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Why Treasury Operations in Banks?...
To meet Statutory requirements
SLR @23% of Net Demand & Time Liabilities
CRR @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)
Treasury
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FUNCTIONAL AREAS OF TREASURY
SLR/CRR
Maintenance
Derivatives Investments
Funds
Forex Treasury Management
Precious
Metals
Bulk Deposits
Equity
Market
Treasury
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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 Treasury
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The Treasury Structure
Front Office
(Strikes Deals)
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Typical Functional Structure of the Division
TREASURY DIVISION (GM)
DGM Risk Management Division
-Head Office
-Central Treasury FEOs (2)* (Extended Arms)-(CMs)
Dealers:
SLR securities Settlement Risk Management
Non SLR Bonds Accounts - Domestic
Funds Audit - Forex
CHIEF DEALER – EQUITY CHIEF MANAGER Investment policy
Equity Dealers Back office Integration ALM
CHIEF DEALER – FOREX/ Establishment
DERIVATIVES
GBP/USD
OIS USD/INR
CCS EUR/USD
INBMK GBP/INR
POS USD/JPY
MIFOR EUR/INR
COS USD/CHF
Etc. JPY/INR
CHF/INR Treasury
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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.
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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’
Treasury
term loan. Division
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.
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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.
Corporate Pays benchmark
linked floating rate to IRS
provider
Corp. Pays Fixed rate 12% Corp. Receives fixed rate in IRS
on fixed rate term loan Corporate A for 5 years from IRS provider
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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.
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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:
Corporate Pays fixed rate to
IRS provider
Corp. Pays Floating rate on Corp. Receives benchmark linked
existing term loan floating rate in IRS for 5 years
Corporate B
from IRS provider
Treasury
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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.
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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.
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A typical OIS deal
Corporate 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
Receives 6.20%
T=0
Fixing Daily; Settlement every 6 months
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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 ??????
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Forward Contracts
Since 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.
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Forward Contracts: Tool to Manage Exchange Rate Risk
Assumption:
USD/ INR Spot Rate: 48.50
One Year Forward Premium: 1.00
Hence, One Year Forward USD/ INR Rate: 49.50
to buy/sell
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MTM Calculation – An Example
Assumption: PNB has received fixed @ 6% pa in 5
Year OIS deal for notional Rs. 25 Crore.
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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.
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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.
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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).
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THANK YOU
Treasury
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