR
limit. Similarly, Liquidity limits should be set relative to market tolerance, credit
lines in place and maximum cash use implied by maximum use of VaR limits. In
short, the various limits set should be logical, coherent and coordinated. This
means reviewing the various possible maximum exposures as defined by chosen
scenarios (Historic, Monte Carlo or forward looking), and looking at the matrix to
correct the illogical limits.

No current software application attempts to automate a coordinated &

customized limit structure design.

Limit structures cannot be standardized across disparate non -commoditized

businesses or business sectors. Risk perception, too, is subjective. Where
some perceive risk, others through knowledge, analysis or setting aside mitigants
see little risk and therefore require different limit structures.

92
 Figure 3

Legal
&
Valuation Regulatory
or
Earnings
Focus

Management
Style Limit
(dynam
A limit structure redesign effort will force a healthy ic/ on core strategies,
focus Structure
reactive)
principles & competencies and will clarify muddy delegated risk management
guidelines. Figure 3 shows some of the things to consider in creating a Limit
Structure. A sample of what the redesign should incorporate includes:

1. Definitions of the types of risks Treasury faces. A lists of specific,

IT/System
controllable related limits and sub-limits. Limits need to
Competencyvia analysis
be justified
of the appropriateness, relevance, measurement and practicality of each vis-à-vis
(complexity) Available &
its related risk. They should address foremost regulatory, statutory and company
(Board-endorsed) policies and business strategies. GAAP disclosures mayValidated
eventually require statements regarding risk management limits as these too are Risk
potential liabilities. Models

2. Risk models used, their assumptions, limitations and parameters need to

be made explicit

a) i.e. For VaR, a 1 week horizon, using Historical simulation, 5 year look
back scenario, with a 95% confidence interval and correlation matrixes validated
by a given firm.

b) Stop Loss limits should be cumulative over time and across

products/portfolios, and be related to risk appetite (itself related to management’s
desired risk/return profile). It may be a notional amount, a percentage of actual
or expected earnings, etc.

93
c) For Stress Testing the scenarios need to be defined  Historic, Monte
Carlo or forward looking. There is no “best practices” here either. Methods
depend on desired simplicity, available computer power and confidence in ability
to judging the future.

3. Limits should be prioritized, with the higher level limits clearly relating to
the Board’s and Executives’ interpretation of risk. Limits such as VaR, a Stop-
loss, and a Stress Test are immediately meaningful to them. Other limits (such
as Gap limits or DV01’s) can be sub limits of these, aiding in Treasury’s
management of the higher level limits. One can get as detailed as one wishes,
however the “KISS” principle (Keep It Simple Stup&#) should be kept in mind.

4. Limit levels should be set relative to a clear risk/return tradeoff decision.

Though non-financial firms with a conservative bent may wish to eliminate risk,
some leeway must be given to allow flexibility in Treasury’s duties. A formal,
documented process is needed to back up each of the below:

a) The setting of the size of each limit. Limits can be set relative to capital,
earnings, or some other measure. For VaR, one estimate is that “a one day VaR
equal to about 3% of the trading capital is a pretty good sized risk in a normal
environment.” (Barry Schachter, Head of Enterprise Risk Management at Caxton
Corporation). Sub-limits can then be chosen as appropriate. Under VaR one can
have separate FX DaR and Fixed Income DV01’s and/or product specific VaR’s.
Derivatives by their nature should receive special attention.

b) How far back from disaster Stress Test limits are set depends on how
probable are the defined extreme event(s), and lead times (if any).

c) Once limits are set procedures should provide for action when limits be
breached:

 Obtaining limit excess approvals from Executive Management (themselves to

be granted limits or authority by the Board of Directors) and,

 Putting into motion self-correcting specific actions that reduce, mitigate or

eliminate the offending risk exposure.

d) Limits can be set in stages of concern or severity. i.e. A lower funding or

credit limit breach will put into motion certain remedial actions, while a higher limit
breach will require more severe actions.

e) Dynamic structures can be created, where limits vary with profits/earnings

or changing market conditions.

5. A limit structure’s success requires,

a) Mathematical validation. Options are backtesting or Monte Carlo

simulations. Will the model make sense and provide the P/L results expected?

94
b) It to be coordinated. 6(a) above should create a matrix of results under
different maximum exposure scenarios that indicate unreasonable or superfluous
limits for correction.

c) Validation of a given level of competency in managers for a given level of

complexity.

d) A system of periodic, preferably independent and automated monitoring

and controls to be implemented.

Operational issues

A final word on change management: Incrementalism. Introduce change in

simple, tested steps, over time with the buy-in of the Board, Executives and
Treasury Management, Risk Management and IT groups. A wholesale one time
change that modifies policies, practices, procedures including system IT issues
begs a meltdown. Managing with a coordinated, cohesive limit structure will
increase manifold the likelihood maintaining a desired risk profile and attaining a
desired valuation.

The audit of treasury

See handout

Discussion

Warning signals and what to look for

Warning Signs Of Full Spectrum Collapse Are Everywhere

95
 http://neithercorp.us/npress/?p=512 Warning Signs Of Full Spectrum Collapse Are
Everywhere
By Giordano Bruno
Neithercorp Press – 05/31/2010
The sovereign debt crisis in Greece and many other European nations has, at least for the moment, opened a gap
in the wash of financial disinformation that has prevailed in the mainstream media for the past year. The average
American is now more aware of the terrible costs of living in an artificially driven and widely manipulated “global
economy”, and has also been exposed (at least for the moment) to the very real frailties in our own markets, which
have been hidden or downplayed by the government as well as disingenuous establishment economists. Events in
the EU, however, are only a glimpse of the greater and more imminent threats we face in the near future. In this
article we will look at some of the latest and most disturbing moves by governments and financial institutions, as
well as tell-tale signs in our own local cities, which signal that a full-spectrum collapse of world markets and
possibly our own currency is not only in progress, but nearing completion.

World Market Signals

All eyes have been focused on the Greek situation for the past month, but we cannot let this one storm of the
financial crisis distract us from the other threats that lie just beyond the horizon. There are many far more pressing
concerns than insolvency in Southern Europe, though we’ve been drowning in “Greek Contagion” rhetoric 24/7 and
it is difficult to think of much else. The idea that instability in Greece is somehow responsible for instability in the
rest of the EU is simply unfounded. Most nations in the EU were on the verge of bankruptcy long before the
sovereign debt crisis in Greece began. Spain, for instance, has just lost its AAA credit grade with Fitch Ratings due
to its massive deficits:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aqiS_6hwClPg&pos=1
Italy, Ireland, and the UK are likely not far behind. The UK posted record deficits in April:

http://www.bloomberg.com/apps/news?pid=20601068&sid=a3CziXMGujDA
Their government has recently called for budget cuts which could target some welfare, unemployment, and
disability payouts in order to blunt the edge of their own growing debt problem. Some say this move is too little too
late, and that Britain may have to face the same austerity measures as Greece just to survive:

http://www.marketwatch.com/story/uk-budget-cutting-begins-with-83-billion-slice-2010-05-24
There are two problems with the news coming out of the EU. First, establishment economists will attempt to dilute
public awareness of the issues by diverting all blame to the Greek crisis. By making claims of Greek contagion,
they give the masses the false impression that stopping the fallout in Greece will somehow cure the systematic
meltdown in the rest of the world. Already, euro-zone economists (propagandists) are feeding the Greek people
the same lie as our economists have been feeding us, declaring that a weak currency and import capability,
combined with greater reliance on other nations and the IMF, will create some kind of ‘export nirvana’, and that
Greece will suddenly rise from the grave as a kind of industrial powerhouse:

http://www.reuters.com/article/idUSTRE64G11U20100517

96
This is the same double-think the globalists have been using everywhere; “Weakness is strength”.

Regardless of what talking-head financial analysts tell us in the next six moths, we must never forget that the
collapse was not caused by a single nation, but the actions of all governments in collusion with international banks
over a period of decades.

Second, we will be hearing a lot in the news over the coming year about the credit grades of rating companies
such as Fitch or Moodys. However, these credit grades are a purely psychological affair. If they were based on
concrete fundamentals, Spain would have lost its AAA credit rating long before now, not to mention the UK or the
U.S. The fact that they are finally willing to begin downgrading the debt value of certain countries only shows that
circumstances have become so untenable that rating agencies know they will look foolish if they do not do
otherwise. Now that they have begun, watch for rating downgrades to accelerate in the coming year, especially in
the EU, punishing the markets with repetitive stock plunges.

The biggest news, though, the news that no one is paying much attention to, is the activity in Asia. In the midst of
all the chaos across the Atlantic, we have forgotten to take note of the activities of the great elephant in the room
just across the Pacific.

China has been busy, and the speed at which they are shifting their economic system is even startling. In past
articles we covered the Chinese dumping of U.S. Treasury Bonds in response to our ever rising national debt and
dangerous liquidity measures by the private Federal Reserve. All this, we believed, was in preparation for a
valuation of the Yuan and a decoupling of the traditional trade relationship between China and America.

To be clear, some economists have begun overstating the recent purchases of new T-bills by China in response to
the European debt crisis. Meaning, they believe China will now turn back to the Dollar as a safe haven asset
against a fall in the Euro. China has only increased its reserves by 2% in response to the possibility of a Euro
collapse, which in my opinion is hardly a show of faith in the Dollar. Also, the vast majority of purchases in recent
months have been for SHORT TERM treasury bonds maturing in 26 weeks or less. You can see the chart for all
April purchases here:

http://1.bp.blogspot.com/_8hz7JYvMfTU/S9pCMlaajjI/AAAAAAAABLY/GP5lbUUmqwI/s1600/Apr10-
Auction.JPG

Countries buy short term bonds in our debt because they see our long term debt as a severe risk. With our deficits
climbing to levels never dreamed of only ten years ago, we need long term investment in our Treasuries if we are
to sustain the U.S. economy. These investments are not coming, nor is it probable that they will in the future. China
is now ready to de-peg the Yuan from the Dollar if not break from the American financial system completely.
Back in 2008, rumor spread in some investment circles that China was planning to issue its own T-bonds; called
“Panda Bonds” or “Yuan Bonds”:

http://www.chinastakes.com/2008/12/panda-bonds-could-help-china-avoid-the-risks-of-us-treasury-
bonds.html

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As it turns out, Yuan Bonds are no longer a rumor. Issued late last year with little fanfare, and considered by some
investors as a novelty, Chinese Treasuries are now growing far beyond expectations:

http://www.businessweek.com/news/2010-03-12/china-bonds-may-return-6-on-banks-buying-fund-says-
update1-.html
http://english.peopledaily.com.cn/90001/90778/90859/6986357.html
Even more intriguing, China has opened its index futures to foreign investors, revealing a desire to take a more
central role in world economic activity:

http://english.peopledaily.com.cn/90001/90778/90862/002046.html
China has had trillions of dollars in currency reserves which help create the trade deficit that allows their industrial
based export economy to thrive. Why would they want to issue bonds in their own currency, increasing the value of
the Yuan and ending their trade advantage? Because China’s goal is to convert its billion citizen society into an
import and consumption hub while making the RMB, or the Yuan, a reserve currency to rival the Euro and the
Dollar.

Indeed, these bonds are meant to strengthen the Yuan, increase its prominence as a reserve currency, and
eventually allow China to break from U.S. treasuries entirely. It is also possible that the valuation of the Yuan could
make it eligible for inclusion in the IMF’s Special Drawing Rights basket currency, a goal China has openly
expressed:

http://www.reuters.com/article/idUSTRE6250LC20100306
China has strengthened ties with Indian markets, African markets, and formed the ASEAN trading block. ASEAN is
now attempting to “unite” with the European Union in order to “combat” the global financial crisis:

http://english.peopledaily.com.cn/90001/90777/90856/7001488.html
Every single action by China in the past two years indicates that they are not only preparing to break with the U.S.,
but that they are ready to do so today if they preferred. The bottom line is this: China wants reserve status for the
Yuan, and China wants the Greenback replaced as the world reserve currency. When China de-pegs the Yuan
from the Dollar, they will begin dumping whatever U.S. treasuries they still hold, allowing the Yuan to strengthen
and the Dollar to fall. This will be a disaster for the U.S. economy, and it could conceivably happen before the end
of this year.

Not far off the coast of China, Japan has found itself in dire straights. Still clinging to the traditional export
relationship with the U.S., America is no longer consuming Japanese goods anywhere near the pace they were
once accustomed. This has resulted in a deflationary spiral in Japan’s markets, as well as wages and wholesale
prices of goods. Expect to hear much more about this before the end of 2010:

http://www.bloomberg.com/apps/news?pid=20601087&sid=a9.PG6nGY6_g&pos=5
The Japanese government has on several occasions suggested ending reliance on the U.S., and to discontinue
purchases of U.S. Treasuries. They have also hinted at the possibility of fully joining China’s ASEAN trading bloc
as a way to offset any damage done by breaking from American markets. The deflationary collapse in Japan is

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extremely hazardous and grows worse now with each passing month. Japan may soon have no other choice but to
turn to ASEAN for trade support and end its relationship with the U.S. Once again, this move would bring calamity
to American stocks and to our currency.

Brazil, a member of the BRIC group of nations along with China, is facing serious upheaval in its bond markets:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aUVznIauvQYg&pos=4
The Brazilian currency is also declining in a fashion much like the Euro, and their sovereign debt issues are
becoming unmanageable. This in turn could lead to greater pressure from BRIC nations to push for a new reserve
currency outside of the Dollar and the Euro.

These signals across the globe are like the swell of the tide just before the onslaught of a hurricane. If you know
how to read the waters, then you know when its time to stop the beach party and run for cover.

American Market Signals

Though the infinite stimulus by the Federal Reserve and the skewing of statistics by government agencies like the
Labor Department have lead the average American to believe a recovery is in the making, the fact is, our situation
has only become worse since the initial collapse began in 2007. Most recent signs indicate we may soon return to
the hyper-volatility we saw in the Dow back in 2008, but this time, the Dollar will follow the plunge of stocks instead
of hedging against it.

Key measurements of credit instability are once again spiking, just as they were before the Dow plummeted out of
control in 2008. As you can see from the chart below, 2 year swap spreads slowly rolled above 60 basis points just
before the Dow began to plunge:

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This year, 2 year swap spreads have rocketed up from 9.6 basis points in March, to as much as 64 basis points in
May! That’s a seven fold increase in the span of a couple of months, unlike the collapse of 2008, which saw
spreads rise much slower:

Credit swap spreads rise when banks charge higher premiums. Banks charge higher premiums when they do not
trust the creditworthiness of other banks. Corporate bond sales have fallen to the lowest levels in a decade:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aZWveN7GJtks&pos=7

The swap spread chart is basically a red flag that goes up when banks are preparing for serious market turmoil. It
seems as though that turmoil may be near due to the explosion in swap spreads in such a short period of time.
You can read more about swap spreads and their warning signs here:
http://www.moneyandmarkets.com/credit-crisis-indicators-going-bonkers-again-batten-down-the-hatches-
39253

The warnings behind swap spreads are substantiated by the behavior of U.S. stocks in May, which had the worst
profit losses since 1940:
http://www.bloomberg.com/apps/news?pid=20601087&sid=apgUzNgFGKLA

Private wages have sunk to historic lows, while government welfare payouts have risen to historic highs. This is a
sure sign of an economy that is about to flop on an epic scale:
http://www.usatoday.com/money/economy/income/2010-05-24-income-shifts-from-private-sector_N.htm

Mass layoffs in April also reveal a rather ironic problem. Ever since the bailouts began, establishment heads have

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been playing up the “advantages” of inflation, claiming that America would soon return to a stronger industrial base
and that more factory jobs were on the way. However, a recent measure of mass layoffs by companies shows that
widespread job cuts were led by manufacturers who shed workers even as the economy was supposedly in the
midst of recovery!
http://finance.yahoo.com/news/April-mass-layoffs-rise-led-rb-2636770438.html?
x=0&sec=topStories&pos=2&asset=&ccode=
This means that there is no growth in industrial jobs, and the hypothetical plans and promises of the pro-inflation
crowd bear little-to-no weight in the real world.

The unemployment issue is also liable to be exacerbated in the next month, largely due to the expiration of
government unemployment benefits on June 2nd. The Senate is not even set to convene discussion on extensions
until June 7th, after Memorial recess. The fact that they refused to handle the matter until after benefits have
already expired may suggest that they do not intend to extend unemployment at all. Millions of people who have
remained unemployed for long periods due to the recession could lose benefits all at once:

http://www.mlive.com/michigan-job-
search/index.ssf/2010/05/senate_to_go_on_recess_without_extending.html
State And Local Signals
The big story in state and local markets is municipal bonds. Investment in local debt has completely dried up.
States and cities across America are amassing impressive budget shortfalls in record time. California as a whole is
best known for being on the verge of debt default, but little do we hear about individual towns and counties within
California that are already talking about filing for Chapter 9:

http://www.time.com/time/business/article/0,8599,1991062,00.html
http://www.reuters.com/article/idUSTRE64Q6CQ20100527
California is not the only state with cities on the brink. The National League of Cities has reported that U.S.
municipalities will come up short on debts to the tune of up to $80 billion:

http://money.cnn.com/2010/05/28/news/economy/american_cities_broke.fortune/index.htm

According to the Economic Policy Journal, 32 states are now technically bankrupt, and are borrowing money from
the Federal Treasury just to keep up with unemployment benefits:
http://www.economicpolicyjournal.com/2010/05/32-states-have-borrowed-from-treasury.html
What we are looking at appears to be a snowballing implosion of municipal funding, starting small with cities and
counties one by one filing for bankruptcy until a crescendo of debt default is reached, resulting in the breakdown of
state governments, making them totally reliant on fiat from the Treasury and the Federal Reserve just to function.
This is yet another opportunity for hyperinflation to fester.

We might think of corporations as international and not local, but since corporate chains now dominate local
economy, it is important to consider them in a local light. Municipal Bonds are not the only train wreck in progress.

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As we mentioned above, corporate bond markets are also now frozen. This could lead to a whole host of financing
issues for corporations, not to mention even more downsizing and job losses.

Wal-Mart is one example of a major corporate chain that is ingrained into the financial root of most communities
(for good or ill), and it is also an example of a chain at risk:

http://money.cnn.com/2010/05/20/news/economy/consumer_retail_walmart.fortune/index.htm
When the sales of a monstrous price undercutting consumer outlet like Wal-Mart start slipping, then we are in
serious trouble.

There are only two cures for the current debt landslide we are now in the midst of. States and cities could make
radical cuts in spending and put new programs on hold until the crisis has passed. It is highly doubtful our
government officials will suddenly take on a fiscally conservative approach at this late juncture. The only other
option is to raise taxes to levels never before seen and print money out of thin air to pay off debts (the most
probable scenario). Printing money does little to actually solve our insolvency issues, though. It does not remove
debt, it just reallocates it. By injecting fiat into state economies and corporate banks, we only move debt from the
local and state sector to the federal sector, not to mention devalue the Dollar itself. Higher taxes would also
squeeze the American consumer (the lifeblood of our 70% consumer based economy) even further, ending what
little chance we had left to rebuild Mainstreet.

These factors and many others that have arisen in the past 6 months do not demonstrate a financial system that is
catching its breath and climbing from the depths, but one on an erratic ride tethered like a daredevil to a frayed
bungee-cord; eventually, things are going to snap, and the ride will end…

Appendix – Definitions & Resources

Resources

ACCA - http://www.accaglobal.com/

ICAEW- http://icaew.com

AIA - www.aiaworldwide.com/

Accounting web - http://www.accountingweb.co.uk/

Investopdeia- http://www.investopedia.com/study-guide/cfa-exam/level-1/financial-
ratios/cfa8.asp

Definitions

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