NCFM - NSE's Certification In Financial Markets

Treasury ManageMenT Module

NATIONAL STOCK EXCHANGE OF INDIA LIMITED

Test details:sr. no.

name of Module Fees (rs.) Test duration (in minutes)

no. of Questions

Maximum Marks

Pass Marks (%)

Certificate Validity (in yrs)

FoundaTIon1 Financial Markets: A Beginners’ Module ^ 1686 * 120 60 100 50 52 Mutual Funds : A Beginners' Module 1686 * 120 60 100 50 53 Currency Derivatives: A Beginner’s Module 1686 * 120 60 100 50 54 Equity Derivatives: A Beginner’s Module 1686 * 120 60 100 50 55 Interest Rate Derivatives: A Beginner’s Module 1686 * 120 60 100 50 56 Commercial Banking in India: A Beginner’s Module 1686 * 120 60 100 50 57 FIMMDA-NSE Debt Market (Basic) Module 1686 * 120 60 100 60 58 Securities Market (Basic) Module 1686 * 120 60 100 60 5 InTerMedIaTe1 Capital Market (Dealers) Module ^ 1686 * 105 60 100 50 52 Derivatives Market (Dealers) Module ^ [Please refer to footnote no. (i)] 1686 * 120 60 100 60 33 Investment Analysis and Portfolio Management Module 1686 * 120 60 100 60 54 Fundamental Analysis Module 1686 * 120 60 100 60 55 Options Trading Strategies Module 1686 * 120 60 100 60 56 Operations Risk Management Module 1686 * 120 75 100 60 57 Banking Sector Module 1686 * 120 60 100 60 58 Insurance Module 1686 * 120 60 100 60 59 Macroeconomics for Financial Markets Module 1686 * 120 60 100 60 510 NSDL–Depository Operations Module 1686 * 75 60 100 60 # 511 Commodities Market Module 2022 * 120 60 100 50 312 Surveillance in Stock Exchanges Module 1686 * 120 50 100 60 513 Corporate Governance Module 1686 * 90 100 100 60 514 Compliance Officers (Brokers) Module 1686 * 120 60 100 60 515 Compliance Officers (Corporates) Module 1686 * 120 60 100 60 5

16Information Security Auditors Module (Part-1) 2528 * 120 90 100 60

2Information Security Auditors Module (Part-2) 2528 * 120 90 100 60

17 Technical Analysis Module 1686 * 120 60 100 60 518 Mergers and Acquisitions Module 1686 * 120 60 100 60 519 Back Office Operations Module 1686 * 120 60 100 60 520 Wealth Management Module 1686 * 120 60 100 60 521 Project Finance Module 1686 * 120 60 100 60 522 Venture Capital and Private Equity Module 1686 * 120 70 100 60 523 Financial Services Foundation Module ### 1123 * 120 45 100 50 NA24 NSE Certified Quality Analyst $ 1686 * 120 60 100 50 NA25 Certified Credit Research Analyst – Level 1 ~ 1686 * 120 80 120 50 NA adVanCed1 Financial Markets (Advanced) Module 1686 * 120 60 100 60 52 Securities Markets (Advanced) Module 1686 * 120 60 100 60 53 Derivatives (Advanced) Module [Please refer to footnote no. (i) ] 1686 * 120 55 100 60 54 Mutual Funds (Advanced) Module 1686 * 120 60 100 60 55 Options Trading (Advanced) Module 1686 * 120 35 100 60 56 FPSB India Exam 1 to 4** 2247 per exam * 120 75 140 60 NA7 Examination 5/Advanced Financial Planning ** 5618 * 240 30 100 50 NA8 Equity Research Module ## 1686 * 120 49 60 60 29 Issue Management Module ## 1686 * 120 55 70 60 210 Market Risk Module ## 1686 * 120 40 65 60 211 Financial Modeling Module ### 1123 * 120 30 100 50 NA nIsM Modules 1 NISM-Series-I: Currency Derivatives Certification Examination ^ 1250 120 100 100 60 3

2 NISM-Series-II-A: Registrars to an Issue and Share Transfer Agents –Corporate Certification Examination 1250 120 100 100 50 3

3 NISM-Series-II-B: Registrars to an Issue and Share Transfer Agents – Mutual Fund Certification Examination 1250 120 100 100 50 3

4 NISM-Series-III-A: Securities Intermediaries Compliance (Non-Fund) Certification Examination 1250 120 100 100 60 3

5 NISM-Series-IV: Interest Rate Derivatives Certification Examination 1250 120 100 100 60 36 NISM-Series-V-A: Mutual Fund Distributors Certification Examination ^ 1250 120 100 100 50 37 NISM Series-V-B: Mutual Fund Foundation Certification Examination 1000 120 50 50 50 3

8 NISM-Series-V-C: Mutual Fund Distributors (Level 2) Certification Examination 1405 * 120 68 100 60 3

9 NISM-Series-VI: Depository Operations Certification Examination 1250 120 100 100 60 3

10 NISM Series VII: Securities Operations and Risk Management Certification Examination 1250 120 100 100 50 3

11 NISM-Series-VIII: Equity Derivatives Certification Examination 1250 120 100 100 60 312 NISM-Series-IX: Merchant Banking Certification Examination 1250 120 100 100 60 313 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination 1250 120 100 100 60 314 NISM-Series-X-B: Investment Adviser (Level 2) Certification Examination 1405 * 120 68 100 60 315 NISM-Series-XI: Equity Sales Certification Examination 1405 * 120 100 100 50 316 NISM-Series-XII: Securities Markets Foundation Certification Examination 1405 * 120 100 100 60 3

* in the ‘Fees’ column - indicates module fees inclusive of service tax^ Candidates have the option to take the tests in English, Gujarati or Hindi languages. # Candidates securing 80% or more marks in NSDL-Depository Operations Module ONLY will be certified as ‘Trainers’.** Following are the modules owf Financial Planning Standards Board India (Certified Financial Planner Certification)- FPSB India Exam 1 to 4 i.e. (i) Risk Analysis & Insurance Planning (ii) Retirement Planning & Employee Benefits (iii) Investment Planning and (iv) Tax

Planning & Estate Planning - Examination 5/Advanced Financial Planning ## Modules of Finitiatives Learning India Pvt. Ltd. (FLIP)### Module of IMS Proschool$ Module of SSA Business Solutions (P) Ltd.~ Module of Association of International Wealth Management of IndiaThe curriculum for each of the modules (except Modules of Financial Planning Standards Board India, Finitiatives Learning India Pvt. Ltd. and IMS Proschool) is available on our website: www.nseindia.com > Education > Certifications. note: (i) SEBI / NISM has specified the NISM-Series-VIII-Equity Derivatives Certification Examination as the requisite standard for associated persons functioning as approved users and sales personnel of the trading member of an equity derivatives exchange or equity derivative segment of a recognized stock exchange.

Treasury Management Module

Background

Treasury management has always been an important function in banking and finance companies. It

is gaining in importance in manufacturing and services companies too. This Workbook discusses the

role and functioning of treasury management in both types of organisations. It also discusses the

role of various products in fulfilling the objectives of treasury management, and approaches to risk

management in treasury operations.

Learning Objectives

• To know how to calculate and interpret return and risk associated with investments

• To understand the working of cash and futures markets and various derivative products and

their role

• To understand the structure of balance sheet of companies and how they help in gauging

inherent risk

• To appreciate the significance of capital structure and know the sources of funds and calculation

of their cost

• To know the various risks that manufacturing companies are exposed to and the treasury

management products that help in mitigating them

• To understand the risks of banking and finance companies and role of treasury management

in mitigating them

• To appreciate the accounting issues that have a role in treasury management decisions

• To know the various treasury management processes and how risk is to be managed in the

treasury

Contents

Acronyms .............................................................................................................7

Chapter 1 Treasury Management Fundamentals ..............................................9

1.1 Background .......................................................................................9

1.2 Return Metrics ....................................................................................9

1.3 Risk Metrics .....................................................................................13

1. Standard Deviation .......................................................................13

2. Beta ...........................................................................................15

3. Weighted Average Maturity ............................................................17

4. Modified Duration .........................................................................17

Self-Assessment Questions ................................................................18

Chapter 2 Product / Exposure Structures ......................................................20

2.1 Background .....................................................................................20

2.2 Cash Market .....................................................................................21

2.3 Futures ...........................................................................................22

2.4 Forwards .........................................................................................25

2.5 Options ...........................................................................................27

2.6 SWAPs ............................................................................................32

1. Interest Rate Swap .......................................................................32

2. Currency Swap ............................................................................34

3. Credit Default Swap (CDS) ............................................................35

4. Swaption ....................................................................................42

2.7 SSELECTIVVELLY-Invest Classification Scheme for Investment Products ...42

2.8 Off-Balance Sheet Exposures ..............................................................43


Chapter 3 Capital Structure & Weighted Average Cost of Capital ....................46

3.1 Background .....................................................................................46

3.2 Capital Structure ..............................................................................46

3.3 Earnings, Interest and Debt Servicing ..................................................48

3.4 Sources of equity funds .....................................................................49

3.5 Cost of equity ..................................................................................49

3.6 Sources of debt funds .......................................................................50

3.7 Cost of debt .....................................................................................51

3.8 Weighted Average Cost of Capital ........................................................52

3.9 Cost of Capital for Trading Portfolios ....................................................53

3.10 Leasing and hire purchase .................................................................54


Chapter 4 Treasury Management in Manufacturing and Services Companies ..57

4.1 Background .....................................................................................57

4.2 Contribution Analysis ........................................................................57

4.3 Operating Leverage & Financial Leverage .............................................58

4.4 Balance Sheet ..................................................................................59

4.5 Liquidity Management .......................................................................60

4.6 Foreign Exchange Exposures (Operations) ............................................62

4.7 Foreign Exchange Exposures (Loans taken or investments made) ............63

4.8 Commodity Exposures .......................................................................65

4.9 Credit Exposures ..............................................................................65


Chapter 5 Treasury Management in Banking & Finance Companies ................69

5.1 Background .....................................................................................69

5.2 Capital Adequacy ..............................................................................69

5.3 Balance Sheet ..................................................................................73

5.4 Yield Curve and Spreads ....................................................................74

5.5 Credit Risk .......................................................................................75

5.6 Interest Risk ....................................................................................78

5.7 Re-financing Risk ..............................................................................79

5.8 Asset-Liability Management ................................................................80

5.9 Securitisation ...................................................................................80

5.10 Foreign currency risk .........................................................................82

5.11 Equity Exposure ...............................................................................83


Chapter 6 Accounting Issues in Treasury Management ..................................87

6.1 Background .....................................................................................87

6.2 Long-term supply arrangements .........................................................88

6.3 Foreign Currency borrowing for a fixed asset ........................................88

6.4 Hedge and Hedged Instrument ...........................................................89

6.5 Investment types..............................................................................90


Chapter 7 Treasury Management Processes and Risk Management in Treasury . 92

7.1 Background .....................................................................................92

7.2 Domestic Remittances .......................................................................92

7.3 International Remittances ..................................................................94

7.4 Liquidity Management .......................................................................95

7.5 Risk Management in Treasury .............................................................96

Self-Assessment Questions .............................................................. 100

References ........................................................................................................ 101

1

Acronyms

BIS Bank for International Settlements

BIFR Board for Industrial and Financial Re-construction

CDS Credit Default Swap

CORF Corporate Operational Risk management Function

CD Certificate of Deposit

CP Commercial Paper

CRAR Capital to Risk-weighted Assets Ratio

DPS Dividend per Share

DSCR Debt Servicing Coverage Ratio

EBIT Earnings before Interest and Tax

EPS Earnings per Share

FII Foreign Institutional Investor

GoI Government of India

ICAI Institute of Chartered Accountants of India

ICR Interest Coverage Ratio

IFRS International Financial Reporting Standards

IMF International Monetary Fund

IndAS Indian Accounting Standards

IPDI Innovative perpetual debt instruments

IRR Internal Rate of Return

MDB Multilateral Development Banks

NBFC Non-banking Finance Company

NCD Non-Convertible Debenture

NEFT National Electronic Funds Transfer

NPA Non-performing Assets

NSE National Stock Exchange

P/E Price Earnings Ratio

PCNPS Perpetual Non-Cumulative Preference Shares

PD Primary Dealer

RBI Reserve Bank of India

RTGS Real Time Gross Settlement

RWA Risk-Weighted Assets

SPV Special Purpose Vehicle

SWIFT Society for Worldwide Interbank Financial Telecommunication

WACC Weighted Average Cost of Capital

2

distribution of weights of the Treasury Management Module Curriculum

Chapter

no.Title

Weights

(%)

1 Treasury Management Fundamentals 20

2 Product / Exposure Structures 14

3 Capital Structure & Weighted Average Cost of Capital 10

4 Treasury Management in Manufacturing and Services Companies 19

5 Treasury Management in Banking & Finance Companies 20

6 Accounting Issues in Treasury Management 4

7 Treasury Management Processes and Risk Management in Treasury 13

Note: Candidates are advised to refer to NSE’s website: www.nseindia.com, click on‘Education’

link and then go to ‘Updates & Announcements’ link, regarding revisions/updations in

NCFM modules or launch of new modules, if any.

This book has been developed for NSE by Mr. Sundar Sankaran, Director, Advantage India

Consulting Pvt. Ltd. and finberry academy pvt ltd.

Copyright © 2013 by National Stock Exchange of India Ltd. (NSE)

Exchange Plaza, Bandra Kurla Complex,

Bandra (East), Mumbai 400 051 INDIA

All content included in this book, such as text, graphics, logos, images, data compilation etc.

are the property of NSE. This book or any part thereof should not be copied, reproduced,

duplicated, sold, resold or exploited for any commercial purposes. Furthermore, the book in

its entirety or any part cannot be stored in a retrieval system or transmitted in any form or by

any means, electronic, mechanical, photocopying, recording or otherwise.

3

Chapter 1 Treasury Management Fundamentals

1.1 Background

At the outset, it is important to differentiate between treasury management and financial

management. Since treasury deals with finance, treasury management can be viewed as a

subset of financial management, in theory. In practice, treasury management has always

been a distinct function in banks and non-banking finance companies – especially, those that

have an active involvement with the markets on their assets or liabilities side. Increasingly, it

is emerging as a distinct function in manufacturing and services companies too.

Some aspects of treasury management are common between companies in the financial

sector and other sectors. However, there are distinct differences in many other aspects.

These similarities and contrasts are discussed in relevant portions of this Workbook.

A common pursuit in most treasury management situations is the balancing of risk and return

metrics. The ideal is to maximise the return for a given level of risk, or minimise the risk for

a given level of return. Measurement of return and risk are therefore a fundamental aspect

of treasury management.

1.2 Return Metrics

Investments are made with a view to earn a return. How is return (yield) to be measured?

Suppose an investment is made in a debenture offering a coupon of 9% p.a., payable half-

yearly. How is the return different from another debenture offering the same coupon of 9%

p.a., but payable annually?

The debenture that offers half-yearly interest gives the investor the option of investing the

interest for the first 6 months in some other instrument for the second 6 months. Therefore,

receiving interest half-yearly is superior to receiving interest annually, if the coupon in both

cases is the same. The benefit of receiving coupons more frequently can be quantified by

compounding, as shown in Table 1.1.

In the case of annual interest, there is nothing to compound during the year. So the return is

the same as the coupon. In the half-yearly interest case, the coupon per period (half-year)

is 4.50%. There are 2 such periods (half-years) in any year. So the compounded return is

worked out as (1+4.50%)2-1 i.e. 9.202%. The more-frequent interest receipt has helped

boost the return from 9% to 9.202%. The implicit assumption here is that the interest for

the first 6 months can be re-invested for the next 6 months at the same coupon of 9% p.a.

If the re-investment rate is lower than 9%, the compounded return would be lower; a higher

re-investment rate will push the compounded return above 9.202%.

4

Table 1.1

Compounded Returns

In MS Excel, the exponential function is denoted by ‘^’. Therefore, the formula is written as

‘=(1+4.50%)^2-1’.

The above simple approach works, so long as investment and redemption are at face value.

Suppose investment was at a 1% discount i.e. investor invests Rs. 99, but receives coupon

calculated at 9% on Rs. 100. In such cases, a crude return measure, ‘current yield’ may be

used. It is calculated as Rs. 9 ÷ Rs. 99 X 100 i.e. 9.091%.

A more professional approach is to use the Internal Rate of Return (IRR) function, as shown

in Table 1.2. Cash flow 1 is a situation where there is no discount; Cash flow 2 is a situation

where the discount of Rs. 1 is applicable.

The calculation entails putting down the cash flows at various points of time – inflows are

denoted as positive and outflows are denoted as negative.

5

Table 1.2

IRR (1 year debenture)

As is obvious from the IRR calculation for Cashflow 1, the calculated IRR is for a period. It

will need to be compounded using (1+4.50%)2-1 i.e. 9.202%. The compounded IRR in the

case of Cash flow 2 works out to 10.33%. The discount of Rs. 1 has boosted the yield by more

than 1%.

The calculations are made in the Table, assuming the debenture will mature in 1 year. The

same calculations work for debentures of any maturity. This can be seen in Table 1.3, where

the tenor of the debentures is extended to 2 years. Further, an additional scenario, Cash flow

3 is introduced. In the new scenario, investment is at par, but redemption is at a premium

of 1%.

6

Table 1.3

IRR (2 year debenture)

Between Cash flow 1 and Cash flow 2, the difference in IRR Compounded is much less than

1%. It is lower than in Table 1.2 because the 1% upfront benefit is now distributed over 2

years.

IRR Compounded is lower for Cash flow 3 as compared to Cash flow 2. Although investor gets

a 1% extra benefit in both cases, in Cash flow 3 the benefit is back-ended (on redemption).

In the case of Cash flow 2, it is front-ended (on investment). Therefore, it can be said that the

earlier the benefit is received, the better (higher return) it is for the investor.

The IRR calculations give the IRR per period. Therefore, the cash flows need to be for periods

that are equal. In practice, this may not always be the case. For instance, suppose the 2-year

debenture is issued on December 31, 2013. However, the issuer would like to standardise the

interest payment cycle as March 31 and September 30. Only the last interest payment would

need to be on another date viz. December 31, 2015.

In this case, the first and last debenture servicing will be for 3 month periods, while the

middle periods are all 6 months. In such cases, IRR cannot be used. XIRR needs to be used,

as shown in Table 1.4. This calls for entering the actual dates for each debenture servicing, in

7

a form that MS Excel recognises as date format. Thereafter, the XIRR function can be used,

where two ranges of cells need to be selected viz. the cash flow values and the dates.

Table 1.4

XIRR

The table also shows IRR, which is wrong to apply. The benefit of XIRR is that no further

compounding is required. XIRR is a compounded return by itself.

Return for the investor is cost for the issuer. Therefore, the same calculations are used to

determine the cost for the issuer. Only difference will be in the signs used for the cash flows.

Initial receipt of money from the investor will be shown as positive and subsequent payments

towards interest and redemption will be negative. The calculated values of IRR and XIRR will

remain the same.

The explanations so far are given in the context of primary issue of securities by an issuer. The

methodology is equally applicable for secondary market trades. There is only one technical

difference viz. accrued interest, when it comes to secondary market trades.

Suppose Party A buys from Party B for Rs. 98, the debenture mentioned in Table 1.4 on

May 5, 2014 and holds it beyond September 30, 2014. On September 30, 2014, the issuer

will pay Party A interest for the entire period from March 31, 2014. However, Party A held

the debenture only from May 5, 2014. Interest for the period April 1, 2014 to May 5, 2014

rightfully belongs to Party B, which held the debenture during that period.

8

Therefore, Party A will not only pay Party B the “clean” price of Rs. 98, but also accrued

interest for the period from the last interest payment date to the settlement date (May 5,

2014). This is paid on the settlement date, although the interest will be received by Party A

from the issuer only on the next interest payment date. The total of Clean Price and accrued

interest is called “dirty” price. The calculations are shown in Table 1.5.

Yield to maturity (YTM) for Party A is 10.907%.

1.3 Risk Metrics

Various qualitative aspects of risk are mentioned in the rest of this Workbook. Quantitatively,

four measures of risk are commonly used viz. standard deviation, beta, weighted average

maturity and modified duration.

1. Standard Deviation

This is applicable for investments that have a market element i.e. their values fluctuate

in the market. In such cases, investors return would be a combination of payments

by the issuer (interest or dividend) and returns from the market (capital gains or

losses).

Since the investment has a value in the market at any point of time, returns can be

worked out for various periods of holding, even if the investment has not been sold.

9

Table 1.5

Secondary Market Yield

For example, if a share is quoted at Rs. 50 on Day 1, Rs. 55 on day 2 and Rs. 66 on day 3.

The return on Day 2 is Rs. 5 ÷ Rs. 50 X 100 i.e. 10%. The return on Day 3 is Rs. 11 ÷ Rs.

55 X 100 i.e. 20%.

Standard deviation measures the extent to which such returns vary over different time periods.

Specifically, it measures how much the returns vary as compared to its own past standards

of return. Unlike returns, which are calculated for each period, standard deviation is a single

number for a series of periods.

This can be easily calculated using the MS Excel function ‘STDEV’ as shown in Table 1.6 in the

context of returns from a mutual fund scheme.

The standard deviation, based on monthly returns is 2.53%. This needs to be compounded to

its annual equivalent, by multiplying it by the square root of 12. (If the periodic returns were

weekly, the multiplication factor would be square root of 52. While working with daily returns,

the norm is to multiply by the square root of 252).

10

Thus, the annualised standard deviation is 8.78%.

A high standard deviation would mean that the investment deviates more from its past

standard i.e it is more risky.

At times, the term ‘variance’ is used. This is nothing but the square of standard deviation.

In the above case, annualised standard deviation was calculated as 8.78%. Variance will be

8.78%2 i.e. 0.77%.

Table 1.6

Standard Deviation

2. Beta

An alternate approach to measure equity risk is based on Capital Assets Pricing Model

(CAPM), discussed in NCFM’s Workbook titled “Securities Market (Basic) Module”. We

saw that there are two risks in investing in equity:

• Systematic risk (β) is inherent to equity investments e.g. the risk arising out

of political turbulence, inflation etc. It would affect all equities, and therefore

cannot be avoided.

11

• Non-systematic risk is unique to a company e.g. risk that a key pharma

compound will not be approved, or the risk that a high performing CEO leaves

the company. Non-systematic risk can be minimized by holding a diversified

portfolio of investments.

Since investors can diversify away their non-systematic risks, they have to be

compensated only for systematic risk.

Calculation of beta calls for information on the value of the market index on each of

the days for which the NAV information is used. A diversified index like S&P CNX Nifty

has to be used.

Based on the value of Nifty on each of those days, the periodic returns can be calculated,

as was done for the scheme returns. Thereafter, the ‘slope’ function can be used in MS

Excel. The details are shown in Table 1.7.

Table 1.7

Beta

The Beta of 0.98 is close to 1. This means that the investment returns are closely

aligned with that of the Nifty.

12

If the beta is more than 1, it means that the investment is more risky than the market.

A value of beta that is less than 1 would mean that the investment is less risky than

the market.

3. Weighted Average Maturity

Fixed rate debt instruments have a price risk. When interest rates in the market go

up, the debt instruments already issued, based on the erstwhile lower interest rates,

lose value. Similarly, when interest rates in the market go down fixed rate debt

instruments gain value.

The extent of such depreciation or appreciation of fixed rate debt instruments in response

to changes in yields in the market, is influenced by the tenor of the instruments.

Instruments that have a longer maturity are more volatile than those with shorter

maturity.

Therefore, the weighted average maturity of a debt portfolio becomes an indicater of

its price risk. Higher the weighted average maturity, more the portfolio value is likely

to fluctuate in response to changes in market yields.

The calculation of weighted average maturity is illustrated in Table 1.8 for a debt

portfolio of Rs. 255 crore. The weighted column is calculated as Tenor X Proportion for

each row.

Table 1.8

Weighted Average Maturity

4. Modified duration

While maturity influences the price risk in a debt security, a more scientific approach

would be to consider its modified duration.

13

Suppose the modified duration is to be calculated as of January 15, 2012, for a security

that offers a coupon of 11% p.a., payable half-yearly, until it matures on January 25,

2014. The security is currently traded in the market at an yield of 11.5%.

The modified duration can be calculated using the MDURATION function in MS Excel.

This is shown in Table 1.9.

Table 1.9

Modified Duration of a Debt Security

The implication is that if the yields in the market were to change by 1%, this debt

security is likely to change in value by 1.68%.

If the coupon payments were quarterly, the frequency would be shown as 4; annual

coupon payment would mean frequency of 1.

In this manner, the modified duration can be calculated for every debt security. Other

things being equal, longer the maturity, higher the modified duration. The modified

duration of a zero coupon bond is the same as its maturity.

Weighted average maturity and modified duration are used for debt investments, beta

is for equity investments and standard deviation is used for both debt and equity

investments.

14

Self-Assessment Questions

• Treasury management is useful for

- Banks

- Non-banking finance companies

- Manufacturing companies

- All the above

• Which of the following spreadsheet functions is to be used for calculating returns if

periods are not the same?

- IRR

- XIrr

- Stdev

- Slope

• Beta is a measure of

- Systematic risk

- Non-systematic risk

- Total risk

- Variance

• Which of the following is used only for equity investments?

- Standard deviation

- Beta

- Weighted average maturity

- Modified duration

• Market yields have gone up by 0.5% for comparable securities. What would be the

revised price of a debt security trading at Rs105 with modified duration of 1.2?

- Rs. 105.63

- Rs. 105.53

- rs. 104.37[105 – (0.5% X 1.2 X 105)]

- Rs. 104.48

15

Chapter 2 Product / Exposure Structures

2.1 Background

Investors can take two kinds of exposures – long and short.

• If an investor is going to make a profit when the asset price goes up and / or make a

loss when the asset price goes down, he is said to be long on the asset.

• If an investor is going to make a loss when the asset price goes up and / or make a

profit when the asset price goes down, he is said to be short on the asset.

Exposures are built in the asset side of the balance sheet through investment in various

products.

• Some products give the desired exposure directly (e.g. gold or shares of Infosys). The

market where these direct exposures trade is referred to as “cash market”.

• In the case of some other products, the exposure is built indirectly (e.g. gold futures

or Infosys stock futures). The products that give the desired exposure indirectly are

called “derivatives”.

Some derivatives trade in the market. These are called “exchange-traded

derivatives”. Those that do not trade in the market are called “over-the-counter (OTC)

derivatives”.

Suppose an investor owns a contract that entitles him to 5 grams of gold. The value of that

contract would vary with the price of gold. This contract is a derivative product. Gold, in the

example, is referred to as the “underlying”. The derivative contract derives its value from the

value of the underlying.

The underlying in a derivative contract could be a financial asset such as currency, stock and

market index, an interest bearing security or a physical commodity. Today, around the world,

derivative contracts are traded on electricity, weather, temperature and even volatility.

According to the Securities Contract Regulation Act, (1956) the term “derivative” includes:

• a security derived from a debt instrument, share, loan, whether secured or unsecured,

risk instrument or contract for differences or any other form of security;

• a contract which derives its value from the prices, or index of prices, of underlying

securities.

A benefit of derivative is the leveraging. For the same outgo, it is possible to have a much

higher exposure to the underlying asset in the derivative market, than in the underlying cash

market. This makes it attractive for speculaters and hedgers, besides normal investors.

16

Derivatives comprise four basic contracts namely Forwards, Futures, Options and Swaps.

Over the past couple of decades several exotic contracts have emerged. But these are largely

variants of these basic contracts. These four basic contract types are discussed later in this

chapter.

2.2 Cash Market

Suppose an investor buys shares of Infosys at Rs. 4,000. If the share price goes up to Rs.

5,000, a profit of Rs. 1,000 is earned (assuming no transaction costs or taxes). If the share

price goes down to Rs. 3,000, a loss of Rs. 1,000 is booked. Thus, the investor is long on

Infosys shares.

On the other hand, suppose an investor sells shares of Infosys at Rs. 4,000. He does not have

the shares. It is possible to sell shares that you do not own in the stock exchange.

• A day trader will seek to cover the position i.e. buy back the sold shares by the end

of the day. Since the position is squared at the end of the day, the trader has no

obligation to receive or deliver the shares. The difference between the two prices is

profit (if bought back at a lower price) or loss (if bought back at a higher price).

• It is not necessary to square the position at the end of the day. An investor can borrow

the shares and deliver them as per the normal stock exchange settlement schedule,

to fulfil the obligation arising out of the shares sold. However, the shares need to be

purchased and given back to the stock lender at some time. Therefore, the investor

continues to have a position in that stock. The investor also keeps paying a fee to the

stock lender until the borrowed shares are returned.

After selling the Infosys shares at Rs. 4,000, if the share price was to go up to Rs. 5,000, then

the investor will have a loss of Rs. 1,000. On the other hand, if the share price goes down to

Rs. 3,000, a profit of Rs. 1,000 is earned. Thus, the investor is short on Infosys shares.

The pay-off on Infosys shares at different subsequent price levels of Infosys shares in the

market for long and short positions are shown in Figure 2.1.

17

long and short positions in Infosys shares

Figure 2.1

2.3 Futures

Infosys stock futures are traded in the market. The underlying is the shares of Infosys.

Therefore, if Infosys shares were to go up in value, its stock futures will also appreciate.

Similarly, a decline in Infosys shares pulls down the value of its stock futures.

18

The rate of interest that equates the cash price to the futures price is the cost of carry. The

futures price is given by the formula

FP = S0 X (1+r)t

Where,

FP = Futures Price

S0 = Spot Price

t = number of days

r = cost of carry

Suppose, cost of carry is 6%, and Infosys shares are trading at Rs. 4,000. Value of Infosys

stock futures, maturing in 20 days, can be calculated as

Rs. 4,000 X (1+6%)(20÷365)

i.e. Rs. 4,012.80 (rounded to nearest 5 paise)

(In practice, the cost of carry is calculated from the independently traded price of the share

and the stock futures.)

If the share price were to increase, other things remaining the same, the stock futures will

also appreciate, as would be evident from the formula.

In the same example, let us now suppose that Infosys is expected to give a dividend of Rs. 1

per share in 12 days.

An investor holding the underlying share will receive the dividend. But the holder of

Infosysfutures will not be entitled to the dividend. The Present Value of Dividend (PVD)

therefore will need to be subtracted from the spot price.

PVD = Rs. 1 ÷ (1 + 6%)(12/365)

= Rs. 0.998

FP = (S0 – PVD) X (1+r)t

= (4,000 – 0.998) X (1+6%)(20÷365)

= Rs. 4,011.80 (rounded to nearest 5paise)

This calculated price is the “no arbitrage” price, where the investor is neutral between buying

in the cash market and futures market. If Infosys futures are available in the market at a

price lower than the “no arbitrage” price, then the investor would prefer to take the position

with Infosys futures instead of the underlying Infosys shares.

As in the case of shares, the pay-off matrix can be prepared for investment strategies of going

long or short on Infosys futures. This is shown in Figure 2.2. (Cost of carry has been kept zero

for the illustration. Addition of cost of carry will not change the pattern of the pay-off).

19

Long and short positions in Infosys stock futures

Figure 2.2

Thus, both cash market and futures market give the investor a similar profile of returns. Why

should an investor opt for the futures market?

One reason was given earlier as part of the calculation of futures price. If the futures are

trading below their theoretical price (given the cost of carry for the investor), then buying the

futures is more sensible than buying the Infosys shares.

20

Another reason to favour futures is the leveraging it offers. On purchase of Infosys shares,

the investor has to pay the entire price by the settlement date. However, in the futures

market, the investor pays only a margin. Suppose the initial margin is 20%, then the investor

needs to pay only 20% of the value of the position taken. For the same outflow as in the case

of cash market, the investor can take a futures position that is 100 ÷20 i.e. 5 times.

In the normal course, companies leverage by borrowing money. In the case of futures, the

leveraging is built into the product. So the investor does not need to go about mobilising debt

to take the higher exposure.

A point to note is that apart from initial margin, there are also daily mark-to-market margins.

Thus, if an investor is long or short on the futures, and the position is in profit on any day,

the investor will receive mark to market margin. However, if the position is in a loss, then the

investor will need to pay mark to market margins. Investors should consider their ability to

pay mark to market margins before taking positions in the futures market.

The explanations given above for stock futures are equally applicable for index futures, interest

rate futures and currency futures. However, in line with the difference in underlying, there are

differences in the contract structure between different types of futures.

2.4 Forwards

Forwards are like futures. The differences are as follows:

• Unlike futures, forwards are not traded in the stock exchange. This raises issues about

liquidity, transparency of pricing, transactional convenience etc.

• In order to enable trading in the stock exchange, futures trade on the basis of

standardised contracts. For example, all futures contracts are settled in the National

Stock Exchange (NSE) on the last Thursday of the concerned month. Since forwards

are OTC products, the parties can customise a contract structure that meets their

mutual needs best.

• Since futures are traded in the stock exchange, transactions are guaranteed by the

clearing house. Therefore, exposure of the investor is not to the party at the other end

of the trade, but to the clearing house.

In the case of forwards, the investor is exposed to the counter-party risk. If the counter-

party defaults, then courts will need to be approached to enforce one’s rights.

While investors can cover their foreign currency risks through currency futures, in many

instances, forward contracts are used. Suppose, an exporter expects to receive USD1mn

after 1 month.He wants to freeze his export receipts in rupees. He will enter into a forward

contract with his banker to sell USD at, say, Rs. 60. If USD subsequently depreciates to a

spot rate ofRs. 59, then his forward contract is profitable to the extent of Rs. 1. But if USD

21

appreciates to a spot rate ofRs. 61, then the forward contract is a loss to the extent of Rs. 1.

Thus, his position is one of being short on the USD.

An importer who needs to pay USD is in a reverse position. In order to freeze the rupee

outflow, he will book a forward contract to receive USD i.e. he will go long on the USD. Pay-

offs in the two cases are shown in Figure 2.3.

Exporter and Importer in USD forward contract

Figure 2.3

22

Point to note is that the profit or loss in the payoff matrix refers to the forward contract in

isolation. The exporter and importer have entered into the forward contract to hedge their

position of USD receivable or payable. When the exporter receives the export proceeds in

USD, these will be sold at a profit (if the USD appreciates and forward contract is in loss) or

a loss (if the USD depreciates and forward contract is in profit). Thus, the overall currency

impact will be neutral, for both exporter and importer. This is the purpose of the hedge.

2.5 options

Let us re-visit the earlier example of importer doing a 1-month forward contract for USD1mn

at Rs. 60 =1USD.

Variation 1

Suppose the importer, instead of being obliged to buy the dollars (which was the case in the

forward contract), had the right to buy the dollars – but he was not obliged to buy them.

Thus, 1 month down the line, importer can choose, NOT to buy them. Such contracts are

option contracts.

In this case, the importer, the buyer of USD, has the option (but the bank is committed. If

the importer decided to buy the dollars, the bank is obliged to sell them at Rs. 60=1USD).

Such contracts, where the party has the option to buy the underlying are called call options.

In option terminology,

• Importer has bought the call option (to buy USD)

• The bank has sold (or written) the call option.

Variation 2

Suppose the exporter, instead of being obliged to sell the dollars (which was the case in the

forward contract), had the right to sell the dollars – but he was not obliged to sell them.

Thus, 1 month down the line, the exporter can choose, NOT to sell them. Such contracts are

also option contracts.

In this case, the exporter, the seller of USD, has the option (but the bank is committed. If

the exporter decided to sell the dollars, bank is obliged to buy them at Rs. 60 =1USD). Such

contracts, where the party has the option to sell the underlying, are called put options. In

option terminology,

• Exporter has bought the put option (to sell USD)

• The bank has sold (or written) the put option.

The party that buys an option (a call or a put) is said to have a long position; the party that

sells (a call or a put) is said to have a short position.

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It should be noted that:

• In the first two types of derivative contracts (forwards and futures), both the parties

(buyer and seller) have an obligation i.e. the buyer needs to pay for the asset to

the seller; and the seller needs to deliver the asset to the buyer on the agreed date

(settlement date).

• In case of options, only the seller of the option (the option writer) is under an obligation

and not the buyer of the option (the option purchaser).

In a call option, the buyer of the option has the right to BUY the underlying

In a put option, the buyer of the option has the right to SELL the underlying.

In either case, the price at which the option can be exercised is called “exercise

price”

The option buyer may or may not exercise his right. In case the buyer of the option

does exercise his right, the seller of the option must fulfil whatever is his obligation (for

a call option, the option-seller has to deliver the asset to the buyer of the option; for

a put option the option-seller has to receive the asset from the buyer of the option).

In order to enter into such a contract, the option seller will expect to receive a

compensation from the option buyer upfront. This is the option premium. It is an

income for the seller and expense for the buyer, irrespective of whether or not the

option is subsequently extinguished.

In the above cases, the option was to be exercised 1 month down the line i.e. on a specific

date (settlement date, at the end of the contract period). Such options are known as European

option contracts.

If in the above cases, the option buyer {Importer (in the case of Variation 1) or Exporter

(in the case of Variation 2)} could exercise their option anytime up to the expiry of the

contract period. This would be an American option contract.

The examples above were explained in the context of OTC options sold by the bank. Options

are also traded in stock exchanges. Exchange-traded options have a standardised contract

structure and are guaranteed by the clearing house. They offer the benefits of liquidity,

pricing transparency, transaction convenience etc.

Since one party (seller of the call or put option) is committed, while the other party (buyer of

the call or put option) has the option, the pay off profile is different as compared to forwards

and futures.

• The maximum income for the seller is the option premium earned. However, if the

market moves adversely (USD becomes stronger for call option or weaker for put

option), then the losses increase.

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• The maximum expense for the buyer is the option premium earned. However, if the

market moves favourably (USD becomes stronger for call option or weaker for put

option), then the profits increase.

• Since the USD can go up to any price, the maximum profit for the buyer of the call and

maximum loss for the seller of the call is unlimited.

• Since the USD cannot go below zero, the maximum profit for the buyer of the put and

maximum loss for the seller of the put are capped.

The payoff graphs are shown in Figures 2.4 (for call) and 2.5 (for put). Option premium is

assumed to be Rs. 3. Breakeven point in the case of call option is at Exercise Price + Option

Premium i.e. Rs. 63. In the case of putoption, it is at Exercise Price – Option Premium i.e.

Rs. 57.

Payoffs in the case of direct exposures, futures and forwards are depicted as a straight line.

Therefore, these products are said to have a symmetric payoff.

Payoffs in the case of options do not follow a straight line. So, options are said to have an

asymmetric payoff.

Option pricing is beyond the scope of this Workbook.

In the case of futures, both buyer and seller are liable to pay margins to the stock exchange.

However, in the case of options, only the option seller pays margins to the stock exchange.

Payments for the option buyer are capped at the option premium (plus exercise price if option

is exercised).

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Payoff for long and short positions on call

Figure 2.4

26

Payoffs for long and short position on puts

Figure 2.5

27

2.6 SWAPs

Swaps are contracts where the two parties commit to exchange two different streams of

payments, based on a notional principal. The payments may cover only interest, or extend

to the principal (in different currencies) or even relate to other asset classes like equity or

commodities.

Unlike futures and options, which are created and traded in the stock exchanges, swaps are

largely OTC products. Often a bank finds two parties with divergent views about the market

(interest rates, exchange rates etc.) and facilitates swap trade/s between them. The bank

performs either of two roles:

• Broker

Here, the swap is direct between the two parties. So, the two parties will know each

other when the bank brokers the swap. As broker, the bank will earn commission from

one or both parties.

• Dealer

Here, the bank executes independent swap trades with both parties. Consequently,

neither party will know the identity of the other; for both parties, the bank is the

counter-party.

In such trades, the bank earns the difference between the two matching trades. Suppose

the bank agrees to pay 7% fixed to one party (in return for MIBOR), and receive 5%

fixed from the other party (in return for MIBOR). The bank neither has an exposure

to MIBOR nor an exposure to fixed interest rate, on account of the combination of the

two swaps. Yet, it will earn a spread of 2% p.a., calculated on the notional principal.

The bank is however exposed to credit risk from both parties.

Since swaps are OTC products, without the benefit of a transparent pricing benchmark,

the spreads can be quite large.

1. Interest rate swap

This is the most elementary form of a swap.

Suppose Party A is worried about its 2-year loan of Rs. 1 crore, on which it

has committed to pay interest at 1-month MIBOR + 2% (Mumbai Inter-Bank

Offered Rate). If interest rates were to go up, it will have to pay higher interest

to its lender.

On the other hand, Party B is worried that interest rates may fall, and it will

earn less on its deposits.

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Party A and Party B can do an interest rate swap. Party A will agree to pay Party

B interest at a fixed rate, say 8%, in return for a receipt of 1-month MIBOR,

calculated on a notional principal of Rs. 1 crore.

While the swap may be direct between Party A and Party B, it is understood

better if we bring in a 3rd party viz. Party A’s Lender. (The bank that brings

Party A and Party B together may be a 4th party). The position of the 3 parties

is shown in Figure 2.6.

swap Parties

Figure 2.6

Party A will pay MIBOR + 2% to its lender, out of which, it will receive MIBOR

from Party B under the swap. Thus, it is no longer exposed to the fluctuations

in MIBOR. If MIBOR rises, it will receive more from Party B and pay the amount

to its lender.

Party A’s cost of funds is the 2% additional it needs to pay its lender, plus the

8% it has to pay Party B i.e. 10% fixed.

Party B, on the other hand, is assured of 8% fixed interest income, from Party

A. In return it has to pay MIBOR, which it expects will fall.

The actual cash flows of the parties are shown in Table 2.1 (the MIBOR rates

are assumed).

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Table 2.1

Cash Flows of Swap Counter Parties

date Mibor Party A's Cashflows Party B's Cashflows

30-Jun-13 9.00% -5,50,000 -4,00,000 4,50,000 -5,00,000 -4,50,000 4,00,000 -50,000

31-Dec-13 9.25% -5,62,500 -4,00,000 4,62,500 -5,00,000 -4,62,500 4,00,000 -62,500

30-Jun-14 8.75% -5,37,500 -4,00,000 4,37,500 -5,00,000 -4,37,500 4,00,000 -37,500

31-Dec-14 7.90% -4,95,000 -4,00,000 3,95,000 -5,00,000 -3,95,000 4,00,000 5,000

Party A’s net interest cost is Rs. 5 lakh every 6 months i.e. Rs. 10 lakh p.a. On

the Rs. 1 crore notional principal, it works out to 10%.

Party B’s benefits if MIBOR goes below 8%.

A few points to note:

Party A's lender will continue receiving MIBOR + 2% from Party A. The

swap is a separate transaction between Party A and Party B. Party A's

lender may not even be aware of the swap.

The parties avoid multiple payments by netting. Thus, either Party A

will pay Party B or Party B will Party A, depending on MIBOR.

2. Currency Swap

In a currency swap, the two streams of payments are in different currencies.

Suppose Party D and Party R, are counter-parties to a 2-year swap. Party

D agrees to pay Party R, 3% p.a., semi-annually, on a notional principal of

USD1mn. In return, Party R commits to pay Party D 7% p.a., semi-annually,

on a notional principal of Rs. 5 crore. When the swap is initiated, Party R pays

USD1mn to Party D; and receives Rs. 5 crore from Party D. On maturity, Party

D pays USD1mn to Party R, and receives Rs. 5 crore from Party R.

Party R’s cash flows are shown in Table 2.2.

Table 2.2

Party R’s Cash Flows

date usd mm rs. Cr.

30-Jun-13 -1.00 5.00

31-Dec-13 0.03 -0.35

30-Jun-14 0.03 -0.35

31-Dec-14 1.03 -5.35

Party D’s cash flows are shown in Table 2.3.

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Table 2.3

Party D’s Cash Flows

date usd mm rs. Cr.

30-Jun-13 1.00 -5.00

31-Dec-13 -0.03 -0.35

30-Jun-14 -0.03 0.35

31-Dec-14 -1.03 5.35

Party R has thus taken up a USD asset and a Rupee liability. Party D has done

the reverse viz. assumed a USD liability and a Rupee asset.

Parties R & D are exchanging interest rates on fixed basis. The swap is ‘Fixed

for Fixed’. Similarly, ‘Fixed for Floating’ is also possible, where interest rate for

one leg is in LIBOR or MIBOR. Alternatively, it can be ‘Floating for Floating’,

where one leg may be in LIBOR and the other may be in MIBOR.

3. Credit default swap (Cds)

Non-Sovereign bonds involve a credit risk. Having invested in such bonds, it is

possible for the investor to seek protection from credit risk by buying a CDS.

A CDS has two parties - buyer and seller. The buyer pays premium to the seller

for the protection. In return, the seller promises to compensate the buyer, if

the issuer of the underlying bond defaults on the payments.

CDS issues without proper credit risk assessment led several CDS issuers to

bankruptcy in the developed markets in the last few years. RBI has therefore

imposed a strict regulatory regime for the product. The key regulations are as

follows:

Participants in the market are classified into two:

users

Commercial Banks, Primary Dealers (PDs), Non-Banking Finance

Companies (NBFCs), Mutual Funds, Insurance Companies, Housing

Finance Companies, Provident Funds, Listed Corporates, Foreign

Institutional Investors (FIIs) and any other institution specifically

permitted by the Reserve Bank.

These entities are permitted to buy credit protection (buy CDS contracts)

only to hedge their underlying credit risk on corporate bonds.

Such entities are not permitted to hold credit protection without having

eligible underlying as a hedged item.

31

Users are also not permitted to sell protection and are not permitted to

hold short positions in the CDS contracts. However, they are permitted

to exit their bought CDS positions by unwinding them with the original

counterparty or by assigning them in favour of buyer of the underlying

bond.

Market Makers

Commercial Banks, standalone PDs, NBFCs having sound financials and

good track record in providing credit facilities and any other institution

specifically permitted by the Reserve Bank.

Insurance companies and Mutual Funds would be permitted as market-

makers subject to their having strong financials and risk management

capabilities as prescribed by their respective regulators (IRDA and SEBI)

and as and when permitted by the respective regulatory authorities.

These entities are permitted to quote both buy and/or sell CDS spreads.

They are permitted to buy protection without having the underlying

bond.

All CDS trades need to have an RBI regulated entity at least on one side of the

transaction.

Detailed eligibility criteria have been specified for every category of market

maker. In case a market-maker fails to meet one or more of the eligibility

criteria subsequent to commencing the CDS transactions, it would not be

eligible to sell new protection. As regards existing contracts, such protection

sellers would meet all their obligations as per the contract.

The party against whose default, protection is bought and sold through a CDS

is called the reference entity. It should be a single legal resident entity [the

term resident is as defined in Section 2(v) of Foreign Exchange Management

Act, 1999] and the direct obligor for the reference asset/obligation and the

deliverable asset/obligation.

CDS is allowed only on the following reference obligations:

Listed corporate bonds

Unlisted but rated bonds of infrastructure companies.

Unlisted/unrated bonds issued by the SPVs set up by infrastructure

companies.

Such SPVs need to make disclosures on the structure, usage, purpose

and performance of SPVs in their financial statements.

32

The reference obligations are required to be in dematerialised form only.

The reference obligation of a specific obligor covered by the CDS contract

should be specified a priori in the contract and reviewed periodically for better

risk management.

Protection sellers should ensure not to sell protection on reference entities /

obligations on which there are regulatory restrictions on assuming exposures in

the cash market such as, the restriction against banks holding unrated bonds,

single/group exposure limits and any other restriction imposed by the regulators

from time to time.

Users cannot buy CDS for amounts higher than the face value of corporate bonds

held by them and for periods longer than the tenor of corporate bonds held by

them. They shall not, at any point of time, maintain naked CDS protection i.e.

CDS purchase position without having an eligible underlying.

Proper caveat has to be included in the agreement that the market-maker,

while entering into and unwinding the CDS contract, needs to ensure that the

user has exposure in the underlying.

Further, the users are required to submit an auditor's certificate or custodian's

certificate to the protection sellers or novating users (users transferring the

CDS), of having the underlying bond while entering into/unwinding the CDS

contract.

Users cannot exit their bought positions by entering into an offsetting sale

contract.

They can exit their bought position by either unwinding the contract with the

original counterparty or, in the event of sale of the underlying bond, by assigning

(novating) the CDS protection, to the purchaser of the underlying bond (the

"transferee") subject to consent of the original protection seller (the "remaining

party").

After assigning the contract, the original buyer of protection (the "transferor")

will end his involvement in the transaction and credit risk will continue to lie

with the original protection seller.

In case of sale of the underlying, every effort should be made to unwind the CDS

position immediately on sale of the underlying. The users are given a maximum

grace period of ten business days from the date of sale of the underlying bond

to unwind the CDS position.

33

In the case of unwinding of the CDS contract, the original counterparty (protection

seller) is required to ensure that the protection buyer has the underlying at the

time of unwinding.

The protection seller should also ensure that the transaction is done at a

transparent market price and this must be subject to rigorous audit discipline.

CDS transactions are not permitted to be entered into either between related

parties or where the reference entity is a related party to either of the contracting

parties.

Related parties are as defined in 'Accounting Standard 18 - Related Party

Disclosures'.

In the case of foreign banks operating in India, the term 'related parties'

includes an entity which is a related party of the foreign bank, its parent, or

group entity.

The user (except FIIs) and market-maker need to be resident entities.

CDS Contracts

The identity of the parties responsible for determining whether a

credit event has occurred must be clearly defined a priori in the

documentation.

The reference asset/obligation and the deliverable asset/obligation

should be to a resident and denominated in Indian Rupees.

The CDS contract has to be denominated and settled in Indian Rupees.

Obligations such as asset-backed securities/ mortgage-backed securities,

convertible bonds and bonds with call/put options are not permitted as

reference and deliverable obligations.

CDS cannot be written on interest receivables.

CDS cannot be written on securities with original maturity up to one

year e.g. Commercial Papers (CPs), Certificate of Deposits (CDs) and

Non-Convertible Debentures (NCDs) with original maturity up to one

year.

The CDS contract must represent a direct claim on the protection

seller.

The CDS contract must be irrevocable; there must be no clause in the

contract that would allow the protection seller to unilaterally cancel

34

the contract. However, if protection buyer defaults under the terms of

contract, protection seller can cancel/revoke the contract.

The CDS contract should not have any clause that may prevent the

protection seller from making the credit event payment in a timely

manner, after occurrence of the credit event and completion of necessary

formalities in terms of the contract.

The protection seller shall have no recourse to the protection buyer for

credit-event losses.

Dealing in any structured financial product with CDS as one of the

components is not permitted.

Dealing in any derivative product where the CDS itself is an underlying

is not permissible.

The CDS contracts need to be standardized. The standardisation of CDS

contracts in terms of coupon, coupon payment dates, etc. will be as put

in place by FIMMDA in consultation with the market participants.

The credit events specified in the CDS contract may cover: Bankruptcy,

Failure to pay, Repudiation/moratorium, Obligation acceleration,

Obligation default, Restructuring approved under Board for Industrial

and Financial Reconstruction (BIFR) and Corporate Debt Restructuring

(CDR) mechanism and corporate bond restructuring.

The contracting parties to a CDS may include all or any of the approved

credit events.

Further, the definition of various credit events should be clearly defined

in the bilateral Master Agreement.

A Determination Committee (DC) formed by the market participants and

FIMMDA has a key role. The DC, based in India, has to deliberate and resolve

CDS related issues such as Credit Events, CDS Auctions, Succession Events,

Substitute Reference Obligations, etc.

At least 25 per cent of the members should be drawn from the users.

The decisions of the Committee are binding on CDS market participants.

The parties to the CDS transaction have to determine upfront, the procedure

and method of settlement (cash/ physical/ auction) to be followed in the

event of occurrence of a credit event and document the same in the CDS

documentation.

35

For transactions involving users, physical settlement is mandatory.

For other transactions, market-makers can opt for any of the three settlement

methods (physical, cash and auction), provided the CDS documentation

envisages such settlement.

While the physical settlement would require the protection buyer to transfer

any of the deliverable obligations against the receipt of its full notional / face

value, in cash settlement, the protection seller would pay to the protection

buyer an amount equivalent to the loss resulting from the credit event of the

reference entity.

Auction settlement may be conducted in those cases as deemed fit by the

DC. Auction specific terms (e.g. auction date, time, market quotation amount,

deliverable obligations, etc.) will be set by the DC on a case by case basis.

If parties do not select Auction Settlement, they will need to bilaterally settle

their trades in accordance with the Settlement Method (unless otherwise freshly

negotiated between the parties).

The accounting norms applicable to CDS contracts are on the lines indicated

in the 'Accounting Standard AS-30 - Financial Instruments: Recognition and

Measurement', 'AS- 31, Financial Instruments: Presentation' and 'AS-32 on

Disclosures' as approved by the Institute of Chartered Accountants of India

(ICAI).

Market participants have to use FIMMDA published daily CDS curve to value their

CDS positions. However, if a proprietary model results in a more conservative

valuation, the market participant can use that proprietary model.

For better transparency, market participants using their proprietary model for

pricing in accounting statements have to disclose both the proprietary model

price and the standard model price in notes to the accounts that should also

include an explanation of the rationale behind using a particular model over

another.

The participants need to put in place robust risk management systems.

Market-makers have to ensure adherence to suitability and appropriateness

criteria while dealing with users.

CDS transactions must be conducted in a transparent manner in relation to

prices, market practices etc.

From the protection buyer's side, it would be appropriate that the senior

36

management is involved in transactions to ensure checks and balances.

Protection sellers need to ensure:

CDS transactions are undertaken only on obtaining from the counterparty, a copy

of a resolution passed by their Board of Directors, authorising the counterparty

to transact in CDS.

The product terms are transparent and clearly explained to the counterparties

along with risks involved.

Market-makers have to report their CDS trades with both users and other

market-makers on the reporting platform of the CDS trade repository within 30

minutes from the deal time.

The users are required to affirm or reject their trade already reported by the

market- maker by the end of the day.

In the event of sale of underlying bond by the user and the user assigning

the CDS protection to the purchaser of the bond subject to the consent of

the original protection seller, the original protection seller has to report such

assignment to the trade reporting platform and the same should be confirmed

by both the original user and the new assignee.

4. swaption

A swaption is an option to enter into a swap.

Suppose that a borrower has entered into a 5-year loan agreement where he

has to pay MIBOR + 2%. He is prepared to take interest risk for 2 years. But,

he is worried about interest rates after 2 years.

At the end of 2 years, he can do a swap to pay fixed and receive floating. The

only problem is that the terms of the swap will depend on the interest rate

scenario at that time.

Instead, he can enter into a swaption today. This will give him the right, but

not an obligation to do the swap after 2 years. The terms of the underlying

swap are decided today, for which he will have to pay an option premium. The

borrower, in this case, can be said to have gone long on a call option (because

he will receive floating under the swap) on the swap.

Suppose that the original loan agreement was on fixed interest rate basis, and

the subsequent swap is for the borrower to pay floating and receive fixed. If

the borrower does a swaption, he is said to have gone long on a put option

(because he will pay floating under the swap) on the swap.

37

2.7 SSELECTIVVELLY- Invest Classification Scheme for Investment Products1

The ever widening range of investment products does create confusion in the market place.

The positives of a product, effectively marketed, can cover up the risk elements inherent to

the product. This can lead the investor to take wrong investment decisions.

SSELECTIVVELLY-Invest Classification Scheme that helps the investor to get a comprehensive

understanding of any investment product. The following drivers of risk and return are the

attributes of SSELECTIVVELLY-Invest:

• Source (Issuer)

• Sector - for non-government exposures

• Exposure (Asset Class)

• Liquidity (offered by Issuer / Issuer's agent / Market)

• End (Maturity)

• Cost

• Tax Exemption

• Insurance level

• Vehicle

(The structure through which investment is being made, e.g. Direct, Mutual Fund,

Insurance, PE Fund, VC Fund, Structured Product, etc.)

• Valuation

• Exchange Rate

• Leverage (asset class)

• Leverage (foreign currency)

• Yield

2.8 Off-Balance Sheet Exposures

The discussions in this chapter so far focussed on items that appear in the balance sheet of

the company. It is possible to have exposures that are not part of the balance sheet numbers,

though they may be mentioned in the Notes to the accounts.

For example, the company may give a guarantee to a party A for the benefit of some third

1 Chapter 29 of “Wealth Engine: Indian Financial Planning & Wealth Management Handbook” by SundarSankaran

38

party, B. It will be mentioned in the Notes to the accounts. However, if Party B defaults, then

the company becomes liable to Party A for the guarantee amount. At that stage, it will be

mentioned in the liability side of the balance sheet.

Securitisation with recourse, discussed in Chapter [5], is another example of Off-Balance

Sheet exposure.

Off-Balance Sheet exposures are a form of financial engineering where the company takes up

risks without it affecting its balance sheet immediately. Such transactions need to be handled

with care. In particular, it should be ensured that the company has the balance sheet strength

to bear the consequences, if the exposure becomes a liability.

39


• Which of the following are traded in an exchange?

- Futures and Options

- Futures

- Options

- Swaps

• Which of the following has asymmetric payoff structure?

- Futures and Options

- Futures

- Options

- Swaps

• ABC buys an option for which exercise price is Rs100 and option premium is Rs5. What

is the breakeven price?

- Rs. 105

- Rs. 95

- Rs. 105 if it is a call

- Rs. 95 if it is a call

• Off-balance sheet exposures are illegal.

- True

- False

• Swaption is

- Option to enter into a swap

- Swap between two options

- Option backed by a swap

- Swap backed by an option

40

Chapter 3 Capital Structure &Weighted Average Cost of Capital

3.1 Background

The previous chapter focused on products / exposures related to the asset side of the balance

sheet of any company. Here, we consider various aspects of the liability side.

3.2 Capital Structure

Capital structure refers to the mix of equity and debt in the balance sheet of a company.

In many of the capital structure and return calculations, the term ‘equity’ includes not only

equity share capital but also reserves. Further, miscellaneous expenses not written off (e.g.

preliminary expenses), if any, appearing on the asset side of the balance sheet, is subtracted.

Thus, ‘equity’ is a loosely worded reference to ‘net worth’ i.e. the entire equity shareholders’

funds.

For example, suppose a company has equity capital of Rs. 30mn, reserves of Rs. 20mn and

preliminary expenses not written off amounting to Rs. 1mn. In a strict sense, equity is only

Rs. 30mn. However, reserves also belong to equity shareholders; preliminary expenses are

to be written off from the books over a period of time i.e. they will not be converted into cash

unlike assets like inventory or investments in other companies. Net worth of the company is

calculated as Rs. 30mn + Rs. 20mn – Rs. 1mn i.e. Rs. 49mn.

Equity does not need to be repaid to investors. Similarly, there is no compulsion to service

the equity. If the company’s performance suffers, it can choose not to pay a dividend to

shareholders. Therefore, equity is often seen as a safe source of funds for companies.

On the other hand, debt needs to be repaid to investors. Debt has to be serviced, even if the

company suffers losses. If it is not serviced, lenders can take-over assets of the company

against which the debt is secured, or even file for winding up of the company. So, debt is

seen as a risky source of funds.

One reason for companies to opt for debt, despite the risk, is the influence it has on the return

on equity, as shown in Table 3.1.

Four companies in the same business are concerned. Each has invested Rs. 100mn in the

business, but with different mixes of equity and debt. Company A is entirely equity funded;

Company B has an equal mix of equity and debt; and Company C and Company D have debt

that is 4 times its equity. Suppose all companies are able to borrow at 10%.

41

Table 3.1

Effect of debt on shareholder return

Company a Company B Company C Company d

Shareholders funds (Net Worth) Rs. Mn. 100 50 20 20

Debt Rs. Mn. 0 50 80 80

Capital Invested Rs. Mn. 100 100 100 100

Interest Rate 10% 10% 10%

Business Return (pre-interest) % 12% 12% 12% 8%

Business Profits (pre-interest) Rs. Mn. 12 12 12 8

Interest Cost Rs. Mn. 0 5 8 8

Profits for Equity Investors Rs. Mn. 12 7 4 0

Return for Equity Investors % 12% 14% 20% 0%

Company A, Company B and Company C are equally efficient, generating a business return of

12%. Company D is less efficient, with a business return of 8%.

Since Company A has no debt, shareholder return (also called “return on equity” or “return on

net worth”) is the same as the business return viz. 12%.

Company B is able to generate 12% as against its cost of debt of 10%. The differential return

becomes available to shareholders. This boosts the shareholder return to 14%.

Company C, too, is able to generate 12% as against its cost of debt of 10%. The differential

return is available for a higher amount of debt than in the case of Company B. This differential

return becomes available to a smaller base of shareholders’ funds. This boosts the shareholder

return to 20%.

A point to note is that the actual business profits are the same for companies A, B and

C. Interest cost is higher for Company C as compared to Company B; Company A has no

interest cost. So the profit for equity investors (in Rs.) is higher for Company A as compared

to Company B, whose profits are higher than Company C’s profits. However, the shareholder

return(%) is higher for Company C as compared to Company B, whose return (%) is higher

than that of Company A.

Company D generated 8% return, which is lower than its cost of debt of 10%. Thus, it lost

money on the debt. Overall, the business return just about covers for the interest cost.

Nothing is left for the shareholders. If the interest rate were higher (which it ought to be,

given the weaker financials) or business return were lower, the return for equity investors

would have become negative.

42

Thus, debt can improve shareholder return, provided the overall business return is higher

than the cost of debt.

In a poor year, Company C’s business return can dip to 8% or lower, in which case it will end

up with no profits or even losses for shareholders. However, at 8% business return, Company

B will still have a profit for shareholders (Calculate and see how?) and Company A will have

the same 8% return for shareholders.

Thus, it is not adequate to only ensure that business return is more than cost of debt. Higher

the debt as a percentage of shareholders’ funds (i.e. debt equity ratio – also called “leverage”),

greater the risk to the shareholders. The debt equity ratio is 1:1 for Company B, and 4:1 for

Company C and Company D.

It follows that more risky the capital structure, lesser should be the risk taken on the asset

side. This is discussed in greater detail in Chapters [4] and [5].

3.3 Earnings, Interest and Debt Servicing

The money flows for debt servicing comes from the earnings of the company. So, another

perspective on risk related to debt comes from the comparision of earnings with debt servicing

requirements of the company. This is measured through the interest coverage ratio (ICR) and

overall debt servicing coverage ratio (DSCR), as shown in Table 3.2 and Table 3.3.

Table 3.2

Interest Coverage Ratio

Rs. Mn.

1 2 3 4 5

EBIT 12 25 43 68 103

Interest 9 8 6 4 2

ICR (EBIT ÷ Interest) 1.33 3.13 7.17 17 51.5

Interest coverage of 1.33 in year 1 means that even if the Earnings before Interest and Tax

(EBIT) of the company were to go down by (1.33 – 1) ÷ 1.33 i.e. 25%, it will have adequate

profits to pay interest. (The legal position is that the company has to service its debts even if

the company does not earn profits)

43

Table 3.3

Debt Servicing Coverage Ratio

Rs. Mn.

1 2 3 4 5 Total

EBIT 12 25 43 68 103

Depreciation 10 9 8 7 7

Cash Flows for Debt Servicing 22 34 51 75 110 292

Interest & Principal Paid 18 17 16 14 13 78

DSCR (Cashflow ÷ EMI) 1.22 2.00 3.19 5.36 8.46 3.74

DSCR of 1.22 in year 1 means that even if the cash flows (EBIT + Depreciation) of the

company were to go down by (1.22 – 1) ÷ 1.22 i.e. 18%, it will have adequate cash flows to

service the debt. (The legal position is that the company has to service its debts even if the

company does not have cash flows)

Higher the ICR and DSCR, the more comfortable is the company’s borrowing. This needs to

be viewed in the context of the company’s business environment and overall cost structure.

These are covered in the discussions on leverage in Chapter [4].

3.4 Sources of equity funds

Initial equity comes from the promoters. Thereafter, profits boost the equity funds of the

company; losses eat into the equity funds. Profits that are not distributed as dividends are

the retained earnings, which become part of reserves (included in shareholders’ funds) of the

company.

Equity capital is also mobilised from venture capital and other private equity funds, foreign

institutional investors, banks, financial institutions, collaboraters, employees and the general

public.

3.5 Cost of equity

The actual payment that a company makes to investors regularly is the dividend. It is declared

as a percentage to face value e.g. 20%. If shares of the company have face value of Rs. 10,

then the Dividend per Share (DPS) is Rs. 2. However, the effective yield for investors depends

on the market price of the shares. An investor who buys share of the company at Rs. 80, has

a dividend yield of only Rs. 2 ÷ Rs. 80 X 100 i.e. 2.5%.

Neither 10% nor 2.5% reflects the true cost of equity, because investors buy equity shares for

44

the capital gain – dividend is incidental to the investment. There are various approaches to

determining the cost of equity. Two methods are more commonly used are as follows:

• D/P + g

D/P is the dividend yield that was worked out earlier. The capital gains is captured

in ‘g’, which stands for earnings growth. If earnings were to go up 12%, then Price-

Earnings ratio remaining the same, the share price will also go up by 12%. This flows

from the relationship EPS X P/E Ratio = Price.

In the above case, dividend yield was 2.5%. If earnings growth is 12%, cost of equity

can be computed as 2.5% + 12% i.e. 14.5%.

• Beta-based approach

Beta as a measure of systematic risk was discussed in Chapter [1]. Investors have

the option of placing their moneys in government securities and earn a risk-free return

(Rf). Suppose this is 8%.

Investing in the market entails greater risk. Suppose investors are able to earn 14%

by investing in a diversified portfolio of equities. The difference between market return

(Rm) and Rf is called ‘risk premium’. It is the premium that investor is earning for taking

the additional market risk.

Investing in a diversified portfolio ensures that non-systematic risk is eliminated. So

risk premium is a return for systematic risk i.e. beta. The market is said to have a beta

of 1. If beta of the company is higher than 1, then it is more risky than the market.

So, its equity ought to offer a higher return to investors, than the market. A company

with beta lower than 1 can afford to offer a lower return than the market. Accordingly,

cost of equity can be computed as per the following formula:

Rf + (Rm – Rf) X β

In the above case, if beta of a company is 1.2, then cost of equity is

8% + (14% - 8%) X 1.2

i.e. 15.2%

3.6 Sources of debt funds

Debt is mobilised either in the form of loans or issue of securities. Loans can be from banks,

domestic financial institutions, international financial institutions and such other lenders. Fixed

deposits mobilised from the public are a form of loan by the depositers to the company.

Debt securities issued may be short term or long term. Bonds and debentures are a form of

long-term debt security. Commercial paper and certificate of deposits meet the short-term

debt needs of companies.

45

Bill discounting is another form of short-term debt funds. Suppose an automobile company

has purchased silencers from an auto ancillary company. The normal credit terms are 1

month. The ancillary company will receive money in the normal course, only after a month.

If the auto ancillary company needs money urgently, it can raise a Bill of Exchange on the

automobile company. A Bill of Exchange is a document prepared by the auto ancillary company,

calling upon the automobile company to pay the said amount in 1 month.

Once the automobile company signs the Bill, as a token of acceptance of its liability, the auto

ancillary can discount it with a bank and receive money upfront. It will endorse the bill in

favour of the bank. At the end of 1 month, the bank will produce the bill to the automobile

company and get paid.

Suppose the Bill is for Rs. 1,000,000 and the bank pays the auto ancillary company a discounted

amount of Rs. 989,750, 28 days before the maturity of the bill. The difference of Rs. 10,250 is

effectively an interest cost for the auto ancillary company for 28 days. The effective borrowing

cost can be computed as Rs. 10,250 ÷ Rs. 989,750 X (365 ÷ 28) i.e. 13.5%.

Besides receiving the money upfront, the automobile ancillary company has other benefits

from this bill discounting transaction:

• Under the bill discounting scheme, the bank is taking a credit risk on the automobile

company. If the auto ancillary company’s financial position is weaker, then direct

funding from the bank will come at a higher rate of interest than the effective bill

discounting cost. Thus, bill discounting helps in reducing cost of funds for the auto

ancillary company.

• The transaction is not reflected as a debt in the books of the auto ancillary company.

So its borrowing limits are available for other needs. Bill discounting becomes an

incremental source of funding.

3.7 Cost of debt

In the case of long-term sources of finance, cost of debt is calculated as discussed in Chapter

[1]. The method used above for bill discounting is used for computing cost of short-term

debt. Thus, pre-tax cost of debt can be computed.

Suppose a company reported Earnings before Interest & Tax (EBIT) of Rs. 500. If its tax rate

is 30%, then it will pay tax of Rs. 500 X 30% i.e. Rs. 150. The profit after tax would thus be

Rs. 500 – Rs. 150 i.e. Rs. 350, assuming it had no borrowings.

If the company had borrowings of Rs. 2,000, on which it pays interest at 15%, the interest it

would pay is Rs. 2,000 X 15% i.e. Rs. 300. The taxable profit is EBIT – Interest i.e. Rs. 500 –

Rs. 300 i.e. Rs. 200. The tax at 30% would amount to Rs. 200 X 30% i.e. Rs. 60. The profit

after tax (PAT) thus becomes Rs. 200 – Rs. 60 i.e. Rs. 140.

46

The interest of Rs. 300 brought down the PAT by only Rs. 350 – Rs. 140 i.e. Rs. 210. This

lower impact on PAT is because the interest cost offered a tax shield – it brought down the

taxable profits, thus reducing the tax liability. The effective borrowing cost was therefore

15% X (1 – 30%) i.e. 10.50%. This is the post-tax borrowing cost.

Post-tax borrowing cost = Pre-tax borrowing cost X (1 – tax rate)

Multiplying the borrowing of Rs. 2,000 by the 10.50% post-tax interest cost gives Rs. 210,

which is the amount by which profit after tax declined on account of the interest payment.

The company enjoyed a tax shield on interest, amounting to the interest cost of Rs. 300

multiplied by the tax rate of 30% i.e. Rs. 90.

Interest – Tax Shield = Post-tax Interest Cost

i.e. Rs. 300 – Rs. 90 = Rs. 210.

In cost of funds calculations, the post-tax cost of debt is used. However, if the company is

making losses or has other exemptions on account of which it does not need to pay a tax, then

the pre-tax cost of debt is to be used.

3.8 Weighted Average Cost of Capital

Treasury needs to know its weighted average cost of capital (WACC). Long term value creation

in the company depends on investing in assets that yield a return higher than WACC.

WACC depends on the cost of equity, cost of debt and the capital structure. It is computed

through either of the two following methods:

• Using the company’s target debt-equity ratio

Suppose the company targets a debt-equity ratio of 1.5:1. The cost of debt is 10.5%

and cost of equity is 15.2%. WACC can be calculated as [(10.5% X 1.5) + (15.2% X

1)] ÷(1.5 + 1) i.e. 12.38%.

• Using the market value of the company’s securities as weight

Suppose the company has issued 1mn shares of Rs. 10 each that are trading at Rs.

50 per share. Thus, the market capitalisation is 1mn X Rs. 50 i.e. Rs. 50 mn, while

the book value is 1mn X Rs. 10 i.e. Rs. 10mn.If the reserves are Rs. 12mn, then the

shareholders’ funds are Rs. 10mn + Rs. 12mn i.e. Rs. 22mn.It has also issued debt

whose worth in the books is Rs. 15mn, but their market value is Rs. 16mn.

Capital structure of the company based on book value and market value are shown in

Table 3.4.

47

Table 3.4

Capital Structure

Book Value Market Value

Equity: Net Worth / Market Cap Rs. Mn 22 50

Debt Rs. Mn 15 16

Debt-Equity Ratio 0.68 0.32

The market value weights are used in this method. WACC on this basis is [(10.5% X

16) + (15.2% X 50)] ÷(16 + 50) i.e. 14.06%.

3.9 Cost of Capital for Trading Portfolios

As discussed, WACC is the minimum post-tax return that assets should earn in order to enhance

the value of the company. This is particularly relevant for strategic decisions, investments of

high value that will change the balance sheet structure etc.

Shorter term decisions (e.g. trading portfolios in line with the past) that will not change the

balance structure significantly are taken on incremental cost basis.

For example, suppose the company has unutilised borrowing limits, based on which it can

mobilise funds at 15%. The regulater has also insisted that 10% of the debt should be

invested in government securities, whose yield in the market is 9%. The pre-tax incremental

cost of debt on the basis is shown in Table 3.5.

Table 3.5

Cost of debt for trading

The 15% pre-tax cost of borrowing has increased to 16.06% on account of the compulsion

to invest in lower yield government securities. If the requirement was to deposit 10% with

48

the Reserve Bank of India as Cash Reserve Ratio (on which no interest will be received), the

incremental cost of debt shoots up to Rs. 15 ÷ Rs. 85 X 100 i.e. 17.65%.

Investment will be made in assets that yield a pre-tax return of at least 16.06% or 17.65% as

the case may be. If the company expects a minimum return of 0.5%, then the pre-tax yield

on the asset needs to be 16.56% or 18.15%, as applicable.

3.10 Leasing and hire purchase

Leasing and hire purchase are forms of off-balance sheet financing. The lessee / hire purchaser

are able to use the assets immediately, based on a small upfront payment. The significant

investment comes from the lessor / seller, who recover their dues from the lessee / hire

purchaser through rentals as per an agreed schedule.

Leases are of two kinds – operating lease and financial lease.

• A financial lease is a pure financing arrangement. The lessor has no use for the asset

e.g. plant and machinery used in a project. So he ensures that he is paid back during

the lease period. The lessee's right to stop the lease early is curtailed. The lessee is

given an optionat the end of the lease period, to buy the asset or roll over the lease

at a nominal rate. The buyback clause is worded properly to ensure that it is not

construed as a hire purchase.

• Many car leasing arrangements are structured as operating leases. The lessor may

be in the car lease business and may not have an interest in selling the car at the end

of the lease period. On account of longer term interest in the asset, the lessor in an

operating lease bears many more costs related to the asset (e.g. insurance, repairs)

than in the case of financial lease. The operating lease rental is kept at a level where

the lessor is able to recover these costs from the lessee.

In the case of hire purchase, ownership moves to the hire purchaser immediately – only

payment is deferred over the hire purchase period. So the hire purchaser is able to claim

income tax depreciation during the hire purchase period.

In contrast, the lessor continues to own the asset leased out (although the lessee is in

possession of the asset and uses it). So income tax depreciation is claimed by the lessor.

Lessees who are exempted from tax and therefore unable to enjoy the depreciation tax shield

can opt for a lease, where the lessor gets the depreciation tax shield. The lessor can pass on

part of the tax benefit to the lessee, in the form of lower lease rentals. The scope for this kind

of tax arbitrage has reduced, with most exemptions under the Income Tax Act, 1961 getting

phased out. Unfavourable treatment under Value Added Tax and Service Tax legislations are

other factors that have led to reduced role of leasing in India.

49


• A company has issued 1mn shares of Rs. 10 each. They are trading in the market at

Rs. 12. Reserves of the company are Rs. 4mn. The company also has not written off

miscellaneous expenditure of Rs. 3mn. What is the company’s net worth?

- rs. 11mn

- Rs. 14mn

- Rs. 16mn

- Rs. 13mn

• A company has issued 1mn shares of Rs. 10 each. They are trading in the market at

Rs. 12. Reserves of the company are Rs. 4mn. The company also has not written off

miscellaneous expenditure of Rs. 3mn. What should be the weightage to equity under

the market value method of determining cost of equity?

- Rs. 11mn

- rs. 12mn

- Rs. 9mn

- Rs. 16mn

• Each of the following is an indication of better financial strength for borrowing

except-

- higher interest coverage ratio

- higher debt servicing coverage ratio

- higher leverage

- higher equity

• A company’s cost of equity is 12%. It can borrow at 14%. If the company’s target

debt-equity ratio is 1.75 and tax rate is 30%, what is its weighted average cost of

capital?

- 13.3%

- 9.8%

- 17.15%

- 10.6%

50

Chapter 4 Treasury Management in Manufac-turing and Services Companies

4.1 Background

Manufacturing and services companies have treasury management issues that are quite

different from those faced by banking and finance companies. Money is a raw material

for banking and finance companies; it is a mere facilitater for manufacturing and services

companies. Yet, money related risks can deeply affect the core business of manufacturing

and services companies, as discussed in this chapter.

4.2 Contribution analysis

Fixed assets are a major feature of manufacturing companies and some service companies.

It can be quite high in specific industries such as steel and power.

Fixed assets (through depreciation and interest costs), fixed labour force, fixed overheads

etc. create fixed costs in the business. The problem with fixed costs is that they need to

be incurred even if the company’s operations suffer. This can pull down the profits of the

company significantly, when business volumes go down. On the other hand, when business

volumes go up, fixed costs do not increase proportionately. Thus, profitability can improve

with increase in business volumes.

In order to understand the impact of change in business volumes on profitability, companies

segregate their costs into fixed and variable. Sales – Variable Cost is called ‘contribution’. The

contribution analysis also helps in finding the company’s breakeven level, as shown in Table

4.1.

Table 4.1

Contribution Analysis

Rs. Mn.

31-Mar-12 31-Mar-13

a sales 3,000 3,600

b Less Variable Costs 1,185 1,638

c Contribution 1,815 1,962

d Less Fixed Costs 265 357

e Profit before Tax 1,550 1,605

f Contribution (%) (c) ÷ (a) 60.5% 54.5%

g Breakeven Sales (d) ÷ (f) 438.02 655.05

h Breakeven Sales (%) (g) ÷ (a) 14.6% 18.2%

51

Contribution of 54.5% means that if the company’s sales were to go up by Rs. 100, then its

profits will go up by Rs. 54.50.

Breakeven sales at 18.2% of sales means that even if sales were to go down by (100% –

18.2%) i.e. 71.8%, the company will still be profitable – a very comfortable position to be in.

This is a key metric for a treasury manager to focus on. Lower the breakeven sales, greater

the latitude the company has to take risks on the treasury front.

As the company adds fixed costs, or its margins shrink, the breakeven point will go up. The

treasury management should therefore track the breakeven point regularly, say, every year.

4.23 Operating Leverage & Financial Leverage

Suppose the fixed costs in the previous case were inclusive of interest cost of Rs. 25 and Rs.

35 in the two years. EBIT i.e. Profit before tax plus Interest is Rs. 1,575 and Rs. 1,640 in the

two years.

The risk to the company’s profits arising out its fixed cost structure is measured through its

Operating Leverage. Similarly, risk to the company’s profits on account of its interest cost is

measured through its Financial Leverage. Total Leverage, the product of Operating Leverage

and Financial Leverage measures the overall risk on account of cost structure and interest

costs. The calculations are given in Table 4.2.

Table 4.2

Calculation of Leverage

Rs. Mn.

31-Mar-12 31-Mar-13

1 Operating Leverage (a) ÷ (b) 1.2 1.2

a Contribution 1,815 1,962

b EBIT 1,575 1,640

2 Financial Leverage (a) ÷ (b) 1.0 1.0

a EBIT 1,575 1,640

b PBT 1,550 1,605

3 Total Leverage (1) X (2) 1.2 1.2

There is no standard for a desirable leverage. It depends on the nature of business. If the

demand for the company’s products is likely to fluctuate from year to year, then it should

minimise the operating leverage, by lowering its fixed cost structure. If that is not possible, then

the company should reduce the financial leverage (by reducing interest cost i.e. borrowing).

This will translate into lower debt-equity ratio.

52

High leverage means that the company’s operations / financial structure is inherently risky. In

that case, the treasury manager needs to be cautious with treasury management. As in the

case of breakeven analysis, the treasury manager should monitor the leverage annually.

4.4 Balance Sheet

The balance sheet of any company is a snapshot of its assets and liabilities. It conveys the

nature of risks the company is exposed to. A generalised balance sheet is shown in Table

4.3.

Table 4.3

Balance Sheet of ABC Company as on

Rs. million

31-Mar-12 31-Mar-13 31-Mar-12 31-Mar-13

liabilities assets

Share Capital 1,000 1,000 Net Fixed Assets & CWIP 12,800 20,000

Reserves 5,000 5,500

Net Worth 6,000 6,500 Investments 300 350

Secured Loans 5,300 12,000 Current Assets

(e.g. Inventory, Debtors)

500 1,150

Unsecured Loans 1,800 1,700 Miscellaneous Exp not

written off

400 300

Current Liabilities

(e.g. Sundry Creditors)

900 1,600

Total liabilities 14,000 21,800 Total assets 14,000 21,800

This can be re-cast as shown in Table 4.4, for better interpretation. The subsequent sections of

this chapter discuss various aspects of treasury management based on the Balance Sheet.

The Balance Sheet needs to be read along with the Notes to the accounts and Auditor’s Report

to know what the balance sheet does not capture. For instance, non-performing assets may

not have been fully recognised and provided, or loss on investments may not have been

recognised. Very high guarantees may have been given for a group company whose finances

may be under stress. These issues need to be understood well, to know the sources of risk to

the balance sheet.

53

Table 4.4

Recast Balance Sheet of ABC Company as on

Rs. million

31-Mar-12 31-Mar-13

Sources of Funds

Net Worth 6,000 6,500

Secured Loans 5,300 12,000

Unsecured Loans 1,800 1,700

Total Sources 13,100 20,200

Application of Funds

Net Fixed Assets & CWIP 12,800 20,000

Investments 300 350

Current Assets 500 1,150

Less Current Liabilities 900 1,600

Working Capital -400 -450

Miscellaneous Exp. 400 300

Total Applications 13,100 20,200

4.5 liquidity Management

Capital expenditure incurred on assets before the project is commissioned is called Capital

Work in Progress (CWIP). The over 50% rise in Net Fixed Assets and Capital Work in Progress

is indicative of a major expansion. In such situations, the treasury manager needs to turn

cautious and plan for contingencies.

A typical contingency is overrun in time or cost or both.

• Time overrun implies that the company’s payments to lenders will increase even before

the project has commenced operations. In extreme cases, this can lead to losses,

lowering of credit risk and rise in borrowing costs for the company.

• Cost overrun has implications in terms of possible fund crunch. The treasury manager

needs to ensure that the project is not delayed further on account of lack of funds.

An effective treasury manager will not borrow in excess (because interest costs will go up),

yet ensure that moneys can be raised at short notice. For example, a higher loan sanction

can be taken, but the amount will be drawn down only in case of need.

54

Lenders levy a commitment charge on the amounts not drawn. At times, it is better to bear

the commitment charges, than to have to run around for funds in the last minute, and end up

borrowing at higher rates of interest on account of the urgency.

Besides the capital investment, the other item that is striking in the balance sheet is the

negative working capital. Raw materials get processed into finished goods and sold, and

thereafter proceeds are recovered. At times, payments for raw materials need to be paid in

advance, while credit is to be extended to customers. The entire cycle from payment for raw

materials to receipt of sale proceeds is called working capital cycle.

The role of working capital is to act as a cushion in adversity. This calls for working capital

being positive i.e. current assets should be more than current liabilities. In that case, even if

it takes time to manufacture or sell the goods and recover the sale proceeds, the company will

be able to pay off its current liabilities i.e. the company will not be strapped for liquidity.

As a measure of this liquidity, companies measure their current ratio (current assets ÷ current

liabilities) and quick ratio [(current assets less inventory) ÷ current liabilities].

• A current ratio of 1.33 is considered safe. This means that there can be a problem

of (1.33 – 1) ÷ 1.33 i.e. 25%, and still the company will have liquidity for day to day

needs.

• Similarly, a quick ratio of 1 is considered safe. In that case, even if inventory does not

move i.e. sales are not effected, the company’s ability to meet its current liabilities is

not affected.

A negative working capital situation obviously does not offer such a cushion. The company has

to guard against a liquidity risk.

Some companies have the practice of running their company with negative working capital.

This is achieved by taking advances from customers, while availing of credit from suppliers.

Since suppliers do not charge for normal credit period, and interest is not paid to customers

for advances, negative working capital is like free money. Deployed prudently, it can generate

returns.

Even if the company adopts negative working capital as a strategy, it should have the money

in liquid investments. This will help it tide over situations such as refund on cancellation of

orders by customers. ABC Company appears to be deploying the money in fixed assets. This

is risky, because selling the fixed assets, in case of need, to pay current liabilities is not a

practical solution.

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4.6 Foreign Exchange Exposures (Operations)

As part of its operations, a company may have exposure to foreign currency risk. For instance,

through imports, exports or royalty payments to foreign collaboraters.

Consider the case of a thermal power generating company. It may import coal and sell the

power generated in the local market. The nature of its business makes it short in dollars.

Let us say a consignment of coal is expected each month for the next 6 months. Each

consignment is worth about USD5mn. Thus, the company is short USD30mn.

Today, suppose the exchange rate is Rs. 60 per USD. Each consignment is therefore worth

USD5mn X Rs. 60 i.e. Rs. 300mn. At the stage of payment, if the exchange rate has moved

to Rs. 65 per USD, the additional Rs. 5 per USD translates to a total incremental outflow of

USD5mn X Rs. 5 i.e. Rs. 25mn.

Since power tariffs are frozen on a long term basis by the power sector regulater, it may not

be possible to pass on such additional costs. It would therefore be sensible for the power

generating company to hedge itself by going long on dollars. What are the alternatives?

• It can ask its bank to offer a forward contract for the power generating company to

buy USD on specific date/s at a price that is decided today. Benefit is that the delivery

dates under the USD forward contract can be closely aligned with expected payment

dates for the coal. Problem is that there is no transparency in the pricing in the

market. The power generating company cannot be sure if it has got a good rate for the

USD forward contract

• It can buy USD futures in the stock exchange. Initial margin is payable on the purchase.

Mark to market margin will be payable or receivable daily, depending on whether the

position is in loss or profit.

Pricing transparency is available. Suppose, after buying the USD futures, USD

appreciates rapidly, and is expected to depreciate again. The power generating

company can sell the USD futures contracts and book a profit.

Problem is that the settlement date in the stock exchange will be different from the

expected payment date for the coal. For instance, if the stock exchange settlement

date is Dec 27, but coal payment date is December 29, the power generating company

is exposed to USD risk for 2 days.

• It can buy USD call options in the stock exchange. Option premium will need to be

borne upfront.

The power generating company can book a profit on the USDINR options, if USD

appreciates. If USD depreciates, then it will let the option lapse; it will buy USD in the

spot market to pay for the coal shipments.

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It is possible to consider a pharma company that manufactures in India and exports the

products. Its natural position therefore is of being long on USD. It can cover itself by going

short on USD. It can do this through any of the following routes:

• It can ask its bank to offer a forward contract. The contract will be for the power

generating company to sell USD.

• It can sell USD futures in the stock exchange.

• It can buy USD put options in the stock exchange.

Many companies that are in the gems business in India, import uncut gems and export them

after processing. Thus, they have imports and exports. It will be costly and senseless to cover

both the imports and exports. The approach is to therefore work out a datewise schedule of

imports and exports and identify the net gaps. For instance, if on Dec 15 an import payment

of USD500mn is to be made, and on Dec 18 an export receipt of USD300mn is expected to be

realised. It will hedge itself as an importer for USD200mn.

Foreign currencyexposure are not evident on the face of the balance sheet. So, the treasury

manager needs to have ongoing communications with the concerned departments to know

what is happening on the ground, so that suitable hedges can be taken.

4.7 Foreign Exchange Exposures (Loans taken or investments made)

Payments for foreign currency loans taken are like import payments. So the hedging strategy

will be similar to an importer. Similarly, the hedging strategy for foreign investments is similar

to that of an exporter.

The date on which importers and exporters need to make payments or will receive payments

will depend on the consignments, credit terms and several other factors. Therefore, although

the broad pattern can be envisaged, there is no fixed schedule of dates for the transactions.

In contrast, loans and investments in the debt market are serviced on specific dates until

repayment of the loan or maturity of the investment. Given the fixed dates for the transactions,

foreign currency swaps can be considered as a hedge product.

The point to note is that if the currency in which one has invested (gone long) depreciates,

57

then the investor suffers. This can be seen in the example in Table 4.5.

Table 4.5

Impact of exchange rate movements

Although the USD asset appreciated by 10%, the 5% depreciation in USD pulled down the

overall investment return in Rupees to 4.50%.

Similarly, if the currency in which one has borrowed appreciates, then the investor suffers.

India has signed Double Taxation Avoidance (DTA) agreements with several countries. This

ensures that if an resident of a treaty country pays a tax in the other country, then that

tax can be claimed as a rebate if the income becomes taxable in the country in which he is

resident. Thus, an Indian investing in Singapore will get a rebate on tax paid in Singapore, if

the investment becomes taxable in India.

58

While investing abroad, there is also a risk that restrictions may be imposed in repatriating

capital or profits. India has signed treaties with various countries to lay the policy framework

for investment and trade transactions between the countries. Preference should be given

for such countries, because the backing of the government and the bi-lateral treaty become

available in case of disputes.

There are some unique accounting issues associated with foreign exchange exposures related

to loans and investments, which are discussed in Chapter [6].

4.8 Commodity exposures

The approach for the power generating company to hedge itself against the USD payments

was discussed. However, it is also exposed to the risk of fluctuation in international coal

prices. Similarly, a steel manufacturer is exposed to risk of fluctuation in international prices

of its iron imports; wire manufacturer is exposed to copper price risk. How can these risks

be covered?

• One approach is to enter into long term pricing arrangements with the supplier. This

would ensure a fixed price for the import, irrespective of changes in prices in the

market.

• Hedging contracts (futures / options) available in the commodities market can be

explored. Even if a suitable product is not available in the local market, it may be

traded in international markets, such as the London Metal Exchange. The contract

structure, regulatory requirements, payment processes and settlement processes will

need to be examined first. Thereafter, either the concerned future can be bought, or

a call option on the concerned product can be purchased.

The treasury manager needs to be creative in identifying the hedges. For instance,

palm oil futures may not be available, or the market may be illiquid. Statistical analyses

will reveal other markets that are liquid and move in synch with the palm oil market.

For instance, petroleum futures may be used to hedge against palm oil risks.

4.9 Credit exposures

Businesses give credit to their dealers / distributers or final consumers of their products.

While this boosts sales of the company, it also creates a credit risk for the company.

While sales will recommend that credit be given, the treasury manager should be involved in

deciding the credit terms viz. how much credit will be given, for what period, at what interest

cost and against what security / documentation.

Where credit has been given, the treasury manager has to monitor to ensure that the dues

are received as scheduled.

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A significant problem with such credit exposures is the concentration risk. When the industry

faces trouble, the company will be strapped for liquidity at the same time that distributors also

find it difficult to pay their dues.

Even otherwise, given the nature of the business relationship, the company may find it difficult

to put pressure on the customer to pay the dues or to pay penal interest on overdue amounts.

There is always the fear that the customer will stop business relationship, thus affecting future

sales of the company.

Keeping these considerations in mind, the treasury manager should explore various ways of

introducing a bank into the chain. For instance, this can be done through a bill discounting

transaction. Bills accepted by the customer can be discounted with the bank. Thereafter, the

bank can follow up with the customer for its dues, without any risk to the company’s customer

relationship.

Another approach that can be taken is ‘factoring’, which is a sale of the debt to a financier

(factor). Thus, the company gets its fund, while the customer will pay the factor on the due

date. The factoring may be with or without recourse to the company. If it is with recourse,

the company continues to carry the credit risk.

In some industries (e.g. housing and consumer durables), it is common to make arrangements

with various banks and other financiers for financing the customers. For example, the builder

will get his project approved for financing by specific institutions. Customers can approach

the institution for financing of purchase of house from the builder. Such arrangements are

called ‘sales aid financing’. The builder may work out concessional funding arrangements to

make it attractive for the customer to buy.

Some of these financing structures are intelligently done. The seller can get advance money

based on loan by the bank to the customer (disbursed directly to the seller). Since the bank

takes a credit risk on the customer (buyer), the company (seller) effectively gets off-balance

sheet financing. The treasury manager has to explore such options to get funds on the most

favourable of terms without putting too much pressure on the balance sheet.

Supplies to international parties is particularly tricky. Organisations like Dun and Bradstreet

provide credit reports to assess the credit worthiness of the buyer. However, recovering

money from debtors in another country imposes huge challenges and costs. Letters of credit

are a good solution in such cases.

Let us say goods are to be shipped from India to South Africa. The Indian company will ask

the South African buyer to open a letter of credit in its favour. The South African buyer will

approach its bank, say, Standard Bank, to open a Letter of Credit in favour of the Indian

company. The Indian company has to be particular about the credit worthiness of the bank

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opening the Letter of Credit. The Letter of Credit will mention an Indian bank, say SBI, with

whom Standard Bank has a correspondent banking relationship.

Once the Indian company despatches the goods, it will give the bill of lading and other

shipping documents to SBI, which will send them to Standard Bank. Standard Bank will hand

over the documents to the South African buyer only against payment from him or a credit

facility already authorised for him. Thus, the Indian company is able to minimise its credit

risks.

This chapter focused on treasury management aspects that are unique to the core operations

of manufacturing and services companies. Such companies may also be active in loans and

investments. Treasury management issues related to such non-core operations are, to an

extent, similar to those faced by banking and finance companies. These are discussed in the

next Chapter.

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• A company has sales of Rs. 5,000 and variable cost of Rs. 3,000. If fixed costs are Rs.

300, what is its breakeven sales as a percentage of current sales?

- 60%

- 10%

- 20%

- 40%

• In the above case, if fixed cost included interest of Rs. 50, what is the company’s total

leverage?

- 1.02

- 1.05

- 1.09

- 1.11

• Which of the following is most likely to have a concentrated credit risk profile?

- Manufacturing company

- Bank

- Financial services company

- Insurance company

• What is the problem with having too many loans that are not drawn down?

- Commitment charge may have to be paid

- Return on capital employed is reduced

- Current ratio is reduced

- Income tax problems

• Which of the following is / are a solution for commodity risk?

- Long term supply contract

- Commodity futures

- Commodity options

- All the above

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Chapter 5 Treasury Management in Banking & Finance Companies

5.1 Background

Fund-based businesses in the banking and financial sector are involved in lending to or

investing in the market, the funds they raise from the market. They perform an important

intermediating role. Loan companies seek to capitalise on the spread between borrowing

and lending rates. Investment companies aim to benefit from movements in the capital

markets.

Unlike manufacturing companies, banking and finance companies do not depend on fixed

assets for generating throughput. Therefore, it is possible for them to scale up quite fast. In

the process of rapidly scaling up, however, it is possible to take extreme risks. Some of these

issues related to managing loan and investment companies are discussed in this Chapter.

5.2 Capital Adequacy

Banks and deposit-taking non-banking finance companies are more closely regulated by the

Reserve Bank of India (RBI). They operate with high debt-equity ratios.

Chapter [1] highlighted how higher debt can help the company boost return on shareholders’

funds; however, beyond a point, debt can get dangerous. ICR and DSCR were discussed as

measures of the company’s repayment ability. Chapter [4] mentioned breakeven volume and

leverage ratios as tools to monitor in the case of manufacturing companies.

RBI sets limits on the debt-equity ratio for deposit-taking finance companies. In the case of

banks, capital adequacy becomes a tool for RBI to control leverage. The prudential guidelines

are based on reports of the Basle Committee on Banking Supervision.

The Basle framework provides for three mutually re-inforcing pillars viz. minimum capital

requirements, supervisory review of capital adequacy and market discipline. Under Pillar 1,

various options have been given for the entities to determine their capital requirements for

credit risk and operational risk.

RBI wanted consistency with Indian banking. So it mandated that all commercial banks in

India (other than local area banks and regional rural banks) should adopt The Standardised

Approach for creditrisk and Basic Indicator Approach for operational risk. Capital requirements

for market risk are determined as per Standardised Duration Approach. This was also applicable

for foreign banks operating in India and Indian banks having operations abroad.

Banks have been given the discretion to adopt the more advanced frameworks envisaged in

the Basle framework. This is subject to prior permission of RBI.

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The broad approach adopted by RBI since April 1992, is to assign prescribed risk weights for

balance sheet assets, non-fundeditems and other off-balance sheet exposures. Banks are

required to maintain, on an ongoing basis, unimpaired minimum capital funds equivalent to

the prescribedratio on the aggregate of the risk weighted assets (RWA) and other exposures.

The minimum Capital to Risk-weighted Assets Ratio (CRAR) has been prescribed at 9 per cent

on an ongoing basis.

Banks are required to compute CRAR on Tier 1 basis and Total basis as follows:

Tier 1 CRAR =

Total CRAR =

Capital funds have been classified into Tier I and Tier II. Tier II capital is considered only upto

100% of Tier II capital.

Tier I capital for Indian banks includes the following:

• Paid-up equity capital, statutory reserves, and other disclosed free reserves, if any;

• Capital reserves representing surplus arising out of sale proceeds of assets;

• Innovative perpetual debt instruments (IPDI) eligible for inclusion in Tier 1 capital,

which comply with specific regulatory requirements;

• Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with specific

regulatory requirements; and

• Any other type of instrument generally notified by the Reserve Bank from time to time

for inclusion in Tier I capital.

Foreign currency translation reserve arising consequent upon application ofAccounting

Standard 11 (revised 2003): ‘The effects of changes in foreign exchange rates’ are not an

eligible item of capital funds.

Tier I capital for foreign banks includes the following:

• Interest-free funds from Head Office kept in a separate account in Indian books

specifically for the purpose of meeting the capital adequacy norms.

• Statutory reserves kept in Indian books.

• Remittable surplus retained in Indian books which is not repatriable so long as the

bank functions in India.

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• Capital reserve representing surplus arising out of sale of assets in India held in a

separate account and which is not eligible for repatriation so long as the bank functions

in India.

• Interest-free funds remitted from abroad for the purpose of acquisition of property and

held in a separate account in Indian books.

• Head Office borrowings in foreign currency by foreign banks operating in India for

inclusion in Tier I capital which comply with specific regulatory requirements; and

• Any other item specifically allowed by the Reserve Bank from time to time for inclusion

in Tier I capital.

The Innovative Perpetual Debt Instruments, eligible to be reckoned as Tier Icapital, is limited

to 15 per cent of total Tier I capital as on March 31 of the previousfinancial year.

The outstanding amount of Tier I preference shares i.e. Perpetual Non-Cumulative Preference

Shares along with Innovative Tier I instruments cannot exceed40 per cent of total Tier I

capital at any point of time.Tier I preference sharesissued in excess of the overall ceiling of

40 per cent, are eligible for inclusion underUpper Tier II capital, subject to limits prescribed

for Tier II capital.

Innovative instruments / PNCPS, in excess of the limit are eligible forinclusion under Tier II,

subject to limits prescribed for Tier II capital.

Tier II capital includes the following:

• Revaluation reserves reflected on the face of the balance sheet (discounted by 55%

i.e. only 45% should be considered)

• General provisions and loss reserves not attributable to the actual diminution in value

or identifiable potential loss in any specific asset and available to meet unexpected

losses

Banks are allowed to include the General Provisions on Standard Assets, Floating

Provisions, Provisions held for CountryExposures, Investment Reserve Account and

excess provisions which arise on account ofsale of NPAs in Tier II capital. However,

these five items are permitted as Tier II capital upto a maximum of 1.25 per cent of

the total risk-weighted assets.

• Hybrid debt capital instruments

Such instruments that have closesimilarities to equity, in particular when they are able

to support losses on an ongoing basiswithout triggering liquidation, can be included in

Tier II capital.

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• Subordinated debt (upto 50% of Tier I capital)

The instrument should be fully paid-up,unsecured, subordinated to the claims of other

creditors, free of restrictive clauses, andshould not be redeemable at the initiative of

the holder or without the consent of RBI. As they approach maturity, they shouldbe

subjected to progressive discount, for inclusion in Tier II capital. Instruments with an

initialmaturity of less than 5 years or with a remaining maturity of one year cannot be

includedas part of Tier II capital.

• IPDI and PNCPS as discussed earlier

RBI has provided a comprehensive list of investments and their risk weights. Some of these

are as follows:

• Fund based and non-fund based claims on the central government and central

government guaranteed claims – Nil

• Direct loan / credit / overdraft exposure to the State Governments and the investment

in State Government securities – Nil

• State Government guaranteed claims – 20%

If the above sovereign exposures become non-performing assets (NPA), then the NPA

regulations will apply.

• Claims on foreign sovereigns depends on credit rating given by international credit

rating agencies. It varies from 0% for AAA / AA to 20% for A, 50% for Baa/BBB and

100% Ba/BB or below.

• Claims on the Bank for International Settlements (BIS), the International Monetary

Fund (IMF) and specified eligible Multilateral Development Banks (MDBs) – 20%

• Claims on Indian scheduled banks

CRAR above 9% - 20%

Depending on CRAR, it goes up to 625%

• Claims on Indian non-scheduled banks

CRAR above 9% - 100%

Depending on CRAR, it goes up to 625%

• Claims on foreign banks – 20% to 150% depending on credit rating

• Claims on companies – 20% to 150% depending on credit rating

The risk weight of assets and off-balance sheet items of the bank need to be first computed.

Capital is divided by the risk-weighted assetsto arrive at CRAR. An example is given in Table

5.1.

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Table 5.1

Crar ratio

Rs. million

Weight Value 31-Mar-13

Capital:

Tier I Capital 3,500

Tier II Capital 7,500

Tier II Capital Limited to 100% of Tier I 3,500

Total Capital 7,000

assets:

Central Government Securities 0% 4,000 0

Claims guaranteed by Centre 0% 3,000 0

State Government Securities 0% 7,500 0

Claims guaranteed by State 20% 1,000 200

Swiss Securities (AAA) 0% 500 0

Loans to IMF 0% 1,200 240

Scheduled Bank bonds * 20% 12,000 2,400

Non-Scheduled Bank bonds* 100% 14,000 14,000

AAA Debentures of companies 20% 15,000 3,000

Claim on AAA foreign bank 20% 5,000 1,000

63,200 20,840

Market Risk RWA 4,000

Operational Risk RWA 2,000

Total RWA 26,840

Tier I Crar (Tier I Capital ÷ RWA) 13.04%

Total Crar (Total Capital ÷ RWA) 26.08%

* CRAR 10%

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5.3 Balance Sheet

A generalised balance sheet for a bank is shown in Table 5.2.

Table 5.2

Balance Sheet of Bank PQ Ltd as on

Rs. million

31-Mar-12 31-Mar-13 31-Mar-12 31-Mar-13

liabilities assets

Share Capital 3,000 3,000 Cash and balances with RBI

3,200 3,800

Reserves 5,000 5,500

Net Worth 8,000 8,500 Balances with banks and money at call & short notice

1,000 1,600

Deposits 30,000 35,000 Investments 5,800 7,000

Borrowings 2,500 2,800 Loans 25,000 28,500

Other Liabilities & Provisions

2,500 3,700 Fixed Assets 2,300 2,600

Other Assets 5,700 6,500

Total liabilities 43,000 50,000 Total assets 43,000 50,000

As compared to a manufacturing company, banks have a significant portion of liabilities in the

form of borrowings. A percentage of this needs to be maintained with RBI in the form of Cash

Reserve Ratio. This is included in the first row in the asset side of the balance sheet.

A comparision with the manufacturing company balance sheet in Table 4.3, shows that banks

present their assets in decreasing order of liquidity. Cash, bank balances and moneys lent

at call or short notice are the most liquid of assets in a bank. They appear at the top of the

list of assets. Fixed assets is almost the last item in the list. However, in Table 4.3, the least

liquid item viz. net fixed assets was at the top of the list of assets. Manufacturing companies

mention their assets in increasing order of their liquidity.

Loans are the most significant item in the asset side. This is unique to banks and loan companies.

Investment companies’ balance sheets have investments as the major contributer to their

assets. Banks and finance companies, in general, have a smaller portion of their balance sheet

represented by fixed assets.

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5.4 Yield Curve and Spreads

Chapter [1] discussed the concept of yield in debt securities. It is calculated from the price

at which they are traded in the market.

Government securities are called sovereign securities. They are considered to be free of

default risk. So they trade at the lowest yields in the market. The yield also depends on

maturity. Shorter term debt securities trade at a yield lower than longer term debt securities.

The curve that plots yield at which sovereign securities of different maturities trade in the

market, is called Sovereign Yield curve. Figure 5.1 gives the GoI yield curve as on November

13, 2013.

Sovereign Yield Curve

Source: www.nseindia.com

Figure 5.1

The short term (1 month) yield is at 8.85%, while long term (20 years) yield is at 9.78%. The

yield for long term is higher by 0.93%.

Since non-sovereign securities have a default risk, they trade at higher yields than sovereign

yields. The difference between the two yields is called ‘yield spread’. The yield spread is higher

for lower rated securities i.e. yield spread for AA securities is higher than AAA securities; A

securities’ yield spread is higher than for AA and so on.

Debt portfolio management is all about deciding on what credit risk to take, what tenor to

borrow and what tenor to lend. These are discussed in the rest of this Chapter.

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5.5 Credit risk

International credit rating agencies, such as Standard and Poor’s, and Moody’s, rate countries,

large banks and other international borrowers. Each rating agency has its own credit rating

symbols to indicate different levels of safety.

Domestic credit rating agencies in India include Crisil, ICRA, CARE and Duff and Phelps. They

rate specific borrowing programs of borrowers. Different symbols are used for short term

instruments, long term instruments and other borrowing programs. CRISIL’s rating scale for

long-term and short-term securities is detailed in Tables 5.3 and 5.4.

Table 5.3

Credit Rating Scale of CRISIL for long term debt securities

CrIsIl aaa

(Highest Safety)

Instruments with this rating are considered to have the highest

degree of safety regarding timely servicing of financial obligations.

Such instruments carry lowest credit risk.

CrIsIl aa

(High Safety)

Instruments with this rating are considered to have high degree

of safety regarding timely servicing of financial obligations. Such

instruments carry very low credit risk.

CrIsIl a

(Adequate Safety)

Instruments with this rating are considered to have adequate degree


instruments carry low credit risk.

CrIsIl BBB

(Moderate Safety)

Instruments with this rating are considered to have moderate degree


instruments carry moderate credit risk.

CrIsIl BB

(Moderate Risk)

Instruments with this rating are considered to have moderate risk of

default regarding timely servicing of financial obligations.

CrIsIl B

(High Risk)

Instruments with this rating are considered to have high risk of


CrIsIl C

(Very High Risk)

Instruments with this rating are considered to have very high risk to


CrIsIl d

Default

Instruments with this rating are in default or are expected to be in

default soon.

note: 1) CRISIL may apply '+' (plus) or '–' (minus) signs for ratings from

'CRISIL AA' to 'CRISIL C' to reflect comparative standing within the

category.

Source: www.crisil.com

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Table 5.4

Credit Rating Scale of CRISIL for short term debt securities

CrIsIl a1 Instruments with this rating are considered to have very strong degree of

safety regarding timely payment of financial obligations. Such instruments

carry lowest credit risk.

CrIsIl a2 Instruments with this rating are considered to have strong degree of safety

regarding timely payment of financial obligations. Such instruments carry

low credit risk.

CrIsIl a3 Instruments with this rating are considered to have moderate degree of


carry higher credit risk as compared to instruments rated in the two higher

categories.

CrIsIl a4 Instruments with this rating are considered to have minimal degree of


carry very high credit risk and are susceptible to default.

CrIsIl d Instruments with this rating are in default or expected to be in default on

maturity.

note: 1) CRISIL may apply '+' (plus) sign for ratings from 'CRISIL A1' to 'CRISIL

A4' to reflect comparative standing within the category.

2) A suffix of 'r' indicates investments carrying non-credit risk.

Source: www.crisil.com

At times, the credit profile of a security is enhanced through a structured obligation, which

may be in the form of specific guarantees or escrow or other security arrangements. Such

structures are called ‘structured obligations’. Debt securities that are backed by such

arrangements have a suffix ‘SO’ added to the short term or long term credit rating symbol,

as applicable.

SEBI has introduced standardisation of rating symbols between different domestic credit rating

agencies. So other credit rating agencies follow similar rating scale, with the prefix ‘CRISIL’

being replaced by their own organisation acronym.

It stands to reason that poorer the credit rating, higher the yield (and consequently, the yield

spread) that the issuer has to offer on its borrowing program. The treasury manager can

boost interest income in the portfolio by taking more credit risk. However, higher credit risk

can translate into more NPAs in the portfolio.

RBI (and other regulaters for non-banks) have legislations regarding provisions to be made

for NPAs, when a borrower stops paying interest or principal. Beyond a few defaults, the

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bank has to stop recognising interest income on the concerned investment. If it is finally not

possible to recover any amount, then the entire book value of the investment will need to be

written off. Provisions and write-offs pull down the total return from the investment and the

overall profitability of the bank. Hence the need for caution in taking credit risk.

When the economic environment is buoyant, most companies do well. In such a situation,

defaults are fewer. Such a scenario is ideal for taking credit risks. However, when the

economic situation turns adverse, more companies default. Recessionary situations therefore

see a rise in credit risk and yield spreads.

Shrewd debt investors start increasing credit risk towards the end of the recessionary period,

when yield spreads are high, but beginning to decline. Similarly, they start decreasing credit

risk when the economy starts taking a dip and fears of defaults start rising.

5.6 Interest risk

Given the upward sloping yield curve, it would be more sensible to invest in longer term

securities, if only the yield is considered. However, as discussed in Chapter [1] longer the

maturity, higher the modified duration. Therefore, if yields in the market were to go up, the

longer maturity securities will fall more sharply than the shorter maturity securities.

If the treasury manager were to prioritise downside protection, then investments would be

made in shorter term securities. This will reduce the modified duration, and also the yield.

The treasury manager therefore needs to decide on the balance between modified duration

and yield.

It is for this reason that the treasury manager needs to track the economy and anticipate the

likely direction of monetary policy.

• In inflationary situations, RBI adopts contractionary monetary policy that pushes up

yields. In such situations, it would be better to go short in terms of maturity.

• In recessionary situations, RBI adopts expansionary monetary policy to boost the

economy. This leads to decline in interest rates, which is favourable for securities with

longer term maturity.

Another strategy for inflationary situations is to invest in floating rate securities. The coupon

in such securities keep going up in line with the benchmark rate to which they are linked.

Thus, rises in yields in the market lead to re-setting of coupons higher. Since the coupon

keeps getting aligned with the market (both upwards and downwards), the value of floating

rate securities is relatively unaffected by changes in the market.

The terms of floating rate investments need to be checked for ‘caps’ and ‘floors’.

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• Cap is a ceiling to the coupon that the issuer will pay on the security. Beyond that,

even if yields go up in the market, the issuer will not pay a higher coupon. Effectively,

it becomes a fixed rate instrument if yields rise too much. Thus, the cap is a negative

feature for the investor; positive for the issuer.

• Floor is a base below which the coupon will not go, even if yields go down. Thus, it

becomes a fixed rate instrument if yields fall too much. Thus, the floor is a positive

feature for the investor; negative for the issuer.

When the same instrument has both a cap and a floor, the feature is called a “collar”.

Another feature to watch out for in debt instruments is “call” and “put” option.

• Call option means that the issuer has the right to call back the security and return

the investors’ money on specific dates or after a specific period. Issuers are likely to

exercise this option when yields in the market fall. Thus, the call option can deprive

the investor of possible capital gains in a declining interest rate scenario. It is a

negative feature for the investor; positive for the issuer.

• Put option means that the investor has the right to return the security to the issuer and

claim return of the moneys invested. This option is exercisable on a specific date or

after a specified period, as mentioned in the terms of the issue. Investors will exercise

this option if yields in the market go higher than the coupon they earn on the security.

Thus, they can avoid having to book capital losses if yields in the market rise. It is a

positive feature for the investor; negative for the issuer.

5.7 Re-financing Risk

Consider the case of a company that has issued a debenture with a put option. If interest

rates go up, investors will exercise the put option. In that case, the company needs to find

the money to refund the investor. Thus, it has a re-finance risk – a risk that it may not be able

to re-finance the borrowing, or it may be able to do it only at a higher cost.

Re-financing risk can also come up in scenarios when interest rates are stable. It can be a

consequence of an investment strategy, where the treasury manager chooses to benefit from

the upward sloping yield curve. This will call for borrowing for the short term (say 1 year at

8%) and invest for the long term (say 5 years at 10%). Let us suppose interest rates remain

stable during the entire 5 year tenor.

The treasury manager will be able to enjoy a spread of 2% p.a. for the 5 years. However,

each year, re-financing will be required to repay the 1-year borrowing.

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5.8 Asset-Liability Management

Given the interest rate dynamics, management of assets and liabilities are a key decision

of banks and loan / investment companies. A senior management asset-liability committee

(ALCO) often take decisions of the following nature:

• Should the investments be in fixed or floating?

• Should the investments be short term or long term?

• What should be the currency in which to invest?

• Should the borrowing be in fixed or floating?

• Should the borrowing be short term or long term?

• What should be the currency in which to borrow?

These are key decisions on which the yields and liquidity of the institution depends.

5.9 Securitisation

An investment company can sell its marketable securities in the market to get liquidity.

However, a loan is a transaction between the lender and borrower – not a security that can

be sold in the market.

Consider a project finance institution or an auto finance company. Its asset base keeps

increasing as it lends more. New loans will be financed partly out of repayment of past loans.

However, a growing company will keep requiring new borrowings to finance new loans.

Securitisation is an alternative to borrowing to finance new loans. It is a structure where

illiquid loans can be taken out of the books of a lender and converted into tradable debt

securities. Trading in those securities facilitates price discovery and enhances the vibrancy

of the bond market. The original lender benefits through re-pricing of the loan portfolio and

release of lending capacity for further loans.

Suppose Bank XYZ has a loan of Rs. 100 crore on its books, on which it earns 12% p.a.

interest. The EMI amounts to Rs. 21.91 crore p.a. The balance tenure of the loan is 7 years.

The loan has been given to Project ABC, whose credit worthiness has improved as the project

progressed. The market is now comfortable with 11% p.a. yield from the borrower for 7 year

funding.

One approach for Bank XYZ to take the loan out of its books and benefit from the credit

improvement is through securitisation.

The present value of a series of coupon payments at 12% p.a. (the original coupon) discounted

at 11% (the prevailing market yield) on a loan of Rs. 100 crores, amounts to Rs. 103.23 crore,

as shown in Table 5.5.

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Table 5.5

Present Value of 12% Series, Discounted at 11%

As part of the securitisation transaction, a special purpose vehicle(SPV) is created that will buy

out the loan from Bank XYZ at Rs. 103.23 crore (transaction costs and margins are ignored

for simplicity). The figure can also be calculated by using the PV function in MS Excel, with

the parameters as market yield, number of annual payments and the annual payment value

[=pv(11%,7,21.91)].

By selling the loan account to the SPV at Rs. 103.23 crore, Bank XYZ will book a profit of

Rs.103.23 minus Rs. 100 i.e. Rs. 3.23 crore.

Where will the SPV get the money to pay Bank XYZ? It will issue securities that are backed

by the EMI receivable from Project ABC. As shown in Table 5.6, if the SPV were to collect

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Rs.103.23 crore from investors and pay them the EMI that is collected from Project ABC every

year, the investors will earn yield of 11%, which is in line with their expectations.

Table 5.6

Yield for Investors in Securities Issued by SPV

Year Opening Interest EMI Closing

0 103.23

1 103.23 11.36 -21.91 92.68

2 92.68 10.19 -21.91 80.96

3 80.96 8.91 -21.91 67.96

4 67.96 7.48 -21.91 53.53

5 53.53 5.89 -21.91 37.51

6 37.51 4.13 -21.91 19.73

7 19.73 2.17 -21.91 -0.01 ^

^ Will be zero if the numbers are not rounded off to 2 decimals

(Interest in the above table is calculated as Opening Balance multiplied by interest at 11%).

The transfer of loan from Bank XYZ can be ‘with recourse’ or ‘without recourse’. If it is with

recourse, then in the event that Project ABC does not pay the EMI, Bank XYZ will pay the SPV.

In such a structure, the contingent liability remains with Bank XYZ and therefore, it cannot

book the entire profit of Rs. 3.24 crore shown above. This is an example of an off balance

sheet exposure for Bank XYZ.

The bank will prefer a transfer without recourse, for which it may have to transfer the loan at

a slightly lower value than Rs. 103.24 crore. Accordingly, its profits will be lower.

5.10 Foreign currency risk

Banking and finance companies do borrow abroad. The intention generally is to benefit from

the lower cost of funds in other currencies.

Suppose that XYZ Bank can raise money abroad in Japanese Yen at 2% p.a. The Rupee cost

of its borrowing is 10% p.a. Prima facie, it can gain 8% p.a. on the borrowing, if it opts for

Yen instead of Rupees. However, it is also taking a foreign currency risk.

If the Yen Rupee exchange rate remains stable, then the bank is able to enjoy the 8%

spread. However, if Yen appreciates, then the bank has to pay more Rupees to meet its Yen

obligations. Thus, its effective Rupee cost for the borrowing goes up. On the other hand, it

can have a spread more than 8%, if the Yen were to depreciate against the Rupee.

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If the bank does not want to be exposed to such risks, it can opt for hedging through any of

the following approaches:

• Ideal for such a situation is a foreign currency swap, where it will receive Yen and pay

Rupees. The counter party could be someone who expects the Yen to depreciate or

who has a Yen receivable (for example, from a Yen-denominated investment).

On each loan servicing cycle, the bank will receive Yen under the swap and pay the

Yen to its lender. Thus, the Yen exposure is neutralised and the bank is able to operate

with a fixed Rupee cost.

• The bank can find a counter party that will sell Yen under a forward contract that meets

the bank’s loan servicing liabilities.

• The bank can also buy Yen futures, which will appreciate if the Yen appreciates. The

profit from the Yen futures trade will balance the loss on the loan servicing, if the Yen

were to appreciate.

• The bank can buy Yen options. Although a cost in the form of option premium is to

be borne, the bank can book a profit on the option if the Yen were to appreciate. This

will compensate for the loss on the loan servicing on account of the stronger Yen.

However, if the Yen were to depreciate, it will benefit on the loan servicing because the

rupee cost of the instalment will be lower. In such a situation, the bank will allow the

Yen options to lapse.

The margin for the bank will obviously be lower than 8%, to the extent of hedging cost.

5.11 equity exposure

Companies take two kinds of exposures to equities – strategic or financial.

• An example of strategic investment is a parent company investing in a subsidiary. It

is normal to have a group holding company (which may also be a bank), which invests

in focused subsidiaries that are into broking, asset management, insurance etc.

Strategic investments are not unique to banking and finance companies. Even

manufacturing companies make strategic investments. For example, a power

generating company may make a strategic investment in a coal mining company.

Or a cement company may invest in another cement company, with the objective of

merging the two companies later.

Strategic investments in the same business can be difficult to execute, especially if the

target company does not want to fall into the net of the purchaser. Further, depending

on market share implications, regulatory objections can come from the Competition

Commission.

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Strategic investments are long term in nature. The intention is not to buy or sell the

strategic investments with a view to benefit from changes in valuation in the market.

The treasury manager has a very limited role in strategic investments. Decisions are

taken by the board to fulfil the strategic agenda.

• Financial investments in equity are aimed at benefiting from valuations in the market.

Within equity exposure, this kind of investment entails the maximum role for the

treasury manager. He needs to be clear on what is the objective of the investment.

For example,

Does the company want to stay invested to benefit from long term appreciation

in equity markets? Invest in a diversified index.

Does the company want to earn returns better than the long term appreciation

in equity markets? Build up fundamental analysis capabilities that will help in

stock and sector selection. Choose between bottom-up approach and top-down

approach.

In bottom-up approach, the focus is on stock selection. Distribution of

fund between sectors is incidental to the stock selection.

In top-down approach, the initial focus is on making allocation between

sectors. Thereafter, good stocks within those sectors are identified.

Does the company want to speculate on short-term movements in the stock

exchange? Invest based on technical analysis in the market.

Most forward looking manufacturing companies limit their financial investments in

the equity market. They prefer to let the company focus on its core business, rather

than let financial investments divert the focus or increase the risk. Some companies

transfer the surpluses from the core business to a focussed investment division or

subsidiary, where the equity risks may be taken.

• Between the two approaches is a median approach called ‘strategic financial investments’.

Here, significant amounts are invested in specific businesses (as in the case of strategic

investment). However, unlike strategic investments, strategic financial investments

are meant to be sold at some time, when the valuations are attractive.

The treasury manager has a greater role in such investments, than in strategic

investments, but lesser role than in financial investments.

Thus, each equity investment objective calls for a different treasury management style and

role. Accordingly, the skill sets to build in the treasury management department vary.

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• RBI has set the minimum capital adequacy for banks at

- 8%

- 9%

- 10%

- 12%

• Which of the following is part of Tier II capital for banks?

- Capital

- Revenue reserve

- Revaluation reserve

- None of the above

• What is likely to be the most important item of liability for a retail bank?

- deposits

- Loans

- Overdraft

- Investment

• The yield curve for India is

- Horizontal

- upward sloping

- Downward sloping

- Vertical

• Which of the following protects the investor?

- put

- cap

- call

- put and cap

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Chapter 6 Accounting Issues in Treasury Management2

6.1 Background

The discussions so far in this Workbook focused on the ‘finance’ aspects of investment. Treasury

management decisions have a larger impact on the financial statements of the company.

Accounting of the investments and hedges can have a significant impact on the company’s

profits / losses and over financial position as captured in the balance sheet. Therefore, the

treasury manager should consider the accounting aspects, besides the financial aspects, while

taking decisions.

Unfortunately, accounting, of derivatives in particular, is an evolving field even abroad. The

Institute of Chartered Accountants of India (ICAI) has come out with various accounting

standards. AS 11 deals with the effect of changes in foreign exchange rates. AS 13 covers

accounting for derivatives. These are mandatory standards.

AS 30, which is non-mandatory is on recognition and measurement of financial instruments. It

is in line with International Financial Reporting Standards (IFRS). But being recommendatory,

cannot prevail over mandatory accounting standards.

A key difference is that under AS 30, gains and losses on financial instruments need to be

recognised. However, AS 1 on disclosure of accounting policies (a mandatory standard)

provides that only MTM losses are to be provided for. Recognising MTM gains will go against

the principle of conservativism.

The Government has been working on a long term agenda of getting accounting of the entire

Indian corporate sector (including private companies) to converge with IFRS. As part of this

exercise, ICAI has issued various Indian Accounting Standards (IndAS). Many of these have

been notified by the ministry, but their date of coming into effect has been left open.

RBI has its own prescriptions on accounting treatment that banks are to follow. Similarly,

other regulaters have their requirements.

The treasury manager needs to understand the accounting standards adopted by his

organisation and take decisions accordingly.A few broad areas to understand are mentioned

here.

2 The discussions in this chapter are for education purposes. They should not be viewed as advice on accounting issues for business. Please check with your Chartered Accountant for advice on accounting for your business

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6.2 Long-term supply arrangements

Suppose a company’s business operations are highly dependent on oil. It works out a long-

term supply contract to buy oil at USD100 per barrel. In financial terms, if oil is trading at

USD90, then the company has a MTM loss of USD10; if it is trading at USD110, there is a MTM

gain of USD10 per barrel.

In the normal course, if an advance is given to the supplier, it will be accounted. Similarly,

receipt of materials from the supplier is accounted. However, the long-term supply contract

itself may not be accounted.

Suppose the long term supply contract covers the entire oil requirements of the company

for 5 years. The MTM profit or loss of USD10 per barrel, mentioned above, for the 5-year

commitment, can be much higher than the normal profit or loss for a single year.

The treasury manager needs to be clear whether the MTM on future oil supplies is to be

recognised? If yes, then will gains and losses be recognised or only losses?

Similar issues arise if the company were to enter into long term supply contracts for the sale

of its goods.

6.3 Foreign Currency borrowing for a fixed asset

Suppose a company has bought equipment worth USD100mn with financing from an

international institution. The loan is to be repaid over 5 years, with a moratorium of 2 years.

At the time of purchase of equipment, the exchange rate was Rs. 50 per USD. After 1 year,

it is at Rs. 65 per USD.

The fixed asset would have been included in the gross block of the company at USD100mn X

Rs. 50 i.e. Rs. 50mn.

The liability on account of the loan remains at USD100mn, but is equivalent to USD100mn X

Rs. 65 i.e. Rs. 65mn.

How is the differential Rs. 15mn to be accounted?

If it is treated as a foreign currency loss and booked in the profit and loss account, then profits

of the year will be reduced by Rs. 15mn.

If the amount is capitalised and added to the value of the fixed asset, then the net fixed assets

of the company will go up. The profits of the year are not so drastically affected. However,

the depreciation charge will be higher in the current year and future years until the asset is

fully written off.

Suppose the change in exchange rate happens in Year 2. The company decides to revalue

the asset and provide higher depreciation. The financial statements for Year 1 are already

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finalised, audited and adopted. The higher depreciation provided in year 2 on account of

revaluation of the asset, should be for only that year? Or should a higher depreciation for year

1 also be charged in the accounts for year 2?

In the following year, if the USD were to depreciate to Rs. 60 per USD, what would be the

impact?

These are the kinds of issues that the treasury manager has to grapple with. Each situation is

different. So, the issues and the solutions will vary with the situation.

Accounting cannot be the sole basis on which decisions are taken. However, decisions cannot

also be taken independent of accounting issues. In some cases, it may be possible to structure

instruments / contracts in a form where the accounting issues are minimised. The treasury

manager has to explore such options.

6.4 Hedge and Hedged Instrument

Some transactions are executed with the intention of hedging against a risk. Hedges are of

two kinds – fair value hedge and cash flow hedge.

In a fair value hedge, the objective is to protect the balance sheet against change in value of

an asset or liability. For instance, an investor in a fixed interest instrument who chooses to

swap from fixed to flexible interest rate,will be able to protect the investment from downside

risks arising out of rise in yields in the market.

The investor can achieve the same result by selling an interest rate future. If interest rates

were to go up, the fixed interest investment will depreciate, but the interest rate future will

appreciate.

Cash flow hedges are aimed to meet specific cash flow requirements. For instance, the

company mentioned earlier that has a USD100mn borrowing may execute a currency swap to

receive USD from a swap counter party, against Rupees. On each debt servicing date, it will

receive USD from the swap counter party and pay its lender.

So long as the hedge and the hedged instrument are both valued based on MTM, the profit

in one will compensate (fully or partly) for loss in the other. Suppose that only the hedge is

valued at MTM, while the hedged instrument is valued on a conservative basis at cost or MTM,

whichever is lower. In that case, if interest rates were to go up, loss in the investment will

be compensated by gain in the hedge. However, if interest rates were to go down, gain in

the investment will not be recognised (on account of conservatism), but loss in the hedge will

have to be provided for. Thus, profits will be hit on account of the hedge.

There are conditions to fulfil before a hedge can be accounted as a hedge. Further, hedges are

rarely perfect. For instance, a lender may have a liability based on 1-year government yield

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while the hedging interest rate swap may be based on 3-year government yield. Since 1-year

and 3-year yield will not go up or down to the same extent, a basis risk remains.

Treasury manager has to be mindful of such issues.

6.5 Investment types

Broadly, accounting policy differentiates between financial assets as follows:

• Held to Maturity (HTM): These are not meant for sale. MTM may not be accounted in

such investments.

• Held for Trading (HFT): Since the objective is trading, MTM is to be accounted.

• Available for Sale (AFS): These might be investments, originally classified as HTM, but

on account of a change in policy, the company may consider selling them.

Regulaters do prescribe percentages of assets which are permitted to be treated as HTM and

AFS. There are also conditions to fulfil for such categorisation, and the accounting treatment

that would follow. The treasury manager needs to be abreast with the applicable policy for

the organisation he works for.

Even where MTM is applicable, there are issues. Whether only losses are to be provided, or

even gains need to be recognised, although they are not realised? Should the treatment be at

individual contract level or for all contracts of a particular type or for all contracts together?

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• Which of the following is a mandatory accounting standard?

- as 11 and as 1

- AS 11

- AS 1

- AS 30

• Who brings out accounting standards?

- MOCI

- RBI

- SEBI

- ICaI

• Which of the following are normally accounted?

- Long term supply contract

- Payment of advance to supplier

- Payment of advance to supplier and receipt of material

- All the above

• Which of the following is / are mostly likely to be marked to market?

- HTM

- HFT

- AFS

- HTM and HFT

• Which of the following is aimed at protecting the balance sheet from MTM valuation

risk?

- Cash flow hedge

- Fair value hedge

- Neither cash flow hedge nor fair value hedge

- Guarantees

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Chapter 7 Treasury Management Processes and risk Management in Treasury

7.1 Background

The Workbook has covered a gamut of issues related to treasury management for manufacturing

and non-manufacturing companies. This Chapter covers the nuts and bolts of treasury

management activity. It also considers risk management issues of relevance for treasury

management.

7.2 Domestic Remittances

Domestic and international remittances are a key daily requirement in any company. The

transactions may be with the central or state government (for taxes), suppliers, service

providers, dealers, customers or other offices of the company.

The local bank-based payment system is managed by RBI. Besides the cheque-based physical

system, there are also two systems of electronic payment – Real Time Gross Settlement

(RTGS) and NEFT (National Electronic Funds Transfer). There is also Electronic Clearing

Service (ECS).

• Physical cheque clearing system

This is the traditional system, where cheque is to be deposited in the recipient’s bank

account. The bank will then process the payment through the clearing house. The

process of transferring money from one party to another through cheque is called

‘cheque clearing’. The process has become simpler for cheques marked CTS (Cheque

Truncation Service). Cheques marked ‘CTS 2010’ have become mandatory.

If a local cheque is deposited before the bank’s cut-off time (say 11 am), then the

amount will be credited on the following night (say 10 pm). Cheques deposited after

the cut-off time will be credited on the second night i.e. it takes one extra day to

receive the funds. It can take longer if the drawee bank (the bank that is responsible

for making the payment) is not part of the local clearing house.

Banks offer the facility to their clients to issue cheques that are payable at par across

the country. If the drawer (the person who issues the cheque) does not have the at

par facility, and if the payee (the beneficiary who is entitled to the amount mentioned

in the cheque) does not have an account with a bank in the same local clearing area

as the drawer, then clearing can take longer.

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• RTGS

RTGS ensures real-time transfer of funds during business hours (9.00 hours to 16.30

hours on week days and from 9.00 hours to 14:00 hours on Saturdays). This is the

fastest mode to receive and make payments. The minimum amount to be remitted

through RTGS is Rs. 2 lakh. There is no upper ceiling for RTGS transactions.

Inward transactions are fee. There is a fee on outward transactions, not exceeding Rs.

30 per transaction, for transactions uptoRs. 5 lakh. Fee for transactions higher than

Rs. 5 lakh cannot exceed Rs. 55 per transaction. Service tax is extra.

• NEFT

In the case of NEFT, cheques are processed in hourly batches. There are twelve

settlements from 8 am to 7 pm on week days and six settlements from 8 am to 1 pm

on Saturdays.

There is no limit – either minimum or maximum – on the amount of funds that could

be transferred using NEFT. However, maximum amount per transaction is limited to

Rs.50,000/- for cash-based remittances and remittances to Nepal.

Inward transactions are fee. The fee for outward transactions varies between Rs.

2.50 to Rs. 25 per transaction, depending on the amount transferred. Service tax is

extra.

• ECS

This is for transactions that are repetitive and periodic in nature. It may be for bulk

payment (e.g. dividends, interest, salaries, pensions etc.) [ECS Credit] or bulk collection

(e.g. utility payments, loan repayments, insurance premia, systematic investment in

mutual funds etc.)[ECS Debit].

In the case of ECS Credit, the User who wishes to make payments has to submit details

of the beneficiaries (like name, bank / branch / account number of the beneficiary,

MICR code of the destination bank branch, etc.) and date on which credit is to be made

to the beneficiaries. The information has to be provided in a specified format (called

the input file) through the sponsor bank (the User’s bank) to one of the ECS Centres

where it is registered as a User.

The bank managing the ECS Centre then debits the account of the sponsor bank on

the scheduled settlement day, and credits the accounts of the destination banks, for

onward credit to the accounts of the ultimate beneficiaries with the destination bank

branches.

In the case of ECS Debit, the User has to submit details of the customers (like name,

bank / branch / account number of the customer and MICR code of the destination

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bank branch) and date on which the customer’s account is to be debited. The data has

to be provided in a specified format (called the input file) through its sponsor bank to

the ECS Centre.

The bank managing the ECS Centre then passes on the debits to the destination banks

for onward debit to the customer’s account with the destination bank branch and

credits the sponsor bank's account for onward credit to the User institution.

Destination bank branches have been directed to treat the electronic instructions

received from the ECS Centre on par with the physical cheques and accordingly debit

the customer accounts maintained with them. All the unsuccessful debits are returned

to the sponsor bank through the ECS Centre (for onward return to the User Institution)

within the specified time frame.

There are three broad categories of ECS Schemes – Local ECS, Regional ECS and

National ECS.

Local ECS covers 81 centres / locations across the country. At each of these

ECS centres, the branch coverage is limited to the geographical coverage of the

clearing house, generally covering one city and/or satellite towns and suburbs

adjoining the city.

Regional ECS operates at 9 centres / locations at various parts of the country.

Itcovers all core-banking-enabled branches in a State or group of States.

Although the inter-bank settlement takes place centrally at one location in the

State, the actual customers under the scheme may have their accounts at

various bank branches across the State or group of States.

National ECS is the centralised ECS. It is operated from Mumbai. It covers all

core-banking enabled branches located anywhere in the country. Customers

can be from any branch across the country.

7.3 International Remittances

Society for Worldwide Interbank Financial Telecommunication (SWIFT) facilitates international

remittances. It is a member-owned co-operative that has its head office in Belgium and offices

in major financial centres and developing markets. The organisation enables its customers to

automate and standardise financial transactions, thereby lowering costs, reducing operational

risk and eliminating inefficiencies from their operations.

SWIFT does not hold funds nor does it manage accounts on behalf of customers, nor does

it store financial information on an on-going basis. However, international remittances are

made between members using the SWIFT platform.

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Suppose a remittance is to be made from India to the US. The Indian party will go to its bank,

say, State bank of India (SBI). SBI will have a relationship with a correspondent bank in the

US, say Chase Manhattan. The Indian party will need to give SBI complete information about

the bank account details of the beneficiary to whom the transfer is to be made. The beneficiary

may have a bank account with some other bank, say Bank of America. Accordingly, SBI will

issue a SWIFT transaction to Chase Manhattan for further transfer of funds to the beneficiary’s

account in Bank of America. SWIFT makes it convenient to transfer funds across the world.

From an accounting point of view, SBI will debit the customer and credit an account called

Vostro account. Bank of America will credit the proceeds to its customer and debit an account

called Nostro account. Thus, Vostro accounts capture all the foreign currency transferred out,

and Nostro accounts capture all the foreign currency transferred in.

7.4 liquidity Management

At the minimum, treasury management has to ensure that adequate funds are available

to meet the various organisational needs. This has to be done on a proactive basis. The

following documents become the basis to do this in any company:

• Long Term Plan

The long term plan sets the broad direction of the company for 3 to 10 years. This

is prepared by the Corporate Planning department in most companies; in others,

Corporate Finance prepares it. Treasury is generally part of Corporate Finance.

Even where treasury does not prepare the long term plan, it should get deeply involved

prior to its finalisation. The strategic direction set in the long term plan will determine

the business risks being accepted by the company, and the medium to long-term

funding needs of the company.

Treasury needs to understand the underlying dynamics of the long term plan. What

are the underlying risks in each business that the company plans to enter or expand?

Which risks will get multiplied, and which ones will balance themselves, if the strategy is

executed? At different levels of project success, what will be the cash flow implications?

What are the risks of slippages in project execution and the implications for funding

requirements?

If the strategy is likely to impose unreasonable burden on the balance sheet or expose

the company to serious financing or other risks, then treasury has to bring this to the

attention of the senior management of the company. It can even examine alternatives

in terms of size or sequencing of the long term plans.

Once the long term plan is approved, treasury will have to start making preparations

for arranging the funds and mitigating any risks. This might involve research into

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the countries from where imports will be made, the countries where the goods will be

exported and experiences of others who may have implemented similar plans.

Treasury should encourage the company to review the long term plan annually. An

alternative would be to have an annual rolling long term plan. If neither is possible,

then treasury should independently understand the developments in implementing the

strategy, the likely changes in course and consequential funding implications.

Such a proactive approach will ensure that treasury is seen as a key contributer to the

implementation of strategy in the company.

• Cash flow plan

The cash flow plan takes a shorter term view of the likely financial flows. It is prepared

at various levels of detail for different periods such as daily for a week, weekly for a

month and monthly for a year.

The daily plan is aimed at ensuring that there is enough money in the bank to ensure

cheques are cleared. At the same time, money should not lie idle in the current account,

where no interest is earned.

In many businesses, it is not possible to know precisely, the collections that will be

received in a day. This increases the challenge in liquidity management. Some banks

provide a ‘sweep’ facility, where surplus funds in current account are automatically

transferred into a fixed deposit, so that at least some interest is earned.

The weekly and monthly plans provide a picture of the persistence of surpluses or

deficits. This will determine the medium term financing or investment arrangements

to make.

The regular reporting should include not only the Rupee denominated picture, but

also the surplus / deficit in various foreign currencies and the hedges taken, if any.

Volatile currencies should be particularly monitored. The foreign currency perspective

is especially important for companies that have significant international transactions.

7.5 risk Management in Treasury

Some of the most structured efforts to managing risk have been taken in the banking sector,

through the efforts of Bank for International Settlements. Its Basel Committee on Banking

Supervision has brought out various requirements that have changed the face and back-end

of banking globally.

Risk is inherent in all banking products, activities, processes and systems, and the effective

management of risk is paramount. This determines the effectiveness of the board and senior

management in administering its portfolio of products, activities, processes, and systems.

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Risk management generally encompasses the process of identifying risks, measuring exposures

to those risks (where possible), ensuring that an effective capital planning and monitoring

programme is in place, monitoring risk exposures and corresponding capital needs on an

ongoing basis, taking steps to control or mitigate risk exposures and reporting to senior

management and the board on the bank’s risk exposures and capital positions.

Internal controls are typically embedded in day-to-day business and are designed to ensure,

to the extent possible, that the activities are efficient and effective, information is reliable,

timely and complete and applicable laws and regulations are complied with.

Common industry practice for sound operational risk governance in banks often relies on

three lines of defence –

• Business line management,

• An independent corporate operational risk management function (CORF), and

• An independent review.

Depending on the nature, size and complexity, and the risk profile of activities, the degree of

formality of how these three lines of defence are implemented will vary. In all cases, however,

the treasury management risk governance function should be fully integrated into the overall

risk management governance structure of the organisation.

The degree of independence of the CORF will differ among banks.

• For small banks, independence may be achieved through separation of duties and

independent review of processes and functions.

• In larger banks, the CORF will have a reporting structure independent of the risk

generating business lines and will be responsible for the design, maintenance and

ongoing development of the operational risk framework within the bank. This function

may include the operational risk measurement and reporting processes, risk committees

and responsibility for board reporting.

A strong risk culture and good communication among the three lines of defence are important

characteristics of good operational risk governance.

Internal audit coverage should include opining on the overall appropriateness and adequacy

of the Framework and the associated governance processes across the bank.

Internal audit should not simply be testing for compliance with board approved policies and

procedures, but should also be evaluating whether the Framework meets organisational needs

and supervisory expectations. For example, while internal audit should not be setting specific

risk appetite or tolerance, it should review the robustness of the process of how these limits

are set and why and how they are adjusted in response to changing circumstances.

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Against this backdrop on risk management, the following specific aspects ought to be part of

risk management in treasury.

• The philosophy and role of treasury in the organisation should be clearly documented.

There has to be clarify on whether treasury is a service centre or a profit centre.

As service centre, it will operate as a support function and help manage risks that

originate elsewhere in the business. At profit centre, it will need to take risks to

maximise returns.

• Within the overall philosophy, the nature of products that treasury can deal in, and

the limits thereof should be put down in writing. Besides limits in exposure for each

product, stop loss limits can also be set. If stop loss is reached, then treasury will

have to compulsorily close the position without waiting for any further instructions or

market input.

• The overall limits for treasury ought to be distilled further, to limits for people in the

treasury department. The treasury head can set the limits for his team.

• There has to be a mechanism of immediately capturing in the system, all trades that

are executed by treasury. Beyond a prescribed value, the trades should be reported

to higher authorities immediately or end of day.

• Depending on size of operations, the classical split of activities between front office,

middle office and back office can be implemented.

The front office is the market interface for executing trade. Dealers are part of

the front office.

Middle office is an important link between front office and back office. It helps

the former execute orders; helps the latter settle the transactions and account

for the same.

The system checks to ensure that adequate limits are available, before trading

are a middle office responsibility. It also handles risk management especially

credit and market risks of theorganisation

Middle office does various validations. For instance, dealers may trade based on

their own models. Middle office will have its own scientific models for valuation

and profit booking.

Some institutional investors, such as Foreign Institutional Investors (FIIs)

appoint custodians for their investments. When trades are done on behalf of

such institutional investors, the custodian has to confirm in the system that it

will settle the transaction. Accordingly, the settlement obligation goes to the

custodian. This again is a back-office function.

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Risk managers, surveillance staff and financial modellers are part of the middle

office.

Back office handles clearing, settlement and accounting. It may also handle

control over operational risks.

Such a split in roles is the hallmark of an effective internal checks and controls.

• The regular reporting formats and frequency should be clearly laid down. Reporting

should include instances where limits were exceeded, irrespective of whether the

position ended in a profit or loss. Similarly, instances of frauds, or cases where standard

processes were not followed should be reported.

• Compensation structures of employees also influence the risks taken. The typical

compensation structure is asymmetric i.e. employee earns a bonus in a good year,

but does not bear the losses in a bad year. This kind of structure can push employees

to take high risks, because he gets the benefits of an upside without any risk of a

downside. Therefore, thought leaders suggest that bonuses should not be excessive.

Further, there has to be a mechanism to ‘claw back’ past bonuses, if subsequently the

profits turn to losses.

Markets are dynamic. Accordingly, treasury management keeps facing newer challenges.

It is to be ensured that the treasury is abreast of changing dynamics of the economy and

markets. Further, the treasury systems and processes should ensure that treasury is able to

act quickly in response to market changes, without compromising on the risk management.

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• Which of the following forms of transfer from a buyer to seller is fastest?

- Physical cheque

- NEFT

- rTgs

- SWIFT

• Which of the following is true of SWIFT?

- Leading global bank

- Platform for international money transfers

- Lender of last resort

- Head office in Switzerland

• Since long term plans are prepared by corporate planning department, treasury

manager has no role.

- True

- False

• Treasury in companies are profit centres.

- True

- False

• Dealers are part of

- Front office

- Middle office

- Back office

- None of the above

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References

Bank for International Settlements (www.bis.org)

Crisil (www.crisil.com)

Global Association of Risk Professionals (www.garp.org)

Jayanth Rama Varma, “Derivatives and Risk Management”, Tata McGraw Hill

John C Hull, “Options, Futures & Other Derivatives”, Prentice-Hall Inc.Robert Cooper (2004),

“Corporate Treasury and Cash Management”, Palgrave Macmillan

Reserve Bank of India, “Master Circular on Prudential Guidelines on Capital Adequacy and

Market Discipline–New Capital Adequacy Framework (NCAF)”, July 1, 2013 www.rbi.org.in

Robert Cooper (2004), “Corporate Treasury and Cash Management”, palgrave Macmillan

Robert Hudson, Alan Colley and Mark Largan (1998), “Treasury Management”, CIB

Publishing

Satyajit Das, “Swaps & Financial Derivatives”, IFR Books

SundarSankaran (2012), “Wealth Engine: Indian Financial Planning & Wealth Management”,

Vision Books

NCFM - NSE's Certification In Financial Markets

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