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| Date post: | 14-Apr-2017 |
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WHAT DOES TREASURY DEPARTMENT DO IN A BANK?• Treasury generally refers to the funds and revenue at the disposal
of a bank and the day-to-day management of same;• The treasury department of a bank is responsible for balancing and
managing the daily cash flow and liquidity of funds within the bank; • The department also handles the bank's investments in securities,
foreign exchange, asset/liability management and cash instruments; and
• The treasury acts as the custodian of cash and other liquid assets.• It is the window through which banks raise funds or place funds for
its operations.
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WHAT DOES TREASURY DEPARTMENT DO IN A BANK?Bank Treasuries may have the following departments:
A Fixed Income or Money Market desk that is devoted to buying and selling interest bearing securities;
A Foreign exchange or "FX" desk that buys and sells currencies; and
A Capital Market or Equities desk that deals in shares listed on the stock market.
In addition, the Treasury function may also have :
A Proprietary Trading desk that conducts trading activities for the bank's own account and capital,
An Asset & Liability Management(ALM) desk that manages the risk of interest rate mismatch and liquidity; and
A Transfer pricing or Pooling function that prices liquidity for business lines (the liability and asset sales teams) within the bank.
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WHY TREASURY OPERATIONS IN BANKS?• To meet Statutory requirements;
• Statutory Liquidity Reserve[SLR]• Cash Reserve Ratio [CRR]
• To Deploy Surplus funds profitably;• To raise resources at competitive rates from domestic & global
markets;• To remove asset-liability mismatches;• To benefit from daily fluctuations in the financial market
through trading activities; and• To hedge open positions (for mitigating interest rate/ exchange
rate risks)
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WHAT IS TREASURY MANAGEMENT?
It is the art of managing, within acceptable level of risk, the consolidated fund of a bank both optimally and profitably.
Treasury management (or treasury operations) includes management of an enterprise's holdings, with the ultimate goal of managing the firm's liquidity
and mitigating its operational, financial and reputational risk.
Treasury Management includes a firm's collections, disbursements, concentration, investment and funding activities.
In larger firms, it may also include trading in bonds, currencies, financial derivatives and the associated financial risk management.
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OBJECTIVES OF TREASURY MANAGEMENT
Availability of funds in the right quantity;
Availability of funds at the right time;
Deployment of Funds in the right quantity;
Deployment of funds at the right time; and
Profiting from availability and deployment of funds.
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THE TREASURY STRUCTURE
Back Office(Settlement &
Accounting of Deals)
Front Office(Strikes Deals)
Mid Office(Risk Mngment)
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STRUCTURE OF AN INTEGRATED TREASURYThe treasury department is manned by the front office, mid office, back office and the audit group. In some cases the audit group forms a part of the middle office only.
The dealers and traders constitute the front office. In the course of their buying and selling transactions, they are the first point of interface with the other participants in the market (dealers of other banks, brokers and customers). They report to their department head and also interact amongst themselves to explore arbitrage opportunities.
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STRUCTURE OF AN INTEGRATED TREASURY
The mid-office set up, independent of the treasury unit, is responsible for risk monitoring, measurement analysis and reports directly to Top management for control.
This unit provides risk assessment to Asset&Liability Committee (ALCO) and is responsible for daily tracking of risk exposures, individually as well as collectively.
The back office undertakes accounting, settlement and reconciliation operations.
The audit group independently inspects/audits daily operations in the treasury department to ensure adherence to internal/regulatory systems and procedures.
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Treasury Dealing Room•Authorized by the bank’s risk management committee.•Interface to international and domestic financial markets.•Clearing house for matching.•Managing and controlling market risk.•Provide funding, liquidity, investment support
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Organizational Structure of a Bank’s TreasuryDealing
• Risk taking• Performed by front office
Risk management• Performed by mid office
Management Information• Performed by mid office
Verification• Confirmation of deals• Settlement of deals• Accounting and reconciliation• Back office
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TREASURY RISK MANAGEMENTTreasury risk management relates to the management of risks arising from foreign exchange, interest rate and commodity prices. A range of tools and financial instruments are available.
Some companies will have a formal Treasury Policy that is a Board approved document that outlines what risks are being managed and how they should be managed.
For smaller companies, there is unlikely to be a formal policy document. However, it is still important that exposures to financial markets are recognised, calculated and mitigated.
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TREASURY RISK MANAGEMENT
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CONCEPT OF RISKRisk is an event that may causes damage to an institution’s income and reputation. In Simple words, a state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome.
The following are types of risks:
Financial RiskCredit RiskLiquidity RiskInterest Rate RiskForeign Exchange RiskMarket RiskCounter-Party RiskRegulatory & Legal RiskOperational RiskEnvironmental Risk
Non-Financial RiskBusiness Risk
Strategic Risk
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RISK INDICATORSLack of Supervision of lending/investment activities by designated officersLack of specific lending or treasury policies or failure to enforce the existing policiesLack of Code of Conduct or failure to enforce existing codeDominant figure allowed to exerting influence without restraintLack of separation of duties Lack of accountabilityLack of written policies and internal controlsEntering into transactions where the institution lacks expertiseHigh Rate high risk investmentsLack of adequate credit analysis
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THE RISK MANAGEMENT PROCESS
Risk avoidanceand contingency
plans
Risk planning
Prioritised risklist
Risk analysis
List of potentialrisks
Riskidentification
Riskassessment
Riskmonitoring
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Treasury Risk
Market risk
• Risk to the bank’s earnings and capital through changes in market rates, security prices,
foreign echange and equity instruments
Liquidity risk
• Ability of banks to meet its liabilities
• Funding risk
• Time risk
• Call risk
Interest rate risk
• Possibility that interest rates adversely affects the bank’s financial position
• Bank’s earnings measured through net interest margin
• Economic valuation of banks
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Treasury Risk
Foreign exchange rate risk
• Loss suffered by banks due to adverse movement of
exchange rate
Credit Risk
• Possible loss of principal and or interest
Operational risk
• Risk of direct or indirect loss from inadequate internal
processes, people, systems, external events
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Internal Control System•Functional separation of trading, settlement, monitoring , control and accounting.•Functional separation of trading and back office functions such as investment accounts of banks, client’s portfolio management scheme, broker’s accounts.•External audit of portfolio management scheme of clients.
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Internal Control System
Dealing slip for each transaction by the trading desk
• Nature of deal
• Number of counter parties
• Direct deal or deal through a broker
• Amount of securities traded
• Price of securities traded
• Contract date and time
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System of Treasury Deal
•No substitution of counter party once trading has been conducted.•No substitution of security purchased or sold once trading has been conducted.•Maintenance of independent books of accounts by the accounts section.•Maintenance of Subsidiary General Ledger (SGL) account and Bank Receipt records.Reconciliation of bank’s books with balances in the books of public debt office at quarterly intervals
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Reporting to Top Management•Reports on a weekly basis.•Details of transactions in securities.•Details of SGL transfer forms issued by other banks that have bounced.•Bank receipts outstanding for more than one month.•Review of investment transactions.
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Monitoring by the Audit Committee•Total exposure of the bank to capital market (fund based and non fund based).
•Ensuring the compliance of RBI guidelines.
•Monitoring of risk management system.
•Monitoring of internal control system.
•Ensure that stock brokers as directors in the bank Board do not take part in investment committee decisions.
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Market Risk Limit
Past performance of the trading unit
Experience and expertise of the traders
Quality of internal control
Pricing, valuation and measurement systems in place
Projected level of trading activity
Liquidity of products and markets
Efficiency of systems in place to settle trades
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Market Risk Limit
Notional or volume limitStop loss limitGap or maturity band limitValue-at-risk limitOptions limit
• Delta limit• Gamma limit• Vega limit• Theta limit• Rho limit
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MEASURING EXPOSURE
Exposure to foreign exchange and interest rates is measured by:
• how financial variables affect operating performance reflected in profits; and
• how they influence the firm’s value as reflected in share prices.
Profit reflects performance over a given time period and is a flow variable.Primary concern of risk management is to protect value reflected in share prices.
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MEASURING EXPOSURE
Estimate how changes in financial prices will affect the firm’s assets and liabilities:
Gap Analysis
• “Gap” – the difference between the values of interest-rate-sensitive assets and interest rate liabilities
• Measuring gap allows one to control the direction of exposure to interest rate risk.
• Gap analysis is limited to its rough binary classifications• Duration is used to deal with value sensitivity of specific
assets, liabilities, or portfolios to changes in interest rates
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FX HEDGINGFX hedging is a fundamental element of every treasurer’s role, with the potential for large swings in financial results if hedging is absent or insufficient. Defining the right hedging policy for the business is essential, taking into account stakeholders’ risk management appetite and objectives. Once the overall approach to FX risk has been established, treasurers can then look at the most appropriate way of achieving this, and how to hedge in practice.
Different forms of hedgeThe first challenge as part of an FX policy is to define when, and when not to hedge. There are typically three types of hedging: fair value hedging, which covers translation risk for net monetary assets and liabilities; cash flow hedging, which covers transaction risk on both actual and projected cash flows, and net investment hedging.
Of these, the most complex business case for hedging is in the areas of projected cash flow hedging and net investment hedging. According to Citi’s 2010 CitiFX Corporate Risk Management Study, comprising 307 companies, 77% hedge net monetary FX assets and liabilities, 76% hedge forecast exposure while 22% hedge net investment exposure.
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FX HEDGINGHedging known exposuresFair value hedging relates to existing financial assets and liabilities, and revaluation of these will have an FX impact on the P&L. Consequently, the business case for hedging is strong. The same also applies to a known transaction such as the purchase of machinery. The result of a hedge transaction is carried on equity, and matched on the P&L when the cash flow occurs, or on the initial asset cost. The accounting treatment of the hedge is determined according to its degree of effectiveness against the underlying cash flow. Some adopt a conservative approach to hedging, and hedge 100% of known commitments and net monetary assets and liabilities using FX forwards. You can divide the world into developed and emerging markets. In the former case, where currencies are more liquid and easily tradable, banks use on-line FX trading platforms to perform these transactions. In emerging markets, where currencies are less liquid and exchange controls may exist, banks often execute transactions directly via the telephone.
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ON-BALANCE SHEET HEDGINGThe term “FX Exposure” refers to a type of risk originating from the involvement in currency that is not the functional currency of the company.
The first choice for protecting your balance sheet is often through the use of natural hedges.
In basic terms, hedging is "the taking of a position, acquiring either a cash flow, an asset, or a contract that will rise or fall in value to offset a fall or rise in the value of the existing position." Click:
https://www.youtube.com/watch?v=03Uk6XAZFys
For example, if you take on a foreign asset, take on a foreign liability and vice versa. However, these natural hedges are not always available. In those situations, banks can provide capital market instruments to synthetically create the offsetting exposure so the hedge neutralizes the effect of currency fluctuations.
Translation risks arise from the translation of overseas income, assets, and liabilities into domestic currency for accounting purposes. Companies that have foreign assets or liabilities have to translate their values into functional currency in order to produce a consolidated statement.
Over time, as the exchange rate moves, the rate at which these items are translated will change.
Traditional hedging
• involves matching assets and liabilities, and revenues and costs such as: maturity dates between short-term assets and short-term liabilities currencies in which the assets and liabilities are denominated the sensitivity of asset and liability values to changes in interest rates.May 13, 2016
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USING DERIVATIVE SECURITIES: OPTIONS AND FUTURES
Options and futures contracts can both be used to hedge financial risk Options provide greater flexibility than forwards contractsDirect hedge – where the underlying asset is the same as that of the original transaction being hedgedCross Hedge – derivative securities denominated in an asset with a value that is highly correlated with the asset of the original transaction
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USING DERIVATIVE SECURITIES: OPTIONS AND FUTURES
Combining Derivative Securities Combining different types of derivative products it is possible to provide almost any payoff pattern
Two of the most common patterns include:
1.The Straddle:1. In finance, a straddle refers to two transactions that share the same security, with positions that
offset one another. One holds long risk, the other short. As a result, it involves the purchase or sale of particular option derivatives that allow the holder to profit based on how much the price of the underlying security moves, regardless of the direction of price movement.
2. The purchase of particular option derivatives is known as a long straddle, while the sale of the option derivatives is known as a short straddle. It combines a put and a call on the same underlying asset with the same strike price, and with the same expiration date.
3. A long straddle involves "going long", in other words, purchasing, both a call option and a put option on some stock, interest rate, index or other underlying. The two options are bought at the same strike price and expire at the same time.
4. The owner of a long straddle makes a profit if the underlying price moves a long way from the strike price, either above or below.
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USING DERIVATIVE SECURITIES: OPTIONS AND FUTURES
2. The Butterfly Spread:
A butterfly spread is a neutral option strategy combining bull and bear spreads. Butterfly spreads use four option contracts with the same expiration but three different strike prices to create a range of prices the strategy can profit from.
The trader sells two option contracts at the middle strike price and buys one option contract at a lower strike price and one option contract at a higher strike price. Both puts and calls can be used for a butterfly spread.
It combines several call options to obtain payoffs only if the price of the underlying asset remains within a given range. The combination involves:
buying an option with a very low strike price writing two options with mid-range strike prices buying an option with a high strike price
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SUMMARY
1. Treasury risk management activity has become increasingly important as volatility
in financial markets increases. Financial markets and institutions have responded with new vehicles for apportioning risk, reducing taxes and issuance costs, or
otherwise enhancing efficiency and value.
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SUMMARY2. Effective risk management requires systematic and reasonably accurate
measurement of exposure. Exposure is defined as the variability in a firm’s value or
cash flows that results from changes in financial variables such as interest rates, exchange rates, and commodity prices.3. Regression analysis and computer
simulation can be used to quantify aggregate exposure. Other techniques
commonly used by financial institutions include gap and duration analysis.
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SUMMARY4. Optimal risk management is closely
related to beliefs about market efficiency.5. On-balance sheet hedging entails the matching of assets and liabilities, and revenues and costs, on the basis of
maturities, currencies, and value sensitivity to changes in interest rates or commodity
prices.
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SUMMARY6. Off-balance sheet hedging relies on
derivative securities whose usage does not directly affect the firm’s financial
statements. Swaps, options, and futures, alone or in various combinations, allow for the design of a variety of creative solutions
to risk management.
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