1. CHAP 1-EXCHANGE RATES AND FOREX BUSINESS
 Foreign Exchange is more broadly used to denote foreign currency, i.e. currency of any country,
as well as the exchange of currency of one country into that of another.
 The bulkof the forex markets are OTC (over the counter),meaningthat the trades are concluded
throughtelephone or other electronic systems (dealingsystemsofvariousnews agencies,banks,
brokers or Internet-based solutions).
 Balance of payment - generally a surplus leads to a stronger currency, while a deficit weakens a
currency.------------ Affects Foreign Exchange rates
 Economic growth rate - a highgrowth leadsto a rise in imports and a fall in the value of currency,
and vice versa. .------------ AffectsForeignExchangerates
 Fiscal policy - an expansionarypolicy,e.g., lowertaxes can lead to a higher economicgrowth. .----
-------- Affects Foreign Exchange rates
 Interest rates - high domestic interest rates tend to attract overseas capital, thus the currency
appreciates in the short term. In the longer term, however, high interest rates slow the economy
down, thus weakening the currency. .------------ Affects Foreign Exchange rates
 Governmentcontrolscan lead to an unrealisticvalueof a currency, resultinginviolent exchange
rates.
 Capital tendsto move from lower yieldingto higheryieldingcurrencies,and results,is movement
in exchangerates.
 Due to the vastnessof the market, operatingindifferent time zones,most ofthe Forex dealsare
done on SPOT basis,meaningthereby that the delivery ofthe fundstakes placeon the second
workingday followingthedate of deal/contract
 Spot rates are the base rates for other FX rates. The date of delivery offundson the date, on
whichthe exchangeof currencies actually takes place,is alsoreferred to as 'valuedate'.
 Forward rate = Spot rate + Premium (or - Discount).
 If the value of the currency is more than that being quoted for Spot, then it is said to be at a
Premium, while if the currency is cheaper at a later date than spot, than it is called at a Discount.
 The forwardpremiumand discountare generallybased on the interest rate differentialsofthe
two currencies involved,asalso onthe demandand supplyofforwardsin the market.
 the forward price of a currency againstanothercan be worked out withthe followingfactors:
(i)Spotprice ofthe currencies involved.
(ii)The interest rate differentialsforthe currencies.
(iii) The term, i.e., the future periodfor which the price is worked out.
 Cross rate mechanism is a possible solution for calculation of rates for currency pairs which are
not actively traded in the market.
 Indiaswitched to a floatingexchangerate regime in 1993
 The buyingrates andsellingrates are alsoreferred to as bidandoffered rates
 V^alue Date is the term used to define the date on which a payment of funds or an entry to an
account becomes actually effective and/or subjected to interest, if any.

2.  payment of the respective currency in each centre takes placeon the sameday, so that no gain or
loss of interest accrues to either party. Such payments are said to be valuer compensee, or,
simply, here and there.
 Arbitragesconsist inthe simultaneousbuyingandsellingof a commodity in two or more markets
to take advantage of temporary discrepancies in prices.
 A dealer has to maintaintwopositions - funds position and currency position. The funds position
reflects the inflow and outflow of funds, i.e. receivables and payables.
 Back Office, which takes care of processing of deals, accounts, reconciliation, etc.
 Mid-Office, which deals with the risk management, and parameterization of risks for forex
dealing operations.
 Midoffice isalso supposedto lookafter the compliance of various guidelines /instructions and is
an independent function.
 Foreign Exchange Dealers' Associadon of India advises the valuation rates based on ongoing
market rates on month-end dates, to enable the authorised dealers to revalue their foreign
currency positions.
 Operational Risk is a risk arising on account of human errors, technical faults, infrastructure
breakdown, faulty systems and procedures or lack of internal controls.
 Credit Risk is a risk of loss which arises due to inability or unwillingness of the counter party to
meet the obligations at maturity of the underlying transaction.
 Settlement risk is the risk of failure of the counter party during the course of settlement, due to
the time zone differences, between the two currencies to be exchanged.
 Liquidity Risk is the potential for liabilities to drain from the bank at a faster rate than assets.
 Gap Risk/Interest Rate Risk is if the purchase and sale take place for different value, while the
bank may completely stand hedged on exchange front, it creates a mismatch between its assets
and liabilities referred to as GAP. It is also the risk arising out of adverse movements in implied
interest rates or actual interest rate differentials.
 Market Risk is the risk that arisesdue to adverse movement of market variableswhen the players
are unable to exit the positions quickly
 Legal Risk is the risk arising on account of non-enforceability of contract against a counter party.
 Systemic Risk is the possibility of a major bank failing and the resultant losses to counter parties
reverberating into a banking crisis.
 Country Risk is the risk of counter party situated in a different country unable to perform its part
of the contractual obligationsdespiteitswillingnesstodo sodue to local governmentregulations
or political or economic instability in that country.
 Entitiesauthorisedto buy and sell foreigncurrency notes,coinsand traveller'schequesare called
Full Fledged Money Changers.
 Foreign Exchange Dealers Association of India. FEDAl, on the other hand, is a non-profit making
body, formed in 1958 with the approval of Reserve Bank of India, consisting of Authorised
dealers as members.
 Sight Bills drawn under Import letters of credit would be crystallized on the tenth day after the
date of receipt if not yet paid.
 Delivery period under the option contract shall not exceed beyond one month.

3.  All contracts, which have matured and have not been picked up, shall be automatically cancelled
on the seventh working day, after the maturity date.
 All cancellationsshall beat bank'sopposite TT rates, TT selling rate for purchase contracts and TT
buying rate for sale contracts.
 All borrowingsof banks,includingECB,andtemporary overdrafts innostro accounts not adjusted
within five days, shall not exceed 50% of their unimpaired Tier 1 capital or USD 10 million, which
ever is higher.
 The forward contract may be booked for tenors up to one year only.
 Main factors effecting exchange rates are technical,fundamental and speculation.
 The dealers are officials, who are actually involved in the buying-and -selling of currencies
 Banks permitted to deal in foreign exchange are called Authorized persons.

4. CHAP 2-BASICS OF FORES DERIVATIVES
 Derivativesare such instruments,which whenadded to the exposure will neutralise or alter to
acceptable levels,the uncertainty profile ofthe exposure.
 A risk can be definedas an unplannedevent with financial consequencesresultinginlossor
reduced earnings
 Transaction Exposure may expose the company/firm to currency risk, when compared to the
value in home currency.
 TranslationExposurearises when firmshave to revalue their assets andliabilitiesorreceivables
and payablesinhome currency, at the end of each accountingperiod.
 credit risk in foreignexchangeoperations,is the risk of failureofa counter party,whether a bank
or a customer, to meet obligationatmaturityof the contract, whichcouldresult in the need for
resultantopen positionto be covered at an ongoingrate.
 Pre-settlement risk isthe risk offailureof the counter party, due to bankruptcy,closure or any
other reason, before maturityof the contract thereby compellingthebank to cover the contract
at the ongoingmarketrates.
 Settlement risk is the risk of failureofthe counter party duringthe course of settlement due to
the time zone differencesbetween the two currencies to be exchanged.
 Principal riskin the settlement of foreignexchange transaction becauseof banksoperatingin
differenttime zones is variouslycalledforeignexchangesettlement risk or temporal risk or
Herstatt risk.
 Sovereign risk can be suitably reduced by inserting disclaimer clauses in the documentation and
also making the contracts and the sovereign counter parties subject to a third country
jurisdiction.
 The bankbuys andsellscurrencies for spot and forwardvalue,borrows andlends foreign
currencies, enters into swaps,futures or optionsrelatingto interest rates, it is not practical and
alsoalwayspossibleto match itsforward purchaseand sales,borrowingand lending, creatinga
mismatchbetween its assets andliabilities.Thismismatchisreferred to as GAP.
 Deal size limit:Highest amountfor whicha deal can be entered. The limitsisfixed to restrict the
operational riskon large deals.
 Mitigation of Settlement Risk: In India, CCIL conducts netted settlements for various segments of
money and Forex markets. CCIL takes over the settlement risk, for which it creates a large pool of
resources, called Settlement Guarantee Fund (SGF), which is used to cover outstanding of any
participant, in case of defaults.
 CCIL: ClearingCorporationofIndiaisan institutioncreated for the purposeof clearingand
settlement in Repos, CBLOs,giltsand inter bank Forex deals.
 Banks are allowedto use derivatives to managerisks oftheir assetsand liabilities,andalsofor
hedgingpurposes.

5. CHAP 3-CORRESPONDENT BANKING AND NRI ACCOUNTS
 Correspondentbankinginits true sense,is the relationshipbetweentwo bankswhich have
mutual accountswith each other, or one of them havingaccountwith the other. It eliminatesthe
need to have a global network of branches
 NOSTRO account: It means "Our account with You". For example, SBI, Mumbai maintaining an
USD account with ClTl Bank New York is Nostro account in the books of SBI, Mumbai.
 VOSTRO account: It means " Your account with Us". Say American Express Bank, New York,
maintaining A Rupee Account with SBI, Mumbai, is Vostro account in the books of SBI, Mumbai.
 LORO account: It refers to accountsof other banks,i.e. "hisaccountwith them". For example,Citi
Bank referring to Rupee accountof AmericanExpress Bank, with SBI Mumbai.
 Mirror account is more or less a reflection or a shadow of the nostro account. The entries in the
mirror account are used for reconciliation of entries in the nostro account. The mirror account is
maintained in two currencies, one of which is the foreign currency and the other one is the home
currency.
 SWIFTstands forSociety for WorldwideInterbankFinancial Telecommunications.
 SWIFTsystem has builtin securitysystem with an automaticauthenticationoffinancial
messages,throughbilateral key exchange(BKE), andis available24 hours a day and365 daysin
a year.
 Authentication of financial messages in SWIFT is based on exchange of RMA/ BIC
 CHIPS (ClearingHouseInterbank PaymentSystem), isa major paymentsystem in the USA,
operatingsince 1970.
 CHIPS is operative only in New York, and as such, is mainly used for foreign exchange Interbank
settlements and Euro Dollar settlements.
 ClearingHouse AutomatedPayments System(CHAPS),is a Britishequivalentto CHIPS, handling
receipts and paymentsin LONDON.
 Trans-EuropeanAutomatedReal-Time GrossSettlement Express Transfer system(TARGET) is an
EURO payment system comprising15 national RTGSsystems workingin EUROPE.
 RTGS: Reserve Bank of India has implemented Real Time Gross Settlement (RTGS) system for the
banks in India, where banks can remit funds to other banks through this mechanism,. The RTGS
system is managedby IDBRT, Hyderabad,whichconnects all banks to a central server maintained
at RBI.
 NEFT: NATIONAL ELECTRONIC FUNDS TRANSFER is another funds transfer facility for banks in
India, which runs on a batch process method. This is used for small remittances by customers
from an account with one bank to another account in another bank. The funds adjustment for
NEFT is also done through the pool accounts maintained by individual banks.
 Overseas corporate bodies(OCB):The level ofownershipof NRIs insuch bodies,shouldbe
minimum60 %,by one or more NRI owners.

6.  Non-Resident (External) Rupee Account (NRE) & Non-Resident Ordinary Rupee Account (NRO)
types of accounts are maintained in Indian rupees
 Foreign Currency (Non-Resident) Account (Banks) [FCNR (B)] can be maintained in one of the
major foreign currencies.
 NRE accounts can be opened by (i) remittances from abroad by way of TT, checks, drafts, or even
transfer from another Non- Resident account, as also (ii) by tendering of foreign currency
travellers cheques or notes by the NRI during his temporary visit to India, provided the bank is
satisfied about his non-resident status.
 Non-Resident Ordinary Rupee Account (NRO) are Rupee accounts Rupee accounts and can be
opened and maintained by any person resident outside India and also by Foreign Tourists, who
are on a short visit to India on tourist visa. The new accounts are to be opened by sending fresh
remittances from abroad or transfer of funds from NRO/NRE/FCNR accounts.
 Whena resident becomes a non-Resident, hisdomesticRupee account,has to be re-designated
as an NRO account.
 This isbasicallya domesticaccountof an NRI, openedand maintainedtofacilitatecredits which
accrue in India,frominvestments that were made prior to his leavingthe country,rent, LIC
maturities,or income fromother investments made onnon-repatriablebasis.
 The interest on NRO accountsissubject to deductionof Income Tax at source, as prescribed.
 Foreign Currency (Non-Resident) Account (Banks) [FCNR(B) Accounts] are foreign currency
accounts, which can be opened by Non-Resident Indians in designated currencies only, viz., US
Dollar, EURO, Great Britain Pounds and Japanese Yen, CAD and AUD.
 NRIs can open these accounts only in the form of Term Deposits, with a minimum period of one
year and maximum period of three years.
 There is no exchange risk for Foreign Currency (Non-Resident) Account (Banks) [FCNR(B) account
holder as the account is maintained in foreign currency.
 FEDAI announces the LIBOR rates for computation of interest on NRE and FCBR deposits, on the
last working day of the month, so that the interest rates of banks are linked to similar
benchmark.
 FCNR deposits are term deposits and can be made for a minimum period of one year and
maximum of five years.
 Interest earned on bonds, invested before getting NRI status, can be credited to NRO account.
 NRIs can investin shares ofIndian companies listed in recognised stock exchange under Portfolio
Investment Scheme (PIS), through a designated AD branch, on repatriation as well as non-
repatriation basis.
 Presently, loansagainstNRE / FCNR depositscan be allowedonly upto Rs 100 lacs,in terms of RBI
guidelines.
 NRIs can acquire shares or property by way of inheritance from a person resident outside India.
 NRIs can acquire property by purchase out of balances held in NRE accounts

7. CHAP 4 - Documentary Letters of Credit
 Rules and procedures for issuance and handling of transactions under letters of credit are called
Uniform Customs and Practices for Documentary Credits (UCPDC)
 The current update ofUCPDC is the publication No. 600 of ICC, which has been implemented with
effect from 1.7.2007.
 A documentarycredit or/and letter of credit, ( DC or LC) can be definedas a signedor an
authenticatedinstrumentissued bythe buyer'sbanker, embodyinganundertakingto pay to the
seller a certain amountof money,uponpresentation ofdocuments,evidencingshipmentof
goods,as specified,andcomplianceofother terms andconditions.
 Revocable LC is the one whichcan be amended or cancelledat anymoment by the issuingbank
withoutthe consentof any other party, aslong asthe LC has notbeen drawnor documentstaken
up
 Irrevocable LC is the one, whichholdsa commitmentby the issuingbankto payor reimbursethe
negotiatingbank,providedconditionsofthe LC are compliedwith.Such anLC cannotbe
amended or cancelledwithoutthe consentof all parties concerned.
 A transferableLetter ofCredit is availablefortransfer infull or in part, in favourof anyparty
other than the beneficiary,by the advisingbankat the request ofthe issuingbank.
 "RedClause" LC enablesthe beneficiaryto avail pre-shipmentcredit from the nominated/
advisingbank.
 SightLC enables the beneficiary to get the payment on presentationofdocuments conforming to
the terms and conditions of the LC at the nominated bank's counters.
 Back to Back LC is Whenan exporter arranges to issuean LC in favourof local supplierto procure
goodson the strength of export LC received in hisfavour.
 UCP600 does not applyby defaultto letters of credit issuedafter July1st 2007. A statement
needs to be incorporatedinto the credit (LC) that expresslystates it is subject to these rules.
 Time AllowedBanks for Document Review as per UCP600 hasbeen broughtdown to a periodof
a maximumoffive "bankingdays".


8. CHAP 8- Risk and Basic Risk Management Framework
 'Risks' are uncertaintiesresultingin adverse outcome,adverse in relationto plannedobjective or
expectations.
 'Financial Risks' areuncertaintiesresulting in adverse variation of profitability or outright losses.
 Factors that are responsiblefor creatinguncertaintiesin cash outflowsandcashinflowsare the
risk elements.
 Minimum capital required for a business should be such that it is able to meet the maximum loss
that may arise from the business to avoid bankruptcy.
 Lower risk implies lower variability in net cash flow with lower upside and downside potential.
Higher risk would imply higher upside and downside potential.
 Zero-Risk wouldimplynovariation in net cash flow. Return on zero-risk investment would he low
as compared to other opportunities available in the market.
 Risk in a businessor investmentis netted againstthe return fromit and is calledRisk Adjusted
Return oninvestment
 Key driver inmanagingabusinessis seekingenhancement in risk-adjustedreturnon capital
(RAROC).Higher the RAROC, higheris the reward to investors/shareholdersandmore preferable
such investmentwouldbe to the market.
 Althoughall the risks are contracted at the transactionlevel,certain risks suchas liquidityrisk
and interest rate risk are managedat the aggregate or portfoliolevel.
 Risks such as credit risk, operational risk and market risk arising from individual transactions are
taken cognizance of at transaction- level as well as at the portfolio-level.
 Volatility over a time horizon 'T' = Daily Volatility x Square root of'T'
 Downsidepotential is the most comprehensivemeasure of risk as it integratessensitivityand
volatilitywiththe adverse effect of uncertainty
 The value at risk (VaR) is a downside risk measure.


9. CHAP 16-FUNDING AND REGULATORY ASPECTS
 The Reserve Bank of India is the Note IssuingAuthority.
 The moneyin circulation isindicatedby 'Broad Money' or M3, which includescurrency in
circulation,demand and time depositswith banks and post office savingdeposits.
 Cash reserve ratio (CRR) is intendedto reduce the multipliereffect.
 CRR and SLR are important instruments in the hands of RBI to control liquidity in the inter-bank
market. The liquidityinturn impacts overall moneysupply,inflation, interest rates and exchange
rates.
 Reserve assetsrefer to the cash depositedbyscheduledcommercial banks with RBI to comply
with Cash Reserve Ratio (CRR) requirement.The reserve ratios are calculatedon the basis of
demand and time liabilities(DTL) of the banks.
 Exemptionsfrom DTL are the “Transactionsin CBLO and CCIL”
 Funds investedinGovernmentsecuritiesandotherapproved securitiesto complywith the
Statutory LiquidityRatio (SLR) requirement.
 Liquidityrefersto surplus fundsavailable with banks, which is an indicator of moneysupplythat
has not beenabsorbed by the real economy.
 Treasury back-office shouldreport relevantinformationto RBI in the fortnightlyreturn (FormA).
 The CRR is to be calculated on the basis of DTL, with a lag of one fortnight,i.e.on the reporting
Friday, the DTL as at the end ofpreviousfortnight will form the basisfor CRR calculation.
 An increase in the reserve ratioswill reduce moneysupply(excessliquidity) andreductionin the
reserve ratios will increase the moneysupply.
 LIQUIDITY ADJUSTMENT FACILITY (LAF) is usedto monitor day-to-day liquidityinthe market.
 LAF refersto RBI lendingfundsto banking sector through Repo instrument.RBI also accepts
depositsfrom banks underReverse Repo.
 Real Time Gross SettlementSystem(RTGS) has beenfullyactivated by RBI from October2004.
 RTGS is a paperlessclearingsystem, where settlementsare on gross basis.
 The Institute for DevelopmentandResearch in Banking Technology(IDRBT) has developedthe
Indian Financial NetWork (INFINET) as a secure communicationbackbone for the banking and
financial sectors.
 The INFINEThas helpedintroductionofStructured Financial MessagingSystem(SFMS) which
facilitatesdomestictransfer of fundsand authenticatedmessages,similarto the SWIFT usedby
banks for international messaging.
 NegotiatedDealingSystem(February2002) is an electronicplatform for facilitatingdealingin
Governmentsecuritiesandmoneymarket instruments.
 CCIL a specializedinstitutionpromotedbymajor banks for clearing ofsecurities,repotrades and
trades in CBLO (securitiesborrowingand lendingscheme).
 FX Clear isa forexdealingsystemdevelopedbyCCIL for foreignexchange transactions (USD/ INR
as well as cross currencies).
 Repo/Reverse Reporates dictate the liquidityparameters.

10.  NSDL and CSDL facilitate deliveryVspayment(DVP) for secondary market dealsin equityand
debt paper.
 CCIL as an intermediarysettlesinter-bankUSD/Rupee dealson netbasis, so that individual banks
neednot exchange paymentsfor eachtransaction.

11. CHAP 17-TREASURY RISK MANAGEMENT
 Market risk in treasury activity is variation in the market price of currency or security, when there
is a gap between the buy leg and sell leg of the transaction.
 The variability of the price, upward or downward, is known as volatility;
 In case of currency it is known as volatility of exchange rate and in case of securities, it is
volatility of interest rates.
 Security prices have inverse relationship with interest rate movement.
 The front office of a Treasury generates deals with counter-party banks (purchase and sale of
foreign exchange, securities etc. & lending and borrowing operations).
 The back office of a Treasury is responsible for confirmation, accounting and settlement of the
deals. It has the overall responsibility for compliance with exposure limits and position limits
imposed by the Management and RBI, as well as for accuracy and objectivity of the transaction
detail.
 Banks also have a Middle Office (mid-office) which is responsible for risk management and
management information system (MIS). Mid-office would ensure treasury's compliance with
Board approved policies bearing upon FX risk management, investment management and
liquidity management.
 Market risk also known as price risk is a confluence of liquidity risk, interest rate risk, exchange
rate risk, equity risk and commodity risk.
 interest rate is domestic cost of currency, while exchange rate is External cost of currency.
 The effective return on a bond (based on the coupon rate, market price and residual maturity) is
known as yield.
 InvertedYieldCurve occurs when short tenure yieldsare higherthan long tenure yield.
 A yield curve is simply a graph that plots bond yields against their time period to
maturity. The curve will show whether short-term interest rates are higher or
lower than long-term rates.

12.  The following diagram is of a normal yield curve, exhibiting a positive slope.
Normal Yield Curve
Normal Yield Curve
 Most of the time, the yield curve will be positively sloped, which means lower interest rates
are correlated with shorter maturities.
 As maturity lengthens, interest rates increase.
 An inverted yield curve means short-term interest rates are higher than long-term rates.
This is an unusual situation, but it does happen.
Figure Inverted Yield Curve
Inverted (or Negative) Yield Curve
 Occurs when there is weak demand for bonds with short maturities, which drives yields up,
while a strong demand for long-term bonds drives these yields down
 An inverted yield curve means short-term interest rates are higher than long-term rates.
This is an unusual situation, but it does happen.
 An inverted yield curve may be an indication of economic decline.

13. Figure Flat Yield Curve
 Flat Yield Curve
o Occurs where yields are the same for short-, intermediate-, and long-termbonds.
o This type of curve is a rare occurrence.
o The flat yield curve is essentially a flat line.
 Cany refers to interest cost of funds locked in a trading position.
 Off-balance sheet: Items such as interest rate swaps and guarantees which may not appear on
balance sheet.
 Yield and price of a bond move in inverse proportion. If the yield rises, price of a bond falls. If the
yield falls the bond price rises. It is the same relationship between interest rates and bond prices.
 Market risk is measured by VaR and duration.
 VaR is the maximum loss that may take place within a time horizon, at a given confidence level.
 In case of a securities purchase, funding account is debited and securities account is credited
simultaneously.

14. CHAP 18-DERIVATIVE PRODUCTS
 derivatives always refer to a future price and the value of derivative depends on spot market.
 The derivativeproducts that can be directly negotiated and obtained from banks and investment
institutions are known as Over-the-Counter (OTC) products.
 Forward contract is a contract to deliver foreign currency on a future date at a fixed exchange
rate. This is a OTC product where the counterparty is always a bank.
 Forward rate, as we stated earlier, represents interest rate differential of the two currencies. The
forward rate is either at premium or discount to the spot rate
 Options refer to contracts where the buyer of an option has a right but no obligation to exercise
the contract.
 Options are either put options or call options. Call option gives a right to the holder to buy an
underlying product (currency/bonds/commodities) at a prefixed rate on a specified future date.
Put option gives a similar right to the holder to sell the underlying at a prefixed rate on a
specified future date or during a specified period.
 The prefixed rate is known as the strike price. The specified time is known as expiry date.
 In India we use only European type of options wherein option can be exercised only on the expiry
date
 The option is known to be at-the-money (ATM) if the strike price is same as the spot price of the
currency.
 The option is in-the-money (ITM), if the strike price is less than the forward rate in case of a call
option, or, if the strike price is more than forward rate in case of a put option.
 The option is out-of-money (OTM), if the strike price is more than the forward rate in case of a
call option, or, if the strike price is less than forward rate in case of a put option.
 ITM is when the strike price is better than the market price, and OTM is when the strike price is
worse than the market price.
 Intrinsic value of an ITM option is the difference between the strike price and current forward
rate of the currency, or zero whichever is less. Intrinsic value cannot be negative.
 The option price less the intrinsic value is time value of the option.
 The time value is maximum for an ATM option, and decreases with the option becoming more
and more ITM or OTM, as the expiry date approaches.
 An option without any conditionalities is called plain vanilla option, which is ideal for hedging.

15.  A convertible option may give the bond-holder option of converting the debt into equity on
specified terms. Such options are called embedded options and have a direct effect on pricing of
the bond.
 An interest rate swap is an exchange of interest flows on an underlying asset or liability, the
value of which is the notional amount of the swap.
 Interest Rate Swap (IRS) is a OTC instrument normally issued by a bank.
 Quanto swaps refer to paying interest in home currency at rates applicable to a foreign currency
(now prohibited in India).
 Coupon swaps refer to floating rate in one currency exchanged to fixed rate in another currency.
 In Indian Rupee market only plain vanilla type swaps are permitted.
 Banks and counterparties (other banks/clients) need to execute ISDA Master Agreement before
entering into any derivative contracts.
CHAP 19- TREASURY AND ASSET LIABILITY MANAGEMENT
 If current interest rates are higher than the contracted rates on mortgage advances, the
mismatch in interest rates leads to negative spread , or reduction in net interest income (Nil).
 If current interest rates are higher than the contracted rates on mortgage advances, the
mismatch in interest rates leads to negative spread , or reduction in net interest income (Nil).
 The differencebetween sources and uses offundsin specific time bands is known as liquidity gap
which may be positive or negative. The liquidity gap arises out of mismatch of assets and
liabilities of the bank.
 Market risk comprises of liquidity and interest rate risks
 Liquidityrisk is reflected as maturity mismatch - which is the gap in cash inflow and outflow. The
risk is not being able to find enough cash, or cash at acceptable rate of interest, to fund the gap.
 Interest rate risk arises when interest earnings are not adequate to set off interest payments due
in a given period, even if the book value of the asset equals that of the liability, owing to a
change in market rates of interest.
 Liquidity and interest rate sensitivity gaps arise out of mismatch of bank's assets and liabilities,
and are measured in specific time bands.

16.  Net interest income (NII) of the bank is the difference between interest earnings and interest
payments in a given accounting period. Hence interest rate risk may be defined as the risk of
erosion of NII, on account of interest rate movements in the market.
 The risk of erosion of NII is on account of deposit rates being floating (repriced every 6 months),
while the loan interest is fixed (repriced only after 5 years when the ftmds are available for fresh
lending, on repayment of the loan), or vice versa. The interest rate mismatch is therefore also
known as repricing risk.
 ALM uses broad time bands, hence even after using appropriate hedges, the market risk may not
be completely mitigated - the residual risk is called basis risk.
 Treasury is mostly concerned with market risk.
 Derivatives, such as swaps and options are extensively used in managing the mismatches in
bank's balance sheet.
 Treasury is also responsible for transfer pricing, whereby market risk is removed from the
banking assets and liabilities and cost of funds and return on assets is arrived at on a rational
basis.
 The process is called securitisation, whereby credit receivables of the bank can be converted into
unitsor bonds (oftencalledpass-throughcertificates - PTCs) that can be traded in the market. For
instance, the mortgage loans of a bank can be securitised and issued in the form of PTCs through
a special purpose vehicle (SPV) - which amounts to sale of bank's loan assets.
 Transfer pricingrefers to fixingthecost of resources and return on assets ofthe bankin a rational
manner.
 Run on the Bank is a situation where depositors of a bank lose confidence in the bank and
withdraw their balances immediately.
 Risk Appetite is the capacity and willingness to absorb losses on account of market risk.
 SPV: Special Purpose Vehicle formed exclusively to handle securities paper, on behalf of the
sponsoringbank- also knownas fire-proofcompany,asit exists independent of parent company.
 Credit default Spread (CDS) is the annual fee the credit protection buyer must pay the protection
seller over the length of the contract, expressed as a percentage of the notional amount.
 Credit derivatives segregate the credit risk from the assets through instruments known as credit
default swaps and transfer the risk from the owner to another person who is in a position to
absorb the credit risk for a fee.
 A transaction where financial securities are issued against the cash flow generated from
a pool of assets is called “ SECURITIZATION”

17. CHAP 20-COMPONENTS OF ASSETS & LIABILITIES IN BANK’S BALANCE SHEET
 At macro-level. Asset Liability Management involves the formulation of critical business policies,
efficient allocation of capital and designing of products with appropriate pricing strategies.
 At micro-level the Asset LiabilityManagementaimsat achievingprofitabilitythroughpricematching
whileensuringliquiditybymeans of maturitymatching.
 ALM is therefore, the managementofthe Net Interest Margin (NIM) to ensure that its level and
riskinessare compatiblewith risk/returnobjectives ofthe bank.
 The strategy ofactively managingthecompositionandmixof assets andliabilitiesportfoliosiscalled
balancesheet restructuring.
 The impact of volatility on the short-term profit is measured by Net Interest Income. Net Interest
Income = Interest Income - Interest Expenses.
 Minimizingfluctuationsin NIIstabilizesthe short term profitsof the banks.
 Net Interest Marginis definedas net interest income dividedbyaverage total assets. Net Interest
Margin(NIM) = Net Interest Income/Averagetotal Assets.
 Net Interest Margincan be viewed as the 'Spread' on earningassets. The higher the spread the more
will be the NIM

18.  The ratio of the shareholders funds to the total assets(Economic Equity Ratio) measures the shifts in
the ratio of owned funds to total funds. This fact assesses the sustenance capacity of the bank.
 Price Matchingbasicallyaimstomaintainspreadsby ensuringthat deploymentof liabilitieswill beat
a rate higherthan the costs.
 Liquidityisensured by groupingthe assets/liabilitiesbasedontheir maturingprofiles.The gapis then
assessedto identifyfuture financingrequirements
 Profit = Interest Income - Interest expense - provision for loan loss + non-interest revenue - non-
interest expense - taxes
Chap 21 - Banking Regulation and Capital
 Systemic riskis the riskthat a default by one financial institutionwill createa 'rippleeffect' that
leadsto defaultsbyother financial instihations andthreatensthe stabilityofthe financial
system.
 In calculatingtheCooke ratio bothon-balance-sheetand off-balance-sheet items are considered.
They are used to calculate bank's total risk-weighted assets. It is a measure of the bank's total
credit exposure. CRAR = Capital/Risk Weighted Assets.
 Tier-I capital consists mainly of share capital and disclosed reserves and it is a bank's highest
quality capital because it is fully available to cover losses.
 Tier-II capital on the other hand consists of certain reserves and certain types of subordinated
debt. The loss absorption capacity of Tier-II capital is lower than that of Tier-I capital.
 The elementsof Tier-I capital includePaid-upcapital (ordinaryshares),statutoryreserves, and
other disclosedfree reserves.

19. Chap 22 -Capital Adequacy - The Basel-II Overview
 The Basel Committee providedthe framework for capital adequacyin 1988, whichis knownas
the Basel-I accord.The Basel-Iaccord providedglobal standardsfor minimumcapital
requirements for banks.
 The Revised Framework consists of three-mutually reinforcing pillars, viz., minimum capital
requirements, supervisory review of capital adequacy, and market discipline.
 The Frameworkoffers three distinctoptionsfor computing capital requirement for credit risk and
three other options for computing capital requirement for operational risk.
 The optionsavailableforcomputingcapital forcredit risk are StandardisedApproach,Foundation
Internal Rating Based Approach and Advanced Internal Rating Based Approach.
 The optionsavailableforcomputingMarketrisk is standardizedapproach(basedonmaturity
ladder anddurationbaSed) and advancedapproach,i.e.,internal modelssuchas VAR
 The options available for computing capital for operational risk are Basic Indicator Approach,
Standardised Approach and Advanced Measurement Approach.

20.  The revisedcapital adequacy normsshall be applicableuniformlytoall Commercial Banks(except
Local Area Banks andRegional Rural Banks).
 A Consolidatedbankisdefinedas a group ofentities where a licensedbank isthe controlling
entity.
 All commercial banks inIndia shall adoptStandardisedApproach(SA) forcredit riskand Basic
IndicatorApproach(BIA) for operational risk.
 Banks shall continue to apply the Standardised Duration Approach (SDA) for computing capital
requirement for market risks.
 The term capital wouldincludeTier-I or core capital,Tier-IIor supplemental capital,andTier-Ill
capital
 Core capital consistsofpaid upcapital,free reserves and unallocatedsurpluses,lessspecified
deductions.
 Supplementarycapital comprisessubordinateddebtof more than five years' maturity,loanloss
reserves, revaluationreserves, investment fluctuationreserves, andlimitedlife preference
shares.
 Tier-II capital isrestricted to 100% of Tier-I capital as before andlong-termsubordinateddebt
may not exceed 50% of Tier-I capital.
 Tier-Ill capital will be limited to 250% of a bank's Tier-1 capital that is required to support market
risk. This means that a minimum of about 28.5% of market risk needs to be supported by Tier-I
capital. Any capital requirement arising in respect of credit and counter-party risk needs to be
met by Tier-I and Tier-II capital.
 Capital adequacy ratio(C) = Regulatory capital(R)/Total risk weighted assets(T).
 Regulatory Capital ‘R’=C*T and Total Risk weighted Assets ‘T’= R/C
 Total Risk weighted assets =(Risk weighted assets for credit risk) +(12.5*Capital requirement for
market risk)+(12.5*Capital requirement for operational risk)
Chap 23- Supervisory Review
 Pillar I: Minimum Capital Requirements - which prescribes a risk-sensitive calculation of capital
requirements that, forthe firsttime, explicitlyincludesoperational risk in addition to market and
credit risk.
 Pillar 2: Supervisory Review Process (SRP) - which envisages the establishment of suitable risk
management systems in banks and their review by the supervisory authority.
 Pillar 3: Market Discipline - which seeks to achieve increased transparency through expanded
disclosure requirements for banks.

21. Chap 24- Pillar 3-Market Discipline
 Market Disciplineis to complimentthe minimumcapital requirements(Pillar1) andthe
supervisoryreview process (Pillar2). Pillar3 provides disclosurerequirementsfor banksusing
Basel-IIframework.
 Informationwouldbe regarded asmaterial ifits omissionormisstatement couldchangeor
influencethe assessmentor decisionofa user relying onthat informationforthe purposeof
makingeconomicdecisions.
Chap 25- Asset Classification and Provisioning Norms
 Banks shouldclassifyanaccountas NPA onlyif the interest charged duringany quarter isnot
serviced fullywithin90 daysfrom the end of the quarter
 An accountshouldbe treated as 'outof order' ifthe outstandingbalance remains continuously in
excess of the sanctioned limit/drawing power In cases where the outstanding balance in the
principal operating account is less than the sanctioned limit/drawing power, but there are no
credits continuously for 90 days as on the date of Balance Sheet or credits are not enough to
cover the interest debited during the same period, these accounts should be treated as 'out of
order'.
 Any amount due to the bank under any credit facility is 'overdue' if it is not paid on the due date
fixed by the bank.
 interest on advances against term deposits, NSCs, IVPs, KVPs and life policies may be taken to
income account on the due date, provided adequate margin is available in the accounts.
 a substandardassetwouldbe one,which hasremained NPA fora periodless thanor equal to 12
months.a substandardassetwould be one, whichhas remainedNPA for a periodless thanor
equal to 12 months.
 If arrears of interest and principal arepaid by the borrower in the case of loan accounts classified
as NPAs, the account should no longer be treated as nonperforming and may be classified as
'standard' accounts.
 Advances against Term Deposits, NSCs, KVP/IVP, etc, need not be treated as NPAs. Advances
against gold ornaments, Government securities and all other securities are not covered by this
exemption.
Chap 26-Liquidity Management

22.  Bank'sliquiditymanagementisthe process of generatingfundsto meet contractual or
relationship obligationsatreasonableprices at all times.
 good management information systems, central liquidity control, analysis of net funding
requirements under alternative scenarios, diversification of funding sources, and contingency
planning are crucial elements of strong liquidity management at a bank of any size or scope of
operations.
 The residual maturity profile of assets and liabilities will be such that mismatch level for time
bucket of 1-14 days and 15-88 days remains around 80% of cash outflows in each time bucket.
 Flow approach is the basic approach being followed by Indian banks. It is called gap method of
measuring and managing liquidity
 Stock approachis basedon the level of assets andliabilitiesaswell as off-balancesheet
exposureson a particulardate.
 Ratio ofCore Deposit toTotal Assets: - Core Deposit/Total Assets:More the ratio,better it is.
 Net Loans to Totals Deposits Ratio:- Net Loans/Total Deposits: It reflects the ratio of loans to
public deposits or core deposits. Loan is treated to be less liquid asset and therefore lower the
ratio, better it is.
 Ratio of Time Deposits to Total Deposits:-Time deposits provide stable level of liquidity and
negligible volatility. Therefore, higher the ratio better it is.
 Ratio of Volatile Liabilities to Total Assets:- Higher portion of volatile assets will pose higher
problems of liquidity. Therefore, lower the ratio better it is.
 Ratio ofShort-Term Liabilitiesto LiquidAssets:- Short-termliabilities are required to be redeemed
at the earliest. It is expected to be lower in the interest of liquidity.
 Ratio ofLiquidAssets to Total Assets:- Higher level of liquidassetsin total assets will ensure
better liquidity.Therefore,higher the ratio,better it is.
 Liquid assets may include bank balances, money at call and short notice, inter bank placements
due within one month, securities held for trading and available for sale having ready market.
 Ratio ofShort-Term Liabilitiesto Total Assets:- A lower ratiois desirable
 Short-term liabilitiesmayincludebalancesincurrent account,volatileportionof savingsaccounts
leavingbehindcore portion ofsavingwhichis constantlymaintained.Maturingdepositswithina
short periodof one month.
 Ratio ofPrime Asset to Total Asset - Prime Asset/Total Assets:- More or higherthe, ratio better it
is.
 Prime assets mayincludecash balanceswith the bank andbalanceswith banksincludingcentral
bank whichcan be withdrawnat any time withoutany notice.
 Ratio ofMarket LiabilitiestoTotal Assets:- Lower the ratio, better it is.
 Market liabilitiesmayincludemoneymarket borrowings,inter-bankliabilitiesrepayablewithina
short period.
 A maturity laddershouldbe used to compare a bank'sfuture cashinflowsto itsfuture cash
outflowsover a series of specifiedtime periods.
 The need to replace net outflows due to unanticipated withdrawal of deposits is known as
Funding risk.
 The need to compensate for non-receipt of expected inflows of funds is classified as Time Risk

23.  Call risk arises due to crystallisation of Contingent liabilities
 Maturity ladders enables the bank to estimate the difference between Cash inflows and Cash
Outflows in predetermined periods.
 Liquidity management methodology of evaluating whether a bank has sufficient liquid funds
based on the behaviour of cash flows under the different 'what if scenarios is known as
Alternative Scenarios
 The capability of bank to withstand a net funding requirement in a bank specific or general
market liquidity crisis is denoted as Contingency planning
Chap 27- Interest Rate Risk Management
 Interest rate risk is the exposure ofa bank'sfinancial conditiontoadverse movementsin interest
rates.
 Gap:The gapis the difference between the amountof assetsand liabilitiesonwhichthe interest
rates are reset duringa givenperiod.
 Interest rate risk refers to volatilityinNet Interest Income (NiI) or invariationsinNet Interest
Margin(NIM)
 The degree of basisrisk isfairlyhigh inrespect ofbanks that create compositeassetsout of
compositeliabilities.
 The riskthat the interest rate of different assetsand liabilitiesmaychangeindifferent
magnitudesiscalledbasisrisk.
 When assets and liabilities fall due to repricing in different periods, they can create a mismatch.
Such a mismatch or gap may lead to gain or loss depending upon how interest rate in the market
tend to move.

24.  The degree of basisrisk isfairlyhigh inrespect ofbanks that create compositeassetsout of
compositeliabilities
 When the variation in market interest rate causes the Nil to expand, the banks have experienced
a favourablebasisshiftandif the interest rate movement causesthe Nil to contract, the basishas
moved against the bank.
 An yield curve is a line on a graph plotting the yield of all maturities of a particular instrument
 Price risk occurs when assets are soldbefore their maturity dates.
 The price risk iscloselyassociatedwith the tradingbook whichis created formakingprofit out of
short-term movementsin interest rates.
 Uncertainty with regard to interest rate at which the future cash flows can be reinvested is called
reinvestment risk.
 Whenthe interest rate goes up, the bondsprice decreases
 Whenthe interest rate declines the bondprice increases resultingin a capital gainbut the
realisedcompoundyielddecreases becauseof lower couponreinvestment income.
 Durationis a measure of the percentage change in the economicvalue ofa positionthat will
occur, givena small change inthe level ofinterest rates.
 Higher durationimpliesthat a givenchange in the level of interest rates will have a larger impact
on economic value.
 Interest Rate SensitiveGap: Interest Rate SensitiveAssets(RSA) - Interest Rate Sensitive Liabilities
(RSL).
 Positive Gap or Asset Sensitive Gap - RSA - RSL > 0 & Negative Gap or Liability Sensitive - RSA -
RSL < 0
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