Description
complete guide to treasury management, it explains the objectives of treasury and how they are achieved using various instruments and methods.
Treasury Management
1
Treasury Management
• Traditionally – limited to CRR and SLR
management
• Forex business – restricted to meeting
customer’s requirements
– Forex requirements – imports, exports, remittances
and deposits
2
Treasury Management
• Objective
– Take advantage of trading & arbitrage opportunities
– To deploy deposit liabilities, internal generation and
cash flows from maturing assets for maximum returns
– To fund balance sheet as cheaply as possible
– To manage forex assets and liabilities
– To manage treasury risk
– To maintain CRR & SLR
– To deploy clearing surpluses
– To meet clearing deficits
3
Treasury Management
• RBI initiated various reforms and measures
– DFHI was set-up – to meet liquidity requirement
• DFHI – dealing in short term money market instruments – treasury
bills, bills rediscounting, CP, CD, etc.
– Improved SGL transfer procedure
• Delivery versus Payment (DVP) for securities settlement at PDO
– Reduced counter party risk
– Market determined exchange rates and interest
rates
– Open market operations (OMO)
4
Treasury Management
• Some important measures taken
– Interest deregulations
– Liberalization of exchange control
– Permission to corporates to raise resources internationally
– Relaxation of end-use clause – GDR/ ECB/ FCCB
– Permissions to Banks to invest abroad – using FCNR(B), EEFC,
etc.
– Bank/ Corporates – derivative trading
– Banks to initiate cross currency positions overseas
– Banks – upto 25% of Tier I – to invest/ borrow abroad
– Authorized Dealers allowed to borrow/ lend forex
– Removal of interbank borrowing from CRR/ SLR requirements
5
Treasury Management
• Investments now viewed as alternative to credit
for profits
• Sources of Profit
– Investments
– Spreads
– Arbitrage
– Relative Value
– Proprietary Trading
– Customer Services
6
Treasury Management
• Treasury Asset & Liability
– Created through a transaction in the Inter-Bank
market
– Loans and advances – not part of treasury assets –
only securitized assets are
• Treasury Assets – tradable
– Only Inter-Bank Participation Certificate is non-
tradable
• Domestic Treasury Instruments
• Forex Products
7
TREASURY OPERATIONS
• The Treasury operations in Indian Banks are broadly divided into :-
• Rupees Treasury :- The Rupee Treasury carries out the bank’s rupee-based
treasury functions in the domestic market. These include asset liability
management, investments and trading & also manages the bank’s position
regarding statutory requirements like the cash reserve ratio (CRR) and the
statutory liquidity ratio (SLR), as per the norms of the RBI. The products
included are :-
– Money Market instruments – Call Money, Notice Money, Term Money,
Commercial Papers, Treasury Bonds, Inter Bank Participation, Repo, Reverse Repo
etc.
– Bonds – Government Securities, Bonds, Debentures etc.
– Equities
• Foreign Exchange Treasury
• Derivatives Desk
Treasury Management
• Functions of Integrated Treasury
– Reserve Management – CRR & SLR – appropriate
mix – optimize yield and duration
– ALM - Liquidity and Funds Management
– Risk Management
– Effective management of interest rates
– Derivative Products
– Arbitrage
– Capital Adequacy
9
Treasury Management
• Risk Analysis and Control
• Financial Risk
– Market Risk
• Interest rate risk
• Price risk
– Credit Risk
– Liquidity Risk, etc.
• Operational Risk
– Systemic risk
– Compliance risk
– Legal risk
– IT risk
– Fraud risk, etc.
10
Treasury Management
• Factors affecting Forex rates
– Macroeconomic, social and political factors
– Exchange control regulations
– Exchange rate policy
– Balance of payment
– Balance of trade
– Inflation
– Market sentiments
– Interest rates
11
Treasury Management
• Factors affecting Interest rates
– Macroeconomic, social and political factors
– Fiscal Policies
– Demand for money
– Government borrowings
– Money supply
– Inflation
– Market sentiments
12
Treasury Management
• Operational Risk
– Systems deficiencies
– Non compliance of procedures
– Fraudulent practices – deal settlements
– Legal risk – inadequate definitions and coverage of
covenants
13
Treasury Management
• Mitigation
– Prudential limits for instruments and counter party
– Stop Loss
– Risk norms – duration and VaR
– No deviations from procedures
– Necessary authorizations
– Delegation of power – prudence
– Prescribed settlement systems
– IT systems updated regularly
– Custodian of demat accounts
– Counterparty authorizations/ power of attorney
– List of approved brokers
– Deals, transactions and legal documentation recorded
14
Treasury Management
• Credit Risk
– Borrower unable to honor obligations
15
Treasury Management
• Mitigation
– Credit Appraisal
– Risk pricing
– Margin arrangements
– Escrow accounts
– Guarantees/ L/Cs
– Security
– Exposure limits
– Diversification
16
Treasury Management
• Liquidity Risk
– Asset cannot be encashed
– Scarcity of funds in market
– Bank’s Creditworthiness a suspect
17
Treasury Management
• Mitigation
– Increase proportion of liquid securities
– Increase proportion of near-maturity high quality
instruments
– Maintain credit rating
– Securitize loan portfolio
18
Treasury Management
• Market Risk
– Interest rate risk
– Systemic risk
19
Treasury Management
• Mitigation
– Increase the proportion of assets in risk-free, high
quality investments of short maturity
20
Treasury Management
• Value at Risk
• It indicates the possible maximum loss which
will be suffered in a specific period and at a
specific confidence level due to a fall in the
price of a security – given the historical price
behavior or assessment of future market
movement
21
Value-at-risk
• The largest banks use a value-at-risk (VAR)
based capital charge, estimated by using an
internally generated risk measurement model.
22
Treasury Management
• VaR
• It is derived – statistical formula based on
volatility of the market
• Volatility is the standard deviation from mean
observed over a period
• Volatility assumes normal distribution
• The Volatility x no. of std. dev. required for a
given confidence = VaR for a given period and
confidence
23
Treasury Management
• VaR at 99% confidence – 1% probability of the
stated loss
• Loss is generally in absolute terms
• What is VaR for Rs. 10 lacs at 99% confidence
for one week for an investment portfolio of Rs.
10 crores?
24
Treasury Management
• What is VaR for Rs. 10 lacs at 99% confidence
for one week for an investment portfolio of Rs.
10 crores?
• The maximum drop with a probability of 1%
over week is Rs. 10 lacs – 99% of the time, the
portfolio will be above or at its current value.
25
Treasury Management
• Risk Management: RBI Guidelines
– Banks required to send monthly reports covering
liquidity mismatches and interest rate sensitivity
– Call Borrowing/ Lending
– Liquid Assets management
– Core Deposits & Non – core deposits
– CRR/ SLR position
– Duration of Liabilities & Investments
– Maximum cumulative outflows across all time bands
– Ratios – including off balance sheet effect
– Forex Assets & Liabilities
26
Treasury Management
• Risk Management: Banks
– ALCO – manages gap, interest rate, liquidity and
currency risk
– Monthly statement to Board and RBI
– Stop loss levels set
– Concurrent audits of securities and fund
management transactions
– Investment committee
– Periodic inspection by internal auditors and RBI
– Broker panel reviewed annually
– IT audit
– Front & back offices segregated
– Deals backed by deal slips and office memos
– Defaults/ arrears monitored
– Comply 100% with RBI guidelines
27
Liquidity Management
• Liquidity – the ability of a bank to meet
liabilities exactly when they fall due or when
the depositor wants the money back
• Liquidity –
– Cash in excess of CRR
– Investments in SLR above requirement
– Prime assets
– Swapping forex into INR
– Undrawn lines from RBI
– Undrawn lines from others
– Sale of assets
– RBI support
28
Liquidity Management
• Excess Liquidity –
– Money market lending or investing
– Reverse REPO
– Buying T-bills, CPs, etc. depending on the tenure
– Repaying refinances
• For doing the above – bank to make liquidity
position projections
29
Liquidity Management
• Liquidity Adjustment Facility of RBI
– Interest rate corridor
– Standing Deposit Facility (SDF) – RBI to offer SDF to
keep their surpluses with RBI – voluntarily. Interest
rate less than CRR or Repo. Part of CRR calculations
– Market Stabilization Fund (MSF) – to absorb
liquidity of endemic nature. MSF proceeds do not
flow to government but completely sterilized by
RBI. However, interest is paid by government.
30
Liquidity Management
• The relationship between cash and liquidity
requirements
– The amount of cash held is heavily influenced by
the bank’s liquidity requirements.
– Vault cash is held to meet reserve requirements
and transactions purposes
31
Liquidity Management
• Liquidity needs arise from net deposit outflows,
as balances held with RBI or correspondent
banks decline.
• Most withdrawals are predictable because they
are either contractually based or follow well-
defined patterns.
• Still, some outflows are totally unexpected.
– Management often does not know whether
customers will reinvest maturing CDs and keep the
funds with the bank or withdraw them.
32
Liquidity Management
• A common definition of liquidity emphasizes the ease of
converting an asset to cash with minimum loss.
• For a bank that regularly borrows in the financial
markets, liquidity takes on the added dimension of the
ability to borrow funds at minimum cost or even the
ability to issue stock.
• It explicitly recognizes that such firms can access cash by
selling assets, by new borrowing, and by new stock
issues.
• Bank liquidity thus refers to a bank’s capacity to acquire
immediately available funds at a reasonable price.
33
Cash versus liquid assets
• Banks own four types of cash assets:
1. vault cash,
2. demand deposit balances at RBI,
3. demand deposit balances at private financial
institutions, and
4. cash items in the process of collection
• Cash assets do not earn any interest, so the
entire allocation of funds represents a
substantial opportunity cost for banks.
• Banks attempt to minimize the amount of cash
assets held and hold only those required by law
or for operational needs.
34
Why do banks hold cash assets?
1. Banks supply coin and currency to meet
customers' regular transactions needs.
2. Regulatory agencies mandate legal reserve
requirements that can only be met by holding
qualifying cash assets.
3. Banks serve as a clearinghouse for the
nation's check payment system.
4. Banks use cash balances to purchase services
from correspondent banks.
35
Liquid assets
• A liquid asset is one that can be easily and
quickly converted into cash with minimum loss.
• Contrary to popular notion "cash assets" do not
generally satisfy a bank's liquidity needs.
– If, for example, the bank experiences an unexpected
drain on vault cash, the bank must immediately
replace the cash or it would have less vault cash than
required for legal or operational needs.
36
Liquid assets
• Cash assets are liquid assets only to the extent
that a bank holds more than the minimum
required.
• Liquid assets are generally considered to be:
1. cash and due from banks in excess of requirements,
2. RBI bonds sold and reverse repurchase agreements,
3. short-term Treasury and agency obligations,
4. high quality short-term corporate and municipal
securities, and
5. some government-guaranteed loans that can be
readily sold.
37
Liquidity versus profitability
• There is a short-run trade-off between liquidity and
profitability.
– The more liquid a bank is, the lower its return on equity
and return on assets, all other things being equal.
• Both asset and liability liquidity contribute to this
relationship.
– Asset liquidity is influenced by the composition and
maturity of funds.
– In terms of liability liquidity, banks with the best asset
quality and highest equity capital have greater access to
purchased funds.
• They also pay lower interest rates and generally report lower returns in the short
run.
38
Liquidity risk, credit risk & interest rate
risk
• Liquidity management is a day-to-day
responsibility.
• Liquidity risk, for a poorly managed bank, closely
follows credit and interest rate risk.
– Banks that experience large deposit outflows can often
trace the source to either credit problems or earnings
declines from interest rate gambles that backfired.
• Few banks can replace lost deposits
independently if an outright run on the bank
occurs.
39
Factors affecting certain liquidity needs:
• New Loan Demand
– Unused commercial credit lines outstanding
– Consumer credit available on bank-issued cards
– Business activity and growth in the bank’s trade area
– The aggressiveness of the bank’s loan officer call programs
• Potential deposit losses
– The composition of liabilities
– Insured versus uninsured deposits
– Deposit ownership between: money fund traders, trust fund
traders, public institutions, commercial banks by size, corporations
by size, individuals, foreign investors, and Treasury tax and loan
accounts
– Large deposits held by any single entity
– Seasonal or cyclical patterns in deposits
– The sensitivity of deposits to changes in the level of interest rates
40
Liquidity planning
• Banks actively engage in liquidity planning at
two levels.
– The first relates to managing the required reserve
position.
– The second stage involves forecasting net funds
needs derived, seasonal or cyclical phenomena
and overall bank growth.
41
Liquidity planning: Monthly intervals
• The second stage of liquidity planning involves
projecting funds needs over the coming year
and beyond, if necessary.
• Projections are separated into three
categories:
1. base trend,
2. short-term seasonal, and
3. cyclical values.
42
Monthly liquidity needs
• The bank’s monthly liquidity needs are
estimated as the forecasted change in loans
plus required reserves minus the forecast
change in deposits:
– Liquidity needs =
Forecasted Aloans + Arequired reserves
- forecasted Adeposits
43
Liquidity GAP measures
• The bank can calculate a liquidity GAP by
classifying potential uses and sources of funds
into separate time frames according to their
cash flow characteristics.
• The Liquidity GAP for each time interval
equals the value of uses of funds minus the
value of sources of funds.
44
Asset Liabilities Management
• Management of a Bank’s portfolio of assets
and liabilities
– In order to maximize profitability and stockholders
earnings over long term
– Consistent with safety and liquidity considerations
• Managing the acquisitions and allocation of
funds –
– To ensure adequate liquidity, maximum
profitability and minimizing risks
45
Asset and liability management
• Managing a bank's entire balance sheet as a
dynamic system of interrelated accounts and
transactions.
• The phrase, asset – liability management has
generally; however, come to refer to managing
interest rate risk
– Interest rate risk
… unexpected changes in interest rates which can
significantly alter a bank’s profitability and market
value of equity.
46
Asset Liabilities Management
• Planning to meet the liquidity needs –
– making funds available at a competitive price
– to proper mix of funds by keeping the level of non-
interest funds to the bare minimum
– maximize the fund allocation to high profit areas
– simultaneously ensuring availability of funds to meet
all eventualities
• Arranging maturity pattern of assets and liabilities
• Controlling the rates received and paid to assets/
liabilities to maximize spread of net interest
income
47
Interest Sensitivity Analysis
• It is an extrapolation of gap management strategy
• It concerns with the analysis of the impact of
interest changes on the bank’s spread/ margin and
resultant overall earnings
• Strategy:
– Separating fixed and variable interest rate components
of balance sheet
– Making alternative assumptions on rise and fall in
interest rates
– Testing the impact of assumed changes in the volume
and composition of the portfolio
• both rising and falling interest rate scenarios
48
Asset Liabilities Management
• Pre-requisites for ALM
– Volatility of interest rates
– Changing deposit mix
– Increasing operating expenses
– Changing asset composition
– Capital adequacy considerations
– Regulatory compliances
– Adopting adequate technology
49
Asset and liability management committee (ALCO)
• A bank's asset and liability management
committee (ALCO) coordinates all policy
decisions and strategies that determine a
bank's risk profit and profit objectives.
• Interest rate risk management is the primary
responsibility of this committee.
50
Duration
• It is the measure of the average (cash weighted) term to
maturity of a bond
• Measured in years
• 2 types – Macaulay’s and modified
• Macaulay’s useful in immunization
• Immunization is a strategy that matches the duration of
assets and liabilities – thereby minimizing the impact of
interest rates
• It is the weighted average of the times that interest
payment and the final return of principal are received
• Weights are amounts of payments discounted by the
YTM of the bond
51
DURATION
• It is weighted average measure of time period of bond’s
life.
• It is the weighted average of the remaining maturity of
the cash flows (discounted to present value) scheduled
to be received under the bond.
• Duration let you know as to how long it will take to
recoup your principal.
• Represent’s a security’s effective maturity
• Unlike maturity, duration takes into account interest
payments received throughout the course of holding
the bond
52
Duration
• For all bonds – duration is shorter than maturity
• Exception??
• The weight of each cash flow is determined by
dividing the PV of the cash flow by the price
• It is an important measure – as bonds with greater
duration are riskier and have higher price volatility
• Duration changes as the coupons are paid to the
bondholders
• Duration will decrease as tie moves closer to
maturity
• Factors that affect duration – coupon and yield
53
DURATION
• Higher the coupon rate, the shorter will be the
duration.
• Duration declines as bond reaches near maturity.
• Duration of a coupon paying bonds is always less than
the remaining period to maturity
54
DURATION
• Duration is used as tool for investment decisions.
• Investors use duration to measure the volatility of the
bond.
• Higher the duration (the longer an investor needs to wait for
the bulk of the payments), the more its price will drop as
interest rates go up.
• When risk is higher, the expected returns will be higher if
interest rates go down.
• If an investor expects interest rates to fall during the course
of the time the bond is held, a bond with a long duration
would be best bet because the bond's price would increase
more than comparable bonds with shorter durations.
• Used for risk measuring
55
56
Duration
• Duration is measure of effective maturity that
incorporates the timing and size of a security’s
cash flow
• It captures the combined impact of market rate,
size of interim payments and maturity on
security’s price volatility
• It is the measure of interest elasticity in
determining a security’s market value
57
Duration
• It is measured in time
• It is a weighted average of the time until the
expected cash flows from a security will be
received, relative to the current price of security
• Weights are the present values of each cash
flows divided by the current price.
58
Duration - a measure of interest
rate risk
• Macaulay’s Duration
where: D = duration of the bond
CF
t
= interest or principal payment at time t
t = number of periods of time until the cash flow payment
n = number of periods to maturity
i = the yield to maturity (interest rate)
D
CF t
i
CF
i
t
t
t
n
t
t
t
n
=
=
1
1
1
1
59
Duration Example
Suppose we have a bond with a 3-year term to
maturity, an 8% coupon paid annually, and a market
yield of 10%. Duration is:
60
Duration Example
If the yield increases to 15%:
61
Duration
• Bond: Government of India
• Coupon: 7.50% YTM: 7.50%
• Maturity: 2014 Price: Rs. 1000
62
Duration
• Bond: Government of India
• Coupon: 7.50% YTM: 7.50%
• Maturity: 2014 Price: Rs. 1000
• Sum = 4260.37 Bond Price: Rs. 1000
• Macaulay’s duration: 4260.37 / 1000 = 4.26
years
63
Coupon date t in yrs Amount PV PV*t
Sep-09 0.5 37.5 36.14 18.07
Mar-10 1.0 37.5 34.84 34.84
Sep-10 1.5 37.5 33.58 50.37
Mar-11 2.0 37.5 32.37 64.74
Sep-11 2.5 37.5 31.20 78.00
Mar-12 3.0 37.5 30.07 90.21
Sep-12 3.5 37.5 28.98 101.43
Mar-13 4.0 37.5 27.93 111.72
Sep-13 4.5 37.5 26.92 121.14
Mar-14 5.0 1037.5 717.97 3,589.85
Modified Duration
• A useful measure of the sensitivity of bond’s
prices (present value of cash flows) to interest
rate movements
• It accounts for changing interest rates
• Interest rates affect yield
• Modified Duration shows how much the
duration changes for each percentage change in
yield
• It is a measure of the price sensitivity of a bond
to interest rate movements.
• There is an inverse relation between modified
duration and change in yield
Modified Duration = Macaulay’s Duration /
(1+YTM/n);
where n is the number of discounting periods in a
year
64
65
Duration concepts
• Higher coupon rates mean shorter duration and less
price volatility.
• Duration equals term to maturity for zero coupon
securities.
• Longer maturities mean longer durations and greater
price volatility.
• The higher the market rate of interest, the shorter the
duration.
66
Duration can be calculated for an
entire portfolio
i
i
n
i
D w Duration Portfolio
=
=
1
where: w
i
= proportion of bond i in portfolio and
D
i
= duration of bond i.
Duration versus maturity
1.) 1000 loan, principal + interest paid in 20
years.
2.) 1000 loan, 900 principal in 1 year,
100 principal in 20 years.
1000 + int
|-------------------|-----------------|
0 10 20
900+int 100 + int
|----|--------------|-----------------|
0 1 10 20
What is the maturity of each? 20 years
What is the "effective" maturity?
2.) = [(900/1000) x 1]+[(100/1000) x 20] = 2.9 yrs
Duration, however, uses a weighted average of the present values.
1
2
67
Duration
• Duration is an approximate measure of the price
elasticity of demand
• Price elasticity of demand
= %A in quantity demanded / %A in price
• Price (value) changes
– Longer duration ÷ larger changes in price for a given
change in i-rates.
– Larger coupon ÷ smaller change in price for a given change
in i-rates.
68
Duration
• Solve for APrice:
– AP ~ -Duration x [Ai / (1 + i)] x P
• Price (value) changes
– Longer maturity/duration larger changes in price for a given
change in i-rates.
– Larger coupon smaller change in price for a given change in
i-rates.
?i
%??
i + 1
?i
P
?P
DUR
°
÷ ~
(
(
(
¸
(
¸
÷ ~
69
Measuring duration
• In general notation, Macaulay’s duration (D):
• Example:
1000 face value, 10% coupon, 3 year, 12% YTM
Sec. the of PV
r) + (1
(t) CF
r) + (1
CF
r) + (1
(t) CF
= D
n
1 = t
t
t
k
1 = t
t
t
k
1 = t
t
t
¿
¿
¿
=
rs yea 2.73 =
951.96
2597.6
(1.12)
1000
+
(1.12)
100
(1.12)
3 1000
+
(1.12)
3 100
+
(1.12)
2 100
+
(1.12)
1 100
D
3
1 = t
3 t
3 3 2
1
=
× × × ×
=
¿
70
Measuring duration
• If YTM = 5%
1000 face value, 10% coupon, 3 year, 5% YTM
71
1136.16
(1.05)
3 * 1000
+
(1.05)
3 * 100
+
(1.05)
2 * 100
+
(1.05)
1 * 100
D
3 3 2
1
=
years 2.75 =
1136.16
3127.31
D =
Measuring duration
• If YTM = 5%
1000 face value, 10% coupon, 3 year, 5% YTM
72
Measuring duration
• If YTM = 20%
1000 face value, 10% coupon, 3 year, 20%
YTM
73
years 2.68 =
789.35
2131.95
D =
Measuring duration
• If YTM = 20%
1000 face value, 10% coupon, 3 year, 20%
YTM
74
Measuring duration
• If YTM = 12% and Coupon = 0
1000 face value, 0% coupon, 3 year, 12% YTM
1000
|-------|-------|-------|
0 1 2 3
75
definition (by 3
(1.12)
1000
(1.12)
3 1000
D
3
3
=
×
=
Measuring duration
• If YTM = 12% and Coupon = 0
1000 face value, 0% coupon, 3 year, 12% YTM
1000
|-------|-------|-------|
0 1 2 3
76
i
i + 1
Duration
P
?P
A
(
¸
(
¸
÷ ~
Compare price sensitivity
• Duration allows market participants to estimate
the relative price volatility of different securities:
• Using modified duration:
• modified duration
= Macaulay’s duration / (1+i)
• We have an estimate of price volatility:
%change in price
= modified duration x change in i
77
Type of Bond
3-Yr. Zero 6-Yr. Zero 3-Yr. Coupon 6-Yr. Coupon
Initial market rate (annual) 9.40% 9.40% 9.40% 9.40%
Initial market rate (semiannual) 4.70% 4.70% 4.70% 4.70%
Maturity value $10,000 $10,000 $10,000 $10,000
Initial price $7,591.37 $5,762.88 $10,000 $10,000
Duration: semiannual periods 6.00 12.00 5.37 9.44
Modified duration 5.73 11.46 5.12 9.02
Rate Increases to 10% (5% Semiannually)
Estimated AP
-$130.51 -$198.15 -$153.74 -$270.45
Estimated AP / P
-1.72% -3.44% -1.54% -2.70%
Initial elasticity 0.2693 0.5387 0.2406 0.4242
Comparative price sensitivity
indicated by duration
• AP = - Duration [Ai / (1 + i)] P
• AP / P = - [Duration / (1 + i)] Ai
where Duration equals Macaulay's duration.
78
The relationship between duration
and actual changes in securities
prices
• The difference between the actual price-yield curve and
the straight line representing duration at the point of
tangency equals the error in applying duration to estimate
the change in bond price at each new yield.
• For both rate increases and rate decreases, the estimated
price, based on duration, will be below the actual price.
– For small changes in yield, such as yields near 10 percent, the
error is small.
– For large changes in yield, such as yields well above or well
below 10 percent, the error is large.
79
Duration and convexity
• The relationship between price and interest
rates is not the same for any change in interest
rates.
• Duration will generally be a ‘good’ estimate of
price volatility only for very small changes in
interest rates.
• The greater the change in interest rates, the less
accurate duration will be as a measure of price
volatility.
80
Convexity
• Convexity is a measure of the rate of change of
Rupee duration as yields change.
• Duration, increases as yields decline and
lengthens as yields increase for all option free
bonds.
– This is positive feature for buyers of bonds because as yields
decline, price appreciation accelerates.
– As yields increase, duration for option free bonds decreases, once
again reducing the rate at which price declines.
• This characteristic is called positive convexity--
the underlying bond becomes more price
sensitive when yields decline and less price
sensitive when yields increase.
81
Convexity
• The actual
reduction in
price will be
less than that
predicted by
duration with
an increase in
interest rates.
Change in price predicted by duration
yield
Price
Actual change in price
82
Net interest income or the market
value of stockholders' equity?
• Banks typically focus on either:
– net interest income or
– the market value of stockholders' equity
as a target measure of performance.
• GAP models are commonly associated with net interest
income (margin) targeting.
• Earnings sensitivity analysis
…provides information regarding how much NII
changes when rates are assumed to increase or fall by
various amounts.
83
Interest rate risk
• Reinvestment rate risk
... the risk that a bank can not reinvest cash flows from assets
or refinance rolled over or new liabilities at a certain rate in
the future
–Cost of funds versus the return on assets
• ¬ Funding GAP, impact on NII
• Price Risk
… changes in interest rates will also cause a change in the
value (price) of assets and liabilities
–Longer maturity (duration)
• ¬ larger change in value for a given change in interest
rates
84
Rate sensitive assets and liabilities
• Those assets and liabilities management expects to
be repriced within a fixed time interval.
• They include:
– maturing instruments,
– floating and variable rate instruments, and
– any full or partial principal payments.
• A bank's GAP is defined as the difference between a
bank's rate sensitive assets and rate sensitive
liabilities.
• It is a balance sheet figure measured in Rupees for
Indian banks over a specific period of time.
85
What determines rate sensitivity?
• In general, an asset or liability is normally classified as
rate-sensitive with a time frame if:
1. It matures
2. It represents and interim, or partial, principal payment
3. The interest rate applied to outstanding principal
changes contractually during the interval
4. The outstanding principal can be repriced when some
base rate of index changes and management expects
the base rate / index to change during the interval
86
Funding GAP
• Focuses on managing NII in the short run.
• Method
– Group assets and liabilities into time "buckets”
according to when they mature or are expected to
re-price
– Calculate GAP for each time bucket
– Funding GAP
t
= Value RSA
t
- Value or RSL
t
• where t = time bucket; e.g., 0-3 months
87
Expected balance sheet for
hypothetical bank
88
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 8.0% 600 4.0%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000
GAP = 500 - 600 = -100
NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)
NIM = 41.3 / 850 = 4.86%
NII = 78.5 - 37.2 = 41.3
Factors affecting net interest income
• 1% increase in the level of all short-term rates
• 1% decrease in spread between assets yields and
interest cost
– RSA increase to 8.5%
– RSL increase to 5.5%
• Proportionate doubling in size.
• Increase in RSA’s and decrease in RSL’s
– RSA = 540, fixed rate = 310
– RSL = 560, fixed rate = 260.
89
1% increase in short-term rates
90
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 9.0% 600 5.0%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000
GAP = 500 - 600 = -100
NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)
NIM = 40.3 / 850 = 4.74%
NII = 83.5 - 43.2 = 40.3
Changes in NII are directly proportional to the
size of the GAP
• ANII
exp
= (GAP) * (A i
exp
)
• The larger is the GAP, the greater is the change
in NII.
• *This applies only in the case of a parallel shift
in the yield curve, which is rare.
– If rates do not change by the same amount, then
the GAP may change by more or less.
91
Positive and negative gap’s
• Positive GAP
…indicates a bank has more rate sensitive assets than
liabilities, and that net interest income will generally
rise (fall) when interest rates rise (fall).
• Negative GAP
…indicates a bank has more rate sensitive liabilities
than rate sensitive assets, and that net interest income
will generally fall (rise) when interest rates rise (fall).
92
Optimal value for a bank’s GAP?
• There is no general optimal value for a bank's GAP in all
environments.
• GAP is a measure of interest rate risk.
• The best GAP for a bank can be determined only by
evaluating a bank's overall risk and return profile and
objectives.
• Generally, the farther a bank's GAP is from zero, the
greater is the bank's risk.
• Many banks establish GAP policy targets to control
interest rate risk by specifying that GAP as a fraction of
earning assets should be plus or minus 15%, or the
ratio of RSAs to RSLs should fall between 0.9 and 1.1.
93
Advantages / disadvantages of GAP
• The primary advantage of GAP analysis is its
simplicity.
• The primary weakness is that it ignores the time
value of money.
• GAP further ignores the impact of embedded
options.
• For this reason, most banks conduct earnings
sensitivity analysis, or pro forma analysis, to
project earnings and the variation in earnings
under different interest rate environments.
94
Earnings sensitivity analysis
• Allows management to incorporate the impact
of different spreads between asset yields and
liability interest costs when rates change by
different amounts.
• Shifts in the yield curve are rarely parallel!
• It is well recognized that banks are quick to
increase base loan rates but are slow to lower
base loan rates when rates fall.
95
Earnings sensitivity analysis
1. Forecast future interest rates,
2. Identify changes in the composition of assets and
liabilities in different rate environments,
3. Forecast when embedded options will be exercised,
4. Identify when specific assets and liabilities will reprice
given the rate environment,
5. Estimate net interest income and net income, and
6. Repeat the process to compare forecasts of net
interest income and net income across rate
environments.
96
Risk Exposure Analysis
• Deal with credit worthy counterparties
• To understand and evaluate risk
• Evaluate the level and trends of the bank’s
aggregated rate risk exposure, particularly
interest rate
• Evaluate the sensitivity and reasonableness of
key assumptions – shape of yield curve,
anticipated pace of loan repayments, deposit
withdrawals
• Verify compliance with established/ prescribed
risk tolerance levels and limits and identify any
policy exceptions
• Determine whether the bank holds sufficient
capital for the risk being taken
97
Stress Testing
• Sensitivity Test – assess the impact of large
movements in financial variables on portfolio
values
• Scenario Test – constructed either within the
context of a specific portfolio or in light of
historical events common across portfolios
• Risk managers identify portfolio’s key financial
drivers and then formulate scenarios in which
these scenarios are stressed beyond standard
VaR levels.
• Hybrid scenarios are commonly used
98
Valuation of fixed income securities
• Traditional fixed-income valuation methods
are too simplistic for three reasons:
1. Investors do not hold securities until maturity
2. Present value calculations assumes all coupon
payments are reinvested at the calculated Yield to
Maturity
3. Many securities carry embedded options, such as
a call or put, which complicates valuation since it
is unknown if the option will be exercised.
99
Total return analysis
• Market participants attempt to estimate the
actual realized yield on a bond by calculating an
estimated total return
= [Total future value / Purchase price]
(1/n)
- 1
100
Money market yields
• Interest rates for most money market yields
are quoted on a different basis.
• In particular, some money market
instruments are quoted on a discount basis,
while others bear interest.
• Some yields are quoted on a 360-day year
rather than a 365 or 366 day year.
101
Interest-bearing loans with
maturities of one year or less
• The effective rate of interest depends on the term of
the loan and the compounding frequency.
• A one year loan which requires monthly interest
payments at 12% annually, carries an effective yield to
the bank of 12.68%:
– i* = (1 + 0.12/12)
12
- 1 = 12.68%
• If the same loan was made for 90 days:
– i* = [1 + 0.12 / (365/90)]
(365/90)
- 1 = 12.55%
• In general:
– i* = [1 + i / (365 / h)]
(365/h)
- 1
102
360-day versus 365-day yields
• Some securities are reported using a 360 year rather
than a full 365 day year.
• This will mean that the rate quoted will be 5 days too
small on a standard annualized basis of 365 days.
• To convert from a 360-day year to a 365-day year:
– i
365
= i
360
(365/360)
• Example: one year instrument at 8% nominal rate on a
360-day year is actually an 8.11% rate on a 365-day
year:
– i
365
= 0.08 (365/360) = 0.0811
103
Discount yields
• Some money market instruments, such as Govt. T-
Bills, are quoted on a discount basis.
• This means that the purchase price is always below
the par value at maturity.
• The difference between the purchase price and par
value at maturity represents interest.
• The pricing equation for a discount instrument is:
i
dr
= [(P
f
- P
o
) / P
f
] (360 / h)
where
i
dr
= discount rate
P
o
= initial price of the instrument
P
f
= final price at maturity or sale,
h = number of days in holding period.
104
The bond equivalent rate on discount
securities
• The problems of a 360-day year for a rate quoted on a discount
basis can be handled by converting the discount rate to a bond
equivalent rate: (i
be
)
– i
be
= [(P
f
- P
o
) / P
o
] (365 / h)
• Example: consider a 1 million T-bill with 182 days to maturity,
price = 964,500.
The discount rate is 7.02%,
i
dr
= [(1,000,000 - 964,500) / 1,000,000] (360 / 182)
= 0.072
The bond equivalent rate is 7.38%:
i
dr
= [(1,000,000 - 964,500) / 964,500] (365 / 182)
= 0.0738
The effective annual rate is 7.52%:
i* = [1 + 0.0738 / (365 / 182)]
(365/ 182)
- 1 = 0.0752
105
Yields on single-payment interest-
bearing securities
• Some money market instruments, such as large
negotiable CD’s, Eurodollars, and Govt. funds, pay
interest calculated against the par value of the security
and make a single payment of interest and principal at
maturity.
• Example: consider a 182-day CD with a par value of
1,000,000 and a quoted rate of 7.02%.
Actual interest paid at maturity is:
– (0.0702)(182 / 360) 1,000,000 = 35,490
– The 365 day yield is:
i
365
= 0.0702(365 / 360) = 0.0712
– The effective annual rate is 7.31%:
i* = {1 + [0.0712 / (365 / 182)]}
(365/182)
- 1 = 0.0724
106
Summary of money market yield quotations
and calculations
• Simple Interest i
s
:
• Discount Rate i
dr
:
• Money Mkt 360-day rate, i
360
• Bond equivalent 365 day rate, i
365
or i
be
:
• Effective ann. interest rate,
Definitions
P
f
= final value
P
o
= initial value
h=# of days in holding
period
Discount Yield quotes:
Treasury bills
Repurchase agreements
Commercial paper
Bankers acceptances
Interest-bearing, Single
Payment:
Negotiable CDs
Federal funds
107
o
o f
s
p
p p
i
÷
=
h
360
p
p p
i
f
o f
dr
÷
=
h
360
p
p p
i
o
o f
360
÷
=
h
365
p
p p
i
o
o f
be
÷
=
1
365/h
i
1 i
365/h
*
÷
(
¸
(
¸
+ =
THE LEVEL OF INTEREST
RATES
108
What are Interest Rates?
• Rental price for money.
• Penalty to borrowers for consuming before
earning.
• Reward to savers for postponing consumption.
• Expressed in terms of annual rates.
• As with any price, interest rates serve to
allocate resources.
109
The Real Rate of Interest
• Producers seek financing for real assets. Expected
ROI is upper limit on interest rate producers can
pay for financing.
• Savers require compensation for deferring
consumption. Time value of consumption is
lower limit on interest rate at which savers will
provide financing.
• Real rate occurs at equilibrium between desired
real investment and desired saving.
110
Determinants of the Real Rate of
Interest
111
Loanable Funds Theory
• Supply of loanable funds—
– All sources of funds available to invest in
financial claims
• Demand for loanable funds—
– All uses of funds raised from issuing financial
claims
• Equilibrium interest rate
112
Supply of loanable funds—
• All sources of funds available to invest
in financial claims:
– Consumer savings
– Business savings
– Government budget surpluses
– Central Bank Action
113
Demand for Loanable Funds
• All uses of funds raised from issuing financial
claims:
Consumer credit purchases
Business investment
Government budget deficits
114
Equilibrium Interest Rate
• If competitive forces operate in financial
sector, laws of supply and demand will
bring rates into equilibrium.
• Equilibrium is temporary or dynamic: Any
force that shifts supply or demand will tend
to change interest rates.
115
Loanable Funds Theory
116
Loanable Funds Theory
117
Loanable Funds Theory
118
Loanable Funds Theory
119
Price Expectations and Interest Rates
• Unanticipated inflation benefits borrowers at
expense of lenders.
• Lenders charge added interest to offset
anticipated decreases in purchasing power.
• Expected inflation is embodied in nominal
interest rates: The Fisher Effect.
120
Fisher Effect
The exact Fisher equation is:
121
( ) ( )( )
inflation. of rate annual expected the
interest, of rate real the r
interest, of rate nominal observed the i
where
1 1 1
= A
=
=
A + + = +
e
e
P
P r i
Fisher Effect
From the Fisher equation, we derive the nominal
(contract) rate:
We see that a lender gets compensated for:
rental of purchasing power
anticipated loss of purchasing power on the principal
anticipated loss of purchasing power on the interest
122
( )
e e
P r P r i A + A + = *
Fisher Effect: Example
• 1-year 1000 loan
• Parties agree on 3% rental rate for money and
• 5% expected rate of inflation.
– Items to pay Calculation Amount
– Principal 1,000.00
– Rent on money 1,000 x 3% 30.00
– PP loss on principal 1,000 x 5% 50.00
– PP loss on interest 1,000 x 3% x 5% 1.50
– Total Compensation 1,081.50
123
Simplified Fisher Equation
The third term in the Fisher equation is negligible, so
it is commonly dropped. The resulting equation is
124
e
P r i A + =
Expectations ex ante v.
Experience ex post
Realized rates of return reflect impact of
inflation on past investments.
r = i - AP
a
, where the "realized" rate of return
from past transactions, r, equals the nominal rate
minus the actual annual rate of inflation.
As inflation increases, expected inflation
premiums, P
e
, may lag actual rates of inflation,
P
a
, yielding low or even negative actual returns.
125
126
Impact of Inflation under Loanable Funds Theory
127
Interest Rate Movements and
Inflation
• Historically, interest rates tend to change with
changes in the rate of inflation, substantiating
the Fisher equation.
• Short-term rates are more responsive to
changes in inflation than long-term rates.
128
THE STRUCTURE OF
INTEREST RATES
129
Factors that Influence Interest Rate
Differences
• Term to Maturity.
• Default Risk.
• Tax Treatment.
• Marketability.
• Call or Put Features.
• Convertibility.
130
Term (Maturity) Structure
• May be studied visually by plotting a yield curve
at a point in time
• A yield curve is a smooth line, which shows the
relationship between maturity and a security's
yield at a point in time.
• The yield curve may be ascending (normal), flat,
or descending (inverted).
• Several theories explain the shape of the yield
curve.
131
Yield Curves
132
The Expectations Theory
• The shape of the yield curve is determined solely
by expectations of future interest rate
movements, and changes in these expectations
lead to changes in the shape of the yield curve .
– Ascending: future interest rates are expected to
increase.
– Descending: future interest rates are expected to
decrease.
• Long-term interest rates represent the geometric
average of current and expected future (implied,
forward) interest rates.
133
Term Structure Formula
134
( ) ( )( )( ) ( ) | |
bond. the of maturity
, applicable is rate the for which period time
rate, forward the
rate, market observed the
: where
1 1 1 1 1
1
1 1 1 2 1 1 1
=
=
=
=
+ + + + = +
÷ + + +
n
t
f
R
f f f R R
n
n t t t t n t
?
An Implied One Year Forward Rate
135
1
1
1
1
1
1 1
÷
÷
÷ +
n
n t
n
n t
n t
R
R
f
Finding a One-Year Implied
Forward Rate
• Using the term structure of interest rates from
September 1, 2004, find the one-year implied
forward rate for year three.
– 1-year Treasury note 1.95%
– 2-year Treasury note 2.39%
– 3-year Treasury note 2.71%
3.35% or f 0335 . 0 1
0239 . 1
0271 . 1
2
3
1 3
= ÷
(
¸
(
¸
+
+
=
136
Liquidity Premium Theory
• Long-term securities have greater risk and
investors require greater premiums to give
up liquidity.
– Long-term securities have greater price
variability.
– Long-term securities have less marketability.
• The liquidity premium explains an upward
sloping yield curve.
• Liquidity premiums change over time.
137
Market Segmentation Theory
• Maturity preferences by investors may affect
security prices (yields), explaining variations in
yields by time
• Market participants have strong preferences for
securities of particular maturity and buy and sell
securities consistent with their maturity
preferences.
• If market participants do not trade outside their
maturity preferences, then discontinuities are
possible in the yield curve.
138
Preferred Habitat Theory
• The Preferred Habitat Theory is an extension of
the Market Segmentation Theory.
• The Preferred Habitat Theory allows market
participants to trade outside of their preferred
maturity if adequately compensated for the
additional risk.
• The Preferred Habitat Theory allows for humps or
twists in the yield curve, but limits the
discontinuities possible under Segmentation
Theory.
139
Which Theory is Right?
• Day-to-day changes in the term structure
are most consistent with the Preferred
Habitat Theory.
• However, in the long-run, expectations of
future interest rates and liquidity premiums
are important components of the position
and shape of the yield curve.
140
Yield Curves and the Business Cycle
Interest rates are directly related to the level of
economic activity.
– An ascending yield curve notes the market
expectations of economic expansion and/or
inflation.
– A descending yield curve forecasts lower rates
possibly related to slower economic growth or
lower inflation rates.
• Security markets respond to updated new
information and expectations and reflect their
reactions in security prices and yields.
141
Yield-Curve Patterns Over the
Business Cycle
142
Uses of the Yield Curve
• At any point in time, the slope of the yield curve
can be used to assess the general expectations of
borrowers and lenders about future interest
rates!
• Investors can use the yield curve to identify
under-priced securities for their portfolios.
• Issuers may use the yield curve to price their
securities.
• Investors use the yield curve for a strategy known
as riding the yield curve.
143
Default Risk
• It is the probability of the borrower not
honoring the security contract
• Losses may range from “interest a few days
late” to a complete loss of principal.
• Risk averse investors want adequate
compensation for expected default losses.
144
Default Risk
• Investors charge a default risk premium (above
riskless or less risky securities) for added risk
assumed
• DRP = i - i
rf
• The default risk premium (DRP) is the difference
between the promised or nominal rate and the
yield on a comparable (same term) riskless
security (Treasury security).
• Investors are satisfied if the default risk premium
is equal to the expected default loss.
145
Risk Premiums
146
Default Risk
• Default risk premiums increase (widen) in
periods of recession and decrease in
economic expansion
• In good times, risky security prices are bid
up; yields move nearer that of riskless
securities.
• With increased economic pessimism,
investors sell risky securities and buy
“quality” widening the DRP.
147
Default Risk
• Credit rating agencies measure and grade
relative default risk security issuers
• Cash flow, level of debt, profitability, and
variability of earnings are indicators of
default riskiness.
• As conditions change, rating agencies alter
rating of businesses and governmental
debtors.
148
Corporate Bond-Rating Systems
149
Tax Effects on Yields
• The taxation of security gains and income affects
the yield differences among securities
• The after-tax return, i
at
, is found by multiplying the
pre-tax return by one minus the marginal tax rate.
i
at
= i
bt
(1-t)
• Municipal bond interest income is tax exempt.
• Coupon income and capital gains have been taxed
differently in the past.
150
To Buy a Municipal or a
Corporate Bond?
151
Impact of Marketability on
Interest Yields
• Marketability -- The costs and rapidity with
which investors can resell a security.
– Cost of trade.
– Physical transfer cost.
– Search costs.
– Information costs.
• Securities with good marketability have
higher prices (in demand) and lower yields.
152
Contract Options and Yields
• Varied option provisions may explain yield
differences between securities
• An option is a contract provision which
gives the holder the right, but not the
obligation, to buy, sell, redeem, or convert
an asset at some specified price within a
defined future time period.
153
Contract Options and Yields
• A call option permits the issuer (borrower) to
call (refund) the obligation before maturity
• Borrowers will “call” if interest rates decline.
• Investors in callable securities bear the risk of
losing their high-yielding security.
• With increased call risk, investors demand a
call interest premium (CIP).
– CIP = i
c
- i
nc
– A callable bond, i
c
, will be priced to yield a higher
return (by the CIP) than a noncallable, i
nc
, bond.
154
Contract Options and Yields
• A put option permits the investor (lender) to
terminate the contract at a designated price
before maturity
• Investors are likely to “put” their security or loan
back to the borrower during periods of increasing
interest rates. The difference in interest rates
between putable and nonputable contracts is
called the put interest discount (PID).
• PID = i
p
- i
np
• The yield on a putable bond, i
p
, will be lower than
the yield on the nonputable bond, i
np
, by the PIP.
155
Contract Options and Yields
• A conversion option permits the investor to
convert a security contract into another security
• Convertible bonds generally have lower yields,
i
con
, than nonconvertibles, i
ncon
.
• The conversion yield discount (CYD) is the
difference between the yields on convertibles
relative to nonconvertibles.
• CYD = i
con
- i
ncon
. Investors accept the lower yield
on convertible bonds because they have an
opportunity for increased rates of return through
conversion.
156
doc_491408542.pptx
complete guide to treasury management, it explains the objectives of treasury and how they are achieved using various instruments and methods.
Treasury Management
1
Treasury Management
• Traditionally – limited to CRR and SLR
management
• Forex business – restricted to meeting
customer’s requirements
– Forex requirements – imports, exports, remittances
and deposits
2
Treasury Management
• Objective
– Take advantage of trading & arbitrage opportunities
– To deploy deposit liabilities, internal generation and
cash flows from maturing assets for maximum returns
– To fund balance sheet as cheaply as possible
– To manage forex assets and liabilities
– To manage treasury risk
– To maintain CRR & SLR
– To deploy clearing surpluses
– To meet clearing deficits
3
Treasury Management
• RBI initiated various reforms and measures
– DFHI was set-up – to meet liquidity requirement
• DFHI – dealing in short term money market instruments – treasury
bills, bills rediscounting, CP, CD, etc.
– Improved SGL transfer procedure
• Delivery versus Payment (DVP) for securities settlement at PDO
– Reduced counter party risk
– Market determined exchange rates and interest
rates
– Open market operations (OMO)
4
Treasury Management
• Some important measures taken
– Interest deregulations
– Liberalization of exchange control
– Permission to corporates to raise resources internationally
– Relaxation of end-use clause – GDR/ ECB/ FCCB
– Permissions to Banks to invest abroad – using FCNR(B), EEFC,
etc.
– Bank/ Corporates – derivative trading
– Banks to initiate cross currency positions overseas
– Banks – upto 25% of Tier I – to invest/ borrow abroad
– Authorized Dealers allowed to borrow/ lend forex
– Removal of interbank borrowing from CRR/ SLR requirements
5
Treasury Management
• Investments now viewed as alternative to credit
for profits
• Sources of Profit
– Investments
– Spreads
– Arbitrage
– Relative Value
– Proprietary Trading
– Customer Services
6
Treasury Management
• Treasury Asset & Liability
– Created through a transaction in the Inter-Bank
market
– Loans and advances – not part of treasury assets –
only securitized assets are
• Treasury Assets – tradable
– Only Inter-Bank Participation Certificate is non-
tradable
• Domestic Treasury Instruments
• Forex Products
7
TREASURY OPERATIONS
• The Treasury operations in Indian Banks are broadly divided into :-
• Rupees Treasury :- The Rupee Treasury carries out the bank’s rupee-based
treasury functions in the domestic market. These include asset liability
management, investments and trading & also manages the bank’s position
regarding statutory requirements like the cash reserve ratio (CRR) and the
statutory liquidity ratio (SLR), as per the norms of the RBI. The products
included are :-
– Money Market instruments – Call Money, Notice Money, Term Money,
Commercial Papers, Treasury Bonds, Inter Bank Participation, Repo, Reverse Repo
etc.
– Bonds – Government Securities, Bonds, Debentures etc.
– Equities
• Foreign Exchange Treasury
• Derivatives Desk
Treasury Management
• Functions of Integrated Treasury
– Reserve Management – CRR & SLR – appropriate
mix – optimize yield and duration
– ALM - Liquidity and Funds Management
– Risk Management
– Effective management of interest rates
– Derivative Products
– Arbitrage
– Capital Adequacy
9
Treasury Management
• Risk Analysis and Control
• Financial Risk
– Market Risk
• Interest rate risk
• Price risk
– Credit Risk
– Liquidity Risk, etc.
• Operational Risk
– Systemic risk
– Compliance risk
– Legal risk
– IT risk
– Fraud risk, etc.
10
Treasury Management
• Factors affecting Forex rates
– Macroeconomic, social and political factors
– Exchange control regulations
– Exchange rate policy
– Balance of payment
– Balance of trade
– Inflation
– Market sentiments
– Interest rates
11
Treasury Management
• Factors affecting Interest rates
– Macroeconomic, social and political factors
– Fiscal Policies
– Demand for money
– Government borrowings
– Money supply
– Inflation
– Market sentiments
12
Treasury Management
• Operational Risk
– Systems deficiencies
– Non compliance of procedures
– Fraudulent practices – deal settlements
– Legal risk – inadequate definitions and coverage of
covenants
13
Treasury Management
• Mitigation
– Prudential limits for instruments and counter party
– Stop Loss
– Risk norms – duration and VaR
– No deviations from procedures
– Necessary authorizations
– Delegation of power – prudence
– Prescribed settlement systems
– IT systems updated regularly
– Custodian of demat accounts
– Counterparty authorizations/ power of attorney
– List of approved brokers
– Deals, transactions and legal documentation recorded
14
Treasury Management
• Credit Risk
– Borrower unable to honor obligations
15
Treasury Management
• Mitigation
– Credit Appraisal
– Risk pricing
– Margin arrangements
– Escrow accounts
– Guarantees/ L/Cs
– Security
– Exposure limits
– Diversification
16
Treasury Management
• Liquidity Risk
– Asset cannot be encashed
– Scarcity of funds in market
– Bank’s Creditworthiness a suspect
17
Treasury Management
• Mitigation
– Increase proportion of liquid securities
– Increase proportion of near-maturity high quality
instruments
– Maintain credit rating
– Securitize loan portfolio
18
Treasury Management
• Market Risk
– Interest rate risk
– Systemic risk
19
Treasury Management
• Mitigation
– Increase the proportion of assets in risk-free, high
quality investments of short maturity
20
Treasury Management
• Value at Risk
• It indicates the possible maximum loss which
will be suffered in a specific period and at a
specific confidence level due to a fall in the
price of a security – given the historical price
behavior or assessment of future market
movement
21
Value-at-risk
• The largest banks use a value-at-risk (VAR)
based capital charge, estimated by using an
internally generated risk measurement model.
22
Treasury Management
• VaR
• It is derived – statistical formula based on
volatility of the market
• Volatility is the standard deviation from mean
observed over a period
• Volatility assumes normal distribution
• The Volatility x no. of std. dev. required for a
given confidence = VaR for a given period and
confidence
23
Treasury Management
• VaR at 99% confidence – 1% probability of the
stated loss
• Loss is generally in absolute terms
• What is VaR for Rs. 10 lacs at 99% confidence
for one week for an investment portfolio of Rs.
10 crores?
24
Treasury Management
• What is VaR for Rs. 10 lacs at 99% confidence
for one week for an investment portfolio of Rs.
10 crores?
• The maximum drop with a probability of 1%
over week is Rs. 10 lacs – 99% of the time, the
portfolio will be above or at its current value.
25
Treasury Management
• Risk Management: RBI Guidelines
– Banks required to send monthly reports covering
liquidity mismatches and interest rate sensitivity
– Call Borrowing/ Lending
– Liquid Assets management
– Core Deposits & Non – core deposits
– CRR/ SLR position
– Duration of Liabilities & Investments
– Maximum cumulative outflows across all time bands
– Ratios – including off balance sheet effect
– Forex Assets & Liabilities
26
Treasury Management
• Risk Management: Banks
– ALCO – manages gap, interest rate, liquidity and
currency risk
– Monthly statement to Board and RBI
– Stop loss levels set
– Concurrent audits of securities and fund
management transactions
– Investment committee
– Periodic inspection by internal auditors and RBI
– Broker panel reviewed annually
– IT audit
– Front & back offices segregated
– Deals backed by deal slips and office memos
– Defaults/ arrears monitored
– Comply 100% with RBI guidelines
27
Liquidity Management
• Liquidity – the ability of a bank to meet
liabilities exactly when they fall due or when
the depositor wants the money back
• Liquidity –
– Cash in excess of CRR
– Investments in SLR above requirement
– Prime assets
– Swapping forex into INR
– Undrawn lines from RBI
– Undrawn lines from others
– Sale of assets
– RBI support
28
Liquidity Management
• Excess Liquidity –
– Money market lending or investing
– Reverse REPO
– Buying T-bills, CPs, etc. depending on the tenure
– Repaying refinances
• For doing the above – bank to make liquidity
position projections
29
Liquidity Management
• Liquidity Adjustment Facility of RBI
– Interest rate corridor
– Standing Deposit Facility (SDF) – RBI to offer SDF to
keep their surpluses with RBI – voluntarily. Interest
rate less than CRR or Repo. Part of CRR calculations
– Market Stabilization Fund (MSF) – to absorb
liquidity of endemic nature. MSF proceeds do not
flow to government but completely sterilized by
RBI. However, interest is paid by government.
30
Liquidity Management
• The relationship between cash and liquidity
requirements
– The amount of cash held is heavily influenced by
the bank’s liquidity requirements.
– Vault cash is held to meet reserve requirements
and transactions purposes
31
Liquidity Management
• Liquidity needs arise from net deposit outflows,
as balances held with RBI or correspondent
banks decline.
• Most withdrawals are predictable because they
are either contractually based or follow well-
defined patterns.
• Still, some outflows are totally unexpected.
– Management often does not know whether
customers will reinvest maturing CDs and keep the
funds with the bank or withdraw them.
32
Liquidity Management
• A common definition of liquidity emphasizes the ease of
converting an asset to cash with minimum loss.
• For a bank that regularly borrows in the financial
markets, liquidity takes on the added dimension of the
ability to borrow funds at minimum cost or even the
ability to issue stock.
• It explicitly recognizes that such firms can access cash by
selling assets, by new borrowing, and by new stock
issues.
• Bank liquidity thus refers to a bank’s capacity to acquire
immediately available funds at a reasonable price.
33
Cash versus liquid assets
• Banks own four types of cash assets:
1. vault cash,
2. demand deposit balances at RBI,
3. demand deposit balances at private financial
institutions, and
4. cash items in the process of collection
• Cash assets do not earn any interest, so the
entire allocation of funds represents a
substantial opportunity cost for banks.
• Banks attempt to minimize the amount of cash
assets held and hold only those required by law
or for operational needs.
34
Why do banks hold cash assets?
1. Banks supply coin and currency to meet
customers' regular transactions needs.
2. Regulatory agencies mandate legal reserve
requirements that can only be met by holding
qualifying cash assets.
3. Banks serve as a clearinghouse for the
nation's check payment system.
4. Banks use cash balances to purchase services
from correspondent banks.
35
Liquid assets
• A liquid asset is one that can be easily and
quickly converted into cash with minimum loss.
• Contrary to popular notion "cash assets" do not
generally satisfy a bank's liquidity needs.
– If, for example, the bank experiences an unexpected
drain on vault cash, the bank must immediately
replace the cash or it would have less vault cash than
required for legal or operational needs.
36
Liquid assets
• Cash assets are liquid assets only to the extent
that a bank holds more than the minimum
required.
• Liquid assets are generally considered to be:
1. cash and due from banks in excess of requirements,
2. RBI bonds sold and reverse repurchase agreements,
3. short-term Treasury and agency obligations,
4. high quality short-term corporate and municipal
securities, and
5. some government-guaranteed loans that can be
readily sold.
37
Liquidity versus profitability
• There is a short-run trade-off between liquidity and
profitability.
– The more liquid a bank is, the lower its return on equity
and return on assets, all other things being equal.
• Both asset and liability liquidity contribute to this
relationship.
– Asset liquidity is influenced by the composition and
maturity of funds.
– In terms of liability liquidity, banks with the best asset
quality and highest equity capital have greater access to
purchased funds.
• They also pay lower interest rates and generally report lower returns in the short
run.
38
Liquidity risk, credit risk & interest rate
risk
• Liquidity management is a day-to-day
responsibility.
• Liquidity risk, for a poorly managed bank, closely
follows credit and interest rate risk.
– Banks that experience large deposit outflows can often
trace the source to either credit problems or earnings
declines from interest rate gambles that backfired.
• Few banks can replace lost deposits
independently if an outright run on the bank
occurs.
39
Factors affecting certain liquidity needs:
• New Loan Demand
– Unused commercial credit lines outstanding
– Consumer credit available on bank-issued cards
– Business activity and growth in the bank’s trade area
– The aggressiveness of the bank’s loan officer call programs
• Potential deposit losses
– The composition of liabilities
– Insured versus uninsured deposits
– Deposit ownership between: money fund traders, trust fund
traders, public institutions, commercial banks by size, corporations
by size, individuals, foreign investors, and Treasury tax and loan
accounts
– Large deposits held by any single entity
– Seasonal or cyclical patterns in deposits
– The sensitivity of deposits to changes in the level of interest rates
40
Liquidity planning
• Banks actively engage in liquidity planning at
two levels.
– The first relates to managing the required reserve
position.
– The second stage involves forecasting net funds
needs derived, seasonal or cyclical phenomena
and overall bank growth.
41
Liquidity planning: Monthly intervals
• The second stage of liquidity planning involves
projecting funds needs over the coming year
and beyond, if necessary.
• Projections are separated into three
categories:
1. base trend,
2. short-term seasonal, and
3. cyclical values.
42
Monthly liquidity needs
• The bank’s monthly liquidity needs are
estimated as the forecasted change in loans
plus required reserves minus the forecast
change in deposits:
– Liquidity needs =
Forecasted Aloans + Arequired reserves
- forecasted Adeposits
43
Liquidity GAP measures
• The bank can calculate a liquidity GAP by
classifying potential uses and sources of funds
into separate time frames according to their
cash flow characteristics.
• The Liquidity GAP for each time interval
equals the value of uses of funds minus the
value of sources of funds.
44
Asset Liabilities Management
• Management of a Bank’s portfolio of assets
and liabilities
– In order to maximize profitability and stockholders
earnings over long term
– Consistent with safety and liquidity considerations
• Managing the acquisitions and allocation of
funds –
– To ensure adequate liquidity, maximum
profitability and minimizing risks
45
Asset and liability management
• Managing a bank's entire balance sheet as a
dynamic system of interrelated accounts and
transactions.
• The phrase, asset – liability management has
generally; however, come to refer to managing
interest rate risk
– Interest rate risk
… unexpected changes in interest rates which can
significantly alter a bank’s profitability and market
value of equity.
46
Asset Liabilities Management
• Planning to meet the liquidity needs –
– making funds available at a competitive price
– to proper mix of funds by keeping the level of non-
interest funds to the bare minimum
– maximize the fund allocation to high profit areas
– simultaneously ensuring availability of funds to meet
all eventualities
• Arranging maturity pattern of assets and liabilities
• Controlling the rates received and paid to assets/
liabilities to maximize spread of net interest
income
47
Interest Sensitivity Analysis
• It is an extrapolation of gap management strategy
• It concerns with the analysis of the impact of
interest changes on the bank’s spread/ margin and
resultant overall earnings
• Strategy:
– Separating fixed and variable interest rate components
of balance sheet
– Making alternative assumptions on rise and fall in
interest rates
– Testing the impact of assumed changes in the volume
and composition of the portfolio
• both rising and falling interest rate scenarios
48
Asset Liabilities Management
• Pre-requisites for ALM
– Volatility of interest rates
– Changing deposit mix
– Increasing operating expenses
– Changing asset composition
– Capital adequacy considerations
– Regulatory compliances
– Adopting adequate technology
49
Asset and liability management committee (ALCO)
• A bank's asset and liability management
committee (ALCO) coordinates all policy
decisions and strategies that determine a
bank's risk profit and profit objectives.
• Interest rate risk management is the primary
responsibility of this committee.
50
Duration
• It is the measure of the average (cash weighted) term to
maturity of a bond
• Measured in years
• 2 types – Macaulay’s and modified
• Macaulay’s useful in immunization
• Immunization is a strategy that matches the duration of
assets and liabilities – thereby minimizing the impact of
interest rates
• It is the weighted average of the times that interest
payment and the final return of principal are received
• Weights are amounts of payments discounted by the
YTM of the bond
51
DURATION
• It is weighted average measure of time period of bond’s
life.
• It is the weighted average of the remaining maturity of
the cash flows (discounted to present value) scheduled
to be received under the bond.
• Duration let you know as to how long it will take to
recoup your principal.
• Represent’s a security’s effective maturity
• Unlike maturity, duration takes into account interest
payments received throughout the course of holding
the bond
52
Duration
• For all bonds – duration is shorter than maturity
• Exception??
• The weight of each cash flow is determined by
dividing the PV of the cash flow by the price
• It is an important measure – as bonds with greater
duration are riskier and have higher price volatility
• Duration changes as the coupons are paid to the
bondholders
• Duration will decrease as tie moves closer to
maturity
• Factors that affect duration – coupon and yield
53
DURATION
• Higher the coupon rate, the shorter will be the
duration.
• Duration declines as bond reaches near maturity.
• Duration of a coupon paying bonds is always less than
the remaining period to maturity
54
DURATION
• Duration is used as tool for investment decisions.
• Investors use duration to measure the volatility of the
bond.
• Higher the duration (the longer an investor needs to wait for
the bulk of the payments), the more its price will drop as
interest rates go up.
• When risk is higher, the expected returns will be higher if
interest rates go down.
• If an investor expects interest rates to fall during the course
of the time the bond is held, a bond with a long duration
would be best bet because the bond's price would increase
more than comparable bonds with shorter durations.
• Used for risk measuring
55
56
Duration
• Duration is measure of effective maturity that
incorporates the timing and size of a security’s
cash flow
• It captures the combined impact of market rate,
size of interim payments and maturity on
security’s price volatility
• It is the measure of interest elasticity in
determining a security’s market value
57
Duration
• It is measured in time
• It is a weighted average of the time until the
expected cash flows from a security will be
received, relative to the current price of security
• Weights are the present values of each cash
flows divided by the current price.
58
Duration - a measure of interest
rate risk
• Macaulay’s Duration
where: D = duration of the bond
CF
t
= interest or principal payment at time t
t = number of periods of time until the cash flow payment
n = number of periods to maturity
i = the yield to maturity (interest rate)
D
CF t
i
CF
i
t
t
t
n
t
t
t
n
=
=
1
1
1
1
59
Duration Example
Suppose we have a bond with a 3-year term to
maturity, an 8% coupon paid annually, and a market
yield of 10%. Duration is:
60
Duration Example
If the yield increases to 15%:
61
Duration
• Bond: Government of India
• Coupon: 7.50% YTM: 7.50%
• Maturity: 2014 Price: Rs. 1000
62
Duration
• Bond: Government of India
• Coupon: 7.50% YTM: 7.50%
• Maturity: 2014 Price: Rs. 1000
• Sum = 4260.37 Bond Price: Rs. 1000
• Macaulay’s duration: 4260.37 / 1000 = 4.26
years
63
Coupon date t in yrs Amount PV PV*t
Sep-09 0.5 37.5 36.14 18.07
Mar-10 1.0 37.5 34.84 34.84
Sep-10 1.5 37.5 33.58 50.37
Mar-11 2.0 37.5 32.37 64.74
Sep-11 2.5 37.5 31.20 78.00
Mar-12 3.0 37.5 30.07 90.21
Sep-12 3.5 37.5 28.98 101.43
Mar-13 4.0 37.5 27.93 111.72
Sep-13 4.5 37.5 26.92 121.14
Mar-14 5.0 1037.5 717.97 3,589.85
Modified Duration
• A useful measure of the sensitivity of bond’s
prices (present value of cash flows) to interest
rate movements
• It accounts for changing interest rates
• Interest rates affect yield
• Modified Duration shows how much the
duration changes for each percentage change in
yield
• It is a measure of the price sensitivity of a bond
to interest rate movements.
• There is an inverse relation between modified
duration and change in yield
Modified Duration = Macaulay’s Duration /
(1+YTM/n);
where n is the number of discounting periods in a
year
64
65
Duration concepts
• Higher coupon rates mean shorter duration and less
price volatility.
• Duration equals term to maturity for zero coupon
securities.
• Longer maturities mean longer durations and greater
price volatility.
• The higher the market rate of interest, the shorter the
duration.
66
Duration can be calculated for an
entire portfolio
i
i
n
i
D w Duration Portfolio
=
=
1
where: w
i
= proportion of bond i in portfolio and
D
i
= duration of bond i.
Duration versus maturity
1.) 1000 loan, principal + interest paid in 20
years.
2.) 1000 loan, 900 principal in 1 year,
100 principal in 20 years.
1000 + int
|-------------------|-----------------|
0 10 20
900+int 100 + int
|----|--------------|-----------------|
0 1 10 20
What is the maturity of each? 20 years
What is the "effective" maturity?
2.) = [(900/1000) x 1]+[(100/1000) x 20] = 2.9 yrs
Duration, however, uses a weighted average of the present values.
1
2
67
Duration
• Duration is an approximate measure of the price
elasticity of demand
• Price elasticity of demand
= %A in quantity demanded / %A in price
• Price (value) changes
– Longer duration ÷ larger changes in price for a given
change in i-rates.
– Larger coupon ÷ smaller change in price for a given change
in i-rates.
68
Duration
• Solve for APrice:
– AP ~ -Duration x [Ai / (1 + i)] x P
• Price (value) changes
– Longer maturity/duration larger changes in price for a given
change in i-rates.
– Larger coupon smaller change in price for a given change in
i-rates.
?i
%??
i + 1
?i
P
?P
DUR
°
÷ ~
(
(
(
¸
(
¸
÷ ~
69
Measuring duration
• In general notation, Macaulay’s duration (D):
• Example:
1000 face value, 10% coupon, 3 year, 12% YTM
Sec. the of PV
r) + (1
(t) CF
r) + (1
CF
r) + (1
(t) CF
= D
n
1 = t
t
t
k
1 = t
t
t
k
1 = t
t
t
¿
¿
¿
=
rs yea 2.73 =
951.96
2597.6
(1.12)
1000
+
(1.12)
100
(1.12)
3 1000
+
(1.12)
3 100
+
(1.12)
2 100
+
(1.12)
1 100
D
3
1 = t
3 t
3 3 2
1
=
× × × ×
=
¿
70
Measuring duration
• If YTM = 5%
1000 face value, 10% coupon, 3 year, 5% YTM
71
1136.16
(1.05)
3 * 1000
+
(1.05)
3 * 100
+
(1.05)
2 * 100
+
(1.05)
1 * 100
D
3 3 2
1
=
years 2.75 =
1136.16
3127.31
D =
Measuring duration
• If YTM = 5%
1000 face value, 10% coupon, 3 year, 5% YTM
72
Measuring duration
• If YTM = 20%
1000 face value, 10% coupon, 3 year, 20%
YTM
73
years 2.68 =
789.35
2131.95
D =
Measuring duration
• If YTM = 20%
1000 face value, 10% coupon, 3 year, 20%
YTM
74
Measuring duration
• If YTM = 12% and Coupon = 0
1000 face value, 0% coupon, 3 year, 12% YTM
1000
|-------|-------|-------|
0 1 2 3
75
definition (by 3
(1.12)
1000
(1.12)
3 1000
D
3
3
=
×
=
Measuring duration
• If YTM = 12% and Coupon = 0
1000 face value, 0% coupon, 3 year, 12% YTM
1000
|-------|-------|-------|
0 1 2 3
76
i
i + 1
Duration
P
?P
A
(
¸
(
¸
÷ ~
Compare price sensitivity
• Duration allows market participants to estimate
the relative price volatility of different securities:
• Using modified duration:
• modified duration
= Macaulay’s duration / (1+i)
• We have an estimate of price volatility:
%change in price
= modified duration x change in i
77
Type of Bond
3-Yr. Zero 6-Yr. Zero 3-Yr. Coupon 6-Yr. Coupon
Initial market rate (annual) 9.40% 9.40% 9.40% 9.40%
Initial market rate (semiannual) 4.70% 4.70% 4.70% 4.70%
Maturity value $10,000 $10,000 $10,000 $10,000
Initial price $7,591.37 $5,762.88 $10,000 $10,000
Duration: semiannual periods 6.00 12.00 5.37 9.44
Modified duration 5.73 11.46 5.12 9.02
Rate Increases to 10% (5% Semiannually)
Estimated AP
-$130.51 -$198.15 -$153.74 -$270.45
Estimated AP / P
-1.72% -3.44% -1.54% -2.70%
Initial elasticity 0.2693 0.5387 0.2406 0.4242
Comparative price sensitivity
indicated by duration
• AP = - Duration [Ai / (1 + i)] P
• AP / P = - [Duration / (1 + i)] Ai
where Duration equals Macaulay's duration.
78
The relationship between duration
and actual changes in securities
prices
• The difference between the actual price-yield curve and
the straight line representing duration at the point of
tangency equals the error in applying duration to estimate
the change in bond price at each new yield.
• For both rate increases and rate decreases, the estimated
price, based on duration, will be below the actual price.
– For small changes in yield, such as yields near 10 percent, the
error is small.
– For large changes in yield, such as yields well above or well
below 10 percent, the error is large.
79
Duration and convexity
• The relationship between price and interest
rates is not the same for any change in interest
rates.
• Duration will generally be a ‘good’ estimate of
price volatility only for very small changes in
interest rates.
• The greater the change in interest rates, the less
accurate duration will be as a measure of price
volatility.
80
Convexity
• Convexity is a measure of the rate of change of
Rupee duration as yields change.
• Duration, increases as yields decline and
lengthens as yields increase for all option free
bonds.
– This is positive feature for buyers of bonds because as yields
decline, price appreciation accelerates.
– As yields increase, duration for option free bonds decreases, once
again reducing the rate at which price declines.
• This characteristic is called positive convexity--
the underlying bond becomes more price
sensitive when yields decline and less price
sensitive when yields increase.
81
Convexity
• The actual
reduction in
price will be
less than that
predicted by
duration with
an increase in
interest rates.
Change in price predicted by duration
yield
Price
Actual change in price
82
Net interest income or the market
value of stockholders' equity?
• Banks typically focus on either:
– net interest income or
– the market value of stockholders' equity
as a target measure of performance.
• GAP models are commonly associated with net interest
income (margin) targeting.
• Earnings sensitivity analysis
…provides information regarding how much NII
changes when rates are assumed to increase or fall by
various amounts.
83
Interest rate risk
• Reinvestment rate risk
... the risk that a bank can not reinvest cash flows from assets
or refinance rolled over or new liabilities at a certain rate in
the future
–Cost of funds versus the return on assets
• ¬ Funding GAP, impact on NII
• Price Risk
… changes in interest rates will also cause a change in the
value (price) of assets and liabilities
–Longer maturity (duration)
• ¬ larger change in value for a given change in interest
rates
84
Rate sensitive assets and liabilities
• Those assets and liabilities management expects to
be repriced within a fixed time interval.
• They include:
– maturing instruments,
– floating and variable rate instruments, and
– any full or partial principal payments.
• A bank's GAP is defined as the difference between a
bank's rate sensitive assets and rate sensitive
liabilities.
• It is a balance sheet figure measured in Rupees for
Indian banks over a specific period of time.
85
What determines rate sensitivity?
• In general, an asset or liability is normally classified as
rate-sensitive with a time frame if:
1. It matures
2. It represents and interim, or partial, principal payment
3. The interest rate applied to outstanding principal
changes contractually during the interval
4. The outstanding principal can be repriced when some
base rate of index changes and management expects
the base rate / index to change during the interval
86
Funding GAP
• Focuses on managing NII in the short run.
• Method
– Group assets and liabilities into time "buckets”
according to when they mature or are expected to
re-price
– Calculate GAP for each time bucket
– Funding GAP
t
= Value RSA
t
- Value or RSL
t
• where t = time bucket; e.g., 0-3 months
87
Expected balance sheet for
hypothetical bank
88
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 8.0% 600 4.0%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000
GAP = 500 - 600 = -100
NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)
NIM = 41.3 / 850 = 4.86%
NII = 78.5 - 37.2 = 41.3
Factors affecting net interest income
• 1% increase in the level of all short-term rates
• 1% decrease in spread between assets yields and
interest cost
– RSA increase to 8.5%
– RSL increase to 5.5%
• Proportionate doubling in size.
• Increase in RSA’s and decrease in RSL’s
– RSA = 540, fixed rate = 310
– RSL = 560, fixed rate = 260.
89
1% increase in short-term rates
90
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 9.0% 600 5.0%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000
GAP = 500 - 600 = -100
NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)
NIM = 40.3 / 850 = 4.74%
NII = 83.5 - 43.2 = 40.3
Changes in NII are directly proportional to the
size of the GAP
• ANII
exp
= (GAP) * (A i
exp
)
• The larger is the GAP, the greater is the change
in NII.
• *This applies only in the case of a parallel shift
in the yield curve, which is rare.
– If rates do not change by the same amount, then
the GAP may change by more or less.
91
Positive and negative gap’s
• Positive GAP
…indicates a bank has more rate sensitive assets than
liabilities, and that net interest income will generally
rise (fall) when interest rates rise (fall).
• Negative GAP
…indicates a bank has more rate sensitive liabilities
than rate sensitive assets, and that net interest income
will generally fall (rise) when interest rates rise (fall).
92
Optimal value for a bank’s GAP?
• There is no general optimal value for a bank's GAP in all
environments.
• GAP is a measure of interest rate risk.
• The best GAP for a bank can be determined only by
evaluating a bank's overall risk and return profile and
objectives.
• Generally, the farther a bank's GAP is from zero, the
greater is the bank's risk.
• Many banks establish GAP policy targets to control
interest rate risk by specifying that GAP as a fraction of
earning assets should be plus or minus 15%, or the
ratio of RSAs to RSLs should fall between 0.9 and 1.1.
93
Advantages / disadvantages of GAP
• The primary advantage of GAP analysis is its
simplicity.
• The primary weakness is that it ignores the time
value of money.
• GAP further ignores the impact of embedded
options.
• For this reason, most banks conduct earnings
sensitivity analysis, or pro forma analysis, to
project earnings and the variation in earnings
under different interest rate environments.
94
Earnings sensitivity analysis
• Allows management to incorporate the impact
of different spreads between asset yields and
liability interest costs when rates change by
different amounts.
• Shifts in the yield curve are rarely parallel!
• It is well recognized that banks are quick to
increase base loan rates but are slow to lower
base loan rates when rates fall.
95
Earnings sensitivity analysis
1. Forecast future interest rates,
2. Identify changes in the composition of assets and
liabilities in different rate environments,
3. Forecast when embedded options will be exercised,
4. Identify when specific assets and liabilities will reprice
given the rate environment,
5. Estimate net interest income and net income, and
6. Repeat the process to compare forecasts of net
interest income and net income across rate
environments.
96
Risk Exposure Analysis
• Deal with credit worthy counterparties
• To understand and evaluate risk
• Evaluate the level and trends of the bank’s
aggregated rate risk exposure, particularly
interest rate
• Evaluate the sensitivity and reasonableness of
key assumptions – shape of yield curve,
anticipated pace of loan repayments, deposit
withdrawals
• Verify compliance with established/ prescribed
risk tolerance levels and limits and identify any
policy exceptions
• Determine whether the bank holds sufficient
capital for the risk being taken
97
Stress Testing
• Sensitivity Test – assess the impact of large
movements in financial variables on portfolio
values
• Scenario Test – constructed either within the
context of a specific portfolio or in light of
historical events common across portfolios
• Risk managers identify portfolio’s key financial
drivers and then formulate scenarios in which
these scenarios are stressed beyond standard
VaR levels.
• Hybrid scenarios are commonly used
98
Valuation of fixed income securities
• Traditional fixed-income valuation methods
are too simplistic for three reasons:
1. Investors do not hold securities until maturity
2. Present value calculations assumes all coupon
payments are reinvested at the calculated Yield to
Maturity
3. Many securities carry embedded options, such as
a call or put, which complicates valuation since it
is unknown if the option will be exercised.
99
Total return analysis
• Market participants attempt to estimate the
actual realized yield on a bond by calculating an
estimated total return
= [Total future value / Purchase price]
(1/n)
- 1
100
Money market yields
• Interest rates for most money market yields
are quoted on a different basis.
• In particular, some money market
instruments are quoted on a discount basis,
while others bear interest.
• Some yields are quoted on a 360-day year
rather than a 365 or 366 day year.
101
Interest-bearing loans with
maturities of one year or less
• The effective rate of interest depends on the term of
the loan and the compounding frequency.
• A one year loan which requires monthly interest
payments at 12% annually, carries an effective yield to
the bank of 12.68%:
– i* = (1 + 0.12/12)
12
- 1 = 12.68%
• If the same loan was made for 90 days:
– i* = [1 + 0.12 / (365/90)]
(365/90)
- 1 = 12.55%
• In general:
– i* = [1 + i / (365 / h)]
(365/h)
- 1
102
360-day versus 365-day yields
• Some securities are reported using a 360 year rather
than a full 365 day year.
• This will mean that the rate quoted will be 5 days too
small on a standard annualized basis of 365 days.
• To convert from a 360-day year to a 365-day year:
– i
365
= i
360
(365/360)
• Example: one year instrument at 8% nominal rate on a
360-day year is actually an 8.11% rate on a 365-day
year:
– i
365
= 0.08 (365/360) = 0.0811
103
Discount yields
• Some money market instruments, such as Govt. T-
Bills, are quoted on a discount basis.
• This means that the purchase price is always below
the par value at maturity.
• The difference between the purchase price and par
value at maturity represents interest.
• The pricing equation for a discount instrument is:
i
dr
= [(P
f
- P
o
) / P
f
] (360 / h)
where
i
dr
= discount rate
P
o
= initial price of the instrument
P
f
= final price at maturity or sale,
h = number of days in holding period.
104
The bond equivalent rate on discount
securities
• The problems of a 360-day year for a rate quoted on a discount
basis can be handled by converting the discount rate to a bond
equivalent rate: (i
be
)
– i
be
= [(P
f
- P
o
) / P
o
] (365 / h)
• Example: consider a 1 million T-bill with 182 days to maturity,
price = 964,500.
The discount rate is 7.02%,
i
dr
= [(1,000,000 - 964,500) / 1,000,000] (360 / 182)
= 0.072
The bond equivalent rate is 7.38%:
i
dr
= [(1,000,000 - 964,500) / 964,500] (365 / 182)
= 0.0738
The effective annual rate is 7.52%:
i* = [1 + 0.0738 / (365 / 182)]
(365/ 182)
- 1 = 0.0752
105
Yields on single-payment interest-
bearing securities
• Some money market instruments, such as large
negotiable CD’s, Eurodollars, and Govt. funds, pay
interest calculated against the par value of the security
and make a single payment of interest and principal at
maturity.
• Example: consider a 182-day CD with a par value of
1,000,000 and a quoted rate of 7.02%.
Actual interest paid at maturity is:
– (0.0702)(182 / 360) 1,000,000 = 35,490
– The 365 day yield is:
i
365
= 0.0702(365 / 360) = 0.0712
– The effective annual rate is 7.31%:
i* = {1 + [0.0712 / (365 / 182)]}
(365/182)
- 1 = 0.0724
106
Summary of money market yield quotations
and calculations
• Simple Interest i
s
:
• Discount Rate i
dr
:
• Money Mkt 360-day rate, i
360
• Bond equivalent 365 day rate, i
365
or i
be
:
• Effective ann. interest rate,
Definitions
P
f
= final value
P
o
= initial value
h=# of days in holding
period
Discount Yield quotes:
Treasury bills
Repurchase agreements
Commercial paper
Bankers acceptances
Interest-bearing, Single
Payment:
Negotiable CDs
Federal funds
107
o
o f
s
p
p p
i
÷
=
h
360
p
p p
i
f
o f
dr
÷
=
h
360
p
p p
i
o
o f
360
÷
=
h
365
p
p p
i
o
o f
be
÷
=
1
365/h
i
1 i
365/h
*
÷
(
¸
(
¸
+ =
THE LEVEL OF INTEREST
RATES
108
What are Interest Rates?
• Rental price for money.
• Penalty to borrowers for consuming before
earning.
• Reward to savers for postponing consumption.
• Expressed in terms of annual rates.
• As with any price, interest rates serve to
allocate resources.
109
The Real Rate of Interest
• Producers seek financing for real assets. Expected
ROI is upper limit on interest rate producers can
pay for financing.
• Savers require compensation for deferring
consumption. Time value of consumption is
lower limit on interest rate at which savers will
provide financing.
• Real rate occurs at equilibrium between desired
real investment and desired saving.
110
Determinants of the Real Rate of
Interest
111
Loanable Funds Theory
• Supply of loanable funds—
– All sources of funds available to invest in
financial claims
• Demand for loanable funds—
– All uses of funds raised from issuing financial
claims
• Equilibrium interest rate
112
Supply of loanable funds—
• All sources of funds available to invest
in financial claims:
– Consumer savings
– Business savings
– Government budget surpluses
– Central Bank Action
113
Demand for Loanable Funds
• All uses of funds raised from issuing financial
claims:
Consumer credit purchases
Business investment
Government budget deficits
114
Equilibrium Interest Rate
• If competitive forces operate in financial
sector, laws of supply and demand will
bring rates into equilibrium.
• Equilibrium is temporary or dynamic: Any
force that shifts supply or demand will tend
to change interest rates.
115
Loanable Funds Theory
116
Loanable Funds Theory
117
Loanable Funds Theory
118
Loanable Funds Theory
119
Price Expectations and Interest Rates
• Unanticipated inflation benefits borrowers at
expense of lenders.
• Lenders charge added interest to offset
anticipated decreases in purchasing power.
• Expected inflation is embodied in nominal
interest rates: The Fisher Effect.
120
Fisher Effect
The exact Fisher equation is:
121
( ) ( )( )
inflation. of rate annual expected the
interest, of rate real the r
interest, of rate nominal observed the i
where
1 1 1
= A
=
=
A + + = +
e
e
P
P r i
Fisher Effect
From the Fisher equation, we derive the nominal
(contract) rate:
We see that a lender gets compensated for:
rental of purchasing power
anticipated loss of purchasing power on the principal
anticipated loss of purchasing power on the interest
122
( )
e e
P r P r i A + A + = *
Fisher Effect: Example
• 1-year 1000 loan
• Parties agree on 3% rental rate for money and
• 5% expected rate of inflation.
– Items to pay Calculation Amount
– Principal 1,000.00
– Rent on money 1,000 x 3% 30.00
– PP loss on principal 1,000 x 5% 50.00
– PP loss on interest 1,000 x 3% x 5% 1.50
– Total Compensation 1,081.50
123
Simplified Fisher Equation
The third term in the Fisher equation is negligible, so
it is commonly dropped. The resulting equation is
124
e
P r i A + =
Expectations ex ante v.
Experience ex post
Realized rates of return reflect impact of
inflation on past investments.
r = i - AP
a
, where the "realized" rate of return
from past transactions, r, equals the nominal rate
minus the actual annual rate of inflation.
As inflation increases, expected inflation
premiums, P
e
, may lag actual rates of inflation,
P
a
, yielding low or even negative actual returns.
125
126
Impact of Inflation under Loanable Funds Theory
127
Interest Rate Movements and
Inflation
• Historically, interest rates tend to change with
changes in the rate of inflation, substantiating
the Fisher equation.
• Short-term rates are more responsive to
changes in inflation than long-term rates.
128
THE STRUCTURE OF
INTEREST RATES
129
Factors that Influence Interest Rate
Differences
• Term to Maturity.
• Default Risk.
• Tax Treatment.
• Marketability.
• Call or Put Features.
• Convertibility.
130
Term (Maturity) Structure
• May be studied visually by plotting a yield curve
at a point in time
• A yield curve is a smooth line, which shows the
relationship between maturity and a security's
yield at a point in time.
• The yield curve may be ascending (normal), flat,
or descending (inverted).
• Several theories explain the shape of the yield
curve.
131
Yield Curves
132
The Expectations Theory
• The shape of the yield curve is determined solely
by expectations of future interest rate
movements, and changes in these expectations
lead to changes in the shape of the yield curve .
– Ascending: future interest rates are expected to
increase.
– Descending: future interest rates are expected to
decrease.
• Long-term interest rates represent the geometric
average of current and expected future (implied,
forward) interest rates.
133
Term Structure Formula
134
( ) ( )( )( ) ( ) | |
bond. the of maturity
, applicable is rate the for which period time
rate, forward the
rate, market observed the
: where
1 1 1 1 1
1
1 1 1 2 1 1 1
=
=
=
=
+ + + + = +
÷ + + +
n
t
f
R
f f f R R
n
n t t t t n t
?
An Implied One Year Forward Rate
135
1
1
1
1
1
1 1
÷
÷
÷ +
n
n t
n
n t
n t
R
R
f
Finding a One-Year Implied
Forward Rate
• Using the term structure of interest rates from
September 1, 2004, find the one-year implied
forward rate for year three.
– 1-year Treasury note 1.95%
– 2-year Treasury note 2.39%
– 3-year Treasury note 2.71%
3.35% or f 0335 . 0 1
0239 . 1
0271 . 1
2
3
1 3
= ÷
(
¸
(
¸
+
+
=
136
Liquidity Premium Theory
• Long-term securities have greater risk and
investors require greater premiums to give
up liquidity.
– Long-term securities have greater price
variability.
– Long-term securities have less marketability.
• The liquidity premium explains an upward
sloping yield curve.
• Liquidity premiums change over time.
137
Market Segmentation Theory
• Maturity preferences by investors may affect
security prices (yields), explaining variations in
yields by time
• Market participants have strong preferences for
securities of particular maturity and buy and sell
securities consistent with their maturity
preferences.
• If market participants do not trade outside their
maturity preferences, then discontinuities are
possible in the yield curve.
138
Preferred Habitat Theory
• The Preferred Habitat Theory is an extension of
the Market Segmentation Theory.
• The Preferred Habitat Theory allows market
participants to trade outside of their preferred
maturity if adequately compensated for the
additional risk.
• The Preferred Habitat Theory allows for humps or
twists in the yield curve, but limits the
discontinuities possible under Segmentation
Theory.
139
Which Theory is Right?
• Day-to-day changes in the term structure
are most consistent with the Preferred
Habitat Theory.
• However, in the long-run, expectations of
future interest rates and liquidity premiums
are important components of the position
and shape of the yield curve.
140
Yield Curves and the Business Cycle
Interest rates are directly related to the level of
economic activity.
– An ascending yield curve notes the market
expectations of economic expansion and/or
inflation.
– A descending yield curve forecasts lower rates
possibly related to slower economic growth or
lower inflation rates.
• Security markets respond to updated new
information and expectations and reflect their
reactions in security prices and yields.
141
Yield-Curve Patterns Over the
Business Cycle
142
Uses of the Yield Curve
• At any point in time, the slope of the yield curve
can be used to assess the general expectations of
borrowers and lenders about future interest
rates!
• Investors can use the yield curve to identify
under-priced securities for their portfolios.
• Issuers may use the yield curve to price their
securities.
• Investors use the yield curve for a strategy known
as riding the yield curve.
143
Default Risk
• It is the probability of the borrower not
honoring the security contract
• Losses may range from “interest a few days
late” to a complete loss of principal.
• Risk averse investors want adequate
compensation for expected default losses.
144
Default Risk
• Investors charge a default risk premium (above
riskless or less risky securities) for added risk
assumed
• DRP = i - i
rf
• The default risk premium (DRP) is the difference
between the promised or nominal rate and the
yield on a comparable (same term) riskless
security (Treasury security).
• Investors are satisfied if the default risk premium
is equal to the expected default loss.
145
Risk Premiums
146
Default Risk
• Default risk premiums increase (widen) in
periods of recession and decrease in
economic expansion
• In good times, risky security prices are bid
up; yields move nearer that of riskless
securities.
• With increased economic pessimism,
investors sell risky securities and buy
“quality” widening the DRP.
147
Default Risk
• Credit rating agencies measure and grade
relative default risk security issuers
• Cash flow, level of debt, profitability, and
variability of earnings are indicators of
default riskiness.
• As conditions change, rating agencies alter
rating of businesses and governmental
debtors.
148
Corporate Bond-Rating Systems
149
Tax Effects on Yields
• The taxation of security gains and income affects
the yield differences among securities
• The after-tax return, i
at
, is found by multiplying the
pre-tax return by one minus the marginal tax rate.
i
at
= i
bt
(1-t)
• Municipal bond interest income is tax exempt.
• Coupon income and capital gains have been taxed
differently in the past.
150
To Buy a Municipal or a
Corporate Bond?
151
Impact of Marketability on
Interest Yields
• Marketability -- The costs and rapidity with
which investors can resell a security.
– Cost of trade.
– Physical transfer cost.
– Search costs.
– Information costs.
• Securities with good marketability have
higher prices (in demand) and lower yields.
152
Contract Options and Yields
• Varied option provisions may explain yield
differences between securities
• An option is a contract provision which
gives the holder the right, but not the
obligation, to buy, sell, redeem, or convert
an asset at some specified price within a
defined future time period.
153
Contract Options and Yields
• A call option permits the issuer (borrower) to
call (refund) the obligation before maturity
• Borrowers will “call” if interest rates decline.
• Investors in callable securities bear the risk of
losing their high-yielding security.
• With increased call risk, investors demand a
call interest premium (CIP).
– CIP = i
c
- i
nc
– A callable bond, i
c
, will be priced to yield a higher
return (by the CIP) than a noncallable, i
nc
, bond.
154
Contract Options and Yields
• A put option permits the investor (lender) to
terminate the contract at a designated price
before maturity
• Investors are likely to “put” their security or loan
back to the borrower during periods of increasing
interest rates. The difference in interest rates
between putable and nonputable contracts is
called the put interest discount (PID).
• PID = i
p
- i
np
• The yield on a putable bond, i
p
, will be lower than
the yield on the nonputable bond, i
np
, by the PIP.
155
Contract Options and Yields
• A conversion option permits the investor to
convert a security contract into another security
• Convertible bonds generally have lower yields,
i
con
, than nonconvertibles, i
ncon
.
• The conversion yield discount (CYD) is the
difference between the yields on convertibles
relative to nonconvertibles.
• CYD = i
con
- i
ncon
. Investors accept the lower yield
on convertible bonds because they have an
opportunity for increased rates of return through
conversion.
156
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