Treasury Management

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Understanding Treasury Dynamics

Understanding Treasury Management

XIMB’ August’2010

Rishi Rakesh

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

Session –II (Treasury Risk)o Managing Interest Rate Risk o Managing Liquidity Risko Managing Foreign Exchange Risk

Session- III (Money Market) Govt Bonds, Yield Curve Interest Rate Swaps, Forwards, Options Foreign Exchange Swaps & Forwards

Contents

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Session- ITreasury Overview

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o Understand basic concepts of Treasury management

o Understand Treasury function and its role in business management process

o Be able to better consider treasury issues as part of the business management process

o Be able to understand Treasury’s different risk exposures and the methods used to manage these risks

o Be able to interpret treasury data and treasury language

Course Outcome

Course Objectives

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The Evolution

Building Blocks of the Banking Business:

Credit/Lending

Marketing

Operations

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Treasury Management

THE MISSING LINK

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The Missing Link

Building Blocks of Banking Business:

Credit

Marketing

Operations

AND Treasury

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Role of Financial Market:1. Interaction of buyers and sellers of risks2. Determination of price of risks3. Reduction of transaction costs

Purposes of Financial Assets:1. Transfer of funds from surplus-holders to deficit-holders2. Redistribute unavoidable risks from risk-providers to seekers

The Finance Industry

Risk Providers / Sellers

Risk Investors / Buyers

B

A

N

K

S

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Product Planning Process

Credit

Funding / Investment

Op. Capacity

Credit Cycle• Credit Initiation• Account Maintenance• Collection - write offs

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

MIS: Portfolio Management

Marketing / Sales

Market Strategy

Customer Business Proposition

Role of Treasury

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o “Central bank” for all internal customers

o Determine price of money

o Bridge funding/lending needs

o Identify/quantify market risk

o Interest rate risk

o Liquidity risk

o Foreign exchange risk

o Manage risk where necessary

o Managing the company's relationships with credit rating agencies

Role of Treasury

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Treasury Actions Hedging Investments Funding Asset / Liability Management

Summary

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The Treasury Balance Sheet

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

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ASSETS

Our accounts

Bank placements

Intercompany (pool) assets

Mandatory reserves

Available for sale (AFS)

Trading account securities

Swap assets

TP assets

LIABILITIES

Their accounts

Bank borrowings

Intercompany (pool) liabilities

Commercial paper

Capital market borrowings

(bond issues)

Swap liabilities

Capital

TP Liabilities

Components of a Typical Bank Treasury Balance Sheet

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Why Have Treasury Assets & Liabilities?

For management of the structural position

For liquidity management

For interest rate risk management

For FCY portfolio management

For regulatory compliance

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Liquidity Management

Treasury Assets

Normal liquidity buffer

Contingency liquidity buffer

Investment of excess liquidity from consumer deposits

Treasury Liabilities

Funding consumer assets Opportunistic Gapping

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Rate Risk Management

Developed markets have derivative (off balance sheet) instruments to manage interest rate risk

Less sophisticated markets use treasury instruments to hedge interest rate risk

Limited by Available instruments Available liquidity to make the investment

Volume and maturity of customer assets may be equal to those of customer liabilities, while having different interest rate repricing profiles

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FCY Portfolio Management

Manage Exchange Risk

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

Generally unwilling to use FCY deposits to fund LCY balance sheet (high MTM volatility, corporate limitations)

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Regulatory Compliance

Reserve requirements

Deposits with central bank

Government securities

Other securities acceptable to central bank

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Treasury Assets

o Bank placements

o Available for sale (AFS)

o Trading account securities

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SummaryTreasury Responsibilities for Balance Sheet Management

Define the liquidity characteristics of each balance sheet item; use treasury assets and liabilities to structure a liquidity plan to manage the risks

Anticipate future balance sheet growth and articulate funding strategies and contingency plans to manage the liquidity risk

Define the rate sensitivity of different customer assets and liabilities and structure a plan to manage the interest rate risk

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Balance Sheet Dynamics

Unit Outline

Key concepts

Re-pricing and Repayment Models

Treasury’s Response

Summary

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Key Concepts

The three variables that Treasury is most interested in are: Re-pricing characteristic Repayment characteristic Foreign exchange risk

These characteristics are the core of: Interest rate risk management Liquidity management Foreign exchange risk management

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Every product has certain characteristics important to Treasury

The goal is to understand the profile of each asset and liability category

Detailed analyses provides actual re-pricing/maturity profile of each asset and liability category

Key Concepts

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Key Concepts

The actual re-pricing/maturity of assets vs. liabilities determines the inherent amount of interest rate risk and liquidity risk

“Matched” or “square” indicates that re-pricing/maturity of assets matches liabilities; there is no position

A “Gap” indicates a mismatch of repricing/maturing assets and liabilities

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A Simplified Balance Sheet

Repricing & Repayment Models

AssetsFixed Rate Loan $150MM

Floating Rate Loan

$50MM

Mortgage Loan $100MM$300MM

LiabilitiesConsumer Time Deposit

$100MM

Floating Rate Deposit

$50MM

Professional CD $150MM$300MM

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Product Tenor Behaviour Loan 3 years Fixed rate

Floating Rate Loans 4 years Repriceable Yearly

Mortgage Loan 10 years Amortizing

Professional CD 3 years Fixed rate

Floating Rate Deposit 4 years Repriceable Yearly

Time Deposit 5 years Fixed rate but 25% matures in Year 1 Fixed rate but 25% matures in Year 2 Fixed rate but 50% matures in Year 5

Repricing & Repayment Models

Product Characteristics

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A Simplified Repricing Model

1 YR 2 YR 3 YR 4 YR 5 YR > 5 YR TOTALFixed Rate Loans 150 150

Floating Rate Loans 50 50 50 50

Mortgages 4 4 5 7 10 70 100

Total 54 54 205 57 10 70 300

Prof CD 150 150

Floating Rate Deposit 50 50 50 50

Time Deposit 25 25 50 100

Total 75 75 200 50 50 0 300

Gap (21) (21) 5 7 (40) 70

Cum (21) (42) (37) (30) (70) 0

50

50

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A Simplified Repricing ModelConclusions

In general, the re-pricing of liabilities in a bank takes place earlier than the re-pricing of assets.

If the yield curve was positively sloped (i.e. if longer maturities have higher rates), a negative gap is profitable.

If interest rates rise and gap is negative, profitability will be squeezed since a higher rates will be paid to raise liabilities whereas the interest being paid on assets are already locked.

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A Simplified Repayment Model1 YR 2 YR 3 YR 4 YR 5 YR > 5 YR TOTAL

Fixed Rate Loans 150 150

Floating Rate Loans 50 50

Mortgages 4 4 5 7 10 70 100

Total 4 4 155 57 10 70 300

Prof CD 150 150

Floating Rate Deposit 50 50

Time Deposit 25 25 50 100

Total 25 25 150 50 50 0 300

Gap (21) (21) 5 7 (40) 70

Cum (21) (42) (37) (30) (70) 0

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A Simplified Repayment ModelConclusions

In general, the repayment of liabilities for a bank takes place faster than the repayment of assets.

Treasury should ensure that existing funding can be rolled over upon maturity or new funding can be sourced to support assets.

There is liquidity risk if cash inflows from asset repayments do not coincide with the cash outflows from liability maturities.

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Benefits

A good model provides insights into profit dynamics and liquidity position of the business.

Once the risk is identified, it can be managed. Needs highlighted by the model can help us evolve

new product offerings. Elimination of risk may not be a goal; as a financial

intermediary, we take some interest rate risk. The key is to determine an acceptable amount of risk

given a certain set of forecast events.

Repricing & Repayment Model

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Product Pricing Liquidity

Product Agreement

Behavior often observed

Product Agreement

Behavior often observed

Term deposit

(e.g. 3 month fixed rate TD)

Agreed upon rate

Market lagging / Pricing pressure (competition)

Contractual for 3 months

Roll-over /

Pre-termination

Current a/c Savings a/c

On demand (short-term)

Sticky pricing On demand (short-term)

Portfolio Dynamics:

Core (LT) vs Non-Core (ST)

15 year Fixed-Rate Mortgages

Agreed upon rate

Refinancing with the same bank

Contractual for 15 years

Refinancing with another bank

Credit cards Can be re-priced upon notice

Limited repricing ability due to competitive pressure or statutory max.

Minimum payment by due date

Portfolio Dynamics:

Transactor vs.

Revolver

Product Dynamics

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Savings ExampleREPAYMENT ANALYSIS

With a large enough population, we can perform statistical behavioral analysis.

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

A portfolio dynamic occurs when: The core portion of the book remains long term. As the book grows, the amount of this core segment will also grow. As the book grows, the percentage which this core segment

represents usually does not grow.

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Savings Example

REPRICING ANALYSIS

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

Although the entire portfolio could (in theory) be re-priced tomorrow, it clearly will NOT be.

However, once the portfolio does re-price:

The amount of the change in basis points will be less than movements in the market rates.

Regardless of market movements, there will be a considerable interval before the next repricing.

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Savings Example

We said that even though Savings is contractually “on demand”, the core portion of the book remains long term.

But how long is long enough for core?

It all depends…

Core: Generally 2 years ~ 5 years

Non-Core: Generally overnight ~ 1 month.

Assumptions should be reviewed periodically.

Assigning a Tenor to Savings is a CHALLENGE!

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Treasury’s Response Statistically Determine Actual Behavior

Take a portfolio approach (providing that a large enough population exists for statistical validation).

Do a redemption analysis (examining the actual payment history of a product set).

Adjust for seasonalities.

Take into account other variables, such as:

Ceilings / Floors Advertising / promotion campaigns Innovation

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Treasury’s Response

Use re-pricing models to predict profitability

The actual re-pricing structure determine future profitability.

A re-pricing model should be able to forecast earnings volatility.

A re-pricing schedule of all assets vs. all liabilities and capital gives us our current interest rate position and exposure to future events.

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Summary Consumer products have certain repayment

and re-pricing characteristics that need to be managed.

A model needs to be built that shows the liquidity and interest rate risks inherent in the balance sheet.

Effective management of repricing and repayment risk results in enhanced and more consistent earnings.

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Treasury Role of Benchmarking

Unit Outline

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

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Benchmarking : The Concept What is a Benchmark?

Benchmarking is a framework that divides the bank into separate product lines & transfers risk to a central unit

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

Benchmarks are matched to the cash flows of each product

Benchmark assumptions operate like a service level agreement between Treasury and Products (reviewed and agreed at least annually)

Benchmarks serve several purposes Product pricing signal Essential to the calculation of product profitability Transfer of interest rate risk from Products to Treasury

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Why is Benchmarking Necessary? Benchmarks are designed to transfer market risk exposure from the individual

product managers to treasury, where all risk is centrally located and professionally managed on a portfolio basis

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

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

Promotes management accountability

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

Benchmarking : The Concept

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Measurement of Margin Components Simplified Yield Curve Example – one asset, one liability, booked today

Time

4%

5% Yield Curve

Liability Spread (Deposits)

Risk Management Gap (tenor mismatch)

Asset Spread (Loans)

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Measurement of Margin Components

Line Unit Assets Liabs Spread

Customer Rate 8.0% 3.0% 5.0%Transfer Price 5.0% 4.0%Matched Spread 3.0% 1.0%

Risk Totally Treasury Mgt MatchedTransfer Price Income 5.0% 5.0%Transfer Price Expense 4.0% 5.0%Treasury Risk Mgt Revenue 1.0% 0.0%

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

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Features of Good Benchmarks Benchmark is a transfer pricing mechanism that aims to reflect

the true economics of the product

Ideally it should be based upon: External markets (as a pricing signal) Market risk neutrality (matched tenors)

It is a representation of a product’s price risk (interest rate) and liquidity risk summarized into a single concept - the benchmark price

The assignment of a benchmark should be driven by the characteristics of cash flow, date of origination, repricing, maturity (with adjustments for liquidity and embedded options)

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Session- IIManaging Treasury Risk

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Managing Interest Rate RiskUNIT OUTLINE

Identifying the Risk

Measuring the Risk

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I. Identifying the Risk Determine the re-pricing profiles of assets and

liabilities in the balance sheet

Distinguish between the actual and contractual profiles (Can we re-price, Do we, How often? How much?)

Portfolio vs. Single Account

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I. Identifying the Risk

INTEREST RATE EXPOSURE DUE TO

Gaps in an existing portfolio

Basis Mismatch

Volume Risk

Sticky rates on new originations

Embedded options

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SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO

A GAP….

Difference in repricing tenor (periods) of assets and liabilities and/or

Difference in the amount of assets and liabilities maturing / re-pricing within a time period.

Can be represented as run-off gaps or as remaining gaps (cumulative gaps).

Can be “Positive” or “Negative”.

Can be Structural or Intentional

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Re-pricing Mismatch: A gap occurs when assets are re-priced at different periods from liabilities

Q1 Q2 Q3 Q4ASSETREPRICING

LIABILITYREPRICING

Asset : A one-year quarterly floating rate loan

Liability : A one-year time deposit


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At the beginning of Mth 1 Mth 2 Mth 3 Mth 4 Mth 5 Mth 6 Mth 7 Asset $100MM 1-mth placement w/CMB 100 Liability $100MM 3-mth deposit (Repriceable in 3 mths time)

(100)

Run-off Gap 0 100 0 (100) 0 0 0 Cumulative Gap 0 100 100 0 0 0 0

Cumulative gaps (Remaining Amount) Mth 1 Mth 2 Mth 3 Mth 4 Mth 5 Mth 6 Mth 7 Asset (100) Liability 100 100 100 Cumulative Gap 0 100 100


RUN-OFF GAPS (Maturing amounts)

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TYPE

DEFINITION / IMPLICATIONS

IF RATES MOVE UP

IF RATES MOVE DOWN

Positive Gap

Assets repricing faster than

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

in

Profits rise

Profits fall

Negative Gap

Liabilities repricing faster

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

locked-in

Profits fall

Profits rise



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STRUCTURAL GAP

Result of the mismatch in the inherent re-pricing characteristics of assets and liabilities

Influenced by product features and determined by customer behavior

INTENTIONAL GAP

Due to Treasury Actions

Dependent on view of interest rates

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SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIOINTENTIONAL GAPPING : NEGATIVE GAP

You believe rates will fall Lend long term to lock in current high rates Borrow short term and roll it over at future lower rates

This results in a Negative Gap…

Year 1 Year 2 Year 3Lend (long) 10% 10% 10%Borrow (short) 10% 9% 8%Spread 1% 2%

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SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIOINTENTIONAL GAPPING : POSITIVE GAP

You believe rates will rise Borrow long term at today’s cheap rates and lend money

short term so when rates rise, you can reinvest it at the higher rates

This results in a Positive Gap

Year 1 Year 2 Year 3Lend (short) 10% 11% 12%Borrow (long) 10% 10% 10%Spread 1% 2%


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SOURCE OF RISK - BASIS MISMATCH

When two products (which may have the same re-pricing or maturity) in the same market, have different degrees of rate sensitivity

To manage the basis mismatch risk, change pricing nature of assets to match pricing nature of liabilities or vice versa

PRODUCT 1st QUARTER 2nd QUARTER

Asset 7.25% 7.25%(90 days Eurodollar)Liability 7.00% 7.50%(90 days Bank CD)

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I. Identifying the Risk Source of Risk – Volume Risk

Changing rate levels could significantly impact forecasted volume of asset/liability originations as well as affect run-off rates of existing portfolio

FYF Actual B/(W) BAU/Status Quo 100 100 - If rates increase after FYF and customer behavior changes 100 120 (20) If rates fall after FYF and customer behavior changes 100 80 20

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SOURCE OF RISK - STICKY RATES ON ORIGINATION

If interest rates rise 2% Current portfolio - no rate risk

New portfolio - may be unable to price new loans upwards while we might have to re-price deposits upwards by close to 2%

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I. Identifying the RiskSOURCE OF RISK - EMBEDDED OPTIONS

EXAMPLES:

Cap/Floor on Floating Rate Products Pre-termination without penalty for Fixed Rate Products Borrow-back at pre-determined rate on Deposit Products

These options add a new dimension to rate risk that is difficult to manage

Introduces element of “convexity”

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II. Measuring the Risk

KEY CONCEPTS

DV01 (Earnings At Risk)

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II. Measuring the Risk

To be more meaningful, the re-pricing gap must be translated into how much earnings risk it represents.

DV01 Management Tool to evaluate risk and define

economic loss parameter

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II. Measuring the RiskDV 01 (A Methodology) Dollar value for 1 basis point move

Captures the potential earnings impact of one basis point movement in interest rates

Calculated by : Repricing Gap * 0.01% * Tenor

Total DV01 are the sum of individually derived Dv01

(deal by deal calculated)

Total DV01 categorized into Rolling 12 mths and Full

Tenor discounted

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II. Dv01

An Example:

Executed Placement deal of USD 100 mio for

Tenor 6 mths

Dv01 = 0.01% * 100 mio * 6/12

= 5,000

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Liquidity Risk

Overview

Introduction – What is Liquidity Risk? How Liquidity Risk Arises Liquidity Management Product Liquidity Characteristics Summary – Liquidity Risk

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

Sahara?

Carrying enough water for 1-day only assuming there will be wells or

suppliers along the way… taking a risk of not being able to find the well

(source of liquidity) before dying of thirst.

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

extra carrying costs (another camel to carry the load)

Carrying just enough water for 7-days… perfectly matched strategy

The art of balancing liquidity risk vs. return

Liquidity Problem?

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What Is Liquidity Risk?

The risk that funds will not be available to meet a financial commitment to a counterparty in any location or any currency at any time. This is our key franchise risk (customer confidence).

Liquidity risk-taking is Fundamental to banking An important source of revenue

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Businesses Need Liquidity

For survival: Having funds available at all times to meet fully and

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

For growth: Having funds available to take advantage of future

business opportunities

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How Liquidity Risk Arises

Liquidity risk may come from: Operating environment:

Exposure arises from daily funding and trading activities in normal markets

Contingency situations:

Exposure arises from external events Market Name

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Contingency Situations

Market Disruption

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

Name Problem

Denial of market access to specific counterparty due to concern over its creditworthiness

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Liquidity Management

Objectiveso To ensure sufficient liquidity to meet all financial

commitments and obligations when they fall due

o To be able to access liquidity in global markets at “reasonable” terms

o To plan, quantify, and monitor what kinds and levels of risk that is prudent for the company

o To balance the cost of maintaining liquidity, with the appropriate level of returns

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Roles & Responsibility

Managing liquidity risk is the joint responsibilities of Business, Treasury, and Risk Management; oversight by Asset and Liability Committee (ALCO).

Country Treasurer Has primary responsibility for liquidity

management Develops funding plan & process for each legal

vehicle

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Summary Effective liquidity management is critical to:

Business survival, growth and expansion Maintaining market confidence

Liquidity mismanagement can result in severe repercussions including loss of market confidence and erosion of capital base

Liquidity risk management is a joint responsibility of business, treasury and ALCO.

Prudent liquidity management requires: Stable and diversified funding structure Limited reliance on single counterparty and/or market Proactive management of asset and liability maturity profiles Disciplined planning for contingency situations

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Session- IIIMoney Market Instruments

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Concept of a Yield Curve

Positive Yield Curve Aka “normal yield curve”

Slopes upward to the right

No specific trend

Premium for longer period

(credit risk, liquidity risk, compounding)

Opportunity cost of inflation

Cost of insulating against rate moves

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

negative gap is generally the profitable position

Rat

es

Maturities

Positive Yield Curve

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Parallel Shift

Ra

tes

Maturities

Positive Yield Curve

Ra

tes

Maturities

Ra

tes

Maturities

Change Shape

Gapping: Examples of Different Yield Curve

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Gapping: Current Yield Curve - USD

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Gapping: Yield Curve Shifts – USD Yr 2003 vs 2004

June 2003

May 2004

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Gapping: Yield Curve Shifts – USD Yr 2004 vs 2005

June 2005

May 2004

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Gapping: Yield Curve Changes – UST Yr 2005 vs 2006

June 2005

August 2006

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Gapping: Yield Curve Changes – USD Yr 2006 vs 2007

May 2007

May 2006

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Gapping: Yield Curve Changes – USD Yr 2007 vs 2008

May 2008

May 2007

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Gapping: Fed Funds Target

First pause in 2 years

Total 425 bps Rate Hikes

225 bps Rate Cut

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Gapping: Yield Curve Comparison

Beginning of rate cut cycle (Yr 2001)

beginning of rate rise cycle (Yr 1993)

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Instrument to Manage Risk

Interest Rate Swap

Forward Rate Agreement

Interest Rate Options (Caps / Floors)

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Interest Rate Swap Definition

Agreement between two parties to exchange interest rate payments on a notional principal sum which is not exchanged

Purpose: Manage interest rate risk Permit large volume transactions Change the interest rate profiles of liabilities or assets Most common swap is fixed-for-floating which one counter-

party agrees to pay a fixed rate over the term of the swap in exchange for a floating rate payment payable by the other counter-party (aka “coupon” swap)

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Interest Rate Swap Example

Bank ABC’s fixed rate mortgage portfolio is funded by 6-month interbank borrowing

Assets Liabilities$50MM mortgages $50MM TDsAvg. Life: 10 yrs Avg. Life: 6 mthsAvg. Rate: 11% Avg. Rate: 8%(fixed for 10 yrs)

Concern: ABC expects interest rates to rise; higher rates will narrow their spread

Solution: ABC decides to enter a SWAP to “pay fixed, receive float” with bank XYZ

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Swap Agreement:

ABC will “pay” fixed rate at 9% for 5 years on notional principal of $50MM (less than full life)

ABC will “receive” the inter-bank rate reset every 6mths for the next 5 years on notional principal of $50MM

No principal is exchanged, only net coupon interest

payments

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FLOATING RATE Liability

MORTGAGEPORTFOLIO

XYZ ABC

FUNDINGSOURCE

FIXED RATE = (9%)

FLOATING RATE = 8%

• No liquidity forfeiture due to notional principal• Only exchange of interest differential

FIXED RATEAsset

SWAP

11%

(8%)

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Results for ABC: The first 6 months

Borrows 6mth interbank (8%) Receives from XYZ 8% Net Spread 0%

Receives from Mortgage 11% Pays fixed to XYZ 9% Net Spread 2%

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Without an interest rate swap, ABC’s net revenues from the mortgage portfolio are reduced by half as a result of rising interest rate environment impacting short term funding

With SWAP

Borrows 6-month libor (10%)

Receives from XYZ, 6-month libor 10%

Net spread 0%

Receives from mortgage portfolio 11%

Pays Bank XYZ 9%

Net spread 2%

Without SWAP

(10%)

11%

--

1%

Interest Rate Swap Example Results for ABC: The Next Six Months (Assume interest rates increase 2%)

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

0

2

4

6

8

10

12

14

R1 R2 R3 R4

Fixed Rate Paid to XYZ

1112

10

8

Resets

Inte

res

t R

ate

s

92

Interest Rate Swap Example R1 R2 R3 R4

a. Borrows Inter-bank (11%) (12%) (10%) (8%)b. Receives from Mortgages 11% 11% 11% 11%c. Net Spread 0% (1%) 1% 3%

d. Receives from XYZ 11% 12% 10% 8%e. Pay XYZ (9%) (9%) (9%) (9%)f. Swap Spread 2% 3% 1% (1%)

Net Spread (c+f) 2% 2% 2% 2%

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

The Swap with XYZ will lock-in a guaranteed earnings spread of 2% on the fixed rate mortgages, regardless of how interest rates change

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Agreement with a counter-party to pay or receive thedifference in interest on a notional principal amountbetween an agreed future interest rate and a reference interest rate for a specified period

Only the difference in interest between the agreed contract rate and the reference rate at the start of theperiod to which the rate refers is paid to or received from the counterparty

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Jargon

Quoting of desired periods is done by calendar months. Thus, a deal for a 3-month tenor in 3 months time is a 3x6.Similarly, the following are:

6x12 : 6-month rate in 6 months time

2x5 : 3-month rate in 2 months time

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Forward Rate Agreement Example

ABC has a $50MM, 1 year fixed rate auto loan portfolio, funded via 3-month interbank borrowings

ASSETS LIABILITIES$50MM auto loans $50MM TDsTenor: 1year Tenor: 3mthsFixed Rate: 10% Rate: 7.5%

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

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

96


o ABC will buy FRA strips to match rollover dates of 3-month borrowings:

$50MM 3 x 6 mths @ 7.75%$50MM 6 x 9 mths @ 8.00%$50MM 9 x 12 mths @ 8.25%

o On maturity of the 3-month interbank cash borrowing at 7.5%, ABC will rollover the US$50MM at the prevailing interbank market rate

97


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

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

0

1

2

3

4

5

6

7

8

9

R0 R1 R2 R3

7.5

Resets

Inte

res

t R

ate

s

8.0

8.5

7.0

98

Forward Rate Agreements Example

Results for ABC rollovers

R0 R1 R2 R3Auto Loan 10% 10% 10% 10%3mth interbank 7.5% 8.0% 8.5% 7.0%Spread before FRA 2.5% 2.0% 1.5% 3.0%

FRA - 7.75% 8.00% 8.25%FRA Gain/(Loss) - 0.25 0.50 (1.25%)

Effective Rate 7.5% 7.75% 8.0% 8.25%Net Spread 2.5% 2.25% 2.0% 1.75%

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Interest Rate Options

Definition: A contract that gives the options buyer the right,

but not the obligation, to lend/borrow funds at a specific rate over a specified time frame

In return, the options buyer pays a fee called a premium at the time of option purchase (Buying insurance)

Purpose: Manage interest rate risk Permit large volume transactions Allow flexibility of rate cover, but still receive

benefit of favorable moves

100

Unit Outline

Foreign Exchange Fundamentals

Types of Foreign Exchange Exposure

Managing FX Exposure - considerations

Factors affecting the market

Introduction to Foreign Exchange

101

Foreign Exchange FundamentalsWhat is Foreign Exchange?

A foreign exchange transaction involves one currency being bought or sold against another currency

Rate Quotation:a. Cross Rates:

A foreign exchange rate between two currencies derived via a third currency

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

b. Price Quotation: Bid and Offer

102

Time element in FX market:

Spot Transaction: Settlement within two business days from deal date

Forward Transaction: Settlement at a specified future date (>two business

days) Common tenors are 1, 2, 3, 6, 9 and 12 months


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Foreign Exchange FundamentalsWhy is there a FX market?

International trade Capital movements Financial transactions Exchange of services Tourism

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Players in the FX market?

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


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Factors affecting FX rate movement

Demand and supply

Sovereign policy Exchange control/regulations

Economic performance Money supply Inflation Interest rates

Speculation


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Types of FX Exposure

Transaction Exposure (daily Mark-to-Market):

Exposures arising from buying and selling foreign currencies

for customer’s account for Banks’s own account

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Types of FX Exposure

Translation Exposure

Exposure arises from translating a local currency balance sheet into Bank’s native country accounting/reporting purposes.

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FX Treasury Products

We will briefly discuss the 3 basic forms of derivative products:

1. Forwards2. FX Swaps3. Options

Treasury Management

Documents

Transcript of Treasury Management