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  1. 1. MFOOO7 TREASURY MANAGEMENT Q.1. Explain the Functions of Integrated Treasury of a Bank. Answer: Traditionally, the forex dealing room of a bank managed the foreign exchange dealings mainly arising out of merchant transactions (FX buying from & selling to customers) and consequent cover operations in inter-bank market. The domestic treasury / investment operations were independent of forex dealings of a bank. Treasury operations were treated as cost centre, specifically devoted to reserve management (CRR &SLR) and consequent fund management. Treasury also undertook investment in both Government and non-Government securities. The need for integration of forex dealings and domestic treasury operations has arisen in the backdrop of interest rate deregulations, liberalization of Exchange Control, development of forex market, introduction of derivative products and technological advancement in settlement systems and dealing environment. The integrated treasury performs not only the traditional roles of forex dealing room and treasury unit but also many other functions as detailed below. The major functions of a treasury unit are as follows: a. Reserve Management & Investment: It involves (i) meeting CRR / SLR obligations, (ii) having an appropriate mix of investment portfolio to optimize yield and duration. Duration is the weighted average ‘life’ of a debt instrument over which investment in that instrument is recouped. Duration Analysis is used as a tool to monitor the price sensitivity of an investment instrument to interest rate changes. b. Liquidity & Funds Management: It involves (i) analysis of major cash flows arising out of asset-liability transactions (ii) providing a balanced and well-diversified liability base to fund the various assets in the balance sheet of the bank (iii) providing policy inputs to strategic planning group of the bank on funding mix (currency, tenor & cost) and yield expected in credit and investment. c. Asset Liability Management & Term Money: ALM calls for determining the optimal size and growth rate of the balance sheet and also prices the Assets and Liabilities in accordance with prescribed guidelines. Successive reduction in CRR rates and ALM practices by banks increase the demand for funds for tenor of above 15 days (Term Money) to match duration of their assets. Page 1 of 10
  2. 2. MFOOO7 TREASURY MANAGEMENT d. Risk Management – Integrated treasury manages all market risks associated with a bank’s liabilities and assets. The market risk of liabilities pertains to floating interest rate risks and asset & liability mismatches. The market risk for assets can arise from (i) unfavorable change in interest rates (ii) increasing levels of disintermediation (iii) securitization of assets (iv) Emergence of credit derivatives etc., While the credit risk assessment continues to rest with Credit Department, the Treasury would monitor the cash inflow impact from changes in asset prices due to interest rate changes by adhering to prudential exposure limits. e. Transfer Pricing: Treasury is to ensure that the funds of the bank are deployed optimally, without sacrificing yield or liquidity. An integrated Treasury unit has an idea of the bank’s overall funding needs as well as direct access to various markets (like money market, capital market, forex market, credit market). Hence, ideally treasury should provide benchmark rates, after assuming market risk, to various business groups and product categories about the correct business strategy to adopt. f. Derivative Products: Treasury can develop Interest Rate Swap (IRS) and other Rupee based / cross-currency derivative products for hedging Bank’s own exposures and also sell such products to customers/other banks. g. Arbitrage: Treasury units of banks undertake this by simultaneous buying and selling of the same type of assets in two different markets to make risk-less profits. h. Capital Adequacy: This function focuses on quality of assets, with Return on Assets (RoA) being a key criterion for measuring the efficiency of deployed funds. An integrated treasury is a major profit centre. It has its own P & L measurement. It undertakes exposures through proprietary trading (deals done to make profits out of movements in market interest / exchange rates) that may not be required for general banking. Page 2 of 10
  3. 3. MFOOO7 TREASURY MANAGEMENT Q.2. Distinguish between Collateralized Borrowing & Lending Obligation, Repo and reverse Repo Answer: “Collateralized Borrowing and Lending Obligation” is popularly known as CBLO. It is recently developed money market instrument in India (developed by CCI Land approved by RBI) for the benefit of the entities who have either been phased out from interbank call money market or have been given restricted participation in terms of ceiling on call borrowing and lending transactions and who do not have access to the call money market. CBLO is a discounted instrument available in electronic book entry form for the maturity period ranging from one day to ninety Days (can be made available up to one year as per RBI guidelines). The main features of CBLO include: • There is an obligation by the borrower to return the money borrowed, at a specified future date; • There is an authority to the lender to receive money lent, at a specified future date with an option/privilege to transfer the authority to another person for value received; • There is an underlying charge on securities held in custody (with CCIL) for the amount borrowed/lent. The participants in this market are banks, financial institutions, insurance companies, mutual funds, primary dealers, NBFCs, non-Government Provident Funds, Corporates' etc. The participants open a Constituent SGL (CSGL) Account with CCIL for depositing securities which are offered as collateral / margin for borrowing and lending of funds. Eligible securities are Central Government securities including Treasury Bills. A repo or repurchase Agreement is an instrument of money market. Usually reserve bank (federal bank in U.S) and commercial banks involve in repo transactions but not restricted to these two. Individuals, banks, financial institutes can also participate in repurchase agreement. Repo is a collateralized lending i.e. the banks which borrow money from Reserve Bank to meet short term needs have to sell securities, usually bonds to Reserve Bank with an agreement to repurchase the same at a predetermined rate and date. In this way for the lender Page 3 of 10
  4. 4. MFOOO7 TREASURY MANAGEMENT of the cash (usually Reserve Bank) the securities sold by the borrower are the collateral against default risk and for the borrower of cash (usually commercial banks) cash received from the lender is the collateral. Reserve bank charges some interest rate on the cash borrowed by banks. This rate is usually less than the interest rate on bonds as the borrowing is collateral. This interest rate is called ‘repo rate’. The lender of securities is said to be doing repo whereas the lender of cash is said to be doing ‘reverse repo’. In a reverse repo Reserve Bank borrows money from banks by lending securities. The interest paid by Reserve Bank in this case is called reverse repo rate. Borrower of funds is called as seller of repo and lender of funds is called as buyer of repo. When the term of the loan is for one day it is known as an overnight repo and if it is for more than one day it is called a term repo. The forward clean price of bonds is set at a level which is different from the spot clean price by adjusting the difference between repo rate and coupon earned on the security. Page 4 of 10
  5. 5. MFOOO7 TREASURY MANAGEMENT Q.3. An Indian company obtains the following quotes (Rs/$) Spot 45.80/46 3 month forward 46.00/46.10 6 month forward 46.10/46.30 The company needs $ funds for 6 months. If Interest rates are given as below, determine whether company should borrow in rupees or in $. 3-month interest rates: Rs- 7% $- 4% 6-month interest rates: Rs- 6.5% $ - 3.5% Answer: Calculation of interests for 6 months: a). 3-month forward rate: i. 1$ X 46.10 X 7% X 2 = 6.454 ii. 1$ X 46 X 4% X 2 = 3.68 b). 6-month forward rate: i. 1$ X 46.30 X 6.5% = 3.01 ii. 1$ X 46 X 3.5% = 1.61 Because of the comparative interest rates are less in 3-month forwards, the company can borrow funds at 3-month forward rate in Rupees. Page 5 of 10
  6. 6. MFOOO7 TREASURY MANAGEMENT Q.4. Explain with the help of an example the concept of ‘Cap’ and ‘Floor’ in relation to an Interest Rate Option. Answer: This cap/floor calculator has been developed by the World Bank’s Treasury staff as a flexible tool for calculating indicative pricing for interest rate caps, floors and collars. This manual provides step-by-step details of how to use the cap/floor calculator. If you have any questions regarding this program, please contact the World Bank staff at the numbers provided on the last page of this manual. Initial principal amount of the loan is to be capped or collared. To value a collar, which is composed of a cap and a floor, the user needs to run the program twice in order to calculate the cap and floor premiums. The value of the collar is obtained by subtracting the floor premium from the cap premium. IBRD collars cannot result in a net premium payable to the borrower; the cap premium must be equal to, or greater than the floor premium. The Cap/Floor Calculator assumes that the strike rate is compared against LIBOR, although the FSL lending rate consists of LIBOR + a fixed spread. If the cap or collar is triggered, the borrower’s net interest obligation will consist of the strike rate plus the FSL or VSL spread. The interest payment date corresponding to the first interest payment period is capped or collared. This date can be no earlier than six months and two business days following the Trade Date, and should fall on an interest payment date on the underlying loan. For IBRD loans, the interest payment date must fall on either the 1st or the 15th of the month. The interest payment date corresponding to the last interest payment period is capped or collared. In most cases, this date would be at least six months after the First Payment Date, should fall on an interest payment date on the underlying loan, and should not exceed the final maturity date of the underlying loan. (See example under “First Payment Date”). The Last Payment Date cannot precede the First Payment Date. To create a caplet (an interest rate cap on a single interest period), the Last Payment Date should be identical to the First Payment Date. The annual interest rate volatility is the Page 6 of 10
  7. 7. MFOOO7 TREASURY MANAGEMENT program will use to calculate the cap or floor premium. The borrower is required to enter the schedule of outstanding loan principal amounts to be capped or collared, beginning on the interest payment date preceding the first interest payment period to be capped or collared. The Cap/Floor Calculator requires market data on money market and swap rates comprising the yield curves for the three major currencies offered – USD, EUR and JPY. Page 7 of 10
  8. 8. MFOOO7 TREASURY MANAGEMENT Q.5) Prepare an estimate of working capital requirement of a manufacturing company from the details furnished below relating to the year 2007-08 Rs Sales for 3 months credit 48,00,000 Raw materials purchased 18,00,000 Wages paid 15 days in arrears 10,80,000 Manufacturing overheads- 1 month in arrears 4,80,000 Administrative overheads- 1 month in arrears 1,20,000 Sales promotion expenses payable 3 months In advance 1,20,000 Income Tax Payable (at the end of each quarter) 1,00,000 The company enjoys one month’s credit from the supplier of raw materials. It maintains two months stock of raw materials and two months stock of finished goods. Cash balance is maintained at Rs50,000. Assume 10% for contingency. Page 8 of 10
  9. 9. MFOOO7 TREASURY MANAGEMENT Answer: Statement of Estimation of Working Capital Particulars Amount Amount A) Current Assets: i) Cash Balance 50,000 ii) Inventory: Raw material (18,00,000 X 2/12) 3,00,000 Finished goods (34,80,000 X 1/12) 2,90,000 6,40,000 iii) Debtors (36,00,000 X 3/12) 9,00,000 iv) Prepaid sales promotion expenses (1,20,000 X 3/12) 30,000 Gross Working Capital - 15,70,000 Less: B) Current Liabilities: i) Creditors (18,00,000 X 1/12) 1,50,000 ii) Manufacturing Expenses (4,80,000 X 1/12) 40,000 iii) Administrative Expenses (1,20,000 x 1/12) 10,000 iv) Income Tax Payable 1,00,000 3,00,000 12,70,000 Add: 10% for Contingency - 1,27,000 Net Working Capital - 13,97,000 Note: 1) Opening stock is considered to be equal to closing stock in value. Hence, Inventory value does not affect cost of production or cost of sale. 2) Inventory of Finished Goods is valued at cost of production i.e., 18,00,000 + 10,80,000 + 4,80,000 + 1,20,000 = Rs.34,80,000 3) Debtors are valued at Cost of Sale i.e., 34,80,000 + 1,20,000 = 36,00,000 Page 9 of 10
  10. 10. MFOOO7 TREASURY MANAGEMENT Q.6. Case study: An Indian company is planning to invest $100 million in USA. The return on investment is expected to be 50%. The spot rate is Rs45 per $. One year forward rate is Rs46.00 per $. The company can access rupee funds in India at 15%. An American Bank has offered to supply $100 million at a rate of Rs44 per $ and swap the same amount at Rs44 per $ after one year. The bank will charge Interest at 10 % on the loan. Explain whether the company should accept the bank’s offer. Assume that there is no restriction for repatriation of funds in both dollars and rupees. Answer: Case I: Company is getting Rupee funds @ 15% = 10,00,00,000 X 45 = 4,50,00,00,000 ----------------------- Spot rate (1) = 10,00,00,000 X 46 = 4,60,00,00,000 ----------------------- Forward rate (2) Thus, (Forward rate - Spot rate) = 10,00,00,000 Minus: Interest rate @ 15% = 1,50,00,000 Net amount = 8,50,00,000 Case II: If company gets loan from American bank the interest receivable by bank is- = $ 10,00,00,000 X 44 X 10% = Rs.44,00,00,000 In this problem, suppose, company accesses the rupee funds, the cost of the borrowings is more while comparing to the borrowings from the American Bank. American Bank provides a fixed of offer and swap rate. So, it is safe to obtain the bank loan. Therefore, Indian company can borrow loan from American Bank. Page 10 of 10