Reg no # 511017114

Sikkim Manipal University Distant Education

Assignment

Name: Registration Number: Learning Center:

Manik Pant 511017114 Chandigarh 03038

Learning Center Code: Course: Subject: Semester:

Masters of Business Administration (MBA)

MA0042 Treasury Management

Fourth

Directorate of Distance Education Sikkim Manipal University II Floor, Syndicate House Manipal 576104
___________________
1/43

_______________

_________________

Reg no # 511017114

Signature of Coordinator Signature of Center Evaluator Master of Business Administration MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set 1

Signature of

Q.1 Explain how organization structure of commercial bank treasury facilitates in handling various treasury operations. Ans: Treasury Organisation The treasury organisation deals with analysing, planning, and implementing treasury functions. It deals with issues of profit centre, cost centre etc. The organisations managing interfaces with treasury functions include intragroup communications, taxation, recharging, measurement and cultural aspects. Structure of treasury organisation Figure depicts the structure of treasury organisation which is divided into five groups.

Fiscal: This group includes budget policy planning division, industrial and environmental division, common wealth state relationships, and social policy division. Macroeconomic: This group deals with economic sector of the organisation. It includes domestic and international economic divisions, macroeconomic policy and modeling division.
2/43

Reg no # 511017114

Revenue: This group is concerned with the taxes in an organisation. It includes business tax division, indirect tax, international and treaties division, personal and income division, tax analysis and tax design division. Markets: This group mainly deals with selling of products in the competitive market. It includes competition and consumer policy, corporations and financial services policy, foreign investments and trade policy division. Corporate services: This group deals with overall management of the treasury organisation. It includes financial and facilities division, human resource division, business solutions and information management division. Treasury as a profit centre The implementation of treasury in the organisation gains profits in several aspects rather than considering it as a cost centre. It helps in providing market rates to the individual business units for the services provided and thereby making operating costs more realistic. The treasurer is motivated to ensure that more services are provided to make profits in market rate. Organisations also experiences the following disadvantages when considering treasury as a profit centre: Profit is a tempting factor to speculate as it sometimes encourages the organisation to invest in wrong direction that brings depreciation in economy as well growth of organisation. Most of the time is duly spent in arguing with business units with respect to charges over services. There may be excessive additional administrative costs. Centralised and decentralised treasury management Most of the multinational organisations face huge challenges in managing transactions globally. As the organisation expands geographically, it is difficult to access and track accurate and timely cash flow information. As the technology has been adversely developed, the need for centralising treasury has evolved; theoretically centralisation allows the treasurers to exercise greater control over operating organisations. The process of centralisation consists of: Providing centralised foreign exchange and interest rate risk management Dealing with cash management Providing fully centralised treasury including incoming and outgoing payments Centralising business treasury functions enhances the organisation to build economies of scale and rationalise costs during acquisition. Centralisation helps
3/43

Reg no # 511017114

to achieve low cost debts, increase investment returns, reduce financial risks and ensure liquidity across the organisation. Decentralisation refers to the challenges of producing overall view of cash position and exposure to risk on a timely basis. Since the organisation contains various recording and reporting information methods, it will be difficult to construct a global risk position while combining information from different sources. In such cases it is impossible to make strategic decisions without access to timely and accurate information during the periods of economic volatility. In a decentralised environment, the company allows its subsidiaries to manage their own payables and payment processes. A lack of standardisation across subsidiaries and automation can lead to risks in transactions like incorrect payments and data redundancy. Treasury management in banks In recent days, most of the Indian banks have classified their business into two primary business segments like treasury operations (investments) and banking operations (excluding treasury). The treasury operations in banks are divided into: Rupee treasury: The rupee treasury carries out various rupee based treasury functions like asset liability management, investments and trading. It helps in managing the banks position in terms of statutory requirements like cash reserve ratio, statutory liquidity ratio according to the norms of the Reserve Bank of India (RBI). The various products in rupee treasury are: = Money market instruments Call, term, and notice money, commercial papers, treasury bonds, repo, reverse repo and interbank participation etc. = Bonds Government securities, debentures etc = Equities Foreign exchange treasury: The banks provide trading of currencies across the globe. It deals with buying and selling currencies. Derivatives The banks make foundation for Over the Counter (OTC). It helps in developing new products, trading in order to lay off risks and form apparatus for much of the industrys self-regulation. The role of policies in strategic management was described in this section. The next section deals with inter-dependency between policy and strategy.

4/43

Reg no # 511017114

Master of Business Administration MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set 1
Q.2 Bring out in a table format the features of certificate of deposits and commercial papers. Ans: 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
5/43

Reg no # 511017114

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. 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 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 CDs in Indian market Features of CPs

Schedule banks are eligible to issue CPs is an unsecured promissory note. CDs CPs can be issued for a maturity period Maturity period varies from three of 15 days to less than one year. months to one year CPs is issued in the denomination of Banks are not permitted to buy back Rs.5 lakh. The minimum size of the their CDs before the maturity issue is Rs. 25 lakh. CDs are subjected Statutory Liquidity requirements to CRR and The ceiling amount of CPs should not Ratio (SLR) exceed the working capital of the issuing company.

They are freely transferable by The investors in CPs market are banks, endorsement and delivery. They have individuals, business organisations and no lock-in period. the corporate units registered in India and incorporated units. CDs have to bear stamp duty at the prevailing rate in the markets The interest rate of CPs depends on
6/43

Reg no # 511017114

The NRIs can subscribe to CDs on the prevailing interest rate on CPs repatriation basis market, forex market and call money market. The attractive rate of interest in any of these markets, affects the demand of CPs. The eligibility criteria for the companies to issue CPs are as follows: - 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.

Master of Business Administration MBA Semester 4

7/43

Reg no # 511017114

MA0042 Treasury Management (Book ID: B1311) Assignment Set 1

Q.3 Critically evaluate participatory notes. Detail the regulatory aspects on it. Ans: Participatory notes International entrance to Indian capital market is limited to Foreign Institutional Investors (FIIs). The market has found a way to avoid the limitation by creating an instrument called Participatory Notes (PNs). PNs are basically contract notes. Indian traders buy securities and then issue PNs to foreign investors. Any dividends or capital gains collected from the primary securities are returned back to the investors. Any entity investing in PNs may not register with SEBI, whereas all FIIs have to register compulsorily. The benefits of PNs are as follows: Entities route their investment through PNs to extract advantage of the tax laws system. It provides a high degree of secrecy, which enables large funds to carry out their operations without revealing their identity. Investors use PNs to enter Indian market and shift to fully fledged FII structure when they are established.

In the case of Participatory Notes (PNs), the nature of the beneficial ownership or the identity is not known unlike in the case of FIIs. These PNs are freely transferable and trading of these instruments makes it all the more difficult to know the identity of the owner. It is also not possible to prevent trading in PNs as the entities subscribing to the PNs cannot be restrained from issuing securities on the strength of the PNs held by them. The Committee is, therefore, of the view that FIIs should be prohibited from investing fresh money raised through PNs. Existing PNholders may be provided an exit route and phased out completely within one year. Non-resident investments in India and use of Participatory Notes (PNotes) All things considered, both the non-resident foreigner and Non-resident Indian pay a hefty premium to a firm which has managed to get the license to operate in the Indian stock market i.e. an FII. Instead of moving towards decreasing
8/43

Reg no # 511017114

these transaction costs, the Committee recommends two actions that will further increase these costs: first, by delaying entry of individuals into the Indian market until 2008/9, and second by recommending a ban on Participatory notes or P-notes. The license raj has shifted from the industrial sector to the financial sector. Instead of reforming this license raj, the Committee, by recommending a ban on P-notes, is recommending a significant move backwards. So as water finds its way, so do investors. The report reveals a lack of understanding of the underlying fundamentals, and reality, of stock market transactions. It is the bans and controls on investment by foreign based individuals and corporates that has created the off-shore P-notes market in Indian securities. P-notes primarily exist because of the large transaction costs that the Indian system imposes on foreign residents and corporates, and because of higher capital gains taxes in India than in other emerging markets. Most important, comparator emerging markets have zero short and long term capital gains taxes. (India has a 10 % tax on short-term gains and a 33 percent tax rate on short-term gains made via futures markets. Unfortunately, the Report did not deem it appropriate to discuss the influence of such differential tax rates on human and investment behavior). Regrettably, P-Notes (an appropriate response to controls) is considered by the Committee to be of such an undesirable nature that it is recommended that they be banned immediately. That this might be a politically correct conclusion, at least in some institutions in India, is irrelevant. Like the FCAC committee, the government of India had also constituted an expert group to look at the issue of Encouraging FII Flows and checking the vulnerability of capital markets to speculative flows. This GOI report was published in November 2005; it reached the opposite conclusion on P-Notes than that reached by the FCAC Committee. The Committees haste towards an immediate ban of P-Notes, and immediate reversal of existing GoI policy, without any documentation or evidence, suggests an ideological bureaucratic predisposition. And is in complete contrast, and perhaps out of character, with the Reports endorsement of a new policy, with immediate implementation, of industrial houses owning commercial banks a policy, incidentally, I support. My only issue is that the Report is inconsistent in its recommendations. The recommendation on industrial houses does not come with any strings attached somewhat surprising, given the extreme caution with which the report proceeds on other matters.

9/43

Reg no # 511017114

Master of Business Administration MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set 1
Q.4 What is capital account convertibility? What are the implications on implementing CAC? Ans: Capital Account Convertibility (CAC) 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
10/43

Reg no # 511017114

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: Open the capital account for residents and non-residents. Initially open the inflow account and later liberalise the outflow account. Approach to simultaneously liberalise control of inflow and outflow account.

Liberalisation of current account transactions Current account transaction refers to converting domestic currencies freely into foreign currency and vice versa. The domestic currency is said to be convertible on the current account. This is known as current account convertibility. The benefits of current account transaction are as follows: Current account convertibility enhances the increase of capital inflow in to the country. The confidence of a country will be enhanced when the country will manage its affairs without exchange restrictions which enhance the international confidence in the countries policies. Relaxing the exchange restrictions has improved the Balance of Payment (BOP) in the country. The exclusion of exchange restrictions tends to increase the capital inflows and thus promote efficient allocation of inflows to the growth of the countrys economy. RBI has introduced more relaxations in current account transactions. The authorised dealers (ADs) have been permitted to provide exchange facilities to their customers up to specified limit without prior approval of the RBI. The liberalisation rules regarding current account transaction of RBI under FEMA 1999 are as follows: Authorised Dealers of Category - I banks permits withdrawal of foreign exchange payments below USD 2million by the individuals and approval of Ministry of Commerce and Industry, GOI is not mandatory. As per the Rule 4 of FEMA (current account transactions), it is mandatory to get approval of Ministry of Commerce and Industries for drawing foreign exchange remittances ,when the payment exceeds 5% on local sales and 8% increase on exports.
11/43

Reg no # 511017114

Liberalised remittance scheme is a facility extended to the residents of India. Under this scheme; the residents can remit in any current or capital account up to USD 2 million per financial year. This facility is only for resident individuals. The resident individuals can purchase and hold immovable property or shares or debt instrument outside India, without the prior approval of RBI. Residents can open, maintain and hold foreign currency accounts with banks outside India. The liberalised remittance scheme is not applicable for the following: - Any purpose under Schedule I and any item under Schedule II are prohibited for remittance under Foreign Exchange Management Rules 2000. - The resident individual cannot remit directly to Nepal, Bhutan and Pakistan. - There can be no remittances made directly or indirectly towards countries identified as non-co-operative countries and territories by the Financial Action Task Force (FATF). - The individuals and organisations identified and advised by the RBI as significant risk of committing terrorism are not eligible for any remittances directly or indirectly. Liberalisation of Exchange Earners Foreign Currency (EEFC) account - EEFC account is a foreign currency account maintained by a resident individual with an authorised dealer in India. These accounts are non-interest bearing and they are used for hedging against foreign currency fluctuations by the business organisations which have exports and imports in foreign currency payments. Some of the liberalised measures in EEFC account are: - RBI has permitted to earn interests on EEFC account if the outstanding balance is USD 1 million. - Due to liberalisation, all categories of foreign exchange earners can avail credit in this account based on their foreign exchange earnings. RBI decides on credit and debit limits. - If the reimbursement for an international credit card is provided in foreign exchange, it may be considered as a remittance through normal banking and the earnings can be credited to EEFC account. Other measures The other measure taken towards CAC is fuller capital account convertibility which is explained as follows: Fuller Capital Account Convertibility (FCAC) Indias cautious approach towards capital account and assessing it as a liberalisation process based on certain pre conditions has held India in good state. But with the changes that have taken place over the last two decades,
12/43

Reg no # 511017114

India felt the need to revisit the CAC and suggested a new map towards FCAC based on current situations. RBI, in consultation with the Government of India (GOI) appointed a committee on FCAC. S.S Tarapore was the chairman of committee. The committee suggested several recommendations for the development of financial market in addition to addressing issues related to interaction of monetary policy and exchange rate management, regulation and supervision of banks, and the timing and sequencing of capital account liberalisation measures. The objectives of FCAC are as follows: Economic growth - It facilitates economic growth through higher capital investment .This will lead to growth in employment opportunities, infrastructure development and other areas. Improvement in financial sector - Huge capital flow into the system will lead to the improvement of financial sector which will enhance performance of the companies. This will enhance the liquidity in the system. Diversify the investment: The diversification of investment will help ordinary people, to invest in foreign countries without restriction. This will help them to diversify their portfolio. Risks involved in FCAC FCAC risk arises from inadequate preparedness before liberalisation in domestic and external sector of policy consolidation, strengthening of regulation and development of financials markets. A transparent financial consolidation is necessary to reduce risk of the currency crisis. The risks are as follows: Market risks - Markets risks like interest rate and foreign exchange risks become more complicated when financial institutions have access to new markets or securities. Participation of foreign investors in domestic market changes the working of the domestic market. For example, banks have to quote rates and take open positions in new and more volatile currencies. Likewise, the change in foreign interest rate, affects the banks interest rate and liabilities. Credit risk: It includes a new dimension with cross border transaction. Cross border transactions introduces country risks to domestic market participants, the risk associated with economic, social, and political environment of the borrowers country. Risk in derivatives transaction It is very important with FCAC as derivatives transaction are main tools used in hedging risks .It includes both market and credit risk. Liquidity risk: It includes risk in foreign currencies denominated assets and liabilities. Large flow of funds in different currencies will expose the banks to greater variations in their liquidity position and complicate their asset-liability management.
13/43

Reg no # 511017114

Operational risk: The difference between domestic and foreign legal rights and obligations and their enforcements is important with FCAC. Operational risk may increase with FCAC. Limitations of FCAC The effort of making the Indian rupee fully convertible has a number of difficulties involved in it. The limitations are as follows: Indian industries lack competitive strength. Lack of emphasis on the quality of labour and management practices. Inadequate technology for industrial economy. Absence of prudent fiscal management. Lack of resilient exchange rate mechanism at work. Inadequate attention on tariff reduction and the rationalisation of tax structure in the adjustment scheme. Inflationary pressure on the economy.

Consequences of FCAC India might face the following consequences if it implements full convertibility without adequate reform measures: It will have to face the danger of becoming vulnerable to free movement of foreign capital, which may further worsen the macro-economic imbalances. Though the banks and financial institutions are fully capitalized, they are not fully prepared to handle the intricacies of the fuller convertibility. Hence it is desirable to further strengthen their financial base. The prevailing high interest rates in the economy will attract capital inflow. This will result in rupee appreciation which will affect Indian exporters.

14/43

Reg no # 511017114

Master of Business Administration MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set 1
Q.5 Detail domestic and international cash management system. Ans: Cash Management System Maintaining the channels of collections and accounting information efficiently has become essential with growth in business transaction sections. This includes enabling greater connectivity to internal corporate systems and providing better IT solutions and services in cash management. A Cash Management System (CMS) is a companys strategy which includes sustainable investment practices to enhance the collection of receivables, control payments to trade creditors and efficiently manage the liquidity margin. CMS involves hiring a debt collection service to recover the borrowed property by a customer, depositing cash into a lock box to ensure its protection. The objectives of cash management system are to bring the companys cash resources within control in an efficient manner and to achieve the optimum conservation and utilisation of the funds. Problems in cash management system are as follows: Controlling the cash level. Controlling inflows and outflows of cash. Optimum investment of surplus cash.

For example, proposition of CMS by HCL in order to enhance its liquidity level. HCL is a recognised leader in multi-service delivery engagement services. Keeping in view of the clients special needs, HCL has set up its cash
15/43

Reg no # 511017114

management system. Few features of HCLs cash management system are as follows: Application designing and development. Application re-engineering. System integration services. Business process outsourcing. Consulting services to select a suitable platform. Infrastructure management.

HCL has an enthusiastic domain practice team for cash management activities which includes bankers and IT professionals from various global banks and techno functionalists who have worked on cash management systems for global banks. The domain practice team supports the product development and delivery teams by continuous training and builds the required competency across the organisation. Domestic Cash Management System Reserve requirement The regulatory bodies like RBI instructs the banks to hold the deposit reserves of the public as cash and deposit. The reserves requirement limits the amount of loan that banks can lend to the domestic economy and thus limit the supply of money. Open market operations The regulatory body trades securities like treasury bills to the banking and non-banking public. The central bank reduces the supply of reserves by selling the securities and increased the supply of reserves by purchasing securities to the deposit money banks and thus affecting the supply of money. Lending by the central bank The regulatory body sometimes provide credit to deposit money banks. It affects the reserve levels and hence the monetary base. Direct credit control Regulatory bodies direct banks on maximum percentage or amount of loans to different economic sectors, liquid asset ratio. In this way the available savings are allocated and investments are directed in significant directions. Prudential guidelines Regulatory bodies require the deposit money banks to exercise particular care in their operations to fulfil the specified outcomes. Vital elements of prudential guidelines remove some choices from bank management and replace it with certain decision making rules. Exchange rate By trading foreign exchange, the regulatory body ensures that the exchange rate is at levels that do not affect domestic money supply in
16/43

Reg no # 511017114

undesired direction, through the balance of payments and the real exchange rate. Multinational Cash Management The strategy of a company which has its businesses in many nations and efficiently manages its cash and liquidity is called multinational cash management programme. The main goal of multinational cash management is the utilisation of local banking and cash management services. Multinational companies are those that operate in two or more countries. Decision making within the corporation is centralised in the home country or decentralised across the countries where the organisation does its business. The reasons for which the firms expand into other countries are as follows: Seeking new markets and raw materials Seeking new technology and product efficiency. Preventing the regulatory obstacles. Retaining customers and protecting its processes. Expanding its business.

Several factors which distinguish multinational cash management from domestic cash management are as follows: Different currency denominations. Political risk and other risk. Economic and legal complications. Role of governments. Language and cultural differences. Difference in tax rates, import duties.

The principle objective of multinational cash management programme is to maximise a companys financial resources by taking benefits from all liability provisions, payable periods. The multinational cash management programme effectively achieve its goals by using excess cash flow from some units across the globe to extend cash needs in other units which is called in-house banking and by relocating funds for tax and foreign exchange management through repricing and invoicing. During multinational cash management system payments by customers to companys branches are basically handled through a local bank. The payments between the branches and the parent company are managed through the
17/43

Reg no # 511017114

branches, correspondents or associates of the parent company. Through the use of electronic reporting systems a parent company observes cash balances in its foreign local banks. Multinational cash management programme specifically evaluate its techniques by timing of billing, use of lockboxes or intercept points, negotiated value range. The multinational cash management system involves exchange rate risk which occurs when the cash flow of one currency during transformation to another currency the cash value gets declined. It occurs due to the change in exchange rates. The exchange rates are determined by a structure which is called the international monetary system. For example, Wincor Nixdorf played an innovative role in enhancing cash handling between various countries. Wincors focus was on the entire process chain which started from head office to stores, crediting to the retail company's account, head office to branches and so on. Wincor Nixdorf's served several countries with its innovative hardware and software elements, IT services to side operations and consulting services to develop custom optimised solutions.

Master of Business Administration MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set 1
Q.6 Distinguish between CRR and SLR. Ans: Cash Reserve Ratio
18/43

Reg no # 511017114

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: CRR influences an economys money supply by effecting the potential of banks CRR influences inflation in an organisation CRR stimulates higher economic activity by influencing the liquidity

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:
19/43

Reg no # 511017114

By changing the SLR level, the RBI increases or decreases banks credit expansion Ensures the comfort of commercial banks Forces the commercial banks to invest in government securities like government bonds

20/43

Reg no # 511017114

Master of Business Administration MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set 2
Q.1 Explain any two major risks associated with banking organization. Ans: Treasury exposure allows treasury management to various risks in the organisation. Following are the few treasury exposures in an organisation: Financial exposure: The treasury management in the organisation are disclosed to the powerful analytics that enable to measure the global treasury operations and control financial market risks. It analyses the price and risk profile of financial dealings on a pre-dealing basis. The exposure in foreign exchange market is intense; hence hedging towards these risks by integrating business exposures and treasury transactions helps an organisation to manage financial risk and stay profitable. Foreign exchange exposure: This occurs due to the low profits and adverse fluctuations in foreign exchange rates. Many organisations suffer from foreign exchange risk by making purchases or sales in foreign currency or by owning assets or liabilities in foreign countries. Hence a relevant course of action must be implemented to reduce exposures in business operations. Currency exposure: It deals with future cash flows arising from domestic and foreign currencies that involve assets and liabilities and generating revenues which are susceptible to variations in foreign currency exchange rates. Hence the identification of existing potential currency relationship that arises from business activities includes hedging and other risk management activities. Event exposure: This happens due to a sudden change in the financial market during an investment (an event) that has a detrimental effect on the value of that investment. It is often associated with corporate bonds. Commodity exposure: This happens due to variations in the prices of commodities which change the future and magnitude of market values. The commodities depend on any production including foreign currencies, financial instruments or any physical substances. Hence treasury management is liable to deal with various risks like price, quantity, cost that are associated with commodities. Need for risk management
21/43

Reg no # 511017114

Risk management helps in minimising the failure of business activities which are based on finance or performance in the organisation. It is the responsibility of the organisation to manage risk effectively and overcome hindrances affecting the overall growth of the organisation. Hence risk management is required in the organisation for the following purposes: To identify the risk in business activities and establish a plan to manage risk and minimise the negative effects. To improve the efficiency of strategic and business plans, and effective use of resources among the stakeholders in the organisation. It helps in increasing the ability to deliver products to the customers within the stipulated time and reduce the production cost. It helps to control the negative political, economic, and financial factors which may harm an organisations growth. To overcome sensitive internal environment, social or safety issues or regulatory and licensing conditions available in most of the organisations. To focus on internal audit process and robust contingency planning.

Corporate risks Corporate risks include non-financial organisational risks that arise during challenging times in the economy. . The corporate risk varies for different organisations based on factors like size, diversity in business activities and sources of capital etc. According to the assumptions of Modiglani and Miller (1958), Corporate risk is a redundant activity. It is mainly concerned with progressive tax rate and expecting costs from financial distress. The value of an organisation depends on the changes in exchange and interest rates, and commodity prices. Hence the corporate risk manager quantifies the exposures occurring in the organisation to reduce risks that hamper the financial sector. Corporate risk is further divided into market, credit and operational risks. Credit risk experiences less challenges compared to operational and market risks. The operational risk occur due to certain factors like back office errors, fraud, natural disaster etc. The organisation faces market risk with respect to commodity price risk and foreign exchange risk. Hidden risks Hidden risks are related to cash and financial risk in an organisation. These risks might harm the growth of an organisation. Hence the manager is responsible to identify the risk and implement relevant actions to eliminate it. A complete and accurate exposure calculation can eliminate the hidden risks. Hidden risks are also concerned with financial accounting. Financial risk is the
22/43

Reg no # 511017114

probability when an actual return on an investment is lower than the expected return. They are the uncertainties in business leading to variations in expected profits and losses. Uncertainties related to several risks affect the net cash flow of any business organisation. Lower uncertainties have lower variations in net cash flow, and vice versa.

Master of Business Administration MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set 2
Q.2 What is liquidity gap and detail the assumptions of it? Ans: 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. Alternative scenarios Alternative scenario method is used to calculate the adequate liquidity in banks. Depending on the behaviour of cash flow the alternative scenario calculates a banks liquidity in different conditions.
23/43

Reg no # 511017114

There are three scenarios for a bank that provides useful benchmarks. They are: Going concern Bank specific crisis General market crisis

A bank should try to account for any major liquidity changes (positive or negative) that could occur in these scenarios. Going concern/general market conditions The going concern/general market conditions scenario is helpful for banks in establishing a standard for the normal business behaviour. Banks use general market conditions to handle the deposit and other debts. With the help of general market conditions the banks avoid the impact of temporary constraints and manage their NFRs. Due to this concern, the banks never face a very large need of cash to be paid on any given day. Bank specific crisis The bank specific crises are liquidity crises for individual banks. The crises remain restricted to the banks and provide a sort of worst-case benchmark. The main idea in bank specific crisis is that, the banks liabilities cannot be replaced or rolled over. The banks must pay the liabilities at the time of maturity. If a bank can survive these types of worst-cases, then the bank can survive any kind of small problems. General market crisis The general market crises are the ones under which liquidity affects every bank in more than one market. Some banks might think that the nations Central bank would ensure that the key markets would continue to function in some form. For bank management, the scenario represents a second type of "worstcase". While surveying the liquidity profile of entire banking sector, the Central bank might find this scenario to be of particular interest. The combined results will suggest the size of the total liquidity buffer in the banking system. The result also suggests the likely distribution of liquidity problems among large institutions. A bank needs to assign the time for cash flow for each category of asset. The decision about the exact time and size of cash flows is an essential part of the construction of the maturity ladder under every situation. Assumptions in preparation of gap report in terms of assets, liabilities and off balance sheet items
24/43

Reg no # 511017114

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. 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: The highly liquid group of 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. A less liquid group of assets consists of bank's saleable loan portfolio. 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. The least liquid group of assets consist of basically unmarketable assets 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. Liabilities To check the cash flows occurring due to a bank's liabilities, a bank should first examine the behaviour of its liabilities under normal business situations. This would include forming: The level of roll-overs of deposits and other liabilities remain normal. The actual maturity of deposits with non-contractual maturities, such as demand deposits and others; the normal growth in new deposit accounts.
25/43

Reg no # 511017114

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 public-sector 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.
26/43

Reg no # 511017114

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. 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 market-maker, with a possibility that in a bank-specific or general market crisis, customers with inthe-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. Other assumptions Until now the discussion was centered on the assumption about the behaviour 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.
27/43

Reg no # 511017114

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.

Master of Business Administration MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set 2
Q.3 Explain loanable fund theory and liquidity preference theory. Ans: Here we will discuss about the theories on interest rate whose main focus is on the charged amount to be paid against the borrowed money. In every case the rate of interest is charged on the total asset values. Different types of interest terms exist in todays global economic environment which has its own identical meanings like simple interest, compound interest, fixed and floating rates of interest, cumulative interest or return. The rate of interest in the global investment market is determined according to the existing conditions of the retail economic organisations like banks, bond market and financial market. Before calculating the rate of interest, each type of debt instruments in the market considers factors like inflation, opportunity cost, and interest rate risk. There are various interest rate theories given by several economists like loanable funds theory, time preference theory, mathematical theory, classical theory of interest. Investment being a function of interest rates, the impact of interest rates on the economy is very significant. We will discuss few of the interest theories in the succeeding section. Loanable funds theory
28/43

Reg no # 511017114

Loanable funds theory explains that the calculation of the rate of interest is on the basis of demand and supply of loanable funds which are available in the capital market. The concept was created by Knut Wicksell (1851-1926), who was a well-known Swedish economist. It was widely accepted before the work of the English economist John Maynard Keynes (1883-1946). An increase in the demand of loanable funds leads to an increase in the interest rate and vice versa. Also an increase in the supply of loanable funds results in the fall of interest rate. If both the demand and supply of the loanable funds changes, the resultant interest rate depends on the level and route of the movement of the loanable funds. The loanable funds theory encourages that both savings and investments are responsible for the determination of the rates of interest. The short-term interest rates are assessed on the basis of the financial conditions of an economy. In case of loanable funds theory the determination of the interest rates depends on the availability of the loan amount. The availability of loan amount is based on certain factors like net increase in currency deposits, amount of savings made, and willingness to enhance cash balances. Liquidity preference theory The liquidity preference theory or liquidity preference hypothesis, proposed by J. M. Keynes, explains the relation between the generation of a debt instrument and its maturity period. The liquidity preference theory states that investors maintain their funds in liquid form like cash rather than less liquid assets like stocks, bonds and commodities. Banks offer interest to investors to compensate for their liquidity losses which ultimately promote long-term investments. The liquidity preference theory does not deal with liquidity, but deals with the risks associated with maturity. According to this theory, the risks related to the maturity of debt instruments are directly proportional to the length of the maturity period. According to the liquidity preference theory, if the investors possess debt instruments that have longer term periods then they will receive a premium of the rates of interest over a long-term period. This premium is known as the liquidity premium. Liquidity premium stabilises the financial risks that the investors have suffered due to the investment in debt instruments that had longer term periods. As a result of the premium, the generation of the debt instrument that has a longer periodic term is higher compared to debt instruments having shorter term periods. Liquidity preference is a potentiality or functional tendency, which arranges the quantity of money which the public will hold when the rate of interest is given;
29/43

Reg no # 511017114

so if r is the rate of interest, M the quantity of money and L the function of liquidity preference, we can define M = L(r). Cause of liquidity preference Liquidity preference theory is preferred among most of the theories. The liquidity preference theory is a short-run model of interest rate determination. It describes economic fluctuations around the long-run drift. It provides a suitable analytical framework to investigate the role of monetary policy and the financial system. The liquidity preference theory also proposes the concept of risks and liquidity premium to predict the future rates. Investors have a preference for investing in short-term securities. But, when the market interest rates change, the prices of long-term bonds fluctuate more than the prices of short-term bonds. The added risk prevents some investors from investing in long-term bonds. To attract investors, the long-term bonds must offer a return that exceeds the expected return on a series of short-term bonds. Therefore, when the yield curve rises up, we cannot be sure whether this is the result of investors expecting interest rates to rise in the future. The liquidity preference theory recognises this problem. It depicts that the yield curve slope is influenced by the expected interest rate changes and the liquidity premium that investors require on long-term bonds. The following are the three divisions of liquidity preference: Transactions motive It is the need of cash for the current transaction of personal and business exchanges. Precautionary motive It is the desire for security as to the future cash equivalent of a certain proportion of total resources. Speculative motive It is the object of securing profit from knowing better than the market what the future will bring forth.

Master of Business Administration MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set 2
Q.4 Explain various sources of interest rate risk. Ans:
30/43

Reg no # 511017114

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. 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 1 depicts the normal yield curve

Figure 1: Normal Yield Curve

31/43

Reg no # 511017114

Figure 2 depicts the inverted yield curve

Figure 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. 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. Optionality risk
32/43

Reg no # 511017114

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. 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. 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
33/43

Reg no # 511017114

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 3 depicts the value of embedded call option varying with respect to changes in interest rates.

Figure 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 4 depicts the value of embedded put option which is obtained by the changes in interest rates.

Figure 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
34/43

Reg no # 511017114

number of options can implicate leverage magnifying the positive or negative influences of financial options positions in the organisation.

Master of Business Administration MBA Semester 4 MA0042 Treasury Management (Book ID: B1311) Assignment Set 2
Q.5 Detail Foreign exchange risk management and control procedure. Ans: Foreign Exchange Risk Management Foreign exchange risk management is intended to preserve the value of currency inflows, investments and loans, while enabling international banks to compete abroad. Even though it is impossible to eradicate all risks, negative exchange outcomes can be predicted and managed effectively by individuals and corporate entities. Although the foreign exchange risk management is different for various banks based on the nature and complexity of their foreign exchange activities, a foreign exchange risk management plan requires: Establishing and executing comprehensive and prudent foreign exchange risk management policies. Evolving and applying suitable and management and control procedures. effective foreign exchange risk

Objectives of foreign exchange risk management Foreign exchange risk management in a bank requires well defined objectives which must reflect the organisations attitude towards foreign exchange risk. Primarily, the objectives of foreign exchange risk management must be in line with the corporate objectives set by the bank. The objectives of foreign exchange risk management are as follows:
35/43

To minimise the possible currency losses. To reduce the variability of the cash flows of business.

Reg no # 511017114

To assist individuals involved in foreign exchange management in the implementation of updated procedures of foreign exchange risk. To develop possible solutions to avoid the negative influence of adverse currency movements in foreign exchange. To outline enhanced procedural guidelines for ongoing control and management of foreign exchange risk.

Foreign exchange risk management policies Well defined policies, set forth the objectives of the banks foreign exchange risk management strategy and its parameters. The foreign exchange risk management policies include the following: A statement of forex risk principles and objectives - Before setting up the foreign exchange risk limits and management controls it is necessary for banks to decide the goals of foreign exchange risk management plan and in particular, readiness of the bank to assume risk. Therefore, the objective of foreign exchange risk management is to manage the influence of exchange rate changes within self-imposed limits after considering a wide range of possible foreign exchange rate scenarios. Limits of forex risks - Risk limits are established according to the relationship between the foreign exchange position and the capital, or according to the foreign exchange volume which includes total cash and the number of transactions. The foreign exchange risk limits cover the following: - The currencies in which the institution is permitted to experience risk exposure. - The level of foreign currency exposure that the bank is willing to assume. Delegation of authority - Clearly defined levels of delegated authority helps in ensuring that a banks foreign exchange positions does not surpass the limits established under the foreign exchange risk management policies. The delegation of authority needs to be clearly recognised, and must include the following: - The absolute and/or incremental authority to be delegated. - The units, entities, positions or committees to whom authority is being delegated. - The ability of receivers to further delegate authority. - The restrictions placed on the use of delegated authority. Foreign exchange risk management tools and techniques

36/43

Reg no # 511017114

Various tools and techniques are used for measuring foreign exchange risk management. Some of the foreign exchange management tools used are as follows: Forward contracts Currency futures Currency options Currency swaps

Forward contracts Foreign exchange forward contracts are the most common resources for hedging transactions in foreign currencies. A forward contract is an agreement to buy or sell foreign exchange for an amount determined in advance, at a specified exchange rate at a designated date in future. The specified rate is called the forward rate, the designated date the settlement date or delivery date. The difference between forward contract and other sales contracts is that the delivery and payment of the commodity occurs at a specified future date in case of forward contracts. Forward contracts are privately exchanged and are not standardized. This gives rise to counterparty risk or default risk arising out of failure of the other party to honour its commitment. For such situations currency futures are more suitable. Currency futures Currency futures are forward contracts in which two parties agree between them to exchange something in the future. As futures contracts are traded on exchange with appropriate controls, counter party risk as prevalent in Forward contracts is prevented. The major currency futures market is the EUR futures market, based upon the Euro to US Dollar exchange rate. The most popular currency futures are provided by the Chicago Mercantile Exchange group, and include the following futures markets: EUR - It is the Euro to US Dollar futures market. GBP - It is the British Pound (Sterling) to US Dollar futures market. CAD - It is the Canadian Dollar to US Dollar futures market. CHF - It is the Swiss Franc to US Dollar futures market. Currency options A currency option is an alternative tool for managing forex risk. A foreign exchange option is an agreement for future supply of a currency interchanged with another, where the owner of the option has the right to buy (or sell) the currency at a settled price. The right to buy is a call; the right to sell is called as put. For such a right the holder pays a price called the option premium. The
37/43

Reg no # 511017114

option seller receives the premium and is indebted to make (or take) delivery at the agreed-upon price if the buyer exercises his option. Currency swaps Currency swaps deal with the exchange of payments in different currencies between two trading partners. For productivity currency swaps feature netting, in which the winning party obtains payment at the end of the swap term. Foreign Exchange Risk Management (FERM) and control procedures Each of the banks engaged in foreign exchange activities is responsible for evolving, applying and supervising procedures to manage and control foreign exchange risk based on the risk management policies. In devising a firms FERM policy, certain factors have to be taken into account the firms exposure, general attitude towards risk management, whether its risk-averse, riskindifferent or risk-seeking, the firms ability to alter exposed positions i.e. the maximum exchange loss it can absorb without much impact, the competitors stance and most importantly regulatory requirements. Foreign exchange risk management procedures include the following: Systems to measure and monitor foreign exchange risk Management of foreign exchange risk involves a clear understanding of the amount of risk and the influence of exchange rate changes on the foreign currency exposure. In order to make these determinations, adequate information must be readily available to permit suitable action to be taken within the acceptable time period. Therefore, each of the banking organisations engaged in foreign exchange activities must have an operative accounting and management information system in place that records and measures the following accurately: - The risk exposures related to foreign exchange trading. - The impact of potential exchange rate changes on the bank. Control of foreign exchange activities: Though the controls of foreign activities vary widely among the banks depending upon the nature and extent of their foreign exchange activities, the main elements of any foreign exchange control plan are well-defined procedures governing: - Organisational controls: To guarantee that there exists a clear and effective isolation of duties between those persons who initiate the foreign exchange transactions and are responsible for operational functions of foreign exchange activities. - Procedural controls: To ensure that the transactions are completely recorded in the accounts of the banks, they are promptly and correctly settled and to identify unauthorised dealing instantly and reported to the management.

38/43

Reg no # 511017114

- Other controls: To make sure that the foreign exchange activities are supervised frequently against the banks foreign exchange risk, counterparty and other limits and those excesses are reported to the management. Independent inspections/audits Independent inspections/audits are an important factor for managing and controlling a banks foreign exchange risk management plan. Banks must use them to ensure compliance with, and the integrity of, the foreign exchange policies and procedures. Independent inspections/audits should examine the banks foreign exchange risk management activities in order to: - Ensure adherence to the foreign exchange management policies and procedures. - Ensure operative management controls over foreign exchange positions. - Verify the capability and accurateness of the management information reports regarding the institutions foreign exchange risk management activities. - Ensure that the foreign exchange hedging activities are consistent with the banks foreign exchange risk management policies and procedures. - Ensure that employees involved in foreign exchange risk management are given accurate and complete information about the institutions foreign exchange risk policies, risk limits and positions.

Master of Business Administration MBA Semester 4 MA0042 Treasury Management

39/43

Reg no # 511017114

(Book ID: B1311) Assignment Set 2

Q.6 Describe the three approaches to determine VaR. Ans: 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 Simulation approaches Extreme value theory

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: The relationship between the underlying asset price and the potential value of the component of a portfolio is nonlinear. The price of the components is also exposed to risk factors like delay in time and the expected volatility of the underlying assets returns. If back testing, a method which is discussed later in this unit indicates that VaR estimations are not accurate, the risk manager should try to analyse whether to change methodology, improve the mapping process, or implement both. 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
40/43

Reg no # 511017114

assumptions underlying the computations of VaR are described by publications by J. P. Morgan in 1996: 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. 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: 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: - The shock effects on the variance of stock market returns. - Effects of increase in the variance of excess returns of bonds on risk premiums. 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. 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
41/43

Reg no # 511017114

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: - Crude Monte Carlo This method concludes the confidence intervals of your method and the accuracy of the answer. - Acceptance Rejection Monte Carlo: This evaluation provides a less accurate approximation when compared to Crude Monte Carlo method. - Stratified sampling: This technique divides the interval into subintervals and then performs Crude Monte Carlo method on each interval. - Importance sampling: 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. 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
42/43

Reg no # 511017114

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.

43/43