Treasury Management Module C

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Chapter 19: INTRODUCTION TO TREASURY CRR: Treasury was responsible for holding
MANAGEMENT (PART-I) minimum cash balances required as per Cash
Reserve Ratio (CRR) with Reserve Bank of India.
What we will study?
SLR: Treasury was responsible for investing funds
in approved securities to the extent required under
*What is Treasury Management? Statutory Liquidity Ratio (SLR).
*What is Integrated Treasury Management? Thus, the Treasury function was essentially liquidity
management.
What is Treasury Management? Service Centre: from an organizational point of view,
Conventionally, the Treasury function was confined Treasury was considered as a service center.
To funds management: Treasury does Liquidity Management:
1-Maintaining adequate cash balances to meet day- To date, liquidity management continues to be an
to-day requirements. important function of Treasury.
2-Deploying surplus funds generated from However, owing to economic reforms and
operations. deregulation of markets which began in India in the
9 's, the scope of Treasury has expanded
3-Sourcing funds to bridge occasional gaps in cash
considerably.
flow.
Treasury As Profit Centre:
4-In the context of a bank, the Treasury is also
Treasury has since evolved as a profit center, with
Responsible to meet the reserve requirements i.e.
its own trading and investment activity.
CRR & SLR.
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Treasury connects the core activity of a bank with Investment in securities and foreign exchange
the financial markets: business:
Treasury connects the core activity of a bank Till late 9 's, the investment in securities and
(deposit taking and lending) with the financial foreign exchange business constituted two
markets which is also true of the corporate separate departments in most of the Indian banks.
treasuries in non-banking companies by
But these two functions have now become part of
continuously accessing the markets for lending, an integrated Treasury, thus adding a new
borrowing, investing and trading in financial assets. dimension to the treasury activity.
Treasury Managing Market Risk:
Since treasury interact with markets, managing Treasury deals with short-term funds:
market risk for the entire bank has become an
integral part of Treasury. Treasury essentially deals with short-term funds-
flow (i.e. with less than one year maturity), with the
Treasury s role in Asset-Liability Management exception that as part of the SLR requirement,
(ALM): investment in some securities is held to maturity
The Treasury plays an active role in Asset-Liability exceeding one year.
Management (ALM), and with its constant exposure Risk management function of treasury:
to markets, is well placed to advise the
management of the bank for taking internal Risk management function, covers the underlying
decisions, say in product pricing and strategic assets and liabilities across short, medium and
investments. long-term maturities.
Concept of Current account and Capital account: FUNCTIONS OF INTEGRATED TREASURY:
The balance of payments account, which is a Integrated Treasury, in a banking set-up, refers to
statement of all transactions made between a integration of money market, securities market and
country and the outside world, consists of two foreign exchange operations.
accounts current and capital account. Integrated Treasury, in the Indian context, is the
While the current account deals mainly with import direct result of reforms in the financial sector, the
and export of goods and services, the capital most important reforms being deregulation of
account is made up of cross-border movement of interest rates and partial convertibility of Rupee.
capital by way of investments and loans. Rupee is already freely convertible on current
Current account convertibility refers to the freedom account, and to a large extent, also convertible on
to convert your rupees into other internationally capital account, owing to major relaxations allowed
accepted currencies and vice versa without any by the Reserve Bank, in the area of foreign direct
restrictions whenever you make payments. investment (FDI), external commercial borrowings
(ECB) and overseas direct investment (ODI).
Similarly, capital account convertibility means the
freedom to conduct investment transactions Banks have also been allowed large limits, in
without any constraints. proportion to their net worth, for overseas
borrowing and investment.
Banks have gained wider access to foreign
currency funds through their off-shore operations,
NRI deposits, resident foreign currency accounts
such as EEFC and funds from external commercial

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borrowings (ECB). Chapter 19: INTRODUCTION TO TREASURY
The process of globalization has contributed to MANAGEMENT (PART-II)
integration of treasuries. What we will study?
Integrated Treasury, therefore, is in a position to
operate across various sectors and across the
*What is Merchant business?
currency markets, either in search of higher returns,
or in order to mobilize low cost funds for liquidity
*What are 3 distinctive roles of Treasury
needs. Management?
Just as cash flow is a cash flow irrespective of the
currency in which it is denominated, the risk Merchant Business:
attached to market operations also needs a Large corporate clients now prefer to deal with
common approach cutting across different markets.
Treasury directly, rather than through bank
When we operate in different currencies and deal
Branches or through other functional departments.
with different segments of debt and equity markets,
we generate currency and interest rate risks or The Treasury's transactions with customers are
price risk, which together is generally referred to as Known as merchant business, as distinct from
market risk. bank's own trading and investment business.
It is hence imperative that Integrated Treasury is Many corporate customers have their own treasury
also fully involved in risk management, in particular,
departments, and they expect to receive an
management of market risk, often using derivative
products.
integrated service from the bank, in areas such as 4-Optimising profit by exploiting market
hedging export receivables, raising foreign currency opportunities in
loans and overseas investments. Forex market
Money market
We may now restate the driving force of Integrated Securities market (debt, equity and credit derivative
Treasury as:
markets)
1-Integrated Cash Flow Management 5-Risk management, i.e., managing the market risk
2-Interest Arbitrage of the bank/entity
3-Access to global resources 6-Assisting bank management in ALM.
4-Corporate demand for high-end services, and Treasury activity thus encompasses fund
5-Risk Management management, investment, forex operations, trading
and risk management services in a multi-currency
We may summarize the functions of Integrated environment.
Treasury as:
1-Meeting reserve requirements (CRR and SLR)
3 distinct roles of Treasury:
2-Global cash management
(a) Liquidity Management:
3-Efficient merchant services, which include foreign
Treasury is responsible for managing short-term
exchange (forex) and advisory services
funds across currencies, and also for complying

Chapter 19: INTRODUCTION TO TREASURY
with reserve requirements (CRR and SLR).
MANAGEMENT (PART-III)
(b) Proprietary Positions: What we will study?
Treasury may trade in currencies, securities and *How treasury work as a profit center?
other financial instruments, including derivatives, in
*What are the sources of profit for treasury?
order to contribute to Bank's profits.
(C) Risk Management:
EVOLVINGROLEOFTREASURYASPROFIT
Treasury will aid Management in bridging asset-
CENTRE:
liability mismatches (ALM), will provide derivative
tools to manage risks in client's business, and will By convention, Treasury was a service center,
also manage risks inherent in its own proprietary primarily intended to attend the cash flow
positions. requirements of the bank, and hence operated only in
money market
Merchant business was attended through the foreign
The multiple roles necessitate Treasury to manage exchange department, while bank’s investment assets
an ALM Book for internal risk management, a were managed through a separate department.
Merchant Book for client-related currency and
derivative transactions, and a Trading Book for
managing its proprietary positions.
Thus there were effectively three treasuries Third:
operating in three different markets, which have Operational costs in Treasury are low as compared
been integrated and integrated treasury was to branch banking, whether retail or wholesale.
formed.
The Treasury is run by a few specialist staff,
The wider scope of integrated treasury has offered engaged in high-value transactions, per transaction
banks an opportunity to generate surpluses, to
size generally not being below Rs. 5 million( 5 Cr).
supplement profits from its core banking activity.
The Treasury also trades in narrow spreads, hence
profit is generated from high volumes of business.
Treasury profits have become attractive for three Treasury profits are generated from the following
reasons: sources:
First: Conventional Sources:
Treasury largely operates in inter-bank markets 1- Foreign Exchange Business
which are almost free of credit risk, and hence
requires very little capital allocation. 2- Money Market Deals
Second: 3- Investment Activity
The treasury activity is highly leveraged (more Contemporary Sources of profit:

debts than equity) and hence, the return on capital 1- Interest Arbitrage
may be quite high.
2- Trading
3- Treasury Products
1-Foreign Exchange Business: change from moment to moment, hence the
Buying and selling foreign currency to customers dealers are careful to maintain only a limited
constitutes a major source of other income for the position during the day time also).
banks. Concept:
The difference between buy rate sell rate which is Transfer Price Mechanism:
known as spread - is the profit for the bank. The basic function of a bank branch is to accept
The banks buy foreign currency from customers deposits for lending so every branch is expected to
(mainly exporters) and sell the same in inter-bank serve as a profit centre.
market. But practically it may not be possible because
The banks also sell foreign currency to customers some branches have more business of deposit than
(importers), which they buy from inter-bank market. advances and some branches have more advances
Banks generally do not maintain a stock of foreign than deposit.
currency for the purpose of merchant business, as As this may not reflect a true picture and to
it is more convenient to buy and sell from inter- compensate for the loss these branches are paid in
bank market. the form of HO interest receivable. These Branches
Open Position: will show a profit after adding HO Interest.
Any residual position of a bank at the end of day Likewise, for the advances given, branches have to
pay HO interest treating it as money borrowed from
overbought or oversold is known as open position,
which involves exchange risk, as the value of HO.
foreign currency may change overnight (may in fact, Such branches having concentration in Advances
will have to pay HO for the funds deployed from the 3-Investment Activity:
interest earned by them. Banks have always been investing in government
Their Profit after HO interest will come down. securities to satisfy the SLR requirement, but
This is called the Transfer Price Mechanism. otherwise were not very active in investing in non-
government securities.
Income from risk-free investments was not
2-Money Market Deals: considered to be significant.
Conventional banking operation in money market Banks have also been investing in strategic assets
was confined to lending surplus funds and such as subsidiary and associate companies
borrowing funds when required. where returns on investment were only of
Interest on funds lent in the market is a source of secondary importance.
income, but it can hardly be called profit - as such The development of corporate debt market in fact,
funds come from deposits, where interest cost is is a recent phenomenon, which followed removal of
higher than the interest earned in money market. RBI restrictions on bank investments, and
To overcome this, Banks come out with a Transfer dematerialisation of securities in the late 9 's.
Pricing Mechanism so that the Treasury comes to Contemporary sources of profit: (next lecture)
know the cost of the funds which they receive from
branches. 1- Interest Arbitrage
Till fairly recently, banks were circumspect in 2- Trading

borrowing funds in inter-bank market only for the 3- Treasury Products
purpose of lending with a profit.

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Chapter 19: INTRODUCTION TO TREASURY Contemporary sources of profit:
MANAGEMENT (PART-IV) 1- Interest Arbitrage
What we will study? 2- Trading
*What are contemporary sources of profit of 3- Treasury Products
treasury? Buying and selling foreign exchange to customers
and interest on investments and money market
Treasury profits are generated from the following lending, continues to be the primary source of
income for bank treasuries.
sources:
Conventional Sources: However, Treasury profits are increasingly derived
from market operations, involving buying and
1- Foreign Exchange Business
selling, or borrowing and lending, or investing in
2- Money Market Deals tradable assets, taking a proprietary position - not
3- Investment Activity with the intention of meeting customer
requirements, or for meeting Reserve requirements
Contemporary Sources of profit:
of the bank, but only to generate profits.
1- Interest Arbitrage
At the same time the range of services the bank
2- Trading
offers to customers has also widened with
3- Treasury Products introduction of new products.
The Treasury profits arise mainly from the following
contemporary sources:
Interest Arbitrage: certificates of deposit, treasury bills and CBLO to
The Treasury operates across the currency and optimize return on funds.
security markets; hence it is in a position to find
where the interest differentials are in its favour. Trading:
The Treasury may borrow in USD and lend in Rupee Trading is a speculative activity, where profits arise
inter-bank market, or vice versa, depending on the out of favorable price movements during the
domestic and foreign interest rates. interval between buying and selling.
Or, the Treasury may borrow in money market and
Currency trading since long has been at the core of
invest short-term fund in commercial paper or T- forex dealing activity in bank treasuries.
bills.
Banks holding AD 1(Authorized Dealer 1) license
Banks with good credit standing, may borrow large are permitted by RBI to trade in currencies within
amounts in money market and lend to other banks, pre-set limits.
highly rated corporates and other institutions, using
market instruments, at marginally higher rates. Treasury may go long (buy currency) or short (sell
currency) on currencies to get profit from exchange
As the futures market continues to develop, rate movements.
Treasury also has the opportunity to arbitrage
between OTC (over-the-counter) and futures Treasury may also swap currencies, buying and
markets. selling currencies at different points of time, to
benefit from changes in forward rate movements.
Treasury today uses a variety of money market
instruments, such as commercial paper, The Treasury may take similar proprietary position
in securities, where, in a rising market, securities
are bought and sold with a profit when the yields Another area which is almost exclusive to banking
fall. sector is trading in credit instruments.
Bank treasuries are fairly aggressive in buying and The instruments available in this segment are
selling Government securities (G-sec), as the banks securitized credit receivables and other assets,
in any case need to hold approved securities, in commonly known as pass-through certificates,
excess of their SLR requirement, in order to issued by special purpose vehicles(SP ) for the
manage their liquidity. specific purpose of securitization.
G-secs constitute the most liquid segment of debt While trading in currencies and securities,
market and are traded on wholesale debt market Treasuries are open to market risk, or price risk,
(WDM) of National Stock Exchange. where they may incur loss if price of the currency
Treasuries over the last decade, have also become (exchange rate) or the security moves adversely.
active in equity markets. In order to minimize such losses, bank treasuries
Equity trading is highly profitable in rising stock are subject to strict risk management controls.
markets, despite the volatility of equity prices, as Banks have also been permitted to trade in some of
Indian economy has been witnessing a steady the derivative products, and some of the larger
growth. banks have been market makers in options and
However, in terms of volume, banks participation in interest rate swaps.
stock market is peripheral, as RBI restricts banks' Derivatives have added to the range of products
direct and indirect exposure to capital markets by available to the Treasury for trading, as well as risk
imposing limits. management.
Treasury Products: Chapter 19: INTRODUCTION TO TREASURY
Treasury sells, in addition to foreign exchange MANAGEMENT (PART-V)
services, derivatives and structured products to What we will study?
corporate customers.
*The Organization structure of Treasury.
Large corporates have an appetite for new products
in order to hedge their currency and interest rate
risks, and at times, also to reduce their interest
ORGANIATION OF TREASURY:
costs. The Treasury is organized either as a Department of
the bank, or as a Specialised Branch under direct
For instance, a company may buy from the Treasury
control of the bank’s head office.
a Forward Rate Agreement (FRA) to fix interest rate
for commercial paper they plan to issue after 3 In either case, the Treasury functions with a degree of
months. autonomy, with its own accounting system.
The branch status is preferred as the books of
The Treasury may offer a currency swap to a
accounts of Treasury can be maintained
corporate customer to convert their floating rate
independently (with its own P&L and GL accounts.)
USD loan into Rupee loan carrying fixed interest
rate, so that the customer no longer has currency On the other hand, the department from has the
risk or interest rate risk. advantage of easier coordination with related
department at head office (such as Central
The rates offered by Treasury for such products
always have a built-in profit margin, or a buy-sell
spread' in bank s favour.
Accounts and Planning Departments). The Treasury is segregated into three main
Treasury as a specialized branch enjoys an divisions:
additional advantage, as the Branch can act as The Dealing Room (or, Front Office),
Authorised Dealer for foreign exchange business The Back Office (or, Treasury Administration) and
and can participate in clearing and settlement
systems directly, while Head Office Department can The Mid-office (or Risk Management).
only act through a branch for its business
operations.
Dealing Room or Front Office:
We may therefore conclude that in the context of
The dealing room is headed by Chief Dealer, who is
integrated treasury operations, a Treasury Branch
in charge of the front office.
should be the preferred form of organisation.
The Dealers working under him, buy and sell in the
Who can be head of treasury?
markets.
The Treasury is headed by a senior management
Each Dealer specializes in one of the markets, i.e.
person A General Manager (GM), Chief Treasury
foreign exchange, money market or securities
Officer (CTO), ice-President or any other official
market, although, in an integrated treasury, the
with a similar designation.
dealers are generally familiar with all the markets.
Treasury being a key activity of the bank, Head of
Depending on the size of operations, there may be
Treasury should be a person who would report
dealers dedicated to major currencies, or dealers
direct to the CFO or CEO of the bank.
specializing only in forward markets or derivatives.
It is also common to have a separate corporate
dealer, exclusively to attend to major corporate The deals are verified on the basis of deal slips
customers/ merchant business. prepared by the dealers and also from the
In larger banks, Treasury will also have an ALM confirmation received from the counterparties.
desk, to exclusively manage Bank's ALM risks. The back-office confirms the deals independently
The Securities Market is normally divided into two with the counterparties (banks and other
parts: institutions) over phone and verifies the
Primary and secondary markets. authenticity of the confirmation document.
The securities dealer deals only with secondary The Back office takes care of all related book-
market, i.e. buying and selling of securities already keeping and submission of periodical returns to RBI.
available in the market. Back-office also maintains Nostro accounts
On behalf of the bank, the dealer may also (foreign currency accounts with correspondent
participate in auction of government securities and banks), funding and security accounts with RBI, and
T-bills, conducted periodically by RBI. Demat accounts with depository participants and
ensures that adequate margin money is held with
Clearing Corporation of India (CCIL) for Rupee and
The Back Office or Treasury Administration: dollar settlements.
Settlement is a key function of Back-office, as all
payments and receipts must take place on value
The back-office is responsible for verification and
date.
settlement the deals concluded by the dealers.
Any delay in settlement would not only result in management.
financial loss to the bank, but delays in payment are As per RBI guidelines, the Mid Office should
considered as a default by the bank, severely comprise of experts in market risk management,
affecting the bank's reputation. economists, statisticians and general bankers and
It is mandatory that Front office and Back Office may be functionally placed directly under the ALCO.
are totally segregated, reporting to two different
The Mid Office should also be separated from
managers. Treasury Department and should not be involved in
The Mid-office (Risk Management): the day to day management of Treasury.
Risk management, Middle office (Mid-office) is The Mid Office should apprise the top management
created exclusively to provide information to the /ALCO/Treasury about adherence to prudential/risk
management (MIS) and to implement risk parameters and also aggregate the total market
management systems. risk exposures assumed by the bank at any point of
Mid-office monitors exposure limits and stop loss time.
limits of Treasury and reports to the management Whenever a suitable offer is received, the
on key parameters of performance. Department would put up an investment proposal
and obtain approval at appropriate level.
Transfer Pricing Mechanism may also be
implemented through Mid-office. Minimum marketable investment being Rs. 5 crore,
In smaller banks, Mid-office may also function as the investment proposals are scrutinized closely
ALM Support Group, as the balance sheet risk and are generally considered by an Investment
management is closely connected to Treasury risk Committee, before the sanction is obtained at
appropriate level.
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Chapter 20: TREASURY PRODUCTS (PART-I) Currencies which are not fully convertible, have
What we will study? limited demand and may not be traded actively, but
they may also enjoy high liquidity, depending on the
*What are various products of FX market?
size and stage of development of domestic market.
*What is spot trade?
*What are Forward Rates?
For instance, Indian Rupee (INR) is only partially
*What are Swaps?
convertible, but the market for USD/INR is fairly
PRODUCTS OF FOREIGN EXCHANGE MARKET: liquid, owing to large domestic market and high
Characteristics of FOREIGN EXCHANGE MARKET: growth rate of the economy.
1- Most Liquid Market:
Foreign exchange (forex) market is the most liquid 2- Most Transparent Market:
Market as free currencies (major currencies which Foreign Exchange Market is also the most
Are fully convertible, e.g., USD, EUR, GBP, JPY etc.) transparent market as most of the transactions
Can be readily bought and sold here. take place online across the time zones in
electronic medium.
Free currencies belong to those countries, whose
Markets are highly developed and where exchange
Controls are practically dispensed with. 2- irtual Market:
It is a virtual market, without physical boundaries,
the only limitation for currency trades being
domestic regulation or convertibility.
There are also internet sites which provide trading 1- 4-2 2 trade date: TOD Rate
platforms. 2- 4-2 2 : TOM Rate
Several banks have their own sites where
3- 4-2 2 : SPOT Rate
customers can deal in foreign exchange on-line.
All the exchange rates quoted on the screen, or in

1. Spot Trades: print, are for spot trade by default, unless otherwise
Currencies are mostly bought and sold in spot mentioned.
trades.
Spot settlement takes place two working days from The TOD and TOM rates are generally quoted at a
the trade date, i.e. on the third day.
discount to the spot rate) i.e. the rate is less
favourable to the buyer of the currency.
1- 4-2 2 trade date
2- 4-2 2 In an integrated market, the premium or discount
charged on the currency is really decided by the
3- 4-2 2 spot settlement date
demand and supply of base currency (in our case it
is US ) and overnight interest rate differentials of
Currency may also be bought and sold, with the currencies bought and sold.
settlement on the same day, i.e. today
(TOD/Cash/Ready), or, on the next day, i.e.
tomorrow (TOM).
2. Forward Rates: Treasury may also enter into forward contracts,
While spot trade refers to current transaction, purely for the purpose of making profit out of price
forwards refer to purchase or sale of a currency on movements.
a future date. Forward exchange rates are not exchange rates
forecast into the future; in other words, they do not
reflect projected rate movements in the market.
The exchange rates for forward sale or forward
purchase are quoted today; hence such Forward exchange rates are arrived at on the basis
transactions are referred to as forward contracts of interest rate differentials of two currencies,
between the buyer and seller. added or deducted from spot exchange rate.
Treasury may enter into forward contracts with The interest rate differential is added to the spot
customers (merchant business) or with banks (inter rate for low-interest yielding currency (representing
-bank market) as counterparties. forward premium) and deducted from the spot rate
for high interest yielding currency (representing
Customers, i.e. importers, exporters and others, forward discount).
who expect payments or receipts in foreign
currency, cover their currency risk by entering into
forward contracts with their respective banks. However, forward rates fully reflect interest rate
differentials only in perfect markets, where the
Treasury in-turn covers its customer exposure by
taking reverse/opposite positions in the inter-bank currencies are fully convertible and where the
market. markets are highly liquid.
Since Rupee is not yet fully convertible, the demand The swap route is generally used for funding
for forward contracts influences the forward requirements, but there is also a profit opportunity
exchange rates more than the interest rate from interest rate arbitrage.
differentials. When we have USD funds, but we need Rupee funds
to invest in a commercial paper for 3 months, we
may enter into a USD/INR swap deal to sell USD
3. Swaps:
at spot rate (converting into Rupee funds) and
The spot and forward transactions are the primary buying back the USD 3 months forward (with Rupee
products in foreign exchange market. funds on maturity of the CP).
A combination of spot and forward transactions, or If the interest earned on CP is higher than the cost
a combination of two forward transactions is called of USD funds, the swap results in a profit.
a swap.
The cost of USD funds consists of interest at
A swap transaction is also described as an market rate plus forward premium for the 3-month
exchange of cash flows. period.
Buying USD (with Rupees) in the spot market and However, interest arbitrage exists only when one of
selling the same amount of USD in the forward the currencies exchanged is not fully convertible.
market, or vice versa, constitutes a USD/INR swap.
The swap is otherwise used to eliminate currency
Similarly, simultaneous purchase and sale of and interest rate mismatches.
currency on two forward dates (forward to forward)
is also a swap.
Chapter 20: TREASURY PRODUCTS (PART-II)
What we will study? 1-Call Money:
*What is Money Market? Lending and borrowing for 1 day.
*What are money market instruments? 2-Notice Money:
*What is Call Money, Notice Money & Term Money?
Lending and borrowing for 2 days to 14 days.
3-Term Money:
MONEY MARKET PRODUCTS:
Lending and borrowing for 15 days to 1 year.
What is money Market?

Call Money:
Money Markets refer to raising and deploying short- Call money refers to overnight placements, i.e.
funds borrowed by banks need to be repaid on the
Term resources, with maturity of funds generally not
next working day.
Exceeding one year.
Call money rates indicate liquidity available in the
The inter-bank market is sub-divided into call inter-bank market.
money, notice money and term money market. Overnight Mumbai Interbank Offered Rate (O/N
MIBOR) is the indicative rate for call money, fixed
daily in the morning, used widely as a benchmark
rate for overnight interest rate swaps.
The call money market is purely an inter-bank The prudential limits in respect of both outstanding
market. borrowing and lending transactions in call/notice
Non-bank players, such as financial institutions and money market:
mutual funds, were phased out of call money
market w.e.f August 2 5. For Scheduled commercial banks:
Only banks, primary dealers and co-operative banks
(other than land development banks) can
participate in the call money market. Max Avg lending in a fortnight:
It can be up to 25 of capital fund (TIER-I TIER-II)
of the lending bank.
Primary Dealers:
But on any particular day of the fortnight lending
PD is a firm that buys government securities can be maximum 5 of the capital fund of lending
directly from government. bank.
Notice Money: Max Avg borrowing in a fortnight:

Under call money market, funds are transacted on It can be maximum 1 of capital fund(TIER-I
an overnight basis, whereas under notice money TIER-II) of the borrowing bank.
market, funds are transacted for a period between 2
days and 14 days. But on any particular day of the fortnight borrowing
can be maximum 125 of the capital fund of
borrowing bank.
Lending : 25 For primary dealers (PDs):
Max in a day: 5
Borrowing : 1 Max Average borrowing:
Max in a day: 125 PDs can borrow on daily average basis up to 225
their Net Owned Funds (NOF) at the end of March
For co-operative bank:
of the previous financial year.
Max Average borrowing:

Max Average Lending:
PDs can lend in call/notice money market on daily
Borrowing for State Co-Operative banks/District average basis up to 25 their Net Owned Funds
central Co-operative banks/ Urban Co-operative (NOF) at the end of March of the previous financial
banks in call money/notice money market, on a year.
daily basis should not exceed 2 of their aggregate
deposit at the end of March of the previous
financial year. Term Money:
Max Average Lending: No limit. Term money market is for placement of funds with
banks for periods in excess of 14 days, but not
exceeding 1 year.
Typically term money placements range from 1 Treasury invests surplus cash in money market,
month to months, and placements for longer after meeting the Cash Reserve Ratio (CRR) and
periods are not very common. Statutory Liquidity Reserve Ratio (SLR) stipulated
Inter-bank markets are at the forefront of financial by RBI.
markets and are the first to signal any changes in Currently the CRR is 3 of bank's demand and time
money supply and the resultant liquidity in the liabilities.
system. CRR is an important monetary policy instrument of
On any particular day, the call money transactions RBI to influence liquidity in the market.
reflect the liquidity available in the system. The RBI does not pay interest on CRR balances held
Inter-bank market is considered to be a risk-free by banks.
market, though in reality, the banks do carry
counterparty risk.
Bank treasuries typically deal in inter-bank markets,
However, for practical purposes, inter-bank market but treasury operations now extend to short-term
carries lowest risk, hence the interest rates investment paper issued by government, financial
prevailing in inter-bank market constitute institutions and companies in public and private
'benchmark rates.
sectors.
The call money rate, as indicated by the overnight
Mumbai Inter-bank Offered Rate (O/N MIBOR) is the
most widely accepted benchmark rate for floating
rate debt paper, as also for overnight interest rate
swaps (OIS).
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Following are the securities mainly dealt with for Chapter 20: TREASURY PRODUCTS (PART-III)
placement of short-term funds. What we will study?
1- Treasury Bills *What is Treasury bill?
2-Cash Management Bills (CMBs) *What is CMB?
3-Commerical Paper (CP) Bank treasuries typically deal in inter-bank markets,
But treasury operations now extend too short-term
4-Certifiate of deposit (CD)
Investment paper issued by government, financial
5-Repo Institutions and companies in public and private
-LAF sectors.
Following are the securities mainly dealt with for
-MSF
Placement of short-term funds.
-CBLO (Centralized Borrowing and Lending
Obligation) 1-Treasury Bills
2-Cash Management Bills (CMBs)
3-Commercial Paper (CP) 4-Certifiate of deposit
(CD)
5-Repo 6-LAF 7-MSF
8-CBLO (Centralized Borrowing and Lending
Obligation)
Treasury Bills: The auction however is open to all players in the
These are issued by Government of India through financial markets, including financial institutions,
Reserve Bank for maturities of mutual funds, corporates, other business entities,
as also individuals.
91-days,
T-bills are issued on fixed dates and for pre-fixed
1 2 days and amounts.
3 4-days, Currently, 91-day T-bill is issued weekly on each
for pre-determined amounts. Wednesday,
The interest is by way of discount, so the bills are 1 2-day T-bill is issued fortnightly on Wednesday
priced below Rs. 1 . preceding the non-reporting Friday, and
3 4-day T-bill is also issued fortnightly on
Wednesday preceding reporting Friday.
Yield of T Bill: (F -M )* 3 5/91
For bank treasury, investment in T-bills is a
For example, T-bill of 91 days is priced at 99.2 ,
convenient way of parking short-term surpluses in a
yielding interest at 2.9 p.a. (1
risk free investment, yielding interest generally
99.2 )*3 5/91), which is known as implicit yield.
higher than the overnight call money rates.
T-bills have a liquid secondary market and the T-bill
The price of T-bills is determined through an yields constitute a valid benchmark rate for debt
auction process where banks and primary dealers paper.
are the main participants.
FIMMDA (Fixed Income Money Market and the proposed Cash Management Bills(CMB)
Derivatives Association of India) and Reuters depends upon the temporary cash requirement of
collaborate to publish benchmark T-bill yields for the Government.
one week to one year based on the residual However, the tenure of the proposed Bills is less
maturity of T-bills in circulation. than 91 days.
The T-bill, like other government securities, is in
(b) The Bills are issued at discount to the face value
electronic form and is to be held in a SGL account. through auctions, as in the case of the Treasury
Secondary market settlement of T-bills takes place Bills.
through Clearing Corporation of India Ltd. (CCIL). (c). The announcement of the auction of the Bills is
Cash Management Bills (CMBs): be made by the Reserve Bank of India through
separate Press Release issued one day prior to the
The Government of India, in consultation with the
RBI, had decided to issue a new short-term date of auction.
instrument, known as Cash Management Bills, to (d) The settlement of the auction is on T 1 basis.
meet the temporary cash flow mismatches of the (e) The Non-Competitive Bidding Scheme for
Government. Treasury Bills is not extended to CMBs.
CMBs in India are non-standard, discounted (f) The Bills are tradable and qualify for ready
instruments issued for maturities less than 91 days. forward facility (Repo, MSF and Reverse Repo
CMBs have the generic character of Treasury Bills. facility).Investment in the proposed Bills is
CMBs have the following features: reckoned as an eligible investment in Government
Securities by banks for SLR purpose.
(a) The tenure, notified amount and date of issue of

Chapter 20: TREASURY PRODUCTS (PART-IV) The issue of CP is governed by guidelines issued by
What we will study? RBI and market practices prescribed by
FIMMDA(Fixed Income Money Market and
*What is Commercial Paper (CP)?
Derivatives Association of India).
*What is Certificate of Deposit (CD)?
Commercial Paper (CP):
As per RBI guidelines, the principal requirements
This is a short-term debt market paper issued by
for issuing Commercial Paper are:
corporates, with a minimum maturity of 7-day sand
maximum maturity of 1 year.
1-the issuing company have minimum credit rating
Minimum Maturity: 7 Days of A3 as per the rating symbol and definition
Maximum Maturity: 1 Year prescribed by SEBI.
2-the tangible net worth of the company as per last
balance sheet must not be below Rs. 4 cr.
Corporates, primary dealers and financial
Institutions are eligible to issue commercial paper· 3-the company should have been sanctioned
Minimum Amount of CP: 5 Lac working capital limit by bank/s or Fls and
Then Multiple of 5 Lac. 4-the borrowal account of the company must be

under the standard asset classification of the
financing bank/institution.
The issue of CP should be for a minimum amount
of Rs. 5 lacs and multiples thereof.
Banks are permitted to invest in CP only if it is in value of Rs. 1 .
demat form hence most of the CPs are issued in The CP is a negotiable instrument and has a fairly
demat form. active market.
CP is to be issued through an IPA (issuing and CP is issued in Demat form, hence the purchase
paying authority) who must be a bank. and sale of CP is effected through the depository
The total amount of CP proposed to be issued participant (DP) accounts of investors.
should be raised within a period of two weeks from Banks tend to invest in CPs through the treasury, as
the date on which the issuer opens the issue for
subscription. (a) Credit risk is relatively low and limited to a short
period
CP may be issued on a single date or in parts on
different dates provided that if issued in parts then (b) Yield on CP is higher than inter-bank money
each CP shall have the same maturity date. market yield and
Every issue of CP, and every renewal of a CP, shall (c) CP being a tradable instrument, there is no
be treated as a fresh issue. liquidity risk.
The CP carries relatively low credit risk, owing to its Secondary market for CPs is fairly active and the
short-term nature and minimum credit rating indexed return on CP is used as a benchmark rate
requirement. for short-term advances.
The CP is issued in the form of a promissory note All OTC trades in CP shall be reported within 15
for discounted amount, i.e. price of CP is less than minutes of the trade to the reporting platform of
the face value, and the price is quoted for face Clear corp Dealing System (India) Ltd. (CDSIL).
The settlement cycle for OTC trades in CP shall approved credit rating agency.
either be T or T 1. CD is meant primarily for high net worth individuals,
Buyback of CP: the minimum amount of the deposit being Rs. 1 lac
(a) Issuers can buyback the CP, issued by them to and multiples thereof.
the investors, before maturity. Minimum Amount of CD: 1 Lac
(b) Buyback of CP shall be through the secondary Then Multiple of 1 Lac
market and at prevailing market price. The period of maturity of CD, issued by banks, can
(c) The CP should not be bought back before a range between days and 1 year from the date of
minimum period of days from the date of issue. issue.
FIs can however issue CDs for a period not less
Certificates of Deposit (CD): than 1 year and not exceeding 3 years from the
date of issue.
This is a debt instrument similar to commercial
paper, but is issued by banks or other eligible
financial institution (FI) against deposit of funds. Minimum Maturity: Days
Unlike a deposit receipt, CD is a negotiable Maximum Maturity: 1 Year
instrument and generally bears interest rates higher CDs can be issued either in demat form, or in
than regular deposits of the bank.
physical form as promissory notes.
It is also more expensive to the bank, as the CD Banks can issue CP and CD only in the format given
attracts stamp duty, and is generally rated by an by RBI.
Since CD is negotiable, it is also an investment Chapter 20: TREASURY PRODUCTS (PART-V)
vehicle for corporates and banks. What we will study?
Banks cannot sanction any loan against CDs or *What is the security market products?
permit premature closure of CDs.
Secondary market for CD market is not very active SECURITIES MARKET PRODUCTS:
and banks find it attractive, only when liquidity
conditions are tight.
Investment Business is an important part of
CDs may be issued at a discount on face value.
Integrated treasury and is composed of buying and
Banks have to maintain appropriate reserve Selling products available in Securities Market.
requirements, i.e.,Cash Reserve Ratio (CRR) and Following are the security market products:
Statutory Liquidity Ratio (SLR), on the issue price of 1-Government securities
the CDs.
2-Corporate Debt Paper
All OTC trades in CP shall be reported within 15
3-Debentures and Bonds
minutes of the trade to the Financial Market Trade
Reporting and Confirmation Platform (F-TRAC) of 4-Convertible Bonds
Clearcorp Dealing System (India) Ltd. (CDSIL). 5-Equities
All OTC trades in CDs shall necessarily be cleared
and settled under D P I mechanism through the
authorised clearing houses.
Government Securities: Bank of India (SIDBI) and National Bank for
Statutory Liquidity Ratio (SLR): Agricultural and Rural Development (NABARD).
However, the number of eligible bonds for this
Treasury invests primarily in Government Securities
to comply with the reserve requirement of the bank, purpose is being curtailed and banks mostly invest
i.e. Statutory Liquidity Ratio (SLR), which is in government securities for the purpose of SLR.
presently at 1 of bank's demand and time Banks can also hold cash or gold to fulfill SLR
liabilities (DTL). requirement.
RBI, at its discretion, can increase or decrease the Who issue Government Securities?
SLR, subject to a cap (max) of 4 , in order to Government Securities are issued by Public Debt
control money supply in the market in fact the Office of Reserve Bank of India on behalf of
SLR has been gradually reduced to 1 , from a
Government of India.
peak of 3 .5 in September, 199 .
State governments also issue State Development
SLR Max 4 SLR Min (earlier 25 ) Bonds through RBI.
The Banking Regulation Act of 1949 was amended Government Securities are sold through auctions
in 2 to allow RBI to stipulate SLR below 25 conducted by RBI.
(which was the earlier minimum SLR level
stipulated under the Act.) Bonds:
To satisfy SLR requirement, banks can also invest The interest is paid on the face value of the bonds
in other approved securities, such as priority sector (expressed as ; minimum value of bonds is Rs.
bonds issued by Small Industries Development 1 , ) at coupon rate, but the price of the bonds is
determined in the auction conducted by RBI.
RBI arrives at a cut-off price based on the bids RBI is the issuing and paying agency for
submitted by banks and primary dealers and the government securities.
price may be higher or lower than the face value of RBI also uses government securities as a policy
Rs. 1 . instrument to control liquidity in the market in order
Government securities are actively traded in to influence the interest rates.
secondary market; hence the price and yield of the
RBI may absorb liquidity by selling the securities in
bonds would be constantly changing depending on the market and may infuse liquidity by buying back
the demand for bonds. the securities from the public.
The yield on bonds is therefore different from These are known as open market operations (OMO)
coupon rate of interest. of the central bank.
For instance, 1 -year G-sec, maturing in January
Types of Government Security:
2 2 and carrying a coupon of .35 is currently
priced at Rs. 9 . giving a yield of . 2 . 1-Held till Maturity (HTM): Banking Book
(Investment)
The price of the bonds and the yield on bonds move
in opposite direction. 2-Available for Sale (AFS): Trading Book (Trade)
Open Market Operations (OMO): 3-Held for Trading (HFT): Trading Book (Trade)
The Government of India borrows from public by Bank's investments are classified into Held till
issue of securities, to finance its deficit which is Maturity (HTM) consist of securities mainly for
the difference between Government's income and investment purpose and hence placed under the
expenses. Banking Book,
Available for Sale (AFS) and Held for Trading (HFT) In December, 2 13, RBI allowed IRFs deriving value
consist of tradable securities and hence placed from the following underlying on the recognised
under the Trading Book. stock exchanges:
Securities under HFT are actively traded and are (i) 91-Day Treasury Bills;
marked-to-market (MTM) regularly for accounting (ii) 2-year, 5-year and 1 -year coupon bearing
purpose.
notional Government of India security.
Banks and institutional investors actively buy and RBI also uses the G-sec market to develop debt
sell government securities in anticipation of price markets.
changes.
G-sec yields set benchmark rates for corporate
The view on prices/interest rate is based on the bonds; RBI issue bonds for various maturities
rate of inflation, GDP growth and other economic
ranging from 1 year to 3 years.
indicators.
RBI has also issued a variety of bonds, with step-up
The yields and prices of securities move in the coupons or coupons linked to inflation index, or
opposite direction prices fall when yields (interest floating rate coupons.
rates) rise, and vice versa.
STRIPS:
Interest rate futures market has also been activated
by RBI with the trading in Interest Rate Futures Current proposals include issue of STRIPS
(IRFs) on a notional coupon bearing 1 -Year (Separate Trading of Registered Interest and
Government of India (Gol) Security introduced in Principal Securities), where the principal and
August, 2 9 on stock exchanges. interest are traded as separate zero-coupon
securities.
Chapter 20: TREASURY PRODUCTS (PART-VI) They are also referred to as non-SLR securities, to
What we will study? distinguish the corporate debt paper from
government securities and other approved
*What is Corporate Debt Paper?
securities, which are eligible for meeting SLR
*What are Debentures and Bonds? requirement of banks.
Tier-2 capital bonds issued by banks also fall under
SECURITIESMARKETPRODUCTS: this category.
Following are the security market products: Treasuries find corporate debt paper as an
1-Government securities (see Part-V) attractive investment, as yields on bonds and
2-Corporate Debt Paper debentures are higher than the yield on government
securities.
3-Debentures and Bonds
Now that most of the corporate debt paper is
4-Convertible Bonds
issued in demat form, there is fairly active
5-Equity secondary market and the bonds issued by top
Corporate Debt Paper: corporates are highly liquid. (Banks are allowed to
Corporate debt paper refers to medium and long- invest only in demat securities.)
Term bonds and debentures issued by corporates Yields on corporate debt paper differs from
And financial institutions, which are tradable. instrument to instrument, depending on the credit
quality, that is, higher the credit risk, higher is the
yield.
Most of the debt issues have credit rating by one of In practice, Company Law requires that debentures
the seven credit rating agencies in the country. issued by companies are always secured; hence
Global ratings are necessary if the debt paper is debentures are generally secured by mortgage or
being issued in the international markets. with a floating charge or a lien on assets.
Treasury can invest FCNR deposit funds and other Bonds, though issued by public sector companies,
do not imply guarantee by the government, unless it
foreign currency surpluses in global debt paper as
per policy guidelines approved by the management. is so mentioned specifically in the terms of the
issue.
Debentures are governed by relevant provisions of
Debentures and Bonds: Company Law and are transferable only by
In India, conventionally, debentures are debt registration.
instruments issued by corporates in private sector, Bonds on the other hand are negotiable
while bonds are issued by institutions in public instruments governed by law of contracts.
sector, this distinction really has no meaning in
international market. Debenture may be convertible or non-convertible.
Convertible debentures may be converted in to
These are debt instruments, issued by corporate equity as per terms of issue.
bodies, literally with a charge on specific assets.
There is no practical difference between non-
The literal meaning has been lost in practice and convertible debentures (NCD) and bonds.
debentures and bonds may be issued with or
without security.
As a matter of convenience, we use bond as Convertible Bonds:
common nomenclature for non-convertible These are a mix of debt and equity, where the bond-
corporate debt paper, with original maturity of 1 holders are given an option to convert the debt into
year and above. equity on a fixed date, or during a fixed period, and
Where the debentures and bonds are convertible in the conversion price is predetermined.
to equity, they are so mentioned specifically.
If the issuer company's stock price is higher than
Bonds may be issued with differing structures in the prefixed conversion price, the investors would
order to enhance the marketability of the prefer to convert the debt into equity.
instruments as also to reduce the cost of issue. The benefit to the company is that there is no debt
The variations include put/call or convertibility repayment and at the same time its equity base is
options, zero coupon bonds, floating rate bonds, strengthened.
deep discount bonds and instruments with step up The coupon on convertible bond is generally lower
coupons. than the coupon on non-convertible bond of similar
Bonds which are not secured by mortgages, but credit standing.
secured by stocks or other collateral, are also In case the bond is converted in to equity, the equity
referred to as collateralised obligations.
holdings of the existing shareholders get diluted.
Finally, there are also bonds with put/ call option
and step up coupons, with the incentive of higher
interest for non-redemption of the bonds in early
stages.
Equities: The derivative products available in the market, viz.
Banks are permitted to invest in equities (shares of index futures, index options, stock futures and
listed companies) subject to a limit on capital stock options have since become highly popular for
market exposure, set by RBI. risk management as well as for speculation.
Equities are traded on stock exchange and the Major investors in domestic market include foreign
institutional investors, mutual funds, insurance
stock prices are influenced by fundamentals
(financial position) of the company as also various companies and private fund managers.
macro-economic factors. Bank treasuries have not been leading investors in
In view of the risks involved in equity trading, bank stock markets, as the stock prices are highly
treasuries are generally cautious in investing volatile, banks prefer low risk investments and are
surplus funds in the stock market. also bound by the prudential ceiling given by RBI on
capital market exposures.
However, we must mention that Indian stock
market is one of the oldest in Asia and the
institutional structure is well developed, with SEBI
as the Regulator.
Bombay Stock Exchange and National Stock
Exchange are the two leading stock exchanges,
where the trading is done on an electronic platform
(also called screen-based trading).
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BFM MODULE - C FEW TERMS:
Chapter 21: International Equity and Debt Products Capital Instruments means equity shares, debentures,
(PART-I) preference shares and share warrants issued by an Indian
company.
What we will study?
Post issue paid up capital refers to the paid-up share capital of
*What is FDI? the Company after issuance of shares being discussed. For
*What is FPI? example, if the paid up share capital of a company is INR
100,000, and Mr. X invests an amount of INR 30,000 and gets
3000 shares of INR 10 each, then the post issue paid up share
capital after Mr. X’s investment shall be INR 1,30,000.
Fully diluted basis means the total number of common shares
of a company that will be outstanding and available to trade
on the open market after all possible sources of conversion,
such as convertible bonds and employee stock options, are
exercised.
Foreign Direct Investments (FDI) & Foreign Portfolio

Investments (FPI):
In a developing country like India, the total capital
requirements cannot be met with internal sources alone, so
foreign investments become important in supplying capital.
The two most regular foreign investments are FDI and FPI.
Foreign Direct Investments (FDI): Foreign Institutional Investors (FII):
As the name suggests, it refers to investing directly in another It is an investor group that brings FPI’s, such institutional
country. A foreign company based in another country invests investors include hedge funds, mutual funds and pension
in India by setting up a wholly-owned subsidiary or getting funds.
into a joint venture with some company occupied in India and
They engage in the secondary market of the economy.
then operates its business in India.
To participate in the markets, the FII needs to get registered
There are two routes in FDI:
with SEBI.
Automatic route:
REGULATORY ENVIRONMENT FOR FOREIGN INVESTMENT:
This route allows FDI without prior approval by India’s
Foreign Investment in India is regulated in terms of Section 6
Government or Reserve bank (RBI).
sub-section 3 clause (b) and Section 47 of the Foreign
Government route: Exchange Management Act, 1999 (FEMA) read with Foreign
Exchange Management (Transfer or Issue of a Security by a
Prior approval by the government is needed across this route.
Person resident Outside India) Regulations, 2017.
The application needs to be made through the Foreign
Investment Facilitation Portal, facilitating the single-window
consent of the FDI application under the approval route.
Foreign Direct Investment (FDI) is the investment through
capital instruments by a person resident outside India.
Foreign Portfolio Investments (FPI): (a) in an unlisted Indian company; or
It is akin to FDI. It is also a direct investment but investments (b) in 10% or more of the post issue paid-up equity capital on
in only financial assets such as bonds, stocks,shares etc., on a a fully diluted basis of a listed Indian company.
company located in another country.
Note: If an existing investment by a person resident outside Note: Any Foreign Institutional Investor (FII) or a sub account
India in capital instruments of a listed Indian company falls to registered under the SEBI (Foreign Institutional Investors)
a level below 10% of the post issue paid-up equity capital on a Regulations, 1995 and holding a valid certificate of
fully diluted basis, the investment will continue to be treated registration from SEBI shall be deemed to be a FPI till the
as FDI. expiry of the block of three years from the enactment of the
Securities Exchange Board of India (FPI) Regulations, 2014.
Foreign Portfolio Investment (FPI) is any investment made by

a person resident outside India in capital instruments where Foreign Investment is any investment made by a person
such investment is resident outside India on a repatriable basis in capital
instruments of an Indian company or to the capital of an
(a) less than 10% of the post issue paid-up equity capital on a
Limited Liability Partnership (LLP).
fully diluted basis of a listed Indian company or
(b) less than 10% of the paid-up value of each series of capital
instruments of a listed Indian company. Prohibited Sectors/Persons:
Explanation: The 10% limit for foreign portfolio investors shall Investment by a person resident outside India is prohibited in
be applicable to each foreign portfolio investor or an investor the following sectors:
group as referred in SEBI Regulations, 2014.
1. Lottery Business including Government/ private lottery,
online lotteries.
2. Gambling and betting including casinos.
Foreign Portfolio Investor (FPI) is a person registered in 3. Chit funds.
accordance with the provisions of Securities Exchange Board
4. Nidhi company.
of India (Foreign Portfolio Investors) Regulations, 2014.
5. Trading in Transferable Development Rights (TDRs).
6. Real Estate Business or Construction of Farm Houses. BFM MODULE - C
7. Manufacturing of Cigars, cheroots, cigarillos and cigarettes, Chapter 21: International Equity and Debt Products
of tobacco or of tobacco substitutes. The prohibition is on (PART-II)
manufacturing of the products mentioned and foreign
investment in other activities relating to these products. What we will study?
8. Activities/sectors not open to private sector investment viz., *All about GDR?
(i) Atomic energy and *All about IDR?
(ii) Railway operations

9. Foreign technology collaboration in any form including
licensing for franchise, trademark, brand name, management
contract is also prohibited for Lottery Business and Gambling
and Betting activities.
Any investment by a person who is a citizen of Bangladesh or
Pakistan or is an entity incorporated in Bangladesh or Pakistan
requires prior Government approval.
A person who is a citizen of Pakistan or an entity incorporated
in Pakistan can, only with the prior Government approval,
invest in sectors/ activities other than defence, space, atomic
energy and sectors/activities prohibited for foreign
investment.
GLOBAL DEPOSITORY RECEIPTS (GDRs): The equivalent number of equity shares is fixed as per pricing
norms of SEBI.
On issuance of GDR, the equity of the issuing company
increases. Therefore, its Debt Equity Ratio is not adversely
affected.
The debt-to-equity ratio (D/E ratio) shows how much debt a
company has compared to its assets. It is found by dividing a
company's total debt by total shareholder equity. A higher
D/E ratio means the company may have a harder time
covering its liabilities.
Dividend is paid out in Rupees to the Depository.
The Depository is entitled to voting rights as it holds the
equity shares on behalf of the GDR holders.
Two-Way Fungibility Scheme:
GDRs represent Receipts that entitle the holder to convert Two-way fungibility means investors can freely convert ADRs
into specified number of equity shares of Indian Company. (American Depository Receipts) /GDRs (Global Depository
The Receipts are issued by a Depository abroad and are traded Receipts) into underlying domestic shares and vice versa.
in overseas markets. GDR are negotiable Receipts. A limited two-way fungibility scheme is in operation by
The underlying shares, issued by the Indian Company, are held Government of India for ADRs / GDRs.
by an Indian Custodian on behalf of the Overseas Depository. Under this, a SEBI registered Stock Broker can purchase the
GDR are denominated in foreign currency.The exchange risk shares from the market for conversion into ADRs/ GDRs.
on the GDR is borne by the overseas investor.
Reissuance of ADR/GDR would be permitted to the extent of The issue of IDRs should comply with the Companies
ADRs/GDRs that have been redeemed into underlying shares (Registration of Foreign Companies) Rules, 2014 and the
and sold in the domestic market. Securities and Exchange Board of India (Issue of Capital and
Disclosure Requirements) Regulations, 2009.
As such, the total outstanding shares under the GDR issuance
remains at same level of original issue for which approval Any issue of IDRs by financial/banking companies having
would have been obtained from Ministry of Finance. presence in India, either through a branch or subsidiary, shall
require prior approval of the sectoral regulator.
American Depository Receipts (ADRs) few points:
IDRs shall be denominated in Indian Rupees only.
American Depository Receipts (ADRs) are traded only in US
while GDRs are traded in other overseas markets too. The proceeds of the issue of IDRs shall be immediately
repatriated outside India by the companies issuing such IDRs.
Soliciting investors for ADRs can be done only from US and the
disclosure standards of the document must comply with US
GAAP accounting standards.
Purchase/Sale of IDRs:
GAAP: Generally Accepted Accounting Principles.
An FPI or an NRI or an OCI may purchase, hold or sell IDRs.
NRIs or OCIs may invest in the IDRs out of funds held in their
INDIAN DEPOSITORY RECEIPTS (IDRs): NRE/ FCNR(B) account, maintained in accordance with the
Foreign Exchange Management (Deposit) Regulations, 2016.
There would be an overall cap of USD 5 billion for raising of
Issue of IDRs:
capital by issuance of IDRs by eligible foreign companies in
Companies incorporated outside India may issue IDRs through Indian markets.
a Domestic Depository, to a person resident in India and a
This limit would be monitored by SEBI.
person resident outside India.
Transfer, Redemption and Two-Way Fungibility of IDRs: BFM MODULE - C
Redemption/conversion of IDRs into underlying equity shares Chapter 21: International Equity and Debt Products
of the issuing company shall comply with the Foreign (PART-III)
Exchange Management (Transfer or Issue of any Foreign
Security) Regulations, 2004. What we will study?
IDRs shall not be redeemable into underlying equity shares *All about ECB?
before the expiry of one year from the date of issue.
Limited two-way fungibility of IDRs is permissible.
(a) Listed Indian companies may either sell or continue to hold
the underlying shares subject to compliance with the Foreign
Exchange Management (Transfer or Issue of any Foreign
Security) Regulations, 2004.
(b) Indian Mutual Funds, registered with SEBI may either sell
or continue to hold the underlying shares subject to
compliance with the Foreign Exchange Management (Transfer
or Issue of any Foreign Security) Regulations, 2004.
(c) Other persons resident in India including resident
individuals are allowed to hold the underlying shares only for
the purpose of sale within a period of 30 days from the date
of conversion of the IDRs into underlying shares.
The FEMA provisions shall not apply to the holding of the
underlying shares, on redemption of IDRs by the FPIs.
EXTERNAL COMMERCIAL BORROWINGS: Eligible a) All entities eligible to receive FDI. a) All entities eligible to raise
Borrower FCY ECB and
Further following entities are also eligible to
External Commercial Borrowings are commercial loans raised
raise ECB: b) Registered entities engaged
by eligible resident entities from recognized non-resident in micro-finance activities, viz.,
i. Port Trust
entities and should conform to parameters such as minimum Registered Not for Profit
maturity, permitted and non-permitted end-uses, maximum ii. Units in SEZ companies, Registered
Societies/ Trusts/ cooperatives
all-in-cost ceiling, etc. iii. SIDBI
and Non-Government
iv. EXIM Bank of India Organizations.
The comprehensive guidelines are given below:
Recognised The lender should be resident of FATF or IOSCO compliant country. However,
Description ECB in Foreign currency (FCY) ECB in Indian Rupee
lenders
a) Multilateral and Regional Financial Institutions where India is a member
(INR) country will also be considered as recognized lenders;
Currency Any freely convertible foreign currency Indian rupee b) Individuals as lenders can only be permitted if they are foreign equity
holders or for subscription to bonds/debentures listed abroad; and
Instrument Loans including bank loans; floating/ fixed Loans including bank loans;
Type rate notes/ bonds/ debentures (other than floating/ fixed rate c) Foreign branches / subsidiaries of Indian banks are permitted as recognised
fully and compulsorily convertible notes/bonds/ debentures/ lenders only for FCY ECB (except FCCBs and FCEBs).
instruments); Trade credits beyond 3 years; preference shares (other than Foreign branches / subsidiaries of Indian banks, subject to applicable
FCCBs; FCEBs. fully and compulsorily prudential norms, can participate as arrangers/underwriters/ market
convertible instruments); makers/traders for Rupee denominated Bonds issued overseas.
FCCB: Foreign Currency Convertible Bonds
Trade credits beyond 3 years;
FCEB: Foreign Currency Exchangeable Bonds. and Financial Lease. However, underwriting by foreign branches/subsidiaries of Indian banks for
issuances by Indian banks will not be allowed.
Also, plain vanilla Rupee
denominated bonds issued
overseas, which can be either Minimum MAMP for ECB will be 3 years.
placed privately or listed on Average
exchanges as per host country Call and put options, if any, shall not be exercisable prior to completion of
Maturity
regulations minimum average maturity.
Period
(MAMP) However, for the specific categories mentioned below, the MAMP will be as
prescribed therein:
Sr.No. Category MAMP All-in-Cost For existing ECBs linked to LIBOR whose Benchmark Rate + 450 basis
ceiling per benchmarks are changed to ARR: Benchmark points
(a) ECB raised by manufacturing companies up to USD 1 year
annum Rate plus 550 bps spread.
50 million or its equivalent per financial year.
For new ECBs: Benchmark rate plus 500 bps
(b) ECB raised from foreign equity holder for working 5 years spread
capital purposes, general corporate purposes or
All-in-cost ceiling has been temporarily
for repayment of rupee loans.
increased by 100 bps for ECBs raised till
(c) ECB raised for 10 years December 31, 2022.
(i) working capital purposes or general corporate The enhanced all-in-cost ceiling shall be
purposes available only to eligible borrowers of
investment grade rating from Indian Credit
(ii) on-lending by NBFCs for working capital
Rating Agencies (CRAs). Other eligible
purposes or general corporate purposes
borrowers may raise ECB within the existing
(d) ECB raised for 7 years all-in-cost ceiling as hitherto.
(i) repayment of Rupee loans availed domestically Other Costs Prepayment charge/ Penal interest, if any, for default or breach of covenants,
for capital expenditure should not be more than 2% over and above contracted rate of interest on the
outstanding principal amount and will be outside the all-in-cost ceiling.
(ii) on-lending by NBFCs for the same purpose
Negative List The negative list, for which the ECB proceeds cannot be utilised, would include
(e) ECB raised for 10 years
for end use the following:
(i) repayment of Rupee loans availed domestically
a) Real estate activities.
for purposes other than capital expenditure
b) Investment in capital market.
(ii) on-lending by NBFCs for the same purpose
c) Equity investment.
For the categories mentioned at (b) to (e)-
d) Working capital purposes, except from foreign equity holder.
(i) ECB cannot be raised from foreign branches / subsidiaries of Indian
banks e) General corporate purposes except from foreign equity holder.
(ii) the prescribed MAMP will have to be strictly complied with under all f) Repayment of Rupee loans, except from foreign equity holder.
circumstances.
g) On-lending to entities for the above activities.
Exchange Rate Change of currency of FCY ECB into INR ECB can be done For conversion to b. Tenor and rollover:
at the exchange rate prevailing on the date of the Rupee, the
A minimum tenor of one year for the financial hedge
agreement for such change between the parties exchange rate shall
would be required with periodic rollover, duly ensuring
concerned or at an exchange rate, which is less than the be the rate
that the exposure on account of ECB is not unhedged at
rate prevailing on the date of the agreement, if prevailing on the
any point during the currency of the ECB.
consented to by the ECB lender. date of settlement.
Hedging The entities raising ECB are required to follow the Overseas investors
Provisions guidelines for hedging issued, if any, by the concerned are eligible to Change of Change of currency of ECB from one freely convertible Change of currency
sectoral or prudential regulator in respect of foreign hedge their Currency of foreign currency to any other freely convertible foreign from INR to any
currency exposure. exposure in Rupee Borrowing currency as well as to INR is freely permitted. freely convertible
through permitted foreign currency is
Infrastructure space companies shall have a Board
derivative products not permitted.
approved risk management policy.
with AD Category I
Further, such companies are required to mandatorily banks in India.
hedge 70% of their ECB exposure in case the average
The investors can
maturity of the ECB is less than 5 years.
also access the Limit and leverage:
The designated AD Category-I bank shall verify that 70% domestic market
hedging requirement is complied with and report the through branches Under the aforesaid framework, all eligible borrowers can raise ECB
position to RBI through Form ECB 2. of Indian banks up to USD 750 million or equivalent per financial year under the
abroad or branches automatic route.
The following operational aspects with respect to
of foreign banks.
hedging should be ensured: Further, in case of FCY denominated ECB raised from direct foreign
a. Coverage: equity holder, ECB liability-equity ratio for ECB raised under the
automatic route cannot exceed 7:1. However, this ratio will not be
The ECB borrower will be required to cover the principal
applicable if the outstanding amount of all ECB, including the
as well as the coupon through financial hedges.
proposed one, is up to USD 5 million or its equivalent.
The financial hedge for all exposures on account of ECB
should start from the time of each such exposure (i.e. Further, the borrowing entities will also be by the guidelines on debt
the day the liability is created in the books of the equity ratio, issued, if any, by governed the sectoral or prudential
borrower). regulator concerned.
The automatic route limit stands increased from USD 750 million or BFM MODULE - C
equivalent to USD 1.5 billion or equivalent.
Chapter 21: International Equity and Debt Products
This relaxation is available for ECBs to be raised till December 31,
2022. (PART-IV)
What we will study?
Issuance of Guarantee, etc. by Indian banks and Financial Institutions: * All about TRADE CREDITS?
Issuance of any type guarantee by Indian banks, All India Financial
Institutions and NBFCs relating to ECB is not permitted.
Further, financial intermediaries (viz., Indian banks, All India Financial

Institutions, or NBFCs) shall not invest in FCCBs/ FCEBs in any manner
whatsoever.
Supplier's Credit: Depending on the source of finance, such TCs include
suppliers' credit and buyers' credit from recognized lenders.
TC for imports into India can be raised in
➢ Any freely convertible foreign currency
(FCY denominated TC). or
➢ Indian Rupee (INR denominated TC)
As per the framework given below:
Buyer's Credit:
Forms of TC:
Buyers’ credit and suppliers’ credit.
Eligible borrower:
Person resident in India acting as an importer.
TRADE CREDITS: Amount under Automatic Route:
Trade Credits (TC) refer to the credits extended by the ➢ Maximum Amount Per Import Transaction:
overseas supplier, bank, financial institution and other
• $50 Million
permitted recognized lenders for maturity (as prescribed in
this framework) for imports of capital/non-capital goods • $150 Million for oil/gas refining & marketing, airline and
permissible under the Foreign Trade Policy of the Government shipping companies
of India. ➢ Above $50 Million, RBI Approval required.
Recognized lenders: ii Exchange rate Change of currency of FCY TC For conversion to
into INR TC can be at the Rupee, exchange rate
1. For suppliers' credit: Supplier of goods located outside India. exchange rate prevailing on shall be the rate
the date of the agreement prevailing on the date
2. For buyers' credit: Banks, financial institutions, foreign between the parties of settlement.
equity holder(s) located outside India and financial concerned for such change or
institutions in IFSCs located in India. at an exchange rate, which is
less than the rate prevailing
Further, foreign branches of Indian banks are permitted as on the date of agreement, if
consented to by the TC lender.
recognized lenders only for FCY TC.
iii Hedging The entities raising TC are The overseas investors
Period of TC: provision required to follow the are eligible to hedge
guidelines for hedging in their exposure in
Maximum Period from the date of shipment:
respect of foreign currency Rupee through
➢ For non capital Goods : Up to 1 year or operating cycle exposure. permitted derivative
products with AD
which ever is less. Such entities shall have a
Category I banks in
board approved risk
➢ For Capital Goods: Up to 3 years. India.
management policy
➢ For shipyards / shipbuilders: for import of non-capital iv Change of Change of currency of TC from Change of currency
currency of one freely convertible foreign from INR to any freely
goods : Up to 3 years.
Borrowing currency to any other freely convertible foreign
Sr. Parameters FCY denominated TC INR denominated TC convertible foreign currency currency is not
as well as to INR is freely permitted.
i All-in-cost For new TCs: Benchmark rate Benchmark rate + 250
permitted.
ceiling per + 300 bps spread. bps spread.
annum
For existing TCs linked to
LIBOR whose benchmarks are
changed to ARR.
Benchmark Rate + 350 bps

spread.

Join CAIIB WITH ASHOK on YouTube & App BFM MODULE – C
RUPEE DENOMINATED BONDS: Chapter 22: FUNDING AND REGULATORY
RBI, vide circular dated November 3, 2016, permitted banks to ASPECTS (PART-I)
issue Rupee Denominated Bonds overseas for the following What we will study?
purposes.
*What is CRR & SLR?
• Perpetual Debt Instruments (PDI) qualifying for inclusion
as Additional Tier I capital under the Basel III Capital *What is role of treasury in managing the CRR &
Regulations. SLR?
• Debt capital instruments qualifying for inclusion as Tier II RESERVE ASSETS: CRR AND SLR:
capital under the Basel III Capital Regulations.
Money multiplier effect:
• Financing of infrastructure and affordable housing.
The Reserve Bank of India is the Note Issuing
Authority, that is, the currency in circulation is
The "eligible amount" for purpose of issue of PDIs in foreign
Directly controlled by RBI.
currency shall be, as on March 31 of the previous financial
year, the higher of: However, the currency is only cash component of
(a) 1.5% of Risk Weighted Assets (RWAs) and Money in circulation, and in that, it is only a small
(b) Total Additional Tier 1 Capital. Part of the total money.
The cash deposited in banks in turn is lent by the
Not more than 49% of the "eligible amount" can be issued in banks, which increases supply of money.
foreign currency and/or in rupee denominated bonds
overseas.
If part of the money, so borrowed, is held in a The sources of M3 include credit availed by the
deposit account with the bank, the chain of public and the government and net foreign currency
relending and creating new deposits will continue. assets of RBI and the banking system.
It is not only cash, but near cash instruments like The cash component (or M1) for 2 1 1 was just
cheques and credit cards also add to the money around 21 of the money supply as indicated by
supply (e.g. money spent on credit card is M3.
deposited with a bank, adding further money). Money Multiplier:
Creation of money in this fashion is called the Money Multiplier M3/M1
money multiplier effect.
During the period 2 to 2 1 -1 , the money
multiplier (which is M3 divided by M1) moved within
Broad Money (M3): a range of 3.4 to 4. times.
The money in circulation is indicated by Broad Multiplier effect reduces the importance of
Money' or M3, which includes currency in currency in circulation.
circulation, demand and time deposits with banks Aim of Monetary Policy:
and post office saving deposits.(M1 is called
Narrow Money or cash component of ) The monetary policy of RBI is aimed at controlling
the rate of inflation (price rise) and ensuring
M1 CURRENCY WITH PUBLIC DEMAND stability of financial markets (including foreign
DEPOSITE WITH BANK OTHER DEPOSITE WITH
exchange markets).
RBI
In order to achieve the twin objectives, RBI must
M3 M1 TIME DEPOSITE WITH BANK exercise full control over the money supply (M3).
Reserve Money: However, an amendment to the Act in 2
Reserve money is the money impounded by RBI by removed the floor and ceiling limits wef April 2 ,
means of cash reserve ratio (CRR) which is enabling RBI to stipulate the CRR at its discretion.
intended to reduce the multiplier effect. Now
Reserve Assets: CRR Minimum : No Limit
Reserve assets refer to the cash deposited by CRR Maximum : No Limit
scheduled commercial banks with RBI to comply Min and Max SLR:
with Cash Reserve Ratio (CRR) requirement, and
funds invested in government securities and other SLR is defined under Banking Regulation Act of
approved securities to comply with the Statutory 1949.
Liquidity Ratio (SLR) requirement. Minimum SLR 25 of demand and time liabilities
The reserve assets enable RBI to control the (DTL) of the bank.
liquidity in the system, though they also serve other Maximum SLR 4 of DTL of the bank.
purposes like providing a cushion to the banks.
An amendment to the Act has removed the
Min and Max CRR: minimum requirement wef January 2 , allowing
CRR is defined under Reserve Bank of India Act of greater flexibility to RBI.
1934. Now
Minimum CRR 3 of demand and time liabilities SLR Minimum : No Limit
(DTL) of the bank.
SLR Maximum : 4
Maximum CRR 2 of DTL of the bank.
RBI as a Lender of Last Resort: RBI needs to calibrate the movement of interest
Hypothetically, the CRR and SLR prescriptions are rates and exchange rates and adopt a policy
intended to provide a cushion to the bank's stance,consistent with the projected growth rate of
operations. the economy.
As a lender of last resort, the RBI would come to RBI Instrument to control Money Supply:
the rescue of a bank, if it is in distress on account The CRR and SLR are the two most important
of shortage of liquidity, i.e. if it does not have instruments in the hands of RBI to directly control
enough cash to repay the deposit obligations. money supply.
However, it is only an extreme case where the RBI Effect of Increase or decrease of CRR and SLR:
has to step in, as the banks which are not solvent An increase in CRR and SLR requirement (together
either go into liquidation or are taken over by a
referred to as reserve ratios) would imply
healthier bank. impounding of cash resources, or absorption of
liquidity by RBI.
Excess or shortage of Liquidity: A decrease in CRR and SLR requirements would
Liquidity refers to surplus funds available with amount to release of part of the impounded funds,
banks, which is an indicator of money supply that or, infusion of liquidity.
has not been absorbed by the real economy.
An excess of liquidity may lead to inflation, while a Treasury s role and responsibility for CRR and SLR:
shortage of liquidity may result in high interest Treasury's primary responsibility is to meet the CRR
rates and depreciation of Rupee exchange rate. and SLR requirements of the bank fully.
Treasury back-office should report the relevant CHAPTER 22: FUNDING AND REGULATORY
information to RBI in the fortnightly return (Form A), ASPECTS (PART-II)

which needs to be submitted strictly within the
prescribed time schedule. What we will study?
Any default or shortfall in meeting the requirements
would not only attract serious penalties from the
RBI, but would also reflect on the viability of the *What are the components of NDTL?
bank and damage its reputation.
NDTL : Net Demand Time Liability
Current CRR and SLR:

Currently, the CRR is 3 of NDTL and SLR is 1 of
NDTL of banks, calculated as of the last Friday of
the second preceding fortnight.
(it keep changing so please check RBI website for
latest rates)
Main components of DTL are: *Credit balances in ACU (US$) Accounts. [CRR]
*Demand deposits (held in current and savings accounts, ACU: Asian Clearing Union
margin money for LCs, overdue fixed deposits etc.).
*Demand and Time Liabilities in respect of their
*Time deposits (in fixed deposits, recurring deposits, Offshore Banking Units (OBUs). [CRR]
reinvestment deposits etc.). *Minimum of Eligible Credit (EC) and outstanding long-
*Overseas borrowings. term Bonds (LB) to finance Infrastructure Loans and
*Foreign outward remittances in transit (FC liabilities affordable housing loans. [CRR & SLR]
net of FC assets). *Liabilities in respect of the bank’s International

Financial Services Centre (IFSC) Banking Units (IBUs).
*Other demand and time liabilities (accrued interest,
credit balances in suspense account etc.). [CRR & SLR]
Scheduled Commercial Banks are exempted from *Funds Borrowed under market repo against
Government securities. [CRR & SLR]
maintaining CRR on the following liabilities:
*Liabilities to the banking system in India as computed

under clause (d) of Section 42(1) of the RBI Act, 1934.
[CRR]
The following liabilities are NOT to be included for NDTL *Net unrealized gain/loss arising from derivatives
stipulation (or CRR or SLR stipulation): transaction under trading portfolio.
*Paid-up capital, reserves, retained profits, refinance *Income flows received in advance such as annual fees
availed from RBI, and apex financial institutions like and other charges which are not refundable.
NABARD and SIDBI. *Subsidy released by Central/ State Government which
*Net income tax provision. is kept in zero per cent fixed deposit account.
*Claims received from DICGC, ECGC, Insurance *Bill rediscounted by a bank with eligible financial
Company ,Court Receiver etc. institutions as approved by RBI.
*Liabilities arising on account of utilization of limits What is Bankers' Acceptance Facility (BAF)?
under Bankers' Acceptance Facility (BAF). Banker's acceptance Facility (BAF) is a negotiable piece
*District Rural Development Agency (DRDA) subsidy of paper that functions like a post-dated check. A bank,
kept in Subsidy Reserve Fund account in the name of rather than an account holder, guarantees the payment.
Self-Help Groups. Banker's acceptances (also known as bills of exchange)
*Subsidy released by NABARD under Investment are used by companies as a relatively safe form of
Subsidy Scheme for Construction/Renovation/ payment for large transactions.
Expansion of Rural Godowns.

What is a Bill Rediscounting? RBI does not pay interest on deposits held by banks to
A rediscount occurs when a short-term negotiable debt meet the CRR, even if the deposits are in excess of
instrument is discounted for a second time. minimum required by RBI.
Time Line for CRR: CRR, therefore, effectively increase cost of deposits to
the banking sector.
The CRR is to be calculated on the basis of DTL, with a
SLR:
lag of one fortnight, i.e., on the reporting Friday, the
DTL as at the end of previous fortnight will form the The SLR requirement is to be computed similarly, as of
basis for CRR calculation. the last Friday of the second preceding fortnight.
This is to allow banks enough time to collect relevant The procedure to compute total NDTL for the purpose
information from the branches. of SLR is broadly similar to the procedure followed for
Banks have to maintain cash balances with RBI to meet CRR.
the prescribed CRR on average during the fortnight, The liabilities excluded from CRR stipulation do not
subject to daily cash balances not falling below 90% of form part of liabilities for the purpose of SLR also.
the amount required for CRR. However, the exemption for the purpose of CRR
This will allow some flexibility to the banks for available to the Scheduled Commercial Banks in case of
mobilizing cash resources. liabilities to the banking system in India, credit balances
in ACU (US$) Accounts; and demand and time liabilities *State Development Loans (SDLs) of the State
in respect of their Offshore Banking Units (OBU) is not Governments.
applicable for the purpose of computation of SLR. *Any other instrument as may be notified by the RBI
General Guideline on CRR & SLR:

The SLR is to be maintained in the form of the following RBI may, from time to time, change the components of
assets:
DTL for calculation of CRR and SLR, as also securities
*Cash balances (excluding balances maintained for CRR). permitted under the approved category.
*Gold (valued at price not exceeding current market Any default in maintaining CRR and SLR will, apart from
price). attracting heavy penalties from RBI, affect reputation of
*Approved securities valued as per norms prescribed by the bank, hence banks are extremely cautious in
RBI. complying with the reserve requirement.
As stated earlier, the CRR and SLR are the principal tools
Approved securities include:
available to RBI for liquidity management.
*Dated securities of the Government of India issued
from time to time An increase in the reserve ratios will reduce money
supply (excess liquidity) and reduction in the reserve
*Treasury Bills of the Government of India
ratios will increase the money supply.
For instance, 0.5% reduction in CRR requirement Chapter 22: FUNDING AND REGULATORY ASPECTS
currently results in a cash inflow of approx. Rs. 50000- (PART-III)
55000 crore into the money market, and the additional What we will study?
*What is LAF?
resources will flow into bank credit or investment in
debt/equity securities.
THE LIQUIDITY ADJUSTMENT FACILITY (LAF):
The money supply, in turn, influences the interest rates
and the exchange rate of Rupee.
The Liquidity Adjustment Facility is monetary policy
The monetary policy of RBI is dictated by the need for Tool of RBI to manage liquidity in market.
While CRR and SLR help changes in liquidity
maintaining price stability (control inflation) and Position on a more permanent basis, LAF is used to
stability of financial markets (control wild fluctuations Monitor day-to-day liquidity in the market.
in interest rates and exchange rates).
LAF refers to RBI lending funds to banking sector
Through Repo instrument.
Current CRR & SLR: RBI also accepts deposits from banks under
Reverse Repo.
CRR : 4.50%
SLR : 18%
In September 2022 (keep changing so refer RBI website

for latest rate)
Repo: back the securities after a fixed period.
The process of purchase of government securities, The difference in sale and purchase prices
with an agreement to sell-back, within a constitutes interest received by RBI.
predetermined period is called Repo transaction. In case of excess liquidity, banks lend funds to RBI
Reverse Repo: under Reverse Repo in similar manner and receive
The process of sale of government securities, with interest.
an agreement to repurchase, within a All the securities are held in the SGL account
predetermined period is called Reverse Repo (Subsidiary General Ledger) of the bank with RBI,
transaction. hence no physical transfer of securities takes place
either way.
While banks can engage in repo transactions with RBI conducts Repo/reverse Repo auctions daily for
other banks/institutions, LAF refers exclusively to overnight funds.
repo transactions with RBI. RBI may conduct Repo auctions twice or thrice a
Bids have to be submitted for a minimum amount day.
of Rs. 5 crore and in multiples of Rs. 5 crore
thereafter. In order to help banks, to wade through the liquidity
constraints, RBI has taken the following measures
RBI, as lender of last resort, provides liquidity to the on February, 3, 2 15:
banks through Repo auction, where RBI purchases
securities from banks with an agreement to sell
1-RBI continues to provide liquidity under overnight interest banks can earn on excess funds, and the
repos (fixed rate repo) of .25 of bank-wise NDTL Repo rate would lay the upper side of the corridor
at the LAF repo rate. (4 as on March 12, 2 1 as the maximum rate of
2- ariable Rate Repo(Term Repo): interest at which banks can borrow overnight funds
from RBI. (when funds are not available in inter-
RBI introduced a new window called ariable Rate bank market).
Repo.
1-Call Money:
Under this window liquidity would be provided for
days, 14 days and 2 days. Lending and borrowing for 1 day.
This is also called as Term Repo. 2-Notice Money:
The limit fixed by RBI, is under this window, is Lending and borrowing for 2 days to 14 days.
. 5 of NDTL of the banking system. 3-Term Money:
Interested banks can avail funds under this route by Lending and borrowing for 15 days to 1 year.
quoting a rate which should be equal to or above
the Repo Rate.
3-RBI has also phased out the Export Credit
Refinance facility. In order to further consolidate its control over the
inter-bank market, with effect from first quarter of
2 3, RBI has imposed ceiling over call money
The Reverse Repo rate would lay the floor (3.35 as lending and borrowing by banks:
on March 12, 2 21), which is the minimum rate of

Max Avg lending in a fortnight: Chapter 22: FUNDING AND REGULATORY ASPECTS
(PART-IV)
It can be up to 25 of capital fund of the lending
bank. What we will study?
But on any particular day of the fortnight lending *What is NEFT & RTGS?
can be maximum 5 of the capital fund of lending *What is INFINET & NDS?
bank. What is STP?
Straight-through Processing ("STP") is a
Mechanism that automates the end-to-end
Processing of transactions of the financial
instruments.
Max Avg borrowing in a fortnight:
It involves use of a single system to processor
It can be maximum 1 of capital fund of the Control all elements of the work-flow of a financial
borrowing bank. transaction, including what is commonly known as
But on any particular day of the fortnight borrowing the Front, Middle, and Back office, and General
can be maximum 125 of the capital fund of
Ledger.
In other words, STP can be defined as electronically
borrowing bank.
capturing and processing transaction in one pass,
Lending : 25 from the point of first ‘deal’ to final settlement.
Max in a day: 5
Borrowing : 1
Max in a day: 125
PAYMENT AND SETTLEMENT SYSTEMS: The important developments in this regard are as
Payment and settlement systems play a vital role in under:
the development of financial markets. Real Time Gross Settlement System (RTGS):
The important reforms relevant to treasury RTGS has been fully activated by RBI from October
operations include the following: 2 4.
Payments refer to inter-bank payments as also RTGS is a paperless clearing system, where
payments on behalf of customers. settlements are on gross basis, rather than day-end
net settlement of cheques in a clearing house.
Settlement refers to payment/receipt in exchange
of securities or foreign exchange. All inter-bank payments and customer remittances
Conventionally, inter-bank payments have been (currently minimum Rs. 2 lakhs) are settled
handled by net settlement through the clearing instantly under the RTGS.
house. In the past, even when transfer of securities Almost all the urban centres of public and private
was taking place instantly through d-mat/electronic sector banks are already participating in the RTGS.
systems, payments needed to be cleared in 1 to 3 Since RTGS involves instant payments, banks need
days, and even longer if it is outstation payment, to maintain adequate funds with RBI throughout the
giving rise to expensive delays and counterparty day.
risks.
To meet any shortfall in funds, RBI has put in place
Operational costs were also high in paper based
systems to provide intra-day liquidity through
(cheque) clearing. automatic repo, against securities lodged by
respective banks.
Indian Financial Net Work (INFINET): RBI had introduced the NDS in February 2 2, in
The Institute for Development and Research in order to achieve:
Banking Technology (IDRBT) has developed the a) Automatic electronic reporting and settlement
Indian Financial Net Work (INFINET) as a secure process
communication backbone for the banking and b) Auctions on electronic platform and
financial sectors.
c) A trading platform for trading in Government
securities on a negotiated basis (telephone based
The INFINET has helped in introduction of trading), as well as quote-driven mechanism.
Structured Financial Messaging System (SFMS) The NDS membership is open to banks, primary
which facilitates domestic transfer of funds and dealers, mutual funds, financial institutions and
authenticated messages, similar to the SWIFT used
insurance companies, who maintain SGL account
by banks for international messaging. (Subsidiary General Ledger a/c) with RBI, and also
those who have constituent SGL accounts through
banks/depository institutions.
Negotiated Dealing System (NDS):

NDS is an electronic platform for facilitating dealing NDS-OM (Negotiated Dealing System-order
in government securities and money market matching system):
instruments. RBI launched in August 2 5, NDS-OM or
anonymous order matching system, as an
improvement over NDS.
In anonymous order matching, the identity of FX Clear:
counter-party is not disclosed till the offered Fx Clear is a Forex dealing system developed by
price/volume is accepted. CCIL for foreign exchange transactions (USD/ INR
The system is purely order driven, with all orders as well as cross currencies).
being matched strictly on price/time priority. Currently CCIL is providing straight through
The NDS - OM coexists with telephone based processing (STP) for USD/INR, and CCIL as an
trading mechanism on NDS. intermediary settles inter-bank USD/Rupee as well
The system allows straight-through processing as cross currency deals on net basis, so that
(STP) and trades executed will flow straight to CCIL individual banks need not exchange payments for
for settlement. each transaction.
Over of dealings in Govt securities now take

place on NDS through screen based trading. Depository Institutions:
CCIL is a specialized institution promoted by major Depository institutions like NSDL (National
banks for clearing of securities, repo trades and Securities Depository Ltd.) and CSDL (Central
trades in CBLO (centralized borrowing and lending Securities Depository Ltd.) provide delivery vs.
obligation). payment (D P) for secondary market deals in
Physical delivery of cheques and written equity and debt paper.
confirmations are no longer necessary for The securities and funds are cleared by their
settlement. respective clearing houses.
Since the funds transfer and securities transfer
takes place between the buyer and seller on the Banks, who have implemented core banking
electronic platform simultaneously, the settlement solutions (CBS), facilitate any time - anywhere
risk is eliminated. funds transfer.
Internal transfer (within bank) of funds from one
NEFT and on-line Payments: account to another account within the bank can be
All inter-bank and intra-bank remittances can now effected instantly, irrespective of the branch
be effected on the same day by electronic funds location.
transfer using the National Electronic Funds
transfer system introduced by RBI. In view of the growing complexities in payment
RBI has developed Structured Financial Messaging systems, the RBI has constituted Board
System (SFMS) similar to SWIFT adopted by forRegulation and Supervision of Payment and
banks for international funds transfer etc. - where Settlement Systems at the highest level, as a sub-
interbank transfers are sorted out and cleared by committee of its Central Board.
National Clearing Cell of RBI.
Banks which are fully computerized can access any India today has sophisticated payment and
account at any branch on line and debit/credit settlement systems comparable or even superior to
funds, instantly for inter-bank transfers, without the systems prevailing in developed markets.
using paper.
Chapter 23: TREASURY RISK MANAGEMENT
(PART-I) Concern for Treasury Risks:
What we will study? The First concern:
*What is treasury risk management? Bank management is highly sensitive to treasury
risk, as the risk arises out of high leverage the
SUPERVISION AND CONTROL OF TREASURY:
treasury business enjoys.
Treasury Risk Management:
Treasury risk management assumes importance The risk of losing capital (by treasury) is much
higher than, say, in the credit business.
For two reasons:
(a) The nature of treasury activity is such that Bank's capacity to extend loans is limited by the
resources at its command, that is, deposits and
Profits are generated out of market opportunities
other borrowings.
And market risk is present at every step.
In case of a loan, the risk is limited to the principal
(b) Treasury is also responsible for balance sheet
and interest, which may be lost, fully or partly, over
management, i.e., market risk generated by other
a period of time.
operational departments.
We will deal with the first aspect a little more Most of the loans are also secured by tangible
assets.
elaborately.
The risk is 'capped' by the amount invested in the
loan asset.
Potential loss in loan assets is known as credit risk.
Treasury on the other hand, has a very low funding If the Treasurer commits an error of judgment,
requirement, which we call as high leverage. consequent losses to the bank would be enormous.
For instance, treasury can buy and sell foreign A third factor closely connected to the above is that
exchange of value Rs. 1 crore without any direct the losses in treasury business materialize in very
investment of funds, except for allocation of risk short-term, and the transactions, once confirmed,
capital as per capital adequacy requirement of RBI. are irrevocable hence no corrective action is
At the same time, an adverse movement of the possible.
exchange rate by Rs. 1 may result in a loss of over Particularly in foreign exchange, markets react so
Rs. 1 crore to the bank - which is a straight loss of fast that profits or losses on trade deals are almost
capital. instantaneous.
A second reason for management concern is the Traders are generally not allowed to hold open
large size of transactions done at the sole positions for long, as the risk of loss increases with
discretion of the Treasurer. time.
As we have learnt earlier, whether it is foreign The source of risk in treasury activity is variation in
exchange or money market or investment business, the market price of currency or security, when there
the value of a single transaction may range from Rs. is a gap between the buy leg and sell leg of the
5 crore to Rs. 5 crore or even more in larger banks. transaction.
The limits are delegated to the Treasurer in The risk is hence termed as market risk, as
advance, and individual market deals rarely need opposed to credit risk of loan assets of the bank.
specific approval from the management.
The variability of the price, upward or downward, is Chapter 23: TREASURY RISK MANAGEMENT
known as volatility. (PART-II)
In case of currency, it is known as volatility of What we will study?
exchange rate and in case of bonds, it is volatility of
*What is treasury risk management?
interest rates
Treasury risks are primarily managed by
Asset liability management (ALM) of the bank is
Conventional control and supervisory measures,
also closely connected to market risk.
Mostly in the nature of preventive steps, which may
Be divided into three parts:
Treasury risks are primarily managed by
1-Organisational Controls
conventional control and supervisory measures,
mostly in the nature of preventive steps, which may 2-Exposure Ceiling
be divided into three parts: 3-Limits on trading positions and stop-loss limits
1-OrganisationalControls:
1-Organisational Controls The organizational controls refer to the checks and
2-Exposure Ceiling Balances within the system.
3-Limits on trading positions and stop-loss limits Treasury is basically divided into three parts:
The front office, back office and the mid office.
(Check chapter 16-V video for more details)
Internal Controls: 2-Limits on open positions:
The most important of the internal controls are Open positions refer to the trading positions, where
position limits and stop loss limits. the buy/sell positions are not matched.
The limits are imposed on the dealers who trade in The Treasury may buy USD 1 million, and hold on to
foreign exchange and securities. the position with an intention to sell when the USD
Trading is a high risk area, vulnerable to sudden appreciates against the Rupee.
market fluctuations and the limits imposed by Not only there is a potential loss if the US dollar
management are preventive measures to avoid or does not appreciate, but there is also a 'carry' cost,
contain losses in adverse market conditions. as the Treasury loses interest on the USD funds or
The trading limits in the context of foreign carry a very minimal interest during the holding
period.
exchange are of three kinds:
(i) limits on deal size Treasury may also take forward positions expecting
a rise or fall in the exchange rate.
(ii) limits on open positions and
The management, therefore, limits the size of open
(iii) stop-loss limits. or unmatched positions.
1-Limits on deal size: The limits in foreign exchange trade are defined as
Limits on deal size prescribe the maximum value daylight and overnight .
for a buy/sell transaction. 2-A)The Daylight limits:
The limit is a protection against potential losses on Pertain to the intra-day positions, say if the dealer
the deal. purchases currency in the morning and sells it in
the afternoon. Stop-loss limits:
2-B)Overnight Limits: Stop-loss limits represent the final stage of
controlling trading operations.
The overnight limits are smaller when compared to
the daylight limits as the dealers may continue to When the market moves adversely, the open
hold the position for next day and during the night positions will result in loss.
the forex market would be active but no one would A dealer typically would like to wait till the market
be tracking the position. turns around, so that he can close the position with
Position limits: a profit.
Position limits are prescribed currency-wise as also There is an added risk in that the market correction
for aggregate position expressed in Rupees. may not take place as anticipated, and the losses
For the purpose of aggregation, currency-wise net may continue to accumulate in the mean time.
position is first translated into USD at the day-end The stoploss limits prevent the dealer from waiting
rate and then converted into Rupees. indefinitely and limit the losses to a level which is
Even when there are matching positions, there is acceptable to the management (which the bank is
scope for loss if the delivery is at different points of in a position to absorb).
time. Any violation of stop-loss limit is viewed seriously
In a swap deal, the dealer may purchase USD at by the management.
spot and sell it forward, say, after three months. The stop-loss limits are prescribed per deal, per day,
It is a matched deal as the purchase and sale prices per month as also an aggregate loss limit per
are prefixed and hence there is no exchange risk. year.Back office need to monitor all the limits
meticulously. its entire surpluses to a single bank or to a handful
2-Exposure Ceiling Limits: of banks and such a procedure would overcome the
risk of concentration.
Exposure limits are kept in place to protect the
bank from credit risk/counter-party risk. Settlement risk:
Credit risk: The settlement risk refers to the possible failure of

the counterparty to the transaction (which is
Credit risk in Treasury may be split into default risk generally a bank or a financial institution) to
and settlement risk. deliver/settle their part of the transaction.
Default risk: While ideally all deals should take place in DvP
Default risk is typically when the bank lends in the (Delivery vs. Payment) mode, it is not always
money market (mainly to other banks), the possible to achieve the standard, either for want of
borrowing bank may fail to repay the amount on institutional mechanism, or due to physical barriers
due date. (such as different time zones).
Similar risk is there in repo transactions also. Delivery of government securities is already taking
place against payment, as the banks have both the
Even though inter-bank market is considered to be
securities account (SGL) and funding account with
relatively risk free, it is not uncommon that a weak
RBI, so that debit and credit can take place
bank may suddenly become bankrupt, or, there is a
simultaneously.
run on the bank squeezing its liquidity.
Similar sophistication is also present in exchange
Even assuming that there is no credit risk in short-
of non-SLR or corporate securities with depository
term lending, it is not prudent that Treasury lends
participants in CCIL mechanism.
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BFM MODULE - C While cross currency derivatives existed for long,

Chapter 24: DERIVATIVES PRODUCTS (PART-I) Rupee derivatives are of fairly recent origin, and
useof certain derivative products is still regulated
What we will study? by RBI.
*What is derivative? Derivative Products:
*What is the difference b/w OTC and Exchange A derivative, as its name suggests, does not
Traded Products? havean independent value.
The value of a derivative is derived from an
underlying asset/market/exposure.
The market may be financial market, or
commoditymarket, or an index of market prices.
DERIVATIVES AND THE TREASURY:
Financial markets relate to products such as
Derivatives are market products widely used by foreign exchange, bonds and equities.
bank treasuries.
Commodity markets may cover any
Treasury uses derivatives chiefly commercial product, ranging from oil and gold
(a) to manage risk, including ALM risks to cotton and wheat.
(b) to cater to the requirements of the clients By definition, derivatives always refer to a future
andmore particularly the corporate customers. price and the value of derivative depends on
and spot market.
(c) to trade, i.e., to take a trading position

inderivative products.
OTC AND EXCHANGE TRADED PRODUCTS: Exchange traded derivatives include currency
Banks may structure a derivative product to suit futures, interest rate futures, commodity futures,
stock and index futures, as well as options.
therequirement of an individual client – based on
his risk appetite, size of transaction and maturity Some of the futures exchanges are organized
requirements. independently (e.g.
For instance, a bank may offer to a client a Chicago Mercantile Exchange,
forward contract or option for sale of USD on a
Eurex,
future date, for whatever period or amount
desired by the client. Euronext, MCX of India),
The derivative products that can be directly or at times associated/or merged with stock
negotiated and obtained from banks and exchange (e.g.
investment institutions are known as Over-the- Hong Kong Exchanges &
Counter (OTC) products.
Clearing,SGX of Singapore,
There are also standardized derivative
NSE in India).
contracts, for a specified sum and for specified
period, whichare purchased or sold on an
exchange.
These are exchange traded derivatives, traded
OTC products are different from exchange
on afutures exchange.
tradedproducts in the following respects:
A forward contract traded on a futures
(SEE PIC)
exchange iscalled a futures contract.
Bank Treasuries and corporate customers of the

bank mostly use OTC products such as forward
contracts, options and swaps.
Only larger banks, which are market makers,
covertheir residual position in Futures traded in
the exchanges.
Where futures exchange is active, OTC derivative
products largely reflect exchange traded prices,
even though the volume of trade in OTC
products ismuch larger than that of the Exchange
Traded Products.
BFM MODULE - C Derivatives are basically of three kinds:

Chapter 24: DERIVATIVES PRODUCTS (PART-II) Forward contracts; Options, and Swaps. Futures
What we will study? arepart of forwards, where execution of contract
at afixed rate is obligatory through an exchange.
* What is Forward Contract?
1. Forward Contract:
Forward contract is a contract to deliver foreign
FORWARDS, OPTIONS, FUTURES AND SWAPS: currency on a future date at a fixed exchange
rate.
In India, derivatives are used for hedging underlying This is an OTC product where the counterparty
currency, interest rate and commodity risks. isalways a bank.
Trading in currency and interest rate An exporter enters into a forward sale contract
derivatives isrestricted to authorized banks, ofhis export proceeds denominated in USD.
except in futures market, where individuals,
A 3-month forward sale contract at 69.00 implies
corporates and other entities can freely
that on expiry date, the exporter can sell the
participate (subject to restrictions on non-
contracted amount to the bank at Rs. 69 per
resident entities).
dollar,irrespective of prevailing market rate.
We shall confine this discussion to currency and
The exporter is protected from the exchange
interest rate derivatives only.
risk, even if, Rupee in the meantime appreciated
to say,Rs. 65.
Similarly, a forward purchase contract protects Interest Rate and Premium and discount:
importers from depreciation of Rupee. Forward rate, as we stated earlier, represents
Forward purchase or sale contracts can be used interest rate differential of the two currencies.
tohedge currency risks in cross-currency deals The forward rate is either at premium or
also. discount tothe spot rate.
Forward contract being simplest of the The currency carrying higher rate of interest is
derivatives,it is available in most currencies. always at a discount.
For instance, domestic interest rate of Rupee is
Delivery of currency must be given or taken, as generally higher than interest rate of USD, hence
percontract terms, on the expiry date of the Rupee is at a discount to Dollar, or Dollar is at
contract, otherwise the contract will be cancelled premium vis-à-vis rupee.
and the difference between spot rate and
By implication, forward rate of USD/INR is higher
forward rate will be credited to or recovered
than spot rate, or, dollar on a forward date is
from the counterparty.
worthmore rupees than today.
Forward option:
Same is the case with Euro/USD- interest rate of
On request banks may allow delivery to take EURO is higher than interest rate of USD, hence
placewithin a month before the expiry date. forward EURO is at a discount to USD.
This facility is known as forward option, where
bankwould quote forward premium (discount)
applicableto either start date or end date of the
option period, whichever is worse to the client or
favorable to the bank.
Forward premium or discount: BFM MODULE - C

In case of freely convertible currencies, forward Chapter 24: DERIVATIVES PRODUCTS (PART-III)
premium or discount is exactly equal to the What we will study?
difference between risk-free interest rates of
thetwo currencies. *What is option?
However, in case of USD/INR, it is not always so, *What is Call option & Put option?
asRupee is not yet fully convertible.
The forward exchange rate of USD/INR, Options:
therefore isalso affected by supply and demand
Options refer to contracts where the buyer of an
for forward dollars.
option has a right but no obligation to exercise
Forward contract is ideal as a hedging thecontract.
instrument to achieve zero risk, as the contracted
Options are of two type :
rate fixes thevalue of forward dollars,
irrespective of the market movement. 1- Call option (buy)
Opportunity Cost: 2- Put option (Sell)
However, the holder of a forward contract
cannot get the benefit of market rate, if it is
Call (4) = Buy (3)
better than thecontracted rate, on the date of
utilization - which is a disadvantage known as Put (3) =Sell (4)
opportunity cost. 3=4 & 4=3
Call option: Options on the basis of mode of settlement:

Call option gives a right to the holder to buy an Options are divided into two types according to
underlying product their mode of settlement.
(currency/bonds/commodities) at a prefixed rate 1-American Type Settlement
(strike price) on a specified futuredate.
2-European Type Settlement
Put option:
Put option gives a similar right to the holder to American Type Settlement:
sell the underlying at a prefixed rate (strike price) An American type option can be exercised any
on a specified future date or during a specified timebefore the expiry date.
period.
After the sub-prime crisis which took place in the
year 2008/2009 in most of the markets,
Strike Price: Americanoption is prohibited.
The prefixed rate is known as the strike price, European Type Settlement:
whichis decided by the customer (Option Holder).
European type option can be exercised only on
Expiry date: theexpiry date.
The specified time is known as expiry date. In India we use only European type of options, a
Writer of Option = Seller of option currency option gives the holder option to buy
orsell a currency at strike price on expiry date.
Option holder = buyer of option
Put option is a right to sell the currency at strike Market: USD/JPY=100 so 1 USD= 100 JPY
price, and call option is a right to purchase the Option: USD/JPY=105 so 1 USD= 105 JPY(yes put)
currency at strike price, the options being
exercisable on their expiry date. In the latter case, the option will be net settled,
i.e.,the counter-party pays the holder 5 yen per
Example:
dollar, being the difference between strike price
USD/JPY=105 so 1 USD= 105 JPY and spot rate.
A Dollar put/JPY call option, for USD 1 million
with strike price at 105 and expiry after 3
months, gives the holder right to sell USD or
ATM ITM & OTM:
purchase JPY, at the rate of 105 JPY per dollar, on
expiry date. ATM: at-the-money
If on expiry date market rate is 108, the option- ITM: in-the-money
holder will not exercise put option, as he can get
OTM: out-of-money
more yen per dollar in the open market.
Market: USD/JPY=108 so 1 USD= 108 JPY The option is known to be at-the-money (ATM) if
Option: USD/JPY=105 so 1 USD= 105 JPY (no put) the strike price is the same as the spot price of
thecurrency.
If the exchange rate on the expiry date is 100,
the option buyer will definitely exercise the put In the context of European option, the spot rate
option on the expiry date, as the strike price is is the rate prevailing on the maturity date; hence
better thanmarket price. it is (spot rate) actually the forward rate as on
the dateof buying the option.
The option is at-the-money, therefore, when the

strike price is the same as the forward rate on
thestart date.
More Examples:
The option is in-the-money (ITM), if the strike
price is less than the forward rate in case of a call Strike Spot rate or Call Put
option,or, if the strike price is more than forward price forward rate Option(buy) Option(sell)
rate in case of a put option. 90 100 ITM OTM
The option is out-of-money (OTM), if the strike 200 180 OTM ITM
priceis more than the forward rate in case of a 102 110 ITM OTM
call option, or, if the strike price is less than
100 990
forward rate in case of a put option. 0
To put simply, ITM is when the strike price is 800 950
betterthan the market price, and OTM is when 600 600
the strike price is worse than the market price.
Examples:
Strike Spot rate or Call Put

price forward rate Option(buy) Option(sell)
105 pen 100 pen OTM ITM
105 pen 105 pen ATM ATM
105 pen 108 pen ITM OTM
BFM MODULE - C The ATM and OTM options do not have any
Chapter 24: DERIVATIVES PRODUCTS (PART-IV) intrinsicvalue.
What we will study? Strike Spot rate or Call Intrinsic value

* What is Premium? price forward rate Option(buy)
105 pen 100 pen OTM (100-105)= -5 =0
* What are important features of options?
105 pen 105 pen ATM (105-105)=0
105 pen 108 pen ITM 108-103= 5
Premium:
Premium is the price of an option payable
upfront.Option premium has two components:
Strike Spot rate or Put Intrinsic
1-Intrinsic value price forward rate Option(sell) value
2-Time Value 105 pen 100 pen ITM 105-100 = 5

105 pen 105 pen ATM (105-105)= 0
1- Intrinsic value: 105 pen 108 pen OTM 105-108= -3 =0
The first component is intrinsic value of an ITM
option, being the difference between the strike 2- Time value:
price and current forward rate of the currency. The option price (strike price), less the intrinsic
Intrinsic value cannot be negative. value, is the time value of the option.
Time value of Option = Option price - intrinsic value
Hence, the second component is the time value, The price of an option is much smaller than the
which is maximum for an ATM option. notional value; the traders and speculators
Time value decreases with the option becoming therefore do not require large investments to
more and more ITM or OTM, as the expiry date tradein options (known as high leverage).
approaches. The buyer of an option pays premium to the
seller(upfront) for purchase of the option.
Some of the important features of options are: The premium depends on the volatility of the
The buyer of an option has the right (but no underlying market, the expiry date (maturity),
obligation) to exercise the option at strike price, interest rates and the strike price – the factors
irrespective of market price prevailing on the thatdetermine the risk to the seller.
expirydate. Option premium increases with the volatility of
Hence his (buyer’s) profit potential is unlimited. themarkets, maturity and intrinsic value of the
option.
The seller of the option is obliged to buy/sell to
the holder of the option at the strike price, Option premium or the price of option is higher or
irrespective of market price; the option-seller's lower based on intrinsic value and time value of
potential loss is therefore unlimited. theoption.
The option is based on an amount which is only In the money (ITM) options are costlier than out-
notional, as only difference in rates is exchanged of-the money (OTM) options.
innet settlement. Time value is linked to residual maturity – longer
the maturity, costlier is the option.
The option always has two legs: A bank as an intermediary sells a USD put option
A put option on USD at USD/JPY tothe exporter, and a USD call option to the
importer, for fully or partially mitigating the risk.
(right to sell USD against JPY at rate X) is also
A stock option is the right to buy or sell equity of
a call option on JPY (right to buy JPY against USD acompany at the strike price.
payment at X rate).
For instance, a put option on 1000 Maruti equity
The option may thus be described as USD put or shares at Rs. 500 with expiry on 30th June 2017,
Yen call at, say, 105. means if the stock is trading below Rs. 500 on the
A call option on a bond gives the right to buy the expiry date, the option-holder can still sell his
bond at a prefixed price (strike price). Maruti shares to the seller of the option, at Rs.
500per share.
Options are primarily used as a hedge against price
fluctuations. If the price on the expiry date is above the
strike price of Rs. 500, the option-holder would
It is similar to insurance against adverse
naturallyprefer to sell his shares in the open
movementof prices, where the risk is transferred
market and does not exercise the option.
to others who are more tolerant of the risk.
For instance, an exporter would like Rupee to
Plain Vanilla Option:
depreciate so that his Rupee income would
increase; while the importer would benefit An option, without any conditionality, is called
from appreciation of Rupee so as to reduce his plainvanilla option, which is a simple product and
Rupee cost. ideal for hedging.
Exotic Option:
There are complex structured products making
useof different types of options, often combining
withother derivatives, and covering different
markets simultaneously, to suit requirements of
some customers.
Such products, often called exotics as they
bundletogether different risks, are highly risky
and are generally not suitable for hedging market
risk.
While exchange risk is protected in both cases,

there are material differences between options
andforwards:
BFM MODULE - C Currency futures are traded for major currencies

Chapter 24: DERIVATIVES PRODUCTS (PART-V) (EURO, GBP, JPY, AUD and CAD) in terms of USD.
A contract of GBP 25000 is traded at The London
What we will study?
International Financial Futures and Options
*What is Futures Option? Exchange (LIFFE) for delivery on 28 March, say at
1.6650, as against spot exchange rate of 1.60.
The contract implies that on 28th March the
sellerwould deliver to the holder of the contract,
Futures: GBP 25000 against payment of equivalent USD at
Futures are forward contracts traded in a the rate of 1.6650.
futuresexchange (Stock exchange). On the settlement date, if the market rate of GBP
Under a futures contract, the seller agrees to is 1.70, the seller will pay to the holder the
deliverto the buyer a specified security/currency difference in contracted price and spot price on
or commodity on a specified date, at a fixed price. that date.
Futures relating to exchange rates (currency (1.70 - 1.6650 = USD .035 per Pound).
futures), Interest rates (bond futures) and equity If the market price is less than the contracted
prices (stock/index futures) are known as price,the buyer of the contract will bear the loss.
financialfutures, as distinct from commodity
Unlike in options, the contract must be executed
futures (oil/metal/ agro-products etc.).
byboth the parties on the due date at the
Futures contracts are of standard sizes with agreed future rate.
prefixed settlement dates.
While the futures contract works like a forward Currency futures are traded actively in the
contract, there are three important differences: futuressegment of NSE and the BSE.
(i) The buyer and seller of the contact do not Interest rate futures are contracts written on
dealwith each other but they deal with the fixedincome securities (Treasury bills, bonds etc.)
Futures Exchange as counter party – the of specified size.
Exchange guarantees performance of the Contracts written on treasury bills trade in short-
contract. term interest rates, while contracts on treasury
(ii) There is no counter party risk in future option. bonds or corporate bonds deal in medium and
long-term interest rates.
(iii) Unlike forwards, futures contracts are
Interest rate futures are the most popular
actively traded on the exchange, the contracts
are bought and sold several times during the instruments to hedge interest rate risk.
day. Treasury bills, being risk free instruments, indicate
In India, the futures market for USD/INR movements in market rate of interest.
commenced in August 2008. The Treasury bills are traded at a discount, the
Contract size of Futures: discount being equal to interest rate for the
period.
The contract size is one unit which denotes USD
A futures contract of USD 1 million, for 1 year on a
1000 and all settlements take place in Rupees.
Treasury bond trades at 96 if the expected interest
Trading in cross-currency - Rupee contracts rate at the end of the period is 4% (i.e. 100 – 4 =
(Euro/INR, GBP/INR and JPY/INR) also 96).
commenced from last quarter of 2009 with the The hedge is based on the inverse relationship
contract size of one unit denoting 1000 Euro, between the interest rates and bond prices, i.e. if
1000GBP and 1,00,000 JPY respectively.
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the interest rate goes up, bond prices come BFM MODULE - C
down,and bond prices would move up if interest Chapter 24: DERIVATIVE PRODUCTS (PART-VI)
rates decline.
What we will study?
Rupee interest rate futures market:
*What is Interest Rate Swap?
Rupee interest rate futures market in India was
originally launched in 2003, but the attempt
failedfor various reasons.
With the initiative of RBI and SEBI, the interest
ratefutures market was relaunched in Aug 2009.
The contract size is Rs. 2 lacs and is based on 6
year, 10-year and 13 year Government securities
with residual maturity between 4 and 8 Years, 8
and11 years and 11 and 15 years respectively.
All futures contracts are of standardized size,
hence several contracts need to be purchased
tohedge an underlying exposure fully.
If an exporter needs to hedge receivables of
USD 560,700, he would need to buy 561 forward
sale contracts of USD 1000 each, aggregating to
USD 561,000.
Interest Rate Swaps: Conventionally, the fixed rate payer is known as the
buyer of swap and the fixed rate receiver is the seller of
A swap is an exchange of cash flow.
the swap.
An interest rate swap is an exchange of interest flows
on an underlying asset or liability, the value of which is The floating rate of interest is always linked to a
the notional amount of the swap. benchmark rate.
An interest rate swap is shifting of basis of interest rate A benchmark rate is a risk-free interest rate determined
by the market, and is widely accepted by market
calculation, from fixed rate to floating rate, floating rate
players for its objectivity and transparency.
to fixed rate or floating rate to floating rate (based on a
different benchmark rate). Interest Rate Swap (IRS) is an OTC instrument normally
issued by a bank.
Benchmark rates used in Indian markets other than
LIBOR, MIBOR are, 90 days T-bill and CP rate index.
SWAP from SWAP to
Market practices on adopting different benchmark rates
Fixed Rate Floating Rate
are standardized by FIMMDA (Fixed Income, Money
Floating Rate Fixed Rate Market and Derivatives Association) which is a self
Floating Rate (LIBOR) Floating Rate (MIBOR) regulatory agency for debt market.
The cash flows representing the interest payments

during the swap period are exchanged accordingly.
Mumbai Interbank Forward Offer Rate (MIFOR):
MIFOR for 3 months/6 months is also a benchmark rate,
announced daily by Reuters, for term lending.
MIFOR is a combination of MIBOR and forward
premium of USD/INR, and is particularly suitable for
foreign currency borrowings swapped into Rupees.
However, RBI has permitted MIFOR to be used as a
benchmark rate only for inter-bank dealings.
Corporate are not permitted to use MIFOR as
benchmark rate.
A floating-to-floating rate swap (also known as basis
swap) involves change of benchmark rate.
If a company, having opted for a T-bill linked rate, later
prefers to have a base rate of MIBOR, it can enter into a
swap whereby it receives T-bill rate and pays MIBOR
linked equivalent rate.
There is a variety of interest rate swaps available in
market.
Quanto swaps refer to paying interest in home currency The type of IRS depends on the client's requirement - if
at rates applicable to a foreign currency (now he has to pay a fixed rate on a long-term borrowing and
prohibited in India). use the funds to meet his working capital requirement,
the working capital typically being a 3-month cycle, he
Coupon swaps refer to floating rate in one currency
may need to convert fixed rate borrowing into floating
exchanged to fixed rate in another currency.
rate borrowing.
There are also swaps with built-in options, known as
swaptions. There may be other clients who have an opposite
requirement, i.e. to convert floating rate into fixed rate.
In Indian Rupee market only plain vanilla type swaps
are permitted. The Treasury also uses IRS for the internal requirement
of the Bank, to bridge asset - liability mismatches.
Plain Vanilla Interest Rate Swap:
The Treasury hedges the residual risk, that is, net
Plain Vanilla Interest Rate Swap is an agreement position after entering into various swaps, through
between two parties (known as counterparties) where futures market.
one stream of future interest payments is exchanged
for another, based on a specified principal amount.
Interest rate swaps often exchange a fixed payment for
a floating payment that is linked to an interest rate
(most often the 3M LIBOR).
BFM MODULE - C Forward Rate Agreement (FRA):
Chapter 24: DERIVATIVE PRODUCTS (PART-VII) A product closely linked with IRS is forward rate
What we will study? agreement (FRA), where the interest payable for a
future period is committed under the agreement.
*What is Forward Rate Agreement (FRA)?
While IRS covers a series of periodical interest
*What does it means FRA 3*9? payments, FRA is for a single payment in future.
Example 1: Suppose a company XYZ Ltd. wants to

borrow Rs. 50 Lac for 6 months but after 3 months not
today.
XYZ approaches to bank and bank says we can give you
loan at 10% PA today.
But bank cannot tell you how much rate of interest will
be after 3 months it may go to 12% or it may become
6% only.
Now XYZ Ltd. is worried about the rate going up after 3
months.
So XYZ Ltd. will contact another bank say FRA bank and
will ask them to book a FRA at 10% after 3 months and
for next 6 months.
This FRA is written as "FRA 3*9". Case 1: After 3 months if r=12% then FRA bank will pay
2% PA (12%-10%) to XYZ Ltd.
It means after 3 months and for next 6 months the rate
of interest will be 10% PA.
Case 2: After 3 months if r=6% then XYZ Ltd. will pay 4%
PA (10%-6%) to FRA bank.
This is how FRA works.
FRA Rate after Rate for next
FRA 3*9 3 months 6 months
Example 2: If a loan carries interest rate linked to LIBOR,
FRA 2*12 2 months 10 months and the interest for next half year is due to be fixed on
FRA 6*12 6 months 6 months 29th June, we run a risk that the LIBOR in June may be
much higher than today's LIBOR.
FRA 9*12 9 months 3 months
We would hence like to fix the interest rate for 29th
June now, based on today's rate.
For this purpose, we need to buy a 6/12 FRA or 6*12
So, FRA 6*9 at 12% means, party will give loan at the FRA (i.e. to fix interest rate 6 months hence, for the
rate 12% after 6 months the 12% rate will be charged next 6-month period).
for next 3 months [ total 9 months = 6+3].
It is normal practice that the floating rate (LIBOR) for an
interest rate payment period is decided in advance, on
Ex: Suppose a company XYZ Ltd. wants to borrow Rs. 50 the last day of the previous period/or (one day before
Lac for 6 months but after 3 months not today and FRA
is booked at 10% PA. then we book FRA 3*9.
the last day, as in the case of LIBOR), but interest is paid BFM MODULE - C
at the end of the interest payment period.
Chapter 24: DERIVATIVE PRODUCTS (PART-VIII)
In the above illustration, the interest settlement takes What we will study?
place at the beginning of the period on 1st July as per
the market convention. *What is Currency SWAP?
The interest is duly discounted for the period, and

hence the effective rate remains the same.
Currency SWAP: At the same time there is a well rated Indian company
needing Euro funds for taking over a company in, say,
A Currency Swap is an exchange of cash flow in one
France.
currency, with that of another currency.
The German investor is in a strong position to raise Euro
The cash flow may relate to repayment of principal and
/or interest under a loan obligation where the lender or funds, at a relatively low rate, as compared to the
the borrower intends to eliminate currency risk. Indian company seeking to raise a Euro loan.
The position is reversed in case of a Rupee loan, where
If only currency is hedged, it will be Principal Only Swap
the Indian company, with a good domestic rating, is in a
(POS).
position to raise Rupee funds at a lower rate.
If only interest rate is hedged, it would be Coupon Only
It is hence logical that the two parties raise the loans in
Swap (COS).
domestic currencies and swap the loans to serve their
It is left to the discretion of the client to hedge currency respective objectives.
and interest rate risks together, or separately.
However, it would be a great coincidence if the two
The need for a swap arises when there is a currency parties with complementary requirements (in terms of
mismatch. amount and period of loan) meet each other to derive
For instance, if a loan is denominated in a currency the advantage of lower rates of interest rates.
different from the currency in which revenue is accruing, Banks, as financial intermediaries, are well placed to
there is a currency mismatch. offer currency swaps to interested clients, without
Let us assume that an investor in Germany intends to waiting for a matching demand.
invest in Indian market and hence is in need of Rupee
funds.

Chapter 25: Treasury and Asset Liability Management maturities, ranging from an overdraft for a few days
(PART-I) to mortgage loans of, say 15 years.
What we will study? Thus the bank modifies and extends maturities
which the retail depositors themselves could not
*What is ALM? afford to.
*What is Liquidity Risk? Similarly, while the depositors have assured safety
of funds together with interest, the bank does not
MEANING OF ASSET-LIABILITY MANAGEMENT
have the same comfort while lending or investing
(ALM):
funds in various avenues with market risk and
Bank collects deposits from customers with
credit risk thus the bank also absorbs risk which
Various maturities ranging from 7 days to 5years individual depositors could not on their own do.
(Though there is no bar on longer term deposits, While credit risk of a bank is obvious and is
Major banks discourage deposits for longer-terms managed conventionally through effective credit
In order to avoid interest rate risk). supervision, what is not so obvious is the market
risk, which is manifest as liquidity risk and interest
However, as per IBA guidelines, Banks can accept
rate risk in banking operations.
Deposits up to 120 months, i.e., 10years.
The risk is spread all over the balance sheet of a
The funds so collected along with capital funds and
bank. To illustrate, assume that the bank has
Call borrowings are lent to borrowers with varying accepted a deposit of 3 years at p.a. and has
been using funds to provide a 9 -day bill
discounting facility to a borrower company.
Over the first year, interest rates start declining and
by the second year, let us say the bank is no longer The risks arise out of mismatch of assets and
able to charge over on the working capital loan. liabilities of the bank and asset-liability
Clearly, there is a negative earning for the bank as management is managing such balance sheet risks.
the deposit has a fixed rate of interest, while the bill The risks, if not controlled, may result in negative
discounting facility is to be repriced every 9 days
spreads or in erosion of net worth.
(effectively, floating rate of interest).
ALM is therefore defined as protection of net worth
In another context, assume that the average of the bank.
deposits of the bank are of one-year maturity, while
they have extended quite a few mortgage loans
with average maturity exceeding over 5 years at a LI UIDITY RISK AND INTEREST RATE RISK:
fixed rate.
1. Liquidity Risk:
Firstly, the bank will face a liquidity problem when
As we have seen earlier, liquidity and interest rate
large deposits are to be paid out on maturity of one
are two sides of the same coin, as the liquidity risk
year and secondly, the bank would have to accept
translates into interest rate risk, when the bank has
fresh deposits or borrow from inter-bank market at
to recycle the deposit funds or rollover a credit on
current rates to meet such obligations.
market determined terms.
If current interest rates are higher than the
However, banks are extra sensitive to liquidity risks,
contracted rates on mortgage advances, the
as they cannot afford to default or delay meeting
mismatch in interest rates leads to negative spread,
their obligations to depositors and other lenders.
or reduction in net interest income (NII).
Even suspicion of pressure over a bank s liquidity The available cash resources are compared with
may prompt a run on the bank, or indeed, threaten immediate liabilities of the bank in the given time
the very survival of the bank. range and the net liquidity is worked out.
Hence special attention is paid to liquidity, in In different time bands, the loans falling due for
particular short-term liquidity (intra-day to one repayment constitute the main source of funds,
month) to ensure funds are promptly made while the deposits and other obligations maturing
available when they are needed. during the same time band constitute uses of funds.
In ALM, assets yield income, hence are shown as (In both cases, interest flows are also considered
cash inflows, while liabilities need to be repaid, as and when they arise.)
hence are shown as cash outflows. The difference between sources and uses of funds
Asset-liability mismatch is therefore, a cash flow in specific time bands is known as liquidity gap
mismatch, with excess inflow or outflow of funds. which may be positive or negative i.e., when
If part of inflow or outflow is denominated in advances are more than deposits in a time bucket,
it becomes a positive gap and when deposits are
foreign currency, there is also currency mismatch
which needs to be managed by the Treasury. more than advances in a time bucket, it becomes
negative gap.
Liquidity implies a positive cash flow.
Hence the liquidity gap arises out of mismatch of
It is not only cash surpluses retained by the bank, assets and liabilities of the bank.
but also other sources where cash can be readily
drawn, such as committed credit lines from other
banks, liquefiable securities and nostro balances.
RBI has prescribed time bands (Next day, 2 to RBI is more particular about short-term liquidity,
days, to 14 days, 15 to 3 days, etc.) for ranging from intra-day to one month.
measuring and monitoring liquidity gaps. Current guidelines stipulate that the net cumulative
ALM process involves plotting of assets and negative mismatches during the next day(5 ), 2-
liabilities maturity wise in time buckets and days(1 ), -14 days(15 ) and 15-2 days(2 )
measuring the gap between assets and liabilities buckets should not exceed 5 , 1 , 15 and 2
maturing in a specific time period. of the cumulative cash outflows in the respective
Liquidity risk is reflected as maturity mismatch time buckets.
which is the gap in cash inflow and outflow. Banks are required to provide in their Liquidity
The risk is not being able to find enough cash, or Management Policy, contingency measures to meet
cash at acceptable rate of interest, to fund the gap. any shortfall in liquidity.
Liquidity risk will also arise if the liquidity in market The contingency measures may include stand-by
dries up and the bank is not able to dispose of its credit lines from other banks, liquid investments
and maintenance of adequate securities (in excess
liquid securities without suffering a loss, or if the
liquefiable securities suddenly become illiquid'. of minimum requirement) to facilitate borrowing
under Liquidity Adjustment Facility of RBI/or under
The Bank should hence take in to account, the CBLO (collateralized borrowing and lending
marketability of securities, while classifying them obligation)
as liquid instruments in the nearest time buckets.
RBI from time to time issues detailed guidelines for
managing ALM risks.

Chapter 25: Treasury and Asset Liability Management In a hypothetical situation, let us assume that the
(PART-II) Bank has mobilized deposits of Rs. 1 cr., with
What we will study? average maturity of months, at 5 interest.
Let us also assume that the bank invested the
*What is interest rate risk? amount in a fixed interest loan payable after 5 years
Interest Rate Risk: at p a. the NII is a clear 2 or Rs. 2 cr. per year.
Interest rate risk arises when interest earnings are The deposits mature after months and need to be
Not adequate to set off interest payments due in a
replaced or recycled at current market rate, say, at
Given period, even if the book value of the asset
as interest rates have risen by that time.
Equals that of the liability, owing to a change in
Market rates of interest. The interest on loan continues to be , hence NII
Net interest income (NII) of the bank is the for second half of the year is reduced by 1 .
Difference between interest earnings and interest If we assume that the deposits become even
Payments in a given accounting period. costlier after next months, demanding renewal at
Hence interest rate risk may be defined as the risk market rate of say, , the NII actually becomes
Of erosion of NII, on account of interest rate
negative by 1 .
Movements in the market.
However, if deposit rates fall by 2 , the NII
correspondingly rises for the specific period.
In a reverse situation, a deposit for 5 years may
have a fixed interest, while the deposit funds are
deployed, say, in discounting 3-month usance bills,
to start with, with a positive spread. However, a loan getting repaid during this period is
If the interest rates fall, subsequent discounting of due for repricing, as fresh lending can take place
bills may earn lower rate of interest, in line with only at market rates.
market rates, while cost of deposit remains fixed, For the purpose of ALM, all assets and liabilities are
thereby adversely impacting the NII. placed in time buckets, based on their repricing
dates (i.e. when the interest rate is due for a
The risk of erosion of NII is on account of deposit
rates being floating (repriced every months), change).
while the loan interest is fixed (repriced only after 5 The mismatch in each time bucket is measured as
years when the funds are available for fresh lending, a gap between rate sensitive assets and rate
on repayment of the loan), or vice versa. sensitive liabilities.
The interest rate mismatch is therefore also known The mismatch may be measured either in absolute
as repricing risk. amounts, or as sensitivity ratio, or as a of rate
Repricing risk exists where, in a given time bucket, sensitive assets to rate sensitive liabilities.
say months to 1 year, the assets and liabilities The mismatch presents a risk to the NII, hence is to
which are due for repricing are not equal. be monitored regularly, with pre-set limits.
A tier-2 bond maturing after years with fixed It is possible to reduce the mismatch by swapping
interest rate of , is not due for repricing during floating rate to fixed rate or fixed rate to floating
m-1 yr time bucket, hence is not sensitive to rate, that is, by using derivative instruments.
changes in market price. RBI stipulates capital adequacy requirement for
market risk, which includes interest rate
mismatches. Under the circumstances, in case, the deposit rate
Capital is also to be provided for any derivatives goes up subsequent to placement of deposit by the
(forwards, options and swaps) used to bridge such depositors, the depositor would come for
mismatches. premature extension of the deposit and get the
enhanced interest rate.
RBI is recommending simplified approach under
Banks also do not charge any penalty for such
Basel 3, for determining the capital requirement for
derivative instruments for Banks which handle a extension.
range of sophisticated derivative products like In case, the deposit rate falls down, the deposit
The gap management is only one way of monitoring would continue with the deposit at the contracted
ALM. rate of interest.
Hence, the depositors are comfortable in fixed rate
There are other methods for measuring asset
liability mismatches, using aR, duration and interest regime in our country and in the process
simulations which would make ALM more effective. effectively pass on the interest rate risk to the bank.
Experience of ALM in Indian Scenario: But in the advances side, RBI has introduced the
MCLR system from 1st April, 2 1 , which is a
Depositors are always comfortable with fixed rate floating rate of interest.
of interest.
Hence, under the interest rate falling scenario, the
Bank like SBI and IDBI in the past introduced banks NII would be come down since the deposits
deposit schemes linked to floating rate interest, but are at fixed rate and advances are at floating rate.
it had not found the flavour of the depositors.Hence,
these products were withdrawn.
In case, interest rate goes up, the banks may not Chapter 25: Treasury and Asset Liability Management
actually get the full benefit of interest rate hike, as (PART-III)

most of the depositors would come premature
extension of the deposit. What we will study?
By this, the interest rate going up is nullified and the
risk is passed on to the banks.
*What is role of treasury in ALM?
*How ALM/treasury uses derivates to hedge the risk?
ROLE OF TREASURY IN ALM: It may also be noted that bank earns profits out of
As stated earlier, the core function of Treasury is fund mismatches and it is not really advisable to remove the
management. mismatches completely from the balance sheet.
It automatically engulfs liquidity and interest rate risks, Treasury uses derivatives and other means, including
as the treasury maintains the pool of bank's funds. new product structures to bridge the liquidity and rate
sensitivity gaps.
We may briefly explain the relationship between
Treasury, while taking trading positions in forex and
Treasury and ALM as under:
securities markets, is also exposed to market risk on its
The balance sheet of a bank carries enormous market own creation.
risk (in addition to credit risk), but the banking
Sometimes the risks are compensatory in nature and
operation itself is confined to accepting deposits, and
help bridge the mismatches on banking side.
extending credit to needy borrowers so we need to deal
with these risks, we can't shy away from this risk. The treasury may therefore hedge only residual risk.
It is treasury which operates in financial markets Residual risk is the risk that remains after efforts to
directly, establishing a link between core banking identify and eliminate some or all types of risk have
functions and market operations. been made.
Hence the market risk is identified and monitored As this market get developed, many credit products are
through treasury. being substituted by treasury products.
The asset-liability mismatches cannot be ironed out as For instance, bank may subscribe to commercial paper,
the assets or liabilities cannot be physically moved instead of extending working capital to an entity.
across the time bands.
Treasury products are marketable and hence liquidity USE OF DERIVATIVES IN ALM:
can be infused in times of need. Derivative instruments are useful in managing the
Treasury also monitors exchange rate and interest rate liquidity and interest rate risks, as also in structuring
movements in the markets, and hence it is much easier new products which help overcome market risk to a
to administer such risks through treasury operations. large extent.
It is for the above reasons that operations relating to Derivatives replicate market movements, and hence can
market risk management have become an integral part be used to counter the risks inherent in regular
of treasury. transactions.
In many banks, either ALM desk is part of dealing room, For instance, if we are buying a stock which is highly
or, ALCO support group is part of treasury team. sensitive to market movements, we can sell index
futures as an insurance/hedge against fall in stock
prices.
ALM: Asset Liability Management.
The advantage in derivatives is that the requirement of
ALCO: Asset Liability Committee. capital is very small, and largely there is no deployment
of funds.
The Treasury head is always an important member of Derivatives can be used to hedge high value individual
ALCO, contributing not only to risk management but transactions, or hedge aggregate risks as reflected in
also to product pricing and other policy issues. the asset-liability mismatches.
In the latter case (hedge aggregate risks), a dynamic The interest rate on the deposit is akin to a floating rate,
management of hedge is necessary as the composition as the bank has to pay the market rate of interest
of assets and liabilities is always changing. whenever the deposit is recycled (repriced).
Market rates can be benchmarked to risk-free interest
The following illustrations show how derivatives can be rates, say, 91-day T-bill rate in the above case.
used to manage ALM risks: The bank may therefore swap the 3-month interest rate
into a fixed rate for 3 years, so that its interest cost is
Assume that the bank is funding a medium-term loan of
3 years with deposits having average maturity of 3 also fixed and the spread over the loan is protected.
months. Note that the derivative transaction is independent of
the banking transaction.
A short-term deposit or borrowing in inter-bank market
is much cheaper than a 3-year deposit, hence many Under the swap the bank is receiving floating rate
banks have resorted to funding their regular loans from linked to T-bill, which meets the (basic) cost of the
short-term resources in order to increase their spreads. deposit.
There is however, liquidity risk as the bank needs to The bank is paying fixed rate under the swap which now
payback the short-term deposits much earlier to is effectively the cost of the deposit.
repayment of the 3-year loan. The 3-month deposit is now as good as a 3-year deposit.
There is also interest rate risk as the deposits will be
Fixed interest income from the loan less the swap cost
repriced 12 times during the life of the loan. of deposit, is gross margin (spread, or net interest
income) which is now protected from market risk.
As an alternative, the bank may swap fixed interest rate Treasury can thus supplement domestic liquidity and
on the loan into floating rate linked to T-bill rate. also ensure a positive spread for the bank.
Assume that ALCO prices the three-month deposit at Treasury may also hedge currency mismatches resulting
91-day T-bill at T+1% and the swap rate of the loan from foreign currency operations of the bank.
yields T+3%. For instance, Treasury may buy call options to meet
There is a clear spread of 2% in bank's favour protected repayment of FC loans, or buy put options to protect
throughout the life of the loan. value of foreign currency receivables in domestic terms.
Treasury often arbitrages in foreign currencies. Treasury enables the bank in structuring new products
which help reduce the mismatches in the balance sheet.
The bank may borrow, say for 6 months, in USD and
lend equivalent Rupee funds in domestic market. Floating rate deposits and floating rate loans, where the
USD funds cost around 3% while the Rupee loan yields, interest rates are linked to a benchmark rate have
say, 6.5% for the same period. become fairly popular.
The spread is a clear 3.5% for the bank. The Treasury In securities market, we have govt. securities where
takes care of exchange risk by paying a forward interest rate is linked to rate of inflation.
premium of 1.5%. Corporate debt paper is also issued with call and put
options, to suit the risk appetite of individual investors.
The bank then earns a spread of 2% (= 3.5-1.5) without
any exchange risk. The embedded options are also useful to improve the
liquidity of the investment.
The forward premium is the cost of hedge against the
currency risk. For instance, a 7-year bond issue with a put option at
the end of 3rd year is as good as a 3-year investment.
Use of derivatives however is subject to certain Chapter 25: Treasury and Asset Liability Management
limitations. (PART-IV)
It is assumed that the bank's products are priced

rationally. What we will study?
If the interest rates on deposits and loans are not based
on benchmark rates, interest rate swaps may not be *We will know about credit risk and treasury?
really helpful.
Even when the interest rates are fairly aligned, the
product prices may not exactly move in line with
market rates, hence the treasury may not be able to
provide a perfect hedge.
ALM uses broad time bands, hence even after using
appropriate hedges, the market risk may not be
completely mitigated.
There are embedded options in certain bank products -
for instance, a fixed deposit or a term loan can be
prepaid, and such prepayment escapes ALM analysis
and cannot be fully hedged.
CREDIT RISK AND CREDIT DERIVATIVES: While credit risk in a loan and bond is similar, unlike a
Treasury and Credit Risk: loan, bond is tradable and hence is a more liquid asset.
As we have seen, treasury is mostly concerned with The bank has an easy exit because the bond can be sold
market risk. at a discount if the credit status of the issuer
deteriorates.
Credit risk in treasury business is only with respect to
While a loan is normally with a fixed rate of interest or
counterparty dealings, contained by exposure limits.
interest linked to Base Rate/MCLRs of the bank, the
In normal course, treasury operations are untouched by bond is priced in the market on the basis of credit
the credit risk present in bank's lending business. quality and interest rate movements - hence, the bond
However, there are two ways in which treasury may get can be marked-to-market as frequently as required, for
involved with banking operations in the credit area. assessing potential gain or loss.
Firstly, there are several treasury products, or more MCLR: Marginal Cost of Funds Based Landing Rate
correctly debt-market products, such as commercial The non-SLR investment portfolio of treasury, which
paper and bonds, which are credit substitutes. supplements bank's credit portfolio, is therefore more
Highly rated companies prefer issue of debt paper over flexible and ideal from ALM point of view.
bank credit, as cost of credit (interest rate) is relatively
lower in the debt market - where in addition to banks,
Secondly, there are new products which convert
there are other investors (insurance companies, mutual
funds etc.) who may invest in debt instruments. conventional credit into tradable treasury assets.
Instead of lending to a company, the bank may also

prefer to invest in corporate bonds through the treasury.
The process is called securitisation, whereby credit Credit derivatives:
receivables of the bank can be converted into units or Credit derivatives have come into vogue only in the last
bonds (often called Pass-Through Certificates - PTCs) 10 years.
that can be traded in the market.
Credit derivatives segregate credit risk from loan/
For instance, the mortgage loans of a bank can be investment assets.
securitised and issued in the form of PTCs through a
special purpose vehicle (SPV). The instruments, known as credit default swap or credit
linked certificate which transfer the credit risk from
Securitisation infuses liquidity into the issuing bank, and owner of the asset to another person who is in a
frees capital blocked in such assets for fresh lending. position to absorb the credit risk, for a fee.
Several banks have used the securitisation route to
There is a protection buyer, say a bank, a protection
encash their future receivables, not only in respect of
seller who may be another bank or an investor, and a
long-term loan assets, but also of medium-term retail
reference asset - which may be a large corporate loan or
assets such as consumer loans.
a bond or any other debt obligation.
Banks with surplus funds can also invest in such PTCs, The protection seller guarantees payment of principal
through their treasury, as a means to expand their or interest or both, of the reference asset owned by the
credit portfolio indirectly. protection buyer, in case of credit default (or, a credit
event defined in the contract).
In consideration of the protection, the protection buyer
pays a premium (akin to a guarantee fee) to the
protection seller.
Credit derivatives (CD) help the issuer diversify the The protection however is not perfect, as there is a
credit risk and use the capital more efficiently. counter party risk (the credit status of protection
The CD is a transferable instrument, though the market provider), which replaces the underlying credit risk of
for CDs is not very liquid. the loan.
The CD products are still emerging and various During the crisis period, credit quality of the assets
guidelines related to the transaction are incorporated in (mainly home loan mortgages) as well as credit status of
the ISDA Master Agreement for Credit Derivatives. the protection providers deteriorated very fast,
threatening the survival of some large commercial and
ISDA: International Swaps and Derivatives Association. investment banks.
The global financial crisis (2008-2009) brought out some Finally, the governments/central banks had to come to
negative aspects of credit derivatives and securitization, rescue by lending against weak assets (troubled assets)
which in fact, aggravated the crisis. to infuse liquidity and support shrinking capital of the
Following two aspects have been of prime concern to banks.
the regulators as well as market players: 2) Credit Derivatives are highly leveraged (profitable) as
1) Banks and investment institutions (in particular, in US, the protection fee or the credit default spread is a tiny
UK and Europe) have rather been negligent in assessing portion of notional value of the underlying credit.
the credit quality of the assets, as they could securitise As there is no initial investment, credit derivatives are
the assets as soon as they are acquired, or transfer the highly profitable so long as credit default does not take
credit risk to a third party who would sell them as credit place.
default protection (by issuing credit default notes or
credit linked notes) for a small fee. Trading in credit derivatives became very active,
particularly as some of the investment institutions and
fund managers created credit default swaps based on The eligible entities under market-makers and users
synthetic assets (virtually, without underlying credit). categories are as under:
Once the mortgage crisis hit the underlying credit Market Makers: Commercial Banks, standalone Primary
market, the protection value offered by these Dealers (PDs), Non-Banking Financial Companies (NBFCs)
institutions almost disappeared, further spreading the having sound financials and good track record in
crisis to protection sellers like investment banks and providing credit facilities and any other institution
insurance companies. specifically permitted by the Reserve Bank.
This necessitated huge bail-outs from governments, as Insurance companies and Mutual Funds would be
the entire financial system was at risk if some of these permitted if permitted by their regulators.
large institutions were to go into bankruptcy. Users: Commercial Banks, PDs, NBFCs, Mutual Funds,
For the above reasons, Reserve Bank of India has been Insurance Companies, Housing Finance Companies,
very cautious in introducing credit derivatives in India. Provident Funds, Listed Corporates.
However, with a view to providing market participants All India Financial Institutions namely, Export Import
a tool to transfer and manage credit risk associated Bank of India (EXIM), National Bank for Agriculture and
with corporate bonds, Reserve Bank of India has Rural Development (NABARD), National Housing Bank
introduced single name Credit Default Swaps (CDS) on (NHB) and Small Industries Development Bank of India
corporate bonds. (SIDBI), Foreign Institutional Investors (FIIs) and any
other institution specifically permitted by the Reserve
Banks can undertake transactions in such CDS, both as
Bank.
market-makers as well as users. As users, banks can buy
CDS to hedge a Banking Book or Trading Book exposure.

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BFM MODULE - C Join CAIIB WITH ASHOK on YouTube

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Second: 3- Investment Activity

The treasury activity is highly leveraged (more Contemporary Sources of profit:

Till fairly recently, banks were circumspect in 2- Trading

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All the exchange rates quoted on the screen, or in

What is money Market?

Notice Money: Max Avg borrowing in a fortnight:

Max Average borrowing:

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Then Multiple of 5 Lac. 4-the borrowal account of the company must be

Foreign Direct Investments (FDI) & Foreign Portfolio

Foreign Portfolio Investment (FPI) is any investment made by

(i) Atomic energy and *All about IDR?

(ii) Railway operations

Further, financial intermediaries (viz., Indian banks, All India Financial

TRADE CREDITS: Amount under Automatic Route:

Benchmark Rate + 350 bps

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information to RBI in the fortnightly return (Form A), ASPECTS (PART-II)

Current CRR and SLR:

net of FC assets). *Liabilities in respect of the bank’s International

*Liabilities to the banking system in India as computed

Subsidy Scheme for Construction/Renovation/ payment for large transactions.

Expansion of Rural Godowns.

instrument is discounted for a second time. minimum required by RBI.

Banks have to maintain cash balances with RBI to meet CRR.

General Guideline on CRR & SLR:

RBI. complying with the reserve requirement.

In September 2022 (keep changing so refer RBI website

This is also called as Term Repo. 2-Notice Money:

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Negotiated Dealing System (NDS):

Over of dealings in Govt securities now take

Credit risk: The settlement risk refers to the possible failure of

BFM MODULE - C While cross currency derivatives existed for long,

(c) to trade, i.e., to take a trading position

Bank Treasuries and corporate customers of the

BFM MODULE - C Derivatives are basically of three kinds:

Forward premium or discount: BFM MODULE - C

Call option: Options on the basis of mode of settlement:

The option is at-the-money, therefore, when the

Strike Spot rate or Call Put

What we will study? Strike Spot rate or Call Intrinsic value

2-Time Value 105 pen 100 pen ITM 105-100 = 5

While exchange risk is protected in both cases,

BFM MODULE - C Currency futures are traded for major currencies

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The cash flows representing the interest payments

Example 1: Suppose a company XYZ Ltd. wants to

The interest is duly discounted for the period, and

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Join CAIIB WITH ASHOK on YouTube BFM MODULE – C