ASSIGNMENT DRIVE WINTER 2014

PROGRAM MBADS (SEM 4/SEM 6) MBAFLEX/ MBA (SEM 4) PGDBMN (SEM 2)

SUBJECT CODE & NAME MA0042 & TREASURY MANAGEMENT
BK ID B1813 CREDITS 4 MARKS 60

Q.No 1 Write the role of financial system in economic development. Explain the functioning of
financial system.

Explanation of role of financial system in economic development

Explanation of functioning of financial system 5+5=10

Answer:
Role of Financial Systems in Economic Development
The function of a financial system is to accelerate the rate of capital formation. This is achieved through the
positive initiatives that are taken up by financial regulators and the government. In any economy, two sets of
people can be found in the financial system; one whose present incomes are more than their expenditures, and
others whose present incomes are lesser than their present expenditures. This gives enough opportunity for
savers or surplus-spending units to invest and get returns from the dormant savings which lie idle with the
investors or deficit-spending units. All this leads to increased production, employment and incomes, which
ultimately lead to higher Gross Domestic Product (GDP), higher per capita income and better economic and
social welfare.
Functioning of the Financial System
An effective and efficient financial system performs the following functions:
Provides a payment system for the exchange of goods and services
Permits multiple payment mechanisms (cash, cheque, demand draft, credit card, electronic fund transfer etc)
Supplies a diversified portfolio of financial investments with different riskreturn profiles to encourage savers
to postpone their present consumption and invest more.
Provides a mechanism for spatial and temporal transfer of funds. The financial system facilitates the transfer
of economic resources across time and space.

 Provides an institutional mechanism for pooling funds, credit risk assessment, risk diversification, loan
monitoring and loan recovery. Financial intermediaries such as commercial banks take up the responsibility of
credit risk assessment, monitoring, recovering funds, asset transformation, risk transformation, size
transformation and maturity transformation. The money received from the customers in the form of a
commercial deposit is pooled with money of other customers and is invested in a variety of financial assets with
varying risk return profiles to diversify its portfolio of investments, thereby, ensuring the safety of the
depositors money.
Stabilizes the interest rates and makes credit available for all purposes to replace an informal and unorganized
financial system.
Offers risk containment to safeguard investors through the mechanism of deposit guarantee (as seen in the
Indian commercial banking, wherein, up to a lakh rupee can be insured against risk with the Deposit and Credit
Guarantee Corporation of India).

2 Under the foreign exchange exposure management explain the transaction exposure with an
example and analysis. Explain translation exposure with example and also economic exposure
with example.

Explanation of transaction exposure

Explanation of translation exposure
Explanation of economic exposure 4+3+3=10

Answer:
Transaction exposure
A transaction exposure arises with a commitment to make a foreign currency payment or receive a foreign
currency income at a future date. The risk involved in an adverse exchange rate movement before the actual
payment or receipt of income could increase costs or reduce income in terms of the domestic currency is
exchange risk. The exchange rate could move favourably or adversely during the period of exposure.
Example
An Indian company sells goods abroad at a price of 100,000 with the customer being given six months credit.
The company intends to convert the pound into rupee after six months. At the time of the transaction the
exchange rate was 1 = ` 91.20.
Analysis: From the time of the transaction to the customer payment period six months later, the company has
an income exposure of 100,000 and is at a risk of falling in the value of the pound. If the exchange rate is 1 =
` 87.00, then the companys income will be just `8.7 crore instead of `9.120 crore.

Translation exposures
Translation exposures occur only because of the financial reporting requirements of the parent companies when
they have to report the financial position of subsidiary companies in consolidated accounts. Investments in
foreign subsidiaries must be translated into an equivalent amount of the parent companys currency. If the value
of a foreign subsidiary has fallen, the group will have to report a foreign exchange loss on its investment.
Translation exposures affect reported profits and balance sheet values but do not involves cash gains or losses
unlike transaction exposures. Hence, translation exposures are not so intimidating.
Example
Suppose a UK company has a US subsidiary with the following financials:
Year 1 profits

$175,000

Balance sheet at end of 2011

Assets

$1,565,000

Loans

$ 515,000

Net assets (equity)

$1,050,000

Year 2012 profits

$175,000

Exchange rates
End of year 2011
End of year 2012

1 = $1.5500
1 = $1.7500

To prepare the consolidate accounts of the group the UK parent translates the profits and investments in the US
subsidiary at the year-end exchange rates. The year-end profits in 2011 are the same at the dollar level. But in
terms of the pound (home currency of parent), the profits have shrunk from 113,000 to 100,000 from 2011 to
2012 while equity investments shrunk from 677,000 to 600,000.
Economic exposure:
Economic exposures arise when companies face business risks due to adverse exchange rate movements. Direct
economic exposure results in expected but uncommitted future receipts or payments in foreign currency.
Indirect economic exposures are risks of loss in competitive edge due to adverse exchange rate movements. Loss
in competitive edge can arise from cost or price disadvantages.
Example of direct economic exposures: ONGC gets its earnings in dollars.
Due to the steady decline in the dollar against the rupee, the earnings of ONGC will be jeopardized.

Example of indirect economic exposure: An Indian company competes with a US firm in the US and the Indian
markets. The costs are $1 in the US and `55 in India. The selling price is $2 and `110, respectively. Exchange
rates are $1= `55. Suppose, the exchange rates between the dollar and the rupee changes
to $1= `50.
The rupee has strengthened against the dollar. It would be devastating for the Indian company in the US where
the product is sold for $2. The Indian company would then earn revenue of `100 instead of the earlier `110.
In the Indian markets, the cost of production to the Indian firm is `55 but for the US company the cost of
production is only `50 ($1). They could reduce their price in India on the product to `100 and force the Indian
company out of business as it would continue to price its product at `110.

3 Explain the individual currency limits with individual gap limit and aggregate gap limit. Write
about the value at risk.

Explanation of individual currency limits

Explanation of individual gap limit and aggregate gap limit
Explanation of value at risk 3+3+4=10

Answer:
Individual Currency Limits
Normally there are specialist dealers allocated to each currency in which case the individual currency limits will
be the dealer limits too. Or the pound could be split between two dealers and each allocated 1.5 million and so
on. Positions could be oversold or overbought in the individual currencies; but they would not be netted out
between dealers or between currencies. However, at the whole, the daylight position would be computed using
the short-hand method.
It is expected that all commercial and market-making positions would be squared (neutralized) during the day
and the only positions carried forward would be the banks proprietary trading positions. One thing to be made
clear is the bank as an entity does not trade but authorizes senior traders to take up proprietary positions.
Proprietary traders may prefer to carry their positions overnight. Overnight positions are again controlled and
the overnight limit for the bank will depend upon Basel Capital adequacy allocation. Overnight limits are
computed using the short-hand method, but individual currency limits operate like the individual daylight
currency limits but smaller in size. Daylight limits are operational limits while overnight limits are related to
capital allocation. Positions will arise out of spot transactions and outright forward transactions. Foreign
exchange swaps do not affect the exchange position.

Individual Gap Limit and Aggregate Gap Limit

The limits on gap risks are:
Individual gap limit: Determines the maximum mismatch for any calendar month; currency-wise.
Aggregate gap limit: Is the limit fixed for all gaps, for a currency, irrespective of their being long or short.
This is computed by adding the absolute values of all overbought and all oversold positions for the various
months, i.e. the total of the individual gaps, ignoring the signs. This limit is also fixed currency-wise.

Value-at-Risk
The market risk of a portfolio refers to the possibility of financial loss due to the adverse movement of variables
such as interest and exchange rates. Quantifying market risk is important to regulators in assessing solvency
and to risk managers in allocating scarce capital. Value-At-Risk (VAR) is a method of measuring the financial
risk of an asset, portfolio, or exposure over some specified period of time. It is often used as an approximation of
the maximum reasonable loss a company can expect to realize from its financial exposures. Value-at-risk is a
summary statistic that quantifies the exposure of an asset or portfolio to market risk or the risk that a position
declines in value with adverse market price changes. It is the maximum loss that an institution can be confident
it would lose on a portfolio of assets due to market movements over a particular horizon.

4 Write short notes on:

a) Methods of cash-flow forecasting
b) Liquidity forecasting
c) Market instruments

Explanation of methods of cash-flow forecasting

Explanation of liquidity forecasting
Explanation of market instruments 3 +3+4=10

Answer:
Methods of cash-flow forecasting
Direct forecasting would mean computing anticipated cash receipts and disbursements. Receipts are accounts
receivable from sales, asset disposals, and miscellaneous proceeds. Whereas disbursements include rent and/or
lease payments, payroll, accounts payable to vendors and suppliers, dividends and debt servicing. To develop a
direct-method of cash flow projection, a bank should:
determine projected revenue.
estimate timing and amount of receipts (Accounts Receivable or AR)
identify any additional expected cash inflows, such as loans, refunds, and deposits

 compile all expenses and other payables

estimate payment dates for disbursements (Accounts Payable or AP)
calculate the amounts in cash disbursements forecast. To forecast cash flow through an indirect method, a
bank should consider the projected income statements of the project.
Liquidity forecasting
Great significance attaches to assessment/ forecasting of short-term liquidity of any central bank operating in a
market. This is crucial for sound management of monetary policy and ensuring smooth functioning of financial
system. The central bank needs to regularly announce the stages of this policy to help market participants.
Dealing with any possible mismatches in the demand and supply of liquidity at regular intervals forms the
cornerstone of this function. Liquidity management function also serves the task of steering the direction of the
operating target (viz., the short-term interest rate).
The central bank is the single supplier of bank reserves. Its assessment of liquidity begins by capturing the
movements of the balance sheet components with a view to estimating aggregate inflows and outflows. This will
give them a picture of the prevailing or likely liquidity position.
Market Instruments
The financial market is characterized by two elementscapital and money markets. Equity or debt securities,
the two intermediate to long-term financing source with maturities of more than one year, are part of the capital
market. The money market on the other hand provides short-term funds to the government and government
bodies. These are debt issues with maturities of one year or less. There are several players in the money market
which is characterized by various instruments. These instruments consist mainly of government securities,
securities issued by private sector and banking institutions.

5 Capital adequacy is one of the major indicators of the financial health of a banking entity.
Explain about capital adequacy and its ratio measures. Also explain the ratios that are necessary
under the assets quality.
Capital adequacy and its ratio measures
Explanation of ratio under assets quality 6+4=10
Answer:
Capital Adequacy
Capital adequacy is one of the major indicators of the financial health of a banking entity. It reflects the overall
financial condition of banks and their ability to manage the need for any additional capital. It also indicates
whether a bank has enough capital to absorb unexpected losses.

The Reserve Bank of India decided, in April 1992, to introduce a risk asset ratio system for banks (including
foreign banks) in India as a capital adequacy measure, in line with the Capital Adequacy Norms prescribed by
the Basel Committee.
The basic approach of capital adequacy framework is that a bank should have sufficient capital to provide a
stable resource to absorb any losses arising from the risks in its business. Capital is divided into tiers according
to the characteristics/qualities of each qualifying instrument. For supervisory purposes, capital is split into two
categories: Tier I and Tier II. These categories represent different instruments quality as capital.
Tier I capital consists mainly of share capital and disclosed reserves and it is a banks highest quality capital
because it is fully available to cover losses.
Tier II capital on the other hand consists of certain reserves and certain types of subordinated debts. The loss
absorption capacity of Tier II capital is lower than that of Tier I capital. When returns of the investors of the
capital issues are counter guaranteed by the bank, such investments will not be considered as Tier I/II
regulatory capital for the purpose of capital adequacy.
Tier III capital are used to meet market risks, that includes a greater variety of debt than Tier I and Tier II
capitals. Tier III capital debts may include a greater number of subordinated issues, undisclosed reserves and
general loss reserves compared to Tier II capital.
The following ratios measure capital adequacy:
(i) Capital Adequacy Ratio (CAR)
Banks need to maintain the Capital Adequacy Ratio (CAR) as stated by RBI from time to time. The latest
directive from the central bank puts the CAR number at 12 per cent.
CAR is arrived at by dividing the sum of Tier-I, Tier-II and Tier-III capital by aggregate of risk weighted assets
(RWA).
CAR = Tier One Capital + Tier Two Capital
Risk Weighted Assets
Tier-I capital includes equity capital and free reserves. (Free reserves are a measurement of a banks reserves
that is equal to the difference between borrowed reserves and excess reserves.)
Tier-II capital includes subordinate debt of five-seven years tenure, revaluation reserves, hybrid debt capital
instruments and undisclosed reserves and cumulative perpetual preference shares.

Tier-III capital comprises short-term subordinate debt. The higher the CAR the stronger the bank stands.
(ii) Debt-equity ratio
It is a measure that indicates the leverage of a bank. It indicates the proportion of debt and equity a bank is
using to finance its assets. This ratio is arrived at by dividing total borrowings and deposits by shareholders net
worth, which includes equity capital, and reserves and surpluses. A high debt-equity ratio means a bank has
been more aggressive in financing its growth through debt and hence, it gives less protection for the creditors
and depositors.
(iii) Advances to assets ratio
This is a ratio of the total advances to total assets. It shows a banks aggressiveness in lending, which leads to
profitability. Total advances include receivables, though the value of total assets excludes the revaluation of all
the assets.
(iv) Government securities to total investments ratio
The measure indicates the risk a bank takes during investment. Government securities are considered the safest
debt instrument hence, they have lower return. Their risk-free characteristic indulgences banks to go for higher
investment ratio, which means lower the risk involved. The measurement is arrived at by dividing the amount
invested in government securities by total investment.

To ascertain assets quality, the following ratios are necessary:

(i) Gross NPAs to net advance ratio
In a case where the bank management has not provided for loss on NPA, this ratio is used to assess the quality
of assets. Gross NPAs are measured as a percentage of net advances; the lower the ratio, the higher the quality of
advances.
(ii) Net NPAs to net advances ratio
If the bank management has not provided for loss on NPAs, this ratio is used to measure the quality of assets.
Net NPAs are gross NPAs minus net of provisions on NPAs and interest in suspense account. In this ratio, net
NPAs are measured as a percentage of net advances.
(iii) Total investments to total assets ratio
This indicates the extent to which assets have been deployed in investment against advances. This ratio
measures the percentage of total assets used in investments, which is not a part of the banks core income. It is
arrived at by dividing total investments by total assets. A higher ratio indicates the bank has been cautious and
kept a huge buffer of investments to guard its NPAs.
(iv) Net NPAs to total assets

This is a measure of the quality of assets where the management has not provided for loss on NPAs. In this case,
the net NPAs are measured as a percentage of total assets. The lower the ratio the better the quality of advances
(v) Percentage change in net NPAs
This measure reflects the movement in net NPAs in relation to net NPAs in the previous year. Higher reduction
in net NPAs levels is a good indicator for the bank.
It is given by the formula:
% change in net NPAs = (net NPAs at the end of the year net NPAs at the beginning of the year.

6 Treasury has become an integral part of all business functions. Explain the areas in which
Information technology plays an effective role. Write about cloud technology and treasury
applications.
Explanation of effective role of information technology (treasury and technology)
Explanation of cloud technology and treasury application 6+4=10
Answer:
Some of the areas where Information Technology (IT) plays an effective role are as follows:
(i) Automate manually-intensive and repetitive tasks: Technology is being leveraged to do jobs such as
data collection, accounting bank polling, portfolio tracking and reporting, which are repetitive in nature. This
not only brings down the percentage of human error but also minimizes the delay. Automation also facilitates
information sharing among departments and regions, and provides accurate audit trail. Consequently,
automation brings more focus on value-added tasks, that are critical to management functions and for smooth
operation. One such software to regulate treasury is Treasury Management System (TMS), also known as a
treasury workstation. This software package specializes in the automation of manually-intensive and repetitive
functions like managing cash flows. The system allows a company to communicate with business houses to
manage cash, transactions, forecasts, and even investments and debts.
Through proper selection and implementation of a TMS, companies can effectively respond to their financial
needs. Electronic Bank Account Management (eBAM) is another process by which treasury professionals can
introduce standard workflows for opening, closing and maintaining bank accounts, eliminating the need to
spend the day filling forms, track missing records and chase incomplete tasks.
(ii) Error detection and time-saving methodology: Each day at the account closing hour, there is a need
to balance that days transactions. In treasury management system, the sources of cash transactions are the
previous days bank data. Through the treasury management system, all repetitive transactions are

automatically tagged with the correct instructions. Most companies using TMS get 90-95 per cent of their
transactions automatically tagged accurately without any manual intervention.
(iii) Cash flow forecasting: Cash flow forecasting is important for every organization, especially for financial
houses, for its growth and success. It is the duty of a treasury to keep a check on the fund reserves, expected
income and cash outflow in order to meet business goals and possible crisis. An effective forecasting about an
impending liquidity crisis or cash shortfall, taking into account the market conditions, both forex and domestic,
foreign currency rate fluctuations and account interest rate changes, helps in tackling a financial risk better.
Cash flow forecasting might be a challenge for companies still relying on spreadsheets.
(iv) Implement internal control: An organization should have an effective system of internal control to
oversee its financial and economic activities and implement its principles set by the management, as well as the
requirements stipulated by the law. A treasury should have detailed and well laid out duty chart of each
employee outlining their responsibilities. It should also have an upgraded and effective internal audit system.
(v) Communicate with operating units: Operating units must be involved while building your forecasts to
ensure incorporation of all necessary and up-to-date information.
(vi) Choose a web-based treasury management system: The real benefit of technology without adding
any unnecessary cost or delays could be achieved by selecting a web-based treasury management system.
Webbased solutions significantly reduce implementation costs and timeframes, and enable a company to access
the system from anywhere anytime.
Upgrading these systems would add value without deploying much internal fund or resources. To ensure
security of information, a system with two factor- authentification and encryption technology should be
selected.
(vii) Rethink treasury process: Performance of the treasury and its functioning should be evaluated at
regular intervals. Each step should be reviewed to extract maximum efficiency. Attention should be paid to
experience and knowledge.
(viii) Pay for performance: To reinforce the importance of forecasting, portfolio management, cash
consolidation and other value-added activities across the treasury department, benchmarks should be defined.
Proper and effective use of information technology in treasury operation increases the efficiency of corporate
officers.
Cloud Technology and Treasury Applications:
Companies are increasingly moving over to cloud technology for a more integrated functioning in a competitive
and uncertain environment, yet a dynamic one. The earlier scepticism about security and capabilities has given

way to dependency. Cloud technology will, in fact, enable corporations to increase mobility, productivity and
register better growth and success. The cloud can act as an enabler for consumable treasury services.
The primary benefits this technology for treasurers are its agility and elasticity. However, due to the critical
nature of the operations and data, hosting treasury services on a public cloud is not advisable. Firms should opt
for either private or hybrid cloud services in order to retain confidentiality. A hybrid cloud helps to deploy a
treasury management solution faster and companies can benefit from the upfront cost reduction, automatic
service upgrades and lesser IT resource requirements. Though private hosting is more expensive, organisations
can benefit from higher levels of availability, resiliency and scalability, along with added security, control and
auditing abilities. That is because it has controls built-in to ensure data integrity.
Companies can also build and run their own cloud, with all of the associated costs, or outsource to a specialist
provider and pay only for the resources they use in terms of software, bandwidth and storage.
For example a service such as eBAM can be hosted in the cloud and used on an as-needed basis. Cloud
technology services can be availed at a fee depending on the usage. Also, these services do not require a license,
which eliminates the related paperwork and costs.
The key benefits of the technology are:
It reduces dependence on scarce internal IT resources
Provides world-wide access to the system
Reduces total costs of ownership