Master of Business Administration - MBA Semester 4
MF0016 – Treasury Management
Assignment Set- 1
Q.1 Explain how organization structure of commercial bank treasury facilitates in
handling various treasury operations.
Ans:- The treasury organization deals with analysing, planning, and implementing
treasury functions. It deals with issues of profit centre, cost centre etc. The
organizations managing interfaces with treasury functions include intragroup
communications, taxation, recharging, measurement and cultural aspects.
Structure of treasury organization
Figure 1.2 depicts the structure of treasury organization which is divided into five
Figure 1.2: Treasury Organizations
• Fiscal – This group includes budget policy planning division, industrial and
environmental division, common wealth state relationships, and social policy
• Macroeconomic – This group deals with economic sector of the organization. It
includes domestic and international economic divisions, macroeconomic policy
and modeling division.
• Revenue – This group is concerned with the taxes in an organization. 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
organization. It includes financial and facilities division, human resource division,
business solutions and information management division.
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
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 bank’s 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:
1. Money market instruments – Call, term, and notice money, commercial
papers, treasury bonds, repo, reverse repo and interbank participation etc.
2. Bonds – Government securities, debentures etc
• 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 industry’s 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.
Q.2 Bring out in a table format the features of certificate of deposits and
Features of commercial papers
Features of CDs in Indian
CPs is an unsecured promissory
Schedule banks are eligible to
CPs can be issued for a maturity
of 15 days to less than one year.
Maturity period varies from three
to one year
CPs is issued in the denomination
Rs.5 lakh. The minimum size of
the issue is Rs. 25 lakh.
Banks are not permitted to buy
their CDs before the maturity
The ceiling amount of CPs should
not exceed the working capital of
the issuing company.
CDs are subjected to CRR and
Liquidity Ratio (SLR) requirements
The investors in CPs market are
banks, individuals, business
organizations and the corporate
units registered in India and
They are freely transferable by
endorsement and delivery.
They have no lock-in period.
The interest rate of CPs depends
on the prevailing interest rate on
CPs market, forex market and call
money market. The attractive rate
of interest. In any of these
markets, affects the demand of
CDs have to bear stamp duty at
prevailing rate in the markets
The eligibility criteria for the
to issue CPs are as follows:
The NRIs can subscribe to CDs
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 Service of India
(CRISIL) and Investment
Information and Credit Rating
Agency of India Limited. (ICRA)
The current ratio of the issuing
company should be 1.33:1.
The issuing company has to be
listed on stock exchange.
Q.3. Critically evaluate participatory notes. Detail the regulatory aspects on it.
Ans:- The participants in forex market are the RBI at the apex, authorised dealers
(ADs) licensed by forex market, exporters, importers, companies and individuals. The
major participants of foreign exchange market are:
• Corporates – They mainly include business houses, international investors, and
multinational corporations. They operate in market by buying or selling currencies
within the framework of exchange control regulations. It deals with banks and
their clients to form retail segment of forex market.
• Commercial banks – They play an important role in forex market. They operate in
market by trading currencies for their clients. Large volume of transactions
consists of banks dealing directly among themselves and smaller transactions
usually consists of intermediary foreign exchange brokers.
• Central bank – It plays a vital role in the country’s economy by controlling money
supply. Central banks get involved in forex market to regain price stability of
exchange rate, protect certain levels of price in exchange rate, and support
economic goals like inflation and growth.
• Exchange brokers – They ensure the most favourable quotations between the
banks at a low cost in terms of time and money. Banks provide opportunities to
brokers in order to increase or decrease the rate of buying or selling foreign
currencies. Exchange brokers have a tendency to specialise in unusual
currencies but also manage major currencies. In India, many banks deal through
recognized exchange brokers or may deal directly among themselves.
The other participants include RBI and its authorised dealers, exporters, importers,
companies and individuals.
Q.4 What is capital account convertibility? What are the implications on
Ans:- 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 1990’s. 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 liberalization 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 liberalized it had been since late 1950’s. 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 liberalize the outflow account.
• Approach to simultaneously liberalize control of inflow and outflow account.
Q.5 Detail domestic and international cash management system
Ans;- 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 utilization of local
banking and cash management services.
Multinational companies are those that operate in two or more countries. Decision
making within the corporation is centralized in the home country or decentralized across
the countries where the organization 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 maximize a
company’s 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 re-pricing and invoicing.
During multinational cash management system payments by customers to company’s
branches are basically handled through a local bank. The payments between the
branches and the parent company are managed through the 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. Wincor’s 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.
Q.6 Distinguish between CRR and SLR
Ans:- Cash Reserve Ratio
Cash Reserve Ratio (CRR) is a country’s 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 country’s 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 organization that holds reserves in excess amount is said to hold excess reserves.
The following are the effects of CRR on economy:
• CRR influences an economy’s money supply by effecting the potential of banks
• CRR influences inflation in an organization
• 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 bank’s leverage position to
drive more money into the economy.
If any Indian bank fails to maintain the required level of SLR, then it is penalized 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:
• By changing the SLR level, the RBI increases or decreases banks’ credit
• Ensures the comfort of commercial banks
• Forces the commercial banks to invest in government securities like government
Master of Business Administration - MBA Semester 4
MF0016 – Treasury Management
Assignment Set- 2
Q.1 Explain any two major risks associated with banking organization.
Ans:- The major risks are associated with banking organizations. Since banks use a
large amount of leverage, it becomes important to manage risks carefully. The various
types of risks are:
• Interest rate risk
• Foreign exchange risk
• Liquidity risk
• Default risk
• Financial risk
• Market risk
• Credit risk
• Personnel risk
• Environmental risk
• Production risk
Interest rate risk
Interest rate risk occurs due to the change in absolute level of interest rates causing
variations in the value of investments. Such changes usually affect the securities like
shares, bonds, mutual funds or money market instruments and can be reduced by
diversifying or hedging techniques. The evaluation of interest rate risk should consider
illiquid hedging products or strategies, and potential impact on fee income which are
sensitive to changes in interest rates. They are classified into the following:
• Term structure risk (yield curve risk) – It arises from the variations in the
movement of interest rates across maturity spectrum. It consists of changes in
relationship between interest rates of various maturities of similar market. The
changes in relationships occur when the shape of yield curve for a market
flattens, steepens, or becomes inverted during interest rate cycle. The yield curve
variations can emphasize a bank’s risk position by increasing the effect of
• Basis risk – It occurs due to the changes in relationship between interest rates
for different market sectors.
• Options risk – It arises when bank or bank customer gains privileges to alter the
level and timing of cash flows of asset, liability or off balance sheet instruments.
The option holder has the rights to buy or sell the financial instruments over a
specified period of time. But the option holder faces limited downside risks
(amount paid for option) and unlimited upside reward. The option seller faces
unlimited downside risk (option exercised during the time of disadvantage) and
limited upside reward (retaining premium).
Foreign exchange risk
Foreign exchange risk occurs during the change of investments value occurring due to
the changes in currency exchange rates. It refers to the probability of loss occurring due
to an adverse movement in foreign exchange rates. For example – Consider an investor
residing in United States purchases a bond denominated in Japanese Yen. By this the
investor experiences decline in rate of return at which the Yen exchanges for dollars.
The three types of foreign exchange risk or exposure are:
• Transaction risk – It is the possibility of affecting future transactions of the
organization due to the changes in currency exchange rates.
• Economic risk – It measures the impact of changes in exchange rate risk on the
organization’s cash flows and earnings.
• Translation risk – It measures the impact of changes in exchange rate of
organization’s financial statements. It is also known as accounting exposure.
Q.2 What is liquidity gap and detail the assumptions of it?
Ans;- Liquidity Gap Report
A liquidity gap is the difference between the due balances of assets and liabilities over
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.
Assets are nothing but any item of economic value owned by an individual or
corporation. Assumptions regarding a bank’s 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 unsalable 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
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 categorizing the assets, banks should take care of the effects on the asset’s
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.
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
• 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.
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 it’s 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
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
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
• 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 bank’s 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 bank’s 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 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.
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
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 bank’s funds to
a large extent.
The other expenses such as rent and salary however are not given much importance in
the analysis of the bank’s liquidity. But they can be sources of cash outflows in some
Q.3 Explain loanable fund theory and liquidity preference theory
Ans: - Loanable funds theory
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
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
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
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; 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).
Q.4 Explain various sources of interest rate risk
Ans:- The interest rate risk adversely affects the organization’s financial situation. It
poses significant threat to the incomes and capital investments of the organization. The
changes occurring in interest rate affects the value of underlying assets of the
organization. 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 organization’s
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
organization 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
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 organization. The effects of recession
impose negative impacts to the organization 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 organization at short term rates borrow cash and lend it at long term rates
to gain profits.
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 organization 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 organization 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 organization 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 arises with various option instruments of banks like assets, liabilities. It
occurs during the process of altering the bank’s instruments’ levels of cash flows by
bank’s 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 bank’s capital value due to unfavorable interest rate movements
such that it exceeds the profits that a bank gains, during the favorable 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
organizations 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 bank’s asset
maturities while the bank desires to extend it.
Repricing risk arises due to the differences between the timing of rate changes and
cash flows occurring in pricing and maturity of bank’s 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 organizations 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 bank’s 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 organizations 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 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 organizations 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.
Q.5 Detail Foreign exchange risk management and control procedure
Ans;- 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 firm’s FERM policy, certain factors
have to be taken into account – the firm’s exposure, general attitude towards risk
management, whether its risk-averse, risk-indifferent or risk-seeking, the firm’s ability to
alter exposed positions i.e. the maximum exchange loss it can absorb without much
impact, the competitor’s 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 organizations engaged in foreign exchange activities must
have an operative accounting and management information system in place that
records and measures the following accurately:
1. The risk exposures related to foreign exchange trading.
2. The impact of potential exchange rate changes on the bank.
• Control of foreign exchange activities – Though the control 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:
1. Organizational 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.
2. 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 unauthorized dealing instantly and reported to the
3. Other controls – To make sure that the foreign exchange activities are
supervised frequently against the bank’s foreign exchange risk,
counterparty and other limits and those excesses are reported to the
• Independent inspections/audits – Independent inspections/audits are an
important factor for managing and controlling a bank’s 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 bank’s foreign exchange risk management
activities in order to:
1. Ensure adherence to the foreign exchange management policies and
2. Ensure operative management controls over foreign exchange positions.
3. Verify the capability and accurateness of the management information
reports regarding the institution’s foreign exchange risk management
4. Ensure that the foreign exchange hedging activities are consistent with the
bank’s foreign exchange risk management policies and procedures.
5. Ensure that employees involved in foreign exchange risk management are
given accurate and complete information about the institution’s foreign
exchange risk policies, risk limits and positions.
Q.6 Describe the three approaches to determine VaR
Ans:- The Value at Risk (VaR) approach is a comprehensive indicator for measuring
foreign exchange risks. VaR approach incorporates all the assets and liabilities of the
national financial system, along with the contingent liabilities, thus permitting rapid
comparison among different countries and the analysis of the evolution over time for a
Value at risk method is used to set market position limits for traders and to decide how
to allocate minimum capital resources. VaR allow creation of a common denominator to
compare risky activities in varied markets. The total risk of the banks can also be
decomposed into incremental VaR to reveal positions that increases total risk. On the
other hand, VaR can be used to regulate the performance of risk. Performance
assessment of risk is vital in banks, where traders have a natural tendency to take on
extra risk. Risk capital charges based on VaR approach provides corrected incentives to
The VaR approach has a number of practical advantages and disadvantages. The
advantages of VaR are as follows:
• The potential losses are computed in simple terms.
• VaR approach is approved by various regulatory bodies concerned with the risks
faced by banks such as RBI (Reserve Bank of India) and SEBI (Securities and
Exchange Board of India).
• VaR acts as a versatile tool for forex risk measurement.
On the other hand, value at risk approach possesses certain limitations too. The
limitations of VaR are as follows:
• VaR faces some difficulties in risk estimation and is sensitive to the estimation
• VaR approach may create a false sense of security.
• VaR may miscalculate the worst-case outcomes for a bank.
• The VaR of a specific market position is not always the same for the VaR of the
overall portfolio of the bank.
• VaR fails to incorporate positive results, thus painting an incomplete picture of