Treasury operations in_banks

Treasury Operations in

Banks

Treasury Treasury DivisionDivision

Why Treasury Operations in Banks?...

To meet Statutory requirementsSLR @23% of Net Demand & Time LiabilitiesCRR @4.25% of NDTL

To Deploy Surplus funds profitably. To raise resources at competitive rates from domestic

& global markets. To remove asset-liability mismatches To gain from daily fluctuations in financial market

through trading activities To hedge open positions (for mitigating interest rate/

exchange rate risks)


Derivatives

Forex

Precious Metals

Equity Market

Bulk Deposits

Funds Management

Investments

SLR/CRRMaintenance

Treasury

FUNCTIONAL AREAS OF TREASURYFUNCTIONAL AREAS OF TREASURY


Broad Constituents of Treasury I INVESTMENTS

• SLR Securities• Non SLR Securities• Raising Tier I/ Tier II Bonds

II FOREX TRANSACTIONS• Merchant Transactions• Trading (Currencies & Gold)• Currency Futures

III DERIVATIVES• Trading• Back to Back Deals for Corporates (Swaps/ Options)• Hedging of Bank’s Balance Sheet • Interest Rate Futures

IV FUNDS MANAGEMENT• Cash Reserve Ratio maintenance• Inter bank Money Market Transactions• Bulk Deposits including Certificate of Deposits


The Treasury Structure

Back Office(Settlement &

Accounting of Deals)

Front Office(Strikes Deals)

Mid Office(Risk Mngment)


Typical Functional Structure of the DivisionTREASURY DIVISION (GM)

DGM Risk Management Division

-Head Office -Central Treasury FEOs (2)* (Extended Arms)-(CMs)

Front Office Back-Office Mid OfficeCHIEF DEALER- FIXED INCOME ASSTT.GEN. MANAGER ASSTT.GEN. MANAGER

Dealers: SLR securities Settlement Risk Management Non SLR Bonds Accounts - Domestic Funds Audit - ForexCHIEF DEALER – EQUITY CHIEF MANAGER Investment policy Equity Dealers Back office Integration ALM CHIEF DEALER – FOREX/ Establishment DERIVATIVES Derivative Dealers CHIEF MANAGER Forex Dealers Computer Systems/ RTGS


Investment Committee: The Investment Committee is constituted in terms

of Board approved Investment Policy every year. The Committee is headed by the Executive

Director. Other members are GM (Credit), GM (Treasury), GM (MASD), GM (RMD), DGM (Treasury) and AGM/ CMs (Front Office, Treasury).

The Committee discusses/ reviews the prevailing market conditions, likely trends in the financial markets, economic scenario, interest rate / liquidity scenario etc. and accordingly formulates broad investment strategy every day.

The decisions taken by Investment Committee are properly recorded and meticulously complied with.


Statutory Liquidity Ratio (SLR) Sec 24 of BR Act Till recently could be stipulated to minimum of

23% of NDTLRecent Amendment to BR Act has removed the lower ceiling for maintenance of SLR

In Central/ State G.Secs and Other approved Secs, Cash balances with RBI, SBI, & identified banks, cash in hand & Gold

Approved Secs- as mentioned in Sec 5 of BR Act

Other Approved Secs- Also known as Trustee Secs

SLR can be kept more than required


Cash Reserve Ratio (CRR) Under RBI Act Sec 42. Till recently could be stipulated to 4.00% of NDTL

Recent Amendment to RBI Act has removed the lower and upper ceilings for maintenance of CRR

Presently stipulated at 4.25% of NDTL

CRR kept in Current A/c with RBI at 18 Designated Centers Daily minimum balance required to be maintained is 70% of

average fortnightly requirement. (e.g. if total CRR balance required to be maintained is Rs.100 cr per day, then on a cumulative product basis, banks have to maintain at least Rs.1400 cr during a reporting fortnight, but on any particular day the balance should not be less than Rs. 70 cr. )

RBI is not paying any interest on balances maintained as CRR.


Non SLR

Equity / Preference Shares Units of Mutual Funds Commercial Papers Corporate Bonds and Debentures Spl. Central Govt. bonds like UTI bonds and

Oil Bonds. Bonds and debentures of PSUs, Government/

Semi Government autonomous bodies Investments abroad in the shape of equity

participation, subscribing to shares, etc.


Money Market Instruments Call Money Notice Money Certificate of Deposits Inter Bank Participation Certificates Term Money Commercial Papers Repo and Reverse Repos –with RBI/Market

participants Rediscounting of Bills Collateralised Borrowing & Lending Obligations

(CBLO)


CLASSIFICATIONI B/S disclosure:

Government securities Other approved securities Shares Debentures & Bonds Subsidiaries/ joint ventures and Others (CP, Mutual Fund Units, etc.).

II Investment portfolio also classified under three categories: Held To Maturity (HTM), Held For Trading (HFT) and Available For Sale (AFS)

Banks to decide category of investment on acquisition


Classification into HTM, HFT & AFS Securities intended to be kept in p’folio till their maturity

can be categorised in Held To Maturity (HTM) p’folio. Securities purchased with the intention to trade and gain

from market yields to be classified under Held For Trading (HFT).

The securities which do not fall under HTM or HFT will be classified under Available for Sale (AFS).

Banks can decide holdings under HFT and AFS considering aspects such as basis of intent, trading strategies, risk management capabilities, tax planning, manpower skills, capital position.

HFT Securities to be sold within 90 days


Valuation of Investment Portfolio:

HTM securities not required to be marked to market, hence no depreciation loss on HTM p’folio.

AFS and HFT securities are to be marked to market at regular intervals and if need be depreciation needs to be provided on the same.

Hence in firming interest rate scenario makes sense to shift securities to HTM category to limit interest rate risk.

Banks, vide RBI guidelines of Sep’04, permitted to keep 25% of NDTL in HTM category.


Shifting among categories:

May shift investments to/from HTM category with approval of Board of Directors once a year.

Such shifting will normally be allowed at the beginning of the accounting year.

Transfer from one category to another has to be done at the acquisition cost/ book value/ market value on the date of transfer, whichever is the least, and the depreciation, if any, on such transfer should be fully provided for.


Derivative Portfolio(excluding Exchange Traded Currency/ Interest Rate Futures)

Swaps Options Structured ProductsSwaps with embedded options

Single currencyIRS

Cross currencyIRS

OISINBMKMIFOR

Etc.

CCSPOSCOS

FX- INR Option FC-FC Option

USD/INRGBP/INREUR/INRJPY/INRCHF/INR

GBP/USDEUR/USDUSD/JPYUSD/CHF


Why Derivatives ?The existence of derivatives is because of uncertainty about

the future movement of financial markets. Derivatives are tools to reduce uncertainties arising due to the following factors:

1. Dynamic nature of interest rates. The interest rates change over a period of time but the quantum of change is not predictable.

2. Uncertain movement of interest rates not only in the local economy but also across globally because of, inter-alia, central banks’ moves on growth vs. stability.

3. Movement in exchange rates between different currency pairs.

All above three factors expose the related parties to interest rate/ exchange rate risks. Use of derivatives enables the exposed parties in risk mitigation by resorting to interest rate / exchange rate hedging by using derivatives.


Scenario 1: Corporate A has raised Rs. 100 crores Term Loan for 5 years

at fixed rate of interest of 12% pa. The corporate holds the view

that tracking business cycle, the interest rates are going to

soften.

Repaying its present high cost borrowings and raising fresh

borrowing on floating rate is the right answer to this situation.

But given the ‘on balance sheet’ rigidities it may not be

practically feasible to repay the fixed rate loan and raise a fresh

low floating rate loan.

Corporate A would like to convert its ‘fixed rate liabilities’ to

‘floating rate liabilities’, without touching its original ‘underlying’

term loan.


Solution 1: Interest Rate Exposure Management Corporate approaches the Interest Rate swap market where

market makers are quoting fixed/ floating rates. Corporate can receive fixed rate of interest on a notional

amount equal to the underlying fixed rate term liability i.e. on Rs. 100 crs. and pay floating rate of interest, based on a quoted benchmark,.

This exchange of interest rate i.e fixed vs floating is called Interest Rate Swap, a Derivative Transaction.

Effectively Corporate’s fixed rate loan payout on loan will get cancelled out by receiving fixed rate of interest in swap transactions and it will be paying the floating rate. Hence, the fixed rate term liability has been converted into floating rate liability as desired by corporate.


Solution 1: Interest Rate Exposure Management Pictorially, it can be represented as below:

It can be seen the corporate is left paying floating rate whereas his fixed rate loan

payment has been offset.

Corp. Receives fixed rate in IRS

for 5 years from IRS provider

Corp. Pays Fixed rate 12%

on fixed rate term loan Corporate A

Corporate Pays benchmark linked floating rate to IRS provider


Scenario 2: Interest Rate Exposure Management

Corporate B has raised Rupee Term Loan for 5 years at floating rate of interest, reset periodically. The corporate holds the view that tracking business cycle, the interest rates are going to harden but it is not in a position to repay its present borrowings and raise fresh borrowing on fixed rate.

Here derivatives come into picture. Corporate B can enter into an “Interest Rate Swap” to

notionally convert its ‘floating rate liabilities’ to ‘fixed rate liabilities’, without touching its original ‘underlying’ term loan.


Scenario 2: Management of Interest Rate Exposure

And how it can be done? Corporate B undertakes to receive floating rate of interest in

the IRS and to pay fixed rate of interest, based on a quoted benchmark, on a notional

amount equal to the underlying floating rate term liability.

Hence, the floating rate term liability has been converted into fixed rate liability as

desired by corporate A. Pictorially, it can be represented as below:

Corp. Receives benchmark linked

floating rate in IRS for 5 years

from IRS provider

Corp. Pays Floating rate on

existing term loan Corporate B

Corporate Pays fixed rate to IRS provider


Interest Rate Swap

This transaction (IRS) is based on an original ‘on balance sheet loan’ which is referred as ‘underlying’ for entering derivative transaction.

The amount of loan on which swap deal is based is called as ‘notional amount’.

It does not represent any asset or debt. It is used as principal for calculation of interest amount.


Overnight Indexed Swap (OIS):A Standard IRS Product

An Overnight Indexed Swap (OIS) is Rupee benchmark Interest rate swap.

This swap is based on overnight NSE Mibor rate which is again based on daily call money market rates.

This is widely used and a very transparent IRS product. Participants quote a fixed rate for different tenor in exchange of

NSE Mibor rate. In other words OIS-IRS is a contractual agreement between two

counterparties, to exchange a series of cash flows Over a pre-defined period of time to offset some existing interest rate exposure.


T=0

5yrs

Receives 6.20%

A typical OIS dealCorporate receives 5 yr OIS at 6.20% for Rs 25 crore. In return, it will pay

overnight NSE Mibor rate. In this case the details are as follows

Rs 25 crores is Notional principal.

Term of the swap is 5 years.

Rate for the receiving side is 6.20% which is called fixed leg

Rate for the paying leg is overnight NSE Mibor rate which is called as floating

leg. It is reset daily.

The cash flows will look as shown below

Pays Daily O/N Mibor

Fixing Daily; Settlement every 6 months


Scenario 3: Management of Exchange Rate Exposure

1. A corporate with domestic operations is not directly affected by the exchange rate of local currency with other currencies.

2. However, corporates with cross-border trade or borrowings/ lendings are directly affected by movement of exchange rate of local currency with other currencies.

3. An exporter or a client with overseas investments may be adversely affected on appreciation of local currency as it will get lesser units of local currency for similar amount of foreign currency that it will receive in future.

4. On the other hand, an importer or a client with overseas borrowings may be adversely affected on depreciation of local currency as it will have to shell out more units of local currency for similar amount of foreign currency it will have to pay in future.

Solution ??????


Forward ContractsSince the future is uncertain, a corporate having

exposure to a foreign currency bears the risk of appreciation/ depreciation of that foreign currency vis-à-vis local currency.

To insulate itself from future uncertain exchange rate movement, a client can “lock” the exchange rate for a future date, which is called Forward Currency contract.

Forwards are the basic building block for other derivative instruments.


Forward Contracts: Tool to Manage Exchange Rate Risk

Assumption: USD/ INR Spot Rate: 48.50 One Year Forward Premium: 1.00Hence, One Year Forward USD/ INR Rate: 49.50

Receivable/ Investment Exposure:By booking forward contract at 49.50, the client will be able to convert his future receivable at assured rate of 49.50 enabling him to do his costing accordingly. No loss if USD/ INR is below 49.50 on maturity but also no gain if USD/ INR on maturity is above 49.50.

Payable/ Borrowing Exposure:By booking forward contract at 49.50, the client will be able to convert his future payable at fixed rate of 49.50 enabling him to do his costing accordingly. No loss if USD/ INR is above 49.50 on maturity but also no gain if USD/ INR on maturity is below 49.50.

The same is true for all other currency pairs.


Currency Options: The improvement over ‘Forward Contracts’

An option agreement can be compared to an Insurance agreement which protects against probable losses, in return for a premium.

Unlike forwards, an option holder can have unlimited gains.

Buyer/ holder of option enjoys the right to purchase or sell the designated instrument, be it a currency, commodity or stock etc., at a specified price within a specified period of time.

Seller of option receives premium for selling that type of right.


Option Terminology Call Option gives the buyer the option without the

obligation to buy the underlying asset on a certain date in future at a certain price.

Put Option gives the buyer the option without the obligation to sell the underlying asset on a certain date in future at a certain price.

Strike Price is the price at which the asset may be brought or sold in an option contract, also called the exercise price.

American Option can be exercised anytime during the term of the option contract.

European Option can be exercised only on the maturity date.


OPTIONS V/S FORWARDS

1) Right to buy/sell Right as well as Obligation to buy/sell

2) Limited loss Unlimited opportunity loss3) Exercise, If profitable Must deliver/ close out4) Customer decides rate Market decides rate5) Premium payable No premium payable6) Unlimited gain potential No upside gain potential


Why Options are better than Forwards?1. Provides pure right and has no obligation. Hence, in case on

maturity date, if exchange rate of currency happens to be better than strike rate, the client may not exercise his right and may deal at the market rate.

2. Thus he enjoys the unlimited upside unlike forward contract where it has to buy/ sell at the strike price only, which may result in opportunity loss.

3. Client can chose the option strike price whereas forward contract rate is market determined. (However, upfront premium payable will change according to strike price chosen.)

4. Option contracts include payment of upfront premium whereas no premium is involved in forward contracts.

5. Options are generally preferred over forward contracts when the direction of movement is not clear but there is high volatility.


Derivatives Operations in TreasuryApproach towards derivative transactions can be

classified as under:1. Trading Portfolio:-To do proprietary trading in Overnight Indexed Swap to

earn profit from movement in OIS rates2. Hedging Portfolio:-To hedge the gaps of Bank’s own balance sheet; to

protect spread/ NIM, and to reduce high cost of fixed rate liabilities.

3. Back to Back Portfolio:-To undertake interest rate and exchange rate hedging

transactions for Corporates and cover the same back to back in the interbank market.


Concept of Marked To Market (MTM) This is an important concept as it reflects ‘market

value’ of the outstanding derivatives position at a particular time on the prevailing market rates.

Though it is a notional number, it is useful, both for trading as well as for customer side trades.

In the trading we mark to market our portfolio on daily basis and account for the same.

On customer side the MTM forms the basis for arriving at the credit exposure amount which we monitor regularly.


MTM Calculation – An ExampleAssumption: PNB has received fixed @ 6% pa in 5

Year OIS deal for notional Rs. 25 Crore.

Scenario 1: Fixed rate moves to 6.25%PNB has right to receive 6% pa whereas now the

market receiving rate is 6.25%.It means PNB is ‘out of money’ by 0.25% pa on

notional Rs. 25 crore for remaining tenor of the deal.

The Present Value (PV) of this 0.25% pa (on notional Rs. 25 crore) negative cashflows over the remaining tenor of the deal is the negative MTM of the deal for PNB.


MTM Calculation – An Example (contd….)

Scenario 2: Fixed rate moves to 5.75%PNB has right to receive 6% pa whereas now the market

receiving rate is 5.75%.It means PNB is ‘in the money’ by 0.25% pa on notional

Rs. 25 crore for remaining tenor of the deal.The Present Value (PV) of this 0.25% pa (on notional Rs.

25 crore) positive cashflows over the remaining tenor of the deal is the positive MTM of the deal for PNB

MTM is the cost or value, as the case may be, for unwinding the existing deal at the present market rate.

Roughly, at around 6% fixed rate, on a standard 5Y OIS deal of Rs. 25 crore, one basis movement in fixed rate changes the MTM by about Rs. 1 Lac.


Currency Futures Permitted Currency Pairs Initially, currency future contracts were allowed only in

USD/ INR pair. Subsequently, GBP/ INR, Euro/ INR and Yen/ INR has been permitted by RBI.

Trading Hours The trading on currency futures is allowed from 9 a.m.

to 5 p.m. From Monday to Friday. Size of the contract The minimum contract size of the currency futures

contract is USD 1000. Tick size Tick size is 0.0025 Rupee.


QuotationThe currency futures contract is quoted in Rupee terms.

However, the outstanding positions is in foreign currency (USD, GBP etc.) terms.

Tenor of the contractThe currency futures contract have a maximum maturity

up to 12 months.Settlement mechanismThe currency futures contract is settled in cash in Indian

Rupee.Expiry date and timeContracts expire two working days prior to the last

business day of the month and the contracts expire at 12 noon on the expiry day at RBI reference rate of the day.


Trading Mechanism Currently, Currency Futures are being traded on

3 exchanges. ( NSE, MCX & BSE) Bank should have membership in MCX & NSE. System Based operations Bank can Buy or Sell on behalf of customers and

take own proprietary position as well. Unlike other OTC products like Forward

Contracts and Options, customers need not have an ‘underlying’ foreign currency exposure to deal in currency futures.


USES OF CURRENCY FUTURES

Hedging:

Risk mitigation of existing exposures to currencies exchange rate

Speculation:

For trading with a view to make profit if positions turn favourable subsequently, and vice-versa

Arbitrage:

To locate and profit from minor rate differences between different cash/ forward markets


Margin RequirementsThe currency futures transactions are characterised by

elimination of market/ settlement risk as the parties have to deposit the margins as under:

Initial Margin When the position is opened, the member has to deposit the

margin with the clearing house as per the rate fixed by the exchange. Initial margin is 1.75% on first day & thereafter 1% in addition to 1.75%.

Marking to Market At the end of trading session, all the outstanding contracts are

re-priced at the settlement price of that session. It means that all the futures contracts are daily settled, and profit and loss is determined on each transaction.

Maintenance Margin Member’s account are debited or credited on a daily basis.


Interest Rate Futures An Interest Rate Futures (IRF) contract is “an

agreement to buy or sell a debt instrument at a specified future date at a price fixed today.”

They are standardised exchange traded financial products which eliminate counterparty risk and price discovery mechanism is transparent.

Exchange traded IRF necessitates keeping of Margins which eliminates settlement risk.

IRF provide avenue for ‘Margin Trading’ for participants who do not want to block funds in ‘long’ positions.


Key Features of IRF

Underlying: 10 Year Notional Coupon bearing GOI security Coupon: Notional Coupon 7% with s/a compounding Lot Size: Rs. 2 Lac Tenor: Maximum maturity 12 months Contract Cycle: 4 quarterly contracts with fixed expiries. Daily Settlement Price: Weighted average price of the futures for last

half an hour Margin: Initial margin (minimum 2.33%), Extreme Loss

and Calendar Spread Margins to be maintained Settlement: Physical delivery of deliverable grade securities


Key Features of Interest Rate Futures (contd.)

IRF are traded on the Currency Derivatives segment of a recognized stock exchange. Presently NSE and MCX-SX are the two exchanges undertaking Currency Derivatives.

The members registered by SEBI for trading in Currency Derivatives shall be eligible to trade in IRFs.

Banks, PDs, Mutual Funds, Insurance Companies, Corporate Houses, Brokers, FIIs and Retail participants shall be the market participants.

Banks are allowed to trade on their own account. Also, they shall be allowed to participate in IRFs for hedging interest rate risk inherent in their entire balance-sheet, including both on and off balance-sheet items. However, banks are not allowed to undertake trades on behalf of clients.


Utility of IRF for Banks

Managing duration gap (mis-match in interest re-setting dates on assets/ liabilities).

Protecting against the devaluation of Govt. securities in AFS and HFT portfolios due to hardening of interest rates.

Generating trading profit from interest rate movements by utilising their experience of substantial statutory investments in Govt. securities.


Operational Issues in Interest Rate Futures

Concept of ‘Cheapest to Deliver (CTD)’ Bond: Bond which can be bought at cheapest price from

underlying bond market and delivered against IRF contract is called CTD bond.

CTD bond is the bond where difference between “Present Quoted Price of Bond” and “IRF Settlement Price * Conversion Factor” is the most beneficial to seller.

Conversion Factor is the multiplication factor to be applied to the current market price of identified deliverable grade securities to raise/ reduce the YTM of these securities to 7% (the notional coupon of the underlying G-sec bond on which the IRF is based).


THANK YOUTHANK YOU

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Treasury operations in_banks