August/Fall 2012 Master of Business Administration - MBA Semester 4 Subject Code MF0016 Subject Name Treasury Management 4 Credits

ts (Book ID: B1311) Assignment Set- 1 (60 Marks) Note: Each question carries 10 Marks. Answer all the questions. Q.1 Explain how organization structure of commercial bank treasury facilitates in handling various treasury operations. [10 Marks] A n s : - The treasury organization deals with analysing, planning, and implementing treasury functions. It deals with issues of profit centre, cost centre etc. The organizations managing interfaces with treasury functions include intergroup communications, taxation, recharging, measurement and cultural aspects. Structure of treasury organization Figure 1.2 depicts the structure of treasury organization which is divided into five groups. Figure 1.2: Treasury Organizations Fiscal This group includes budget policy planning division, industrial and environmental division, common wealth state relationships, and social policy division. Macroeconomic This group deals with economic sector of the organization. It includes domestic and international economic divisions, macroeconomic policy and modeling division. Revenue This group is concerned with the taxes in an organization. It includes business tax division, indirect tax, international and treaties division, personal and income division, tax analysis and tax design division. Markets This group mainly deals with selling of products in the competitive market. It includes competition and consumer policy, corporations and financial services policy, foreign investments and trade policy division. 2With Lots of Luck: Ali Corporate services This group deals with overall management of the treasuryorganisation. It includes financial and facilities division, human resource division, business solutions and information management division. Treasury management in banks In recent days, most of the Indian banks have classified their business into two primary business segments like treasury operations (investments) and banking operations (excluding treasury). The treasury operations in banks are divided into: Rupee treasury The rupee treasury carries out various rupee based treasury functions like asset liability management, investments and trading. It helps in managing the banks position in terms of statutory requirements like cash reserve ratio, statutory liquidity ratio according to the norms of the Reserve Bank of India (RBI). The various products in rupee treasury are:1. Money market instruments Call, term, and notice money, commercial papers, treasury bonds, repo, reverse repo and interbank participation etc.2. Bonds Government securities, debentures etc3.Equities Foreign exchange treasury The banks provide trading of currencies across the globe. Ideals with buying and selling currencies. Derivatives The banks make foundation for Over the Counter (OTC). It helps in developing new products, trading in order to lay off risks and form apparatus for much of the industrys self-regulation. The role of policies in strategic management was described in this section. The next section deals with inter-dependency between policy and strategy

Q.2 Bring out in a table format the features of certificate of deposits and commercial papers. [10 marks] Ans:-Features of commercial papers Features of CDs in Indian market

CPs is an unsecured promissory note. Schedule banks are eligible to issue CPs can be issued for a maturityperiodof 15 days to less than one year. Maturity period varies from threemonthsto one yearCPs is issued in the denomination of Rs.5 lakh. The minimum size of the issue is Rs. 25 lakh.Banks are not permitted to buy back their CDs before the maturity The ceiling amount of CPs should not exceed the working capital of the issuing company.CDs are subjected to CRR andStatutoryLiquidity Ratio (SLR) requirements The investors in CPs market arebanks,individuals, business organisationsandthe corporate units registered in India and incorporated units.They are freely transferable byendorsement and delivery.They have no lock-in period. The interest rate of CPs depends onthe prevailing interest rate on CPsmarket, forex market and call moneymarket. The attractive rate of interestIn any of these markets, affects thedemand of CPs.CDs have to bear stamp duty at theprevailing rate in the marketsThe eligibility criteria for thecompaniesto issue CPs are as follows:The NRIs can subscribe to CDs onrepatriation basisThe tangible worth of the issuingcompany should not be less than Rs. 4.5 Crores.The company should have aminimum credit rating of P2 andA2 obtained from Credit RatingInformation Service of India(CRISIL) andInvestment Information and CreditRating Agency of India Limited. (ICRA)respectivelyThe current ratio of the issuingcompany should be 1.33:1.The issuing company has to belisted on stock exchange. Q.3 Critically evaluate participatory notes. Detail the regulatory aspects on it. [10 Marks] A n s : - The participants in forex market are the RBI at the apex, authorised dealers (ADs) licensedby forex market, exporters, importers, companies and individuals. The major participants of foreign exchange market are: Corporates They mainly include business houses, international investors, andmultinational corporations. They operate in market by buying or selling currencies withinthe framework of exchange control regulations. It deals with banks and their clients toform retail segment of forex market. Commercial banks They play an important role in forex market. They operate in marketby trading currencies for their clients. Large volume of transactions consists of banksdealing directly among themselves and smaller transactions usually consists of intermediary foreign exchange brokers. Central bank It plays a vital role in the countrys economy by controlling moneysupply. Central banks get involved in forex market to regain price stability of exchangerate, protect certain levels of price in exchange rate, and support economic goals likeinflation and growth. Exchange brokers They ensure the most favourable quotations between the banks at alow cost in terms of time and money. Banks provide opportunities to brokers in order toincrease or decrease the rate of buying or selling foreign currencies. Exchange brokershave a tendency to specialise in unusual currencies but also manage major currencies. InIndia, many banks deal through recognised exchange brokers or may deal directly amongthemselves. The other participants include RBI and its authorised dealers, exporters, importers, companiesand individuals. Q.4 What is capital account convertibility? What are the implications on imple menting C A C ? A n s : - C a p i t a l A c c o u n t C o n v e r t i b i l i t y (CAC) refers to relaxing controls on capital accounttransactions. It means freedom of currency conversion in terms of inflow and outflows withrespect to capital account transaction. Most of the countries have liberalised their capital accountby having an open account, but they do retain some regulations for influencing inward andoutward capital flow. Due to global integration, both in trade and finance, CAC enhances growthand welfare of country. The perception of CAC has undergone some changes following the events of emerging marketeconomies (EMEs) in Asia and Latin America, which went through currency and banking crisesin 1990s. A few counties backtracked and re-imposed capital controls as part of crisisresolution. Crisis such as economic, social, human cost and even extensive presence of capitalcontrols creates distortions, making CAC either ineffective or unsustainable. The cost andbenefits from capital account liberalisation is still being debated among academics and policymakers. These developments have led to considerable caution being exercised by EMEs in opening up capital account. The Committee on Capital Account Convertibility (Chairman: Shirass. Tarapore) which submitted its report in 1997 highlighted the benefits of a more open capitalaccount but at the same time cautioned that CAC could pose tremendous pressures on thefinancial system. India has cautiously opened its capital account and the state of capital control inIndia is considered as the most liberalised it had been since late 1950s. The different ways of implementing CAC are as follows: Open the capital account for residents and non-residents.

Initially open the inflow account and later liberalize the outflow account. Approach to simultaneously liberalize control of inflow and outflow account.

Q.5 Detail domestic and international cash management system [10 Marks] A n s ; - The strategy of a company which has its businesses in many nations and efficientlymanages its cash and liquidity is called multinational cash management programme. The maingoal of multinational cash management is the utilisation of local banking and cash managementservices.Multinational companies are those that operate in two or more countries. Decision making withinthe corporation is centralised in the home country or decentralised across the countries where theorganisation does its business.The reasons for which the firms expand into other countries are as follows: Seeking new markets and raw materials Seeking new technology and product efficiency. Preventing the regulatory obstacles. Retaining customers and protecting its processes Expanding its business.Several factors which distinguish multinational cash management from domestic cashmanagement are as follows: Different currency denominations Political risk and other risk. Economic and legal complications. Role of governments Language and cultural differences. Difference in tax rates, import duties.The principle objective of multinational cash management programme is to maximise acompanys financial resources by taking benefits from all liability provisions, payable periods.The multinational cash management programme effectively achieve its goals by using excess cash flow from some units across the globe to extend cash needs in other units which is called in- house banking and by relocating funds for tax and foreign exchange management throughrepricing and invoicing.During multinational cash management system payments by customers to companys branchesare basically handled through a local bank. The payments between the branches and the parentcompany are managed through the branches, correspondents or associates of the parent company.Through the use of electronic reporting systems a parent company observes cash balances in itsforeign local banks.Multinational cash management programme specifically evaluate its techniques by timing of billing, use of lockboxes or intercept points, negotiated value range.The multinational cash management system involves exchange rate risk which occurs when thecash flow of one currency during transformation to another currency the cash value getsdeclined. It occurs due to the change in exchange rates. The exchange rates are determined by astructure which is called the international monetary system.For example, Wincor Nixdorf played an innovative role in enhancing cash handling betweenvarious countries. Wincors focus was on the entire process chain which started from head officeto stores, crediting to the retail companys account, head office to branches and so on. WincorNixdorfs served several countries with its innovative hardware and software elements, ITservices to side operations and consulting services to develop custom optimised solutions.

Q.6 Distinguish between CRR and SLR [10 Marks] A n s : - C a s h R e s e r v e R a t i o Cash Reserve Ratio (CRR) is a countrys central bank regulation that sets the minimum reservesfor banks to hold for their customer deposits and notes. These reserves are considered to meet thewithdrawal demands of the customers. The reserves are in the form of authorised currency storedin a bank treasury (vault cash) or with the central bank. CRR is also called liquidity ratio as itcontrols money supply in the economy. CRR is occasionally used as a tool in monetary policiesthat influence the countrys economy.CRR in India is the amount of funds that a bank has to keep with the RBI which is the centralbank of the country. If RBI decides to increase CRR, then the banks available cash drops. RBIpractices this method, that is, increases CRR rate to drain out excessive money from banks. TheCRR in the economy as declared by RBI in September 2010 is 6 percent.An organisation that holds reserves in excess amount is said to hold excess reserves. The following are the effects of CRR on economy: CRR influences an economys money supply by effecting the potential of banks CRR influences inflation in an organization CRR stimulates higher economic activity by influencing the liquidity Statutory Liquidity Ratio Statutory Liquidity Ratio (SLR) is the percentage of total deposits that banks have to invest ingovernment bonds and other approved securities. It means the percentage of demand and timematurities that banks need to have in forms of cash, gold and securities like GovernmentSecurities (G-Secs). As gold and government securities are highly liquid and safe assets they areincluded along with cash.In India, RBI determines the

percentage of SLR. There are some statutory requirements forplacing the money in the government bonds. After following the requirements, the RBI arrangesthe level of SLR. The maximum limit of SLR is 40 percent and minimum limit of SLR is 25percent.The RBI increases the SLR to control inflation, extract liquidity in the market and protectscustomers money. Increase in SLR also limits the banks leverage position to drive more moneyinto the economy.If any Indian bank fails to maintain the required level of SLR, then it is penalised by RBI. Thenonpayer bank pays an interest as penalty which is above the actual bank rate. The main objectives for maintaining SLR are the following: By changing the SLR level, the RBI increases or decreases banks credit expansion Ensures the comfort of commercial banks Forces the commercial banks to invest in government securities like government bonds

Master of Business Administration - MBA Semester 4 Subject Code MF0016 Subject Name Treasury Management 4 Credits (Book ID: B1311) Assignment Set- 2(60 Marks) Note: Each question carries 10 Marks. Answer all the questions. Q.1 Explain any two major risks associated with banking organization. [10Marks] A n s : - The major risks are associated with banking organizations. Since banks use a large amount of leverage, it becomes important to manage risks carefully. The various types of risks are: Interest rate risk Foreign exchange risk Liquidity risk Default risk Financial risk Market risk Credit risk Personnel risk Environmental risk Production risk Interest rate risk Interest rate risk occurs due to the change in absolute level of interest rates causing variations in the value of investments. Such changes usually affect the securities like shares, bonds, mutual funds or money market instruments and can be reduced by diversifying or hedging techniques. The evaluation of interest rate risk should consider illiquid hedging products or strategies, and potential impact on fee income which are sensitive to changes in interest rates. They are classified into the following T e r m s t r u c t u r e r i s k ( y i e l d c u r v e r i s k ) It arises from the variations in the movementof interest rates across maturity spectrum. It consists of changes in relationship betweeninterest rates of various maturities of similar market. The changes in relationships occurwhen the shape of yield curve for a market flattens, steepens, or becomes inverted duringinterest rate cycle. The yield curve variations can emphasise a banks risk position byincreasing the effect of maturity mismatches. Basis risk It occurs due to the changes in relationship between interest rates fordifferent market sectors. O p t i o n s r i s k It arises when bank or bank customer gains privileges to alter the leveland timing of cash flows of asset, liability or off balance sheet instruments. The optionholder has the rights to buy or sell the financial instruments over a specified period of time. But the option holder faces limited downside risks (amount paid for option) andunlimited upside reward. The option seller faces unlimited downside risk (optionexercised during the time of disadvantage) and limited upside reward (retainingpremium). Foreign exchange risk Foreign exchange risk occurs during the change of investments value occurring due to thechanges in currency exchange rates. It refers to the probability of loss occurring due to anadverse movement in foreign exchange rates. For example Consider an investor residing inUnited States purchases a bond denominated in Japanese Yen. By this the investor experiencesdecline in rate of return at which the Yen exchanges for dollars. The three types of foreignexchange risk or exposure are: Transaction risk It is the possibility of affecting future transactions of the organisationdue to the changes in currency exchange rates. Economic risk It measures the impact of changes in exchange rate risk on theorganisations cash flows and earnings. Translation risk It measures the impact of changes in exchange rate of organisationsfinancial statements. It is also known as accounting exposure.

Q.2 What is liquidity gap and detail the assumptions of it? [10 Marks] Ans;- Liquidity Gap Report A liquidity gap is the difference between the due balances of assets and liabilities over time.At any point of time, a positive gap between assets and liabilities is equivalent to shortage of cash. The marginal gap refers to the difference between the changes of assets and liabilities overtime. A positive marginal gap means that the change in the values of assets exceeds that of liabilities. The gap profile changes as and when new assets and liabilities are added. The gapprofile is represented either in the form of tables or charts. All the assets and liabilities areaccounted in

liquidity gap report and it is dependent on the dates of maturity and the actual date. A s s u m p t i o n s i n p r e p a r a t i o n o f g a p report in terms of assets, liabilities and off balance sheetitems Since the future liquidity position of a firm cannot always be predicted based on the factors,assumptions play an important role in determining the continuing due to the rapidly changingbanking markets. But the number of assumptions to be made should be limited. The assumptionscan be made based on three aspects. They are assets, liabilities, and off-balance sheet assets. Assets Assets are nothing but any item of economic value owned by an individual or corporation.Assumptions regarding a banks future stock of assets include their possible marketability anduse an asset as a guarantee of existing assets which could increase flow of cash and others.To determine the marketability of an asset, the method segregates the assets into three categoriesaccording to their degree of relative liquidity: The highly liquid group of assets consists of components such as interbank loans, cashand securities. Some of the assets might instantaneously be converted into cash atexisting market values under almost any situation whereas others, such as interbank loansmight lose liquidity in a common crisis. A less liquid group of assets consists of banks saleable loan portfolio. The assignmenthere is to develop assumptions about a reasonable plan for the clearance of a banksassets. Some assets, while marketable, might be viewed as unsaleable within the timeframe of the liquidity analysis. The least liquid group of assets consist of basically unmarketable assets such as loans thatare not capable of being readily sold, bank premises and investments in subsidiaries.Because of the difference in the banks internal asset-liability management, different banks canallot the same assets to different groups on maturity ladder.While categorising the assets, banks should take care of the effects on the assets liquidity underthe various conditions. Under normal conditions, there may be assets which are much liquid thenduring a time of crisis. Therefore a bank may classify the assets according to the type of scenarioit is forecasting. Liabilities To check the cash flows occurring due to a banks liabilities, a bank should first examine thebehaviour of its liabilities under normal business situations. This would include forming: The level of roll-overs of deposits and other liabilities remain normal. The actual maturity of deposits with non-contractual maturities, such as demand depositsand others; the normal growth in new deposit accounts.While examining the cash flow arising from a banks liabilities during the two crisis scenario, abank would look at four basic questions. The first two questions represent the proceedings in the flow of cash that tend to reduce the cash outflows planned directly from contractual maturities.The four questions are as follows: What are the different sources of funding that are likely to stay with a bank under anysituation, and can the count of these sources be increased?Other than the liabilities identified from this step, a banks capital and term liabilities thatare not maturing within the prospect of the liquidity analysis provide a liquidity buffer.The total liabilities identified in the first category may be assumed to stay with the bank even when its a worst scenario. Some core deposits generally remain with a bank because retail and small scale industry depositors may rely on the public-sector securitynet to shield them from occurring loss, or because the cost of changing banks, especiallyfor some business services that include transactions accounts, is unaffordable in the veryshort term. What are the sources of funding that can be estimated to run off gradually if problemsoccur, and at what rate? Is deposit pricing a way for controlling the rate of runoff?The second category consists of liabilities that have chances of staying back with thebank during the period of slight difficulties and can be used during crisis. Liabilities,includes core deposits that are not already included in the first category. In somecountries, other than core deposits, some of the interbank deposits and governmentfunding remains with the bank even though they are considered volatile .for these kindsof cash flows a banks very own past experience related to liabilities and the experiencesof other such firms with similar problems may come handy. And help in creating a timetable. Which maturing liabilities can be estimated to run off instantly at the first warning of trouble?The third category consists of the maturing liabilities that remained, including somewithout contractual maturities, such as wholesale deposits. Under each case, thisapproach adopts a conservative stand and assumes that these remaining liabilities will bepaid back at as early as possible before the maturity date, especially when there is highcrisis, as such money may flow to government securities and other safe refuges.Factors such as diversification and relationship building are considered important duringthe evaluation of the degree of the outflow of funds and a banks capacity to replacefunds. Nevertheless, in a general market crisis, sometimes high scale firms may find thatthey receive larger than the usually got wholesale deposit inflows, even though there arena cash inflows existing for other firms in the market. Does the bank have a reliable back-up facility? For example, small banks in local areas may also have credit lines that they can bring down to offset cash discharges. These facilities are rarely found in larger banks but however it depends on the assumptions made on the banks liabilities. Such facilitiesusually need to undergo many changes but only to a limit, especially in a bank specificcrisis. Off balance sheet item

A bank should also examine the availability of sufficient cash flows from its off balance sheetactivities (other than the loan commitments already considered), even if they are not a portion of the banks recent liquidity analysis.In addition, the Contingent liabilities, such as letters of credit and financial guarantees, representpotentially significant cash outflow for a bank, but are usually not dependent on a bankscondition. A bank may be able to create a "normal" level of out flow of cash on a regulatorybasis, and then estimate the possibility a raise in these flows during periods of stress. However, ageneral market crisis may generate a considerable increase in the total invocation of letters of credit because of an increase in defaults and liquidations in the market.Other possible sources of cash outflows are swaps, written Over-The-Counter (OTC) options,and forward foreign exchange rate contracts. For instance, consider that a bank has a large swapbook; it would then want to study the circumstances under which it could become a net payer,and whether or not the total net pay-out is significant.Consider another situation wherein a bank acts as a swap market-maker, with a possibility that ina bank-specific or general market crisis, customers with in-the-money swaps (or a net in-the-money swap position) would try to reduce their credit exposure to the bank by requesting thebank to buy the swaps back. Similarly, a bank would like to review its written OTC options book and any warrants that are due, along with hedges if any against these positions, since certaintypes of crises sometimes arouse an increase in early exercises or requests that the banks shouldbuy the offer back. These activities could result in an unexpected cash loss, if hedges can neitherbe quickly liquidated to generate cash nor provide insufficient cash. Other assumptions Until now the discussion was centered on the assumption about the behaviour of the specificinstrument under different scenarios. At the time of looking the components exclusively, theremight be some of the factors that might have a major impact on the cash flows.The need for liquidity arises from business activities. The banks too need excess funds to supportextra operations.For example, the majority of the banks provide clearing services to financial institutions andcorrespondent banks. These institutions generate a major sum of cash inflow and cash outflowsand unpredicted variations in these services can reduce a banks funds to a large extent.The other expenses such as rent and salary however are not given much importance in theanalysis of the banks liquidity. But they can be sources of cash outflows in some cases.

Q.3 Explain loan able fund theory and liquidity preference theory [10 Marks] Ans;- Loanable funds theory Loanable funds theory explains that the calculation of the rate of interest is on the basis of demand and supply of loanable funds which are available in the capital market. The concept wascreated by Knut Wicksell (1851-1926), who was a well-known Swedish economist. It waswidely accepted before the work of the English economist John Maynard Keynes (1883-1946).An increase in the demand of loanable funds leads to an increase in the interest rate and viceversa. Also an increase in the supply of loanable funds results in the fall of interest rate. If boththe demand and supply of the loanable funds changes, the resultant interest rate depends on thelevel and route of the movement of the loanable funds.The loanable funds theory encourages that both savings and investments are responsible for thedetermination of the rates of interest. The short-term interest rates are assessed on the basis of thefinancial conditions of an economy.In case of loanable funds theory the determination of the interest rates depends on the availabilityof the loan amount. The availability of loan amount is based on certain factors like net increasein currency deposits, amount of savings made, and willingness to enhance cash balances. Liquidity preference theory The liquidity preference theory or liquidity preference hypothesis, proposed by J. M. Keynes,explains the relation between the generation of a debt instrument and its maturity period.The liquidity preference theory states that investors maintain their funds in liquid form like cashrather than less liquid assets like stocks, bonds and commodities. Banks offer interest to investorsto compensate for their liquidity losses which ultimately promote long-term investments.The liquidity preference theory does not deal with liquidity, but deals with the risks associatedwith maturity. According to this theory, the risks related to the maturity of debt instruments aredirectly proportional to the length of the maturity period.According to the liquidity preference theory, if the investors possess debt instruments that havelonger term periods then they will receive a premium of the rates of interest over a long-termperiod. This premium is known as the liquidity premium. Liquidity premium stabilises thefinancial risks that the investors have suffered due to the investment in debt instruments that hadlonger term periods. As a result of the premium, the generation of the debt instrument that has alonger periodic term is higher compared to debt instruments having shorter term periods.Liquidity preference is a potentiality or functional tendency, which arranges the quantity of money which the public will hold when the rate of interest is given; so if r is the rate of interest,M the quantity of money and L the function of liquidity preference, we can define M = L(r). Q.4 Explain various sources of interest rate risk [10 Marks] Ans:The interest rate risk adversely affects the organisations financial situation. It posessignificant threat to the incomes and capital investments of the organisation. The changesoccurring in interest rate affects the value of underlying assets of the organisation. It changes theprice values of

interest bearing asset and liability based on the magnitude level of fluctuations ininterest rates. We shall discuss some of the sources of interest rate risk in the followingsubsections. Yield curve risk The yield refers to the relationship between short term and long term interest rates. The yieldcurve risk occurs due to the yield curve fluctuations which affect the organisations income andeconomic values of underlying assets. The short term interest rates are lower than long terminterest rates and hence the occurring fluctuation exposes the organisation to maturity gap of interest rate risk. The variations in movements of interest rates changes when the yield curve of amarket flattens or steepens in the interest rate cycle.The yield curve slopes upwards when the short term interest rates are lower than the long terminterest rates. This yield curve is known as normal yield curve. The yield curve flattens when theshort term interest rates increases across the long term interest rates. This occurs during thetransition of the normal yield curve to an inverted curve. It is called as flat curve. The invertedyield curve refers to the economic recession period. Therefore the market status overviews theyield curve of long term interest rate as decline in the long term fixed income of the organisation.The effects of recession impose negative impacts to the organisation hence they must concentrateon diversifying the investment portfolio.Figure 10.1 depicts the normal yield curve Figure 10.1: Normal Yield Curve The yield curve has major impacts on the consumers, equity and fixed income investors. Thefixed rate loans will be encouraged when the short term rates exceeds the long term rates. Hencethe consumers who invest in financing properties experience higher mortgage payments. Thefixed income investors are benefited with better returns with short term investments due to theelimination of risk premium for long term investments. During the phase of inverted yield curvethe margins of the profits decline such that the organisation at short term rates borrow cash andlend it at long term rates to gain profits. Basis risk Basis risk occurs due to the changes in relationship between the various financial markets orfinancial instruments. The different market rates of financial instruments differ with time andamounts. In the banking organisation basis risk occurs due to the differences in the prime rateand offering rates on money market deposits, saving accounts. The changes of interest rates cangive rise to unexpected changes of asset and liability cash flows and earnings. For example - anorganisation holds large untraded stocks. If the company tries to sell those stocks in wholesale, itexperiences liquidity risk because the selling prices may be depressed in the market. Hence toovercome this issue, the company enters into futures contract with stock index. This reduces theliquidity risk but increases the basis risk due to the differences between the selling and stock index prices. The basis risk affects the profits of an organisation by striking the cash positions. The basis risk changes the storable commodities based on the changes of the storage costs over a period of time. Optionality risk Optionality risk arises with various option instruments of banks like assets, liabilities. It occursduring the process of altering the banks instruments levels of cash flows by banks customersor by bank itself. The option allows the option holder to buy or sell financial instruments. Itusually results in a risk or rewards to the bank. The option holder experiences limited downsiderisk (paid amount) and unlimited upside reward whereas the option seller has unlimited risk andlimited upside reward.The bank faces losses during the sold position option to its customers. There are chances of losses in banks capital value due to unfavourable interest rate movements such that it exceedsthe profits that a bank gains, during the favourable movements. Therefor it has more downsideexposure than upside reward.The options are traded in banks with stand-alone instruments such as over the counter (OTC),exchange traded options, bond loans and so on. The stand-alone instruments are explicitly pricedand are not linked with other bank products. Most of the banking organisations allowprepayment option of commercial loans which includes the prepayment process without anypenalties. Hence during the decline of rates the customers will perform prepaying loan processwhich shortens the banks asset maturities while the bank desires to extend it. Repricing risk Repricing risk arises due to the differences between the timing of rate changes and cash flowsoccurring in pricing and maturity of banks instruments such as assets, liabilities and off balancesheets. It is measured by comparing the liability volume with asset volume that reprice withinspecified period of time. The repricing risk increases the earnings of the banks. Liabilitysensitivity occurs in banking organisations since repricing asset maturities are longer than therepricing liability maturities. The income of the liability sensitive bank increases during the fallof interest rates and declines when the interest rate increases. Inversely, the asset sensitive bank benefits from rise in rates and detriments with fall in rates.Repricing risk affects the banks earnings performance. Since the banks focus on short termrepricing imbalances are initiated to implement increase interest rate risk by extending maturitiesto improve profits. The banking organisations must consider long term imbalances during therepricing risk evaluation. If the gauging of long term repricing is improper, there are chances of bank experiencing variations in interest rate movements of future earnings. Embedded option risk The embedded option refers to other option securities such as bonds, financial instruments. Theembedded option is a part of another instrument which cannot be separated. The callableembedded option bond consists of hold (option free bond) option and embedded call option. The value of the bond changes according to the changes occurring in interest rates of embeddedoptions values. The price of callable

bond is equal to the price of hold option bond minus priceof call option bond. The decline in interest rates increases the callable option price bond.Figure 10.3 depicts the value of embedded call option varying with respect to changes in interestrates. Figure 10.3: Value of Embedded Call Option The embedded putable bond consists of option free bond and embedded put option. The price of putable bond is equal to price of option bond plus price of embedded put option.Figure 10.4 depicts the value of embedded put option which is obtained by the changes ininterest rates. Figure 10.4: Value of Embedded Put Option Source: http://www.analystnotes.com/browse_los.php?id=13868The organisations must handle the options effectively such that the various types of bonds underembedded option are exposed to low level of risks. During the selling process of financialinstruments there are chances of exposure to significant risks since the holding options areexplicit and embedded which provides advantage to holder and disadvantage to seller. The With Lots of Luck: Ali 18 exceeding number of options can implicate leverage magnifying the positive or negativeinfluences of financial options positions in the organisation

Q.5 Detail Foreign exchange risk management and control procedure [10 Marks] Ans;- Foreign Exchange Risk Management (FERM) and control procedures Each of the banks engaged in foreign exchange activities is responsible for evolving, applyingand supervising procedures to manage and control foreign exchange risk based on the risk management policies. In devising a firms FERM policy, certain factors have to be taken intoaccount the firms exposure, general attitude towards risk management, whether its risk-averse,risk-indifferent or risk-seeking, the firms ability to alter exposed positions i.e. the maximumexchange loss it can absorb without much impact, the competitors stance and most importantlyregulatory requirements. Foreign exchange risk management procedures include the following: Systems to measure and monitor foreign exchange risk Management of foreignexchange risk involves a clear understanding of the amount of risk and the influence of exchange rate changes on the foreign currency exposure. In order to make thesedeterminations, adequate information must be readily available to permit suitable actionto be taken within the acceptable time period. Therefore, each of the bankingorganisations engaged in foreign exchange activities must have an operative accountingand management information system in place that records and measures the followingaccurately:1. The risk exposures related to foreign exchange trading.2. The impact of potential exchange rate changes on the bank. Control of foreign exchange activities Though the control of foreign activities varywidely among the banks depending upon the nature and extent of their foreign exchangeactivities, the main elements of any foreign exchange control plan are well-definedprocedures governing:1. Organisational controls To guarantee that there exists a clear and effectiveisolation of duties between those persons who initiate the foreign exchangetransactions and are responsible for operational functions of foreign exchangeactivities.2. Procedural controls To ensure that the transactions are completely recorded inthe accounts of the banks, they are promptly and correctly settled and to identifyunauthorised dealing instantly and reported to the management.3. Other controls To make sure that the foreign exchange activities are supervisedfrequently against the banks foreign exchange risk, counterparty and other limitsand those excesses are reported to the management. Independent inspections/audits Independent inspections/audits are an important factorfor managing and controlling a banks foreign exchange risk management plan. Banksmust use them to ensure compliance with, and the integrity of, the foreign exchange policies and procedures. Independent inspections/audits should examine the banksforeign exchange risk management activities in order to:1. Ensure adherence to the foreign exchange management policies and procedures.2. Ensure operative management controls over foreign exchange positions.3.

Verify the capability and accurateness of the management information reportsregarding the institutions foreign exchange risk management activities.4. Ensure that the foreign exchange hedging activities are consistent with the banksforeign exchange risk management policies and procedures.5. Ensure that employees involved in foreign exchange risk management are givenaccurate and complete information about the institutions foreign exchange risk policies, risk limits and positions

Q.6 Describe the three approaches to determine VaR [10 Marks] Ans:The Value at Risk (VaR) approach is a comprehensive indicator for measuring foreignexchange risks. VaR approach incorporates all the assets and liabilities of the national financialsystem, along with the contingent liabilities, thus permitting rapid comparison among differentcountries and the analysis of the evolution over time for a country.Value at risk method is used to set market position limits for traders and to decide how toallocate minimum capital resources. VaR allow creation of a common denominator to comparerisky activities in varied markets. The total risk of the banks can also be decomposed intoincremental VaR to reveal positions that increases total risk. On the other hand, VaR can be usedto regulate the performance of risk. Performance assessment of risk is vital in banks, wheretraders have a natural tendency to take on extra risk. Risk capital charges based on VaR approachprovides corrected incentives to the traders.The VaR approach has a number of practical advantages and disadvantages. The advantages of VaR are as follows: The potential losses are computed in simple terms. VaR approach is approved by various regulatory bodies concerned with the risks faced bybanks such as RBI (Reserve Bank of India) and SEBI (Securities and Exchange Board of India). VaR acts as a versatile tool for forex risk measurement.On the other hand, value at risk approach possesses certain limitations too. The limitations of VaR are as follows: VaR faces some difficulties in risk estimation and is sensitive to the estimation methodsused. VaR approach may create a false sense of security. VaR may miscalculate the worst-case outcomes for a bank. The VaR of a specific market position is not always the same for the VaR of the overallportfolio of the bank. VaR fails to incorporate positive results, thus painting an incomplete picture of thesituation.