MODULE - C

Treasury Management

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2014
 Treasury

Concept of Treasury
It deals with short term fund flow (i.e. Securities with Less than 1 year maturity) except part of
SLR requirement. Previously, Liquidity Management was main function of Treasury. But now, it
includes all Trading and Investment activities in financial markets.

Treasury has become profit centre for all the banks

It also plays important role in ALM (Asset Liability Management)

Functions of Integrated Treasury

Integrated Treasury refers to integration of the following:

1. Money Market
2. Security Market
3. Forex Market

Why Treasury has become so important

Rupee is freely convertible on account of Current Account transactions. In Capital

account transactions, it is convertible to a larger extent. Therefore, banks are free to
operate in FDI, ECB and ODI.
Banks source funds from Global markets and invest in Domestic currency or vice versa.
Banks invest in Equity and Debt Market.
Use of Derivatives with reference to forex market as per requirement of our corporate
customers.

Role of Treasury

Liquidity Management : Managing short term funds besides maintaining CRR and SLR
Proprietary Positions: Trading in Currencies, Securities and other financial instruments
including Derivatives.
Risk Management: Bridging Asset Liability mismatches and managing Risks through
Derivative tools.

Treasury Manages 3 books:

1. ALM Book
2. Merchant Book
3. Trading Book

ALM book deals with Internal Risk Management. Merchant Book deals with Client related
Derivatives. Trading Book deals sales and purchase of financial instruments for bank itself.

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Globalization and Growth : Rapid Economic growth is not possible without free capital flows
i.e. Overseas Companies invest in India and Domestic Companies invest outside India.
Exchange of technology and human resources has been made possible only after liberalization
after 1990.

Overseas operations of a bank include Portfolio investment,

Direct Investment,
ECB
Issue of Equity and Debt Capital in Global market
Mergers and Acquisitions
Payment of technology, and
Receipt of Interest, fees and dividend etc.

RBI has permitted large movement of capital though

Automatic route
Approval Route

Impact of Globalization

1. Interest rates are influenced by global trends

2. Exchange rates become volatile and affect GDP as well as Markets of Stock and
Commodity.
3. Institutional Structure has changed. SEBI, IRDA, CCIL, NSDL and CIBIL have come up.
4. There is widespread use of Swaps, Forwards and Options.
5. Rupee Derivatives are also available in the market.

Banks can Borrow and Invest Outside India through Overseas Correspondents in Foreign
Currency up to 50% of Tier1 Capital or USD 10 Million (whichever is higher)

Treasury as Profit Centre Due to following:

1. Inter- bank market is free from Credit risk and requires little capital allocation.
2. Treasury activity is highly leveraged. The risk ranges from 2% to 5%.
3. Operational costs are low.

Sources of Treasury Profit

1. Forex Business
Buy Low and Sell High
Position is generally squared on daily basis.
Stock of currency is not generally kept.
Overbought and Oversold is called Open Position
2. Money Market
Banks lend surplus funds in Money Market and borrow the same when required. Interest
is earned.

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 3. Investment in Govt. Securities and Other Securities
Treasury profit is earned by investment in G-sec and other securities in Debt and Equity
Market.
4. Interest Arbitrage
If interest rates are in favour, banks borrow from centers having low rate of interest and
lend at other centers where rate of interest is high. This is called Arbitrage.
5. Trading in market
It is speculative activity. Banks trade in securities and currencies. Swap transactions are
also done to increase profits of the bank.

Organization Structure

In every bank, General Manager is CTO (Chief Transaction Officer) who reports direct to CEO.
There are four sections at HO:

1. Dealing Room : Chief Dealer is Head. There are separate dealers for Forex Operations,
Money market operations and Security Operations. For corporate, separate dealer is
appointed who deals with securities in Secondary as well as Primary market.
2. Mid-Office: It provides MIS, implements Risk Management system and monitors
exposure limits and Stop Loss Limit.
3. Back Office: This office is responsible for verification and settlement of deals,
confirmation of deals with counterparts, book-keeping of all deals and Maintaining
Nostro accounts.
4. Investment Office: This office deals with Primary Issues of Shares

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 Treasury Products

Treasury Products are of 3 types:

Products of Forex Market

Products of Money Market
Products of Security Market

Forex Market Products: It is virtual market without boundaries, highly volatile and liquid and
most transparent. It includes the following products.

1. Spot Trades: Currencies are generally bought and sold at spot rates when payment and
settlement takes place on 2nd working day. Cash and Tom rates are quoted at discount
from Spot rate.
2. Forward Trades : Purchase or sale of currency at future rates. Exchange takes place
after few days/months. Importers and Exporters cover risks by Forward trades. Forward
rates are arrived at on the basis of interest rate differentials of two currencies.
3. Swaps: Foreign Exchange transactions where one currency is sold and purchased for
another simultaneously is called Swap. Swap Deal may involve: Simultaneous purchase
of spot and sale of forward or vice versa. It may also involve Simultaneous sale and
purchase, both forward but for different maturities. It is called Forward to Forward
Swap.
4. Investment in Foreign Currencies: If forex is surplus with bank, it makes investment.
Surplus arises from profits of treasury business, overseas operations, forex borrowings,
NRE, FCNR and EEFC deposits. Investment can be of following 3 types:
Interbank loans- normally not more than 1 year
Short term investments in T-bills and CPs issued by multinational agencies
Some Correspondent banks offer automatic investment facility in Nostro
Accounts subject to minimum balance.
5. Foreign Currency Loans: Banks extend WC loans in foreign currency and for this
purpose, clearance of Treasury is required.
6. Rediscounting of Foreign Bills : Treasury refinances the Foreign currency bills
purchased/negotiated by another bank. The advance covers Usance period 15-360
days.

Money Market Products : Money market products relate to raising and deploying short
term resources with maturity Maximum 1 year. The money market products are:

1. Call Money: It refers to Overnight placement. It needs to be repaid on Next Working

Day. O/N MIBOR Rate is the indicative rate. Non bank players (FIs/MFs) are not
eligible to participate.
2. Notice Money: It is placement of funds beyond overnight up to maximum period of
14 days.

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 3. Term Money: It deals with placement of funds in excess of 14 days up to 1 year.
1 to 6 month products are very common.

Other Money Market Products:

1. Treasury Bills:
These are issued by Govt. of India through RBI.
Tenure is 91Days, 182 Days and 364 Days.
These are issued at Discount in auction.
Banks and PDs participate in the auction.
The auction is also available to all financial players (FIs/MFs/Corporate).
Auction takes place on Wednesday every week in case of 91 days bills.
It takes place on Wednesday every Fortnight in case of 182 D and 364 D bills.

2. Commercial Papers & 3. Certificates of Deposits

CP and CD Commercial Papers CP:

CP is issued by Corporate with Net Worth minimum 4
Crore, Rating min.P2 (now A2) and availing WC limit from
any bank.
CP is issued with tenure 7 Days to 1 year.
CP is issued in multiples of Rs. 5.00 lac.
CP is Promissory Note and is Negotiable and also attracts
Stamp Duty.
It is fairly active in Secondary market.
It is in Demat form and the price is less than Face Value.
Certificate of Deposit CD
CD is issued by banks
CD is issued with tenure 7 Days to 1 year.
CD is issued in multiples of Rs. 1.00 lac
CD is Promissory Note and is Negotiable and also attracts
Stamp Duty.
CD is not very active in Secondary market

.
3. LAF Repo and Reverse Repo
It is Lending and Borrowing money for short term period (1 day to 1 year)
Under Repo, RBI purchases securities with commitment to sell at a later date in order to
Inject Liquidity. Presently, Govt. securities are dealt with. All Repo transactions are
routed through CCIL. RBI has permitted Repo in Corporate securities for only AA rated
companies. But the market is yet to be activated.
Under Reverse Repo, RBI sells securities with a commitment to buy at a later date in
order to Contain Liquidity.
Repo and Reverse Repo transactions are generally conducted for Overnight period
through Auction Twice Daily. The minimum Bid is Rs. 5.00 crore and its multiples.
Margin is normally 5%.

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 (Total available funds to a bank under LAF will be capped at 0.5% of NDTL w.e.f.
24.7.2013)

Latest Repo Guidelines as per Monetary policy dt. 3.6.2014

Cap of Overnight Repo reduced from 0.5 % to 0.25% of NDTL

Continuation of Term Repo up to 0.75% (cap) of NDTL under 7 days to 14 days
term repos.

4. CBLO : Collateralized Borrowings and Lending Obligations:

It is money market instrument launched by CCIL. Borrower can deposit G-sec with CCIL
and borrow funds from others who have surplus funds subject to re-purchase of
securities. The tenure is 1 day to 1 year.

Bills Rediscounting:
Treasury re-discounts bills which are already discounted by other banks. The tenure is 3-
6 months.

Security Market Products: Securities constitute Shares, Debentures, Bonds, and Govt
Securities etc. The various types of securities are:

1. Govt. Securities
These are issued by PDO (Public Debt Office) of RBI.
Price is determined in auction
There is active trading in Secondary market.
If Yield rate is more than coupon rate, these are issued at a discount.
Open Market Operations are conducted by GOI to maintain liquidity position.
SLR requirements are met by banks by investing in HTM securities.
2. Corporate Debt Papers
These are medium and long term Bonds and Debentures issued by Corporate
and FIs.
These are non-SLR securities.
These form part of Tier II Capital.
Yield is more than that of Govt. Securities.
3. Debentures and Bonds: Both are Debt instruments and form part of Tier-II Capital.
SEBI has control over issuance and redemption.

Debenture Bond
Issued by Corporate in Private sector Issued by institutions in Public sector
It is Secured by Floating charge It is not secured
Provisions of Company Law applies It is governed by Indian Contract Act

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 It can be transferred through registration It is negotiable instrument
It can be convertible or non-convertible Bond, if given option can be convertible
into equity shares.
It can be
Zero Coupon Bond
Perpetual Bond
Floating Bond
Deep Discount

4. Equities: It is Share Capital issued by both Private sector and Public sector Companies
to raise funds from public. The people who invest are called Shareholders:
Bank can invest subject to limit exposure set by RBI for Capital Market
SEBI has full control and these are traded in Stock Exchanges.
Derivative products are also available.
If offered by Company, it is called Primary Market. If purchased through Stock
Exchanges, it is called Secondary market.

Equity Share Preference Share

It is permanent capital and is not
redeemed. It forms part of Tier-I Capital.
Dividend is paid out of profits after making
payment to Preference Share holders.
The Company, if liquidated, pays to Equity
Shares at last.
These carry Voting Rights.
It may be redeemable or non-redeemable.
If redeemable, forms part of Tier-II Capital
Preference is given while paying dividend.
Unpaid dividend can be carried forward.
This is why these are called Cumulative
Preference shares.
Preference Shares are given preference
for payment at the time of liquidation.
These dont carry Voting rights.
Generally Preference Shares are
Cumulative and Redeemable.

Domestic and Global Markets

Rupee is fully convertible on account of Current Account transactions and partially on account of
Capital Account transactions. Interaction between Domestic and Global markets takes place in
respect of following:

1. FII Investments: These are made by way of FDI (Foreign Direct Investments) and
Portfolio Investments. FDI is for Long term Project related investment whereas Portfolio
Investment related to Investment in Equity and Debt Market. In some areas, FDI is 100%
whereas it is up to 74% in other areas.
2. ADR/GDR

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 American Depository Receipts are Receipts or Certificates issued by US Banks
representing specified number of shares of non-US Companies.

Global Depository Receipt is a Dollar denominated instrument which is traded in

European Markets but represents Securities of non-European Companies.

3. ECB (External Commercial Borrowings

External Commercial Borrowings are medium and long term loans as permitted by RBI
for the purpose of :
Fresh investments
Expansion of existing facilities
Trade Credit (Buyers Credit and Sellers Credit) for 3 years ar more.
Automatic Rout
ECB for investment in Real Estate sector , Industrial sector and Infrastructure do
not require RBI approval
It can be availed by Companies registered under Indian Company Act.
Funds to be raised from International recognized sources such as banks, Capital
markets etc.
Maximum amount is USD 20 million with minimum average maturity of 3
years and USD 750 million with average maturity of 5 years.
All in cost ceiling is :
ECB up to 5 years : 6M LIBOR+350 bps.
ECBs above 5 years: 6M LIBOR+500 bps.
Approval Route
Under this route, funds are borrowed after seeking approval from RBI.
The ECBs not falling under Automatic route are covered under Approval Route.
Under this route, Issuance of guarantees and Standby LC are not allowed.
Funds are to be raised from recognized lenders with similar caps of all-in-cost ceiling.

4. Foreign Currency Funds of Banks

Banks can use FCNR deposits for the purpose of Investing outside India as well as for
domestic lending in foreign currency. They are also permitted to borrow/invest in
overseas market within a ceiling of 50% of Unimpaired Tier Capital with minimum
USD10 million.

5. ODI (Overseas Direct Investment)

Corporate can invest in Joint Venture/Subsidiary units outside India from Rupee
resources subject to cap of 4 times of Net worth i.e. 400% of Networth.
This way, Indian Companies can have global presence.

Any financial committee exceeding 1 billion USD in a financial year would require prior
permission of RBI even within overall limit of 400% of Net Worth.

LRS (Liberalized Remittance Scheme)

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 The scheme is meant for Resident Indians individuals. They can freely remit up to USD
125000 per financial year in respect of any current or capital account transaction without
prior approval of RBI. The precondition is that the remitter should have been a customer
of the bank for the last 1 year. PAN is mandatory.
Not Applicable
The scheme is not applicable for remittance to Nepal, Bhutan, Pak, Mauritius or
other counties identified by FATF.
The scheme is not meant for remittance by Corporate.

Latest Guidelines
The scheme should not be used for making remittances for any prohibited or
illegal activities such as margin trading, lottery etc., as hitherto.
Resident individuals have now been allowed to set up Joint Ventures (JV) /
Wholly Owned Subsidiaries (WOS) outside India for bonafide business activities
outside India within the limit of USD 125000.
The limit for gift in Rupees by Resident Individuals to NRI close relatives and
loans in Rupees by resident individuals to NRI close relatives shall accordingly
stand modified to USD 125000 per financial year.
RBI has clarified that Scheme can now be used for acquisition of IP outside India.

MSF Marginal Standing Facility

The banks will use Marginal Standing Facility to borrow overnight money from RBI only
when they have exhausted all other existing channels like Collateralized Borrowing and
Lending Obligations (CBLO) and Liquidity Adjustment Facility (LAF). The features of the
scheme are as under:
The eligible entities can avail overnight, up to 2% of their respective
nd
NDTL outstanding at the end of the 2 preceding fortnight.
For the intervening holidays, the MSF facility will be for one day except on
Fridays when the facility will be for 3 days or more, maturing on the
following working day.
The facility is available on all working days in Mumbai, excluding
Saturdays between 3.30 P.M. and 4.30 P.M.
Interest on amount availed will be 100 bps above Repo i.e. 9.00%.
Requests will be received for a minimum amount of Rs. One Crore and in
multiple of Rs. One Crore thereafter.
MSF will be undertaken in all SLR-eligible transferable Government of
India dated Securities/Treasury Bills and State Development Loans
(SDL).
A margin of 5% will be applied in respect of GOI dated securities and Treasury Bills. In
respect of SDLs, a margin of 10 per cent will be applied

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 FDI (Foreign Direct Investment)

Foreign direct investment (FDI) is a direct investment into production or business in a

country by an individual or company in another country, either by buying a company in
the target country or by expanding operations of an existing business in that country.
Foreign direct investment is in contrast to portfolio investment which is a passive
investment in the securities of another country such as stocks and bonds.

FDI Limits in different sectors are as under:

%age of Net Owned
Capital
Defense Sector 49%
Insurance Sector 49%
Power Exchanges 49%
Civil Aviation 49%
Credit Information Companies 74%
Railways 100%
Retail- Multi brand 51%
Retail Single brand 100%
Courier Service 100%
Foreign Banks in wholly owned 100%
subsidiary
Telecom Sector 100%
Private Sector banks 74%
Public sector Banks 20%
A citizen/Entity of Pakistan may participate in FDI with prior approval of
Government.
ODI It has now been decided:
(Overseas
Direct a) To restore ODI up to 400% of Net Worth. Any financial
Investment ) commitment exceeding 1 billion USD in a financial Year would
require prior approval of RBI even within overall limit of 400% of
Net worth.

b) Any ODI in excess of 400% of the net worth shall be considered

under the Approval Route by the Reserve Bank of India.
FPIs FPIs are now allowed access to :
(Foreign Currency futures
Portfolio Exchange traded currency options

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 Investors For the purpose of hedging currency risk arising out of market value of
their exposure to Indian Debt and Security market.

UP TO USD 10 MILLION or equivalent without having to establish

existence of any underlying exposure.

Beyond USD 10 million, FPI will have to establish underlying exposure.

PRESENT RATES AT A GLANCE

Previous Rate Present Rate

w.e.f 29.10.2013 W.e.f. 28.1.2014
Repo 7.75% 8%
Reverse 6.75% 7%
Repo
MSF 8.75% 9%
Bank Rate 8.75% 9%
CRR 4% 4%
SLR 23% 22.0% (9.8.14)

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 Funding and Regulatory Aspects
Broad Money (M3) includes currency in circulation, Demand and Time Liabilities of Banks and
Post Office SB accounts. Narrow money (M1) includes Currency in circulation, Demand
Liabilities of Banks and other deposits with RBI. M3 is 3-4 times than M1.

Money is impounded by RBI to reduce multiplier effect by means of CRR and SLR.

Cash Reserve Ratio (Presently 4% of DTL)

Banks have to maintain cash balance equal to 4% of DTL with RBI.
There is No minimum and No ceiling limit.
No interest is paid by RBI.
Non-maintenance of CRR attracts penalty @ 3% above Bank rate on Ist day and 5%
above bank rate on 2nd day.
It is calculated as fortnightly average.
However daily cash balance should not fall below 95% (Previously 70%) of the amount
required.
Statutory Liquidity Ratio (Presently 22.00% of DTL)
Banks have to maintain liquid funds in the form of cash, gold and un-encumbered Govt.
securities @22.0% of DTL.
There is no floor limit. However, ceiling limit is 40%.
Non-compliance attracts penalty @ 3% above Bank rate on Ist day and 5% above bank
rate on 2nd day.
It is computed as on last Friday of 2nd preceding fortnight every month.
What Constitutes DTL?
Demand deposits (CA, SB, Margin money for LC and Overdue FDs)
Time Deposits (FD and RD).
Overseas borrowings
Foreign outward remittances in transit.
Accrued Interest and credit balance of Suspense account.
Exemptions
Capital, Reserves and Surplus
Net Interbank borrowings, Credit balance in ACU Dollar accounts, Transactions in
CBLO and CCIL
Refinance from NABARD, SIDBI, NHB and RBI.
DTL in respect of Off-shore banking units.

Payment and Settlement System

RTGS & NEFT in India

1. RTGS (Real Time Gross Settlement) is a payment system for Interbank transfer
with minimum Rs. 2.00 lac. This system is managed by IDBRT, Hyderabad, which
connects all banks to Central server maintained by RBI. The network is INFINET (Indian
Financial Network)

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Timings are:
R-41 transactions 9:00AM to 4:30PM (Saturday: 9:00 to 1:30 PM)
R-42 transactions 9:00 AM to 6:00 PM

2. NEFT (National Electronic Fund Transfer) is mainly used for low amount
transactions. However, there is no minimum and maximum limit. The timings are:
8:00AM to 7:00PM (Saturday 8:00 to 1:00 PM). There are 12 batches daily except
Saturday with 6 batches. The time period is B+2.

3. Negotiated Dealing System (NDS): It is an electronic platform which facilitates sale

and purchase of Govt. securities. Auctions are made and trading is done electronically.
Banks, PDs, Insurance Cos., MFs and FIs are members. Improved version of NDS
called OM (Anonymous Order matching system) takes care that identity of counter party
is not disclosed till offer is accepted.

4. FX Clear: It is Forex Dealing system developed by CCIL. CCIL provides straight

through processing (STP) between banks for USD/INR transactions and settlement in
made in Indian Rupees.

5. NSDL and CDSL: National Securities Depository Ltd. (NSDL) and Central Depository
Services India Ltd.(CDSL) provide a settlement platform for shares and other securities
in the Secondary market. These institutions also maintain Demat accounts.

NEW RTGS SYSTEM EFFECTIVE FROM 14.7.2014

Two new features have been added:

1. Hybrid System
Offsetting after every 5 minutes.
The transactions with normal priority would be settled in off-setting mechanism
within maximum 2 attempts.
Maximum time a transaction would be in normal queue is 10 minutes.
If transaction with normal priority is unable to be settled on offsetting mode within
10 minutes, it would be automatically converted to Urgent.
2. Future Value Transactions
Value Dated transactions would enable the customers/participants to initiate
RTGS transactions 3 working days in advance for setting in RTGS on Value
Date.

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 Treasury Risk Management
Why Treasury is risky?

Treasury is risky because of the following:

1. High Leverage- Value of transaction is very high say 100 crore and 1% adverse
movement may result into loss of 1.00 crore.
2. There is sole discretion of Treasury Department to sell, buy or keep open position.
3. Transactions are confirmed and irrevocable.

Risks involved in the Treasury are mainly:

Market Risk It consists of Liquidity risk, Exchange rate risk, Interest rate risk, Equity
risk and Commodity risk

Take an example:
We borrow from Money market and invest in 5 year G-securities. If Bond prices come
down, we are not willing to sell the bond, but loan has to be repaid. This may lead to
shortage of funds which is called Liquidity Risk.

Liquidity Risk is translated into Interest Rate Risk when funds have to be arranged at
higher rate. Mismatch between Assets and Liabilities also lead to Interest Rate Risk.

Fluctuation of exchange rates due to many domestic and international factors can lead
to Currency Risk.

Risk of fluctuation in market price of Shares and Bonds is called Equity Risk whereas
Risk of Fluctuation in market price of Commodities such as Gold, Silver etc. lead to
Commodity Risk.

Credit Risk It is risk of default by counter party due to various reasons such as Buyer
Risk, Seller Risk, Country Risk and Sovereign Risk.

Types of Control are:

1. Organizational Control
Segregation of Front, Back and Mid office for effective monitoring and control.
2. Internal Control
Setting up of limits like Deal Size limit, Open Position limit, Stop loss limit, Day light limit
and Overnight limit

3. Exposure Ceiling Limit

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 Exposure limit of counterparty is fixed on the basis of Credit Rating. Ideally all deals
should take place DVP Delivery Vs Payment and there is no risk. But ideal position is
not there always.
RBI has imposed a ceiling of 5% of Total Business in a year for Individual broker

Measurement of Risk

There are two methods to measure Risk:

1. Value At Risk (VaR)

2. Duration Approach

1.VaR (Value at Risk) It is statistical measure indicating worse movement of market rate over
given period of time under normal market conditions.

For example: Overnight VaR of 45 bps for USD/INR at 95% confidence level. If spot rate is
46.00, there are only 5% chances that the rate will be worse than 45.55 (46.00-0.45).

Another Example is: If Overnight VaR of 1 year G-Sec is 0.35%, the current yield of 7.75% is
expected to fall/rise not more than 0.35% by tomorrow.

VaR is based on Volatility.

Volatility is sd calculated from mean observations over a period of time.
VaR is suggested for shorter period.

2. Duration or Macaulay Duration

Duration is the period during which Present Value of Outflows become equal to the Present
Value of Inflows.

Bonds carry coupon rate. If rate of return is higher than coupon rate, Value of Bond falls.
Effective rate of Bond is called Yield.

Duration is Weighted Average measure of life of Bond where time of receipt of cash is
weighted by Present Value of Cash Flow.
It is expressed in number of years during which PV of the bond equals the market price.

Formula is :

Duration (Macaulay Duration) = pvT

pv
Modified Duration = Duration
1+ Yield

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 Derivative Products

Derivatives dont have independent value. Their value is derived from the underlying market.
The market may be financial market dealing in forex, bonds and equities as well as commodity
market dealing with underlying commodities like Gold, Silver etc.

Derivatives refer to Future Price based on Spot Market. Two types of Products are as under:

1. OTC Products
These are Over The Counter products which include Forward Contracts and Options.
These are offered by FIs. These derivatives offer contracts with date, amount of terms
fixed as per requirement of the client. Price is quoted by banks/FIs after adding margin.
Settlement is made by physical delivery. Counterparty Risk is always present.
2. Exchange Traded products
These include Futures traded on organized exchanges. Size of the contract is
standardized. Price is transparent. The exchanges collect margin based on Mark to
Market price. Physical delivery is not must. There is no counter party risk.

Types of Derivatives
1. Forward Contracts
2. Futures
3. Options
4. Interest Rate Swaps
5. Currency Swaps

Forward Contracts
It is a deal to buy or sell Shares, Commodity or Foreign Exchange at a contracted rate with
desired maturity. Forward rate is the interest rate differentiation of two currencies. If Interest
rate is high in a country, its currency will be cheaper.

Futures
It is OTC product. The seller agrees to deliver a specified security, currency or commodity on
specified date at a fixed price. Currency Futures are traded in EURO, GBP, JPY, CHF, AUD &
CAD.

Forward Contract Futures

It is OTC (Over the Counter) Product It is Exchange traded product
It can be for any odd amount It is always for Standard amount
It can be for any Odd period It is always for Standard period
Delivery is essential Delivery is not must
Margin is not essential It is based on Margin requirement and
Marked to market
Contract size of USD/INR is USD 1000. The settlement takes place in INR.
EURO/INR/GBP is traded in cross currency rates.
Future of INR is allowed with Contract size minimum Rs. 2.00 lac based on 7% synthetic
10 year G-Sec.

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 OPTIONS

Option is a contract to buy or sell currency, bonds or Equity on future date. The party has right to
exercise option but there is no obligation.

Option is Right to buy or sell an agreed quantity of currency or commodity without obligation to
do so. The buyer will exercise the option if market price is in favor or otherwise option may be
allowed to lapse.

There are two types of Option: 1. Call Option 2. Put Option

Call Option
Right to buy at fixed price on or before fixed date.
Put Option
Right to sell at fixed price on or before fixed date.
Final day on which it expires is called maturity. The pre-fixed rate is called Strike Rate.
CALL OPTION;
If Strike price is below the spot price, the option is In the money (ITM)
If Strike price is equal to the spot price, the option is At the money.(ATM)
If Strike price is above the spot price, the option is Out of money.(OTM)
PUT OPTION
If Strike price is more the spot price, the option is In the money.
If Strike price is equal to the spot price, the option is At the money.
If Strike price is less than spot price, the option is Out of the money.
American Option
Option can be exercised on any day before expiry.
European Option
Option can be exercised on maturity only.
Plain Vanilla Option
It is an option without any conditions. It is ideal for Hedging.
Zero Cost Option
It does not attract any premium. There is risk of holder i.e. importer to pay higher rate if market
rises beyond certain level.
Embedded Option
The bond holder is given option to convert its debt into equity.

Other features of an Option Contract

Option is based on Notional amount as only exchange difference is settled.
Price of Option is much smaller than the Notional Value.
The premium depends upon Volatility of the underlying product.
Longer the maturity, costlier will be the option.

Interest Rate Swaps (IRS)

It is OTC product. It deals with exchange of Interest flows on an underlying assets and liability.

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For Example: A company is paying interest on 5 years Debentures @7%. In market, rate of
interest is declining; the company will be benefitted if Interest rate is linked to market rate of
interest. The Company enters into Interest rate swap with bank with the terms that Fixed rate of
interest on Debentures will Swap 3M T-bills @5%. The fixed rate of 7 % on Debentures will be
swapped with T+2%. After every 3 months, bank will pay the company @ T-bills+2%.

Assuming that in the next quarter, 90 days T-bill rate is 4%, the Company will pay to
bank@6%(4+2%) and will receive from bank 7% thereby saving of 1%.

On the other hand, if T-bill rate is increased to 5%, the company will lose by 1%.

FRA (Forward Rate Agreement) is a product where interest payable for future period is
committed. IRS covers series of periodic interest payments whereas FRA is for single interest
payment in future.

Currency Swaps

It is exchange of cash flow in one currency with that of another currency. Two types of currency
swaps are there: Currency Only Swap & Principal Only Swap. Currency Swaps are used to
mitigate exchange risks for meeting Principal or Interest obligations.
Example: An investor in Germany needs INR to Invest in India. On the other hand, Reliance in
India needs Euro to acquire a Co. in France. German Investor will raise Euro funds at low rates
and Reliance India will raise Rupee loans at low rates from India. Two parties will Swap Loans
with Bank as financial intermediary.
Principal Only Swap allows the borrower to pay interest in USD. But payment of
Principal is made in home currency. As such risk fluctuations in respect of Principal are
eliminated.
Coupon Only Swap allows the borrower to pay interest in INR. Whereas Principal
amount is hedged by using some other derivative.
P+I Swap is there when borrower eliminates Currency risks as well as Interest Risk. The
risk is zero. Borrower will pay Principal + Interest in Domestic currency to settle Foreign
Currency borrowings. The swap cost is included in rupee interest rates.

RBI Guidelines on Risk Exposure

1. Banks and Counter parties will sign agreement known as ISDA (International Swap
Derivative Association) Master Agreement which is standardized by SDA (Swap
Derivative Association). The agreement is cleared by FIMMDA (Fixed Income Money
Market and Derivatives Association) and FEDAI.
2. RBI allowed MIFOR (combination of LIBOR and Forward Premium) for Inter-bank
dealings only.
3. RBI permitted banks under ISDA agreement to opt for dual jurisdiction.
4. Ceiling for Forward Contract for Designated Importers and Exporters is 100% of
previous years exports or average of 3 years exports (whichever is higher). The ceiling
is 50% for other Importers and Exporters.

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 Treasury and ALM
ALM refers to risk management to avoid mismanagement between Assets and Liabilities. The
risk of Liquidity and Interest rates, if not controlled may result into negative spread and can
cause loss to bank. Therefore ALM manages two risks : 1. Liquidity Risk & 2. Interest Rate Risk.

Liquidity Risk and Interest Rate Risk

We borrow from Money market and invest in 5 year G-securities. If Bond prices come down, we
are not willing to sell the bond, but loan has to be repaid. This may lead to shortage of funds
which is called Liquidity Risk.

Liquidity Risk is translated into Interest Rate Risk when funds have to be arranged at higher
rate. Mismatch between Assets and Liabilities also lead to Interest Rate Risk.

Role of ALM to mitigate Liquidity Risk

Liquidity Gap arises when there is difference between souses and uses of funds. RBI has
prescribed Time bands to measure Liquidity Gaps. These are

1-14 days.
14-29 days
1M 3M

ALM measures the gap between Uses and Sources between above said Time bands.
RBI has also prescribed limits of maximum negative mismatch as under:

Next Day -------5%

2-7 Days------10%
8-14 Days-15%
15-28 Days--20%

ALM takes steps to meet shortfall as a contingent measure at a reasonable rate.

Interest rate Gap leads to erosion of NII (Net Interest Income) due to difference between
earnings and payments.

ALM has the following role to play:

Treasury establishes a link between Core banking and market operations to manage
risks.
Treasury earns profits by managing funds out of mismatches.
Treasury hedges residual risk in Forex market.
Treasury monitors exchange rates and interest rate movements in the market.
Use of Derivatives in ALM
Derivatives are used to hedge high value individual transactions.

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For Example: Medium Term Loan of 3 Years is funded by Deposit of 3M because 3M deposit is
cheaper and NII is increased.
Bank may swap 3M interest rate into fixed rate into Fixed rate for 3 years. Bank may
also swap Fixed interest rate on loan into floating rate linked to T-bill rate. If 3M deposit
rate is T+1% and 3Year interest rate on loan is T+3%, there will be NII@2%.
Bank may arbitrage Forex. It can buy USD funds at cheaper rate (say 3%) and invest in
rupee loan at 6.5%. The spread can be 3.5%

Risks of Derivatives: Derivatives are not free from risks. Two risks involved in Derivatives are:
1. Residual risk i.e. basis risk.
2. Embedded Option Risk :There are embedded options in certain bank products. E.g. FD
is paid premature or TL is pre-paid. It affects the ALM policy if pre-mature payments are
large.

Treasury and Credit Risk

There are chances of failure on the part of counter party to meet its obligations especially when
Treasury deals in:
1. Debt Market products such as CPs, Bonds, Debentures etc,
2. Securitization of Credit Receivables when credit receivables are converted into Units
or Bonds which are called PTCs ( Pass-through certificate).
3. SPV Special Purpose Vehicle enables the banks to securitize the Mortgage loans

Credit Derivatives
1. Credit Default Swaps
2. Total Returns Swap
3. Credit Linked Notes

Transfer Pricing
It is important function of ALM. It relates to:
Fixing cost of recourses and return on Assets.
ALM notionally buys and sells deposits and loans of the bank.
Price is paid for buying deposits and price is received for selling loans. This is called
Transfer Pricing.
The prices vary according to the tenure or maturity of deposits and loans.
Deposits are bought by Treasury at a rate arrived at by adjusting hedging cost from rate
of deposit. If bank accepts deposits%7% and cost of hedging is 1%, the deposits will be
bought by Treasury @6%.
Loans are sold to Treasury at transfer cost. For example, 10% loan may be notionally
sold to Treasury @7%. The balance is denoted as Risk premium.
Treasury Division, after implementing the Transfer Pricing takes care of Liquidity Risk
and Interest rate risk.

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