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XIMB’ August’2010
Understanding Treasury
Rishi Rakesh
Dynamics 1
Contents
Session –I (Overview):
o Role of Treasury in an organization
o Balance Sheet Dynamics
o Benchmark\Transfer Pricing
2
Session- I
Treasury Overview
3
Course Objectives
o Understand basic concepts of Treasury
management
o Understand Treasury function and its
role in business management process
Course Outcome
o Be able to better consider treasury
issues as part of the business
management process
o Be able to understand Treasury’s
different risk exposures and the
methods used to manage these risks
o Be able to interpret treasury data and
treasury language
4
The Evolution
Credit/Lending
Marketing
Operations
5
Treasury Management
6
The Missing Link
Building Blocks of Banking Business:
Credit
Marketing
Operations
AND Treasury
7
The Finance Industry
Role of Financial Market:
1. Interaction of buyers and sellers of risks
2. Determination of price of risks
3. Reduction of transaction costs
B
A
Risk Providers / N Risk Investors /
Sellers Buyers
K
S
8
Role of Treasury
Customer Business Proposition
Market Strategy
Funding / Investment
Treasury Cycle
• Transaction initiation Credit Cycle
• Revenue / Expense • Credit Initiation
Stream management • Account Maintenance
Marketing / Sales
- Interest rate • Collection - write offs
- FX rate
• Liquidity / Cash flow
management.
MIS: Portfolio Management
9
Role of Treasury
o “Central bank” for all internal customers
o Determine price of money
o Bridge funding/lending needs
o Identify/quantify market risk
o Interest rate risk
o Liquidity risk
o Foreign exchange risk
o Manage risk where necessary
o Managing the company's relationships
with credit rating agencies
10
Summary
Treasury Actions
Hedging
Investments
Funding
11
The Treasury Balance Sheet
Unit Outline
Treasury components of a balance sheet
Treasury assets
Treasury liabilities
Summary
12
Components of a Typical Bank Treasury Balance Sheet
ASSETS LIABILITIES
Our accounts Their accounts
Swap assets
Swap liabilities
TP assets
Capital
TP Liabilities
13
Why Have Treasury Assets & Liabilities?
For management of the structural position
14
Liquidity Management
Treasury Assets Treasury Liabilities
15
Rate Risk Management
Developed markets have derivative (off balance sheet)
instruments to manage interest rate risk
Limited by
Available instruments
Available liquidity to make the investment
16
FCY Portfolio Management
FCY deposits are used to fund LCY balance sheets in certain markets (e.g. India FX
swaps)
Generally unwilling to use FCY deposits to fund LCY balance sheet (high MTM
volatility, corporate limitations)
17
Regulatory Compliance
Reserve requirements
Government securities
18
Treasury Assets
o Bank placements
19
Summary
Treasury Responsibilities for
Balance Sheet Management
Define the liquidity characteristics of each balance
sheet item; use treasury assets and liabilities to
structure a liquidity plan to manage the risks
20
Balance Sheet Dynamics
Unit Outline
Key concepts
Re-pricing and Repayment Models
Treasury’s Response
Summary
21
Key Concepts
The three variables that Treasury is most interested in are:
Re-pricing characteristic
Repayment characteristic
Foreign exchange risk
22
Key Concepts
Every product has certain characteristics important to
Treasury
23
Key Concepts
24
Repricing & Repayment Models
25
Repricing & Repayment Models
Product Characteristics
Product Tenor Behaviour
26
A Simplified Repricing Model
1 YR 2 YR 3 YR 4 YR 5 YR > 5 YR TOTAL
Fixed Rate Loans 150 150
Mortgages 4 4 5 7 10 70 100
27
A Simplified Repricing Model
Conclusions
In general, the re-pricing of liabilities in a bank
takes place earlier than the re-pricing of
assets.
If the yield curve was positively sloped (i.e. if
longer maturities have higher rates), a
negative gap is profitable.
If interest rates rise and gap is negative,
profitability will be squeezed since a higher
rates will be paid to raise liabilities whereas
the interest being paid on assets are already
locked.
28
A Simplified Repayment Model
1 YR 2 YR 3 YR 4 YR 5 YR > 5 YR TOTAL
Fixed Rate Loans 150 150
Mortgages 4 4 5 7 10 70 100
29
A Simplified Repayment Model
Conclusions
In general, the repayment of liabilities for a
bank takes place faster than the repayment of
assets.
Treasury should ensure that existing funding
can be rolled over upon maturity or new
funding can be sourced to support assets.
There is liquidity risk if cash inflows from asset
repayments do not coincide with the cash
outflows from liability maturities.
30
Repricing & Repayment Model
Benefits
A good model provides insights into profit dynamics
and liquidity position of the business.
Once the risk is identified, it can be managed.
Needs highlighted by the model can help us evolve
new product offerings.
Elimination of risk may not be a goal; as a financial
intermediary, we take some interest rate risk.
The key is to determine an acceptable amount of risk
given a certain set of forecast events.
31
Product Dynamics
Product Pricing Liquidity
Term deposit Agreed upon rate Market lagging / Contractual for 3 Roll-over /
(e.g. 3 month fixed Pricing pressure months Pre-termination
rate TD) (competition)
Current a/c Savings On demand (short- Sticky pricing On demand (short- Portfolio Dynamics:
a/c term) term) Core (LT) vs Non-
Core (ST)
15 year Fixed-Rate Agreed upon rate Refinancing with the Contractual for 15 Refinancing with
Mortgages same bank years another bank
Credit cards Can be re-priced Limited repricing ability Minimum payment by Portfolio Dynamics:
upon notice due to competitive due date Transactor vs.
pressure or statutory Revolver
max.
32
Savings Example
REPAYMENT ANALYSIS
With a large enough population, we can perform statistical behavioral
analysis.
This analysis will identify a certain core percentage of deposits that can
be said to have an indefinite maturity.
As the book grows, the amount of this core segment will also grow.
33
Savings Example
REPRICING ANALYSIS
Movements of product price vs. market rates generally show a weak
but notable relationship.
Although the entire portfolio could (in theory) be re-priced tomorrow, it
clearly will NOT be.
However, once the portfolio does re-price:
The amount of the change in basis points will be less than
movements in the market rates.
Regardless of market movements, there will be a considerable
interval before the next repricing.
34
Savings Example
Assigning
We said that even though Savings is
a Tenor to contractually “on demand”, the core
Savings is portion of the book remains long
term.
a
CHALLENG But how long is long enough for core?
E!
It all depends…
35
Treasury’s Response
Statistically Determine Actual Behavior
Take a portfolio approach (providing that a large
enough population exists for statistical validation).
Do a redemption analysis (examining the actual
payment history of a product set).
Adjust for seasonalities.
Take into account other variables, such as:
Ceilings / Floors
Advertising / promotion campaigns
Innovation
36
Treasury’s Response
Use re-pricing models to predict profitability
The actual re-pricing structure determine future
profitability.
A re-pricing model should be able to forecast earnings
volatility.
A re-pricing schedule of all assets vs. all liabilities and
capital gives us our current interest rate position and
exposure to future events.
37
Summary
Consumer products have certain repayment
and re-pricing characteristics that need to be
managed.
A model needs to be built that shows the
liquidity and interest rate risks inherent in the
balance sheet.
Effective management of repricing and
repayment risk results in enhanced and more
consistent earnings.
38
Treasury Role of Benchmarking
Unit Outline
Benchmarking: the concept
Benchmark determination
Summary
39
Benchmarking : The Concept
What is a Benchmark?
Benchmarking is a framework that divides the bank into separate
product lines & transfers risk to a central unit
40
Benchmarking : The Concept
Why is Benchmarking Necessary?
Benchmarks are designed to transfer market risk exposure from the individual product
managers to treasury, where all risk is centrally located and professionally managed on
a portfolio basis
Fundamental to the overall concept of market risk neutrality and stable Net Interest
Margin (NIM)
Provides acute focus upon product profitability, customer pricing, positioning and
product development
Without benchmark, the impact of market risk is buried in the results of the product
manager
41
Measurement of Margin Components
Simplified Yield Curve Example
– one asset, one liability, booked today
Asset Spread
(Loans)
5% Yield Curve
Risk Management
Gap (tenor
mismatch)
4%
Time
42
Measurement of Margin Components
Adding the matched spreads (3%+1%) and the treasury spread (1.0%)
equates to the total business spread of 5.0%. The 1% treasury spread is
the net impact arising from the bank’s market risk. Generally the spread
is positive when the asset tenors are longer than liabilities.
43
Features of Good Benchmarks
Benchmark is a transfer pricing mechanism that aims to reflect
the true economics of the product
44
Session- II
Managing Treasury Risk
45
Managing Interest Rate Risk
UNIT OUTLINE
46
I. Identifying the Risk
Determine the re-pricing profiles of assets and
liabilities in the balance sheet
47
I. Identifying the Risk
INTEREST RATE EXPOSURE DUE TO
Gaps in an existing portfolio
Basis Mismatch
Volume Risk
Sticky rates on new originations
Embedded options
48
I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
A GAP….
Difference in repricing tenor (periods) of assets and
liabilities and/or
Difference in the amount of assets and liabilities
maturing / re-pricing within a time period.
Can be represented as run-off gaps or as remaining gaps
(cumulative gaps).
Can be “Positive” or “Negative”.
Can be Structural or Intentional
49
I. Identifying the Risk
Q1 Q2 Q3 Q4
ASSET
REPRICING
LIABILITY
REPRICING
50
I. Identifying the Risk
51
I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
STRUCTURAL GAP
Result of the mismatch in the inherent re-pricing
characteristics of assets and liabilities
Influenced by product features and determined by
customer behavior
INTENTIONAL GAP
Due to Treasury Actions
Dependent on view of interest rates
53
I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
INTENTIONAL GAPPING : NEGATIVE GAP
54
I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
INTENTIONAL GAPPING : POSITIVE GAP
55
I. Identifying the Risk
SOURCE OF RISK - BASIS MISMATCH
56
I. Identifying the Risk
Source of Risk – Volume Risk
FYF Actual B/(W)
BAU/Status Quo 100 100 -
57
I. Identifying the Risk
58
I. Identifying the Risk
SOURCE OF RISK - EMBEDDED OPTIONS
EXAMPLES:
Cap/Floor on Floating Rate Products
Pre-termination without penalty for Fixed Rate Products
Borrow-back at pre-determined rate on Deposit Products
59
II. Measuring the Risk
KEY CONCEPTS
DV01
(Earnings At Risk)
60
II. Measuring the Risk
DV01
Management Tool to evaluate risk and define economic loss
parameter
61
II. Measuring the Risk
DV 01 (A Methodology)
Dollar value for 1 basis point move
Captures the potential earnings impact of one basis point
movement in interest rates
Calculated by : Repricing Gap * 0.01% * Tenor
Total DV01 are the sum of individually derived Dv01
(deal by deal calculated)
Total DV01 categorized into Rolling 12 mths and Full
Tenor discounted
62
II. Dv01
An Example:
63
Liquidity Risk
Overview
64
Liquidity Problem?
How much water should you bring if you are going to a 7-day trip across the
Sahara?
Carrying enough water for 1-day only assuming there will be wells or
suppliers along the way… taking a risk of not being able to find the well
(source of liquidity) before dying of thirst.
65
What Is Liquidity Risk?
The risk that funds will not be
available to meet a financial
commitment to a counterparty in any
location or any currency at any time.
This is our key franchise risk
(customer confidence).
Liquidity risk-taking is
Fundamental to banking
An important source of revenue
66
Businesses Need Liquidity
For survival:
Having funds available at all times to meet fully and
promptly all contracted liabilities, including demand
deposits and off-balance sheet commitments
For growth:
Having funds available to take advantage of future
business opportunities
67
How Liquidity Risk Arises
Liquidity risk may come from:
Operating environment:
Contingency situations:
Name
68
Contingency Situations
Market Disruption
Name Problem
69
Liquidity Management
Objectives
o To ensure sufficient liquidity to meet all financial
commitments and obligations when they fall due
70
Roles & Responsibility
Managing liquidity risk is the joint
responsibilities of Business, Treasury, and
Risk Management; oversight by Asset and
Liability Committee (ALCO).
Country Treasurer
Has primary responsibility for liquidity
management
Develops funding plan & process for each legal
vehicle
71
Summary
Effective liquidity management is critical to:
Business survival, growth and expansion
Maintaining market confidence
72
Session- III
Money Market Instruments
73
Concept of a Yield Curve
Positive Yield Curve
Rates
Slopes upward to the right
No specific trend
Premium for longer period Maturities
(credit risk, liquidity risk, compounding)
Opportunity cost of inflation
Cost of insulating against rate moves
With a positive yield curve, all things being equal, a
negative gap is generally the profitable position
74
Gapping: Examples of Different Yield Curve
Rates
Rates
Rates
75
Gapping: Current Yield Curve - USD
76
Gapping: Yield Curve Shifts – USD Yr 2003 vs
2004
May 2004
June 2003
77
Gapping: Yield Curve Shifts – USD Yr 2004 vs 2005
June 2005
May 2004
78
Gapping: Yield Curve Changes – UST Yr 2005 vs 2006
August 2006
June 2005
79
Gapping: Yield Curve Changes – USD Yr 2006 vs 2007
May 2006
May 2007
80
Gapping: Yield Curve Changes – USD Yr 2007 vs 2008
May 2007
May 2008
81
Gapping: Fed Funds Target
82
Gapping: Yield Curve Comparison
83
Instrument to Manage Risk
84
Interest Rate Swap
Definition
Agreement between two parties to exchange interest rate
payments on a notional principal sum which is not
exchanged
Purpose:
Manage interest rate risk
Permit large volume transactions
Change the interest rate profiles of liabilities or assets
Most common swap is fixed-for-floating which one counter-
party agrees to pay a fixed rate over the term of the swap
in exchange for a floating rate payment payable by the
other counter-party (aka “coupon” swap)
85
Interest Rate Swap Example
Assets Liabilities
$50MM mortgages $50MM TDs
Avg. Life: 10 yrs Avg. Life: 6 mths
Avg. Rate: 11% Avg. Rate: 8%
(fixed for 10 yrs)
86
Interest Rate Swap Example
Swap Agreement:
87
Interest Rate Swap Example
11%
FIXED RATE = (9%)
88
Interest Rate Swap Example
89
Interest Rate Swap Example
Results for ABC: The Next Six Months
(Assume interest rates increase 2%)
With SWAP
Without SWAP
Borrows 6-month libor (10%) (10%)
Receives from XYZ, 6-month libor 10%
Net spread 0%
Receives from mortgage portfolio 11% 11%
Pays Bank XYZ 9% --
Net spread 2% 1%
90
Interest Rate Swap Example
14
12 12
11
10 10
Fixed
Interest Rates
8 8 Rate Paid
to XYZ
6
4
2
0
R1 R2 R3 R4
Resets
91
Interest Rate Swap Example
R1 R2 R3 R4
a. Borrows Inter-bank (11%) (12%) (10%) (8%)
b. Receives from Mortgages 11% 11% 11% 11%
c. Net Spread 0% (1%) 1% 3%
Without the interest rate swap, ABC has interest rate risk based on the
changing cost of 6 month borrowings
The Swap with XYZ will lock-in a guaranteed earnings spread of 2% on the
fixed rate mortgages, regardless of how interest rates change
92
Forward Rate Agreement
Agreement with a counter-party to pay or receive the
difference in interest on a notional principal amount
between an agreed future interest rate and a reference
interest rate for a specified period
93
Forward Rate Agreement
Jargon
94
Forward Rate Agreement Example
ASSETS LIABILITIES
$50MM auto loans $50MM TDs
Tenor: 1year Tenor: 3mths
Fixed Rate: 10% Rate: 7.5%
95
Forward Rate Agreement Example
96
Forward Rate Agreement Example
Interest Rates
6
R3 - 1.0%
5
4
3
2
1
0
R0 R1 R2 R3
Resets
97
Forward Rate Agreements Example
Results for ABC rollovers
R0 R1 R2 R3
Auto Loan 10% 10% 10% 10%
3mth interbank 7.5% 8.0% 8.5% 7.0%
Spread before FRA 2.5% 2.0% 1.5% 3.0%
98
Interest Rate Options
Definition:
A contract that gives the options buyer the right, but
not the obligation, to lend/borrow funds at a specific
rate over a specified time frame
In return, the options buyer pays a fee called a
premium at the time of option purchase (Buying
insurance)
Purpose:
Manage interest rate risk
Permit large volume transactions
Allow flexibility of rate cover, but still receive benefit
of favorable moves
99
Introduction to Foreign Exchange
Unit Outline
Foreign Exchange Fundamentals
Types of Foreign Exchange Exposure
Managing FX Exposure - considerations
Factors affecting the market
100
Foreign Exchange Fundamentals
What is Foreign Exchange?
A foreign exchange transaction involves one currency
being bought or sold against another currency
Rate Quotation:
a. Cross Rates:
A foreign exchange rate between two
currencies derived via a third currency
Example: GBP/HKD via USD (GBP/USD and
USD/HKD)
b. Price Quotation:
Bid and Offer
101
Foreign Exchange Fundamentals
Time element in FX market:
Spot Transaction:
Settlement within two business days from deal date
Forward Transaction:
Settlement at a specified future date (>two business
days)
Common tenors are 1, 2, 3, 6, 9 and 12 months
102
Foreign Exchange Fundamentals
Why is there a FX market?
International trade
Capital movements
Financial transactions
Exchange of services
Tourism
103
Foreign Exchange Fundamentals
Players in the FX market?
Commercial banks
Speculators
Fund Managers
Non financial businesses
Central banks
Investment houses
104
Foreign Exchange Fundamentals
Factors affecting FX rate movement
Demand and supply
Sovereign policy
Exchange control/regulations
Economic performance
Money supply
Inflation
Interest rates
Speculation
105
Types of FX Exposure
Transaction Exposure
(daily Mark-to-Market):
106
Types of FX Exposure
Translation Exposure
107
FX Treasury Products
We will briefly discuss the 3 basic forms of
derivative products:
1. Forwards
2. FX Swaps
3. Options
108