Description
Profitability Ratios Asset Quality Ratios, Capital Adequacy Ratios, Liquidity Ratios and Valuation Ratios, different types of techniques to measure risks, indian debt and bonds market, interest rate swaps, CBLO and index futures
MANAGING NONINTEREST INCOME AND NONINTEREST EXPENSE
Key Profitability Ratios in Banking
Net Income After Taxes Return on Equity Capital (ROE) ? Total Equity Capital
Net IncomeAfter Taxes Return on Assets (ROA) ? Total Assets
Net Interest Income Net Interest Margin ? Total Assets
Net Noninterest Income Net Noninterest Margin ? Total Assets
2
Key Profitability Ratios in Banking
Total Operating Revenues Total Operating Expenses Net Bank Operating Margin ? Total Assets
Net Income After Taxes Earnings Per Share (EPS) ? Common Equity Shares Outstanding
3
Breaking Down ROE
ROE = Net Income/ Total Equity Capital
ROA = Net Income/Total Assets
x
Equity Multiplier = Total Assets/Equity Capital
Net Profit Margin = Net Income/Total Operating Revenue
x
Asset Utilization = Total Operating Revenue/Total Assets
4
Bank Performance Model
Returns to Shareholders ROE = NI / TE Interest INCOME Non Interest Return to the Bank ROA = NI / TA Interest
Rate Composition (mix) Volume Fees and Serv Charge Trust Other Rate Composition (mix) Volume
EXPENSES Overhead Degree of Leverage EM = 1 / (TA / TE) Prov. for LL Taxes
Salaries and Benefits
Occupancy Other
5
Five categories of banking ratios
• Profitability Ratios • Asset Quality Ratios • Capital Adequacy Ratios • Liquidity Ratios • Valuation Ratios
6
Return on equity (ROE = NI / TE)
• The measure of stockholders’ returns • ROE is composed of two parts:
• Return on Assets (ROA = NI / TA)
• represents the returns to the assets the bank has invested in
• Equity Multiplier (EM = TA / TE)
• the degree of financial leverage employed by the bank. Leverage or Financing Policies
7
Profitability
• ROA Decomposition:
• ROA= Profit Margin (PM)*Asset Utilization (AU)
ROA ? Net Income Total Oper ating Income ? Total Operating Income Total Asse ts
• Profit Margin: measures a bank’s ability to control expenses and reduce taxes. Effectiveness of Expense Management • Asset Utilization: represents the gross yield on assets. Portfolio Management Policies
8
ROA
• ROA is driven by the bank’s ability to generate income (AU) and control expenses (ER) • Income generation (AU) as:
Int. Inc. Non. int. Inc. Sec gains (losses) AU ? ? ? TA TA TA ? Expense Control (ER) as:
Int. Exp. Non ? int . Exp. PLL ER ? ? ? TA TA TA
*
? Note, ER* does not include taxes.
9
Expense ratio (ER = Exp / TA)
• The ability to control expenses • Interest expense / TA
• Cost per liability (rate)
• Composition of liabilities • Volume of debt and equity
• Non-interest expenses / TA
• Salaries and employee benefits / TA • Occupancy expenses / TA • Other operating expense / TA
• Provisions for loan losses / TA
• Taxes / TA
10
Asset utilization (AU = TR / TA):
• The ability to generate income • Interest Income / TA
• Asset yields (rate) • Composition of assets (mix)
• Volume of Earning Assets
• Non interest income / TA
• Fees and Service Charges • Securities Gains (Losses) • Other income
11
Aggregate profitability measures
• Net interest margin
• NIM = NII / earning assets (EA)
• Spread
• Spread = (int inc / EA) ? (int exp / int bear. Liab.)
• Earnings base
• Eb = EA / TA
• Burden / TA
• (Noninterest exp. - Noninterest income) / TA
• Efficiency ratio
• Non int. Exp. / (Net int. Inc. + Non int. Inc.)
12
Asset Quality Ratios
• Adequacy of Loan Loss Allowance:
• Loss allowance to loans
• Allowance for loan and lease losses as a percent of total loan and lease financing receivables, excluding unearned income. • This measures whether the loan loss allowance is adequate to cover potential loan losses.
13
Capital Adequacy Ratios
• Equity capital to assets • Total equity capital as a percent of total assets. • Core capital (leverage) ratio • Tier 1 (core) capital as a percent of average total assets minus ineligible intangibles. • Tier 1 (core) capital includes: common equity plus noncumulative perpetual preferred stock plus minority interests in consolidated subsidiaries less goodwill and other ineligible intangible assets, includes loan loss reserves, preferred stock, and mandatory convertible debt. • Total Capital = Tier 1 capital + Tier 2 capital
14
Capital Adequacy Ratios
• Total Risk-Based Capital Ratio
• Total risk based capital as a percent of risk-weighted assets as defined by RBI • Banks must meet minimum ratio of capital to risk-weighted
assets of 9%, with at least 4% taking the form of Tier (1)
capital.
15
Liquidity Ratios
• Asset Liquidity Ratios:
• Current Ratio
• Liability Liquidity Ratios:
• Net Loans and leases to deposits
• Loans and lease financing receivables net of unearned income as a percent of total deposits. • This ratio is an indicator of a bank’s ability to support loan growth with deposits.
16
Liquidity Ratios
• Net loan and leases to core deposits:
• Loan and lease financing receivables, net of allowances and reserves, as a percent of total domestic deposits, less time deposits of Rs.1 lac or more.
• Net noncore funding dependence ratio
• (Noncore Liabilities – Short-term investments)/Long-term assets.
• This ratio highlights how dependent a bank is on volatile
funding sources; the ratio attempts to measure a bank’s ability to withstand the sudden loss of its noncore liabilities.
17
Fundamental risks
• Credit risk
• Liquidity risk • Market risk • Operational risk • Capital or solvency risk
• Legal risk
• Reputational risk
18
Areas of Concentration
• Credit Risk Loans and Securities quality & type
• Liquidity Risk S/T to L/T composition of Assets and Liabs
• Market Risk Int Rate sensitivity of Assets & Liabs (GAP) • Operating Risk Employee usage and efficiency • Legal Risk Lawsuits, Contract Exposure, negative publicity
• Capital/Solvency Risk Equity Capital used and availed vs. Risk categories of usage
19
Credit risk
• The potential variation in net income and market value of equity resulting from nonpayment or delayed payment • • The Probability that Some of the Bank’s Assets Will
Decline in Value and Perhaps Become Worthless
Three Question need to be addressed:
1. 2. 3. What has been the loss experience? What amount of losses do we expect? How prepared is the bank?
20
Credit Risk Measures
• • • • • Nonperforming Loans/Total Loans Net Charge-Offs/Total Loans Provision for Loan Losses/Total Loans Provision for Loan Losses/Equity Capital Total Loans/Total Deposits
21
Liquidity risk
• The variation in net income and market value of equity caused by a bank's difficulty in obtaining cash at a reasonable cost from either the sale of assets or new borrowings Probability the Bank Will Not Have Sufficient Cash and Borrowing Capacity to Meet Deposit Withdrawals and Other Cash Needs Banks can acquire liquidity in two distinct ways:
1.
•
•
•
By liquidation of assets.
Composition of investments
•
Maturity of investments
2.
• •
By borrowing.
Core deposits Volatile deposits
22
Liquidity Risk Measures
• Net Loans/Total Assets • Cash and Due from Banks/Total Assets • Cash and Government Securities/Total Assets
23
Market risk
• The risk to a financial institution’s condition resulting from adverse movements in market rates or prices • Probability of the Market Value of the Bank’s Investment Portfolio Declining in Value Due to a Rise
in Interest Rates
• Market risk arises from changes in:
• Interest rates • Foreign exchange rates • Equity and security prices.
24
Market Risk Measures
• • • • Book-Value of Assets/ Market Value of Assets Book-Value of Equity/ Market Value of Equity Book-Value of Bonds/Market Value of Bonds Market Value of Preferred Stock and Common Stock
25
Interest Rate Risk
• The Danger that Shifting Interest Rates may adversely affect a Bank’s Net Income, the Value of its Assets or Equity
26
Interest Rate Risk Measures
• Interest Sensitive Assets/Interest Sensitive Liabilities • Uninsured Deposits/Total Deposits
27
Earnings Risk
The Risk to the Bank’s Bottom Line – Its Net Income After All Expenses
28
Earnings Risk Measures
• Standard Deviation of Net Income • Standard Deviation of ROE • Standard Deviation of ROA
29
Foreign exchange risk
• The risk to a financial institution’s condition resulting from adverse movements in foreign exchange rates • Foreign exchange risk arises from changes in foreign exchange rates that affect the values of assets,
liabilities, and off-balance sheet activities denominated
in basket of international currencies. • This risk is often found in off-balance sheet loan commitments and guarantees denominated in foreign currencies; foreign currency translation risk.
30
Equity and security price risk
• Change in market prices, interest rates and foreign
exchange rates affect the market values of equities,
fixed income securities, foreign currency holdings, and associated derivative and other off-balance sheet contracts • Large banks must conduct value-at-risk analysis to
assess the risk of loss with their trading account
portfolios.
31
Operational risk
• Measures the cost efficiency of the bank's activities; i.e., expense control or productivity • Typical ratios focus on:
• total assets per employee • total personnel expense per employee • noninterest expense ratio
• There is no meaningful way to estimate the likelihood of fraud or other contingencies from published data
• A bank’s operating risk is closely related to its operating policies and processes and whether it has adequate controls
32
Capital risk
• Closely tied to asset quality and a bank's overall risk profile • The more risk taken, the greater is the amount of capital required. • Appropriate risk measures include all the risk measures -
measuring the ratio of:
• tier 1 capital and total risk based capital to risk weighted assets, • equity capital to total assets, • dividend payout, and growth rate in tier 1 capital.
33
Capital Risk Measures
• Stock Price/Earnings Per Share • Equity Capital/Total Assets • Equity Capital/Risk Assets
34
Trading Risk
• If the price at which an instrument is purchased differs from the price at which it is sold, the risk is that the instrument may go down in value rather than up. • This type of risk is called trading risk
35
Legal risk
• The potential that unenforceable contracts, lawsuits, or adverse judgments can disrupt or otherwise negatively affect the operations or condition of banking organization • Legal risk include:
• Compliance risks • Strategic risks • General liability issues
36
Other Risks
• Foreign exchange risk comes from holding assets denominated in one currency and liabilities denominated in another • Sovereign risk arises from the fact that some foreign
borrowers may not repay their loans, not because
they are unwilling to, but because their government prohibits them from doing so.
37
Other Forms of Risk in Banking
• • • • Inflation Risk Currency or Exchange Rate Risk Political Risk Crime Risk
38
CAMELS Ratings
• C - Capital Adequacy • A - Asset Quality • M - Mgmt Quality, Mgmt & BoD ability and systems
(policies & procedures)
• E - Earnings, not just quantity, but quality,
sustainability
• L - Liquidity • S - Sensitivity to market fluctuations, Interest rates,
FX, Commodity prices (thru loans)
39
Traditional bank performance -three basic flaws
1. Ignores the wide diversity in strategies pursued by different institutions – banks may pursue sharply different strategies 2. A bank’s total assets no longer serve as a meaningful yardstick when banks engage in off-balance sheet activities – bank with servicing income profit will report a higher ROA, due to higher noninterest income 3. The analysis provides no direct information concerning how or which of the bank’s activities contribute to the creation of shareholder value – ignores other performance benchmarks that customer-focused managers must consider to identify the best strategies going forward
40
ROE
• When considering the entire bank, stockholders’ equity must support all activities, whether on- or off-balance sheet. • Thus, a comparison of net income to equity captures the returns to owners’ contributions.
41
The appropriate peer group
• As long as banks have a similar strategic focus and offer similar products and services, asset size and ratios can provide meaningful comparisons. To identify the appropriate peer institutions, management should consider the following:
1. What is the bank’s strategic focus? 2. What are the traditional balance sheet and offbalance sheet characteristics of firms with this focus? 3. How do the bank’s activities affect its operating revenue?
•
42
Accounting data and ratios
• A bank should compare its ratios with those from a select sample of peer institutions that are similarly loan-driven or deposit-driven. • Peers should operate the same approximate number of offices in the same metropolitan or non-metropolitan markets and have the same product and service mix. • Asset-based ratios are thus directly comparable. • Analysts can easily construct peer bank averages by direct comparison to other similar Banks
43
Total Operating Revenue
• Fundamentally this means calculate performance measures using total operating revenue as the denominator rather than assets.
• Here, total operating revenue equals the sum of net interest income and noninterest income.
44
The efficiency ratio
• Measured as noninterest expense divided by total operating revenue, is a popular measure used by stock analysis based on operating revenue rather than assets.
• Analysts strongly encourage banks, regardless of size, to meet fairly specific targets in this ratio.
• Because operating revenue includes both interest income and noninterest (fee-based) income, it captures all activities.
• Efficiency Ratio
= noninterest expense / net operating revenue
where net operating revenue = the sum of net interest income + noninterest income.
45
Standard procedure - evaluating firm performance
• Initially use financial information to calculate performance measures
• adjust the data to omit the impact of nonrecurring items, such as one-time asset sales and restructuring charges • compare these historical ratios with a carefully selected group of peer institutions, matching each bank’s primary strategic focus
• Based on analysis and conversations with specialists within the bank, then assesses the quality of earnings based on:
• their sustainability • the bank’s market power in specific product or service areas • the bank’s franchise value
• Forecast earnings, cash flow, and market value of equity over a three- to five-year time horizon • The analyst makes a stock recommendation:
• accumulate (buy) • neutral (hold) • below-market performance (sell)
46
Investors
• When analysts compare performance over some historical period, they are less concerned with ROE, ROA, and efficiency ratios – rather the overall total return from investing in the bank’s stock. • Total return equals dividends received plus stock price appreciation/depreciation relative to the initial investment.
47
Key stock market-based performance
• Return to stockholders = (Dprice + dividends) / pricet-1
• Earnings per share
?
?NI after taxes and dividends on preferred stock number of shares of common s tock outstanding
• Price to earnings (P/E) = stock price / EPS • Price to book value = stock price / book value per share
• Market value (MV) of equity = MV of assets - MV of liabilities or = # share of common stock x stock price
48
Value of the Bank’s Stock
E(D t) P0 ? ? t t ? 0 (1 ? r)
49
?
Value of a Bank’s Stock Rises When:
• Expected Dividends Increase • Risk of the Bank Falls • Combination of Expected Dividend Increase and Risk Decline
50
Value of Bank’s Stock if Earnings Growth is Constant
D1 P0 ? r-g
51
Example:
• Buy 100 shares of ABC Bank at the beginning of 2006 for Rs.73.06. The bank paid Rs.1.92 per share in dividends that generated reinvestment income of Rs.09. At the end of 2006, the price of stock was Rs.56.20. • Return to stockholders in 2006 was?
52
Example:
• Buy 100 shares of ABC Bank at the beginning of 2006 for Rs.73.06. The bank paid Rs.1.92 per share in dividends that generated reinvestment income of Rs.09. At the end of 2006, the price of stock was Rs.56.20. • Return to stockholders in 2006 was -20.3%. -0.203 = [56.20 - 73.06 + 2.01] ÷ 73.06
53
Line of business profitability analysis
• By allocating operating expenses to activities that support bank customers and bank management, banks can obtain at least a rough estimate of segment net income. • Reporting based on specific customers. • Many banks attempt to measure profitability by:
• type of loan customer (small business, middle market, consumer installment, etc.)
• type of depositor; by characteristics of the relationship (account longevity, cross-sell patterns, profitability, etc.) and • delivery system (branch, ATM, telephone, home banking, etc.).
54
RAROC/RORAC analysis
• RAROC refers to risk-adjusted return on capital, while RORAC refers to return on risk-adjusted capital
• In order to analyze profitability and risk precisely, each line of business must have its own balance sheet and income statement.
• These statements are difficult to construct because many nontraditional activities, such as trust and mortgage-servicing, do not explicitly require any direct equity support. • Even traditional activities, such as commercial lending and consumer banking, complicate the issue because these business units do not have equal amounts of assets and liabilities generated by customers. • The critical issue is to determine how much equity capital to assign each unit.
55
Assigning equity capital to each unit
• The objective of RAROC analysis is to assist in risk management and the evaluation of line of business performance. It is necessary to assign capital to each line of business • Banks allocate risk capital by: 1. Regulatory risk-based capital standards 2. Asset size 3. Benchmarking versus “pure-play” stand-alone businesses 4. Perceived riskiness of the business unit • Unfortunately, most lines of business do not have market value balance sheets. • Many banks focus on the volatility in economic earnings (earnings-at-risk) or estimate a value-at-risk figure.
56
RAROC/RORAC
• Risk adjust return on capital (RAROC)
• RAROC = Risk-adjusted income / Allocated capital
• Using this method, income is adjust for risk. • Typically, income is adjusted for expected losses.
• Return on risk adjusted capital (RORAC)
• RORAC = Net income / Allocated risk capital
• Using this method, capital is adjusted for risk. • Typically, capital is adjusted for a maximum potential loss based on the probability of future returns or volatility of earnings.
57
Risk-adjusted income and economic income
• Two adjustments are frequently made to income in line of business profitability analysis:
1.
2.
The return is adjusted for risk by subtracting expected losses The return nets out required returns expected by stockholders.
•
•
This minimum required return, or cost of equity, represents a hurdle rate, or stockholders’ minimum required rate of return. The specific concern is whether RAROC is greater than the firm’s cost of equity.
58
Earnings-at-risk
• Securities underwriting and letters of credit (guarantees) against customer exposures at a large bank do not require much capital to support day-to-day operations. • One way to measure the required risk capital is to relate it to the volatility of earnings from this line of business; i.e., earnings-at-risk.
59
Earnings-at-risk applied to loans
1. Using historical data for each of the past 30 months, estimate revenues obtained directly from these loans. 2. Using historical data for each of the past 30 months, estimate direct expenses from offering these services and expected losses. 3. Using the 60 observations for revenues minus expenses and losses, estimate one standard deviation of earnings. This is earnings-at-risk.
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Management of market risk
• Market risk is the risk of loss to earnings and capital related to changes in the market values of bank assets, liabilities, and offbalance sheet positions • RBI imposes special capital requirements against the market risk associated with large banks’ trading positions.
• Market risk arises from taking positions and dealing in foreign exchange, equity, interest rate, and commodity markets, and the items affected are the securities trading account, derivatives positions, and foreign exchange positions.
• The new capital requirements address market risk associated with a bank’s trading activities.
61
MVA/ EVA
• If the objective of the firm is to maximize
stockholders’ wealth, ROE/ ROA measures do not
indicate whether stockholder wealth has increased over time, let alone whether it has been maximized.
• Stern, Stewart & Company has introduced the
concepts of market value added (MVA) and its associated economic value added (EVA) in an attempt to directly link performance to shareholder wealth creation.
62
Economic value added (EVA)
• An approach to measuring performance that compares a bank’s (or line of business) net operating profit aftertax (NOPAT) with a capital charge • Economic Value Added (EVA) is the capital charge which represents the required return to stockholders assuming a specific allocated risk capital amount.
63
Market and economic value added
• MVA represents the increment to market value and is determined by the present value of current and expected economic profit:
MVA = Mkt Value of Capital - Hist. Amt of Invested Capital
• Stern Stewart and Company measures economic profit with EVA, which is equal to a firm's operating profit minus the charge for the cost of capital:
EVA = Net Operating Profit After Tax (NOPAT) - Capital Charge
where the capital charge equals the product of the firm’s value of capital and the associated cost of capital
64
Difficulties in measuring EVA for the entire bank
• It is often difficult to obtain an accurate measure of a firm's cost of capital. • The amount of bank capital includes not just stockholders' equity, but also includes loan loss reserves, deferred (net) tax credits, non-recurring items such as restructuring charges and unamortized securities gains. • NOPAT should reflect operating profit associated with the current economics of the firm. Thus, traditional accounting data, which distort true profits, must be modified to obtain estimates of economic profit.
65
A. Balance Sheet Assets Cash Securities Commercial loans Credit card loans -Loss reserve Other assets Total assets
$Millions $150 $800 $2000 $1900 -$100 -$250 $5,000
Rate 0 6.5% 9.0% 10.0%
Liabilities & Equity Demand deposits MMDAs CDs Small time deposits Deferred tax credits Equity Liabilities + equity
$Millions $800 $1800 $1300 $680 $100 - $320 $5,000
Rate 3% 5.5% 4.5%
Risk-weighted assets: .50($800) + 1($2,000) + 1($1,900) + 1($250) = $4,550 Tier 1 capital = $320 Total capital = $420 Tier I ratio: $320/$4,550 = 7.03% Total capital ratio: $420/$4,550 = 9.23% $422 -$156.1 $265.9 -$25 $60 -$190 $110.90 $44.36 $66.54
EVA calculation For Ameribank
B. Income Statement Interest income: .065($800) + .090($2,000) + .10($1,900) = Interest expense: .03($1,800) + .055($1,300) + .045($680) = Net interest income Provision for loan losses Noninterest income Noninterest expense Pre tax Income Taxes @ 40% Net income
C. Profit Measures ROE = (66.54 / 320 ) = 20.8% ROA = (66.54 / 5,000) = 1.33% Assuming that net charge-offs $22, cash taxes pai, = $39, and allocated risk capital $550 with a capital charge of 12%: NOPAT = $110.90 + $25 - $22 - $39 = $74.9 EVA = $74.9 - 0.12($550) = $8.9
66
EVA calculation for ameribank after sale of 1 billion in credit card loans
A. Change In Balance Sheet items Assets D Amount Credit card loans -$1,000 Loan loss reserve +$30 Total assets -$970 B. Income Statement
Liablilties CDs Equity Total
D Amount -$940 -$30 -$970 Change -$100 -$46.2 -$53.8 +$30.0 +$12 -$5 -$16.8 -6.72 -10.08
Interest income: .065($800) + .09($2,000) + .10($900) Interest expense: .03($1,800) + .055($460) + .045($680) Net interest income: Provision for loan losses: Noninterest income: Noninterest expense: Pre tax income: Taxes @ 40%: Net income: C.
$322 -$109.9 $212.1 +$5 $72 -$195 $94.1 $37.64 $56.46
Profit Measures: Actual net charge-oft $14, cash taxes paid = $31, and risk capital falls to $500. ROE = $56.46/$290 = 19.47% ROA = $56.46/$4,030 = 1.40% EVA = [$94.1 - $5 - $14 - $31] - $60 = -$15.9 Risk-weighted assets: .50($800) + 1($2,000) + 1($900) + 1($250) = $3,550 Tier 1 capital = $290 Tier I ratio: $290/$3,550 = 8.17% 67 Tier 2 capital = $420 Total capital ratio: $420/$3,550 = 11.83%
Balanced scorecard
• Performance measures that look beyond just financial measures • An attempt to balance management decisions based on financial measures with decisions based on a firm’s relationships with its customers and the effectiveness of support processes in designing and delivering products and services • The result is that line of business managers use indicators such as:
• market share, • customer retention and attrition, • customer profitability, and • service quality to evaluate performance
• Internally, they also track productivity and employee satisfaction Such nonfinancial indicators provide information regarding whether a bank is truly customer-focused and whether its systems are appropriate
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Balanced scorecard framework - 4 blocks
1. Financial Performance:
• How Do Stockholders View its Risk and Return Profile?
2. Customer Performance:
• How Do Customers See It?
3. Internal Process Management:
• At What Must It Excel?
4. Innovation and Learning:
• How Can It Continue to Improve and Create Value?
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Scorecard measures
Financial Measures Customer profitability Lifestyle segment profitability Product profitability Delivery channel cost Return on investment Revenue growth Deposit service cost change Revenue mix Sales growth and target markets Dollars past due divided by total dollar loans Customer Measures Life cycle segment market share Customer satisfaction Customer retention Market share Customer acquisition Customer profitability Share of segment Depth of relationship Brand name rating Number of customer complaints Internal Measures Channel usage Product usage Percentage of revenue from new products Learning Measures Skill competency Sales productivity Employer satisfaction
Percentage of revenue from product Employee retention promotions Product development cycle Hours with customer New product revenue Cross-sale ration Channel mix change Service error rate Request fulfillment time Loss ratio Underwriting quality audit Overhead ratio Ratio of branch to on-call transactions—ATM transactions Sales per sales call Sales per referral New sales divided by banker Productivity Efficiency ratio New product revenue as percent of total Employee satisfaction Employee productivity Strategic job coverage ratio Strategic information availability ratio Personal goals alignment Revenue per employee Sales force average length of service Turnover Training hours divided by FTE Number of training programs offered Turnover ratio Turbulence
Fee revenue divided by total revenue Closed accounts by reason Net income Share of wallet Return on risk-adjusted equity Net income after capital charge Cost of capital Efficiency Economic value added Assets per employee Percent of target accounts
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EVERGREENING
• A practice of `managing' the balance sheet through means, which may not be violating banking laws in letter but breaching them in spirit. • For example, one bank can lend money to a company, so that the company can pay off loan taken from some other bank. • In this way, the borrowal account with the second bank will not become NPA and thus it will be also to show reduced non-performing assets (NPAs). • The second bank can then extend a similar facility to another company, which has not been able to repay loans from the first bank. • This is the most common method of ever-greening.
EVERGREENING
• Another method of doctored balance sheet is done by some banks by disbursing large number of loans at the end of the year. • This way they can increase their advances portfolio and reduce the NPA in terms of percentage.
• Reserve Bank of India (RBI) issues stern warnings to public sector banks against any attempt to `evergreen' their balance sheets
What is CRR
• CRR means Cash Reserve Ratio. • Under section 42 (1) of RBI act, 1934, every scheduled commercial bank is required to maintain with the RBI every fortnight a minimum average daily cash reserve equivalent to 5% of its Net Demand and Time Liabilities (NDTL) outstanding as on the Friday of the previous week. • The RBI is empowered to vary the CRR between 3% and 15%.
What is CRR
• CRR is one of the important weapons available to the Central Bank of a country to influence and control the monetary aggregates of the country. • RBI is using the CRR either to impound the excess liquidity or to release funds needed for the economy from time to time. • CRR also ensures that a portion of bank deposits is totally risk-free and in times of crisis the bank has at least certain minimum cash balance with RBI.
What is CRR
• CRR is maintained at fortnightly average basis on reporting Friday. • To avoid any wide fluctuations in CRR maintenance by banks, RBI has issued guidelines whereby a minimum of 70% of the CRR required to be maintained has to be maintained on daily basis.
What is SLR
• SLR means Statutory Liquidity Ratio. • The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). • Under section 24 (b) of the Banking Regulation Act, 1949, every bank is required to maintain at the close of business every day, a minimum proportion (at least 24%) of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and un-encumbered approved securities. • The RBI is empowered to increase the SLR upto 40%.
Impact of change in CRR / SLR
• CRR and SLR have been used by RBI to control the liquidity in the market. • An increase in CRR or SLR - to suck liquidity from the market and thus hardening the interest rates. • Lowering of these results in higher liquidity in the system and thus softening interest rates. • SLR has already has lost most of its relevance. • Most of the banks have investments in approved securities much more than the minimum required levels of SLR. • The SLR has lost its edge as a tool to control liquidity.
• CRR is still relevant as banks do not keep extra funds with RBI and always try to invest the extra funds in call money, Repo, Treasury Bills or in government securities so as to earn extra amount of interest.
VALUATION OF SECURITIES
• Classification and Valuation of approved securities for SLR :
• The entire investment portfolio of the banks (including SLR securities and non-SLR securities) should be classified under three categories viz. 'Held to Maturity', 'Available for Sale' and 'Held for Trading'. In the Balance Sheet, the investments will continue to be disclosed as per the existing six classifications viz.
• • • • • • Government securities, Other approved securities, Shares, Debentures & Bonds, Subsidiaries/joint ventures and Others (CP, Mutual Fund Units, etc.).
• Banks should decide the category of the investment at the time of acquisition and the decision should be recorded on the investment proposals.
NDTL
• The calculation of the NDTL is a complex issue as RBI keeps on issuing finer guidelines as to what is to be include and what is to be excluded from NDTL based on the clarifications sought by banks and as per requirements of the banking sector.
NDTL
• Demand Liabilities: 'Demand Liabilities' include all liabilities which are payable on demand and they include current deposits, demand liabilities portion of savings bank deposits, margins held against letters of credit/guarantees, balances in overdue fixed deposits, cash certificates and cumulative/recurring deposits, outstanding Telegraphic Transfers (TTs), Mail Transfer (MTs), Demand Drafts (DDs), unclaimed deposits, credit balances in the Cash Credit account and deposits held as security for advances which are payable on demand. Money at Call and Short Notice from outside the Banking System should be shown against liability to others.
NDTL
• Time Liabilities : Time Liabilities are those which are payable otherwise than on demand and they include fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of savings bank deposits, staff security deposits, margin held against letters of credit if not payable on demand, deposits held as securities for advances which are not payable on demand, India Millennium Deposits and Gold Deposits.
NDTL
• Borrowings from banks abroad
• Loans/borrowings from abroad by banks in India will be considered as 'liabilities to others' and will be subject to reserve requirements.
NDTL
• Arrangements with correspondent banks for remittance facilities
• When a bank accepts funds from a client under its remittance facilities scheme, it becomes a liability (liability to others) in its books. • The liability of the bank accepting funds will extinguish only when the correspondent bank honours the drafts issued by the accepting bank to its customers. • The balance amount in respect of the drafts issued by the accepting bank on its correspondent bank under the remittance facilities scheme and remaining unpaid should be reflected in the accepting bank's books as an outside liability and the same should also be taken into account for computation of NDTL for CRR/SLR purpose. • The amount received by correspondent banks has to be shown as 'Liability to the Banking System' by them and not as 'Liability to others' and this liability could be netted off by the correspondent banks against the inter-bank assets. • Likewise sums placed by banks issuing drafts/interest/dividend warrants are to be treated as 'Assets with Banking System' in their books and can be netted off from their inter-bank liabilities.
NDTL
• Other Demand and Time Liabilities (ODTL) • Other Demand and Time Liabilities (ODTL) include
• • • • • • interest accrued on deposits, bills payable, unpaid dividends, suspense account balances representing amounts due to other banks or public, net credit balances in branch adjustment account, any amounts due to the "Banking System" which are not in the nature of deposits or borrowing.
• Such liabilities may arise due to items, like • collection of bills on behalf of other banks, • interest due to other banks and so on.
• Participation Certificate issued to other banks, • the balances outstanding in the blocked account pertaining to segregated outstanding credit entries for more than 5 years in inter branch adjustment account, • the margin money on bills purchased / discounted and • gold borrowed by banks from abroad, also should be included in ODTL.
NATURE OF MONEY MARKET INSTRUMENTS
• The money market is a market for short term instruments. • They are considered as the most liquid of all the investments and are frequently referred as “Near Money Instruments”. • The instruments of less than one year maturity is referred to as money market instruments. • This market acts as an equilibrating mechanism and helps to deploy or borrow funds for short durations. • The only difference between the money market and the bond market is that the money market specializes in a short term debt securities and they these are sometimes referred as “cash investments” also.
FEATURES OF THE MONEY MARKET INSTRUMENTS
• • • • Maturity of the instruments is less than 1 year They are generally unsecured Dominated by large institutional players Issued in the form of - promissory notes / receipt of deposits
TYPES OF MONEY MARKET INSTRUMENTS
• • • • • • • • • Call Money / Notice Money Term Money Treasury Bills Repo and Reverse Repo Commercial Paper Certificate of Deposits Bills Rediscounting Inter corporate Deposits Liquid Mutual Funds
CALL / NOTICE MONEY
• Historically this market has few players and restricted to commercial, cooperative and foreign banks and primary dealers. • The Calls are placed for overnight, whereas Notice Money is placed for 2 to 14 days. • RBI issues certain guidelines for the call money market so as to avoid volatility in the market and to restrict excessive dependence on this market to meet the long term needs of the institutions.
• Some Non-banking entities like Financial Institutions, Insurance Cos., Mutual Funds are allowed only as lenders in the Call Money market.
TERM MONEY
• Inter-bank market for deposits of maturity exceeding 14 days is called as Term Money deposits. • In this market Financial Institutions are granted specific limits by RBI for borrowing. • RBI puts restrictions to certain type of identities to borrow in the market. For example, Mutual Funds are not permitted to borrow under term money
COMMERCIAL PAPERS
• These are popularly called “CPs” - short term money market instruments comprising of unsecured negotiable short term usance promissory note with fixed maturity issued at discount to the face value. • Another important feature of these instruments is that these are freely transferable by endorsement and delivery. • Now these can be issued only in demat form.
COMMERCIAL PAPERS
• Some other features of these are :• • • • • can be issued/ traded in multiples of Rs 5 lacs each minimum net worth of the issuing entity should be 4 crores minimum rating should be AA issued by FIs/ Corporates/ PDs etc. issued for minimum of 15 days, maximum period of 1 year
CERTIFICATE OF DEPOSITS
• These are popularly called “CDs” and are short term money market instruments comprising of unsecured negotiable short term usance promissory note with fixed maturity issued at discount to the face value. • CD is a negotiable interest-bearing debt instrument of specific maturity issued by banks
CERTIFICATE OF DEPOSITS
• Freely transferable by endorsement and delivery and are available in physical form. • Issued by banks and FIs to mobilize bulk resources and can be issued / traded in multiples of Rs.5 lacs each. • CD represents the title to a TIME DEPOSIT with a bank. • Liquid instrument – can be traded in the Secondary Market. • It is issued with a maturity of less than one year and is issued at a discount from the face value. • Interest is the difference between the issue price and the face value, which the holder receives at maturity
BILLS REDISCOUNTING
• As per recommendations of the Narasimhan Committee, all licensed scheduled commercial banks are eligible to rediscount with RBI, genuine trade bills arising out of sale/ purchase of goods. • Maturity date of the bill can fall within 90 days of rediscounting. • Primary Dealers are also permitted to rediscount bills.
INTER-CORPORATE DEPOSITS
• It is a deposit made by one corporate having surplus funds with another Corporate/Institution. • Such deposits are governed by Section 372A of The Companies Act,1956. • These are Non negotiable/ non transferable. • They have no secondary market. • Interest rate can be fixed /floating and is decided by the parties
Types of Treasury Bills
• These are issued by RBI for different maturities, but not exceeding 364 days. • At present RBI issues only 91 days and 364 days Treasury Bills. • These T-Bills, as they are popularly known in the market, are issued at discount to face value by RBI for funding the short term requirement of Central Government. • The payment of discount and repayment of Principle is guaranteed by central government
Types of Treasury Bills
• Some of the special features of investment In Treasury Bills are as follows :• • • • Highly liquid money market instrument Zero default risk No tax deducted at source Good returns especially in the short term
LIQUID MUTUAL FUNDS
• These are new instruments for the Indian money market.
• The institutions and individuals with large surpluses can use this mode.
• They are unsecured money market instruments and funds are generally invested for few weeks, but exit from the Fund is usually available at a 24 hour notice. • Net Asset Value is declared by the Mutual Fund on daily basis. • Returns fluctuate with rise and fall of the financial markets
REPO
• Repo is short for “Repurchase Agreement”. • It is also termed as 'Buy Back', 'RP', or 'Ready Forward' (RF). • It is a sale of securities with an agreement to repurchase the same on a future date and at a specific price. • Institutions like Banks who deal in government securities use this instrument as a form of overnight borrowing.
REPO
• Under this method, a dealer or other holder of government securities sells the securities to a lender and agrees to repurchase them at an agreed future date at an agreed price. • Usually very short-term, from overnight to 30 days or more. • Short-term maturity and government backing - repos provide lenders with extremely low risk. • Repo is the sale of a security with a commitment to repurchase the same security at a specified price on a specified date for a pre-determined period.
REVERSE REPO
• The term 'REVERSE REPURCHASE AGREEMENT' (Reverse Repo) refers to a repos deal viewed from the perspective of the supplier of funds. • In this case, the assets are bought with an agreement to resell them at a fixed price on a future date. • Thus transaction is called Repo for the institution who is a borrowing the money and it is “Reverse Repo” for the institution who is lending the money.
Term Repo
• It is exactly the same as “Repo” except that the period of borrowing / lending is greater than 30 days
Market Repo
• In the Monetary Policy 2005-06, RBI declared the following in respect of REPO market:• An electronic trading platform for conduct of market repo operations in government securities facilitated.
• Participation in market repo facility in government securities for non-scheduled urban co-operative banks (UCBs) and listed companies having gilt accounts with scheduled commercial banks allowed subject to eligibility criteria and safeguards
Repo / Reverse Repo
• The operations whereby RBI injects liquidity in the system are termed as “Repo”, and operations whereby the RBI absorbs liquidity are termed as “Reverse Repo” • RBI absorbs surplus funds from banks through its daily reverse repo auctions.
• A hike in reverse repo rates will usually immediately lead to higher yields in the short term papers e.g. Treasury Bills
• Repo rate are generally linked to the reverse repo rate. • The spread between the reverse repo rate and the repo rate had been reduced by 25 basis points from 125 basis points to 100 basis points and raised to 150 basis points
Indian Debt Market
• Indian debt market can be broadly classified into two categories, namely debt instruments issued by Central or State Governments and debt instruments issued by Public and Private Sector. • Different instruments issued have some prominent features in respect of period of maturity and the investors for such instruments.
Indian Debt Market
GOVERNMENT:Central Government Zero Coupon Bonds; Coupon Bearing GOI securities Treasury Bills Banks, Insurance and PF Trusts, RBI, Mutual Funds, Individuals Banks, Insurance and PF Trusts, RBI, Mutual Funds, Individuals Banks, Insurance and PF Trusts
1 year to 30 years
Central Government
91 days and 364 days
State Government
Coupon Bearing State Govt securities
5 years to 10 years
Indian Debt Market
PUBLIC AND PRIVATE SECTOR:Government Enterprises & PSU Bonds PSU Private Sector Corporates Private and Public Sector Corporates Govt guaranteed bonds PSU Bonds, Zero coupon bonds Debentures and Bonds 5 years to 10 years Banks, Insurance, PF Trusts and Individuals Banks, Insurance, PF Trusts, Corporate amd, Individuals Banks, Corporate, Mutual Funds and Individuals Banks, Corporate, Mutual Funds, Financial Institutions and Individuals
5 years to 10 years
1 year to 12 years
Commercial Paper
15 days to 1 year
Banks and FIs
Certificate of Deposits
15 days to 3 years
Banks and Corporate
Bonds and Debentures
• Debt market in India consists of Bonds & Debentures. • A debt instruments:
• • • • • a contract one party lends money to another at a pre-determined rate of interest the periodicity of such interest payment the repayment of the principal amount borrowed.
• Bonds and debentures - a loan wherein:
• the lender is called investor • the borrower is known as “issuer”.
• Sometimes - termed IOU given by a borrower to a lender.
Main Segments of Debt Market in India
• Indian debt market can be broadly categorized into following three segments, namely (here we have excluded short term papers like Treasury Bills, Commercial Papers and Certificate of Deposits):
• Government Securities • Public Sector Units (PSU) bonds • Corporate securities
Some popular myths about bonds
• • • • There are no risks for investing in Bonds Gilt Edge Bonds are absolutely risk free Deep Discount Bond are free from interest rate risks Company having AAA rating is free from risk
Debt Market Terms
• • • • • • • Issuer Face Value / Par Value Coupon Maturity Date Put / Call Options Ratings Risk
Debt Market Terms
• Interest rate changes • Yield
• • • • • • • Nominal Yield Holding Yield Current Yield Real Yield Net Yield INTERNAL RATE OF RETURN Yield To Maturity (YTM)
Debt Market Terms
• • • • • • Price Duration Convexity Yield Curve Zero Coupon Bond Relation Between YTM & Price
YIELD
• Yield is a very broad term and there are various variants of the yield used by the market players. Some of common yields used in the bond market are:
• Coupon Rate : It is also called nominal yield. It is the actual rate of interest paid by the issuers and is usually printed on the bond certificate itself. It is the fixed rate of interest that will be received by the investor
Yield
• Holding Yield : It is the rate of return based on the cost incurred by the investor for buying such a bond. • For example, a person who has bought one bond with a Face Value of Rs. 100/- and bearing coupon rate of 12% at a purchase price of Rs.120/-, the holding yield will be 10%. (coupon rate x 100 / purchase price of bond). In case a bond is purchased at Face Value, the holding yield will always be equal to the coupon rate
Yield
• Current Yield : This is the return on a bond based on the current price of the bond in the market. • For example, a person who has bought one bond with a Face Value of Rs.100/- and bearing coupon rate of 10% at a price of Rs.110/-, but due to change in the interest rates, the current market price of the bond rises to Rs.125/-. The current yield on the bond is 8%. (coupon rate x 100 / current market price). Current yield for a bond selling at premium will be less than the coupon rate. Current yield for a bond selling at discount will be more than the coupon rate
Yield
• Real Yield : In this case the nominal yield (i.e. coupon rate) is adjusted for depreciation in the value of rupee i.e. the increase in the price of goods and services. For example, if the coupon rate (nominal yield) on a bond is 7%, but the rate of inflation is 9% during the tenure of the bond, it means there is a negative yield of 2%.
Yield
• Net Yield : The net yield is arrived at by taking into account the tax liability of the investor. Thus, on the same bond with the same price at which two investors have purchased, the net yield can be different depending on the tax bracket in which each of these investor falls
Yield To Maturity
• Yield To Maturity (YTM) : This is the most frequently used concept in the market. • It is the discount rate at which the present value of a bond’s cash flows equals to the bond’s current market price. • Thus it is the rate of return at which NPV of a bond is equal to zero
Yield
• Some of the major assumptions of the YTM are:
• the intermediate cash flows are assumed to be re-invested at the YTM itself; • there will be no default / delay in receipt of the coupon payments and redemption proceeds, and • the bonds will be held till maturity
• The YTM is determined from the discounted cash flows up to redemption. • To arrive at YTM, present values of cash flows from coupon payments and present value of the principal repayment are computed first. Then from the current market rate of the bond, the “internal rate of return” (IRR) is determined.
Yield
• For example, we can calculate YTM of a three-year bond with a face value of Rs100 with a coupon payment of 10% annually and selling at Rs.95 in the current market. Assume 'r ' be the IRR. Present value of the coupon payments will be 10/(1+r)+10/(1+r)(1+r)+10/(1+r)(1+r)(1+r) Present value of principal repayment after three years will be 100/(1+r))(1+r)(1+r). Equating the total receipts to the market value (in above example it is Rs.95/-) of the bond one can find 'r". It is usual to quote yields in terms of half-yearly (semi-annual) compounded rates of interest. This is useful because most bonds have semi-annual coupons.
PRICE
• Bonds may be available in the market at “at par”, “premium” or “discount”. • When a bond is available at a price less than the Face Value, it is said to be available at “discount”. • If the price is more than the Face Value, it is said to be available at “premium”. • In case the price of the bonds is exactly the same as the Face Value of the bond, it is said to be available “at par”.
YIELD CURVE
• It is a graphical representation of the pattern of yields on a specific date for government securities or bonds with varying maturities. • Yield curve can take different shapes depending upon the prevailing conditions at any point of time. • It gives us the broad about the expectations of the market for interest rates
RELATION BETWEEN PRICE AND YTM
• If the YTM is equal to the coupon rate the market price of a bond will be equal to the par value of the bond. • If YTM increases above coupon rate, market price will drop below the par value. • If YTM decreases below the coupon rate, the market price goes above the par value
OTHER RELATION BETWEEN YTM, INTEREST RATES AND PRICE
• Bond's prices are inversely related to its YTM i.e. if YTM increases the price of bond falls, and if the YTM decreases the price of the bond increases. • The longer the term to maturity, the greater will be the change in price with change in YTM.
• The percentage price change described above increases at a diminishing rate as the bond's maturity increases.
• The change in price will be greater with a decrease in the bond's YTM than the change in bond price (for a given maturity). • With a change in YTM, the percentage price change in the case of bonds of high coupon rate will be smaller than in the case of bonds of low coupon rates, other things remaining the same.
Future value and present value
• PV(1+i) = FV1 • Example: 1,000 PV and 1,080 FV means:
• i = 80 / 1,000 = 0.08 = 8%
• If we invest 1,000 at 8% for 2 years:
• 1,000 (1+0.08) (1+0.08) = 1,080 (1.08) = 1,166.40
In general, the future value is…
• FVn = PV(1+i)n • Alternatively, the yield can be found as:
• i = [FVn / PV](1/n) - 1
• Example: 1,000 invested for 6 years at 8%:
• FV6 = 1,000(1.08)6 = 1,586.87
• Example: Invest 1,000 for 6 years, Receive 1,700 at the end of 6 years.
• What is the rate of return? i = [1,700 / 1,000](1/6) - 1 = 0.0925
Future value and present value with multiple payments
• The cumulative future value of a series of cash flows (CFVn) after n periods is:
• CFVn =CF1(1+i)n +CF2(1+i)n-1 +...+CFn(1+i)
• The present value of a series of n cash flows:
• PV = [CF1 / (1+i)] + [CF2 / (1+i)2] + [CF3 / (1+i)3] . . . +[CFn / (1+i)n]
• Example:
• rate of interest = 10%, what is the PV of a security that pays 90 at the end of the next three years plus 1,000 at the end of three years? • PV = 90/(1.1) + 90/(1.1)2 + 1090/(1.1)3 = 975.13
Simple interest versus compound interest
• Simple interest is interest that is paid only on the initial principal invested:
• simple interest = PV x (i) x n
• Example, simple interest:
• if i = 12% per annum, n = 1 and principal of 1,000: • simple interest = 1,000 (0.12) 1 = 120
• Example, interest is paid monthly:
• monthly simple interest = 1,000 (0.12 / 12) 1= 10
• Compounded interest is interest that is paid on the interest:
• PV (1 + i/m)nm = FVn and • PV = FVn / (1 + i/m)nm
Compounding frequency
• Example: 1,000 invested for 1 year at 8% with interest compounded monthly:
• FV1 = 1,000 (1 + 0.08/12)12 = 1083.00
• The effective annual rate of interest, i* can be calculated from:
• i* = (1 + i/m)m - 1
• In this example:
• i* = (1 + 0.08/12)12 - 1 = 8.30%
The effect of compounding on future value and present value
A. What is the future value after 1 year of $1,000 invested at an 8% annual nominal rate? Compounding Interval Year Semiannual Quarter Month Day Continuous Number of Compounding Intervals in I Year (m) 1 2 4 12 365 infinite Future Value (FVI)* $1080.00 1081.60 1082.43 1083.00 1083.28 1083.29 Effective Interest Rate* 8.00% 8.16 8.24 8.30 8.33 8.33
B. What is the present value of $1,000 received at the end of 1 year with compounding at 8%? Compounding Interval Year Semiannual Quarter Month Day Continuous Number of Compounding Intervals in 1 Year (m) 1 2 4 12 365 ? Present Value (PV)* $925.93 924.56 923.85 923.36 923.12 923.12 Effective Interest Rate* 8.00% 8.16 8.24 8.30 8.33 8.33
Bond prices and interest rates vary inversely
• Consider a bond which pays semi-annual interest payments of 470 with a maturity of 3 years. • If the market rate of interest is 9.4%, the price of the bond is: 6
470 10,000 • Price ? ? ? ? $10,000 t 6 1.047 t ?1 1.047
• If the market rates of interest increases to 10%, the price of the bond falls to 9,847.72:
470 10,000 ? ? $9,847.73 • Price ? ? t 6 1.05 t ?1 1.05
6
Price and yield relationships for bonds
Relationship Market interest rates and bond prices vary inversely. For a specific absolute change in interest rates, the proportionate increase in bond prices when rates fall exceeds the proportionate decrease in bond prices when rates rise. The proportionate difference increases with maturity and is larger the lower a bond's periodic interest payment. Long-term bonds change proportionately more in price than short-term bonds for a given change in interest rates from the same base level. Low-coupon bonds change proportionately more in price than high-coupon bonds for a given change in interest rates from the same base level. Impact Bond prices fall as interest rates rise and rise as interest rates fall. For the identical absolute change in interest rates, a bondholder will realize a greater capital gain when rates decline than capital loss when rates increase. Investors can realize greater capital gains and capital losses on long-term securities than on shortterm securities when interest rates change by the same amount. Low-coupon bonds exhibit greater relative price volatility than do high-coupon bonds.
In general
• Par Bond
• Yield to maturity = coupon rate
• Discount Bond
• Yield to maturity > coupon rate
• Premium Bond
• Yield to maturity < coupon rate
Relationship between price and interest rate on a 3-year, 10,000 option-free par value bond that pays 270 in semiannual interest
’s
For a given absolute change in interest rates, the percentage increase in a bond’s price will exceed the percentage decrease.
10,155.24
D = +155.25
10,000.00
D = -152.77
This asymmetric price relationship is due to the convex shape of the curve-plotting the price interest rate relationship.
9,847.73
Bond Prices Change Asymmetrically to Rising and Falling Rates
8.8
9.4 10.0
Interest Rate %
The effect of maturity on the relationship between price and interest rate on fixed-income, option free bonds
’s
For a given coupon rate, long-term bonds price changes proportionately more in price than do short-term bonds for a given rate change.
10,275.13 10,155.24 10,000.00
9,847.73 9,734.10
9.4%, 3-year bond 9.4%, 6-year bond
8.8 9.4 10.0 Interest Rate %
The effect of coupon on the relationship between price and interest rate on fixed-income, option free bonds
% change in price For a given change in market rate, the bond with the lower coupon will change more in price than will the bond with the higher coupon.
+ 1.74
+ 1.55 0
Market Price of Price of Zero Rate 9.4% Bonds Coupon 8.8% $10,155.24 $7,723.20 9.4% 10,000.00 7,591.37 10.0% 9.847.73 7,462.15
9.4%, 3-year bond Zero Coupon, 3-year bond
8.8 9.4 10.0 Interest Rate %
- 1.52 - 1.70
DURATION
• It is weighted average measure of time period of bond’s life. • We can also say that duration 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. • Duration is stated in years. • Unlike maturity, duration takes into account interest payments received throughout the course of holding the bond
DURATION
• For a zero coupon bond, maturity and duration are the same since there are no cash flows intermediately. • Higher the coupon rate, the shorter will be the duration. • Duration declines as bond reaches near maturity. • Moreover, the duration of a coupon paying bonds is always less than the remaining period to maturity
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. • Also used for risk measuring.
• It is used to study the effect of changes in interest rates on bond prices and yields
MDURATION
• It is short form for Modified Duration. • Mduration = Duration divided by (1+ (bond yield/k)). • Where k is the number of compounding periods per year. • Mduration is therefore inversely proportional to the approximate percentage change in price for a given change in yield. • It is a measure of the price sensitivity of a bond to interest rate movements.
CONVEXITY
• Convexity is a volatility measure for bonds used in conjunction with mduration in order to measure how the bond's price will change as interest rates change. • It is equal to the negative of the second derivative of the bond's price relative to its yield, divided by its price. • For example, since a non-callable bond's duration usually increases as interest rates decrease, its convexity is positive
SWAPS
• Swap is defined in number of ways. • Simple speaking Swap is a contract between two parties to exchange cash flows in the future according to agreed terms • Swaps are used to change the currency or interest rate exposure associated with investments. • Thus, we can say swap involves combined or simultaneous buying and selling operation in which two counterparties agree to exchange streams of payments occurring over time according to predetermined terms.
SWAPS
• To elaborate more, we can say Swap is the simultaneous purchase and sale of the same amount of a given currency for two different dates, against the sale and purchase of another. • In essence, swapping is somewhat similar to borrowing one currency and lending another for the same period. • However, any rate of return or cost of funds is expressed in the price differential between the two sides of the transaction.
Interest Rate Swaps (IRS)
• Interest Rate Swaps are those agreements where one side pays the other a particular interest rate (fixed or floating) and the other side pays the first party other different interest rates (fixed or floating). • IRS allow the entities to move from a fixed interest rate to a floating rate or vice versa in the same currency.
Interest Rate Swaps (IRS)
• IRS is a bilateral financial contract under which the parties agree to pay or receive the difference between an interest rate, fixed in advance for the swap tenor, and a floating rate that is based upon an agreed benchmark on a notional principal and for a specified period. • The difference between the rates is settled in cash on a series of payment dates that occur during the life of a swap. • Thus, it is a series of FRAs (i.e. Forward Rate Agreements).
Interest Rate Swaps (IRS)
• In interest rate swaps, there are no exchange of principals between the parties. • There is only exchange of interest obligations. • The principal is notional and is used only to calculate the interest payments between the parties.
Currency Swap
• These help the treasury managers to hedge the exchange risk. • The currency swaps allow Banks to change both the interest rate profile and currency denominations of its loans. • Unlike in interest rate swaps, where only interest payments are exchanged, in a currency swap both interest and principal are exchanged.
Currency Swap
• It involves exchanging principal and interest payment on a loan in one currency for principal and interest payments on an approximately equal loan in another currency, usually at the prevailing spot exchange rate. • On maturity of the swap, the respective principals are re-exchanged at the same exchange rate.
Coupon Swap
• This derivative product is like a currency swap with a difference that only the interest components of a loan is exchanged. • In this case, the Banks buy the instrument if it is expected that interest rates on the other currency is likely to be lower. • Interest rate caps and collar are used. • A cap is an option which gives the corporate the right but not the obligation, to exercise it. • This derivative product involves a strike price and an upfront premium.
Exchange Traded Funds
• Financial instruments, tradable on a stock exchange, that invests in the stocks of an index in approximately the same proportion as held in the index.
• • • • • • hybrid of open-ended mutual funds and listed individual stocks. funds that are listed on stock exchanges - trade like stocks. Unlike MFs, ETFs do not sell their shares directly to investors. Create ETFs by depositing a basket of stocks. This large block of stocks is called a creation unit. ETF receives shares, which are then offered to investors over the stock exchange.
Exchange Traded Funds
• Therefore, ETFs bring the trading and real time pricing advantages of individual stocks to mutual funds. To sum up some of the features of these Funds are :• These are a hybrid of open and close-ended funds; • They are listed on the stock exchange (Similar to the close-ended funds); • They create and redeem units in keeping with rise and fall in demand (Like open-ended funds). • They are passively managed (similar to index funds).
Exchange Traded Funds
• ETFs in India ?
• Benchmark AMC’s Nifty "Benchmark Exchange Traded Scheme" (BeES). It tracks the S&P CNX Nifty • Junior BeES. It tracks the CNX Nifty Junior Index comprising of mid-cap stocks. • Prudential ICICI Mutual Fund’s SPIcE (Sensex Prudential ICICI ETF) which tracks the BSE Sensex.
CBLO
• “Collateralized Borrowing and Lending Obligation” CBLO. • Money market instrument - for the benefit of the entities:• phased out from inter-bank call money market • restricted participation in terms of ceiling on call borrowing and lending transactions • do not have access to the call money market
CBLO
• CBLO - discounted instrument available in e-form for the maturity period ranging from 1 day to 90 days (can be made available up to one year as per RBI guidelines). • The main features of CBLO include :
• Obligation by the borrower to return the money borrowed, at a specified future date; • Authority to the lender to receive money lent, at a specified future date with an option/privilege to transfer the authority to another person for value received; • Underlying charge on securities held in custody (RBI) for the amount borrowed/lent.
CBLO
• The participants in this market are
• • • • • • • • banks, financial institutions, insurance companies, mutual funds, primary dealers, NBFCs, non-Government Provident Funds, Corporates etc.
• Participants open a Constituent SGL (CSGL) Account with RBI for depositing securities - offered as collateral / margin for borrowing and lending of funds. • Eligible securities are Central Government securities including Treasury Bills.
DERIVATIVES
• Derivatives have their origin in mathematics, where it is referred to a variable that has derived it value from another variable. • In financial market - those financial instruments whose value is derived from the price of some underlying asset - stocks, bonds, currencies or commodities. • One very interesting example to understand the concept of underlying asset is considering “curd” as a derivative. • The price of curd always depends on the price of milk. • We can say the underlying asset on which the value of curd depends is the milk.
DERIVATIVES
• Example :
• Assume that a farmer wish to contract to sell his rice harvest at a future date so as to eliminate the risk of a change in prices by that time. • Such a contract can take place in the Rice Forward Market. • The price of such a contract would certainly depend upon the current spot price of the rice. • In this transaction, the "rice forward" is the derivative
DERIVATIVES
• Derivatives are grouped into three categories namely,
• derivative securities; • exchange-traded derivatives; and
• Types of Underlying Assets :• • • • Equity shares Interest rates Foreign Exchange Commodities
DERIVATIVES
• Different types of Derivatives :• • • • Forwards or Forward Contracts Futures Options Swaps, etc.
INDEX FUTURES
• Index Futures - Future contracts - underlying asset - Index.
• The index futures contracts - based on the popular market benchmark Nifty index.
• Both the Bombay Stock exchange (BSE) and the National Stock Exchange (NSE) launched index futures in June 2000.
• To take a position on market movements.
• Suppose you feel that the markets are bullish and the Sensex would cross 15000 points. • Instead of buying shares that constitute the Index you can buy the market by taking a position on the Index Future.
INDEX FUTURES
• Index futures - used for
• hedging,
• speculating, • arbitrage,
• cash flow management and
• asset allocation.
INDEX FUTURES
• BSE / NSE defines the characteristics of the futures contract such as the underlying index, market lot, and the maturity date of the contract. • The futures contracts are available for trading from introduction to the expiry date. • Long and short positions indicate whether you have a net overbought position (long) or over-sold position (short).
doc_291929143.pptx
Profitability Ratios Asset Quality Ratios, Capital Adequacy Ratios, Liquidity Ratios and Valuation Ratios, different types of techniques to measure risks, indian debt and bonds market, interest rate swaps, CBLO and index futures
MANAGING NONINTEREST INCOME AND NONINTEREST EXPENSE
Key Profitability Ratios in Banking
Net Income After Taxes Return on Equity Capital (ROE) ? Total Equity Capital
Net IncomeAfter Taxes Return on Assets (ROA) ? Total Assets
Net Interest Income Net Interest Margin ? Total Assets
Net Noninterest Income Net Noninterest Margin ? Total Assets
2
Key Profitability Ratios in Banking
Total Operating Revenues Total Operating Expenses Net Bank Operating Margin ? Total Assets
Net Income After Taxes Earnings Per Share (EPS) ? Common Equity Shares Outstanding
3
Breaking Down ROE
ROE = Net Income/ Total Equity Capital
ROA = Net Income/Total Assets
x
Equity Multiplier = Total Assets/Equity Capital
Net Profit Margin = Net Income/Total Operating Revenue
x
Asset Utilization = Total Operating Revenue/Total Assets
4
Bank Performance Model
Returns to Shareholders ROE = NI / TE Interest INCOME Non Interest Return to the Bank ROA = NI / TA Interest
Rate Composition (mix) Volume Fees and Serv Charge Trust Other Rate Composition (mix) Volume
EXPENSES Overhead Degree of Leverage EM = 1 / (TA / TE) Prov. for LL Taxes
Salaries and Benefits
Occupancy Other
5
Five categories of banking ratios
• Profitability Ratios • Asset Quality Ratios • Capital Adequacy Ratios • Liquidity Ratios • Valuation Ratios
6
Return on equity (ROE = NI / TE)
• The measure of stockholders’ returns • ROE is composed of two parts:
• Return on Assets (ROA = NI / TA)
• represents the returns to the assets the bank has invested in
• Equity Multiplier (EM = TA / TE)
• the degree of financial leverage employed by the bank. Leverage or Financing Policies
7
Profitability
• ROA Decomposition:
• ROA= Profit Margin (PM)*Asset Utilization (AU)
ROA ? Net Income Total Oper ating Income ? Total Operating Income Total Asse ts
• Profit Margin: measures a bank’s ability to control expenses and reduce taxes. Effectiveness of Expense Management • Asset Utilization: represents the gross yield on assets. Portfolio Management Policies
8
ROA
• ROA is driven by the bank’s ability to generate income (AU) and control expenses (ER) • Income generation (AU) as:
Int. Inc. Non. int. Inc. Sec gains (losses) AU ? ? ? TA TA TA ? Expense Control (ER) as:
Int. Exp. Non ? int . Exp. PLL ER ? ? ? TA TA TA
*
? Note, ER* does not include taxes.
9
Expense ratio (ER = Exp / TA)
• The ability to control expenses • Interest expense / TA
• Cost per liability (rate)
• Composition of liabilities • Volume of debt and equity
• Non-interest expenses / TA
• Salaries and employee benefits / TA • Occupancy expenses / TA • Other operating expense / TA
• Provisions for loan losses / TA
• Taxes / TA
10
Asset utilization (AU = TR / TA):
• The ability to generate income • Interest Income / TA
• Asset yields (rate) • Composition of assets (mix)
• Volume of Earning Assets
• Non interest income / TA
• Fees and Service Charges • Securities Gains (Losses) • Other income
11
Aggregate profitability measures
• Net interest margin
• NIM = NII / earning assets (EA)
• Spread
• Spread = (int inc / EA) ? (int exp / int bear. Liab.)
• Earnings base
• Eb = EA / TA
• Burden / TA
• (Noninterest exp. - Noninterest income) / TA
• Efficiency ratio
• Non int. Exp. / (Net int. Inc. + Non int. Inc.)
12
Asset Quality Ratios
• Adequacy of Loan Loss Allowance:
• Loss allowance to loans
• Allowance for loan and lease losses as a percent of total loan and lease financing receivables, excluding unearned income. • This measures whether the loan loss allowance is adequate to cover potential loan losses.
13
Capital Adequacy Ratios
• Equity capital to assets • Total equity capital as a percent of total assets. • Core capital (leverage) ratio • Tier 1 (core) capital as a percent of average total assets minus ineligible intangibles. • Tier 1 (core) capital includes: common equity plus noncumulative perpetual preferred stock plus minority interests in consolidated subsidiaries less goodwill and other ineligible intangible assets, includes loan loss reserves, preferred stock, and mandatory convertible debt. • Total Capital = Tier 1 capital + Tier 2 capital
14
Capital Adequacy Ratios
• Total Risk-Based Capital Ratio
• Total risk based capital as a percent of risk-weighted assets as defined by RBI • Banks must meet minimum ratio of capital to risk-weighted
assets of 9%, with at least 4% taking the form of Tier (1)
capital.
15
Liquidity Ratios
• Asset Liquidity Ratios:
• Current Ratio
• Liability Liquidity Ratios:
• Net Loans and leases to deposits
• Loans and lease financing receivables net of unearned income as a percent of total deposits. • This ratio is an indicator of a bank’s ability to support loan growth with deposits.
16
Liquidity Ratios
• Net loan and leases to core deposits:
• Loan and lease financing receivables, net of allowances and reserves, as a percent of total domestic deposits, less time deposits of Rs.1 lac or more.
• Net noncore funding dependence ratio
• (Noncore Liabilities – Short-term investments)/Long-term assets.
• This ratio highlights how dependent a bank is on volatile
funding sources; the ratio attempts to measure a bank’s ability to withstand the sudden loss of its noncore liabilities.
17
Fundamental risks
• Credit risk
• Liquidity risk • Market risk • Operational risk • Capital or solvency risk
• Legal risk
• Reputational risk
18
Areas of Concentration
• Credit Risk Loans and Securities quality & type
• Liquidity Risk S/T to L/T composition of Assets and Liabs
• Market Risk Int Rate sensitivity of Assets & Liabs (GAP) • Operating Risk Employee usage and efficiency • Legal Risk Lawsuits, Contract Exposure, negative publicity
• Capital/Solvency Risk Equity Capital used and availed vs. Risk categories of usage
19
Credit risk
• The potential variation in net income and market value of equity resulting from nonpayment or delayed payment • • The Probability that Some of the Bank’s Assets Will
Decline in Value and Perhaps Become Worthless
Three Question need to be addressed:
1. 2. 3. What has been the loss experience? What amount of losses do we expect? How prepared is the bank?
20
Credit Risk Measures
• • • • • Nonperforming Loans/Total Loans Net Charge-Offs/Total Loans Provision for Loan Losses/Total Loans Provision for Loan Losses/Equity Capital Total Loans/Total Deposits
21
Liquidity risk
• The variation in net income and market value of equity caused by a bank's difficulty in obtaining cash at a reasonable cost from either the sale of assets or new borrowings Probability the Bank Will Not Have Sufficient Cash and Borrowing Capacity to Meet Deposit Withdrawals and Other Cash Needs Banks can acquire liquidity in two distinct ways:
1.
•
•
•
By liquidation of assets.
Composition of investments
•
Maturity of investments
2.
• •
By borrowing.
Core deposits Volatile deposits
22
Liquidity Risk Measures
• Net Loans/Total Assets • Cash and Due from Banks/Total Assets • Cash and Government Securities/Total Assets
23
Market risk
• The risk to a financial institution’s condition resulting from adverse movements in market rates or prices • Probability of the Market Value of the Bank’s Investment Portfolio Declining in Value Due to a Rise
in Interest Rates
• Market risk arises from changes in:
• Interest rates • Foreign exchange rates • Equity and security prices.
24
Market Risk Measures
• • • • Book-Value of Assets/ Market Value of Assets Book-Value of Equity/ Market Value of Equity Book-Value of Bonds/Market Value of Bonds Market Value of Preferred Stock and Common Stock
25
Interest Rate Risk
• The Danger that Shifting Interest Rates may adversely affect a Bank’s Net Income, the Value of its Assets or Equity
26
Interest Rate Risk Measures
• Interest Sensitive Assets/Interest Sensitive Liabilities • Uninsured Deposits/Total Deposits
27
Earnings Risk
The Risk to the Bank’s Bottom Line – Its Net Income After All Expenses
28
Earnings Risk Measures
• Standard Deviation of Net Income • Standard Deviation of ROE • Standard Deviation of ROA
29
Foreign exchange risk
• The risk to a financial institution’s condition resulting from adverse movements in foreign exchange rates • Foreign exchange risk arises from changes in foreign exchange rates that affect the values of assets,
liabilities, and off-balance sheet activities denominated
in basket of international currencies. • This risk is often found in off-balance sheet loan commitments and guarantees denominated in foreign currencies; foreign currency translation risk.
30
Equity and security price risk
• Change in market prices, interest rates and foreign
exchange rates affect the market values of equities,
fixed income securities, foreign currency holdings, and associated derivative and other off-balance sheet contracts • Large banks must conduct value-at-risk analysis to
assess the risk of loss with their trading account
portfolios.
31
Operational risk
• Measures the cost efficiency of the bank's activities; i.e., expense control or productivity • Typical ratios focus on:
• total assets per employee • total personnel expense per employee • noninterest expense ratio
• There is no meaningful way to estimate the likelihood of fraud or other contingencies from published data
• A bank’s operating risk is closely related to its operating policies and processes and whether it has adequate controls
32
Capital risk
• Closely tied to asset quality and a bank's overall risk profile • The more risk taken, the greater is the amount of capital required. • Appropriate risk measures include all the risk measures -
measuring the ratio of:
• tier 1 capital and total risk based capital to risk weighted assets, • equity capital to total assets, • dividend payout, and growth rate in tier 1 capital.
33
Capital Risk Measures
• Stock Price/Earnings Per Share • Equity Capital/Total Assets • Equity Capital/Risk Assets
34
Trading Risk
• If the price at which an instrument is purchased differs from the price at which it is sold, the risk is that the instrument may go down in value rather than up. • This type of risk is called trading risk
35
Legal risk
• The potential that unenforceable contracts, lawsuits, or adverse judgments can disrupt or otherwise negatively affect the operations or condition of banking organization • Legal risk include:
• Compliance risks • Strategic risks • General liability issues
36
Other Risks
• Foreign exchange risk comes from holding assets denominated in one currency and liabilities denominated in another • Sovereign risk arises from the fact that some foreign
borrowers may not repay their loans, not because
they are unwilling to, but because their government prohibits them from doing so.
37
Other Forms of Risk in Banking
• • • • Inflation Risk Currency or Exchange Rate Risk Political Risk Crime Risk
38
CAMELS Ratings
• C - Capital Adequacy • A - Asset Quality • M - Mgmt Quality, Mgmt & BoD ability and systems
(policies & procedures)
• E - Earnings, not just quantity, but quality,
sustainability
• L - Liquidity • S - Sensitivity to market fluctuations, Interest rates,
FX, Commodity prices (thru loans)
39
Traditional bank performance -three basic flaws
1. Ignores the wide diversity in strategies pursued by different institutions – banks may pursue sharply different strategies 2. A bank’s total assets no longer serve as a meaningful yardstick when banks engage in off-balance sheet activities – bank with servicing income profit will report a higher ROA, due to higher noninterest income 3. The analysis provides no direct information concerning how or which of the bank’s activities contribute to the creation of shareholder value – ignores other performance benchmarks that customer-focused managers must consider to identify the best strategies going forward
40
ROE
• When considering the entire bank, stockholders’ equity must support all activities, whether on- or off-balance sheet. • Thus, a comparison of net income to equity captures the returns to owners’ contributions.
41
The appropriate peer group
• As long as banks have a similar strategic focus and offer similar products and services, asset size and ratios can provide meaningful comparisons. To identify the appropriate peer institutions, management should consider the following:
1. What is the bank’s strategic focus? 2. What are the traditional balance sheet and offbalance sheet characteristics of firms with this focus? 3. How do the bank’s activities affect its operating revenue?
•
42
Accounting data and ratios
• A bank should compare its ratios with those from a select sample of peer institutions that are similarly loan-driven or deposit-driven. • Peers should operate the same approximate number of offices in the same metropolitan or non-metropolitan markets and have the same product and service mix. • Asset-based ratios are thus directly comparable. • Analysts can easily construct peer bank averages by direct comparison to other similar Banks
43
Total Operating Revenue
• Fundamentally this means calculate performance measures using total operating revenue as the denominator rather than assets.
• Here, total operating revenue equals the sum of net interest income and noninterest income.
44
The efficiency ratio
• Measured as noninterest expense divided by total operating revenue, is a popular measure used by stock analysis based on operating revenue rather than assets.
• Analysts strongly encourage banks, regardless of size, to meet fairly specific targets in this ratio.
• Because operating revenue includes both interest income and noninterest (fee-based) income, it captures all activities.
• Efficiency Ratio
= noninterest expense / net operating revenue
where net operating revenue = the sum of net interest income + noninterest income.
45
Standard procedure - evaluating firm performance
• Initially use financial information to calculate performance measures
• adjust the data to omit the impact of nonrecurring items, such as one-time asset sales and restructuring charges • compare these historical ratios with a carefully selected group of peer institutions, matching each bank’s primary strategic focus
• Based on analysis and conversations with specialists within the bank, then assesses the quality of earnings based on:
• their sustainability • the bank’s market power in specific product or service areas • the bank’s franchise value
• Forecast earnings, cash flow, and market value of equity over a three- to five-year time horizon • The analyst makes a stock recommendation:
• accumulate (buy) • neutral (hold) • below-market performance (sell)
46
Investors
• When analysts compare performance over some historical period, they are less concerned with ROE, ROA, and efficiency ratios – rather the overall total return from investing in the bank’s stock. • Total return equals dividends received plus stock price appreciation/depreciation relative to the initial investment.
47
Key stock market-based performance
• Return to stockholders = (Dprice + dividends) / pricet-1
• Earnings per share
?
?NI after taxes and dividends on preferred stock number of shares of common s tock outstanding
• Price to earnings (P/E) = stock price / EPS • Price to book value = stock price / book value per share
• Market value (MV) of equity = MV of assets - MV of liabilities or = # share of common stock x stock price
48
Value of the Bank’s Stock
E(D t) P0 ? ? t t ? 0 (1 ? r)
49
?
Value of a Bank’s Stock Rises When:
• Expected Dividends Increase • Risk of the Bank Falls • Combination of Expected Dividend Increase and Risk Decline
50
Value of Bank’s Stock if Earnings Growth is Constant
D1 P0 ? r-g
51
Example:
• Buy 100 shares of ABC Bank at the beginning of 2006 for Rs.73.06. The bank paid Rs.1.92 per share in dividends that generated reinvestment income of Rs.09. At the end of 2006, the price of stock was Rs.56.20. • Return to stockholders in 2006 was?
52
Example:
• Buy 100 shares of ABC Bank at the beginning of 2006 for Rs.73.06. The bank paid Rs.1.92 per share in dividends that generated reinvestment income of Rs.09. At the end of 2006, the price of stock was Rs.56.20. • Return to stockholders in 2006 was -20.3%. -0.203 = [56.20 - 73.06 + 2.01] ÷ 73.06
53
Line of business profitability analysis
• By allocating operating expenses to activities that support bank customers and bank management, banks can obtain at least a rough estimate of segment net income. • Reporting based on specific customers. • Many banks attempt to measure profitability by:
• type of loan customer (small business, middle market, consumer installment, etc.)
• type of depositor; by characteristics of the relationship (account longevity, cross-sell patterns, profitability, etc.) and • delivery system (branch, ATM, telephone, home banking, etc.).
54
RAROC/RORAC analysis
• RAROC refers to risk-adjusted return on capital, while RORAC refers to return on risk-adjusted capital
• In order to analyze profitability and risk precisely, each line of business must have its own balance sheet and income statement.
• These statements are difficult to construct because many nontraditional activities, such as trust and mortgage-servicing, do not explicitly require any direct equity support. • Even traditional activities, such as commercial lending and consumer banking, complicate the issue because these business units do not have equal amounts of assets and liabilities generated by customers. • The critical issue is to determine how much equity capital to assign each unit.
55
Assigning equity capital to each unit
• The objective of RAROC analysis is to assist in risk management and the evaluation of line of business performance. It is necessary to assign capital to each line of business • Banks allocate risk capital by: 1. Regulatory risk-based capital standards 2. Asset size 3. Benchmarking versus “pure-play” stand-alone businesses 4. Perceived riskiness of the business unit • Unfortunately, most lines of business do not have market value balance sheets. • Many banks focus on the volatility in economic earnings (earnings-at-risk) or estimate a value-at-risk figure.
56
RAROC/RORAC
• Risk adjust return on capital (RAROC)
• RAROC = Risk-adjusted income / Allocated capital
• Using this method, income is adjust for risk. • Typically, income is adjusted for expected losses.
• Return on risk adjusted capital (RORAC)
• RORAC = Net income / Allocated risk capital
• Using this method, capital is adjusted for risk. • Typically, capital is adjusted for a maximum potential loss based on the probability of future returns or volatility of earnings.
57
Risk-adjusted income and economic income
• Two adjustments are frequently made to income in line of business profitability analysis:
1.
2.
The return is adjusted for risk by subtracting expected losses The return nets out required returns expected by stockholders.
•
•
This minimum required return, or cost of equity, represents a hurdle rate, or stockholders’ minimum required rate of return. The specific concern is whether RAROC is greater than the firm’s cost of equity.
58
Earnings-at-risk
• Securities underwriting and letters of credit (guarantees) against customer exposures at a large bank do not require much capital to support day-to-day operations. • One way to measure the required risk capital is to relate it to the volatility of earnings from this line of business; i.e., earnings-at-risk.
59
Earnings-at-risk applied to loans
1. Using historical data for each of the past 30 months, estimate revenues obtained directly from these loans. 2. Using historical data for each of the past 30 months, estimate direct expenses from offering these services and expected losses. 3. Using the 60 observations for revenues minus expenses and losses, estimate one standard deviation of earnings. This is earnings-at-risk.
60
Management of market risk
• Market risk is the risk of loss to earnings and capital related to changes in the market values of bank assets, liabilities, and offbalance sheet positions • RBI imposes special capital requirements against the market risk associated with large banks’ trading positions.
• Market risk arises from taking positions and dealing in foreign exchange, equity, interest rate, and commodity markets, and the items affected are the securities trading account, derivatives positions, and foreign exchange positions.
• The new capital requirements address market risk associated with a bank’s trading activities.
61
MVA/ EVA
• If the objective of the firm is to maximize
stockholders’ wealth, ROE/ ROA measures do not
indicate whether stockholder wealth has increased over time, let alone whether it has been maximized.
• Stern, Stewart & Company has introduced the
concepts of market value added (MVA) and its associated economic value added (EVA) in an attempt to directly link performance to shareholder wealth creation.
62
Economic value added (EVA)
• An approach to measuring performance that compares a bank’s (or line of business) net operating profit aftertax (NOPAT) with a capital charge • Economic Value Added (EVA) is the capital charge which represents the required return to stockholders assuming a specific allocated risk capital amount.
63
Market and economic value added
• MVA represents the increment to market value and is determined by the present value of current and expected economic profit:
MVA = Mkt Value of Capital - Hist. Amt of Invested Capital
• Stern Stewart and Company measures economic profit with EVA, which is equal to a firm's operating profit minus the charge for the cost of capital:
EVA = Net Operating Profit After Tax (NOPAT) - Capital Charge
where the capital charge equals the product of the firm’s value of capital and the associated cost of capital
64
Difficulties in measuring EVA for the entire bank
• It is often difficult to obtain an accurate measure of a firm's cost of capital. • The amount of bank capital includes not just stockholders' equity, but also includes loan loss reserves, deferred (net) tax credits, non-recurring items such as restructuring charges and unamortized securities gains. • NOPAT should reflect operating profit associated with the current economics of the firm. Thus, traditional accounting data, which distort true profits, must be modified to obtain estimates of economic profit.
65
A. Balance Sheet Assets Cash Securities Commercial loans Credit card loans -Loss reserve Other assets Total assets
$Millions $150 $800 $2000 $1900 -$100 -$250 $5,000
Rate 0 6.5% 9.0% 10.0%
Liabilities & Equity Demand deposits MMDAs CDs Small time deposits Deferred tax credits Equity Liabilities + equity
$Millions $800 $1800 $1300 $680 $100 - $320 $5,000
Rate 3% 5.5% 4.5%
Risk-weighted assets: .50($800) + 1($2,000) + 1($1,900) + 1($250) = $4,550 Tier 1 capital = $320 Total capital = $420 Tier I ratio: $320/$4,550 = 7.03% Total capital ratio: $420/$4,550 = 9.23% $422 -$156.1 $265.9 -$25 $60 -$190 $110.90 $44.36 $66.54
EVA calculation For Ameribank
B. Income Statement Interest income: .065($800) + .090($2,000) + .10($1,900) = Interest expense: .03($1,800) + .055($1,300) + .045($680) = Net interest income Provision for loan losses Noninterest income Noninterest expense Pre tax Income Taxes @ 40% Net income
C. Profit Measures ROE = (66.54 / 320 ) = 20.8% ROA = (66.54 / 5,000) = 1.33% Assuming that net charge-offs $22, cash taxes pai, = $39, and allocated risk capital $550 with a capital charge of 12%: NOPAT = $110.90 + $25 - $22 - $39 = $74.9 EVA = $74.9 - 0.12($550) = $8.9
66
EVA calculation for ameribank after sale of 1 billion in credit card loans
A. Change In Balance Sheet items Assets D Amount Credit card loans -$1,000 Loan loss reserve +$30 Total assets -$970 B. Income Statement
Liablilties CDs Equity Total
D Amount -$940 -$30 -$970 Change -$100 -$46.2 -$53.8 +$30.0 +$12 -$5 -$16.8 -6.72 -10.08
Interest income: .065($800) + .09($2,000) + .10($900) Interest expense: .03($1,800) + .055($460) + .045($680) Net interest income: Provision for loan losses: Noninterest income: Noninterest expense: Pre tax income: Taxes @ 40%: Net income: C.
$322 -$109.9 $212.1 +$5 $72 -$195 $94.1 $37.64 $56.46
Profit Measures: Actual net charge-oft $14, cash taxes paid = $31, and risk capital falls to $500. ROE = $56.46/$290 = 19.47% ROA = $56.46/$4,030 = 1.40% EVA = [$94.1 - $5 - $14 - $31] - $60 = -$15.9 Risk-weighted assets: .50($800) + 1($2,000) + 1($900) + 1($250) = $3,550 Tier 1 capital = $290 Tier I ratio: $290/$3,550 = 8.17% 67 Tier 2 capital = $420 Total capital ratio: $420/$3,550 = 11.83%
Balanced scorecard
• Performance measures that look beyond just financial measures • An attempt to balance management decisions based on financial measures with decisions based on a firm’s relationships with its customers and the effectiveness of support processes in designing and delivering products and services • The result is that line of business managers use indicators such as:
• market share, • customer retention and attrition, • customer profitability, and • service quality to evaluate performance
• Internally, they also track productivity and employee satisfaction Such nonfinancial indicators provide information regarding whether a bank is truly customer-focused and whether its systems are appropriate
68
Balanced scorecard framework - 4 blocks
1. Financial Performance:
• How Do Stockholders View its Risk and Return Profile?
2. Customer Performance:
• How Do Customers See It?
3. Internal Process Management:
• At What Must It Excel?
4. Innovation and Learning:
• How Can It Continue to Improve and Create Value?
69
Scorecard measures
Financial Measures Customer profitability Lifestyle segment profitability Product profitability Delivery channel cost Return on investment Revenue growth Deposit service cost change Revenue mix Sales growth and target markets Dollars past due divided by total dollar loans Customer Measures Life cycle segment market share Customer satisfaction Customer retention Market share Customer acquisition Customer profitability Share of segment Depth of relationship Brand name rating Number of customer complaints Internal Measures Channel usage Product usage Percentage of revenue from new products Learning Measures Skill competency Sales productivity Employer satisfaction
Percentage of revenue from product Employee retention promotions Product development cycle Hours with customer New product revenue Cross-sale ration Channel mix change Service error rate Request fulfillment time Loss ratio Underwriting quality audit Overhead ratio Ratio of branch to on-call transactions—ATM transactions Sales per sales call Sales per referral New sales divided by banker Productivity Efficiency ratio New product revenue as percent of total Employee satisfaction Employee productivity Strategic job coverage ratio Strategic information availability ratio Personal goals alignment Revenue per employee Sales force average length of service Turnover Training hours divided by FTE Number of training programs offered Turnover ratio Turbulence
Fee revenue divided by total revenue Closed accounts by reason Net income Share of wallet Return on risk-adjusted equity Net income after capital charge Cost of capital Efficiency Economic value added Assets per employee Percent of target accounts
70
EVERGREENING
• A practice of `managing' the balance sheet through means, which may not be violating banking laws in letter but breaching them in spirit. • For example, one bank can lend money to a company, so that the company can pay off loan taken from some other bank. • In this way, the borrowal account with the second bank will not become NPA and thus it will be also to show reduced non-performing assets (NPAs). • The second bank can then extend a similar facility to another company, which has not been able to repay loans from the first bank. • This is the most common method of ever-greening.
EVERGREENING
• Another method of doctored balance sheet is done by some banks by disbursing large number of loans at the end of the year. • This way they can increase their advances portfolio and reduce the NPA in terms of percentage.
• Reserve Bank of India (RBI) issues stern warnings to public sector banks against any attempt to `evergreen' their balance sheets
What is CRR
• CRR means Cash Reserve Ratio. • Under section 42 (1) of RBI act, 1934, every scheduled commercial bank is required to maintain with the RBI every fortnight a minimum average daily cash reserve equivalent to 5% of its Net Demand and Time Liabilities (NDTL) outstanding as on the Friday of the previous week. • The RBI is empowered to vary the CRR between 3% and 15%.
What is CRR
• CRR is one of the important weapons available to the Central Bank of a country to influence and control the monetary aggregates of the country. • RBI is using the CRR either to impound the excess liquidity or to release funds needed for the economy from time to time. • CRR also ensures that a portion of bank deposits is totally risk-free and in times of crisis the bank has at least certain minimum cash balance with RBI.
What is CRR
• CRR is maintained at fortnightly average basis on reporting Friday. • To avoid any wide fluctuations in CRR maintenance by banks, RBI has issued guidelines whereby a minimum of 70% of the CRR required to be maintained has to be maintained on daily basis.
What is SLR
• SLR means Statutory Liquidity Ratio. • The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). • Under section 24 (b) of the Banking Regulation Act, 1949, every bank is required to maintain at the close of business every day, a minimum proportion (at least 24%) of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and un-encumbered approved securities. • The RBI is empowered to increase the SLR upto 40%.
Impact of change in CRR / SLR
• CRR and SLR have been used by RBI to control the liquidity in the market. • An increase in CRR or SLR - to suck liquidity from the market and thus hardening the interest rates. • Lowering of these results in higher liquidity in the system and thus softening interest rates. • SLR has already has lost most of its relevance. • Most of the banks have investments in approved securities much more than the minimum required levels of SLR. • The SLR has lost its edge as a tool to control liquidity.
• CRR is still relevant as banks do not keep extra funds with RBI and always try to invest the extra funds in call money, Repo, Treasury Bills or in government securities so as to earn extra amount of interest.
VALUATION OF SECURITIES
• Classification and Valuation of approved securities for SLR :
• The entire investment portfolio of the banks (including SLR securities and non-SLR securities) should be classified under three categories viz. 'Held to Maturity', 'Available for Sale' and 'Held for Trading'. In the Balance Sheet, the investments will continue to be disclosed as per the existing six classifications viz.
• • • • • • Government securities, Other approved securities, Shares, Debentures & Bonds, Subsidiaries/joint ventures and Others (CP, Mutual Fund Units, etc.).
• Banks should decide the category of the investment at the time of acquisition and the decision should be recorded on the investment proposals.
NDTL
• The calculation of the NDTL is a complex issue as RBI keeps on issuing finer guidelines as to what is to be include and what is to be excluded from NDTL based on the clarifications sought by banks and as per requirements of the banking sector.
NDTL
• Demand Liabilities: 'Demand Liabilities' include all liabilities which are payable on demand and they include current deposits, demand liabilities portion of savings bank deposits, margins held against letters of credit/guarantees, balances in overdue fixed deposits, cash certificates and cumulative/recurring deposits, outstanding Telegraphic Transfers (TTs), Mail Transfer (MTs), Demand Drafts (DDs), unclaimed deposits, credit balances in the Cash Credit account and deposits held as security for advances which are payable on demand. Money at Call and Short Notice from outside the Banking System should be shown against liability to others.
NDTL
• Time Liabilities : Time Liabilities are those which are payable otherwise than on demand and they include fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of savings bank deposits, staff security deposits, margin held against letters of credit if not payable on demand, deposits held as securities for advances which are not payable on demand, India Millennium Deposits and Gold Deposits.
NDTL
• Borrowings from banks abroad
• Loans/borrowings from abroad by banks in India will be considered as 'liabilities to others' and will be subject to reserve requirements.
NDTL
• Arrangements with correspondent banks for remittance facilities
• When a bank accepts funds from a client under its remittance facilities scheme, it becomes a liability (liability to others) in its books. • The liability of the bank accepting funds will extinguish only when the correspondent bank honours the drafts issued by the accepting bank to its customers. • The balance amount in respect of the drafts issued by the accepting bank on its correspondent bank under the remittance facilities scheme and remaining unpaid should be reflected in the accepting bank's books as an outside liability and the same should also be taken into account for computation of NDTL for CRR/SLR purpose. • The amount received by correspondent banks has to be shown as 'Liability to the Banking System' by them and not as 'Liability to others' and this liability could be netted off by the correspondent banks against the inter-bank assets. • Likewise sums placed by banks issuing drafts/interest/dividend warrants are to be treated as 'Assets with Banking System' in their books and can be netted off from their inter-bank liabilities.
NDTL
• Other Demand and Time Liabilities (ODTL) • Other Demand and Time Liabilities (ODTL) include
• • • • • • interest accrued on deposits, bills payable, unpaid dividends, suspense account balances representing amounts due to other banks or public, net credit balances in branch adjustment account, any amounts due to the "Banking System" which are not in the nature of deposits or borrowing.
• Such liabilities may arise due to items, like • collection of bills on behalf of other banks, • interest due to other banks and so on.
• Participation Certificate issued to other banks, • the balances outstanding in the blocked account pertaining to segregated outstanding credit entries for more than 5 years in inter branch adjustment account, • the margin money on bills purchased / discounted and • gold borrowed by banks from abroad, also should be included in ODTL.
NATURE OF MONEY MARKET INSTRUMENTS
• The money market is a market for short term instruments. • They are considered as the most liquid of all the investments and are frequently referred as “Near Money Instruments”. • The instruments of less than one year maturity is referred to as money market instruments. • This market acts as an equilibrating mechanism and helps to deploy or borrow funds for short durations. • The only difference between the money market and the bond market is that the money market specializes in a short term debt securities and they these are sometimes referred as “cash investments” also.
FEATURES OF THE MONEY MARKET INSTRUMENTS
• • • • Maturity of the instruments is less than 1 year They are generally unsecured Dominated by large institutional players Issued in the form of - promissory notes / receipt of deposits
TYPES OF MONEY MARKET INSTRUMENTS
• • • • • • • • • Call Money / Notice Money Term Money Treasury Bills Repo and Reverse Repo Commercial Paper Certificate of Deposits Bills Rediscounting Inter corporate Deposits Liquid Mutual Funds
CALL / NOTICE MONEY
• Historically this market has few players and restricted to commercial, cooperative and foreign banks and primary dealers. • The Calls are placed for overnight, whereas Notice Money is placed for 2 to 14 days. • RBI issues certain guidelines for the call money market so as to avoid volatility in the market and to restrict excessive dependence on this market to meet the long term needs of the institutions.
• Some Non-banking entities like Financial Institutions, Insurance Cos., Mutual Funds are allowed only as lenders in the Call Money market.
TERM MONEY
• Inter-bank market for deposits of maturity exceeding 14 days is called as Term Money deposits. • In this market Financial Institutions are granted specific limits by RBI for borrowing. • RBI puts restrictions to certain type of identities to borrow in the market. For example, Mutual Funds are not permitted to borrow under term money
COMMERCIAL PAPERS
• These are popularly called “CPs” - short term money market instruments comprising of unsecured negotiable short term usance promissory note with fixed maturity issued at discount to the face value. • Another important feature of these instruments is that these are freely transferable by endorsement and delivery. • Now these can be issued only in demat form.
COMMERCIAL PAPERS
• Some other features of these are :• • • • • can be issued/ traded in multiples of Rs 5 lacs each minimum net worth of the issuing entity should be 4 crores minimum rating should be AA issued by FIs/ Corporates/ PDs etc. issued for minimum of 15 days, maximum period of 1 year
CERTIFICATE OF DEPOSITS
• These are popularly called “CDs” and are short term money market instruments comprising of unsecured negotiable short term usance promissory note with fixed maturity issued at discount to the face value. • CD is a negotiable interest-bearing debt instrument of specific maturity issued by banks
CERTIFICATE OF DEPOSITS
• Freely transferable by endorsement and delivery and are available in physical form. • Issued by banks and FIs to mobilize bulk resources and can be issued / traded in multiples of Rs.5 lacs each. • CD represents the title to a TIME DEPOSIT with a bank. • Liquid instrument – can be traded in the Secondary Market. • It is issued with a maturity of less than one year and is issued at a discount from the face value. • Interest is the difference between the issue price and the face value, which the holder receives at maturity
BILLS REDISCOUNTING
• As per recommendations of the Narasimhan Committee, all licensed scheduled commercial banks are eligible to rediscount with RBI, genuine trade bills arising out of sale/ purchase of goods. • Maturity date of the bill can fall within 90 days of rediscounting. • Primary Dealers are also permitted to rediscount bills.
INTER-CORPORATE DEPOSITS
• It is a deposit made by one corporate having surplus funds with another Corporate/Institution. • Such deposits are governed by Section 372A of The Companies Act,1956. • These are Non negotiable/ non transferable. • They have no secondary market. • Interest rate can be fixed /floating and is decided by the parties
Types of Treasury Bills
• These are issued by RBI for different maturities, but not exceeding 364 days. • At present RBI issues only 91 days and 364 days Treasury Bills. • These T-Bills, as they are popularly known in the market, are issued at discount to face value by RBI for funding the short term requirement of Central Government. • The payment of discount and repayment of Principle is guaranteed by central government
Types of Treasury Bills
• Some of the special features of investment In Treasury Bills are as follows :• • • • Highly liquid money market instrument Zero default risk No tax deducted at source Good returns especially in the short term
LIQUID MUTUAL FUNDS
• These are new instruments for the Indian money market.
• The institutions and individuals with large surpluses can use this mode.
• They are unsecured money market instruments and funds are generally invested for few weeks, but exit from the Fund is usually available at a 24 hour notice. • Net Asset Value is declared by the Mutual Fund on daily basis. • Returns fluctuate with rise and fall of the financial markets
REPO
• Repo is short for “Repurchase Agreement”. • It is also termed as 'Buy Back', 'RP', or 'Ready Forward' (RF). • It is a sale of securities with an agreement to repurchase the same on a future date and at a specific price. • Institutions like Banks who deal in government securities use this instrument as a form of overnight borrowing.
REPO
• Under this method, a dealer or other holder of government securities sells the securities to a lender and agrees to repurchase them at an agreed future date at an agreed price. • Usually very short-term, from overnight to 30 days or more. • Short-term maturity and government backing - repos provide lenders with extremely low risk. • Repo is the sale of a security with a commitment to repurchase the same security at a specified price on a specified date for a pre-determined period.
REVERSE REPO
• The term 'REVERSE REPURCHASE AGREEMENT' (Reverse Repo) refers to a repos deal viewed from the perspective of the supplier of funds. • In this case, the assets are bought with an agreement to resell them at a fixed price on a future date. • Thus transaction is called Repo for the institution who is a borrowing the money and it is “Reverse Repo” for the institution who is lending the money.
Term Repo
• It is exactly the same as “Repo” except that the period of borrowing / lending is greater than 30 days
Market Repo
• In the Monetary Policy 2005-06, RBI declared the following in respect of REPO market:• An electronic trading platform for conduct of market repo operations in government securities facilitated.
• Participation in market repo facility in government securities for non-scheduled urban co-operative banks (UCBs) and listed companies having gilt accounts with scheduled commercial banks allowed subject to eligibility criteria and safeguards
Repo / Reverse Repo
• The operations whereby RBI injects liquidity in the system are termed as “Repo”, and operations whereby the RBI absorbs liquidity are termed as “Reverse Repo” • RBI absorbs surplus funds from banks through its daily reverse repo auctions.
• A hike in reverse repo rates will usually immediately lead to higher yields in the short term papers e.g. Treasury Bills
• Repo rate are generally linked to the reverse repo rate. • The spread between the reverse repo rate and the repo rate had been reduced by 25 basis points from 125 basis points to 100 basis points and raised to 150 basis points
Indian Debt Market
• Indian debt market can be broadly classified into two categories, namely debt instruments issued by Central or State Governments and debt instruments issued by Public and Private Sector. • Different instruments issued have some prominent features in respect of period of maturity and the investors for such instruments.
Indian Debt Market
GOVERNMENT:Central Government Zero Coupon Bonds; Coupon Bearing GOI securities Treasury Bills Banks, Insurance and PF Trusts, RBI, Mutual Funds, Individuals Banks, Insurance and PF Trusts, RBI, Mutual Funds, Individuals Banks, Insurance and PF Trusts
1 year to 30 years
Central Government
91 days and 364 days
State Government
Coupon Bearing State Govt securities
5 years to 10 years
Indian Debt Market
PUBLIC AND PRIVATE SECTOR:Government Enterprises & PSU Bonds PSU Private Sector Corporates Private and Public Sector Corporates Govt guaranteed bonds PSU Bonds, Zero coupon bonds Debentures and Bonds 5 years to 10 years Banks, Insurance, PF Trusts and Individuals Banks, Insurance, PF Trusts, Corporate amd, Individuals Banks, Corporate, Mutual Funds and Individuals Banks, Corporate, Mutual Funds, Financial Institutions and Individuals
5 years to 10 years
1 year to 12 years
Commercial Paper
15 days to 1 year
Banks and FIs
Certificate of Deposits
15 days to 3 years
Banks and Corporate
Bonds and Debentures
• Debt market in India consists of Bonds & Debentures. • A debt instruments:
• • • • • a contract one party lends money to another at a pre-determined rate of interest the periodicity of such interest payment the repayment of the principal amount borrowed.
• Bonds and debentures - a loan wherein:
• the lender is called investor • the borrower is known as “issuer”.
• Sometimes - termed IOU given by a borrower to a lender.
Main Segments of Debt Market in India
• Indian debt market can be broadly categorized into following three segments, namely (here we have excluded short term papers like Treasury Bills, Commercial Papers and Certificate of Deposits):
• Government Securities • Public Sector Units (PSU) bonds • Corporate securities
Some popular myths about bonds
• • • • There are no risks for investing in Bonds Gilt Edge Bonds are absolutely risk free Deep Discount Bond are free from interest rate risks Company having AAA rating is free from risk
Debt Market Terms
• • • • • • • Issuer Face Value / Par Value Coupon Maturity Date Put / Call Options Ratings Risk
Debt Market Terms
• Interest rate changes • Yield
• • • • • • • Nominal Yield Holding Yield Current Yield Real Yield Net Yield INTERNAL RATE OF RETURN Yield To Maturity (YTM)
Debt Market Terms
• • • • • • Price Duration Convexity Yield Curve Zero Coupon Bond Relation Between YTM & Price
YIELD
• Yield is a very broad term and there are various variants of the yield used by the market players. Some of common yields used in the bond market are:
• Coupon Rate : It is also called nominal yield. It is the actual rate of interest paid by the issuers and is usually printed on the bond certificate itself. It is the fixed rate of interest that will be received by the investor
Yield
• Holding Yield : It is the rate of return based on the cost incurred by the investor for buying such a bond. • For example, a person who has bought one bond with a Face Value of Rs. 100/- and bearing coupon rate of 12% at a purchase price of Rs.120/-, the holding yield will be 10%. (coupon rate x 100 / purchase price of bond). In case a bond is purchased at Face Value, the holding yield will always be equal to the coupon rate
Yield
• Current Yield : This is the return on a bond based on the current price of the bond in the market. • For example, a person who has bought one bond with a Face Value of Rs.100/- and bearing coupon rate of 10% at a price of Rs.110/-, but due to change in the interest rates, the current market price of the bond rises to Rs.125/-. The current yield on the bond is 8%. (coupon rate x 100 / current market price). Current yield for a bond selling at premium will be less than the coupon rate. Current yield for a bond selling at discount will be more than the coupon rate
Yield
• Real Yield : In this case the nominal yield (i.e. coupon rate) is adjusted for depreciation in the value of rupee i.e. the increase in the price of goods and services. For example, if the coupon rate (nominal yield) on a bond is 7%, but the rate of inflation is 9% during the tenure of the bond, it means there is a negative yield of 2%.
Yield
• Net Yield : The net yield is arrived at by taking into account the tax liability of the investor. Thus, on the same bond with the same price at which two investors have purchased, the net yield can be different depending on the tax bracket in which each of these investor falls
Yield To Maturity
• Yield To Maturity (YTM) : This is the most frequently used concept in the market. • It is the discount rate at which the present value of a bond’s cash flows equals to the bond’s current market price. • Thus it is the rate of return at which NPV of a bond is equal to zero
Yield
• Some of the major assumptions of the YTM are:
• the intermediate cash flows are assumed to be re-invested at the YTM itself; • there will be no default / delay in receipt of the coupon payments and redemption proceeds, and • the bonds will be held till maturity
• The YTM is determined from the discounted cash flows up to redemption. • To arrive at YTM, present values of cash flows from coupon payments and present value of the principal repayment are computed first. Then from the current market rate of the bond, the “internal rate of return” (IRR) is determined.
Yield
• For example, we can calculate YTM of a three-year bond with a face value of Rs100 with a coupon payment of 10% annually and selling at Rs.95 in the current market. Assume 'r ' be the IRR. Present value of the coupon payments will be 10/(1+r)+10/(1+r)(1+r)+10/(1+r)(1+r)(1+r) Present value of principal repayment after three years will be 100/(1+r))(1+r)(1+r). Equating the total receipts to the market value (in above example it is Rs.95/-) of the bond one can find 'r". It is usual to quote yields in terms of half-yearly (semi-annual) compounded rates of interest. This is useful because most bonds have semi-annual coupons.
PRICE
• Bonds may be available in the market at “at par”, “premium” or “discount”. • When a bond is available at a price less than the Face Value, it is said to be available at “discount”. • If the price is more than the Face Value, it is said to be available at “premium”. • In case the price of the bonds is exactly the same as the Face Value of the bond, it is said to be available “at par”.
YIELD CURVE
• It is a graphical representation of the pattern of yields on a specific date for government securities or bonds with varying maturities. • Yield curve can take different shapes depending upon the prevailing conditions at any point of time. • It gives us the broad about the expectations of the market for interest rates
RELATION BETWEEN PRICE AND YTM
• If the YTM is equal to the coupon rate the market price of a bond will be equal to the par value of the bond. • If YTM increases above coupon rate, market price will drop below the par value. • If YTM decreases below the coupon rate, the market price goes above the par value
OTHER RELATION BETWEEN YTM, INTEREST RATES AND PRICE
• Bond's prices are inversely related to its YTM i.e. if YTM increases the price of bond falls, and if the YTM decreases the price of the bond increases. • The longer the term to maturity, the greater will be the change in price with change in YTM.
• The percentage price change described above increases at a diminishing rate as the bond's maturity increases.
• The change in price will be greater with a decrease in the bond's YTM than the change in bond price (for a given maturity). • With a change in YTM, the percentage price change in the case of bonds of high coupon rate will be smaller than in the case of bonds of low coupon rates, other things remaining the same.
Future value and present value
• PV(1+i) = FV1 • Example: 1,000 PV and 1,080 FV means:
• i = 80 / 1,000 = 0.08 = 8%
• If we invest 1,000 at 8% for 2 years:
• 1,000 (1+0.08) (1+0.08) = 1,080 (1.08) = 1,166.40
In general, the future value is…
• FVn = PV(1+i)n • Alternatively, the yield can be found as:
• i = [FVn / PV](1/n) - 1
• Example: 1,000 invested for 6 years at 8%:
• FV6 = 1,000(1.08)6 = 1,586.87
• Example: Invest 1,000 for 6 years, Receive 1,700 at the end of 6 years.
• What is the rate of return? i = [1,700 / 1,000](1/6) - 1 = 0.0925
Future value and present value with multiple payments
• The cumulative future value of a series of cash flows (CFVn) after n periods is:
• CFVn =CF1(1+i)n +CF2(1+i)n-1 +...+CFn(1+i)
• The present value of a series of n cash flows:
• PV = [CF1 / (1+i)] + [CF2 / (1+i)2] + [CF3 / (1+i)3] . . . +[CFn / (1+i)n]
• Example:
• rate of interest = 10%, what is the PV of a security that pays 90 at the end of the next three years plus 1,000 at the end of three years? • PV = 90/(1.1) + 90/(1.1)2 + 1090/(1.1)3 = 975.13
Simple interest versus compound interest
• Simple interest is interest that is paid only on the initial principal invested:
• simple interest = PV x (i) x n
• Example, simple interest:
• if i = 12% per annum, n = 1 and principal of 1,000: • simple interest = 1,000 (0.12) 1 = 120
• Example, interest is paid monthly:
• monthly simple interest = 1,000 (0.12 / 12) 1= 10
• Compounded interest is interest that is paid on the interest:
• PV (1 + i/m)nm = FVn and • PV = FVn / (1 + i/m)nm
Compounding frequency
• Example: 1,000 invested for 1 year at 8% with interest compounded monthly:
• FV1 = 1,000 (1 + 0.08/12)12 = 1083.00
• The effective annual rate of interest, i* can be calculated from:
• i* = (1 + i/m)m - 1
• In this example:
• i* = (1 + 0.08/12)12 - 1 = 8.30%
The effect of compounding on future value and present value
A. What is the future value after 1 year of $1,000 invested at an 8% annual nominal rate? Compounding Interval Year Semiannual Quarter Month Day Continuous Number of Compounding Intervals in I Year (m) 1 2 4 12 365 infinite Future Value (FVI)* $1080.00 1081.60 1082.43 1083.00 1083.28 1083.29 Effective Interest Rate* 8.00% 8.16 8.24 8.30 8.33 8.33
B. What is the present value of $1,000 received at the end of 1 year with compounding at 8%? Compounding Interval Year Semiannual Quarter Month Day Continuous Number of Compounding Intervals in 1 Year (m) 1 2 4 12 365 ? Present Value (PV)* $925.93 924.56 923.85 923.36 923.12 923.12 Effective Interest Rate* 8.00% 8.16 8.24 8.30 8.33 8.33
Bond prices and interest rates vary inversely
• Consider a bond which pays semi-annual interest payments of 470 with a maturity of 3 years. • If the market rate of interest is 9.4%, the price of the bond is: 6
470 10,000 • Price ? ? ? ? $10,000 t 6 1.047 t ?1 1.047
• If the market rates of interest increases to 10%, the price of the bond falls to 9,847.72:
470 10,000 ? ? $9,847.73 • Price ? ? t 6 1.05 t ?1 1.05
6
Price and yield relationships for bonds
Relationship Market interest rates and bond prices vary inversely. For a specific absolute change in interest rates, the proportionate increase in bond prices when rates fall exceeds the proportionate decrease in bond prices when rates rise. The proportionate difference increases with maturity and is larger the lower a bond's periodic interest payment. Long-term bonds change proportionately more in price than short-term bonds for a given change in interest rates from the same base level. Low-coupon bonds change proportionately more in price than high-coupon bonds for a given change in interest rates from the same base level. Impact Bond prices fall as interest rates rise and rise as interest rates fall. For the identical absolute change in interest rates, a bondholder will realize a greater capital gain when rates decline than capital loss when rates increase. Investors can realize greater capital gains and capital losses on long-term securities than on shortterm securities when interest rates change by the same amount. Low-coupon bonds exhibit greater relative price volatility than do high-coupon bonds.
In general
• Par Bond
• Yield to maturity = coupon rate
• Discount Bond
• Yield to maturity > coupon rate
• Premium Bond
• Yield to maturity < coupon rate
Relationship between price and interest rate on a 3-year, 10,000 option-free par value bond that pays 270 in semiannual interest
’s
For a given absolute change in interest rates, the percentage increase in a bond’s price will exceed the percentage decrease.
10,155.24
D = +155.25
10,000.00
D = -152.77
This asymmetric price relationship is due to the convex shape of the curve-plotting the price interest rate relationship.
9,847.73
Bond Prices Change Asymmetrically to Rising and Falling Rates
8.8
9.4 10.0
Interest Rate %
The effect of maturity on the relationship between price and interest rate on fixed-income, option free bonds
’s
For a given coupon rate, long-term bonds price changes proportionately more in price than do short-term bonds for a given rate change.
10,275.13 10,155.24 10,000.00
9,847.73 9,734.10
9.4%, 3-year bond 9.4%, 6-year bond
8.8 9.4 10.0 Interest Rate %
The effect of coupon on the relationship between price and interest rate on fixed-income, option free bonds
% change in price For a given change in market rate, the bond with the lower coupon will change more in price than will the bond with the higher coupon.
+ 1.74
+ 1.55 0
Market Price of Price of Zero Rate 9.4% Bonds Coupon 8.8% $10,155.24 $7,723.20 9.4% 10,000.00 7,591.37 10.0% 9.847.73 7,462.15
9.4%, 3-year bond Zero Coupon, 3-year bond
8.8 9.4 10.0 Interest Rate %
- 1.52 - 1.70
DURATION
• It is weighted average measure of time period of bond’s life. • We can also say that duration 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. • Duration is stated in years. • Unlike maturity, duration takes into account interest payments received throughout the course of holding the bond
DURATION
• For a zero coupon bond, maturity and duration are the same since there are no cash flows intermediately. • Higher the coupon rate, the shorter will be the duration. • Duration declines as bond reaches near maturity. • Moreover, the duration of a coupon paying bonds is always less than the remaining period to maturity
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. • Also used for risk measuring.
• It is used to study the effect of changes in interest rates on bond prices and yields
MDURATION
• It is short form for Modified Duration. • Mduration = Duration divided by (1+ (bond yield/k)). • Where k is the number of compounding periods per year. • Mduration is therefore inversely proportional to the approximate percentage change in price for a given change in yield. • It is a measure of the price sensitivity of a bond to interest rate movements.
CONVEXITY
• Convexity is a volatility measure for bonds used in conjunction with mduration in order to measure how the bond's price will change as interest rates change. • It is equal to the negative of the second derivative of the bond's price relative to its yield, divided by its price. • For example, since a non-callable bond's duration usually increases as interest rates decrease, its convexity is positive
SWAPS
• Swap is defined in number of ways. • Simple speaking Swap is a contract between two parties to exchange cash flows in the future according to agreed terms • Swaps are used to change the currency or interest rate exposure associated with investments. • Thus, we can say swap involves combined or simultaneous buying and selling operation in which two counterparties agree to exchange streams of payments occurring over time according to predetermined terms.
SWAPS
• To elaborate more, we can say Swap is the simultaneous purchase and sale of the same amount of a given currency for two different dates, against the sale and purchase of another. • In essence, swapping is somewhat similar to borrowing one currency and lending another for the same period. • However, any rate of return or cost of funds is expressed in the price differential between the two sides of the transaction.
Interest Rate Swaps (IRS)
• Interest Rate Swaps are those agreements where one side pays the other a particular interest rate (fixed or floating) and the other side pays the first party other different interest rates (fixed or floating). • IRS allow the entities to move from a fixed interest rate to a floating rate or vice versa in the same currency.
Interest Rate Swaps (IRS)
• IRS is a bilateral financial contract under which the parties agree to pay or receive the difference between an interest rate, fixed in advance for the swap tenor, and a floating rate that is based upon an agreed benchmark on a notional principal and for a specified period. • The difference between the rates is settled in cash on a series of payment dates that occur during the life of a swap. • Thus, it is a series of FRAs (i.e. Forward Rate Agreements).
Interest Rate Swaps (IRS)
• In interest rate swaps, there are no exchange of principals between the parties. • There is only exchange of interest obligations. • The principal is notional and is used only to calculate the interest payments between the parties.
Currency Swap
• These help the treasury managers to hedge the exchange risk. • The currency swaps allow Banks to change both the interest rate profile and currency denominations of its loans. • Unlike in interest rate swaps, where only interest payments are exchanged, in a currency swap both interest and principal are exchanged.
Currency Swap
• It involves exchanging principal and interest payment on a loan in one currency for principal and interest payments on an approximately equal loan in another currency, usually at the prevailing spot exchange rate. • On maturity of the swap, the respective principals are re-exchanged at the same exchange rate.
Coupon Swap
• This derivative product is like a currency swap with a difference that only the interest components of a loan is exchanged. • In this case, the Banks buy the instrument if it is expected that interest rates on the other currency is likely to be lower. • Interest rate caps and collar are used. • A cap is an option which gives the corporate the right but not the obligation, to exercise it. • This derivative product involves a strike price and an upfront premium.
Exchange Traded Funds
• Financial instruments, tradable on a stock exchange, that invests in the stocks of an index in approximately the same proportion as held in the index.
• • • • • • hybrid of open-ended mutual funds and listed individual stocks. funds that are listed on stock exchanges - trade like stocks. Unlike MFs, ETFs do not sell their shares directly to investors. Create ETFs by depositing a basket of stocks. This large block of stocks is called a creation unit. ETF receives shares, which are then offered to investors over the stock exchange.
Exchange Traded Funds
• Therefore, ETFs bring the trading and real time pricing advantages of individual stocks to mutual funds. To sum up some of the features of these Funds are :• These are a hybrid of open and close-ended funds; • They are listed on the stock exchange (Similar to the close-ended funds); • They create and redeem units in keeping with rise and fall in demand (Like open-ended funds). • They are passively managed (similar to index funds).
Exchange Traded Funds
• ETFs in India ?
• Benchmark AMC’s Nifty "Benchmark Exchange Traded Scheme" (BeES). It tracks the S&P CNX Nifty • Junior BeES. It tracks the CNX Nifty Junior Index comprising of mid-cap stocks. • Prudential ICICI Mutual Fund’s SPIcE (Sensex Prudential ICICI ETF) which tracks the BSE Sensex.
CBLO
• “Collateralized Borrowing and Lending Obligation” CBLO. • Money market instrument - for the benefit of the entities:• phased out from inter-bank call money market • restricted participation in terms of ceiling on call borrowing and lending transactions • do not have access to the call money market
CBLO
• CBLO - discounted instrument available in e-form for the maturity period ranging from 1 day to 90 days (can be made available up to one year as per RBI guidelines). • The main features of CBLO include :
• Obligation by the borrower to return the money borrowed, at a specified future date; • Authority to the lender to receive money lent, at a specified future date with an option/privilege to transfer the authority to another person for value received; • Underlying charge on securities held in custody (RBI) for the amount borrowed/lent.
CBLO
• The participants in this market are
• • • • • • • • banks, financial institutions, insurance companies, mutual funds, primary dealers, NBFCs, non-Government Provident Funds, Corporates etc.
• Participants open a Constituent SGL (CSGL) Account with RBI for depositing securities - offered as collateral / margin for borrowing and lending of funds. • Eligible securities are Central Government securities including Treasury Bills.
DERIVATIVES
• Derivatives have their origin in mathematics, where it is referred to a variable that has derived it value from another variable. • In financial market - those financial instruments whose value is derived from the price of some underlying asset - stocks, bonds, currencies or commodities. • One very interesting example to understand the concept of underlying asset is considering “curd” as a derivative. • The price of curd always depends on the price of milk. • We can say the underlying asset on which the value of curd depends is the milk.
DERIVATIVES
• Example :
• Assume that a farmer wish to contract to sell his rice harvest at a future date so as to eliminate the risk of a change in prices by that time. • Such a contract can take place in the Rice Forward Market. • The price of such a contract would certainly depend upon the current spot price of the rice. • In this transaction, the "rice forward" is the derivative
DERIVATIVES
• Derivatives are grouped into three categories namely,
• derivative securities; • exchange-traded derivatives; and
• Types of Underlying Assets :• • • • Equity shares Interest rates Foreign Exchange Commodities
DERIVATIVES
• Different types of Derivatives :• • • • Forwards or Forward Contracts Futures Options Swaps, etc.
INDEX FUTURES
• Index Futures - Future contracts - underlying asset - Index.
• The index futures contracts - based on the popular market benchmark Nifty index.
• Both the Bombay Stock exchange (BSE) and the National Stock Exchange (NSE) launched index futures in June 2000.
• To take a position on market movements.
• Suppose you feel that the markets are bullish and the Sensex would cross 15000 points. • Instead of buying shares that constitute the Index you can buy the market by taking a position on the Index Future.
INDEX FUTURES
• Index futures - used for
• hedging,
• speculating, • arbitrage,
• cash flow management and
• asset allocation.
INDEX FUTURES
• BSE / NSE defines the characteristics of the futures contract such as the underlying index, market lot, and the maturity date of the contract. • The futures contracts are available for trading from introduction to the expiry date. • Long and short positions indicate whether you have a net overbought position (long) or over-sold position (short).
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