Acknowledgement

At the onset of making a career in the avenue of Finance, an experience in the

same was extremely necessary in the form of a Final Project.

In carrying out my final project entitled "Treasury Management in Banks", I have

received help, assistance and guidance from many sources. I take this opportunity
to thank all those who took a keen interest in it and enabled the completion of this
project successfully.

I would like to extend my sincere thanks to Mr. Raja S. Nalawade for facilitating
this project for me and for providing his vital inputs and guidance throughout the
duration of the project. Without his help and support this project wouldn‘t have
reached its logical conclusion.

I would also like to thank Dr. M. B. Shah, our Director for continuously helping and
motivating us to do well throughout the course.

I would like to thank the office staff and other people in the institute for their
valuable support and co-operation.
 EXECUTIVE SUMMARY
If cash is the lifeblood of any organization, the treasury is the heart where all the
cash is circulated. The primary functions of treasury department in any bank are:-

• Manage the market risk the bank faces. This could mean market risk on account
of interest rate or market risk on account of foreign exchange.
• Maintain the Cash Reserve Ratio (CRR) of the bank. As per the RBI Act, banks in
India are expected to maintain 6.00% of their Net Demand and Time Liabilities
(NDTL) as cash reserve with Reserve Bank of India.
• Maintain the Statutory Liquidity Ratio (SLR) of the bank. As per the Banking
Regulation Act, banks in India are expected to maintain 24% of their Net
Demand and Time Liabilities (NDTL) in notified Government of India bonds.
• Servicing the customer requirements with respect to money market and forex
products.

Proprietary trading in government bonds and foreign exchange, Advisory Services

for the customers of the bank on market risk management, Treasury management
includes the management of cash flows, banking, money market and capital-market
transactions; the effective control of the risks associated with those activities; and
the pursuit of optimum performance consistent with those risks. This definition is
intended to embrace an organization‘s use of capital and project financings,
borrowing, investment, and hedging instruments and techniques.

The project discusses on various risk management instruments like interest rate
swaps and forward rate agreement etc. It discusses the importance of asset liability
management and ways of maintaining a balance between them. It throws some
light on Interest rate management, liquidity management, Foreign exchange
management all of which are the important elements of treasury management. It
provides us guidelines regarding the investment and borrowing decisions to be
taken by banks as and when needed. Last but not the least it gives a brief
explanation on securitization.

Banks may properly anticipate that, within appropriate risk exposure criteria, their
treasury-management activities will make a contribution towards their profits or
surpluses. On the other hand, the essentially more cautious nature of many
organizations, particularly those in the public services, will lead to the focus of
treasury management falling largely on the effective control of risk. Whatever the
organization, the achievement of optimum performance consistent with its risk
exposure criteria in its treasury management activities is an important indicator of
effective corporate management.
 TABLE OF CONTENTS

Sr. Particulars Page

No. No.
1 Introduction 7

2 Functions of Treasury Management 8

3 Elements Of Treasury Management 9

1 i. CRR/SLR Management

2 ii. Dated Government Security

3 iii. Money Market Operations

4 Asset Liability management 18

5 Interest Rate Risk management 22

6 Liquidity Risk Management 41

7 Foreign Exchange risk management 55

8 Investment & borrowing decisions 59

9 Securitization 62

10 Conclusion 63

11 Bibliography 64
 1 1. Introduction
In general terms and from the perspective of commercial banking, treasury refers to
the fund and revenue at the possession of the bank and day-to-day management of
the same. Idle funds are usually source of loss, real or opportune, and, thereby need
to be managed, invested, and deployed with intent to improve profitability. There is
no profit or reward without attendant risk. Thus treasury operations seek to
maximize profit and earning by investing available funds at an acceptable level of
risks. Returns and risks both need to be managed. Interest income from
investments has overtaken interest income from loans/advances. The special
feature of such bloated portfolio is that more than 85% of it is invested in
government securities.

The reasons for such developments appear to be as under:

• Banks' reluctance to cut-down the size of their balance sheets.

• Government's aggressive role in lowering cost of debt, resulting in high

inventory profit to commercial banks.

• Capital adequacy requirements.

• The income flow from investment assets is real compared to that of loan-
assets, as the latter is sizably a book-entry.
 2. Functions of Treasury management in
banks

A treasury department of a bank is concerned with the following functions:

• Risk exposure management, which embraces credit, country, liquidity and

interest rate risk consideration together with those risks associated with dealing
in foreign exchange.

• Asset and liability management, where liquidity, interest rate structures and
sensitivity, together with future maturity profiles, are the major considerations in
addition to managing day-to-day funding requirements.

• Control and development of dealing functions.

• Funding of investments in subsidiaries and affiliates.

• Capital debt/ loan stock raising.

• Fraud protection.

• Control of investments.
 3. Elements of Treasury Management

3.1 Cash Reserve Ratio / Statutory Liquidity Ratio

Management
CRR or cash reserve ratio, refers to the portion of deposits that banks have to
maintain with RBI. This serves two purposes. First, it ensures that a portion of bank
deposits is totally risk-free. Second, it enables RBI control liquidity in the system,
and thereby, inflation. Besides CRR, banks are required to invest a portion (24 per
cent now) of their deposits in government securities as a part of their statutory
liquidity ratio (SLR) requirements. The government securities (also known as gilt-
edged securities or gilts) are bonds issued by the Central government to meet its
revenue requirements. Although the bonds are long-term in nature, they are liquid
as they have a ready secondary market.

 What impact does a cut in CRR have on interest rates?

From time to time, RBI prescribes a CRR, or the minimum amount of cash that
banks have to maintain with it (current 6.0%). The CRR is fixed as a percentage of
total deposits. RBI uses CRR as a tool to suck liquidity from the market. A 50 basis
point increase in CRR results in reduction of Rs. 20000 crore (approx.) from banks.
The apex bank said it would pay interest to banks on the eligible balance of CRR at
the rate of 3.5 per cent for the period between June 24 and December 8, 2006, and
at 2 per cent for the period between December 9, 2006, and February 16, 2007.For
the period beginning February 17, 2007, until further notice, the RBI will pay an
interest of one per cent. Total deposits mobilized by banking system as at the end
of March 31, 2006 is Rs. 21, 94,900 crores.

 Does a change in SLR impact interest rates?

SLR reduction is not so relevant in the present context for two reasons: One, as a
part of the reforms process, the government has begun borrowing at market-related
rates. Therefore, banks get better interest rates compared with the earlier days for
their statutory investments in Government securities. Second, banks are still the
main source of funds for the government which means despite a lower SLR
requirement, banks‘investment in government securities will go up as government
borrowing rises. As a result, bank investment in gilts continues to be higher than 30
per cent despite RBI bringing down the minimum SLR to 24 per cent.

Therefore, for the purpose of determining the interest rates, it is not the SLR
requirement that is important but the size of the government-borrowing program.
As government borrowing increases, interest rates, too, look up. Besides, gilts also
provide another tool for RBI to manage interest rates. RBI conducts open market
operations by offering to buy or sell gilts. If it feels interest rates are too high, it
may bring them down by offering to buy securities at a lower yield than what is
available in the market.

3.2 Dated Government Securities

The Government securities comprise dated securities issued by the Government of
India and state governments. The date of maturity is specified in the securities
therefore it is known as dated government securities.

The Government borrows funds through the issue of long term-dated securities, the
lowest risk category instruments in the economy. These securities are issued
through auctions conducted by RBI, where the central bank decides the coupon or
discount rate based on the response received. Most of these securities are issued as
fixed interest bearing securities, though the government sometimes issues zero
coupon instruments and floating rate securities also. In one of its first moves to
deregulate interest rates in the economy, RBI adopted the market driven auction
method in FY 1991-92. Since then, the interest in government securities has gone
up tremendously and trading in these securities has been quite active. They are not
generally in the form of securities but in the form of entries in RBI's Subsidiary
General Ledger (SGL).

The investors in government securities are mainly banks, FIs, insurance companies,
provident funds and trusts. These investors are required to hold a certain part of
their investments or liabilities in government paper. Foreign institutional investors
can also invest in these securities up to 100% of funds-in case of dedicated debt
funds and 49% in case of equity funds.

Till recently, a few of the domestic players used to trade in these securities with a
majority investing in these instruments for the full term. This has been changing of
late, with a good number of banks setting up active treasuries to trade in these
securities. Perhaps the most liquid of the long term instruments, liquidity in gilts is
also aided by the primary dealer network set up by RBI and RBI's own open market
operations.
Features:

RBI, as an agent of the Government, manages and services these securities through
its Public Debt Offices (PDO) located at various places.

At present, there are dated securities with a tenor up to 20 years in the market.
These securities are open to all types of investors including individuals and there is
an active secondary market. These securities are eligible for SLR requirements.
These securities are revocable.

3.3 Money Market Operations

The bank engages into a number of instruments that are available in the Indian
money market for the purpose of enhancing liquidity as well as profitability. Some of
these instruments are as follows:

A. Call Money Market

Call/Notice money is an amount borrowed or lent on demand for a very short period.
If the period is more than one day and up to 14 days it is called 'Notice money'
otherwise the amount is known as Call money'. Intervening holidays and/or Sundays
are excluded for this purpose. No collateral security is required to cover these
transactions.

Features:

• The call market enables the banks and institutions to even out their day-to-day
deficits and surpluses of money.
• Commercial banks, Co-operative Banks and primary dealers are allowed to
borrow and lend in this market for adjusting their cash reserve requirements.
• Specified All-India Financial Institutions, Mutual Funds and certain specified
entities are allowed to access Call/Notice money only as lenders.
• It is a completely inter-bank market hence non-bank entities are not allowed
access to this market.
• Interest rates in the call and notice money markets are market determined.
• In view of the short tenure of such transactions, both the borrowers and the
lenders are required to have current accounts with the Reserve Bank of India.
• It serves as an outlet for deploying funds on short-term basis to the lenders
having steady inflow of funds.

B. Treasury Bills Market

In the short term, the lowest risk category instruments are the treasury bills. RBI
issues these at a prefixed day and a fixed amount. There are four types of treasury
bills.
• 14-day T-bill - maturity is in 14 days. Its auction is on every Friday of every
week. The notified amount for this auction is Rs. 100 cr.
• 91-day T-bill - maturity is in 91 days. Its auction is on every Friday of every
week. The notified amount for this auction is Rs. 100 cr.
• 182-day T-bill - maturity is in 182 days. Its auction is on every alternate
Wednesday (which is not a reporting week). The notified amount for this auction
is Rs. 100 cr.
• 364-Day T-bill - maturity is in 364 days. Its auction is on every alternate
Wednesday (which is a reporting week). The notified amount for this auction is
Rs. 500 cr.

Features:

• A considerable part of the government's borrowings happen through T-bills of

various maturities. Based on the bids received at the auctions, RBI decides the
cut off yield and accepts all bids below this yield.
• The usual investors in these instruments are banks who invest not only to
part their short-term surpluses but also since it forms part of their SLR
investments, insurance companies and FIs. FIIs so far have not been allowed to
invest in this instrument.
• These T-bills, which are issued at a discount, can be traded in the market.
Most of the time, unless the investor requests specifically, they are issued not as
securities but as entries in the Subsidiary General Ledger (SGL), which is
maintained by RBI. The transactions cost on T-bill are non-existent and trading is
considerably high in each bill, immediately after its issue and immediately
before its redemption.
• The yield on T-bills is dependent on the rates prevalent on other investment
avenues open for investors. Low yield on T-bills, generally a result of high
liquidity in banking system as indicated by low call rates, would divert the funds
from this market to other markets. This would be particularly so, if banks already
hold the minimum stipulated amount (SLR) in government paper.

C. Inter-Bank Term Money market

Interbank market for deposits of maturity beyond 14 days and up to three months is
referred to as the term money market. The specified entities are not allowed to lend
beyond 14 days. The market in this segment is presently not very deep. The
declining spread in lending operations, the volatility in the call money market with
accompanying risks in running asset/liability mismatches, the growing desire for
fixed interest rate borrowing by corporate, the move towards fuller integration
between forex and money markets, etc. are all the driving forces for the
development of the term money market. These, coupled with the proposals for
Nationalization of reserve requirements and stringent guidelines by
regulators/managements of institutions, in the asset/liability and interest rate risk
management, should stimulate the evolution of term money market sooner than
later. The DFHI, as a major player in the market, is putting in all efforts to activate
this market

The development of the term money market is inevitable due to the following
reasons

• Declining spread in lending operations

• Volatility in the call money market
• Growing desire for fixed interest rates borrowing by corporate
• Move towards fuller integration between forex and money market
• Stringent guidelines by regulators/management of the institutions

D. Certificates of Deposits

After treasury bills, the next lowest risk category investment option is the certificate
of deposit (CD) issued by banks and FIs.

Features:

• Allowed in 1989, CDs were one of RBI's measures to deregulate the cost of
funds for banks and FIs.
• A CD is a negotiable promissory note, secure and short term (up to a year) in
nature. It is issued at a discount to the face value, the discount rate being
negotiated between the issuer and the investor. Though RBI allows CDs up to
one-year maturity, the maturity most quoted in the market is for 90 days.
• The secondary market for this instrument does not have much depth but the
instrument itself is highly secure.
• CDs are issued by banks and FIs mainly to augment funds by attracting
deposits from corporate, high net worth individuals, trusts, etc. the issue of CDs
reached a high in the last two years as banks faced with reducing deposit base
secured funds by these means.
• The foreign and private banks, especially, which do not have large branch
networks and hence lower deposit base use this instrument to raise funds.
• The rates on these deposits are determined by various factors. Low call rates
would mean higher liquidity in the market. Also the interest rate on one-year
bank deposits acts as a lower barrier for the rates in the market.

E. Commercial Paper (CP)

Commercial Paper (CP) is an unsecured money market instrument issued in the

form of a promissory note. CP was introduced in India in 1990 with a view to
enabling highly rated corporate borrowers to diversify their sources of short-term
borrowings and to provide an additional instrument to investors.
 Who can issue Commercial Paper (CP)

Highly rated corporate borrowers, primary dealers (PDs) and satellite dealers (SDs)
and all-India financial institutions (FIs) which have been permitted to raise resources
through money market instruments under the umbrella limit fixed by Reserve Bank
of India are eligible to issue CP.

A company shall be eligible to issue CP provided –

(a) the tangible net worth of the company, as per the latest audited balance sheet,
is not less than Rs. 4 crore;
(b) the working capital (fund-based) limit of the company from the banking system
is not less than Rs.4 crore and
(c) the borrower account of the company is classified as a Standard Asset by the
financing bank/s.

 Rating Requirement

All eligible participants should obtain the credit rating for issuance of Commercial
Paper, from either the Credit Rating Information Services of India Ltd. (CRISIL) or the
Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit
Analysis and Research Ltd. (CARE) or the Duff & Phelps Credit Rating India Pvt. Ltd.
(DCR India) or such other credit rating agency as may be specified by the Reserve
Bank of India from time to time, for the purpose. The minimum credit rating shall be
P-2 of CRISIL or such equivalent rating by other agencies. Further, the participants
shall ensure at the time of issuance of CP that the rating so obtained is current and
has not fallen due for review.

 Maturity

CP can be issued for maturities between a minimum of 15 days and a maximum up

to one year from the date of issue. If the maturity date is a holiday, the company
would be liable to make payment on the immediate preceding working day.

 Denominations

CP can be issued in denominations of Rs.5 lakh or multiples thereof.

 Investment in CP

CP may be issued to and held by individuals, banking companies; other corporate

bodies registered or incorporated in India and unincorporated bodies, Non-Resident
Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by FIIs
would be within the 30 per cent limit set for their investments in debt instruments.

 Mode of Issuance
CP can be issued only in a dematerialized form through any of the depositories
approved by and registered with SEBI. CP can be held only in dematerialized form.
CP will be issued at a discount to face value as may be determined by the issuer.
Banks and All-India financial institutions are prohibited from underwriting or co-
accepting issues of Commercial Paper.

 Payment of CP

On maturity of CP, the holder of the CP will have to get it redeemed through the
depository and receive payment from the IPA.

F. Ready Forward Contracts

It is a transaction in which two parties agree to sell and repurchase the same
security. Under such an agreement the seller sells specified securities with an
agreement to repurchase the same at a mutually decided future date and a price.
Similarly, the buyer purchases the securities with an agreement to resell the same
to the seller on an agreed date in future at a predetermined price. Such a
transaction is called a Repo when viewed from the prospective of the seller of
securities (the party acquiring fund) and Reverse Repo when described from the
point of view of the supplier of funds. Thus, whether a given agreement is termed
as Repo or a Reverse Repo depends on which party initiated the transaction.

Features:

 The lender or buyer in a Repo is entitled to receive compensation for use of

funds provided to the counter party. Effectively the seller of the security borrows
money for a period of time (Repo period) at a particular rate of interest mutually
agreed with the buyer of the security who has lent the funds to the seller. The
rate of interest agreed upon is called the Repo rate.
 The Repo rate is negotiated by the counter parties independently of the coupon
rate or rates of the underlying securities and is influenced by overall money
market conditions.

Uses of Repo

 It helps investor achieve money market returns with sovereign risk.

 It helps borrower to raise funds at better rates

 An SLR surplus and CRR deficit bank can use the Repo deals as a convenient way
of adjusting SLR/CRR positions simultaneously.

 RBI uses Repo and Reverse repo as instruments for liquidity adjustment in the
system.
G. Commercial Bills

Bills of exchange are negotiable instruments drawn by the seller (drawer) of the
goods on the buyer (drawee) of the goods for the value of the goods delivered.
These bills are called trade bills. These trade bills are called commercial bills when
they are accepted by commercial banks. If the bill is payable at a future date and
the seller needs money during the currency of the bill then he may approach his
bank for discounting the bill. The maturity proceeds or face value of discounted bill,
from the drawee, will be received by the bank. If the bank needs fund during the
currency of the bill then it can rediscount the bill already discounted by it in the
commercial bill rediscount market at the market related discount rate.
The RBI introduced the Bills Market scheme (BMS) in 1952 and the scheme was
later modified into New Bills Market scheme (NBMS) in 1970. Under the scheme,
commercial banks can rediscount the bills, which were originally discounted by
them, with approved institutions (viz., Commercial Banks, Development Financial
Institutions, Mutual Funds, Primary Dealer, etc.).

4. Asset Liability Management

ALM is concerned with strategic balance sheet management involving risks caused
by changes in the interest rates, exchange rates and the liquidity position of the
bank. While managing these three risks forms the crux of ALM, credit risk and
contingency risk also form a part of the ALM. The significance of ALM to the financial
sector is further highlighted due to dramatic changes that have occurred in recent
years in the assets (uses of funds) and liabilities (sources of funds) of banks. Thus a
comprehensive ALM process aims on profitability and long term viability. The
process of ALM has to be carried out against many balance sheet constraints, which
amongst others include maintaining credit quality, meeting liquidity needs and
acquiring required capital.

 Significance of ALM

The main reasons for the growing significance of ALM are:

1 1. Volatility
2 2. Product Innovations
3 3. Regulatory environment
4 4. Enhanced awareness of top management

1. Volatility

The recent times have witnessed an increasing number of free economies, with
more and more nations globalizing their operations. Closely regulated markets are
paving the way for market-driven economies. Such deregulations have changed the
dynamics of the financial markets. The vagaries of such free economic environment
are reflected in the interest rate structures, money supply and the overall credit
position of the market, the exchange rates and price levels. For a business which
involves trading and money, rate fluctuations invariably affect the market value,
yields / cost of the assets/liabilities which further affect the market value of the
bank and its Net Interest Income (NII). Tackling this situation would have been a
very easy task, in a setup where the interest rate movements are known with
accuracy and where the volatility in the exchange rates was considerably lower.

2. Product Innovation:

The second reason for the growing importance of ALM is the rapid innovations
taking place in the financial products of the bank. Whatever may be the features of
the products, most of them have an impact on the risk profile of the bank thereby
enhancing the need for ALM. Consider the flexi deposit facility the banks are now
offering for their term deposits. Earlier, if the depositor who has a term deposit of
Rs. 1 lakh was in need of funds, say Rs. 25000 before the date of maturity of the
term deposit, then the depositor would go for a premature withdrawal of the term
deposit or raise a loan. In order to discourage this, banks charge a penalty on the
entire amount for premature withdrawal. This served as a disincentive for
premature withdrawals and also reduced the risk for the bank.
However, with the introduction of flexi deposit facility, the deposit of Rs. 1, 00,000
will be segregate into deposits of smaller denominations, say 100 deposits of 1,000
each. This enables the investor to withdraw the required amount before the
maturity since the burden of penalty is limited. However, it will also enhance the
risk of the bank. With the reduction in the penalty amount, the depositor would
make a demand for the premature withdrawal at any time.

To reduce the impact of the asset-liability mismatch that arises due to these early
withdrawals of funds, the bank will have to raise a liability to match the outflow. In
such case, the bank will be faced with a liquidity risk when there is a sudden outflow
of funds as well as interest rate risk since it may have to raise a liability at a higher
cost.

3. Regulatory Environment

In order to enable the banks to cope up with the changing environment that has
resulted due to integration of the domestic markets with the international markets,
the regulatory bodies of various financial markets have initiated a number of
measures. These measures were taken with an objective to prevent major losses
that may arise due to the market vagaries. One step in this direction was the
increased focus on the management of the banks‘ assets and liabilities. At the
international level, the Bank of International Settlement (BIS) provides a framework
for the banks to tackle the market risk that may arise due to rate fluctuations and
excessive credit risk.

Purpose of ALM

At the macro-level, ALM leads to the formulation of critical business policies,

efficient allocation of capital and designing of products with appropriate pricing
strategies.

At the micro-level, the objective functions of the ALM are two-fold. It aims at
profitability through price matching while ensuring liquidity by means of maturity
matching.

Price matching basically aims to maintain spreads by ensuring that the deployment
of liabilities will be at a rate higher than the costs.

Similarly, liquidity is ensured by grouping the assets/liabilities based on their

maturing profiles. The gap is then assessed to identify the future financing
requirements. This ensures liquidity. However maintaining profitability by matching
prices and ensuring liquidity by matching the maturity levels is not an easy task.

The following tables explain the process involved in price matching and maturity
matching.
Price Matching

Table I Table I (Rearranged)

Liabilities Assets Liabilities Asset
s
Amt Rat Am Rate Am Rate Amt Rate Spread
(%) e t t (%) (%)
(% (%)
)
15 0 10 0 10 0 10 0 0
25 5 20 12 5 0 5 12 12
30 12 50 15 15 5 15 12 7
30 13 20 18 10 5 10 15 10
30 12 30 15 3
10 13 10 15 2
20 13 20 18 5
100 8.7 10 13.5 10 8.75* 100 13.5* 4.75*
5* 0 * 0

* Weighted average cost/return on liabilities/assets.

Maturity Matching

Table II Table II (Rearranged)

Liabilit Maturing within Asse Maturing Liabilit Asse Ga Cumulat
ies (months) ts within ies ts p ive
(months) Gap
10 1 15 <1 10 15 -5 -5
5 3 10 3 5 10 -5 -10
8 6 5 6 8 5 +3 -7
4 12 10 12 4 10 -6 -13
45 24 30 24 45 30 +1 +2
5
20 36 10 36 20 10 +1 +12
0
8 >36 20 >36 8 20 -12 0
100 100 100 100

Table I shows how proper deployment of liabilities can ensure positive spreads.
These spreads can however, be attained if the interest rate movements are known
with accuracy, and the forecasts made fall close to actual movements. This
approach further ignores maturity mismatches, which may to a certain extent affect
the expected results.

Similarly, table II helps in determining the gap that exists by using forecasted cash
flows, both inflows and outflows. It further forecasts the surplus deficit fund position
and thereby enables better financing plan. Maturity matching, however, is possible
if the financial requirements are forecasted accurately. This approach does not
integrate fully with the price-matching concept. Though these two approaches i.e.
price matching and maturity matching effectively reduce risks the methodology
adopted may not be feasible in reality.

5. Interest Rate Risk Management

Due to the very nature of its business, a bank should accept interest rate risk not by
chance but by choice. And when the bank has to take a risk as a choice, then it
should ensure that the risk taken is firstly manageable and secondly it does not get
transformed into yet another undesirable risk. As stated earlier, the focal point in
managing any risk will be to understand the nature of the risk. This is especially
essential for interest rate risk management. Interest rate risk is the gain/loss that
arises due to sensitivity of the interest income/interest expenditure or values of
assets/liabilities to the interest rate fluctuations.

 Types of Interest Rate Risks

The sensitivity to interest rate fluctuations will arise due to the mixed affect of a
host of other risks that comprise the interest rate risk. These risks when segregated
fall into the following categories.

1. Rate Level Risk

During a given period there is possibility for restructuring the interest rate levels
either due to the market conditions or due to regulatory intervention. This
phenomenon will, in the long run, affect decisions regarding the type and the mix of
assets/liabilities to be maintained and their maturing periods.
The present interest rate restructuring taking place in the Indian markets is a very
good example of this aspect. The Reserve Bank of India which is the apex body
regulating the Indian monetary system, constantly increase or decrease Cash
Reserve Ratio for banks in a phased manner. Every time the CRR is increased, there
is a shortage in the liquidity which further results in hardening of the interest rate
levels. A 1.5% increase in the CRR from 5% to 6.5 % in the Busy Season Credit
Policy announced since 2006 was immediately followed by a rise in the PLR/interest
rates of Banks and FI‘s. The risk that arises due to this hike can be understood from
the fact that the revised rates of interest will be applicable to all the new deposits,
which will increase the marginal costs of funds. However, the affect will be seen on
all the existing assets. Consequently the loss of interest income on assets is likely to
be higher than the increase in the interest cost of deposits leading to lower spreads.

2. Volatility Risk

In additions to the long run implications of the interest rate changes, there are short
term fluctuations which are to be considered in deciding on the mix of assets and
liabilities, the pricing policies and thereby the business volumes. However, the risk
will acquire serious proportions in a highly volatile market when the impact will be
felt on the cash flows and profits. The 1994 volatility witnessed in the Indian call
money market explains the presence and the impact of volatility risk. The interest
rate in the call money market, which generally hovered around 5-7 %, zoomed to
7.5% during March 2007. While some banks defaulted in the maintenance of CRR,
and corporate tax outflow made banks borrow funds at high rates, which had
substantially reduced their profits. Thus, it can be seen that the affect of
fluctuations in the short term have a greater impact since the adjustment period is
very short.

3. Prepayment Risk

The fluctuations in the interest rate may sometimes lead to prepayment of loans.
For instance, in a situation where the interest rate is declining, any cash inflows that
arise due to prepayment of loans will have to be redeployed at a lower rate
invariably resulting in lowered yields.

4. Call/Put Risk

Sometimes when the funds are raised by the issue of bonds/securities, it may
include call/put options. A call option is exercised by an issuer to redeem the bonds
before maturity, while the put option is exercised by the investor to seek
redemption before maturity. These two options expose to a risk when the interest
rate fluctuate. A call option is generally exercised in a declining interest rate
scenario. This will affect the bank if it invests in such bonds since the intermediate
cash inflows will have to be reinvested at a lower rate. Similarly, when the investor
exercises the put option in an increasing interest rate scenario, the banks, which
issue the bonds, will have to face greater replacement costs.

5. Reinvestment Risk

The risk can be associated to the intermediate cash flows arising due to the
payment of interest, installments on loans etc. These intermediate cash flows
arising from a security/loan are usually reinvested and the income from such
reinvestments will depend on the prevailing rate of interest at the time of
reinvestment and the reinvestment strategy. Due to the volatility in the interest
rates, these intermediate cash flows when received may have to be reinvested at a
lower rates resulting in lower yields. This variability in the returns from the
reinvestments due to changes in the interest rates is called the reinvestment risk.

6. Basis Risk

When the cost of liabilities and the yields of assets are linked to different
benchmarks resulting in a floating rate and there are no simultaneous matching
movements in the benchmark rates, it leads to basis risk. For instance, consider
that the funds raised by way of 1 yr bank deposits are invested in the Easy Exit
Bond of the IDBI flexi bond issue. In this case, the cost of funds for 1 yr bank
deposits will be 9% ( 1 % less than the prevailing Bank Rate 10%), while the yields
from the bonds will be 14.55% which is 1.5% over 10 yr government bond of
13.05%. with these floating rates of interest, on the assets and liability spreads of
5.55% (14.55-9) is available. Assume that there is a 1% cut in the bank rate. This
will bring down the cost of funds to 8%. Further, assume that the return on 10 yr
government bond has also come down to 12.75%, thereby bringing down the return
on the Easy Exit Bond to 14.25%. As a result of this interest rate change, the spread
will increase to 6.25%. While the bank rate declined by 1%, the yield on 10 yr
government security came down only by 30bp.

Thus, when the change in the interest rates, which are set as a benchmark
for assets/liabilities, is not uniform, it will lead to a decrease/increase in
the spreads.

7. Real Interest Rate Risk

Yet another dimension of the interest rate risk is the inflation factor, which has to be
considered in order to assess the real interest cost/yields. This occurs because the
changes in the nominal interest rates may not match with the changes in inflation.

The presence of the above mentioned risk would either individually or collectively
result in interest rate risk. These risks will affect the income/expenses of the bank‘s
asset/liability portfolio. This, further, will also have an impact on the value of assets
and liabilities of the bank, thereby affecting even the market value of the bank.

Management of Interest Rate Risk

Mere Identification of the presence of the interest rate risk will not suffice. A system
that quantities the risk and manages the same should be put in place so that timely
action can be taken. Any delay or lag in the follow up action may lead to a change
in the dimension of the risk i.e. lead to some other risks like credit risk, liquidity risk,
etc. and make the Situation uncontrollable. Initiating the risk exposure control
process is the classification of all assets and liabilities based on their rate
sensitivity. For this classification, a bank should first be able to forecast the interest
rate fluctuations. Based on these fluctuations, it should identify the rate sensitive
assets/liabilities within the forecasting period. Thus, all assets/liabilities that are
subjected to re pricing within the planning horizon are categorized as Rate Sensitive
Assets (RSAs)/Rate Sensitive liabilities (RSLs).

The need for-re pricing arises from the fact that in a going concern, all assets and
liabilities are replaced as and when they mature- Replacement of these
assets/liabilities may subsequently lead to re-pricing especially in the following
three situations:

a) when assets/liabilities approach maturity,

b) when the assets/liabilities have floating rate of interest, and
c) when regulations prescribe re pricing.

When an asset/liability is maturing, the changing interest rate structure leads to

revision of the price at which they are replaced. For example, the IDBI Flexi bonds
issue consisted of the regular income bond with a face value of Rs. 5,000 and
having a coupon rate of 16 percent p.a. payable half-yearly. This bond has a
maturity period of 10 years. Once the redemption date approaches, IDBI will have to
replace the same by raising a liability at a rate which will be either less than/greater
than the 16 percent rate level.
Similarly, re pricing becomes invariable when the asset/ liability are priced at
floating rate. For instance, consider the Easy Exit Bond of the IDB1 Flexi bonds
issue. The coupon rate of this bond is fixed at 1.5 percent over 10-year Government
Bond rate or 2.5 percent over 3-year FD rate of SBI, whichever is higher. Thus, any
change in the Government bond rate/SBI FD rate leads to a corresponding change
in the rate of the Bond,.

Replacement of the assets/liabilities subsequently leads to re pricing which explains

their sensitivity to rate fluctuations. The need for such a classification of assets-and
liabilities based on their sensitivity is essential since a consequential affect of the
rate fluctuation is its impact on the net income of the firm.

There are two aspects that- need to be taken care of in order to understand the
total impact of the rate fluctuation on the net income. These two aspects refer to
the effect of the rate changes on the non-interest income and the interest income.
In the first case, there can be a use tall in the non-interest income since rate
fluctuations affect the value of the assets/liabilities, while in the second case, the
interest rate changes will in certain situations create a mismatch in the pricing of
the assets and liabilities which affect the net interest income.

Thus, it can be observed that the effect of rate fluctuation is extended to both the
balance sheet and the income statement of a financial intermediary. However, while
measuring the interest rate risk, greater emphasis is laid on its affect on interest
income. This is due to a high degree of correlation between the rate fluctuations
and its affect on RSAs/RSLs, which further gives greater scope for maneuverability.

 Approaches Adopted To Quantify Interest Rate Risks:

• Maturity Gap Method

• Rate Adjusted Gap
• Hedging

1. Maturity Gap Method:

This asset-liability management technique aimed to tackle the interest rate risk,
highlights on the gap that is present between the RSAs and the RSIs, the maturity
periods of the same and the gap period.

The objective of this method is to stabilize/improve the net interest income in the
short run over discreet, periods of time called the gap periods-

The first step is Thus-to select the gap period which can be anywhere between a
month to a year. Having chosen the same, all the RSAs and RSLs are grouped into
'maturity bucket' based on the maturity and the time until the first possible re
pricing due to change in the interest rate.

The gap is then calculated by considering the difference between the absolute
values of the RSAs and the RSLs, which is mathematically expressed as:

RSG = RSAs – RSLs ….. Eq. 3.1

Gap Ratio = RSAs / RSLs ……Eq. 3.2

Where,

RSG = Rate Sensitive Gap based on maturity

The gap so analyzed can be used to cut down the interest rate exposure in two
ways, As mentioned earlier, The bank can use it to maintain/improve its net interest
income for changing interest rates, otherwise adopt a speculative strategy wherein
by altering the gap effectively depending on the interest rate forecasts net interest
income can be improved. In either way, the basic assumption of this model is that
there will be an equal change in interest rates for all assets and liabilities.

During a selected gap period, The RSG will be positive when the RSAs are more
than the RSLs, negative when the RSLs are in excess of the RSAs and zero when the
RSAs and RSLs are equal. Based on these outcomes, the maturity gap method
suggests various positions that the treasurer can take in order to tackle with the
rising/falling interest rate structures. Consider the following illustration to
understand the approach.
Illustration 3.1

In the illustration given below, for the three different gap portion i.e. positive,
negative and zero, the impact of rate fluctuations i.e. a rise or a fail, on the NII are
explained-

Option I: Positive Gap

(Rs. Cr)

Liability Rate Increased Decreased Asset Rate Increased Decrea

(%) Rate (%) Rate (%) (%) Rate (%) sed
Rate
(%)
200 200
1800* 10 11 9 800* 12 13 11
2000 11 11 11 1000* 14 15 13
1000* 16 17 15
1000 18 18 18
4000 4000
Interest 400 418 382 Inter 576 604 548
Expens est
e Inco
me
Net 176 186 166
Interest
Income
**

RSAs: Rs 2800, RSLs: Rs1800, GAP: Rs1000

Option II – Negative Gap

(Rs. Cr.)

Liability Rate Increased Decreased Asset Rate Increased Decrea

 (%) Rate (%) Rate (%) (%) Rate (%) sed
Rate
(%)
200 200
1800* 10 11 9 800* 12 13 11
2000 11 11 11 1000* 14 14 14
1000* 16 16 16
1000 18 18 18
4000 4000
Interest 400 418 382 Inter 576 584 568
Expens est
e Inco
me
Net 176 166 186
Interest
Income
**
RSAs: Rs 800, RSLs: Rs1800, GAP: Rs 1000

Option III- Zero Gap

(Rs. Cr.)

Liability Rate Increased Decreased Asset Rate Increased Decrea

(%) Rate (%) Rate (%) (%) Rate (%) sed
Rate
(%)
200 200
1800* 10 11 9 800* 12 13 11
2000 11 11 11 1000* 14 15 13
1000* 16 16 16
1000 18 18 18
4000 4000
Interest 400 418 382 Inter 576 594 558
Expens est
e Inco
me
Net 176 176 176
Interest
Income
**
RSAs: Rs 1800, RSLs: Rs 1800, GAP: Rs 0

NOTE: * Represents RSAs and RSLs,

** Net Interest Income (NII) = Interest Income – Interest Expense

The following are the implications of an increase/decrease in interest rates

for a given RSG level.
i. RSG is Positive

When RSG is positive it is understood that the yield earned in such a situation will
be more than the rate at which the liabilities are serviced. In the illustration given
above, option I has a positive gap of Rs.1000 cr. Initially, the cost of funds is Rs.400
cr., while the total returns are Rs-576 cr. resulting in a NII of Rs 176cr. This will,
however, be affected by changes in the interest rates. When the interest rates
rise/fall by equal amounts, then the increase/decrease in the interest income will be
more than the servicing cost of liabilities, merely due to the fact that there are more
re priceable assets than the re priceable liabilities.

ii. RSG is Negative

In the second situation where the RSG is negative, an increase/decrease in the

interest rates by an equal amount will lead to a greater rise/fall in the interest
expenses than the interest income earned. The presence of more RSLs as compared
to the RSAs explains this phenomenon. Consider option II where the RSAs and RSLs
are Rs.800 cr. and Rs.1800 cr. respectively resulting in a negative gap of Rs. 1000.
When there is a negative gap, the consequence of a rate fluctuation is a decrease in
the net interest income when the interest rates rise and decrease in the same when
the rates fail.

iii. RSG is Nil

As a third option, the bank can maintain a zero gap and thus remain neutral to the
interest rate fluctuations. It can be observed in Option III of the illustration that
when the RSAs and the RSLs are equal to Rs 1800 cr. The NII remains at Rs.176 cr.
in a rising/falling interest rate scenario.

The utility of the Maturity Gap approach is that for a given level of RSG and with a
forecast of a rise/fall in interest rates, the banker can take the following positions to
improve the net income,

• Maintain a positive gap when the interest rates are rising;

• Maintain a negative gap when the interest rates are on a decline,
• Alternatively, maintain a zero gap position for the firm to ensure a complete
hedge against any movements in the future interest rates. Though this policy
will reduce the interest rate risk to a large extent, it will not lead to any
speculative gains. While such a situation may not occur in reality, it will also be
unwarranted since there are no major benefits arising from it.

The process of maturity gap approach discussed above assesses the impact of a
percentage change in the interest rates on the NII.
The relationship is given by:

∆ NII = Gap x ∆ r ...... Eq. (3.3)

Where,

∆ NII = Change in net interest income

∆ r = Change in interest rates

Consider Option I of illustration 3.1

Gap Change in Change in

interest rate NII

+10 Increase by 1% 1000 * 0.01 =

00 10

+10 Decrease by 1% 1000 * -0.01

00 = -10

However, the objective of an ALM policy will be to maintain the NIM within certain
limits by managing the risks. And since risks are an inherent quality of the banking
business, it implies that the bank should first decide on the maximum and minimum
levels, for the NIM. Following this will be an ALM technique, which allows a bank to
lake various risk exposure levels, and still remain within the limits set for NIM.

While the above helps in quantifying the interest rate risk, it is more relevant for a
bank to identify the gap, which it should target for a given forecast of interest rate
change. For this purpose one has to go through the following steps:

1. Assess the percentage change in NIM that is acceptable to the bank,

2. Make a forecast for the quantum and direction of interest rate change.
3. Based on the above determine the gap level (positive/negative).

We are aware that NII is affected by the Net Interest Margin (NIM) and the earning
Assets.

NII = Earning Assets x NIM ..... Eq. (3.4)

The bank has to decide as a matter of policy the percentage variation in NIM, which
is acceptable/ tolerable. Let that percentage be indicated by ∆ c. then acceptable
variation in the value of NII is given by

∆ NII = Earning Assets x NIM x ∆ c

Since, ∆ NII = Gap x ∆ r

Gap x ∆ r = Earning Assets x NIM x ∆ c

Therefore,

Gap = (Earning Assets x NIM x ∆ c) / ∆ r ……Eq. 3.5

Where,

Earning Assets = Total Assets of the bank

NIM = Net Interest Margin

∆ c = Acceptable change in the NIM

∆ r = Expected change in interest rates

At the outset it must be clear that the above computation of gap is with reference
to future and hence all the above parameters are estimates.

• Earning assets represent the projected level of assets, either absolute or average
levels collected from the bank's short-term forecasts like credit budget.
• NTM represents the margin projected for the relevant period.
• ∆ c is a policy variable to be decided by the top management of the bank-
• ∆ r is a variable which is obtained by using the forecasting techniques and is
provided by the specialist officer.

The following illustration helps in explaining the above.

Illustration 3.2

AFC Banking Corporation Ltd. has earning assets worth Rs. 1,980 cr. and a net
interest margin (NIM) of 4 percent. In a policy decision made by the Bank it has
been decided that a 2.5 percent increase/decrease in the NIM can be the acceptable
limit. It further forecasts a 0.75 percent increase in the interest rate. Assess the
target gap, which the company can maintain to remain within the acceptable limits
of the NII.

Solution

Given this information, the target gap can be assessed as follows:

Target Gap = ∆ c x (Earning Assets x NIM) / Change in interest rate

= (0.025 x 1980 x 0.04) / 0.075

= Rs.264 cr.
Thus, the company can maintain a ±Rs.204 cr. gap in order to manage the interest
rate exposure, for a 0.75 percent increase in interest rate. Since the forecast is an
increase in interest rates, the bank should attempt to maintain a positive gap of
Rs.264 cr.

LIMITATIONS:

• The success/failure of the maturity gap method in tackling the interest rate
exposure depends to a extent on the accuracy level of the forecasts made
regarding the quantum and the direction of the interest rate changes. The
accuracy will, however, be higher when the forecasts are made for shorter
intervals of time. This also applies to other models.

• While gap measurement is an easy task, gap management is not. Having

forecasted the interest rate movement to the nearest possible accuracy level,
the treasurer may not have the flexibility in managing the gap so as to
effectively produce the targeted impact on the net interest income. Further, it
also assumes that there will be an equal change in interest rates for all RSAs and
RSLs.

• It assumes that the change in the interest rates is immediately affecting all
the RSAs and RSLs by the same quantum which is not always the case in reality.

• This model ignores the time value of money for the cash flows occurring
during the gap period.

In reality, the market value of even those assets/liabilities, which are not re priced
during the gap period, will be affected. For instance, when an investment is made in
a bond with a 15 percent coupon rate, a rising interest rate scenario implies better
investment opportunities other than the bond. This may lead to fall in the value of
the bond. By ignoring these assets/liabilities, the Gap method does not consider the
total risk arising from the interest rate fluctuations.

We have earlier mentioned that gap ratio (Eq. 3-2) also can be computed along with
gap. Gap ratio by its definition can indicate whether the bank has a positive gap or
negative gap but it does not help in quantifying the risk involved. Gap ratio cannot
be effectively used to counter the interest rate risk since it ignores the size. The
affect of rate fluctuations on the profitability of the company cannot be reflected in
a gap ratio.

Consider the following illustration of two banks, which have a same gap ratio:

Bank A Bank
B
RSAs 2700 900
RSLs 1800 600
GAP (RSAs – RSLs) 900 300
GAP Ratio 1.5 1.5
NII 750 350
Decrease in interest .75 0.75
(%)
Change in NII (Gap x -6.75 -2.25
∆ r)
% change in NII 0.9% 0.64
(∆ NII / NII) %

Thus, it can be observed that in spite of a similar gap ratio in both the cases, a 0.75
percent decrease in the interest rate led to a greater fail in the NII of the Bank A
when compared to Bank B. This explains the fact that while the gap level can aid in
taking positions to tackle a particular interest rate change, the gap ratio cannot do
the same.
Given these limitations, a bank can adopt the Maturity Gap Method to tackle the
interest rate fluctuations so that the impact on net interest income is monitored and
managed.

2) Rate Adjusted Gap method

The Maturity Gap approach assumes a uniform change in the interest rates for all
assets and liabilities. In reality, however, it may not be the case basically due to two
main reasons. Firstly, the market perception towards the change in the interest rate
may be different from the actual rise/fall in the interest rates, For instance, If the
bank rate is cut by 1 percent, according to the gap method, there will be a 1
percent fall in the rate of in the rate of interest for both assets and liabilities.
However this may not be the case if the market perception for the decline in the
interest rate is short-term in nature. This might eventually lead to a fall in the
interest rate by less than 1 percent.

Alternatively, the market may also perceive the rate fluctuations differently for the
long-term interest rates and the short-term interest rates. For instance rate
fluctuation may lead to a 0,75 percent fall in the short term interest rates while the
long-term rates may witness a mere decrease by 0.25 percent.

The second reason for differential rise/fall in interest rates of assets/liabilities can be
the presence of a certain regulation. To explain this further, consider the differential
interest rate loan extended by banks, which has an interest rate of 4 percent. This
rate remains constant irrespective of any amount of fluctuation in the interest rate
of the bank. Similarly, it is quite common to find that the interest rates on term
deposits rise fall with changes in interest rates though the same does not affect the
interest paid on savings bank.
Having done away with the assumption of a uniform change in interest rates of
assets/liabilities, the Rate Adjusted Gap methodology seems to be superior to the
Maturity Gap methodology. In this approach all the rate sensitive assets and
liabilities will he adjusted by assigning weights based on the estimated change in
the rate for the different assets/liabilities for a given change in interest rates.

Rate Adjusted Gap = [RSA1 x WA1 + RSA2 x WA2 +….] - [RSL1 x WL1 + RSL2 x
WL2 +…]

Where,

W A1, WA2 = Weights of the corresponding RSAs

WL1, WL2 = Weights of the corresponding RSLs

Consider the following illustration which measures the rate adjusted gap for option
1 of illustration 3.1.

Illustration 3.3

Positive Gap

(Rs Cr.)

Liability Rate Increased Weig Asset Rate (%) Increased Weig

(Rs) (%) Rate % ht (Rs) Rate % ht
200 200
1800* 10.00 10.75 0.75 800* 12.00 12.50 0.50
2000 11.00 11.00 1000* 14.00 14.25 0.25
1000* 16.00 16.50 0.5
1000 18.00 18.00

Rate Adjusted Liabilities = 1800 x 0.75 = 1350

Rate Adjusted Assets = (800 x 0.50) + (10000.25) + (1000x0.50)

= 1150

Rate Adjusted Gap = 1,150 - 1,350

= (200)

In this case, the interest rate change for the liability of Rs-1800 cr. is given as 0.75
percent (10.75 - 10.00). This implies that on account of rate fluctuation, the interest
rate for that particular liability has increased by 0.75 percent. Thus the weight
attached to this is 0, 75. Similarly, for the asset valuing Rs.800 cr. the weight
assigned is 0.50 percent since the rate fluctuation led to an increase in the yield
from 12 to .12.50 percent. The Gap will then be assessed from these rate adjusted
assets and liabilities which are termed as the rate adjusted gap.

Thus, it can be observed from the illustration that by assigning weights, the positive
gap has actually become negative. If policies were formulated to control the interest
exposure based on the Maturity Gap methodology, it might actually lead to a
different and a very serious situation by changing the nature and size of the risk,

3) Hedging

It is often felt that a floating rate mechanism can minimize the interest-rate risk.
Though this is true, it should however be noted that the possibility of the interest
rate risk getting transformed into credit risk due to this mechanism is always
present. This situation occurs as the floating rate passes the burden of the interest-
rate risk on the borrower.

Yet another means of managing the interest-rate risk is by hedging with the use of
derivative securities, viz. swaps, futures and options. This approach seems to be a
better alternative, especially in a situation where there is a maturity mismatch.

a) Interest Rate Swaps:-

An Interest Rate Swap (IRS) is a financial contract between two parties exchanging
or swapping a stream of interest payments for a notional principal amount on
multiple occasions during a specified period. Such contracts generally involve
exchange of fixed to floating or floating to floating rates of interest. Accordingly, on
each payment date that occurs during the swap period-cash payments based on
fixed/floating and floating rates, are made by the parties to one another.

b) Forward Rate Agreement:-

A forward rate agreement (FRA) is an over-the-counter agreement between two

parties, a notional borrower and a notional lender, to lock in an interest rate for a
short period of time. The period is typically one month or three months, beginning
at a future date. The notional nature is important because the contract amount
itself does not change hands between the counterparties. A borrower buys an FRA
to protect against rising interest rates, while a lender sells an FRA to protect against
declining interest rates. Counterparties to an FRA can continue to borrow or invest
through normal channels. The FRA provides interest rate protection against changes
in rates as measured by the reference rate specified in the contract. Rates being
hedged should be the same or similar to the FRA reference rate to avoid basis risk.

At the beginning of the period covered by the FRA, the settlement reference rate is
compared to the FRA rate. If the reference rate is higher, the FRA seller pays a
compensating payment (the settlement amount) to the FRA buyer. If the reference
rate is lower, the FRA buyer pays the settlement amount to the FRA seller. The
notional contract amount is used for calculating the settlement amount.
c) Interest Rate Futures

Interest rate futures are exchange-traded forwards. They permit an organization to

manage exposure to interest rates or fixed income prices by locking in a price or
rate for a future time period. Futures contracts are transacted through a broker, and
there are transaction commissions and margin requirements. Interest rate futures
contracts do not require the establishment of a line of credit with a bank. The risk of
dealing with other counterparties is replaced with exposure to the exchange
clearinghouse. The underlying asset for an interest rate futures contract may be a
benchmark interest rate, composite index, or fixed income instrument.

For example, in the case of a bond futures contract, the futures Price locks in the
price for the bond and the resultant yield, since Prices and yields move inversely. As
with other forwards, locking in a price for the underlying asset or an interest rate
through a futures contract also means forfeiting the Possibility of subsequent
favorable market moves.

d) Interest Rate Options

The two basic types of options are puts and calls. A call option on interest rates
provides protection to the option buyer from rising rates, as defined by the
reference rate. A put option on interest rates provides protection to the option
buyer from declining rates, as defined by the reference rate. The reference rate is
set out in the option contract as the benchmark against which the potential benefits
to the option buyer are measured. The business of options is analogous to
insurance. One party pays to reduce or eliminate risk, while the other party accepts
the risk in exchange for option premium. Option premium paid increases the
effective borrowing cost, or decreases the effective return on assets, for hedgers.
Although the mechanics are similar, the contractual details of an interest rate
option are important because the underlying interest may be specific interest rates,
a fixed income security such as a government bond, swap contract, or futures
contract. The user should clearly understand the contractual details to judge the
appropriateness of the option as a hedge, given the organization‘s own exposure
and objectives.

The interest rate option contract details include:

1. Strike price, which is the interest rate that the option buyer is permitted to
borrow or lend funds (in the case of an option on interest rates)

2. Reference rate, which is the applicable interest rate specified in the contract,
or underlying fixed income security
 3. Expiry, which is the date the option contract, if not exercised, expires.

4. Contract or notional amount, which is the amount of funds that can be

borrowed or lent under the terms of the contract (or alternatively, the amount of
a fixed income security that can be purchased or sold)

5. Exercise, which is the use of the contract by the option buyer, including how
and when it can be exercised, whether it is cash-settled or settled by delivery of
the underlying asset, and, if permitted, delivery opportunities

Common interest rate option strategies include caps, floors, and collars used to
protect against specific reference interest rates or underlying asset prices. Although
option strategies usually involve over-the-counter options, they can also be
constructed from exchange-traded options.
Strike rate, reset dates, term to expiry, and reference interest rate can be
customized in the over-the-counter market. Purchased interest rate options can be
costly if the underlying rate is volatile. If underlying rates move, but not enough to
make the option worth exercising, the option will expire worthless, resulting in a
potential loss through adverse market rates as well as the cost of the option
premium.
Once the bank is exposed to the interest rate risk, the immediate step to be
followed is the quantification of the same by means of a suitable methodology.
Some of the approaches used to tackle interest rate risk are given below and a
discussion on the same is followed.

10 6. Liquidity Risk Management:

While introducing the concept of asset-liability management it has been mentioned
that the object of any ALM policy is twofold – ensuring profitability and liquidity.
Working towards this end, the bank generally maintains profitability/spreads by
borrowing short (lower costs) and lending long (higher yields). Though this process
of price matching can be done well within the risk/exposure levels set for rate
fluctuations it may, however, place the bank in a potentially illiquid position.

Efficient matching of prices to manage the interest rate risk does not suffice to
meet the ALM objective. Price matching should be coupled with proper maturity
matching. The interlink age between the interest rate risk and the liquidity of the
firm highlights the need for maturity matching. The underlying implication of this
inter-linkage is that rate fluctuations may lead to defaults severely affecting the
asset-liability position. Further in a highly volatile situation it may lead to liquidity
crisis forcing the closure of the bank.

Thus, while management of the prices of assets and liabilities is an essential part of
ALM, so is liquidity. Liquidity, which is represented by the quality and marketability
of the assets and liabilities, exposes the firm to liquidity risk. Though the
management of liquidity risk and interest rate risks go hand in hand, there is,
however, a phenomenal difference in the approach to tackle both these risks. A
bank generally aims to eliminate the liquidity risk while it only tries to manage the
interest rate risk. This differential approach is primarily based on the fact that
elimination of interest rate risk is not profitable, while elimination risk does result in
long-term sustenance. Before attempting to analyze the elimination of liquidity risk,
it is essential to understand the concept of liquidity management.

The core activity of any bank is to attain profitability through fund management i.e.
acquisition and deployment of financial resources. An intricate part of fund
management is liquidity management. Liquidity management relates primarily to
the dependability of cash flows, both I flows and outflows and the ability of the bank
to meet maturing liabilities and customer demands for cash within the basic pricing
policy framework. Liquidity risk hence, originates from the potential inability of the
bank to generate cash to cope with the decline in liabilities or increase in assets.

Thus, the cause and effect of liquidity risk are primarily linked to the nature of the
assets and liabilities of the bank. All investment and financing decisions of the bank,
irrespective of whether they have long term or short term implications do effect the
asset-liability position of the bank which may further affect its liquidity position. In
such a scenario, the bank should continuously monitor its liquidity position in the
long run and also on a day-to-day basis.

 Approaches:

Given below are two approaches that relate to these two situational decisions:

I. Fundamental Approach.
II. Technical Approach.
These two methods distinguish from each other in their strategically approach to
eliminate liquidity risk. While the fundamental approach aims to ensure the liquidity
for long run sustenance of the bank, the technical approach targets the liquidity in
the short run. Due to these features, the two approaches supplement each other in
eliminating the liquidity risk and ensuring profitability.

I. Fundamental Approach:

Since long run sustenance is driving factor in this approach, the bank tries to
tackle /eliminate the liquidity risk in the long run by basically controlling its assets-
liability position. A prudent way of tackling this situation can be by adjusting the
maturity of assets and liabilities or by diversifying and broadening the sources of
funds.

The two alternatives available to control the liquidity exposure under this approach
are Asset Management and Liability Management. This implies that liquidity can be
imparted into the system either by liability creation or by asset liquidation,
whichever suite the situation.

Asset Management:

Asset management is to eliminate liquidity risk by holding near cash assets i.e.
those assets, which can be turned into cash whenever required. For instance, sale
of securities from the investment portfolio can enhance liquidity.

When asset management is resorted to, the liquidity requirements are generally
met from primary and secondary reserves. Primary reserves refer to cash assets
held to meet the statutory cash reserve requirements (CRR) and other operating
purposes. Though primary reserves do not serve the purpose of liquidity
management for long period, they can be held as second line of defense against
daily demand for cash. This is possible mainly due to the flexibility in the cash
reserve balances (statutory cash reserves are required to be maintained only on a
daily average basis for a reserve maintenance period).

However, most of the liquidity is generally attained from the secondary reserves,
which include those assets held primarily for liquidity purposes. These secondary
reserves are highly liquid assets, which when converted into cash carry little risk of
loss in their value. Further, they can also be converted into cash prior to their
maturity at the discretion of the management. When asset management is resorted
to for liquidity, it will be through liquidation of secondary reserves. Assets that fall
under this category generally take the form of unsecured marketable securities. The
bank can dispose these secondary reserves to honor demands for deposit
withdrawals, adverse clearing balances or any other reasons.

Liability Management:
Converse to the asset management strategy is liability management, which focuses
on the sources of funds. Here the bank is not maintaining any surplus funds, but
tries to achieve the required liquidity by borrowing funds when the need arises. The
underlying implications of this process will be that the bank mostly will be investing
in long-term securities /loans (since the short-term surplus balance will mostly be in
a deficit position) and further, it will not depend on its liquidity position/surplus
balance for credit accommodation/business proposals. Thus in liability management
a proposal may be passed even when there is no surplus balance since the bank
intends to raise the required funds from external sources. Though it involves a
greater risk for the bank, it will also fetch higher yields due to the long-term
investments. However, sustenance of such high spreads will depend on the cost of
borrowing. Thus, the cost and the maturity of the instrument used for borrowing
funds play a vital role in liability management. The bank should on the one hand be
able to raise funds at low cost and on the other hand ensure that the maturity
profile of the instrument does not lead to or enhance the liquidity risk and the
interest rate risk. Of the two strategies available in fundamental approach, it is
understood that while asset management tries to answer the basic question of how
to deploy the surplus to eliminate liquidity risk, liability management tries to
achieve the same by mobilizing additional funds.

Applicability:

However, selection of an appropriate alternative from these two strategies depends

to a considerable extent on the size and the nature of operations of the bank. For
instance, consider a bank that basically concentrates on retail banking and which
deploys funds based on its deposit level. This suits the retail bank since it has a
customer profile comprising mostly of the household and the small/medium-scale
sectors, whose requirements for funds will be reasonably low. Due to this client
network, the bank will generally be deposit-rich and proper deployment of these
funds into assets can be done to manage the liquidity. Hence, asset management
seems to be the appropriate strategy for managing the liquidity position of such a
bank.

Differentiating from this retail entry is the large bank, which is mostly into
wholesale business activities and fund requirement for which is generally in large
quantum. Its customer profile, which comprises of large corporate, other banks and
high net worth individuals, explains the need for such large amounts. Since its
exposure is limited only to a selected few customers, its deposit base is poor when
compared to the retail bank. However, it has the ability to raise large volumes of
funds at short notice. In such a situation, the strategy adopted by this bank can be
that of liability management so that it can mobilize funds to meet its asset
requirements.
After making clear the basic distinction between the deposit-rich and the deposit-
poor bank, a suitable liquidity management strategy can now be identified for each
of them.

Consider the statement of assets and liabilities of the Bank of Baroda (BoB) for the
year ended March 31, 1996:

(Rs. Cr)

Liabilities Amoun Assets Amoun

t t
Capital 577.00 Cash and Balances 3870.5
Reserves And 800.03 with 2
Surplus 28369. RBI 2656.1
Deposits 53 Call Money 4
Borrowings 1206.8 Advances 16012.
Other Liabilities 4 Investments 56
and 3116.8 Fixed Assets 9594.7
Provisions 5 Other Assets 1
223.00
1713.3
2
34070. 34070.
25 25

It can be observed from the balance sheet that the BoB is a deposit-rich bank since
it has a basic objective of accepting deposits and financing investments to the
industry. Setting aside the cash and bank balances, advances, fixed and other
assets, the bank has Rs.12,250.85 cr. at its disposal. The bank is a net lender in the
call/money as seen from the deployment of Rs.2,656.14 cr. as against borrowing of
Rs.1,206.84 crore which in fact includes refinance. To stabilize its liquidity position
and thereby eliminate liquidity risk, BoB will now have to invest these surplus funds
effectively through a proper asset management policy. Thus, asset management
involves acquisition of liabilities first and then determining the composition of
assets.
Investments can be made in call the market, in government securities or
instruments of other corporate. When funds are put into the call market, they are
invested only for a very short period of time and are rolled over. There is a high
level of liquidity in such investments, which is, however, attached with a lower yield.
Technically, the deployment in cal market is unsecured. However, the risk perceived
is lower since all the participants in the call market are institutions such as banks,
DFI‘s, Discount Houses, etc. When compared to call market instruments,
government securities offer higher yields and are at the same time highly secured
with moderate liquidity when compared to call market and marketability. The main
disadvantage in this investment will be the transaction costs involved while
buying/selling the instruments. Compared to the call market instruments and the
government securities, the corporate instruments provide lesser liquidity but at the
same time higher returns for greater risk involved in such investments.

Due to these short-term investments, the bank opting for asset management may
have to forego higher yields. To overcome this shortfall, in certain cases of asset
management, the bank would like to take the benefit of higher yields by investing
long. It can disinvest these long-term securities in the secondary market as when it
needs funds. However, the major considerations in opting for long-term investments
are the transaction costs and the secondary market characteristics. The second
factor influences the banks ability to liquidate the asset prior to maturity.

Whichever may be the investment policy, it should, however, be made within the
interest rate exposure limits. This implies that an effective asset management
policy requires meeting the dual purpose of profitability and liquidity.

After having studied the management of liquidity position from the assets side,
consider liability management for tackling the liquidity position.

The following is the balance sheet of ICICI Ltd. for the year ended March 31,1996:

(Rs. Cr)

Liabilities Amount Assets Amount

Current Liabilities 31661.57 Loans to Industrial 287217.
and 272534.8 Concerns 59
Provisions 8 Investments 73300.0
Indebtness 101950.6 Current Assets, 1
Rupee loans 3 Loans and Advances 64509.1
Foreign Currency 11132.67 Fixed Assets 0
Loans 41921.76 Miscellaneous 31119.3
Equity Expenses 0
Reserves and 3055.51
Surplus
4592011. 459201.
51 51
The balance sheet of ICICI Ltd. reveals that its sources of funds are basically
borrowings from the government and the domestic and international markets. From
the assets side, it can be observed that nearly 79 percent of the deployment has
been made into long-term assets (investments and loans). Further, the most liquid
current assets that are cash and bank balances and securities as stock-in-trade are
only to the extent of 45 percent of the total current assets (RS. 29131 million). Thus
being a large player, catering mostly to the high net worth clients, ICICI‘s liquidity
position can be managed by prudent liability management.

The strategy adopted in liability management makes it an aggressive policy.

Nevertheless, it enhances the bank‘s income. This increase will be the outcome of a
decrease in the short-term investments and an increase in the long-term credit
deployment, which offer higher yields.

There are, however, a few inherent risks present in liability management. Firstly
since funds are raised by borrowing from various sources and different markets,
rate fluctuations in any of the markets can enhance the cost of borrowing and
thereby increase the interest rate exposure. Secondly, the bank will have to
maintain its credibility throughout. Since the borrowings are from well-qualified
institutions and investors who are well aware of the happenings in the market, a
default or decrease in its credibility might affect the interest rates and other
borrowing terms, costing dearly to the bank. Other critical aspects in liability
management relate to the sources and the time period for the borrowings. Over
indulgence in short-term/overnight borrowings at low costs should be avoided so as
to maintain stability in the sources of funds and also to control the interest rate
exposure. At the same time medium and long-term loans should be selected in a
manner so as to reduce asset-liability mismatch. One major consideration for
adopting this strategy is that the bank should be in a strong borrowing position lest
it may lead to liquidity risk.

II. Technical Approach:

As mentioned earlier, technical approach focuses on the liquidity position of the

bank in the short run. Liquidity in the short run is primarily linked to the cash flows
arising due to the operational transactions. Thus, when technical approach is
adopted to eliminate liquidity risk, it is the cash flows position that needs to be
tackled. The bank should know its cash requirements and the cash inflows and
adjust these two to ensure a safe level for its liquidity position.

Working Funds Approach and the Cash Flows Approach are the two methods to
assess the liquidity position in the short run. Of these two approaches, the former
concentrates on the actual cash position and depending on the factual data, it
forecasts the liquidity requirements. The latter approach goes a step forward and
forecasts the cash flows i.e. estimates any change in the deposits withdrawals
credit accommodation etc. Thus apart from assessing the liquidity requirements, it
also advises the bank on its investments and borrowing requirements well in
advance.

Discussed below are these two models of technical approach used for
liquidity risk management.

1. Working Funds Approach:

Under this approach, liquidity position is assessed based on the quantum of working
funds available to the bank. Since working funds reflect the total resources available
with the bank to execute its business operations, the amount of liquidity is given as
a percentage to the total working funds. The bank can arrive at this percentage
based on its historical performance. This approach of forecasting liquidity
requirement takes a broad overview of the liquidity position since the working funds
are taken as a consolidated figure.

The working funds comprise of owned funds, deposits and float funds. Instead of a
consolidated approach, the bank can have a segment-wise break up of the working
funds to arrive at the percentage for maintaining liquidity. Based on the position of
the limit arrived as above and the available liquidity, the bank will have to invest
borrow the surplus/deficit balances to adjust the liquidity position. In this approach,
the bank will have to assess the liquidity requirements for each of the components
of working funds.

The liquidity for the owned funds component, due to its very nature of being
owners‘ capital will be nil. The second component of working funds is deposits, the
liquidity requirements of which depend on the maturity profile. Thus, prior to
assessing the liquidity requirements of these deposits, the bank should categorize
them into different segments based on the withdrawal pattern. All deposits based
on their maturity fall under the following three categories:

• Volatile Funds

• Vulnerable Funds

• Stable Funds

Volatile funds include those deposits, which are sure to be withdrawn during the
period for which the liquidity estimate is to be made. These include, short-term
deposits like the 30 days deposits, etc. raised from the corporate high net worth
clients of the bank. The probability of these funds being withdrawn before or on
their maturity is high. Included in this category of volatile funds are current deposits
of corporates that also have a high degree of variability. Due to the nature of the
volatile funds, they demand almost 100 percent liquidity maintenance since the
demand for funds can arise at any time.
Deposits, which are likely to be withdrawn during the planning tenure, are
categorized as vulnerable deposits. A very good example of this type of deposits is
the savings deposits. However, the entire quantum of savings deposits cannot be
considered as vulnerable. On an average, it can be observed from the operations of
the bank, that there will be a certain level up to which the funds are stable i.e. the
level below which the funds will not be withdrawn. Hence, the liquidity requirements
to meet the maturity of the vulnerable funds will be less than 100 percent and
varies depending upon the risk-return policy of the bank.

Finally, the residual of the deposit base after segregating them into the above two
categories will fall under the stable funds category. These deposits have the least
probability of being withdrawn during the planning period and hence the liquidity to
be maintained to meet the maturing stable deposits will also be lower when
compared to the other two types of deposits. As explained above, the stable portion
of the savings deposits fall under this category. Most of the term deposits, by their
nature fall under this category.

Float funds, which are the third component of the working funds, are much similar
to the volatile funds. These funds are generally in transit and comprise of DD‘s,
Banker‘s cheques, etc. which may be presented for payment at any time. However,
this segment also has a minimum level over and above which the variability occurs.
Hence, 100 percent liquidity will have to be provided for the variable component.

Based on the working funds, consolidated or component-wise, the bank will have to
assess the cash balances/ liquidity position in the following manner:

• Lay down the average cash and bank balances to be maintained as a

percentage of total working funds.
• Lay down the range of variance that can be taken as the acceptance level.

Having obtained the consolidated/component-wise working funds, the bank will now
have to estimate the average cash and bank balances that are to be maintained.
This average balance can be maintained as a percentage to the total working funds.
This percentage level is based on forecasts, the accuracy levels of which vary
depending on the factors affecting the cash flows. Hence, it is advisable for the
bank to set up a variance range for acceptance depending on its profitability
requirements. Thus, as long as the average balances vary within this tolerance
range, profitability and liquidity are ensured. Any balance beyond this range will
necessitate corrective action either by deploying the surplus funds or by borrowing
funds to meet the deficit. This acceptance level is, however, a dynamic figure since
it depends on the working funds that may keep changing from time to time.

Illustration 3.7
MM Financial Institution Ltd. (MMFI) which has been offering banking and
investment services for the past 2 decades has a branch network of 250. The
working funds of MMFI at the end of 1996-97 are Rs. 1500 crore. The average cash
balances are maintained at 1 percent of the total working funds. Further, the
management has decided that to ensure proper liquidity, the acceptance range for
variance can be up to 5 percent.

With this data compute the following:

• The average cash balance to be maintained and the acceptance range;

• The average cash balance and the acceptance range, if the working funds
have increased to Rs. 2300 crore.

Solution:

Average cash balance = 1,500 * .01 = Rs 15 crore.

Acceptance range = 15 +- (15*0.05)

= Rs. 14.25 – 15.75 crore.

Thus, the cash balances of MMFI can lie between Rs. 14.25 – 15.75 crore.

Average cash balance with increased working funds = 2300 * .01 = Rs. 23
crore.

Acceptance range = 23 +- (23 * .05)

= Rs. 21.85 – 24.15 crore

Thus, if the working funds of the bank are increased to Rs. 2300 crore the range for
maintaining cash balances will be Rs. 21.85 – 24.15.

In case the variance in the cash balances is beyond this range, the bank should take
the corrective measures. However, before taking any such measures it is advisable
for the bank to first identify the reasons for such variances. If there has been any
fundamental change in the operating environment of the bank, then the variance in
the cash balance will generally be long-term in nature. Thus, there will be a need for
adjusting the cash balances as per the situation. However, in cases where the
deviation in the cash balances has been due to certain short-term changes in the
market, the variance will not last for long and hence it may not necessitate any
corrective action.

Of the two different methods of forecasting within the working funds approach, the
consolidated method suits the bank, which is mainly playing the role of a
development bank. This is basically due to its small deposit base and less volatile
working funds. Distinguishing from this bank is the deposit-rich commercial bank,
which has a greater component of working funds falling into the deposits category.
Due to this, the volatility level is also higher and hence the consolidated approach
of working funds may not indicate the real liquidity requirements. In such a case, a
component-wise assessment of liquidity would be a better alternative.

The working funds approach of estimating the liquidity position, however, has a few
limitations: Firstly, it is a subjective decision to some extent to classify deposits
based on their withdrawal pattern. Secondly, the focus is laid only on the existing
deposits and it ignores potential deposits. Thus, the forecasts may go haywire when
there is an unanticipated change in incremental deposits and loan demands. To
avoid subjectivity, the variation in different types of deposits may be considered
based on the historical data. The percentages can be worked out as weighted
average of individual segments. However, the methodology involved in the
computation of the percentages will be different for different banks since it depends
on the deposit mobilization, branch networking and the liquidity policy of the banks.

2. Cash Flows Approach:

This method of forecasting liquidity tries to eliminate the drawback faced in the
Working Funds approach by forecasting the potential increase/decrease in
deposits/credits accommodation. To tackle such a situation, trend can be
established based on historical data about the change in the deposits and loans.

Before proceeding to discuss about the cash flows approach it is essential to

understand two important parameters that relate to the approach. Firstly, it is the
decision regarding the planning horizon for the forecasts and secondly, the costs
involved in forecasting.

The planning horizon of a bank may be a financial year or a part of it i.e. a few
months to a quarter/half-year period. The bank should ensure that the planning
horizon for estimating the liquidity position should neither be too long or too short if
the benefits of forecasting are to be reaped. There are various factors both external
and internal to the bank which has an impact on the forecasted cash flows. Thus,
when the forecasts are made for a long period they might actually not remain the
same thereby affecting all the decisions that have been taken based on such
forecasts. Similarly when the planning horizon is too short, decisions relating to
borrowings and investments may not be effective enough to increase profitability.
Considering these factors, the bank should decide on a period which will not affect
the forecasted cash flows to a large extent and at the same time will enable it to
make optimal investment-borrowing decisions.

Forecasting cash flows to assess and manage the liquidity position of the bank,
however, involves expenditure. These forecasting costs can further be classified
into recurring costs and non-recurring costs. Non-recurring costs are those, which
occur when the bank initiates the cash forecasting process. These include cash
outflows for installation of the necessary information system that collates and
maintains the data necessary for forecasting. On the other hand, there are certain
recurring costs occurring on a regular basis, which include the man-hours spent,
data transmission costs and the maintenance of the systems used for this process.

These costs incurred in forecasting further depend on three important factors viz.
branch networking, forecasting periods within the planning horizon and the details
of information required for forecasting. By nature, these three factors have a direct
influence on the forecasting costs. This can be explained by the fact that if the bank
has a wide branch network, it will definitely have to incur more expenditure since
data has to be collated from such a wide network accurately and at regular
intervals. Similarly, when the bank plans to forecast its cash position for every
month during the planning horizon of, say a year, the cost of forecasting will be
more as compared to the expenditure incurred for forecasting will be more as
compared to the expenditure incurred for forecasting for every quarter/half-yearly
period. Higher costs are involved when detailed information is sought, which needs
no explanation.

The bank should first decide on the planning horizon that suits its operational style
and then based on the cost constant decide on the number of forecasting periods
and other such details. Following such decisions will be the assessment of the
liquidity position based on the forecasts made for the cash inflows and outflows. The
basic steps involved in this process are as follows:

• Estimate anticipated changes in deposits

• Estimate the cash inflows by way of loan recovery
• Estimate the cash outflows by way of deposit withdrawals and credit
accommodations
• Forecast these for the end of each period
• Estimate the liquidity needs over the planning horizon

The most critical task of liquidity management is predicting the expected cash
inflows coming by way of incremental deposits and recovery of credit and the
outflows relating to deposit withdrawals and loan disbursals. In this process,
accuracy levels when a bank forecasts cash outflows by way of deposit withdrawals
and credit disbursals are fairly high, when compared to the cash inflow forecasts
relating to loan repayments and deposit accretion. This difficulty in the forecasting
of cash flows coupled with the mismatches arising due to the maturity pattern of
assets and liabilities result in the liquidity risk. Thus the process of forecasting cash
flows with a high degree of accuracy holds the key to risk management.
All estimates are generally given as at the beginning of the month or at the end of
the month and are silent upon the fluctuations that may occur during the month,
when the forecasting period is chosen as a month. In order to manage the intra-
month liquidity problems, there should always be a surplus balance. In such a
scenario, it is always better for the bank to consider that the deficit occurs at the
beginning of the period while the surplus occurs at the end of the period. Thus,
funds should be provided to meet the deficit balance at the beginning of the
forecasting period.

4 7. Foreign Exchange Management

Foreign exchange requirements arise from the commercial transactions of an
organization, including purchases from suppliers and vendors and sales to
customers in other countries and currencies. Foreign exchange requirements also
arise as a result of foreign currency assets or liabilities. In addition, foreign
exchange requirements may be influenced by exposure to commodities prices, if
prices are denominated in a currency other than the domestic currency, and by the
location and activities of major competitors.

 Foreign Exchange Risk

Foreign exchange risk arises through various sources, including transactions,

translation of financial statements, and the activities of competitors.

a) Transaction Risk

Transaction risk arises from transactions reported in an organization‘s income

statement. It exists as a result of purchases of inventory from suppliers and
vendors, contractual payments, royalties or license fees, and sales to customers in
currencies other than the domestic one. Organizations that buy or sell products and
services denominated in a foreign currency, including companies with operations or
subsidiaries in other countries, typically are exposed to transaction risk.

b) Translation Risk

Translation risk traditionally referred to risk that arose from the accounting
translation of assets and liabilities for financial statement purposes. Translation risk
can result when assets, liabilities, or profits are translated from the operating
currency into a reporting currency— for example, the reporting currency of a parent
company.

 Management of foreign exchange risk:-

Following tools are used for foreign exchange risk management

1) Foreign Exchange Forwards

A foreign exchange forward is a bilateral agreement to purchase or sell a
predetermined amount of currency for a future delivery date. Most forward
contracts have a specific delivery date, although other varieties, including non
deliverable forwards and flexible forwards, also exist. Most forwards mature within
one to two years, although there is no theoretical maximum maturity date.
Forwards trade actively between dealers and with customers, and the forward price
generally includes a profit for the dealer. The forward market for major currencies is
liquid, due in part to the fact that forwards can be replicated using money market
instruments. A forward price consists of a spot price plus or minus forward points
that represent the interest rate differential between the two currencies. Whether
these points are added to or subtracted from the spot price depends on whether the
forward rate is at a discount or premium. This in turn depends on whether the
domestic interest rate is higher or lower than the foreign interest rate. For example,
if Canadian dollar interest rates are higher than U.S. interest rates, the forward
points are added to the spot rate (quoted in the indirect method) making the
Canadian dollar cheaper in the forward market. The forward price makes the
purchaser of the higher yielding Canadian dollar indifferent between taking delivery
now or at the forward date. Together, the forward points and the spot rate are
known as the all-in forward rate.

2) Currency Futures

Currency futures are standardized forward contracts that trade on an organized

exchange. Contract sizes, expiry dates, and trading and settlement rules are
standardized by the exchange on which they trade.

Unlike forward contracts, there is no requirement for a line of credit with a financial
institution to transact a futures contract. Futures contracts are transacted through a
broker or futures commission merchant. Futures contracts are contractual
obligations and both margin and transaction commissions apply to them. U.S.
exchanges quote currency futures prices in U.S. dollars per foreign currency unit.
Performance of parties to a futures contract is guaranteed by a clearing corporation,
replacing credit risk of any individual contract holder with exposure to the clearing
corporation.

3) Currency Swaps

Currency swaps enable two parties to exchange their respective payments,

changing the effective nature of an asset or liability without altering the underlying
exposure. Currency swaps usually have periodic payments between the
counterparties for the term of the swap and cover a longer period of time than
foreign exchange swaps.

A currency swap is similar to a loan combined with an investment.

An exchange takes place at the beginning of the currency swap for the desired
currency. Over the term of the swap, each party makes regular periodic interest
payments on the currency received and receives periodic interest payments on the
currency given up. Payments usually are not netted because they are in different
currencies. An exchange back to the original currencies occurs at the swap‘s
maturity, so there is no foreign exchange risk on the principal. A currency swap
sometimes involves only a change in the currency. A currency basis swap (or
floating-to-floating swap) involves a change in the currency and in the floating
interest rate known as the basis. Most commonly, a currency swap involves both a
change in the currency and a change from floating to fixed (or vice versa). The need
for a currency swap might arise from a company‘s long-term foreign currency debt
issue, for example. A currency swap might be used to convert the foreign currency
payments to payments in the domestic currency. Currency swaps can also be used
to lock in the cost of existing foreign currency debt or for changing the revenue
stream on an asset.

4) Foreign Exchange Options

Foreign exchange options are similar to insurance contracts. The option buyer
purchases a contract that provides protection for a particular currency (the
underlying currency) beyond a predetermined exchange rate. The option buyer
receives protection against adverse exchange rates, while maintaining the flexibility
to take advantage of more favourable exchange rates. A call option permits the call
option buyer to buy the underlying currency at the strike rate. A put option permits
the put option buyer to sell the underlying currency at the strike rate. Currency
transactions always involve the sale of one currency and the purchase of another
currency. As a result, a currency option is a put option on one currency and a call
option on the other currency. In exchange for paying option premium to the option
seller, the option buyer obtains the right, but not the obligation, to exercise the
option if it is favourable to do so. The purchase of an option provides protection
beyond the strike rate for the contracted amount while maintaining the flexibility to
take advantage of favourable exchange rates. From the option buyer‘s standpoint,
the maximum loss associated with the purchase of a currency option is the
premium paid, although there may be other losses related to the option buyer‘s
currency exposure.

The foreign exchange option contract sets out the contractual details including:

• Strike price. The exchange rate at which the underlying currency can be bought
or sold according to the terms of the option contract

• Notional contract amount. The amount of currency that can be sold or bought
according to the terms of the option contract

• Expiry date. The date at which the option contract, if not exercised, expires
• Exercise. How and when the option contract can be exercised (or used) by the
option buyer.

In exchange for receiving option premium from the option buyer, the option seller
takes on the obligation to deliver or accept delivery of the underlying currency at
the strike price if the option is exercised by the option buyer. The option seller has
considerably more risk than the option buyer, and it is not always possible to
quantify the maximum loss to the option seller. The option buyer decides whether
to exercise the option or not.

8. Investment-Borrowing decisions
Assessment of the liquidity gap based on the forecasts is essentially one aspect of
the liquidity management. The other major task of liquidity management is to
manage this liquidity gap by adjusting the residual surplus/deficit balances.
Considering the high costs associated with cash forecasting, it is essential that the
benefits drawn by the bank from such forecasting should be substantially large to
give some residual gains after meeting the forecasting costs. This objective can,
however, be attained only if the bank makes prudent investment/borrowing
decisions to manage the surplus/deficit.

There are, however, a few factors which must be considered before deciding on the
deployment of excess funds/borrowings for meeting the deficit which are given
below:

• Deposit Withdrawals
• Credit Accommodation
• Profit fluctuation
The liquidity level to be maintained by a bank should firstly, provide for deposits
withdrawals and secondly to accommodate the increase in credit demands. While
deposit withdrawals must be honored immediately, it is also of priority to ensure
that legitimate loan requests of customers are met regardless of the funds position.
Satisfactory credit accommodation ultimately results in more business for the bank.

Liquidity is further influenced by the fluctuation in the business profits of the bank.
Any fluctuation in the interest rates may result in an increase or decrease in the net
interest earnings of the bank.

Considering these factors, the bank should adjust its surplus/ deficit to meet the
liquidity gap. While surplus funds can be invested in short/long-term securities
depending on the bank‘s investment policy, the shortfalls can be met either by
disinvesting the securities or by borrowing funds from the market. This again will
depend on the strategical issue of whether the bank prefers to manage its liquidity
risk using asset management or liability management.

Surplus Balance:

In case of a surplus balance, the bank has the option of either maintaining cash
balances or investing these excess funds in securities/loans. Though holding
adequate cash reserves can eliminate the liquidity risk completely, the cost
involved in doing so could be prohibitive, especially for a bank. Hence the bank
should make optimum use of its idle funds by investing in such a way that the yields
earned are greater.

There are generally 2 options available to the bank while it makes its investment
decisions. It can invest either for a short term and roll over until the funds are
required for some other purpose of, invest for a longer period after properly
assessing the cash requirements through the forecasting process.

In this decision making process one has to, however, consider/understand the
behavior of the yield curves on the long/short-term investments. The long-term
investments do give higher yields than short-term investments. The firm will also
have to consider the transaction cost involved while converting its marketable
securities.

Deficit Balance:

The second important question that the bank will have to face is, how to meet the
deficit cash balances. The only alternative available to meet its deficit is by
borrowing funds from the market. While doing this, the aim of the bank should be to
keep its cost of raising such short-term funds as low as possible. The bank also has
an option of meeting its deficit by internal sources by adjusting against surplus
balances obtained earlier. In this option, the number of forecasting periods plays a
vital role.
There are various models that discuss the suitable ratio that can be maintained
between the cash balances and the investments.

Thus, the criteria while taking such decisions will be to increase yields on
investments and lower the costs of borrowings. Thus there should be optimization in
the investment deposit ratio to ensure that the level of idle funds at any point of
time is not as high so as to cut into profitability of the bank. This trade off decision
of the bank depends upon its attitude towards the liquidity policy i.e.
aggressive/conservative. Depending on the liquidity position to be maintained, the
risk preferences and risk factors, management can have a policy which has a
relatively large/small amount of liquidity.

9. Securitization

Yet another method of imparting liquidity into the system is by way of

securitization. There is, however, a remarkable difference in this strategy used in
this approach when compared to the earlier models.

Distinguishing it from the earlier methods, which resort to a sale of

securities/borrowings as and when the need for funds arises, securitization can
impart liquidity on a continuous basis and has little or no relation to be surplus
deficit balances.

The loan profile of the bank will generally be long term in nature. Large volumes of
funds get blocked in project financing and asset financing activities of the
institution.

Securitization is an effective way to release these funds for further investments. In

securitization the future cash flows from the advances made by the bank are
repackaged into negotiable securities and issued to the investors.

This arrangement induces liquidity into the system by imparting liquidity to the
highly illiquid asset. In the process of enhancing liquidity, securitisation also reduces
the interest rate exposure for the bank since risk associated to the risk fluctuations
will also be eliminated.

Securitization can in fact be taken up on a continuous basis to supplement the other

approaches.

10. Conclusion

To sum up, the paradigm shift in the risk exposure levels of the financial
institutions, has definitely led to Treasury management assuming a center stage.
Undoubtedly all financial institutions need to perform Treasury management. But to
have a proper Treasury management process in place, a thorough understanding of
the various operations on its assets & liabilities becomes essential. Such an
understanding will enable the financial institution to identify and unbundled the
risks and further aid in adopting and developing appropriate risk management
models to manage risks.

11. BIBLIOGRAPHY
Books:

• Essentials of managing treasury by Karen A. Horcher

• Commercial banking by Fraser+Gup+Kolari
• Treasury management by D.C.Gardner
• Commercial bank financial management by Joseph.F.Sinkey, Jr
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Magazines & newspapers:

• Business world
• Articles from economic times
• Articles from Business Standard
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Web Sites:

• www.indiainfoline.com
• www.investopedia.com
• www.treasury-management.com.
• www.financialexpress.com
• www.itmbc.com