Question No.

1
Bring out in a table format the features of certificate of deposits and commercial papers. Answer:Certificate of Deposits (CDs): Certificate of deposit (CDs) is a short-term instrument issued by commercial banks and financial institutions. It is a document issued for the amount deposited in a bank for a specified period at a specified rate of interest. The concerned bank issues a receipt which is both marketable and transferable in the market. The receipts are in bearer or registered form. CDs are known as negotiable instruments and they are also known as Negotiable Certificates of Deposit. Basically they are a part of banks deposit; hence they are riskless in terms of payments and principal amount. CDs are interest-bearing, maturitydated obligations of banks. CDs benefit both the banker and the investor. The bankers need not encash the deposit before the maturity and the investor can sell the CDs in the secondary market before the maturity. This contributes to the liquidity and ready marketability for the instrument. CDs can be issued only by the schedule banks. It is issued at discount to face value. The discount rate depends on the market conditions. CDs are issued in the multiples of Rs. 25 lakh and the minimum size of the issue is Rs.1 crore. The maturity period ranges from three months to one year. The introduction of CDs in Indian market was assessed in 1980. RBI appointed the Vaghul Working Group to study the Indian market for five years. Based on the suggestions of Vaghul committee; RBI formulated a scheme for the issue of CDs. As per the scheme, CDs can be issued only by the scheduled banks at a discount rate to face value. There is no restriction on the discount rate by the RBI. Features of CDs in Indian market The characteristic features of CDs in Indian money market are as follows: Commercial Papers (CPs): Commercial Papers (CPs) is a type of instrument in money market and it was introduced in Jan 1990. Commercial paper is a short-term unsecured promissory note issued by large corporations. They are issued in bearer forms on a discount to face value. It issued by the corporations to raise funds for a shortterm. The maturity period ranges from 30 days to one year. CPs is negotiable by endorsement and delivery. They are highly liquid as they have buy-back facility. The CPs is issued in denominations of Rs. 5 lakh or multiples of Rs. 5 lakh. Generally CPs is issued through banks, dealers or brokers. Sometimes they are issued directly to the investors. It is purchased mostly by the commercial banks, Non-Banking

CRR and Statutory Liquidity Ratio (SLR) requirements lock-in period. basis

Finance Companies (NBFCs) and business organisations. CPs is issued in domestic as well as international financial markets. In international financial markets, they are known as Euro commercial paper. Features of commercial papers The salient features of CPs are as follows:

year.

issue is Rs. 25 lakh. not exceed the working capital of the issuing company. organisations and the corporate units registered in India and incorporated units. rest rate on CPs market, forex market and call money market. The attractive rate of interest in any of these markets, affects the demand of CPs. The tangible worth of the issuing company should not be less than Rs. 4.5 Crores. The company should have a minimum credit rating of P2 and A2 obtained from Credit Rating Information Services of India (CRISIL) and Investment Information and Credit Rating Agency of India Limited. (ICRA) respectively The current ratio of the issuing company should be 1.33:1. The issuing company has to be listed on stock exchange.

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Question No.2
What is capital account convertibility? What are the implications on implementing CAC? Answer: Capital Account Convertibility (CAC) refers to relaxing controls on capital account transactions. It means freedom of currency conversion in terms of inflow and outflows with respect to capital account transaction. Most of the countries have liberalised their capital account by having an open account, but they do retain some regulations for influencing inward and outward capital flow. Due to global integration, both in trade and finance, CAC enhances growth and welfare of country. The perception of CAC has undergone some changes following the events of emerging market economies (EMEs) in Asia and Latin America, which went through currency and banking crises in 1990s. A few counties backtracked and re-imposed capital controls as part of crisis resolution. Crisis such as economic, social, human cost and even extensive presence of capital controls creates distortions, making CAC either ineffective or unsustainable. The cost and benefits from capital account liberalisation is still being debated among academics and policy makers. These developments have led to considerable caution being exercised by EMEs in opening up capital account. The Committee on Capital Account Convertibility (Chairman: Shri. S.S. Tarapore) which submitted its report in 1997 highlighted the benefits of a more open capital account but at the same time cautioned that CAC could pose tremendous pressures on the financial system. India has cautiously opened its capital account and the state of capital control in India is considered as the most liberalised it had been since late 1950s. The different ways of implementing CAC are as follows: -residents. h to simultaneously liberalise control of inflow and outflow account.

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Question No.3
Distinguish between CRR and SLR. Answer: Treasury function was restricted to fund or liquid management. Fund management includes maintaining adequate cash balances to meet the daily requirements, implementing the surplus funds in other operations, sourcing the funds to even the gaps in cash flow. The treasury departments in banks are responsible to meet the Cash Reserve Requirement (CRR) and invest the funds in securities under Statutory Liquid Ratio (SLR). Treasury basically deals with short-term cash flows(less than one year), but investment in some securities exceeds more than one year. Cash Reserve Ratio: - Cash Reserve Ratio (CRR) is a countrys central bank regulation that sets the minimum reserves for banks to hold for their customer deposits and notes. These reserves are considered to meet the withdrawal demands of the customers. The reserves are in the form of authorised currency stored in a bank treasury (vault cash) or with the central bank. CRR is also called liquidity ratio as it controls money supply in the economy. CRR is occasionally used as a tool in monetary policies that influence the countrys economy. CRR in India is the amount of funds that a bank has to keep with the RBI which is the central bank of the country. If RBI decides to increase CRR, then the banks available cash drops. RBI practices this method, that is, increases CRR rate to drain out excessive money from banks. The CRR in the economy as declared by RBI in September 2010 is 6 percent. An organisation that holds reserves in excess amount is said to hold excess reserves. The following are the effects of CRR on economy: influences an economys money supply by effecting the potential of banks Statutory Liquidity Ratio: Statutory Liquidity Ratio (SLR) is the percentage of total deposits that banks have to invest in government bonds and other approved securities. It means the percentage of demand and time maturities that banks need to have in forms of cash, gold and securities like Government Securities (G-Secs). As gold and government securities are highly liquid and safe assets they are included along with cash. In India, RBI determines the percentage of SLR. There are some statutory requirements for placing the money in the government bonds. After following the requirements, the RBI arranges the level of SLR. The maximum limit of SLR is 40 percent and minimum limit of SLR is 25 percent. The RBI increases the SLR to control inflation, extract liquidity in the market and protects customers money. Increase in SLR also limits the banks leverage position to drive more money into the economy. If any Indian bank fails to maintain the required level of SLR, then it is penalised by RBI. The nonpayer bank pays an interest as penalty which is above the actual bank rate. The main objectives for maintaining SLR are the following: expansion government bonds

Question No.4
Explain various sources of interest rate risk. Answer: The interest rate risk adversely affects the organisations financial situation. It poses significant threat to the incomes and capital investments of the organisation. The changes occurring in interest rate affects the value of underlying assets of the organisation. It changes the price values of interest bearing asset and liability based on the magnitude level of fluctuations in interest rates. We shall discuss some of the sources of interest rate risk in the following subsections. 1. Yield curve risk: - The yield refers to the relationship between short term and long term interest rates. The yield curve risk occurs due to the yield curve fluctuations which affect the organisations income and economic values of underlying assets. The short term interest rates are lower than long term interest rates and hence the occurring fluctuation exposes the organisation to maturity gap of interest rate risk. The variations in movements of interest rates changes when the yield curve of a market flattens or steepens in the interest rate cycle. The yield curve slopes upwards when the short term interest rates are lower than the long term interest rates. This yield curve is known as normal yield curve. The yield curve flattens when the short term interest rates increases across the long term interest rates. This occurs during the transition of the normal yield curve to an inverted curve. It is called as flat curve. The inverted yield curve refers to the economic recession period. Therefore the market status overviews the yield curve of long term interest rate as decline in the long term fixed income of the organisation. The effects of recession impose negative impacts to the organisation hence they must concentrate on diversifying the investment portfolio. Figure 10.1 depicts the normal yield curve

Figure 10.1: Normal Yield Curve

Figure 10.2 depicts the inverted yield curve

Figure 10.2: Inverted Yield Curve The yield curve has major impacts on the consumers, equity and fixed income investors. The fixed rate loans will be encouraged when the short term rates exceeds the long term rates. Hence the consumers who invest in financing properties experience higher mortgage payments. The fixed income investors are benefited with better returns with short term investments due to the elimination of risk premium for long term investments. During the phase of inverted yield curve the margins of the profits decline such that the organisation at short term rates borrow cash and lend it at long term rates to gain profits. 2. Basis risk: -Basis risk occurs due to the changes in relationship between the various financial markets or financial instruments. The different market rates of financial instruments differ with time and amounts. In the banking organisation basis risk occurs due to the differences in the prime rate and offering rates on money market deposits, saving accounts. The changes of interest rates can give rise to unexpected changes of asset and liability cash flows and earnings. For example - an organisation holds large untraded stocks. If the company tries to sell those stocks in wholesale, it experiences liquidity risk because the selling prices may be depressed in the market. Hence to overcome this issue, the company enters into futures contract with stock index. This reduces the liquidity risk but increases the basis risk due to the differences between the selling and stock index prices. The basis risk affects the profits of an organisation by striking the cash positions. The basis risk changes the storable commodities based on the changes of the storage costs over a period of time. 3. Optionality risk: - Optionality risk arises with various option instruments of banks like assets, liabilities. It occurs during the process of altering the banks instruments levels of cash flows by banks customers or by bank itself. The option allows the option holder to buy or sell financial instruments. It usually results in a risk or rewards to the bank. The option holder experiences limited downside risk (paid amount) and unlimited upside reward whereas the option seller has unlimited risk and limited upside reward. The bank faces losses during the sold position option to its customers. There are chances of losses in banks capital value due to unfavourable interest rate movements such that it exceeds the profits that a bank gains, during the favourable movements. Therefor it has more downside exposure than upside reward. The options are traded in banks with stand-alone instruments such as over the counter (OTC), exchange traded options, bond loans and so on. The stand-alone instruments are explicitly priced and are not linked

with other bank products. Most of the banking organisations allow prepayment option of commercial loans which includes the prepayment process without any penalties. Hence during the decline of rates the customers will perform prepaying loan process which shortens the banks asset maturities while the bank desires to extend it. 4. Repricing risk: -Repricing risk arises due to the differences between the timing of rate changes and cash flows occurring in pricing and maturity of banks instruments such as assets, liabilities and off balance sheets. It is measured by comparing the liability volume with asset volume that reprice within specified period of time. The repricing risk increases the earnings of the banks. Liability sensitivity occurs in banking organisations since repricing asset maturities are longer than the repricing liability maturities. The income of the liability sensitive bank increases during the fall of interest rates and declines when the interest rate increases. Inversely, the asset sensitive bank benefits from rise in rates and detriments with fall in rates. Repricing risk affects the banks earnings performance. Since the banks focus on short term repricing imbalances are initiated to implement increase interest rate risk by extending maturities to improve profits. The banking organisations must consider long term imbalances during the repricing risk evaluation. If the gauging of long term repricing is improper, there are chances of bank experiencing variations in interest rate movements of future earnings. 5. Embedded option risk: -The embedded option refers to other option securities such as bonds, financial instruments. The embedded option is a part of another instrument which cannot be separated. The callable embedded option bond consists of hold (option free bond) option and embedded call option. The value of the bond changes according to the changes occurring in interest rates of embedded options values. The price of callable bond is equal to the price of hold option bond minus price of call option bond. The decline in interest rates increases the callable option price bond. Figure 10.3 depicts the value of embedded call option varying with respect to changes in interest rates.

Figure 10.3: Value of Embedded Call Option

The embedded putable bond consists of option free bond and embedded put option. The price of putable bond is equal to price of option bond plus price of embedded put option. Figure 10.4 depicts the value of embedded put option which is obtained by the changes in interest rates.

Figure 10.4 value of embedded put option The organisations must handle the options effectively such that the various types of bonds under embedded option are exposed to low level of risks. During the selling process of financial instruments there are chances of exposure to significant risks since the holding options are explicit and embedded which provides advantage to holder and disadvantage to seller. The exceeding number of options can implicate leverage magnifying the positive or negative influences of financial options positions in the organisation.

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Question No.5
Describe the three approaches to determine VaR Answer: Approaches to Compute VaR: In most of the organisations including financial and non-financial sectors, VaR has become an established risk exposure measurement tool. Multiple approaches are used to compute VaR and they have numerous variations. The measure of VaR can be calculated analytically through assumptions about return distributions in market risks, and the variances across these risks. In spite of the variations in different approaches to compute VaR, the three basic approaches used to calculate VaR are: Variance covariance method 1. Variance covariance method: -Variance covariance method is an approach that has the advantage of simplicity but it is limited by the difficulties related with derived probability distributions. As VaR measures the probability of loss going beyond a specific amount in a particular time period, it should be moderately simple to calculate if we can derive a probability distribution of potential values. The method of mapping equity positions through beta is often used in this approach as it is a very crucial stage in computing VaR. But it is simplistic as it neglects the following factors while calculating VaR for nonlinear positions: o The relationship between the underlying asset price and the potential value of the component of a portfolio is nonlinear. o The price of the components is also exposed to risk factors like delay in time and the expected volatility of the underlying assets returns. Risk metrics contribution: -Risks metrics contribution has two major basic contributions. They are making variance and covariance method freely available to everyone, and providing easy access to compute the VaR logically for a portfolio. The following assumptions underlying the computations of VaR are described by publications by J. P. Morgan in 1996: o Returns may not distribute themselves normally and the outliers are very common. It is assumed that the return divided by the forecasted standard deviation is normally distributed. o The attention on the standardised returns indicates that we should focus on the size relative to the standard deviation rather than the size of the return. The focus on normal standardised returns attains more exposure of VaR estimation to the frequent outliers risks than that could be assumed with a normal distribution. The risk metrics approach also covers standard normal and normal mixture distributions.

ARCH and GARCH model: -To generate more accurate variance covariance values in VaR estimations, few recommended improving the sampling methods and data innovations. Others suggested that arithmetical innovations in existing data can bring better accuracy. R F Engle, an American economist, suggested the following two variants which provide better forecasts of variance and better estimations of VaR: o Autoregressive Conditional Heteroskedasticity (ARCH) model The basic idea of ARCH is that the error terms conditional variance at time (t) depends on the squared error term (t-1). ARCH is crucially applied in the following areas: premiums. Of Generalised Autoregressive Conditional Heteroskedasticity (GARCH) model This model was introduced by Taylor (1986) and Schwert (1989). It is described by a symmetric response of current volatility to positive and negative lagged errors. 2. Simulation approaches: -In this approach, we estimate VaR by assuming the distribution of basic risk factors or targeting asset returns, extracting a sample from the joint distribution and then recalculating the portfolio of assets. Here, the revaluation of VaR of each asset is computed as per the value of each set of risk factors. They recalculate the portfolio with a simple approach that is based on partial derivatives. Analysing the assumptions based on marginal distributions and dependence structure among various benchmark assets is relevant. The three methods of simulation approaches are as follows: Historical simulation It is the most popular among simulation approaches. It represents the simplest way to evaluate VaR for many portfolios. This approach estimates VaR by creating imaginary returns of that portfolio based on time series. These returns are gained by applying historical data on the portfolio and evaluating the changes occurred in each period. Hybrid model In this method, portfolio returns are categorised based on historical stimulation in decreasing order. Then, the manager would evaluate the gathered weights of portfolio returns. VaR is detected by the value for which the total weight would be equal to the aspired confidence level. This approach has both the advantages of risk metrics contribution and historical simulation. Monte Carlo simulation This method is based on using random data and probability to gain an approximate solution to an issue in lesser time when compared to the formal techniques. It depends on the assumption that more simulations provide higher level of accuracy. Various Monte Carlo methods are introduced as an attempt to minimise the approximation error. The four methods of Monte Carlo simulation are as follows: This method concludes the confidence intervals of your method and the accuracy of the answer. Rejection Monte Carlo This evaluation provides a less accurate approximation when compared to Crude Monte Carlo method. This technique divides the interval into subintervals and then performs Crude Monte Carlo method on each interval.

This method uses more samples on more important functional areas. It achieves good approximation on the important functional areas which has greater impact on the overall approximation value and reduces variance.

3.

Extreme value theory: Extreme value theory is used for measuring extreme risks. It concentrates only on the samples of returns data carrying information about extreme behaviour. The samples of non-overlapping returns is categorised into n blocks in each block. A series of maxima and minima are generated by extracting the respective largest rise and fall in returns from each block. A Generalised Extreme Value (GEV) or Generalised Pareto (GP) distributions is used to one of these series through method of moments to evaluate the tail index parameter. This parameter illustrates the way in which the extreme events in the data can occur. The probability of occurrence of an extreme event is estimated from the VaR value for a given probability when the tail index is available. Extreme value theory provides a significant set of techniques to quantify the boundaries between different loss classes. It also delivers a scientific language for translating management guidelines on the boundaries into actual numbers. Extreme value theory generates methods for quantifying events and their consequences in a statistically optimal way. It also helps in the patterning of default probabilities and the evaluation of divergence factors in the management of bond portfolios. It has developed as one of the most important statistical fields for applied sciences and is widely used in many other subjects. This modeling is applied in the fields of management strategy, thermodynamics of earthquakes, memory cell failure and bio-medical data processing.

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Question No.6
What is liquidity gap and detail the assumptions of it? Answer: Liquidity Gap Report: A liquidity gap is the difference between the due balances of assets and liabilities over time. At any point of time, a positive gap between assets and liabilities is equivalent to shortage of cash. The marginal gap refers to the difference between the changes of assets and liabilities over time. A positive marginal gap means that the change in the values of assets exceeds that of liabilities. The gap profile changes as and when new assets and liabilities are added. The gap profile is represented either in the form of tables or charts. All the assets and liabilities are accounted in liquidity gap report and it is dependent on the dates of maturity and the actual date. Assumptions in preparation of gap report in terms of assets, liabilities and off balance sheet items : -Since the future liquidity position of a firm cannot always be predicted based on the factors, assumptions play an important role in determining the continuing due to the rapidly changing banking markets. But the number of assumptions to be made should be limited. The assumptions can be made based on three aspects. They are assets, liabilities, and off-balance sheet assets. 1. Assets: -Assets are nothing but any item of economic value owned by an individual or corporation. Assumptions regarding a banks future stock of assets include their possible marketability and use an asset as a guarantee of existing assets which could increase flow of cash and others. To determine the marketability of an asset, the method segregates the assets into three categories according to their degree of relative liquidity: assets consists of components such as interbank loans, cash and securities. Some of the assets might instantaneously be converted into cash at existing market values under almost any situation whereas others, such as interbank loans might lose liquidity in a common crisis. The assignment here is to develop assumptions about a reasonable plan for the clearance of a bank's assets. Some assets, while marketable, might be viewed as unsaleable within the time frame of the liquidity analysis. such as loans that are not capable of being readily sold, bank premises and investments in subsidiaries. Because of the difference in the banks internal asset-liability management, different banks can allot the same assets to different groups on maturity ladder.

While categorising the assets, banks should take care of the effects on the assets liquidity under the various conditions. Under normal conditions, there may be assets which are much liquid then during a time of crisis. Therefore a bank may classify the assets according to the type of scenario it is forecasting.

2.

Liabilities: -To check the cash flows occurring due to a bank's liabilities, a bank should first examine the behavior of its liabilities under normal business situations. This would include forming:

-overs of deposits and other liabilities remain normal. ts with non-contractual maturities, such as demand deposits and others; the normal growth in new deposit accounts.

While examining the cash flow arising from a bank's liabilities during the two crisis scenario, a bank would look at four basic questions. The first two questions represent the proceedings in the flow of cash that tend to reduce the cash outflows planned directly from contractual maturities. The four questions are as follows: What are the different sources of funding that are likely to stay with a bank under any situation, and can the count of these sources be increased? Other than the liabilities identified from this step, a bank's capital and term liabilities that are not maturing within the prospect of the liquidity analysis provide a liquidity buffer. The total liabilities identified in the first category may be assumed to stay with the bank even when its a worst scenario. Some core deposits generally remain with a bank because retail and small scale industry depositors may rely on the publicsector security net to shield them from occurring loss, or because the cost of changing banks, especially for some business services that include transactions accounts, is unaffordable in the very short term. What are the sources of funding that can be estimated to run off gradually if problems occur, and at what rate? Is deposit pricing a way for controlling the rate of runoff? The second category consists of liabilities that have chances of staying back with the bank during the period of slight difficulties and can be used during crisis. Liabilities, includes core deposits that are not already included in the first category. In some countries, other than core deposits, some of the interbank deposits and government funding remains with the bank even though they are considered volatile .for these kinds of cash flows a bank's very own past experience related to liabilities and the experiences of other such firms with similar problems may come handy. And help in creating a time table. Which maturing liabilities can be estimated to run off instantly at the first warning of trouble? The third category consists of the maturing liabilities that remained, including some without contractual maturities, such as wholesale deposits. Under each case, this approach adopts a conservative stand and assumes that these remaining liabilities will be paid back at as early as possible before the maturity date, especially when there is high crisis, as such money may flow to government securities and other safe refuges. Factors such as diversification and relationship building are considered important during the evaluation of the degree of the outflow of funds and a bank's capacity to replace funds. Nevertheless, in a general market crisis, sometimes high scale firms may find that they receive larger than the usually got wholesale deposit inflows, even though there are no cash inflows existing for other firms in the market. Does the bank have a reliable back-up facility? For example, small banks in local areas may also have credit lines that they can bring down to offset cash discharges. These facilities are rarely

found in larger banks but however it depends on the assumptions made on the banks liabilities. Such facilities usually need to undergo many changes but only to a limit, especially in a bank specific crisis. 3. Off balance sheet item: -A bank should also examine the availability of sufficient cash flows from its off balance sheet activities (other than the loan commitments already considered), even if they are not a portion of the banks recent liquidity analysis. In addition, the Contingent liabilities, such as letters of credit and financial guarantees, represent potentially significant cash outflow for a bank, but are usually not dependent on a bank's condition. A bank may be able to create a "normal" level of out flow of cash on a regulatory basis, and then estimate the possibility a raise in these flows during periods of stress. However, a general market crisis may generate a considerable increase in the total invocation of letters of credit because of an increase in defaults and liquidations in the market. Other possible sources of cash outflows are swaps, written Over-The-Counter (OTC) options, and forward foreign exchange rate contracts. For instance, consider that a bank has a large swap book; it would then want to study the circumstances under which it could become a net payer, and whether or not the total net pay-out is significant. Consider another situation wherein a bank acts as a swap marketmaker, with a possibility that in a bank-specific or general market crisis, customers with in-the-money swaps (or a net in-the-money swap position) would try to reduce their credit exposure to the bank by requesting the bank to buy the swaps back. Similarly, a bank would like to review its written OTC options book and any warrants that are due, along with hedges if any against these positions, since certain types of crises sometimes arouse an increase in early exercises or requests that the banks should buy the offer back. These activities could result in an unexpected cash loss, if hedges can neither be quickly liquidated to generate cash nor provide insufficient cash. 4. Other assumptions: Until now the discussion was centered on the assumption about the behavior of the specific instrument under different scenarios. At the time of looking the components exclusively, there might be some of the factors that might have a major impact on the cash flows. The need for liquidity arises from business activities. The banks too need excess funds to support extra operations. For example, the majority of the banks provide clearing services to financial institutions and correspondent banks. These institutions generate a major sum of cash inflow and cash outflows and unpredicted variations in these services can reduce a banks funds to a large extent. The other expenses such as rent and salary however are not given much importance in the analysis of the banks liquidity. But they can be sources of cash outflows in some cases.

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