A PROJECT REPORT

ON

“DOMESTIC TREASURY OPERATIONS AND RISKS INVOLVED”

FOR

BANK OF MAHARASHTRA

BY

SHARMILA A. CHOUDHARY

MBA-II

2007-2009

UNDER THE GUIDANCE OF

Dr .SHARAD JOSHI

Submitted To

UNIVERSITY OF PUNE

In partial fulfillment of the requirement for the award of the degree of

Master of Business Administration (MBA)

Through

Vishwakarma Institute of Management

PUNE – 48

1

ACKNOWLEDGMENT

It’s a great privilege that I have done my project in such a well-organized and

diversified organization. I am great full to all those who helped and supported me in

completing the project.

I express my gratitude to Mr. SANJAY ARYA (D.G.M.), who gave me this

opportunity to undergo summer training at Bank of Maharashtra. He has been a great

mentor and supplemented my study with requisite sources and inputs. He has been a

constant source of knowledge, information, help and motivation for me. The project

has been a great experience and I am indebt to Ms. INDRAYANI DEEKSHIT

(A.G.M) and Mr. ABHAY SHAHAPURKAR (CHIEF MANAGER) for their time

and efforts. I am also thankful to all the officials who helped me during the training.

I am thankful to our director and my project guide Dr. SHARAD JOSHI for helping

me in completing the project.

Last but not least, I am also thankful to all college staff and my friends for helping me

directly or indirectly in my project.

2

TABLE OF CONTENTS

Sr. No. Topic Page No.

1 Executive summary 1

2 Company Profile 3

3 Objective of Project 7

4 Research Methodology 9

5

Data Presentation

Introduction to treasury

Working of a Treasury department

Domestic Treasury products

11

6Data Analysis & Findings

Risk Management 44

7 Conclusion of the study 60

8 Suggestion & Recommendation 62

9 Limitation 65

10 Bibliography 67

3

CHAPTER 1

EXECUTIVE SUMMARY

1

EXECUTIVE SUMMARY

Efficient funds management, sail an organization or an

economy for that matter, through even the toughest times.

It is regarded as one of the most crucial functions.

Banking industry is a backbone of economy in every

country. It is banks, through which government can steer

the monetary stability and long-term sustainability within

the geographical boundaries. Banks deal purely in money.

The industry holds the cash for the investors and lends it

in turn. Thus, cash (or funds) management becomes vital

function at the banks.

Apart from meeting various statutory reserve

requirements, a treasury department explores various other

investment options both in the domestic and international

forays.

Risk can be defined as “Possibility of suffering losses”.

“The chance of something happening that will have an

impact upon objectives. It is measured in terms of

consequences and likelihood”.

2

3

CHAPTER 2

COMPANY PROFILE

4

PROFILE OF THE ORGANIZTAION

Profile of Bank of Maharashtra

The Birth

Registered on 16th Sept 1935 with an authorized capital of

Rs 10.00 lakh and commenced business on 8th Feb 1936.

The Childhood

Known as a common man's bank since inception, its initial

help to small units has given birth to many of today's

industrial houses. After nationalization in 1969, the bank

expanded rapidly. It now has 1375 branches (as of 31st

March 2008) all over India. The Bank has the largest

network of branches by any Public sector bank in the state

of Maharashtra.

The Adult

The bank has fine tuned its services to cater to the needs of

the common man and incorporated the latest technology in

banking offering a variety of services.

Our Philosophy

Technology with personal touch.

Our Emblem

The 3 M's

Symbolizing

Mobilization of Money

5

Modernization of Methods and

Motivation of Staff.

Our Aims

Bank wishes to cater to all types of needs of the entire

family, in the whole country. Its dream is "One Family,

One Bank, Bank of Maharashtra ".

The Autonomy

The Bank attained autonomous status in 1998. It helps in

giving more and more services with simplified procedures

without intervention of Government.

Our Social Aspect

The bank excels in Social Banking, overlooking the profit

aspect; it has a good share of Priority sector lending

having 38% of its branches in rural areas.

Other Attributes

Bank is the convener of State level Bankers committee.

Bank offers Depository services and Demat facilities at

131 branches.

Bank has a tie up with LIC of India and United India

Insurance Company for sale of Insurance policies. All the

branches of the Bank are fully computerized.

Bank of Maharashtra – Important Landmarks

6

1935 - Registered on 16th Sept.

1958 – Bank’s shares listed on Bombay Stock Exchange.

1960 – License to deal in all foreign currencies.

1969 – Nationalised on 19th July.

1975 – Tax consultancy cell launched.

2002 – Record profit rose by 222% amounting to

Rs.145.41cr.

Following chart depicts the review of

performance in the past 3 financial years.

Parameter Mar-06 Mar-07 Mar-08

(Rupees in Crores)

Total Deposits 26906.2 33919.3 41758.3

Aggregate Deposits 26527.4 33663.2 41580.4

Gross Advances 17079.8 23462.3 29798

Net Bank Credit 16872 23220.9 23462.3

CD ratio 64.39 69.7 71.66

% of Priority Sector Adv. to Net Bank

Credit 42.71% 41.24 48.63

% of Agricultural Adv. To Net Bank

Credit 16.3 16.73 21.04

Total Investments 11354.3 11298.4 12283

Gross NPAs 944.08 820.28 766.27

% to Gross Advances 5.53 3.5 2.57

Net NPAs 334.06 277.38 254.05

% to Net Advances 2.03 21.21 0.87

Operating Profit 364.07 613.2 672.63

Net Profit 50.79 271.84 328.39

Other Income 177.24 265.05 280.17

Capital Adequacy Ratio 11.27 12.06 10.75

7

Per Employee Business ( in lacs ) 306.18 413.03 526.54

No. of Branches 1300 1345 1375

Of which Metro 248 264 351

Urban 269 290 257

Semi Urban 197 202 251

Rural 586 589 516

8

CHAPTER 3

OBJECTIVES OF THE

PROJECT

9

OBJECTIVES OF THE PROJECT

Introduction of Treasury Department.

To comprehend Various Functions of a Treasury

Department.

To study the operations of Treasury Department.

To examine the scope of the Dealing (Various

Domestic Treasury Instruments).

To identify the Potential Risks Involved At

Various Stages of Operations.

To manage and reduce the identified risks.

10

CHAPTER 4

RESEARCH

METHODOLOGY

11

RESEARCH METHODOLOGY

The report is prepared with better understanding of the

Bank’s Treasury- DOMESTIC segment and its settlement

process. This was possible as I received training from

trained and specialized dealers in the dealing room as well

as the officers in the Back Office and Mid office.

When I decided the topic for the project there were many

questions that came to my mind, which are as follows:

What is treasury?

What are the functions of treasury?

Why does treasury play such an important role?

What are the various risk involved and how can they be

minimized?

Based on the questions I made the rough framework of the

project and decided to approach the officers of the bank.

I have also read the Investment policy, Treasury manual,

circulars, documents and visited various websites to

enhance my knowledge. I have included what I have seen

and learnt during my training period in my project.

12

Report will focus on the Domestic Treasury products and

also on the Risks Involved at Various Stages of

Operations.

CHAPTER 5

DATA PRESENTATION

13

DATA PRESENTATION

TREASURY OPERATIONS -

INTRODUCTION

Idle funds are usually source of loss, real or opportune,

and, thereby need to be managed, invested, and deployed

with intent to improve profitability. There is no profit or

reward without attendant risk. Thus treasury operations

seek to maximize profit and earning by investing available

funds at an acceptable level of risks.

Money is one of the essential driving forces of any

business. In order to employ and deploy these monetary

resources effectively and efficiently, not only banks but

also the corporate entities have realized the need for a

specialized department to look after these operations.

That’s how the treasury department has gained the

importance in recent times.

In the further parts of this project, we will have an

inclusive look at the treasury operations in a bank.

Treasury forms a vital part of any commercial bank’s

activities. It is the window through which the Bank raises

funds from or places funds in either financial or interbank

markets. The treasury unit acts as the custodian of cash

and other liquid assets. Apart from employment and

14

deployment of funds, the department also has to take care

of the liquidity i.e. managing the availability of the

monetary resources whenever they are required. The art of

managing, within the acceptable level of risk, the

consolidated fund of the bank optimally and profitably is

called treasury management.

Traditionally, in banks in India, the role of Treasury was

limited to ensuring the maintenance of the RBI –

stipulated norms for Cash Reserve Ratio (CRR) – which

mandates that a minimum proportion of defined liabilities

must be kept on deposit with the central bank – and the

Statutory Liquidity Ratio (SLR), which obliges banks to

invest a specified percentage of their liabilities in notified

securities issued by the Government of India and State

Governments or guaranteed by them.

RBI- The central bank of India, uses the instruments like

CRR and SLR along with some others viz. repos (and

reverse repos), open market options, etc. to manage the

liquidity in the economy.

Activity in foreign exchange was confined to meeting

merchants’ requirements for imports and exports and

customers’ deposits. The rupee’s exchange rate has

become volatile. There is sufficient fluctuation both

15

intraday and interday to earn trading profits on buying and

selling the currency. The forward market in India is

another potential source of profits as, more or often than

not, it deviates from interest parity conditions (which state

that forwards will differ from spot rates exactly to the

extent of the interest differential). Cross–currency

(dollar/yen, sterling/dollar, dollar/Swiss franc) trading

opportunities are, of course, older and have come to life in

Indian banks after liberalization.

Traditionally the banks used to accept the deposits and

lend the money keeping the margin (interest rates) in

between. After meeting the mandatory deposit

requirements (SLR & CRR), the surplus money demands

an efficient and effective employment. Thus, banks lately

have started exploring various options like investment in

the capital, bond markets, foreign exchange, etc. in order

to get the returns on it.

An active Treasury also ‘arbitrages’ (earns profits without

risk) by borrowing cheap and investing high in money and

bond markets. New products, such as derivatives, enable

spotting and capitalizing on such opportunities. Another

key function of Treasury is asset-liability management and

hedging (i.e., insulating) the Bank’s balance sheet from

interest and exchange rate fluctuations. This involves

reordering the maturity and interest rate pattern of assets

16

and liabilities, either through direct portfolio actions or

derivatives (e.g., swaps and futures) to reduce, minimize

or eliminate the risks arising from mismatches between the

two sides of the balance .

ROLE OF TREASURY

OPERATIONS OF TREASURY:

Reserve Management & Investment:

It involves:

17

Integrated role

Merchant dealing

Independent FX role

Corporate FX trading

Proprietary trading

Derivatives (non-INR) dealing

Overseas Borrowings /Investment

ALM & Term money

Equities trading

Securities trading

SLR / Non-SLR investments

Liquidity & CRR and SLR Mgt

Funds Mgt

Independent Investment/Treasury

Derivatives INR dealing

FCNR Swap Mgt

Arbitrage

Meeting CRR/ SLR obligations

Having an appropriate mix of investment portfolio

to optimize yield and duration.

Duration is the weighted average 'life' of a debt

instrument over which investment in that

instrument is recouped. Duration analysis is used

as a tool to monitor the price sensitivity of an

investment instrument to interest rate changes.

Liquidity & Funds Management:

It involves:

Analysis of major cash flows arising out of asset-

liability transactions

Providing a balanced and well-diversified liability

base to fund the various assets in the balance sheet

of the bank

Providing policy inputs to strategic planning group

of the bank on funding mix (currency, tenor &

cost) and yield expected in credit and investment.

Asset Liability Management & Term

Money:

ALM calls for determining the optimal size and

growth rate of the balance sheet and also prices the

Assets and Liabilities in accordance with the

prescribed guidelines. Successive reduction in

18

CRR rates and ALM practices by banks increase

the demand for funds for tenor of above 15 days

(Term Money) to match duration of their assets.

Risk Management:

Treasury manages all market risks associated with

a bank's liabilities and assets. The market risk of

liabilities pertains to floating interest rate risk and

assets & liability mismatches. The market risk for

assets can arise from (i) unfavorable change in

interest rates (ii) increasing levels of

disintermediation (iii) securitization of assets (iv)

emergence of credit derivatives etc. While the credit

risk assessment continues to rest with Credit

Department, the Treasury would monitor the cash

inflow impact from changes in asset prices due to

interest rate changes by adhering to prudential

exposure limits.

Transfer pricing:

Treasury is to ensure that the funds of the bank are

deployed optimally, without sacrificing yield or

liquidity. Treasury unit has an idea of the bank's

overall funding needs as well as direct access to

various markets (like money market, capital

market, forex market, credit market). Hence,

ideally treasury should provide benchmark rates,

19

after assuming market risk, to various business

groups and product categories about the correct

business strategy to adopt.

Derivative Products:

Treasury can develop interest rate swaps and other

rupee based/ cross-currency derivative products for

hedging bank's own exposures and also sell such

products to customers/ other banks.

Capital Adequacy:

This function focuses on quality of assets, with

Return on Assets (RoA) being a key criterion for

measuring the efficiency of deployed funds.

SOURCES OF PROFITS OF

TREASURY:

Investments: where the Bank earns a higher yield than its

cost of funds. An example is buying a corporate bond

maturing in three years and yielding 7%, financed by

deposits of the same maturity costing 6%.

20

The investments made by the treasury department can be

categorized as follows:

Spreads: Spreads between yields on money market

assets and money market funding. The Bank may, for

instance, borrow short-term for 5% and deploy in

commercial paper returning 6%.

Arbitrage: A classic example is a buy/sell swap in

the forex market, where the Bank converts its rupee

funds to a dollar deposit, earns LIBOR and gets back

to rupee on deposit maturity. This generates a risk –

free profit (“arbitrage”), if LIBOR plus the forward

premium on dollar/rupee is more than the domestic

interest rate.

Relative Value: This is a form of arbitrage in which

the Bank exploits anomalies in market prices. The

Bank may have an ‘AAA’ bond, which yields only

21

INVESTMENTS

Held Till Maturity

Held For Trade Available For Sale

6%, compared to another with the same rating and

maturity, but of a different issuer, which offers 6.5%.

It is worth selling the first bond and investing in the

second to improve the yield by 0.5% without any

incremental risk, as both bonds have the same credit

quality.

Proprietary Trading: The focus of proprietary

trading is entirely short-term, as opposed to

investment. The aim is to earn trading profits from

interday (or even intraday) movements in security and

forex prices. They are mostly directional trades.

Treasury may buy (say) 9.81% Government of India

security 2013 at Rs.129.50 at a yield of 5.89% in

anticipation of the yield falling to 5.80%, on

fundamental (or technical) grounds. If this happens,

the bond appreciates and the Bank exits the position

with a profit.

Forex trading: is also directional, involving, for

example, buying dollar/yen in the expectation that the

dollar will appreciate or selling euro/dollar hoping that

the euro will decline.

Customer Services: Bank Treasuries offer their

products and services to (generally) non-bank

22

customers. The income to banks in these activities

comprises fees for and / or margins on trade execution.

Profits would be higher on structured (i.e., non-

standard) transactions compared to plain vanilla (e.g.,

a straightforward buy/sell USD/INR) deals.

Treasuries are also involved in Investment Banking

where their responsibility covers trade execution on behalf

of the Bank’s clients in the cash or derivatives markets.

These may generate good margins, depending on the

complexity and skills required to design and put through

customized structures in the market.

Integrated Treasury Operations

Broadly, Treasury department deals into to verticals viz.

domestic and forex (i.e. Foreign Exchange). Traditionally,

the forex dealing room of a bank managed the foreign

exchange dealings mainly arising out of merchant

transactions (FX buying from & selling to customers) and

consequent cover operations in inter-bank market. The

domestic treasury/ investment operations were

independent of forex dealings of a bank. Treasury

operations were treated as cost centre, specifically devoted

to reserve management (CRR & SLR) and consequent

fund management. Treasury also undertook investment in

both government and non-government securities.

23

The need for integration of forex dealings and domestic

treasury operations has arisen in the backdrop of interest

rate deregulations, liberalization of Exchange Control,

development of forex market, introduction of derivative

products and technological advancement in settlement

systems and dealing environment. The integrated treasury

performs not only the traditional roles of forex dealing

room and treasury unit but also many other functions as

described above. Apart from that, an integrated treasury is

a major profit centre. It has its own P&L measurement.

TREASURY DEPARTMENT SET-UP AT

BANK OF MAHARASHTRA

The Treasury Division has a clear cut demarcation

between Front office, Mid office and Back Office

functions.

The Front Office shall undertake actual Treasury

operations while the Back Office shall undertake all

accounting and related operations in terms of the

guidelines issued in the Investment Management Policy.

The Mid Office shall track the magnitude of market risk

on a real time basis and shall not be involved in the day to

24

day management of Treasury. The Mid Office shall report

to ALCO/Treasury about adherence to various prudential

and risk parameters and provide an aggregate of the total

market risk exposures assumed by the Bank.

The dealing rooms either of domestic treasury fall under

front office. Dealers in the dealing room are responsible to

undertake and execute the investment decisions. There are

proper guidelines and the norms laid down to govern the

dealings in both domestic treasury.

Domestic dealing room has to take the decisions regarding

right mix of the instruments available for investment in

domestic market. Banks put more emphasis on the ‘fixed

interest bearing securities’. Some of these securities are

classified as ‘SLR Securities’ whereas, some are classified

as ‘NON-SLR Securities’. Possession of SLR Securities

would contribute towards the statutory SLR maintenance.

There are also some other factors that are being taken into

consideration even while investing into the Fixed Interest

Securities. The rate of the interest, duration of maturity,

current market scenario, credit rating of the instrument,

etc. needs to be looked into.

Before concluding any deal the Dealer has to ensure the

following:

25

He holds the sanction from the competent

authority.

The security to be purchased/ sold should not be

under shut period

There is sufficient stock of the security/securities to be

sold and ensure that the existing balance at the time of

deal is mentioned in the deal slip. The dealer will ensure

that at no point of time there will be oversold position in

any security. However, in terms of RBI, Banks successful

in the auction of Govt. Securities, may enter into contracts

for sale of the allotted securities, on the day of auction, in

accordance with the following terms and conditions:

The contract for sale can be entered into only once

by the allot-tee bank on the basis of an

authenticated allotment advice issued by RBI. The

selling bank should make suitable noting /

stamping on the allotment advice indicating the

sale contract number etc., the details of which

should be intimated to the buying entity. The

buying entity should not enter into a contract to

further resell the securities until it actually holds

the securities in its investment account.

The contract for sale of allotted securities can be

entered into by banks with and between entities

maintaining SGL Account / CSGL Account with

RBI for delivery and settlement on the next

26

working day through the Delivery versus Payment

(DVP) System.

The face value of securities sold should not exceed

the face value of securities indicated in the

allotment advice.

The sale deal should be entered into directly

without the involvement of brokers.

Separate record of such sale deals should be

maintained containing details such as number and

date of allotment advice, description and the face

value of securities allotted, the purchase

consideration, the number, date of delivery and

face value of securities sold, sale consideration, the

date and details of actual delivery i.e. SGL Form

No., etc. This record should be made available to

RBI for verification. Bank should immediately

report any cases of failure to maintain such

records.

Such type of sale transactions of Govt. securities

allotted in the auctions for primary issues on the

same day and based on authenticated allotment

advice should be subjected to concurrent audit and

the relative audit report should be placed before the

Investment Committee / Chairman & Managing

Director once every month. A copy thereof should

27

also be sent to DBOD (Department of Banking

Operations and Development), RBI Mumbai.

Banks will be solely responsible for any failure of

the contracts due to the securities not being credit

to their SGL A/c on account of non-payment /

bouncing of cheque etc.

RBI has now permitted sale of a government

security already contracted for purchase, provided:

The purchase contract is confirmed prior to the

sale

The purchase contract is guaranteed by CCIL

or the security is contracted for purchase from

the Reserve Bank

RBI has advised to adopt a standardized settlement

on T+1 basis of all outright secondary market transactions

in Government Securities effective May 24, 2005.

Standardizing the settlement period to T+1 would provide

participants more processing time for transactions and

hence will help better funds management as well as risk

management. In the case of Repo transactions in

28

Government Securities, however, market participants will

have the choice of settling the first leg on either ‘T+0’

basis or ‘T+1’ basis, as per their requirements.

So far as purchase of securities from the Reserve Bank

through Open Market Operations (OMO) is concerned, no

sale transactions should be contracted prior to receiving

the confirmation of the deal/advice of allotment from the

Reserve Bank.

Ready forward (Repo) transactions in government

securities, which are settled under the guaranteed

settlement mechanism of CCIL, may be rolled over,

provided the security prices and Repo interest rate are

renegotiated on roll over.

All the deals should be concluded by the dealer on

receipt of relative sanction (sanction may be on

telephone or oral to be confirmed in writing

subsequently) based on delegated authority. In any

deal or transactions, the dealer may negotiate the

terms of sanction with the counter party/broker for

better advantage to the bank and the same may be

subsequently reported to the respective sanctioning

authority for information.

The deals should as far as possible be done through

approved brokers on our panel subject to 5% limit

per broker on the basis of yearly business through

brokers(both purchase and sales) as per R.B.I

29

guidelines. Where the limit of 5% is required to be

exceeded because of a more advantageous offer,

the matter should be reported to Board for

ratification. The existing panel is to be used for

capital market purposes also.

The brokerage is to be paid as per Stock

Exchange/s guidelines. The brokerage on the deal

payable to the broker, if any, (if the deal was put

through with the help of a broker) should be

clearly indicated on the notes/ memoranda put up

to the top management seeking approval for

putting through the transaction and a separate

account of brokerage paid, broker-wise, should be

maintained.

The deal should be settled through BSE/NSE,

OTCEI or any other recognized stock Exchange as

per rules.

For any transaction/deals done by trading desk, the

respective dealer should prepare a deal slip

containing all the relevant information. The deal

slip should contain nature of deal, name of counter

party, direct deal or through broker, name of

broker, details of security, amount, price, YTM,

contract date, time, terms of payment, name of the

Stock Exchange, etc. Every deal slip should be

serially numbered and controlled separately to

30

ensure that each deal slip has been properly

accounted for.

Once the deal is concluded, the broker and the

counter party bank should not be substituted. Like

wise the security sold/purchased in the deal should

not be substituted by another security. The dealer

should immediately pass on the deal slip to the

Back Office for processing.

ROLE OF CLEARING CORPORATION OF

INDIA Ltd (CCIL)

The Clearing Corporation of India Ltd. (CCIL) was set

up in April, 2001 for providing exclusive clearing and

settlement for transactions in Money, Govt. Securities and

Foreign Exchange. The prime objective has been to

improve efficiency in the transaction settlement process,

insulate the financial system from shocks emanating from

operations related issues, and to undertake other related

activities that would help to broaden and deepen the

31

money, debt and forex markets in the country. The

company commenced operations on February 15, 2002

when the Negotiated Dealing System (NDS) of RBI went

live. CCIL started providing the settlement of forex

transactions since November 2002. CCIL launched the

Collateralized Borrowing and Lending Obligation (CBLO)

in January 2003, a money market product based on Gilts

as collaterals. It has developed a forex trading platform

“FX-CLEAR” which went live on August 7, 2003. CCIL

has started the settlement of cross-currency deals through

the CLS Bank from April 6, 2005. At the request of RBI,

CCIL developed and currently manages the NDS-OM and

NDS-CALL electronic trading platforms for trading in the

government securities and call money.

Excerpts from Investment Policy regarding NON-SLR

Investments:

“In addition to the prudential limits prescribed by the RBI,

the bank will observe following limits/ Sub limits, caps in

respect of Non SLR Investment-

1. The investment in Non-SLR category shall be to

the extent of 25% of the Gross Investments

(excluding Recapitalization Bonds).

2. The investment in Bonds/Debentures under Non

SLR category shall be to the extent of 15% of the

32

Gross Investments. (Excluding Recapitalization

Bonds).

3. The investment in Private Corporate Bonds shall

not exceed 40% of the investment in

Bonds/Debentures.

4. Total holding in AA-Rated Bonds/Debentures

should not exceed 5% of Total Non-SLR.

5. The bank will continue to invest in rated privately

placed issues of Bonds/ Debentures under Non

SLR category.

6. The investment in Bonds guaranteed by central/

state governments issued under Non SLR category

(unsecured) shall not exceed 1/3 of the total

investments in Bonds.

7. The investment under Non SLR category in any

industry will not exceed 3% of gross Investments.

This cap is not applicable to the exposure under

Inter-Bank Deposits.

As per RBI guidelines the aggregate exposure of a bank to

the capital markets in all forms (both fund based and non-

fund based) should not exceed 40 per cent of its net worth

as on March 31 of the previous year.

Within this overall ceiling, the bank’s direct investment in

shares, convertible bonds/ debentures, units of equity-

oriented mutual funds and all exposures to Venture Capital

33

Funds (both registered and unregistered) should not

exceed 20 per cent of its net worth.

Recently the RBI has increased the CRR rates by 75 basis

points in a gradual progression, it has also increased the

REPO rate (the rate at which banks borrows money from

RBI and vice versa for REVERSE-REPO). This led to the

interest rate hike in loans by the leading lending banks like

HDFC. Though it seems that the implications end there

but it has so many micro and macro indirect implications.

If HDFC has increased the lending rate for housing loans,

it will also lead to fall in the revenues of the most interest

rate sensitive industry – Real Estate. So, if someone wants

to invest in DLF (Real Estate), he needs to consider all the

direct and indirect factors concerning the industry as

whole and the company itself.

Real Time Gross Settlement (RTGS) is an

online system for settling transactions of financial

institutions, especially banks. RTGS is a large value funds

transfer system whereby financial intermediaries can settle

inter-bank transfers for their own account as well as for

their customers. The system effects final settlement of

inter-bank funds transfers on a continuous, transaction-

by-transaction basis throughout the processing day.

The statistics of transactions for the month of March 2004

shows that in the inter-bank market transactions involving

34

45000 instruments and aggregating Rs. 179,000 crore

were settled. High value instruments (317,000) settlement

aggregated Rs. 274,000 crore. However, settlement of

MICR instruments (145 lakhs) accounted for only Rs.

54,000 crore. RTGS will eliminate settlement risk in the

case of inter-bank and high value transactions.

The deals are undertaken into the dealing

rooms. The notion of "trading room" (sometimes used as a

synonym of "trading floor") is widely used in financial

markets to refer to the office space where market activities

are concentrated in investment banks or brokerage houses.

Financial trading rooms often consists of open-space large

offices where financial workers (often referred to as

"traders") monitor the markets, develop financial products,

or engage into trading activities with other counterparties

(through the telephone or through electronic interfaces).

Contemporary trading rooms are highly technological

spaces. The different trading or sales desks are equipped

with financial data technologies such as the ones provided

by companies such as Bloomberg or Reuters.

The Mid-Office in TIBD, Bank of Maharashtra

performs under the Risk Management department which is

responsible for identifying and managing the risks

centrally. This department takes into account the whole of

the banks’ operations. The duty of the mid office is to look

after the compliance and control matters. It reports to the

35

Risk Management department and not the DGM at TIBD.

This reporting matrix ensures the non prevalence of the

collective malpractices. As mentioned earlier, each dealer

is assigned a particular limit within which he’s allowed to

trade. It’s the duty of the mid office executive to look after

whether the dealer is acting in the permissible limits or

not. He also sees to it that the settlement is being made

through proper channels and as per the set norms by both

RBI and Banks policies. He also ensures that the

accounting and record keeping is being done properly and

is reviewed periodically. The dealings usually happen over

the phone. So, to keep the track of these dealings, the calls

are recorded for compliance purposes. If any issue arises

regarding the deal, both the parties to the deal can go back

to these tapes and verify the matter. Mid office has to

make sure that these tapes are preserved for the minimum

period prescribed by norms.

If an executive of mid office happens to come

across any deviation from the set doctrines, he escalates

the matter to the Risk Management department.

Subsequent actions are taken into the matter by the

department. Mid office also does the calculation of the

permissible limits of the risks. On a daily basis it reports

the risk involved in any instrument.

E.g. Value-at risk is calculated in order

to determine what would be the permissible limit of

36

risk that can be allowed, if the decision is to be made

for the investment in a particular instrument.

37

DOMESTIC TREASURY PRODUCTS

The Domestic operations of Treasury can be broadly

classified in to three categories as mentioned below:

Money Market Operations

Debt Market Operations

Capital Market Operation

MONEY MARKET OPERATIONS

The Money market provides an avenue for equilibrating

the short-term lending and borrowing needs of participants

for periods ranging from O/N up to a year. In this process,

it provides a focal point for the RBI to influence the

liquidity in the system and thereby transmit the monetary

policy impulses. The instruments traded in the money

markets are close substitutes for money and are less risky,

marketable and liquid. Money Market operations facilitate

effective management of short-term asset-liability miss-

matches for the bank. It enables the bank to reduce the

cost of liquidity by deploying their short-term surpluses

and thereby maintaining the liquidity position at an

optimum level.

The most commonly traded money market instruments

are as under:

Call/Notice Money: Call/ Notice Money is a liquidity

management tool whereby commercial banks, cooperative

38

banks, primary dealers lend and borrow between

themselves. Non-bank institutions are not permitted in the

call/notice money market. The call/notice money market

forms an important segment of the Indian Money Market.

Under call money market, funds are transacted on

overnight basis and under notice money market funds are

transacted for the period between 2 days and 14 days. The

need arises mostly for covering short-term liquidity

mismatches as well as for covering shortfall in

maintenance of Cash Reserve Ratio (CRR).

Specific Risk Factors

Operational Risk

Empowered authorizations of deals

before settlement activities

commence. Complete, updated

records of counterparty

signatures/powers of attorney of

counterparties should be maintained.

Financial Risk

Credit risk relating to counterparties exists.

Collateralized Borrowing and Lending Obligation

(CBLO) : CBLO is a money market instrument

operationalised by Clearing Corporation of India in

January 2003. It is a discounted instrument with

maturity ranging from 1day up to 1year, backed by

39

collaterals, and redeemable at par. CBLOs are traded

electronically, on-line, on an anonymous order

matching system facilitating price discovery and

transparency. Banks, financial institutions, primary

dealers, mutual funds, NBFCs and corporate can be

members.

What is CBLO?

CBLO is explained as under:

• An obligation by the borrower to return the money

borrowed, at a specified future date;

• An authority to the lender to receive money lent, at a

specified future date with an option/privilege to transfer

the authority to another person for value received;

• An underlying charge on securities held in custody

(with CCIL) for the amount borrowed/lent.

Treasury Bills: These are the instruments of short-term

borrowings of Government issued in the form of

promissory notes at a discount and redeemable at par.

Treasury Bills are liquid and the same are issued by RBI

on behalf of the Government. RBI presently issues

Treasury Bills in three maturities, i.e., 91 days, 182 days

and 364 days. Treasury Bills have a Primary as well as a

Secondary market.

Specific Risk Factors

Documentation Risk

40

Authencity of document and counterparty

signatures / powers of attorney.

Credit Risk

In case of default on a rediscounted bill, the

discounting bank has (ownership) rights to

the underlying bill.

Interest Rate Risk

Price is sensitive to short-term interest rates.

Commercial Paper: Commercial Paper (CP) is a short

term unsecured money market instrument issued at a

discount in the form of a promissory note. CP’s are issued

by reputed companies that carry high credit rating, have a

strong financial background and facilitate borrowing

short-term resources from the market. RBI has made it

mandatory to issue CPs in electronic/ dematerialized form

with effect from 30 June 2001. Corporate, Primary

Dealers, Satellite Dealers and All-India Financial

Institutions that are permitted to raise short-term resources

under the umbrella limit fixed by RBI are eligible to

issue CP and are called the “Issuers”. CP's can be of any

maturity between 15 days to 364 days. CP can be issued in

denominations of Rs.5 lakh or multiples thereof. Amount

invested by single investor should not be less than Rs.5

lakh (face value).

41

Specific Risk Factor

Liquidity Risk

Arises if there is no buyer of the paper before

maturity. May happen if there is a sudden significant

credit downgrade or money market becomes tight.

Interest Rate Risk

If money market rates shoot up, existing CP will

suffer price losses as these are short-term instruments

whose prices are determined by the short-end (up to

one year) portion of the yield curve.

Certificate of Deposit : CDs are securitized, tradable

term deposits issued in demat form or as a Usance

promissory (UP) note. Banks can issue CDs with a

minimum maturity of 7days to 1yr, whereas FIs can issue

for periods not less than 1year and not exceeding 3 years.

CDs are issued in denominations size of Rs.1lakh or

multiples thereof. This instrument provides an avenue for

investments at better rate of interest. Moreover, the CD

market is very liquid and provides ample opportunities for

trading. CDs can be issued to individuals, corporations,

companies, trusts, funds, associations.

Specific Risk Factors

Credit Risk

42

CD issues are sometimes rated by credit rating

agencies. Otherwise, one has to go on image,

reputation and financials of issuing bank or FI.

Liquidity Risk

Liquidity suffers on credit/market downgrade of the

issuing bank.

Interest Rate Risk

CD prices are sensitive to movements in short-term

interest rates (up to 1 year).

Repos/Reverse repos: Repos are re-purchase

agreements or ready forward contracts, whereby the

counter parties agree to sell and buy back the same

security at an agreed price at a future date. It is a

combination of security trading (purchase/sale) and money

market (borrowing/lending) operations.

Repo transaction is a collateralized borrowing by

pledging approved securities and the borrower is

under obligation to buy back the securities at a

specified date. Repo transaction is a secured form

of lending, the underlying securities being the

collateral. Under a Repo transaction there are 2

counter parties, a lender and a borrower. The

Borrower in a Repo borrows cash and pledges

(sells) securities. The Lender lends cash and

purchases the securities and is said to enter into a

43

Reverse Repo transaction, hence borrowing by

pledging securities is a Repo transaction and

lending by accepting the pledge is a Reverse Repo

transaction. Securities received under Reverse repo

cannot be sold during the tenure of Reverse Repo.

Securities sold under Repo should be recon trolled

at the same holding rate.

Repo and Reverse Repo transactions are

undertaken to manage liquidity and/or for SLR

maintenance. The borrower in the transaction is

short of cash and has excess of SLR and hence

lends securities and borrows cash. The lender in a

Repo transaction has excess of cash and/or is short

in SLR and hence lends cash and borrows security.

Liquidity Adjustment Facility (LAF): Liquidity

Adjustment Facility has emerged as one of the important

tool of liquidity management for RBI.

Presently Reserve Bank of India conducts Overnight

Reverse Repo auctions @6.00% (for absorption of

liquidity) and Overnight Repo auctions @8.50% (for

injection of liquidity) on a daily basis from Monday to

Friday once a day. All Scheduled Commercial Banks and

PDs having Current and SGL Account with RBI are

eligible to participate in the auction. Reverse Repos/Repos

will be undertaken in all SLR-eligible GOI dated

44

Securities/Treasury Bills and SDLs. A margin will be

uniformly applied in respect of the above eligible

securities i.e.5% for GOI/TB and 10% for SDLs. RBI has

the right to accept or reject the bids under LAF either

wholly or partially. Securities received under Reverse

Repo will count for SLR purpose and vice versa.

DEBT MARKET OPERATIONS

The Debt market operations include the banks

participation in debt issued by the Central Government,

State government, PSUs, and corporate, primarily with a

view to enhance the interest income for the bank and also

to trap trading gains. The debt market can be broadly

divided into the SLR and Non SLR market.

SLR: In terms of Section 24 of Banking Regulation Act,

1949 (10 of 1949) every scheduled commercial bank is

required to maintain SLR @ 25 per cent of the total net

demand and time liabilities in India as on the last Friday of

the second preceding fortnight, in the form of:

(a)Cash

(b) Gold valued at a price not exceeding the current

market price, or

(c) Unencumbered investment in the following

instruments which will be referred to as 'statutory

liquidity ratio (SLR) securities’:

Central Government securities (G-Sec)

State Development Loans (SDL)

Treasury Bills (TB)

OTS Central

OTS State

Shares of Central Government Corporations.

45

Shares of State Government Corporations.

Government of India Securities (also called G-Secs, Gilts,

Treasury bonds, Guvvies)

Government of India securities are sovereign obligations

of the Union of India. They are defined by:

Redemption Value

The price at which the bond is redeemed (i.e., repaid to the

holder/investor). Invariably the same as the face value of

Rs.100.

Coupon is the interest payable semi-annually on

the face value of the security.

Maturity/Redemption Date

The date on which the bond repays to its holders.

TYPES OF G-Secs

Fixed Rate

G-Secs are generally fixed rate (coupon) bonds.

Floating Rate

The RBI has issued floating rate bonds (FRBs), in which

the coupon is reset every six months or annually. An issue

in May 2003 had the following terms:

Issued at par of Rs.100 face value.

46

Tenor: 11 years (issue date: May 20 2003, redemption

at par on May 20 2014).

Interest will be paid half-yearly.

Coupon will comprise a variable base rate plus spread.

Put and Call Options

These are bonds, which can be redeemed before maturity

at the option of the investor (put) or issuer (call).

A straight bond with put and call options was issued

enabling Government to redeem the issue at par after five

years and at intervals of six months thereafter. In effect,

the bond has an initial certain life of only five years (even

though it is issued for ten years). If it is not called after

five years, it will survive for six month – periods, with the

call exercise still with the Government at six-month

intervals.

The same privileges have been given to bondholders. They

can demand premature redemption of the issue (a put

option) after five years or exercisable at six-monthly

intervals thereafter, if the first put after five years is not

exercised.

State Government Securities

Bonds issued by States of the Indian Union. Also called

State Development Loans (SDLs) to denote their original

purpose of raising funds for the economic development of

47

States. Thus, 7.8% Karnataka SDL 2012 refers to a

Karnataka State Government security maturing in 2012

and carrying a coupon of 7.8%.

Mostly, issues of State Government securities are of the

fixed interest rate (coupon) type.

Primary Issues

Through the RBI. Generally offered on tap at a fixed price

(usually face value).

However, the RBI has, of late, been conducting auctions

of State Loans; especially those perceived as economically

sounder by the market and propose to allow them to

borrow directly from the market. In the case of weaker

States, the RBI uses moral suasion to ensure that their

issues are fully invested. It has also been proposed that the

Government of India borrow on behalf of such States and

lend to them.

New issues are regulated and scheduled by the RBI. The

amount to be raised annually and their tranches are

determined for each State by the Finance Ministry and

Planning Commission, Government of India in

consultation with the RBI, which implements the market

programme. The allotment to each State depends on its

Plan size and means of financing, decided upon by the

Government of India and the respective State

Governments.

48

G-Secs and State Government securities are evaluated on

the basis of the following:

Current yield

Yield to Maturity

Duration

Current Yield

Measures the return without taking into account the capital

gain or loss on redemption. (If the security is bought for

less (more) than its redemption value, there is a capital

gain (loss). Thus, if the coupon is 8% and Bank buys the

bond for Rs.105 (including accrued interest), the current

yield is 8/105 = 7.62% p.a.

Yield to Maturity (YTM) also called Internal Rate of

Return (IRR)

The interest rate which equates the future coupon and

principal redemption cash flows from the bond with its

current market price. Solve for Y in the formula (formula

assumes 180 days coupon intervals and 360 days in a

year):

C C C C C + F

P = --------- + ------------------- + -------------------- + ------------- +…+ -------------------

49

d/180 (d + 180)/180 ( d + 360)/180 (d+540)/180 (d+(n.180))/180 (1 + Y) (1 + Y) (1+Y) (1+Y) (1+Y)

Where: P = current market (dirty, i.e., including broken period interest) of the bond

C = semi-annual coupon

d = no. of days to next coupon

n = no. of coupons left including the final

F = redemption value of the bond

Y= YTM, i.e., cash flow-equating rate of interest

(also called internal rate of return).

An important assumption in the above calculation is that

the coupon cash flows before maturity are reinvested at

the IRR. The actual (post-facto) IRR will invariably be

different as the coupon reinvestment rates will not be the

same as the YTM calculated today.

For example, Bank buys 7.40% 2012 maturing May 3

2012 on April 28 2003 for Rs.110.30. Settlement is same

day. Last coupon was paid on November 3 2002.

Clean price = Rs.110.30

Dirty price should include accrued interest for:

November 28

December 30

January 30

February 30

March 30

50

April 27

Total 175

This works out to:

Rs.(175/180 x 3.7) = Rs.3.60

Dirty price = Rs. (110.30+3.60) = Rs.113.9

The YTM formula is:

C C C C

C + F

P = ------------- + -------------------- + -------------------- + ---------------- +

…. + ----------------

d/180 (d + 180)/180 (d + 360)/180 (d+540)/180

(d+(nX180))/180

(1 + Y) (1 + Y) (1+Y) (1+Y)

(1+Y)

P = Rs.113.9

C = Rs.3.7 (semi-annual coupon)

F = Rs. 100

d = 5 (175 days since last coupon)

n = no. of coupons left till maturity

Y = yield to maturity

Substituting and solving:

Y = 2.95% (semi-annual) or 5.98% annualized.

51

Duration

Duration measures the interest rate sensitivity of a bond.

The formula for duration (also called Macaulay duration)

is:

1 1 C 2 C 3 C

n (C + F)

+ +

+ +…

P (1 + Y) (1 + Y)² (1+Y)³

(1+Y)n

Where: C = semi-annual coupon

F = redemption price of the bond

Y = YTM (semi-annual)

52

P = market (dirty) price of the

bond

Take the same data as in YTM Example

C = Rs.3.7

Y = 2.95% or 0.0295

P = Rs.113.90

F = Rs.100

Applying the formula, (Macaulay) duration is = 13.8694

(in half years)

Annualized Macaulay duration = 13.8694/2 = 6.93 years

Modified duration is a more accurate measure of interest

rate sensitivity for which Macaulay duration is divided by

the semi-annual yield.

Modified duration= 6.93/1.0295 years

= 6.74 years

(Macaulay) duration is divided by the YTM to get

modified duration.

The modified duration of 6.74 years in the Modified

Duration Example means that every 0.01% change in

YTM will lead to a 0.0674% change in the price of the

bond, either upward or downward, depending on whether

the YTM falls or rises.

For the bond considered in the Modified Duration

Example, the price increase will be Rs. (0.0674 x 113.90)

= 7.68 paisa, if the yield falls 0.01% (as yield and price are

53

inversely related). This is also called the Price Value of a

Basis Point (PVBP).

Modified duration is an accurate estimate of price

sensitivity of a bond only for small changes in yield.

The duration of bond portfolio is the weighted average of

the durations of individual bonds in the portfolio.

However, this will not accurately measure the interest rate

change impact on the portfolio, unless the yield curve shift

(upwards or downwards) is entirely parallel.

Duration is the spot measure of interest rate sensitivity. It

keeps changing with YTM and time.

Yield Curve

If the YTMs of bonds are plotted in ascending order of

maturity, with maturities on the x-axis and yields on the y-

axis, we get a yield curve. The normal yield curve

represents the yield pattern on coupon – bearing G-Secs,

while the spot yield curve is the zero coupon yield pattern

on G-Secs. The spot yield curve is also referred to as the

term structure of interest rates. It shows the hypothetical

yields on G-Secs if they do not pay any interest till

maturity. Thus, the 3-year zero coupon yield would be the

pure yield for that maturity as there is no reinvestment risk

from the need to reinvest coupons as in a coupon – bearing

bond, whose holding period yield is not known with

54

certainly at the time of investment because the

reinvestment yields on the coupons are unknown.

Yield curves come in different shapes:

Ascending (upward sloping)

Descending (downward sloping)

Flat

In an ascending yield curve, medium and long-term yields

are higher than short-term yields, while the opposite is true

of descending yield curves. Most of the time, yield curves

are upward sloping, but at times when inflation is high and

monetary policy is tight, short-term interest rates may be

above medium and long-term.

The shape of the yield curve actually reflects market

expectations on future interest rates: an ascending yield

curve means the market thinks rates will go up and vice-

versa.

55

CAPITAL MARKET OPERATIONS

Capital Market Operations are undertaken by the bank

both in the Primary as well as the Secondary markets. The

bank deals in the Scrips of different companies with in the

specifications laid down by the RBI and the Treasury

Policy.

Classification:

Investment in equity shares is classified into 'Available for

Sale' and 'Held for Trading' categories.

Investment in subsidiaries/Joint Ventures (a joint venture

would be one in which, Bank along with its subsidiaries,

holds more than 25% of the equity) is classified into ‘Held

to Maturity’ category.

Specific Risk Factors

Debt Funds

Quality of investment portfolio of the fund

Quality of portfolio management of the fund

Market Risk

56

Interest Rate Risk

Money market funds are much less risky than debt funds

as they invest mostly in short-term instruments.

Equity Funds

Quality of investment portfolio of the fund

Quality of portfolio management of the fund

Market Risk

57

CHAPTER 6

DATA ANALYSIS AND

FINDINGS

58

DATA ANALYSIS & FINDINGS

The investment function at bank demands a

careful examination of various factors. Besides calculating

the expected rate of returns, executives must consider the

risks involved in it and try to cushion it up by cover

operations. Bank has a document dedicatedly talking about

the potential risks involved in investments. This Risk

Management Policy is framed, recognizing the need to

effectively identify measure and manage these risks in

view of their implication on the Bank’s Investment

Portfolio.

In the era of liberalization and globalization of

the Economy and resultant Economic Scenario in India,

the Investment Portfolio of the Bank is faced with the

challenge of managing a variety of financial and non-

financial risks, viz.,

Credit Risk

Interest Rate Risk

Liquidity Risk

Equity Risk

Operational Risk

CREDIT RISK

Description:

This is one of the oldest of all financial risks. In

its simplest form, it refers to the possibility of the issuer of

a debt instrument being unable to honor his interest

59

payments and / or principal repayment obligations. But, in

modern financial markets, it includes non-performance by

counterparty in a variety of off-balance sheet contracts

such as forward contracts, interest rate swaps and currency

swaps and counterparty risk in the inter-bank market.

These have necessitated prescribing maximum exposure

limits for individual counterparties for fund and non-fund

exposures.

Mitigation (sample for non-bank

counterparties/instruments)

Credit Appraisal

Investment only in rated instruments

Risk Pricing

Credit enhancement through margin arrangements

Guarantees/letters of comfort from rated entities

Adequate financial and / or physical assets as

security

Exposure limits by counterparty, industry, location,

business group, on and off balance sheet

Diversification by industry, sector, location, etc.

Mitigation (sample for bank

counterparties)

Exposure limits for individual bank

counterparties for funded/non-funded

60

assets

Reputation and image of counterparties

Collateralization of transactions

through repos

61

MARKET RISK MANAGEMENT

Market Risk is a generic term to describe both interest

rate risk and event (“systemic”) risk.

Event Risk

Description

The risk that an unexpected happening,

which is extreme, sudden or dramatic (e.g.

the September 11 terrorist attacks), will

cause an all-round fall in market prices.

Mitigation

Increase proportion of assets in risk-free, high quality investments of short maturity.

Interest Rate Risk – Investment/Trading Book

The prices of bonds are affected by changes in

interest rates. When interest rates come down, their prices

go up. The opposite happens when interest rates rise. The

most price – affected bonds in response to rate movements

are those of long maturity – indeed maturity and price

changes are strongly positively correlated.

Duration measures the price sensitivity of a bond

to changes in interest rates. Increasing duration makes the

bond portfolio more sensitive to interest rates while

decreasing duration reduces it.

As bond prices and interest rates are inversely

related, if the Bank expects interest rates to fall, it will

increase duration by buying long-dated securities. Per

62

contra, in anticipation of a rise in interest rates, the Bank

will lower duration by selling long-dated securities.

63

Liquidity Risk:

Description

The risk that an asset cannot be

converted into cash when needed is

termed as Liquidity Risk. It’s quite

characteristic of the vast majority of

bonds.

The risk of scarcity of funds in the

market to borrow arises for number of

reason. E.g. when the RBI deliberately

tightens liquidity

When a bank’s creditworthiness

becomes suspect, there may be no

willing lenders, even though there is no

liquidity shortage in the market.

Mitigation

Increase proportion of investments in

liquid securities

Increase proportion of investments in

near-maturity high quality instruments.

Maintain credit rating, reputation and

image.

Securitization of loan portfolio of large

as well as small borrowers.

Let’s now have look at the market risks in the

context of investments.

Market risk arises from adverse changes in market

variables such as interest rates, forex rate, equity price and

commodity price. Even a small change in these variables

64

can cause substantial changes in the income and economic

value of the Portfolio.

Market risk takes the following forms —

1. Liquidity Risk

2. Interest Rate Risk

3. Equity Risk

4. Foreign Exchange Risk

Liquidity Risk:

Liquidity Risk arises essentially from funding long

term assets by short term liabilities, thereby subjecting the

liabilities to roll over or refinancing risk and manifests

itself in different dimensions such as –

Funding Risk – need to re place net out-flows.

Time Risk __ need to compensate for non-receipt

of expected in-flows

Call Risk – due to crystallization of contingent

liabilities.

The liquidity management prescriptions spelling out

funding strategies, liquidity planning under alternative

scenarios, prudential limits, liquidity reporting / reviewing

are laid down in the ALM Policy.

INTEREST RATE RISK:

The management of interest rate risk is critical to

market risk management especially in a deregulated

environment, which has exposed the Banking system to

65

the adverse impacts of interest rate risk. Interest Rate risk

can be of following types –

Basis Risk

Market interest rates of various instruments

seldom change by the same degree during a given

period of time. The situation prevails in the Bank

also as the changing interest rate on advances are

immediately given effect, the change does not

affect deposits/investments to a great extent as they

continue at the contractual rates.

Yield curve risk

The pricing of Investments are based on

different benchmarks i.e. Treasury Bill Yield, G-

Sec Yield, Call Money Rates, LIBOR/MIBOR etc.

In a floating interest rate scenario, the Yield Curve

Risk is high.

66

Interest Risk Management:

In a rising interest rate scenario, long dated low

coupon securities can be sold and short dated high

coupon securities can be purchased to protect the

value of holding Portfolio.

In a falling interest rate scenario, short dated high

coupon securities can be sold and long dated low

coupon securities can be purchased to enhance the

value of holding Portfolio.

Trading in volatile securities should be undertaken

with due caution and within the laid down

prudential limits.

All deal settlements should be tracked till their

conclusion.

In the event of a fall in prices of the Securities, the

stop loss principle shall apply.

VaR limits on the Trading book of Investments

[all AFS-SLR/Non-SLR (excluding overdue

investments, Equity, Mutual Funds and COD

securities) and HFT portfolio]: The following

VaR limits are fixed for the different time span on

the Trading book of Investments [all

AFS-SLR/Non-SLR (excluding overdue

investments, Equity, Mutual Funds and COD

securities) and HFT portfolio] as under:

Time span 1 Day 10 Days 30 Days

VaR Limit 1% of the Trading

book of

3% of the Trading

book of

6% of the Trading

book of

67

Investments Investments Investments

The limit may be reviewed on Half-yearly basis.

Any incident of abnormal volatility and exceeding the VaR limit should be

immediately reported to the ALCO by the treasurer so that prompt remedial action

can be taken.

Trading Portfolio:

The Trading Portfolio of the Bank shall be managed in

accordance with the Investment Management policy

guidelines, which spell out the volume, maximum

maturity, holding period, Duration, Stop Loss, Rating

standards etc. for classifying securities in the Trading

Book.

The securities held in Trading Portfolio should be

reviewed on a daily basis to evaluate increase / diminution

in their value and to trigger appropriate sale / purchase

action while the Trading Portfolio would be marked to

market on monthly basis for providing depreciation, if

any, in the Portfolio.

Price risk and market risk are to be estimated by adopting

the VAR model. Securities in the Trading Portfolio

should be sold at the earliest opportunity to book profit or

minimize loss within the outer limit of 90 days and such

trading shall be undertaken within the powers delegated to

the functionaries.

Stop loss limit: While monitoring the Portfolio Stop

loss limits as prescribed for cutting losses that may

arise be exercised.

To enable the authorities to exercise the powers

judiciously, the Board has delegated 1% stop loss limit on

68

the holding cost to the Deputy General Manager TIBD and

above 1% but up to 2% to the General Manager.

Similarly in the case of purchase for Trading Portfolio, the

movement of value of the Security in the preceding month

should be reckoned along with future price forecast while

deciding upon the same.

The Bank has in place an Asset Liability Management

Policy, duly approved by the Board on an annual basis to

address and deal with the above risk issues. The policy

prescriptions and operating guidelines as laid down in the

ALM Policy shall be followed in Market Risk

management as it articulates the market risk management

policies, procedures, prudential Risk limits, review

mechanism , reporting and audit system.

The ALM Policy addresses the Bank’s exposure on a

consolidated basis and articulates risk measurement

systems to be adopted, which would capture all sources of

market risk and the impact thereof on the Bank.

The market risk faced by the Bank would be

essentially managed by the Integrated Treasury.

EQUITY RISK MANAGEMENT:

Bank undertakes buying and selling of shares to

earn profit. In order to minimize the risk associated with

the capital market, the bank adopts the following risk

management strategies:

The shares purchased will be sold only after

getting the delivery in demat form.

69

The shares will be sold on getting a reasonable

profit.

The Dealers will take a view regarding sale of

equity shares /equity oriented mutual fund when

their market value goes below the average holding

cost.

The loss/depreciation will be restricted to 10% of

the average cost.

The overall exposure to Capital Market will be

kept within limits prescribed by RBI.

The Trading Equity Portfolio will be valued on

Weekly basis.

It should be ensured that the exposure to

stockbrokers is well diversified in terms of number

of broker clients, individual inter-connected

broking entities.

70

Operational Risk Management:

Operational Risk arises in situations involving

settlement or payment risks or business interruptions or

administrative and legal risks. However, the most serious

type of operational risk arises when there is a break down

in internal controls and corporate governance. Operational

Risk differs from other banking risks in that it is typically

not directly taken in return for an expected reward but is

implicit in the ordinary course of corporate activity and

has the potential to affect the risk management process.

Identification of operational risk is, therefore, crucial to

the management. Various areas have been identified

regarding operational risk as under:

Non-adherence to laid down procedure

Non-adherence to compliance required by the

System

Non-adherence to policy guidelines

Lack of control over security items / numbered

stationery

In-adequate checks / accuracy and processing of

transactions

In-adequate supervision over accounting system

In-correct reporting of data

71

Delayed action in circumstances warranting

immediate action

Incorrect / improper /delayed handling of

transactions

Observance of maximum brokerwise limits in

transactions.

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The Basel Committee has identified the following types

of operational risk events as having the potential to result

in substantial losses:

Internal fraud

External fraud

Employment practices and workplace safety

Clients, products and business practices

Damage to physical assets

Business disruption and system failures

Execution, delivery and process management.

Monitoring / Control and Management of operational

risk assumes significance for the Bank and the risk is

sought to be managed in the following manner

Defining of responsibilities and accountability of

various functionaries, segregation of duties, clear

management reporting lines and adequate

operating procedure.

Concurrent audit of the Investment Portfolio on

monthly basis.

Dealers must operate strictly within the single deal,

portfolio and prudential limits by instrument and

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counterparty. Stop loss and risk norms of duration

and value at risk should be adhered to at all times.

No deviation from approved and implemented

work and document flows should be allowed.

The necessary authorizations must accompany

documents as they pass from one stage of the

transaction cycle to the next.

Delegations of powers must be strictly adhered to.

Deals or transactions exceeding powers must be

immediately and formally ratified in accordance

with management/ Board edicts on ratification.

The prescribed settlement systems in each

product/instrument and market must be followed.

Deviations from delivery and payment practices

should not be allowed.

Computer systems – hardware, networks and

software – should have adequate backups. They

should be put through periodic stress tests to

determine their ability to cope with increased

volumes and outlying data combinations.

Custodian’s creditworthiness is paramount in

demat systems of records of ownership and

transfer. Custodial relationships should be only

with those with the highest credit rating.

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Counterparty authorizations/powers of attorney

must be kept current.

The list of approved brokers should be

reviewed periodically to satisfy the Bank’s credit

standards and ethics.

Deal, transaction and legal documentation

should be adequate to protect the Bank, especially

in one-off transactions and structured deals.

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Value-at-Risk (VaR)

Value-at-risk is the maximum loss which will be

suffered in a specified period and at a specified confidence

level due to a fall in the price of a security (or exchange

rate), given historic data on the price behavior of the

security (exchange rate) or assessment of likely future

market movements. The concept is applied to calculate the

risk content of an individual security, a foreign exchange

position, an equity share, a derivative or a portfolio of

these instruments.

The following are the steps involved in the calculation of

VaR for an individual security:

Value at Risk (VaR) is the maximum loss not

exceeded with a given probability defined as the

confidence level, over a given period of time. Although

VaR is a very general concept that has broad applications,

it is most commonly used by security firms or investment

banks to measure the market risk of their asset portfolios

(market value at risk). VaR is widely applied in finance

for quantitative risk management for many types of risk.

VaR does not give any information about the severity of

loss by which it is exceeded. Other measures of risk

include volatility/standard deviation, semi variance (or

downside risk) and expected shortfall.

VaR has three parameters:

The time horizon (period) to be analyzed may

relate to the time period over which a financial

institution is committed to holding its portfolio, or

to the time required to liquidate assets. Typical

periods using VaR are 1 day, 10 days, or 1 year. A

76

10 day period is used to compute capital

requirements under the European Capital

Adequacy Directive (CAD) and the Basel II

Accords for market risk, whereas a 1 year period is

used for credit risk.

The confidence level is the interval estimate in

which the VaR would not be expected to exceed

the maximum loss. Commonly used confidence

levels are 99% and 95%. Confidence levels are not

indications of probabilities.

Value at risk (VaR) is given in a unit of the

currency.

The following are the steps involved in the calculation of

VaR for an individual security:

Take a price series of the asset for which VaR is required.

Example: Asset (8.85% 2015 Government of India bond)

DAY (From yesterday) PRICE (Rs.)

1 101.24

2 101.50

3 101.45

4 101.42

5 101.55

6 101.70

7 101.90

8 101.80

9 101.75

10 101.85

a) Calculate the natural logarithm of a day’s price divided by the previous day’s price and their mean.

DAY PRICE (Rs.) Natural Logarithm of

77

Price of Day (n/n-1)

1 101.24

2 101.50 0.00256

3 101.45 -0.000493

4 101.42 -0.000296

5 101.55 0.00128

6 101.70 0.00148

7 101.90 0.00196

8 101.80 -0.000982

9 101.75 -0.000491

10 101.85 0.000982

MEAN 0.006

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b) Calculate difference of each natural logarithm from the mean and square the difference. Sum up the squares of the differences.

DAY Natural logarithm

of Price diff.

Diff. from Mean (Diff.) ²

½ 0.00256 -0.00344 0.0000118

3/2 -0.000493 -0.00649 0.0000421

4/3 -0.000296 -0.00630 0.0000397

5/4 0.00128 -0.00472 0.0000223

6/5 0.00148 -0.00452 0.0000204

7/6 0.00196 -0.00404 0.0000163

8/7 -0.000982 -0.00698 0.0000487

9/8 -0.000491 -0.00649 0.0000421

10/9 0.000982 -0.00502 0.0000252

TOTAL 0.0002686

Total of (diff) ²

Calculate variance = ------------------

Data less one

0.0002686

= --------------- 9-1

= 0.0000336

Calculate standard deviation = variance

= 0.0000336

79

= 0.0058

Multiply the standard deviation by 1.65 to obtain

the 95% confidence level for maximum loss. This is 1.65

X 0.0058 = 0.00957. Assuming the acquisition cost of the

bond is Rs.110, the maximum loss in the next 24 hours at

95% confidence level and based on historical data is

Rs.110 X 0.00957 = Rs.1.05. (A bigger loss is not ruled

out if something unexpected or unusual occurs, which did

not in the past 10 days).

Of course, the VaR is a function of the standard

deviation of relative price changes (i.e., the price change

from one day to the next). Whether historical data or a

forecast should be used for this purpose is entirely the

judgement of the user. A forecast is better if the immediate

future is going to be very different from historical data.

VaR can be calculated for any period as desired.

In every case, the standard deviation as calculated above is

multiplied by the number of working days in the period for

which the VaR is required. The number of working days

in a year is 252 (forex market) and 300 (securities market),

while in a month it is 22 (forex) and 26 (securities).Thus,

the annual VaR in the above example is 0.0058 x √ 300 =

10.05%. At 95% confidence, this is Rs.(110 X 0.1005) =

Rs. 11.05. 95% of the time, annual loss should not exceed

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this. Monthly VaR is similarly calculated as 0.0058x √ 26

= 2.96% or Rs. (110 X 0.0296) = Rs.3.26. Thus, in a

month, the loss should be within Rs. 3.26, 95% of the

time.

The same methodology can be followed to

calculate the VaR of other assets like foreign exchange

and equity shares. To calculate the VaR of a portfolio,

simply add the VaR of the individual instruments in the

portfolio (on the assumption that their price movements

are wholly uncorrelated). Otherwise, to calculate the VaR

of a portfolio, its daily change in value must be used to

calculate the volatility and VaR as above for a single

security.

CHAPTER 7

81

CONCLUSION OF THE

STUDY

82

CONCLUSION OF THE STUDY

Conventionally, the Treasury function was confined to

funds management- maintaining cash balances to meet day

to day requirements, deploying surplus funds generated in

the operations, and sourcing funds to bridge occasional

gaps in cash flow.

Owing to economic reforms and deregulation of markets

over the last decade, the scope of Treasury has expanded

considerably. Treasury has since evolved as a profit

centre, with its own trading and investment activity.

Till recently, investment in securities and foreign

exchange business constituted two separate departments in

most of the Indian banks. These two functions are now

become part of the integrated treasury, thus adding new

dimension to treasury activity.

With increasing deregulation and more exposure

opportunities over the globe, banks should make the

maximum out of this with the help of Risk management.

This project has helped me to appreciate the role and

functions of Treasury, its global dimensions and typical

organizations of treasury activity in a bank.

83

CHAPTER 8

SUGGESTIONS &

RECOMMENDATIONS

84

SUGGESTIONS AND

RECOMMENDATIONS

The Bank’s Domestic Treasury is functioning within the

RBI regulations and comes across as a well managed

Treasury.

Based on the information gathered during the completion

of my project I wish to suggest the following which the

Bank may look to implement.

1. Operational Risk:

The Mid Office reporting should cover aspects of

operational risk on a regular basis, even though

operational risk cannot be directly taken in return for an

expected reward but is implicit in the ordinary course of

corporate activity and has the potential to affect the risk

management process.

2. Stop Loss:

Bank has prescribed Stop Loss limits for its Held for

Trading portfolio. The percentage of Bank’s holding in its

Held to Trading portfolio on an ongoing basis is about

0.1% of its total investments.

Thus to have effective risk mitigation it is suggested that

Bank should look into prescribing a suitable stop loss

limits for its Available for Sale portfolio. The Available

for Sale portfolio is required, as per Regulatory Norms, to

be marked to market on a periodical basis. An effective

stop loss implemented on a timely basis will help the Bank

85

to mitigate the Mark to Market Losses in Available for

Sale portfolio.

3. Take profit levels:

Bank can document the take profit levels which can be

reviewed periodically. During the course of my study I did

not come across any such document where the take profit

levels where documented.

86

4. Benchmark rates:

Being very much in the market, the Treasury should

provide the benchmark rates for various activities on a

regular basis. As per present practice TIBD on a daily

basis informs prevailing rates on selected Money and Debt

market instruments but is not directly involved in the

finalizing of the Bank’s rates.

5. Transfer Pricing:

Treasury being an independent Branch unit should come

under the ambit of transfer pricing. At the moment the

Transfer pricing for TIBD is effected at CO.

6. Client business is nil.

7. Bank has very less involvement in derivative

products.

8. Bank can try making the process more automotive

rather than being manual.

9. More professional people are required.

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88

CHAPTER 9

LIMITATIONS

89

LIMITATIONS

The treasury department plays the most vital role;

hence the data used by them was very confidential

and critical, so couldn’t have much access to

overall data.

The project report scope pertains only to this

organization and is not applicable elsewhere.

Due to the time constraint, it was not possible to

get all the minute details about the domestic

treasury department.

The limited working hours was a constraint,

because of which the officers were not able to give

enough time for training.

The data provided by the staff can’t be held true as

100% correct.

90

CHAPTER 10

BIBLIOGRAPHY

91

BIBLIOGRAPHY

1) www.rbi.org.in

2) www.ccilindia.com

3) www.amfiindia.com

4) http://www.hdfcbank.com/wholesale/sme/ Custody_Services.htm

5) http://en.wikipedia.org/

6) Investment Risk Management Policy, 2007-08, Bank of Maharashtra.

7) http://www.bankofmaharashtra.in

8) www.iib-online.org

9) www.fedai.org.in

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