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Understanding Treasury Management

XIMB August2010

Rishi Rakesh

Understanding Treasury
Dynamics

Contents
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o
o

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Session I (Overview):
Role of Treasury in an organization
Balance Sheet Dynamics
Benchmark\Transfer Pricing

Session II (Treasury Risk)


Managing Interest Rate Risk
Managing Liquidity Risk
Managing Foreign Exchange Risk
Session- III (Money Market)

Govt Bonds, Yield Curve

Interest Rate Swaps, Forwards, Options

Foreign Exchange Swaps & Forwards

Session- I
Treasury Overview

Course Objectives
o
o

Understand basic concepts of Treasury


management
Understand Treasury function and its role
in business management process

Course Outcome
o

Be able to better consider treasury


issues as part of the business
management process
Be able to understand Treasurys
different risk exposures and the
methods used to manage these risks
Be able to interpret treasury data and
treasury language

The Evolution
Building Blocks of the Banking Business:

Credit/Lending

Marketing

Operations

Treasury Management

THE MISSING LINK

The Missing Link


Building Blocks of Banking Business:

Credit

Marketing

Operations

AND Treasury

The Finance Industry


Role of Financial Market:
1.
2.
3.

Interaction of buyers and sellers of risks


Determination of price of risks
Reduction of transaction costs

Purposes of Financial Assets:


1.
2.

Transfer of funds from surplus-holders to deficit-holders


Redistribute unavoidable risks from risk-providers to seekers

Risk Providers /
Sellers

B
A
N
K
S

Risk Investors /
Buyers

Role of Treasury
Customer Business Proposition
Market Strategy
Credit

Op. Capacity
Product Planning Process
Funding / Investment

Treasury Cycle
Transaction initiation
Revenue / Expense
Stream management
- Interest rate
- FX rate
Liquidity / Cash flow
management.

Marketing / Sales

Credit Cycle
Credit Initiation
Account Maintenance
Collection - write offs

MIS: Portfolio Management

Role of Treasury
o

Central bank for all internal customers

Determine price of money

Bridge funding/lending needs

Identify/quantify market risk


o

Interest rate risk

Liquidity risk

Foreign exchange risk

Manage risk where necessary

Managing the company's relationships


with credit rating agencies

10

Summary
Treasury Actions
Hedging
Investments
Funding
Asset / Liability Management

11

The Treasury Balance Sheet


Unit Outline
Treasury components of a balance sheet
Why have treasury assets & liabilities?
Treasury assets
Treasury liabilities
Example balance sheets
Summary

12

Components of a Typical Bank Treasury Balance Sheet


ASSETS

LIABILITIES

Our accounts

Their accounts

Bank placements

Bank borrowings

Intercompany (pool) assets

Intercompany (pool) liabilities

Mandatory reserves

Commercial paper

Available for sale (AFS)

Capital market borrowings

Trading account securities

Swap assets

Swap liabilities

TP assets

Capital

TP Liabilities

(bond issues)

13

Why Have Treasury Assets & Liabilities?

For management of the structural position

For liquidity management

For interest rate risk management

For FCY portfolio management

For regulatory compliance

14

Liquidity Management

Treasury Assets

Normal liquidity buffer

Treasury Liabilities

Funding consumer assets


Opportunistic Gapping

Contingency liquidity
buffer
Investment of excess
liquidity from
consumer deposits

15

Rate Risk Management

Developed markets have derivative (off balance sheet)


instruments to manage interest rate risk

Less sophisticated markets use treasury instruments to


hedge interest rate risk

Limited by

Available instruments
Available liquidity to make the investment

Volume and maturity of customer assets may be equal


to those of customer liabilities, while having different
interest rate repricing profiles

16

FCY Portfolio Management

Manage Exchange Risk

FCY deposits are used to fund LCY balance sheets in certain markets
(e.g. India FX swaps)

Generally unwilling to use FCY deposits to fund LCY balance sheet


(high MTM volatility, corporate limitations)

17

Regulatory Compliance

Reserve requirements
Deposits

with central bank

Government
Other

securities

securities acceptable to central bank

18

Treasury Assets
o

Bank placements

Available for sale (AFS)

Trading account securities

19

Summary
Treasury Responsibilities for
Balance Sheet Management

Define the liquidity characteristics of each balance


sheet item; use treasury assets and liabilities to
structure a liquidity plan to manage the risks

Anticipate future balance sheet growth and articulate


funding strategies and contingency plans to manage
the liquidity risk

Define the rate sensitivity of different customer assets


and liabilities and structure a plan to manage the
interest rate risk

20

Balance Sheet Dynamics


Unit Outline

Key concepts

Re-pricing and Repayment Models

Treasurys Response

Summary

21

Key Concepts
The three variables that Treasury is most interested in are:

Re-pricing characteristic

Repayment characteristic

Foreign exchange risk

These characteristics are the core of:

Interest rate risk management

Liquidity management

Foreign exchange risk management

22

Key Concepts

Every product has certain characteristics important to


Treasury

The goal is to understand the profile of each asset and


liability category

Detailed analyses provides actual re-pricing/maturity


profile of each asset and liability category

23

Key Concepts

The actual re-pricing/maturity of assets vs. liabilities


determines the inherent amount of interest rate risk and
liquidity risk

Matched or square indicates that re-pricing/maturity


of assets matches liabilities; there is no position

A Gap indicates a mismatch of repricing/maturing


assets and liabilities

24

Repricing & Repayment Models


A Simplified Balance Sheet
Assets
Fixed Rate Loan

$150MM

Liabilities
Consumer Time
Deposit

$100MM

Floating Rate
Loan

$50MM

Floating Rate
Deposit

$50MM

Mortgage Loan

$100MM
$300MM

Professional CD

$150MM
$300MM

25

Repricing & Repayment Models


Product Characteristics
Product

Tenor

Behaviour

Loan

3 years

Fixed rate

Floating Rate Loans

4 years

Repriceable Yearly

Mortgage Loan

10 years

Amortizing

Professional CD

3 years

Fixed rate

Floating Rate Deposit 4 years

Repriceable Yearly

Time Deposit

Fixed rate but 25% matures in Year 1


Fixed rate but 25% matures in Year 2
Fixed rate but 50% matures in Year 5

5 years

26

A Simplified Repricing Model


1 YR

2 YR

3 YR
150

4 YR

50

50

50

50

10

70

100

54

54

205

57

10

70

300

Fixed Rate Loans


Floating Rate Loans
Mortgages
Total
Prof CD

5 YR

> 5 YR

50

150

Floating Rate Deposit

50

50

50

Time Deposit

25

25

Total

75

75

200

Gap

(21)

(21)

Cum

(21)

(42)

(37)

TOTAL
150

150
50

50
50
50

100

50

(40)

70

(30)

(70)

300

27

A Simplified Repricing Model


Conclusions

In general, the re-pricing of liabilities in a bank


takes place earlier than the re-pricing of
assets.

If the yield curve was positively sloped (i.e. if


longer maturities have higher rates), a
negative gap is profitable.

If interest rates rise and gap is negative,


profitability will be squeezed since a higher
rates will be paid to raise liabilities whereas
the interest being paid on assets are already
locked.
28

A Simplified Repayment Model


1 YR

2 YR

Fixed Rate Loans

3 YR
150

Floating Rate Loans

4 YR

5 YR

> 5 YR

50

TOTAL
150
50

Mortgages

10

70

100

Total

155

57

10

70

300

Prof CD

150

Floating Rate Deposit

150
50

50

Time Deposit

25

25

50

100

Total

25

25

150

50

50

Gap

(21)

(21)

(40)

70

Cum

(21)

(42)

(37)

(30)

(70)

300

29

A Simplified Repayment Model


Conclusions

In general, the repayment of liabilities for a


bank takes place faster than the repayment of
assets.

Treasury should ensure that existing funding


can be rolled over upon maturity or new
funding can be sourced to support assets.

There is liquidity risk if cash inflows from asset


repayments do not coincide with the cash
outflows from liability maturities.

30

Repricing & Repayment Model


Benefits

A good model provides insights into profit dynamics


and liquidity position of the business.

Once the risk is identified, it can be managed.

Needs highlighted by the model can help us evolve


new product offerings.

Elimination of risk may not be a goal; as a financial


intermediary, we take some interest rate risk.

The key is to determine an acceptable amount of risk


given a certain set of forecast events.

31

Product Dynamics
Product

Pricing

Liquidity

Product
Agreement

Behavior often
observed

Product
Agreement

Behavior often
observed

Term deposit
(e.g. 3 month
fixed rate TD)

Agreed upon
rate

Market lagging /
Pricing pressure
(competition)

Contractual for 3
months

Roll-over /
Pre-termination

Current a/c
Savings a/c

On demand
(short-term)

Sticky pricing

On demand (shortterm)

Portfolio
Dynamics:
Core (LT) vs NonCore (ST)

15 year FixedRate Mortgages

Agreed upon
rate

Refinancing with the


same bank

Contractual for 15
years

Refinancing with
another bank

Credit cards

Can be repriced upon


notice

Limited repricing
ability due to
competitive pressure
or statutory max.

Minimum payment
by due date

Portfolio
Dynamics:
Transactor vs.
Revolver

32

Savings Example
REPAYMENT ANALYSIS

With a large enough population, we can perform statistical behavioral


analysis.

This analysis will identify a certain core percentage of deposits that can
be said to have an indefinite maturity.

A portfolio dynamic occurs when:


The core portion of the book remains long term.
As the book grows, the amount of this core segment will also grow.
As the book grows, the percentage which this core segment
represents usually does not grow.

33

Savings Example
REPRICING ANALYSIS

Movements of product price vs. market rates generally show a weak


but notable relationship.

Although the entire portfolio could (in theory) be re-priced tomorrow, it


clearly will NOT be.

However, once the portfolio does re-price:

The amount of the change in basis points will be less than


movements in the market rates.

Regardless of market movements, there will be a considerable


interval before the next repricing.

34

Savings Example
Assigning
a Tenor to
Savings is
a
CHALLENG
E!

We said that even though Savings is


contractually on demand, the core
portion of the book remains long term.

But how long is long enough for core?

It all depends

Core: Generally 2 years ~ 5 years

Non-Core: Generally overnight ~ 1


month.

Assumptions should be reviewed


periodically.

35

Treasurys Response

Statistically Determine Actual Behavior

Take a portfolio approach (providing that a large


enough population exists for statistical validation).

Do a redemption analysis (examining the actual


payment history of a product set).

Adjust for seasonalities.

Take into account other variables, such as:

Ceilings / Floors
Advertising / promotion campaigns
Innovation

36

Treasurys Response

Use re-pricing models to predict profitability

The actual re-pricing structure determine future


profitability.

A re-pricing model should be able to forecast earnings


volatility.

A re-pricing schedule of all assets vs. all liabilities and


capital gives us our current interest rate position and
exposure to future events.

37

Summary

Consumer products have certain repayment


and re-pricing characteristics that need to be
managed.

A model needs to be built that shows the


liquidity and interest rate risks inherent in the
balance sheet.

Effective management of repricing and


repayment risk results in enhanced and more
consistent earnings.

38

Treasury Role of Benchmarking


Unit Outline
Benchmarking:

the concept
Benchmark determination
Benchmark pricing examples
Benchmark pricing in practice
Summary

39

Benchmarking : The Concept

What is a Benchmark?

Benchmarking is a framework that divides the bank into separate


product lines & transfers risk to a central unit

A benchmark is the rate of interest charged (to assets) or paid (to


liabilities) by Treasury

Benchmarks are matched to the cash flows of each product

Benchmark assumptions operate like a service level agreement


between Treasury and Products (reviewed and agreed at least
annually)

Benchmarks serve several purposes

Product pricing signal


Essential to the calculation of product profitability
Transfer of interest rate risk from Products to Treasury

40

Benchmarking : The Concept

Why is Benchmarking Necessary?

Benchmarks are designed to transfer market risk exposure from the individual product
managers to treasury, where all risk is centrally located and professionally managed on
a portfolio basis

Fundamental to the overall concept of market risk neutrality and stable Net Interest
Margin (NIM)

Provides acute focus upon product profitability, customer pricing, positioning and
product development

Promotes management accountability

Without benchmark, the impact of market risk is buried in the results of the product
manager

41

Measurement of Margin Components

Simplified Yield Curve Example


one asset, one liability, booked today

Asset Spread
(Loans)

5%

Yield Curve
Risk Management
Gap (tenor
mismatch)

4%
Liability Spread (Deposits)

Time
42

Measurement of Margin Components


Line Unit
Assets
Customer Rate 8.0%
Transfer Price 5.0%
Matched Spread

Liabs
3.0%
4.0%
3.0%

Spread
5.0%
1.0%

Risk Totally
Treasury
Mgt
Matched
Transfer Price Income 5.0% 5.0%
Transfer Price Expense
4.0%
Treasury Risk Mgt Revenue
1.0%

5.0%
0.0%

Adding the matched spreads (3%+1%) and the treasury spread (1.0%)
equates to the total business spread of 5.0%. The 1% treasury spread
is the net impact arising from the banks market risk. Generally the
spread is positive when the asset tenors are longer than liabilities.

43

Features of Good Benchmarks

Benchmark is a transfer pricing mechanism that aims to reflect


the true economics of the product

Ideally it should be based upon:

External markets (as a pricing signal)


Market risk neutrality (matched tenors)

It is a representation of a products price risk (interest rate)


and liquidity risk summarized into a single concept - the
benchmark price

The assignment of a benchmark should be driven by the


characteristics of cash flow, date of origination, repricing,
maturity (with adjustments for liquidity and embedded
options)

44

Session- II
Managing Treasury Risk

45

Managing Interest Rate Risk


UNIT OUTLINE

Identifying the Risk

Measuring the Risk

46

I. Identifying the Risk

Determine the re-pricing profiles of assets and


liabilities in the balance sheet

Distinguish between the actual and contractual


profiles (Can we re-price, Do we, How often?
How much?)

Portfolio vs. Single Account

47

I. Identifying the Risk


INTEREST RATE EXPOSURE DUE TO

Gaps in an existing portfolio

Basis Mismatch

Volume Risk

Sticky rates on new originations

Embedded options

48

I. Identifying the Risk


SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
A GAP.

Difference in repricing tenor (periods) of assets and


liabilities and/or

Difference in the amount of assets and liabilities


maturing / re-pricing within a time period.

Can be represented as run-off gaps or as remaining gaps


(cumulative gaps).

Can be Positive or Negative.

Can be Structural or Intentional

49

I. Identifying the Risk


SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
Re-pricing Mismatch: A gap occurs when assets are repriced at different periods from liabilities
ASSET
REPRICING

Q1

Q2

Q3

Q4

LIABILITY
REPRICING
Asset

: A one-year quarterly floating rate loan

Liability

: A one-year time deposit


50

I. Identifying the Risk


SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
RUN-OFF GAPS (Maturing amounts)
At the beginning of
Asset
$100MM 1-mth placement w/CMB
Liability
$100MM 3-mth deposit
(Repriceable in 3 mths time)

Mth 1 Mth 2 Mth 3 Mth 4 Mth 5 Mth 6 Mth 7

Run-off Gap
Cumulative Gap

0
0

100
(100)
100
100

0
100

(100) 0
0
0

0
0

0
0

Cumulative gaps (Remaining Amount)


Asset
Liability
Cumulative Gap

Mth 1 Mth 2 Mth 3 Mth 4 Mth 5 Mth 6 Mth 7


(100)
100
100
100
0
100
100
51

I. Identifying the Risk


SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO

TYPE

DEFINITION / IMPLICATIONS

IF RATES
MOVE UP

IF RATES
MOVE DOWN

Positive
Gap

Assets repricing faster than


liabilities
More liabilities to be placed
Lend short Borrow long
Over-Borrowed
COF (Depos Rates) lockedin

Profits rise

Profits fall

Negative
Gap

Liabilities repricing faster


than assets
More assets to be funded
Borrow short Lend long
Over-Lent
Revenue (Lending rates)
locked-in

Profits fall

Profits rise

52

I. Identifying the Risk


SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
STRUCTURAL GAP

Result of the mismatch in the inherent re-pricing


characteristics of assets and liabilities

Influenced by product features and determined by


customer behavior

INTENTIONAL GAP

Due to Treasury Actions

Dependent on view of interest rates

53

I. Identifying the Risk


SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
INTENTIONAL GAPPING : NEGATIVE GAP
You believe rates will fall
Lend long term to lock in current high rates
Borrow short term and roll it over at future lower rates
This results in a Negative Gap

Lend (long)
Borrow (short)
Spread

Year 1
10%
10%

Year 2
10%
9%
1%

Year 3
10%
8%
2%

54

I. Identifying the Risk


SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
INTENTIONAL GAPPING : POSITIVE GAP
You believe rates will rise
Borrow long term at todays cheap rates and lend money
short term so when rates rise, you can reinvest it at the
higher rates

This results in a Positive Gap

Lend (short)
Borrow (long)
Spread

Year 1
10%
10%

Year 2
11%
10%
1%

Year 3
12%
10%
2%

55

I. Identifying the Risk


SOURCE OF RISK - BASIS MISMATCH
When two products (which may have the same re-pricing or
maturity) in the same market, have different degrees of
rate sensitivity
PRODUCT
Asset
(90 days Eurodollar)
Liability
(90 days Bank CD)

1st QUARTER 2nd QUARTER


7.25%

7.25%

7.00%

7.50%

To manage the basis mismatch risk, change pricing nature


of assets to match pricing nature of liabilities or vice versa

56

I. Identifying the Risk

Source of Risk Volume Risk


BAU/Status Quo

FYF
100

Actual
100

B/(W)
-

100

120

(20)

100

80

20

If rates increase after FYF


and customer behavior changes

If rates fall after FYF and customer


behavior changes

Changing rate levels could significantly impact


forecasted volume of asset/liability originations as well
as affect run-off rates of existing portfolio
57

I. Identifying the Risk


SOURCE OF RISK - STICKY RATES ON ORIGINATION
If interest rates rise 2%
Current portfolio - no rate risk

New portfolio - may be unable to price new loans


upwards while we might have to re-price deposits
upwards by close to 2%

58

I. Identifying the Risk


SOURCE OF RISK - EMBEDDED OPTIONS
EXAMPLES:

Cap/Floor on Floating Rate Products


Pre-termination without penalty for Fixed Rate Products
Borrow-back at pre-determined rate on Deposit Products
These options add a new dimension to rate risk that is difficult
to manage
Introduces element of convexity

59

II. Measuring the Risk

KEY CONCEPTS

DV01
(Earnings At Risk)

60

II. Measuring the Risk

To be more meaningful, the re-pricing gap must be


translated into how much earnings risk it represents.

DV01
Management Tool to evaluate risk and define
economic loss parameter

61

II. Measuring the Risk


DV 01 (A Methodology)

Dollar value for 1 basis point move

Captures the potential earnings impact of one basis point


movement in interest rates

Calculated by : Repricing Gap * 0.01% * Tenor

Total DV01 are the sum of individually derived Dv01


(deal by deal calculated)

Total DV01 categorized into Rolling 12 mths and Full


Tenor discounted

62

II. Dv01
An Example:
Executed Placement deal of USD 100 mio for
Tenor 6 mths
Dv01 = 0.01% * 100 mio * 6/12
= 5,000

63

Liquidity Risk
Overview

Introduction What is Liquidity Risk?


How Liquidity Risk Arises
Liquidity Management
Product Liquidity Characteristics
Summary Liquidity Risk

64

Liquidity Problem?

How much water should you bring if you are going to a 7-day trip across the
Sahara?

Carrying enough water for 1-day only assuming there will be wells or
suppliers along the way taking a risk of not being able to find the well
(source of liquidity) before dying of thirst.

Carrying additional water as a safety buffer enough for 10-days incurring


extra carrying costs (another camel to carry the load)

Carrying just enough water for 7-days perfectly matched strategy

The art of balancing liquidity risk vs. return

65

What Is Liquidity Risk?

The risk that funds will not be


available to meet a financial
commitment to a counterparty in any
location or any currency at any time.
This is our key franchise risk
(customer confidence).

Liquidity risk-taking is

Fundamental to banking
An important source of revenue

66

Businesses Need Liquidity

For survival:

Having funds available at all times to meet fully and


promptly all contracted liabilities, including demand
deposits and off-balance sheet commitments

For growth:

Having funds available to take advantage of future


business opportunities

67

How Liquidity Risk Arises


Liquidity risk may come from:
Operating environment:

Exposure arises from daily funding and trading


activities in normal markets

Contingency situations:

Exposure arises from external events


Market
Name

68

Contingency Situations

Market Disruption

Displacement of market arising from abnormal


events (often economic crisis, political turmoil, or
central bank policy change) affecting market liquidity
and ability of most participants to transact at normal
volumes, rates, or tenors.

Name Problem

Denial of market access to specific counterparty due


to concern over its creditworthiness

69

Liquidity Management
Objectives
o

To ensure sufficient liquidity to meet all financial


commitments and obligations when they fall due

To be able to access liquidity in global markets at


reasonable terms

To plan, quantify, and monitor what kinds and levels


of risk that is prudent for the company

To balance the cost of maintaining liquidity, with the


appropriate level of returns

70

Roles & Responsibility

Managing liquidity risk is the joint


responsibilities of Business, Treasury, and
Risk Management; oversight by Asset and
Liability Committee (ALCO).

Country Treasurer

Has primary responsibility for liquidity


management
Develops funding plan & process for each legal
vehicle

71

Summary

Effective liquidity management is critical to:

Business survival, growth and expansion


Maintaining market confidence

Liquidity mismanagement can result in severe


repercussions including loss of market confidence and
erosion of capital base

Liquidity risk management is a joint responsibility of


business, treasury and ALCO.

Prudent liquidity management requires:

Stable and diversified funding structure


Limited reliance on single counterparty and/or market
Proactive management of asset and liability maturity profiles
Disciplined planning for contingency situations

72

Session- III
Money Market Instruments

73

Concept of a Yield Curve


Positive Yield Curve

Positive Yield Curve

Aka normal yield curve

Slopes upward to the right

No specific trend

Premium for longer period

Rates

(credit risk, liquidity risk, compounding)

Maturities

Opportunity cost of inflation

Cost of insulating against rate moves

With a positive yield curve, all things being equal, a


negative gap is generally the profitable position

74

Gapping: Examples of Different Yield Curve

Positive Yield Curve

Rates

Rates

Rates
Maturities

Change Shape

Parallel Shift

Maturities

Maturities

75

Gapping: Current Yield Curve - USD

76

Gapping: Yield Curve Shifts USD Yr 2003 vs 2004

May 2004

June 2003

77

Gapping: Yield Curve Shifts USD Yr 2004 vs 2005

June 2005

May 2004

78

Gapping: Yield Curve Changes UST Yr 2005 vs 2006

August 2006

June 2005

79

Gapping: Yield Curve Changes USD Yr 2006 vs 2007

May 2006

May 2007

80

Gapping: Yield Curve Changes USD Yr 2007 vs 2008

May 2007

May 2008

81

Gapping: Fed Funds Target

First pause in 2 years

Total 425 bps Rate Hikes

225 bps Rate Cut

82

Gapping: Yield Curve Comparison

Beginning of rate cut cycle (Yr 2001)

beginning of rate rise cycle (Yr 1993)

83

Instrument to Manage Risk

Interest Rate Swap

Forward Rate Agreement

Interest Rate Options (Caps / Floors)

84

Interest Rate Swap

Definition

Agreement between two parties to exchange interest rate


payments on a notional principal sum which is not
exchanged

Purpose:

Manage interest rate risk


Permit large volume transactions
Change the interest rate profiles of liabilities or assets
Most common swap is fixed-for-floating which one counterparty agrees to pay a fixed rate over the term of the swap
in exchange for a floating rate payment payable by the
other counter-party (aka coupon swap)

85

Interest Rate Swap Example

Bank ABCs fixed rate mortgage portfolio is funded by 6-month


interbank borrowing

Assets
$50MM mortgages
Avg. Life: 10 yrs
Avg. Rate: 11%
(fixed for 10 yrs)

Liabilities
$50MM TDs
Avg. Life: 6 mths
Avg. Rate: 8%

Concern: ABC expects interest rates to rise; higher rates will


narrow their spread

Solution: ABC decides to enter a SWAP to pay fixed, receive


float with bank XYZ
86

Interest Rate Swap Example

Swap Agreement:

ABC will pay fixed rate at 9% for 5 years on notional


principal of $50MM (less than full life)

ABC will receive the inter-bank rate reset every 6mths


for the next 5 years on notional principal of $50MM

No principal is exchanged, only net coupon interest


payments

87

Interest Rate Swap Example


MORTGAGE FIXED RATE
PORTFOLIO Asset

11%

FIXED RATE = (9%)

XYZ

SWAP

ABC
(8%)

FLOATING RATE = 8%

FUNDING
SOURCE

FLOATING RATE
Liability

No liquidity forfeiture due to notional principal


Only exchange of interest differential

88

Interest Rate Swap Example

Results for ABC: The first 6 months

Borrows 6mth interbank


Receives from XYZ
Net Spread

(8%)
8%
0%

Receives from Mortgage


Pays fixed to XYZ
Net Spread

11%
9%
2%

89

Interest Rate Swap Example

Results for ABC: The Next Six Months


(Assume interest rates increase 2%)

Borrows 6-month libor


Receives from XYZ, 6-month libor
Net spread
Receives from mortgage portfolio
Pays Bank XYZ
Net spread

With SWAP
(10%)
10%
0%
11%
9%
2%

Without SWAP
(10%)

11%
-1%

Without an interest rate swap, ABCs net revenues from


the mortgage portfolio are reduced by half as a result of
rising interest rate environment impacting short term
funding
90

Interest Rate Swap Example


Assume rates continued to rise by 1.0% at each of the
next 2 resets (1 year), then begin to fall by 2% for each
of the next 2 resets (1 year)
12
11

10

Interest Rates

Fixed
Rate Paid
to XYZ

Resets

91

Interest Rate Swap Example


R1
a. Borrows Inter-bank
b. Receives from Mortgages
c. Net Spread

R2
R3
(11%) (12%)
11%
11%
0%
(1%)

R4
(10%)
11%
1%

(8%)
11%
3%

d. Receives from XYZ


e. Pay XYZ
f. Swap Spread

11%
(9%)
2%

12%
(9%)
3%

10%
(9%)
1%

8%
(9%)
(1%)

2%

2%

2%

2%

Net Spread (c+f)

Without the interest rate swap, ABC has interest rate risk based on the
changing cost of 6 month borrowings

The Swap with XYZ will lock-in a guaranteed earnings spread of 2% on


the fixed rate mortgages, regardless of how interest rates change

92

Forward Rate Agreement


Agreement with a counter-party to pay or receive the
difference in interest on a notional principal amount
between an agreed future interest rate and a reference
interest rate for a specified period
Only the difference in interest between the agreed
contract rate and the reference rate at the start of the
period to which the rate refers is paid to or received
from the counterparty

93

Forward Rate Agreement

Jargon

Quoting of desired periods is done by


calendar months. Thus, a deal for a 3month tenor in 3 months time is a 3x6.
Similarly, the following are:

6x12 : 6-month rate in 6 months time


2x5 : 3-month rate in 2 months time

94

Forward Rate Agreement Example

ABC has a $50MM, 1 year fixed rate auto loan portfolio,


funded via 3-month interbank borrowings

ASSETS
$50MM auto loans
Tenor: 1year
Fixed Rate: 10%

Concern: ABC expects rates to rise in the future; higher


rates will narrow spreads
Solution: ABC decides to enter a series of FRA strips to
lock-in rollover rates with Bank XYZ to ensure a predictable
spread is maintained

LIABILITIES
$50MM TDs
Tenor: 3mths
Rate: 7.5%

95

Forward Rate Agreement Example


o

ABC will buy FRA strips to match rollover dates


of 3-month borrowings:
$50MM 3 x 6 mths @ 7.75%
$50MM 6 x 9 mths @ 8.00%
$50MM 9 x 12 mths @ 8.25%

On maturity of the 3-month interbank cash


borrowing at 7.5%, ABC will rollover the
US$50MM at the prevailing interbank market
rate

96

Forward Rate Agreement Example


Assume rates continued to increase by 0.5% at the next
rollover, then another 0.5% and then fall -1.0% by the
last quarter:

R1 + 0.5%
R2 + 0.5%
R3 - 1.0%

8.5
7.5

8.0
7.0

Interest Rates

Resets

97

Forward Rate Agreements Example


Results for ABC rollovers

Auto Loan
3mth interbank
Spread before FRA
FRA
FRA Gain/(Loss)
Effective Rate
Net Spread

R0
R1
10% 10%
7.5% 8.0%
2.5% 2.0%
-

R2
R3
10% 10%
8.5% 7.0%
1.5% 3.0%

7.75% 8.00% 8.25%


0.25
0.50 (1.25%)

7.5% 7.75% 8.0% 8.25%


2.5% 2.25% 2.0% 1.75%

98

Interest Rate Options

Definition:

A contract that gives the options buyer the right,


but not the obligation, to lend/borrow funds at a
specific rate over a specified time frame
In return, the options buyer pays a fee called a
premium at the time of option purchase (Buying
insurance)

Purpose:

Manage interest rate risk


Permit large volume transactions
Allow flexibility of rate cover, but still receive
benefit of favorable moves

99

Introduction to Foreign Exchange


Unit Outline

Foreign Exchange Fundamentals

Types of Foreign Exchange Exposure

Managing FX Exposure - considerations

Factors affecting the market

100

Foreign Exchange Fundamentals

What is Foreign Exchange?

A foreign exchange transaction involves one currency


being bought or sold against another currency

Rate Quotation:
a. Cross Rates:

A foreign exchange rate between two


currencies derived via a third currency

Example: GBP/HKD via USD (GBP/USD and


USD/HKD)

b. Price Quotation:

Bid and Offer

101

Foreign Exchange Fundamentals


Time element in FX market:

Spot Transaction:
Settlement within two business days from deal date

Forward Transaction:
Settlement at a specified future date (>two business
days)
Common tenors are 1, 2, 3, 6, 9 and 12 months

102

Foreign Exchange Fundamentals


Why is there a FX market?

International trade
Capital movements
Financial transactions
Exchange of services
Tourism

103

Foreign Exchange Fundamentals


Players in the FX market?

Commercial banks
Speculators
Fund Managers
Non financial businesses
Central banks
Investment houses

104

Foreign Exchange Fundamentals


Factors affecting FX rate movement

Demand and supply

Sovereign policy
Exchange control/regulations

Economic performance
Money supply
Inflation
Interest rates

Speculation

105

Types of FX Exposure
Transaction Exposure
(daily Mark-to-Market):

Exposures arising from buying and selling foreign


currencies

for customers account


for Bankss own account

106

Types of FX Exposure
Translation Exposure

Exposure arises from translating a local currency balance


sheet into Banks native country accounting/reporting
purposes.

107

FX Treasury Products
We will briefly discuss the 3 basic forms of
derivative products:
1. Forwards
2. FX Swaps
3. Options

108

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