CAIIB BFM Module C - Treasury Risk Management

Chapter 4 – Treasury Risk Management

Management of Treasury Risk

Following steps can be taken for management of treasury risk

Organisational Controls

Front Office

The front office generates deals with counter-party banks. Treasury may enter into currency dealing either on its own (trading books) or on behalf of clients (merchant book) or for bank’s internal requirement.

Front office is headed by chief dealer, assisted by other dealers in foreign exchange, securities market and money market. Larger banks may have dealer specializing in specific activities such as corporate dealers, cross-currency dealers, equity traders etc.

Back Office

The Back Office settles the deals only after verification of compliance with internal regulations. It obtains independent confirmation of each deal from each counterparty and settles the deal within the exposure limits. The verification of rates & prices is done by comparing to screen based information about rates.

Mid Office

Middle Office that is responsible for overall risk management. It maintains profile of treasury and monitors the liquidity and interest rate risk

Internal Controls

Limits on Deal Size

The limit fixes the maximum value of the buy or sell transaction and corresponds to the marketable size of the transactions.

Limits on Open Position

The limits are also fixed on open positions

Stop Loss Limit

It represents the final stage of the controlling a trading operation if adverse position emerges (for example, the rates are declining while the bank had purchased the forex at a higher rate). The stop loss limits prevent the dealer from waiting indefinitely and limits the loss level which is acceptable to the management. The loss limits are prescribed per deal, per day, per month and aggregate loss limit per year.

Exposure Ceiling Limits

These limits are fixed for protecting the bank from credit risk (default and counterparty risk) that arises in treasury operations when the Treasury lends in money market to other banks. Though .the risk in lend in to other banks is low but it is not zero. Ceilings are also prescribed on inter-bank liabilities by RBI.

The counter-party risk arises due to failure of the counterparty (another bank) to deliver the securities or complete the settlement. The counterparty risk can be bankruptcy or inability of the counterparty for any reason to complete the transaction. By fixing the limits on inter-bank exposure and limits on counterparties, the banks are able to limit their losses. The ceilings can be with reference to time duration also say for overnight, I month, 3 months etc_ The ceilings are reviewed at least once in a year, by the banks.

Market Risk and Credit Risk

Credit risk arises on account of default by the counter-party in which the bank may lose the principal and interest.

Market risk arises on account of movements in the price of the security, interest rates or exchange rates in such a way

The three main components of market risk are liquidity risk, interest rate risk and currency risk

Liquidity risk : This risk arises on account of mismatch that the Treasury could not cover. For example, Treasury purchases a 1-year Govt. security by borrowing in the call market, with a view to sell the security next day when there is increase in its value. If on the 214 day the value declines, the bank will face a liquidity position. To manage liquidity risk, the Treasury need to have a contingency plan.

Interest rate risk : This risk exists in a transaction where there is mismatch. In the above example, to square the call money transaction of the previous day, the Treasury have to borrow from alternate sources and pay interest. The total interest cost in this manner may be higher than the profits anticipated from the sale of Govt. security.

Currency risk : Currency risk or exchange rate risk is also a manipulation of interest rate risk. Interest rates are influenced by factors like domestic money supply, rate of inflation, activity in debt and equity market etc. which also influence exchange rates. However exchange rates are influenced more by external trade, global interest rates and capital flows. As globalization progress, exchange rates and interest rates are increasingly influenced by similar factors, most prominent being GDP growth rate, global interest rates and capital flows.

Risk Measures : VaR & Duration

The uncertainty associated with the price movement of securities or foreign exchange (which cannot be predicted accurately), exposes the Treasury to Price Risk. To have some idea of the inherent risks and their effect on the position maintained by the Treasury, VaR and duration can be used.

Value at Risk (VaR)

VaR is used to make assessment of possible loss or the worst case scenario, during the period, when a position in securities or forex is held by the Treasury. Hence, VaR refers to the most probable loss that the Treasury may incur in normal market conditions due to volatility of exchange rates, commodity prices or security prices, over a given period, at a given confidence level. It is expressed as a %age (say VaR at 98% confidence level, means a 2% probability of incurring loss). The loss is expressed in absolute amount for a given transaction value.

For example if there is confidence level of 95% (which means a VaR of 5%) for 30 days period, the rupee is likely to lose 5p in exchange value within 30 days, with 5% probability. Hence rupee is likely to depreciate maximum Sp on 1.5 days of the period (30 days x 5% = 1.5 days ). Similarly, a VaR of Rs.l lac at 99% confidence level for one week, for a portfolio of Rs.100 lac means, that the value of the portfolio may drop by maximum Rs.1 lac with 1% probability over one week.

Calculation of VaR : It is derived from the statistical formula that are based on volatility of the market. Volatility is the standard deviation from the mean observed over a period. There are 3 approaches to calculate VaR. i.e.

(a) Parametric approach which is based on sensitivity of various risk components (price of the a particular stock depends on its sensitivity to index change).

(b) Monte Carlo Model, where the no. of scenario are generated at random and their impact on the variable (stock price or exchange rate) is observed.

Duration

It is used in all asset and liability positions where interest rate risk is prevalent Duration is weighted average measure of life of a bond, where the time of receipt of a cash flow is weighted by the present value of the cash flow.

Duration is expressed in no. of years. For a longer duration, the sensitivity of price change is greater to change in interest rate.

Example : If the first cash flow (receipt of interest on bond) is after 6 months from date of investment, the period of 6 months is multiplied by the present value of the cash flow. If the 2′ cash flow is after 12 months, it is multiplied by the present value of the cash flow. In this way, all the present value of all future cash flows is multiplied with the period of receipt of cash flows. The aggregate of these is divided by the total of weights, to work out the Duration. This is based on the formula given by Frederick Mecaulay and is called Mecaulay Duration.

Modified duration : It is arrived by dividing the duration with the interest rate (which is actually the principal + interest for 1 year expressed at Y+1, where the Y is yield). If the duration of bond yielding 5% is 2.5%, the MD = 2.5 / (1+0.5) or 1.66.

Any change in the yield multiplied by MD will give the likely percentage change in the price of the bond.

If the yield rises by 1%, the change in price of the above bond will be 1.66% ( 1.66 x 1%). The increase in yield of 1% give cause decline in price of bond by 1.66%, because the yield and price have inverse relationship.

YTM : To understand duration better, the understanding of the concept of Yield to Maturity (YTM) is essential. For example, the current price of a bond may be different from its face value and the value at which the bond was originally purchased, (due to current interest rate which is expected during the residual maturity of the bond). Hence, the current price of bond, there may be premium (if the current interest rates are lower than the coupon rate) or discount (if the current interest rates are higher than the coupon), to face value.

YTM The effective return on a bond (based on coupon rate, current market price and residual maturity) is called Yield. It should be noted that the yield is different from interest rate, which is a fixed amount. Yield depends upon the amount of investment made in the bond, its residual period and its coupon rate. The rate at which the present value of a bowl equals the market price of the bond, is called YTM. The yield and price of bond, move in opposite direction, i.e. if yield rises, the price of the bond declines.

YTM can be calculated from bond tables or bond calculator. For example a bond carrying 5% coupon with balance maturity of 2 years is traded at a discount of 2% i.e. at Rs.98. Interest at 5% on a price of Rs.98 will work out to 5.1% which turns out to be YTM of 6.08%