36306989 Treasury Management
-
Upload
ahmer-khan -
Category
Documents
-
view
17 -
download
1
description
Transcript of 36306989 Treasury Management
1
Understanding Treasury Dynamics
Understanding Treasury Management
XIMB’ August’2010
Rishi Rakesh
2
Session –I (Overview):o Role of Treasury in an organizationo Balance Sheet Dynamics o Benchmark\Transfer Pricing
Session –II (Treasury Risk)o Managing Interest Rate Risk o Managing Liquidity Risko Managing Foreign Exchange Risk
Session- III (Money Market) Govt Bonds, Yield Curve Interest Rate Swaps, Forwards, Options Foreign Exchange Swaps & Forwards
Contents
3
Session- ITreasury Overview
4
o Understand basic concepts of Treasury management
o Understand Treasury function and its role in business management process
o Be able to better consider treasury issues as part of the business management process
o Be able to understand Treasury’s different risk exposures and the methods used to manage these risks
o Be able to interpret treasury data and treasury language
Course Outcome
Course Objectives
5
The Evolution
Building Blocks of the Banking Business:
Credit/Lending
Marketing
Operations
6
Treasury Management
THE MISSING LINK
7
The Missing Link
Building Blocks of Banking Business:
Credit
Marketing
Operations
AND Treasury
8
Role of Financial Market:1. Interaction of buyers and sellers of risks2. Determination of price of risks3. Reduction of transaction costs
Purposes of Financial Assets:1. Transfer of funds from surplus-holders to deficit-holders2. Redistribute unavoidable risks from risk-providers to seekers
The Finance Industry
Risk Providers / Sellers
Risk Investors / Buyers
B
A
N
K
S
9
Product Planning Process
Credit
Funding / Investment
Op. Capacity
Credit Cycle• Credit Initiation• Account Maintenance• Collection - write offs
Treasury Cycle• Transaction initiation• Revenue / Expense Stream management - Interest rate - FX rate• Liquidity / Cash flow management.
MIS: Portfolio Management
Marketing / Sales
Market Strategy
Customer Business Proposition
Role of Treasury
10
o “Central bank” for all internal customers
o Determine price of money
o Bridge funding/lending needs
o Identify/quantify market risk
o Interest rate risk
o Liquidity risk
o Foreign exchange risk
o Manage risk where necessary
o Managing the company's relationships with credit rating agencies
Role of Treasury
11
Treasury Actions Hedging Investments Funding Asset / Liability Management
Summary
12
The Treasury Balance Sheet
Unit Outline Treasury components of a balance sheet Why have treasury assets & liabilities? Treasury assets Treasury liabilities Example balance sheets Summary
13
ASSETS
Our accounts
Bank placements
Intercompany (pool) assets
Mandatory reserves
Available for sale (AFS)
Trading account securities
Swap assets
TP assets
LIABILITIES
Their accounts
Bank borrowings
Intercompany (pool) liabilities
Commercial paper
Capital market borrowings
(bond issues)
Swap liabilities
Capital
TP Liabilities
Components of a Typical Bank Treasury Balance Sheet
14
Why Have Treasury Assets & Liabilities?
For management of the structural position
For liquidity management
For interest rate risk management
For FCY portfolio management
For regulatory compliance
15
Liquidity Management
Treasury Assets
Normal liquidity buffer
Contingency liquidity buffer
Investment of excess liquidity from consumer deposits
Treasury Liabilities
Funding consumer assets Opportunistic Gapping
16
Rate Risk Management
Developed markets have derivative (off balance sheet) instruments to manage interest rate risk
Less sophisticated markets use treasury instruments to hedge interest rate risk
Limited by Available instruments Available liquidity to make the investment
Volume and maturity of customer assets may be equal to those of customer liabilities, while having different interest rate repricing profiles
17
FCY Portfolio Management
Manage Exchange Risk
FCY deposits are used to fund LCY balance sheets in certain markets (e.g. India FX swaps)
Generally unwilling to use FCY deposits to fund LCY balance sheet (high MTM volatility, corporate limitations)
18
Regulatory Compliance
Reserve requirements
Deposits with central bank
Government securities
Other securities acceptable to central bank
19
Treasury Assets
o Bank placements
o Available for sale (AFS)
o Trading account securities
20
SummaryTreasury Responsibilities for Balance Sheet Management
Define the liquidity characteristics of each balance sheet item; use treasury assets and liabilities to structure a liquidity plan to manage the risks
Anticipate future balance sheet growth and articulate funding strategies and contingency plans to manage the liquidity risk
Define the rate sensitivity of different customer assets and liabilities and structure a plan to manage the interest rate risk
21
Balance Sheet Dynamics
Unit Outline
Key concepts
Re-pricing and Repayment Models
Treasury’s Response
Summary
22
Key Concepts
The three variables that Treasury is most interested in are: Re-pricing characteristic Repayment characteristic Foreign exchange risk
These characteristics are the core of: Interest rate risk management Liquidity management Foreign exchange risk management
23
Every product has certain characteristics important to Treasury
The goal is to understand the profile of each asset and liability category
Detailed analyses provides actual re-pricing/maturity profile of each asset and liability category
Key Concepts
24
Key Concepts
The actual re-pricing/maturity of assets vs. liabilities determines the inherent amount of interest rate risk and liquidity risk
“Matched” or “square” indicates that re-pricing/maturity of assets matches liabilities; there is no position
A “Gap” indicates a mismatch of repricing/maturing assets and liabilities
25
A Simplified Balance Sheet
Repricing & Repayment Models
AssetsFixed Rate Loan $150MM
Floating Rate Loan
$50MM
Mortgage Loan $100MM$300MM
LiabilitiesConsumer Time Deposit
$100MM
Floating Rate Deposit
$50MM
Professional CD $150MM$300MM
26
Product Tenor Behaviour Loan 3 years Fixed rate
Floating Rate Loans 4 years Repriceable Yearly
Mortgage Loan 10 years Amortizing
Professional CD 3 years Fixed rate
Floating Rate Deposit 4 years Repriceable Yearly
Time Deposit 5 years Fixed rate but 25% matures in Year 1 Fixed rate but 25% matures in Year 2 Fixed rate but 50% matures in Year 5
Repricing & Repayment Models
Product Characteristics
27
A Simplified Repricing Model
1 YR 2 YR 3 YR 4 YR 5 YR > 5 YR TOTALFixed Rate Loans 150 150
Floating Rate Loans 50 50 50 50
Mortgages 4 4 5 7 10 70 100
Total 54 54 205 57 10 70 300
Prof CD 150 150
Floating Rate Deposit 50 50 50 50
Time Deposit 25 25 50 100
Total 75 75 200 50 50 0 300
Gap (21) (21) 5 7 (40) 70
Cum (21) (42) (37) (30) (70) 0
50
50
28
A Simplified Repricing ModelConclusions
In general, the re-pricing of liabilities in a bank takes place earlier than the re-pricing of assets.
If the yield curve was positively sloped (i.e. if longer maturities have higher rates), a negative gap is profitable.
If interest rates rise and gap is negative, profitability will be squeezed since a higher rates will be paid to raise liabilities whereas the interest being paid on assets are already locked.
29
A Simplified Repayment Model1 YR 2 YR 3 YR 4 YR 5 YR > 5 YR TOTAL
Fixed Rate Loans 150 150
Floating Rate Loans 50 50
Mortgages 4 4 5 7 10 70 100
Total 4 4 155 57 10 70 300
Prof CD 150 150
Floating Rate Deposit 50 50
Time Deposit 25 25 50 100
Total 25 25 150 50 50 0 300
Gap (21) (21) 5 7 (40) 70
Cum (21) (42) (37) (30) (70) 0
30
A Simplified Repayment ModelConclusions
In general, the repayment of liabilities for a bank takes place faster than the repayment of assets.
Treasury should ensure that existing funding can be rolled over upon maturity or new funding can be sourced to support assets.
There is liquidity risk if cash inflows from asset repayments do not coincide with the cash outflows from liability maturities.
31
Benefits
A good model provides insights into profit dynamics and liquidity position of the business.
Once the risk is identified, it can be managed. Needs highlighted by the model can help us evolve
new product offerings. Elimination of risk may not be a goal; as a financial
intermediary, we take some interest rate risk. The key is to determine an acceptable amount of risk
given a certain set of forecast events.
Repricing & Repayment Model
32
Product Pricing Liquidity
Product Agreement
Behavior often observed
Product Agreement
Behavior often observed
Term deposit
(e.g. 3 month fixed rate TD)
Agreed upon rate
Market lagging / Pricing pressure (competition)
Contractual for 3 months
Roll-over /
Pre-termination
Current a/c Savings a/c
On demand (short-term)
Sticky pricing On demand (short-term)
Portfolio Dynamics:
Core (LT) vs Non-Core (ST)
15 year Fixed-Rate Mortgages
Agreed upon rate
Refinancing with the same bank
Contractual for 15 years
Refinancing with another bank
Credit cards Can be re-priced upon notice
Limited repricing ability due to competitive pressure or statutory max.
Minimum payment by due date
Portfolio Dynamics:
Transactor vs.
Revolver
Product Dynamics
33
Savings ExampleREPAYMENT ANALYSIS
With a large enough population, we can perform statistical behavioral analysis.
This analysis will identify a certain core percentage of deposits that can be said to have an indefinite maturity.
A portfolio dynamic occurs when: The core portion of the book remains long term. As the book grows, the amount of this core segment will also grow. As the book grows, the percentage which this core segment
represents usually does not grow.
34
Savings Example
REPRICING ANALYSIS
Movements of product price vs. market rates generally show a weak but notable relationship.
Although the entire portfolio could (in theory) be re-priced tomorrow, it clearly will NOT be.
However, once the portfolio does re-price:
The amount of the change in basis points will be less than movements in the market rates.
Regardless of market movements, there will be a considerable interval before the next repricing.
35
Savings Example
We said that even though Savings is contractually “on demand”, the core portion of the book remains long term.
But how long is long enough for core?
It all depends…
Core: Generally 2 years ~ 5 years
Non-Core: Generally overnight ~ 1 month.
Assumptions should be reviewed periodically.
Assigning a Tenor to Savings is a CHALLENGE!
36
Treasury’s Response Statistically Determine Actual Behavior
Take a portfolio approach (providing that a large enough population exists for statistical validation).
Do a redemption analysis (examining the actual payment history of a product set).
Adjust for seasonalities.
Take into account other variables, such as:
Ceilings / Floors Advertising / promotion campaigns Innovation
37
Treasury’s Response
Use re-pricing models to predict profitability
The actual re-pricing structure determine future profitability.
A re-pricing model should be able to forecast earnings volatility.
A re-pricing schedule of all assets vs. all liabilities and capital gives us our current interest rate position and exposure to future events.
38
Summary Consumer products have certain repayment
and re-pricing characteristics that need to be managed.
A model needs to be built that shows the liquidity and interest rate risks inherent in the balance sheet.
Effective management of repricing and repayment risk results in enhanced and more consistent earnings.
39
Treasury Role of Benchmarking
Unit Outline
Benchmarking: the concept Benchmark determination Benchmark pricing examples Benchmark pricing in practice Summary
40
Benchmarking : The Concept What is a Benchmark?
Benchmarking is a framework that divides the bank into separate product lines & transfers risk to a central unit
A benchmark is the rate of interest charged (to assets) or paid (to liabilities) by Treasury
Benchmarks are matched to the cash flows of each product
Benchmark assumptions operate like a service level agreement between Treasury and Products (reviewed and agreed at least annually)
Benchmarks serve several purposes Product pricing signal Essential to the calculation of product profitability Transfer of interest rate risk from Products to Treasury
41
Why is Benchmarking Necessary? Benchmarks are designed to transfer market risk exposure from the individual
product managers to treasury, where all risk is centrally located and professionally managed on a portfolio basis
Fundamental to the overall concept of market risk neutrality and stable Net Interest Margin (NIM)
Provides acute focus upon product profitability, customer pricing, positioning and product development
Promotes management accountability
Without benchmark, the impact of market risk is buried in the results of the product manager
Benchmarking : The Concept
42
Measurement of Margin Components Simplified Yield Curve Example – one asset, one liability, booked today
Time
4%
5% Yield Curve
Liability Spread (Deposits)
Risk Management Gap (tenor mismatch)
Asset Spread (Loans)
43
Measurement of Margin Components
Line Unit Assets Liabs Spread
Customer Rate 8.0% 3.0% 5.0%Transfer Price 5.0% 4.0%Matched Spread 3.0% 1.0%
Risk Totally Treasury Mgt MatchedTransfer Price Income 5.0% 5.0%Transfer Price Expense 4.0% 5.0%Treasury Risk Mgt Revenue 1.0% 0.0%
Adding the matched spreads (3%+1%) and the treasury spread (1.0%) equates to the total business spread of 5.0%. The 1% treasury spread is the net impact arising from the bank’s market risk. Generally the spread is positive when the asset tenors are longer than liabilities.
44
Features of Good Benchmarks Benchmark is a transfer pricing mechanism that aims to reflect
the true economics of the product
Ideally it should be based upon: External markets (as a pricing signal) Market risk neutrality (matched tenors)
It is a representation of a product’s price risk (interest rate) and liquidity risk summarized into a single concept - the benchmark price
The assignment of a benchmark should be driven by the characteristics of cash flow, date of origination, repricing, maturity (with adjustments for liquidity and embedded options)
45
Session- IIManaging Treasury Risk
46
Managing Interest Rate RiskUNIT OUTLINE
Identifying the Risk
Measuring the Risk
47
I. Identifying the Risk Determine the re-pricing profiles of assets and
liabilities in the balance sheet
Distinguish between the actual and contractual profiles (Can we re-price, Do we, How often? How much?)
Portfolio vs. Single Account
48
I. Identifying the Risk
INTEREST RATE EXPOSURE DUE TO
Gaps in an existing portfolio
Basis Mismatch
Volume Risk
Sticky rates on new originations
Embedded options
49
I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
A GAP….
Difference in repricing tenor (periods) of assets and liabilities and/or
Difference in the amount of assets and liabilities maturing / re-pricing within a time period.
Can be represented as run-off gaps or as remaining gaps (cumulative gaps).
Can be “Positive” or “Negative”.
Can be Structural or Intentional
50
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
Re-pricing Mismatch: A gap occurs when assets are re-priced at different periods from liabilities
Q1 Q2 Q3 Q4ASSETREPRICING
LIABILITYREPRICING
Asset : A one-year quarterly floating rate loan
Liability : A one-year time deposit
I. Identifying the Risk
51
I. Identifying the Risk
At the beginning of Mth 1 Mth 2 Mth 3 Mth 4 Mth 5 Mth 6 Mth 7 Asset $100MM 1-mth placement w/CMB 100 Liability $100MM 3-mth deposit (Repriceable in 3 mths time)
(100)
Run-off Gap 0 100 0 (100) 0 0 0 Cumulative Gap 0 100 100 0 0 0 0
Cumulative gaps (Remaining Amount) Mth 1 Mth 2 Mth 3 Mth 4 Mth 5 Mth 6 Mth 7 Asset (100) Liability 100 100 100 Cumulative Gap 0 100 100
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
RUN-OFF GAPS (Maturing amounts)
52
TYPE
DEFINITION / IMPLICATIONS
IF RATES MOVE UP
IF RATES MOVE DOWN
Positive Gap
Assets repricing faster than
liabilities More liabilities to be placed Lend short Borrow long Over-Borrowed COF (Depos Rates) locked-
in
Profits rise
Profits fall
Negative Gap
Liabilities repricing faster
than assets More assets to be funded Borrow short Lend long Over-Lent Revenue (Lending rates)
locked-in
Profits fall
Profits rise
I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
53
I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIO
STRUCTURAL GAP
Result of the mismatch in the inherent re-pricing characteristics of assets and liabilities
Influenced by product features and determined by customer behavior
INTENTIONAL GAP
Due to Treasury Actions
Dependent on view of interest rates
54
I. Identifying the Risk
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIOINTENTIONAL GAPPING : NEGATIVE GAP
You believe rates will fall Lend long term to lock in current high rates Borrow short term and roll it over at future lower rates
This results in a Negative Gap…
Year 1 Year 2 Year 3Lend (long) 10% 10% 10%Borrow (short) 10% 9% 8%Spread 1% 2%
55
SOURCE OF RISK - GAPS IN AN EXISTING PORTFOLIOINTENTIONAL GAPPING : POSITIVE GAP
You believe rates will rise Borrow long term at today’s cheap rates and lend money
short term so when rates rise, you can reinvest it at the higher rates
This results in a Positive Gap
Year 1 Year 2 Year 3Lend (short) 10% 11% 12%Borrow (long) 10% 10% 10%Spread 1% 2%
I. Identifying the Risk
56
I. Identifying the Risk
SOURCE OF RISK - BASIS MISMATCH
When two products (which may have the same re-pricing or maturity) in the same market, have different degrees of rate sensitivity
To manage the basis mismatch risk, change pricing nature of assets to match pricing nature of liabilities or vice versa
PRODUCT 1st QUARTER 2nd QUARTER
Asset 7.25% 7.25%(90 days Eurodollar)Liability 7.00% 7.50%(90 days Bank CD)
57
I. Identifying the Risk Source of Risk – Volume Risk
Changing rate levels could significantly impact forecasted volume of asset/liability originations as well as affect run-off rates of existing portfolio
FYF Actual B/(W) BAU/Status Quo 100 100 - If rates increase after FYF and customer behavior changes 100 120 (20) If rates fall after FYF and customer behavior changes 100 80 20
58
I. Identifying the Risk
SOURCE OF RISK - STICKY RATES ON ORIGINATION
If interest rates rise 2% Current portfolio - no rate risk
New portfolio - may be unable to price new loans upwards while we might have to re-price deposits upwards by close to 2%
59
I. Identifying the RiskSOURCE OF RISK - EMBEDDED OPTIONS
EXAMPLES:
Cap/Floor on Floating Rate Products Pre-termination without penalty for Fixed Rate Products Borrow-back at pre-determined rate on Deposit Products
These options add a new dimension to rate risk that is difficult to manage
Introduces element of “convexity”
60
II. Measuring the Risk
KEY CONCEPTS
DV01 (Earnings At Risk)
61
II. Measuring the Risk
To be more meaningful, the re-pricing gap must be translated into how much earnings risk it represents.
DV01 Management Tool to evaluate risk and define
economic loss parameter
62
II. Measuring the RiskDV 01 (A Methodology) Dollar value for 1 basis point move
Captures the potential earnings impact of one basis point movement in interest rates
Calculated by : Repricing Gap * 0.01% * Tenor
Total DV01 are the sum of individually derived Dv01
(deal by deal calculated)
Total DV01 categorized into Rolling 12 mths and Full
Tenor discounted
63
II. Dv01
An Example:
Executed Placement deal of USD 100 mio for
Tenor 6 mths
Dv01 = 0.01% * 100 mio * 6/12
= 5,000
64
Liquidity Risk
Overview
Introduction – What is Liquidity Risk? How Liquidity Risk Arises Liquidity Management Product Liquidity Characteristics Summary – Liquidity Risk
65
How much water should you bring if you are going to a 7-day trip across the
Sahara?
Carrying enough water for 1-day only assuming there will be wells or
suppliers along the way… taking a risk of not being able to find the well
(source of liquidity) before dying of thirst.
Carrying additional water as a safety buffer… enough for 10-days incurring
extra carrying costs (another camel to carry the load)
Carrying just enough water for 7-days… perfectly matched strategy
The art of balancing liquidity risk vs. return
Liquidity Problem?
66
What Is Liquidity Risk?
The risk that funds will not be available to meet a financial commitment to a counterparty in any location or any currency at any time. This is our key franchise risk (customer confidence).
Liquidity risk-taking is Fundamental to banking An important source of revenue
67
Businesses Need Liquidity
For survival: Having funds available at all times to meet fully and
promptly all contracted liabilities, including demand deposits and off-balance sheet commitments
For growth: Having funds available to take advantage of future
business opportunities
68
How Liquidity Risk Arises
Liquidity risk may come from: Operating environment:
Exposure arises from daily funding and trading activities in normal markets
Contingency situations:
Exposure arises from external events Market Name
69
Contingency Situations
Market Disruption
Displacement of market arising from “abnormal” events (often economic crisis, political turmoil, or central bank policy change) affecting market liquidity and ability of most participants to transact at normal volumes, rates, or tenors.
Name Problem
Denial of market access to specific counterparty due to concern over its creditworthiness
70
Liquidity Management
Objectiveso To ensure sufficient liquidity to meet all financial
commitments and obligations when they fall due
o To be able to access liquidity in global markets at “reasonable” terms
o To plan, quantify, and monitor what kinds and levels of risk that is prudent for the company
o To balance the cost of maintaining liquidity, with the appropriate level of returns
71
Roles & Responsibility
Managing liquidity risk is the joint responsibilities of Business, Treasury, and Risk Management; oversight by Asset and Liability Committee (ALCO).
Country Treasurer Has primary responsibility for liquidity
management Develops funding plan & process for each legal
vehicle
72
Summary Effective liquidity management is critical to:
Business survival, growth and expansion Maintaining market confidence
Liquidity mismanagement can result in severe repercussions including loss of market confidence and erosion of capital base
Liquidity risk management is a joint responsibility of business, treasury and ALCO.
Prudent liquidity management requires: Stable and diversified funding structure Limited reliance on single counterparty and/or market Proactive management of asset and liability maturity profiles Disciplined planning for contingency situations
73
Session- IIIMoney Market Instruments
74
Concept of a Yield Curve
Positive Yield Curve Aka “normal yield curve”
Slopes upward to the right
No specific trend
Premium for longer period
(credit risk, liquidity risk, compounding)
Opportunity cost of inflation
Cost of insulating against rate moves
With a positive yield curve, all things being equal, a
negative gap is generally the profitable position
Rat
es
Maturities
Positive Yield Curve
75
Parallel Shift
Ra
tes
Maturities
Positive Yield Curve
Ra
tes
Maturities
Ra
tes
Maturities
Change Shape
Gapping: Examples of Different Yield Curve
76
Gapping: Current Yield Curve - USD
77
Gapping: Yield Curve Shifts – USD Yr 2003 vs 2004
June 2003
May 2004
78
Gapping: Yield Curve Shifts – USD Yr 2004 vs 2005
June 2005
May 2004
79
Gapping: Yield Curve Changes – UST Yr 2005 vs 2006
June 2005
August 2006
80
Gapping: Yield Curve Changes – USD Yr 2006 vs 2007
May 2007
May 2006
81
Gapping: Yield Curve Changes – USD Yr 2007 vs 2008
May 2008
May 2007
82
Gapping: Fed Funds Target
First pause in 2 years
Total 425 bps Rate Hikes
225 bps Rate Cut
83
Gapping: Yield Curve Comparison
Beginning of rate cut cycle (Yr 2001)
beginning of rate rise cycle (Yr 1993)
84
Instrument to Manage Risk
Interest Rate Swap
Forward Rate Agreement
Interest Rate Options (Caps / Floors)
85
Interest Rate Swap Definition
Agreement between two parties to exchange interest rate payments on a notional principal sum which is not exchanged
Purpose: Manage interest rate risk Permit large volume transactions Change the interest rate profiles of liabilities or assets Most common swap is fixed-for-floating which one counter-
party agrees to pay a fixed rate over the term of the swap in exchange for a floating rate payment payable by the other counter-party (aka “coupon” swap)
86
Interest Rate Swap Example
Bank ABC’s fixed rate mortgage portfolio is funded by 6-month interbank borrowing
Assets Liabilities$50MM mortgages $50MM TDsAvg. Life: 10 yrs Avg. Life: 6 mthsAvg. Rate: 11% Avg. Rate: 8%(fixed for 10 yrs)
Concern: ABC expects interest rates to rise; higher rates will narrow their spread
Solution: ABC decides to enter a SWAP to “pay fixed, receive float” with bank XYZ
87
Interest Rate Swap Example
Swap Agreement:
ABC will “pay” fixed rate at 9% for 5 years on notional principal of $50MM (less than full life)
ABC will “receive” the inter-bank rate reset every 6mths for the next 5 years on notional principal of $50MM
No principal is exchanged, only net coupon interest
payments
88
Interest Rate Swap Example
FLOATING RATE Liability
MORTGAGEPORTFOLIO
XYZ ABC
FUNDINGSOURCE
FIXED RATE = (9%)
FLOATING RATE = 8%
• No liquidity forfeiture due to notional principal• Only exchange of interest differential
FIXED RATEAsset
SWAP
11%
(8%)
89
Interest Rate Swap Example
Results for ABC: The first 6 months
Borrows 6mth interbank (8%) Receives from XYZ 8% Net Spread 0%
Receives from Mortgage 11% Pays fixed to XYZ 9% Net Spread 2%
90
Without an interest rate swap, ABC’s net revenues from the mortgage portfolio are reduced by half as a result of rising interest rate environment impacting short term funding
With SWAP
Borrows 6-month libor (10%)
Receives from XYZ, 6-month libor 10%
Net spread 0%
Receives from mortgage portfolio 11%
Pays Bank XYZ 9%
Net spread 2%
Without SWAP
(10%)
11%
--
1%
Interest Rate Swap Example Results for ABC: The Next Six Months (Assume interest rates increase 2%)
91
Interest Rate Swap Example
Assume rates continued to rise by 1.0% at each of the next 2 resets (1 year), then begin to fall by 2% for each of the next 2 resets (1 year)
0
2
4
6
8
10
12
14
R1 R2 R3 R4
Fixed Rate Paid to XYZ
1112
10
8
Resets
Inte
res
t R
ate
s
92
Interest Rate Swap Example R1 R2 R3 R4
a. Borrows Inter-bank (11%) (12%) (10%) (8%)b. Receives from Mortgages 11% 11% 11% 11%c. Net Spread 0% (1%) 1% 3%
d. Receives from XYZ 11% 12% 10% 8%e. Pay XYZ (9%) (9%) (9%) (9%)f. Swap Spread 2% 3% 1% (1%)
Net Spread (c+f) 2% 2% 2% 2%
Without the interest rate swap, ABC has interest rate risk based on the changing cost of 6 month borrowings
The Swap with XYZ will lock-in a guaranteed earnings spread of 2% on the fixed rate mortgages, regardless of how interest rates change
93
Forward Rate Agreement
Agreement with a counter-party to pay or receive thedifference in interest on a notional principal amountbetween an agreed future interest rate and a reference interest rate for a specified period
Only the difference in interest between the agreed contract rate and the reference rate at the start of theperiod to which the rate refers is paid to or received from the counterparty
94
Forward Rate Agreement
Jargon
Quoting of desired periods is done by calendar months. Thus, a deal for a 3-month tenor in 3 months time is a 3x6.Similarly, the following are:
6x12 : 6-month rate in 6 months time
2x5 : 3-month rate in 2 months time
95
Forward Rate Agreement Example
ABC has a $50MM, 1 year fixed rate auto loan portfolio, funded via 3-month interbank borrowings
ASSETS LIABILITIES$50MM auto loans $50MM TDsTenor: 1year Tenor: 3mthsFixed Rate: 10% Rate: 7.5%
Concern: ABC expects rates to rise in the future; higher rates will narrow spreads
Solution: ABC decides to enter a series of FRA “strips” to lock-in rollover rates with Bank XYZ to ensure a predictable spread is maintained
96
Forward Rate Agreement Example
o ABC will buy FRA strips to match rollover dates of 3-month borrowings:
$50MM 3 x 6 mths @ 7.75%$50MM 6 x 9 mths @ 8.00%$50MM 9 x 12 mths @ 8.25%
o On maturity of the 3-month interbank cash borrowing at 7.5%, ABC will rollover the US$50MM at the prevailing interbank market rate
97
Forward Rate Agreement Example
Assume rates continued to increase by 0.5% at the next rollover, then another 0.5% and then fall -1.0% by the last quarter:
R1 + 0.5% R2 + 0.5% R3 - 1.0%
0
1
2
3
4
5
6
7
8
9
R0 R1 R2 R3
7.5
Resets
Inte
res
t R
ate
s
8.0
8.5
7.0
98
Forward Rate Agreements Example
Results for ABC rollovers
R0 R1 R2 R3Auto Loan 10% 10% 10% 10%3mth interbank 7.5% 8.0% 8.5% 7.0%Spread before FRA 2.5% 2.0% 1.5% 3.0%
FRA - 7.75% 8.00% 8.25%FRA Gain/(Loss) - 0.25 0.50 (1.25%)
Effective Rate 7.5% 7.75% 8.0% 8.25%Net Spread 2.5% 2.25% 2.0% 1.75%
99
Interest Rate Options
Definition: A contract that gives the options buyer the right,
but not the obligation, to lend/borrow funds at a specific rate over a specified time frame
In return, the options buyer pays a fee called a premium at the time of option purchase (Buying insurance)
Purpose: Manage interest rate risk Permit large volume transactions Allow flexibility of rate cover, but still receive
benefit of favorable moves
100
Unit Outline
Foreign Exchange Fundamentals
Types of Foreign Exchange Exposure
Managing FX Exposure - considerations
Factors affecting the market
Introduction to Foreign Exchange
101
Foreign Exchange FundamentalsWhat is Foreign Exchange?
A foreign exchange transaction involves one currency being bought or sold against another currency
Rate Quotation:a. Cross Rates:
A foreign exchange rate between two currencies derived via a third currency
Example: GBP/HKD via USD (GBP/USD and USD/HKD)
b. Price Quotation: Bid and Offer
102
Time element in FX market:
Spot Transaction: Settlement within two business days from deal date
Forward Transaction: Settlement at a specified future date (>two business
days) Common tenors are 1, 2, 3, 6, 9 and 12 months
Foreign Exchange Fundamentals
103
Foreign Exchange FundamentalsWhy is there a FX market?
International trade Capital movements Financial transactions Exchange of services Tourism
104
Players in the FX market?
Commercial banks Speculators Fund Managers Non financial businesses Central banks Investment houses
Foreign Exchange Fundamentals
105
Factors affecting FX rate movement
Demand and supply
Sovereign policy Exchange control/regulations
Economic performance Money supply Inflation Interest rates
Speculation
Foreign Exchange Fundamentals
106
Types of FX Exposure
Transaction Exposure (daily Mark-to-Market):
Exposures arising from buying and selling foreign currencies
for customer’s account for Banks’s own account
107
Types of FX Exposure
Translation Exposure
Exposure arises from translating a local currency balance sheet into Bank’s native country accounting/reporting purposes.
108
FX Treasury Products
We will briefly discuss the 3 basic forms of derivative products:
1. Forwards2. FX Swaps3. Options