treasury division & its functions

11

Treasury Division & its

functions

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TREASURY ACTIVITIESTREASURY ACTIVITIES

Treasury Division – Heart of the Treasury Division – Heart of the bankbank

Managing Asset & Liabilities of the bank – Managing Asset & Liabilities of the bank – ‘The Balance Sheet Management’. ‘The Balance Sheet Management’. Thereby enhancing the risk-adjusted Thereby enhancing the risk-adjusted return on equity.return on equity.

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Objectives: Maximizing Risk Weighted Objectives: Maximizing Risk Weighted ReturnsReturns

Risk Weighted ReturnsRisk Weighted Returns take into account take into account liquidity and interest rate gap risk liquidity and interest rate gap risk associated with certain asset or liability instead of applying same interest rate to associated with certain asset or liability instead of applying same interest rate to assess the cost/return of liability/assetassess the cost/return of liability/asset

e.g.: Branch ‘A’e.g.: Branch ‘A’

Assets:i. Cashii. Running Finance & ERFiii. Advances linked with KIBOR, T Bills – Short Term

iv. Advances linked with PIBs- Long Term Fixed

v. Advances linked with PIBs- Long Term Floating

vi. Investments – Advances converted into Bonds vii. Others

Liabilities:

i. Current Deposits

ii. Savings Deposits

iii. Term Deposits (TDRs)

iv. Interest Payables

v. Others

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MONEY MARKETMONEY MARKET

MECHANISM, MARKET MECHANISM, MARKET & INSTRUMENTS& INSTRUMENTS

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Functions of Money Market DeskFunctions of Money Market Desk The need for financial institutions to indulge in money market transactions arises The need for financial institutions to indulge in money market transactions arises

primarily from the primarily from the statutory reserve and liquidity requirementsstatutory reserve and liquidity requirements imposed by the imposed by the State Bank.State Bank.

Statutory Cash Reserve

Requirement

Average 5% of Total Time & Demand Liabilities for Week

& Minimum Daily 4% of TDL

A/C with SBP Rate of Return = 0%

Opportunity Cost = Av. WeeklyO/N Rate

Statutory Liquidity

Requirement

15% of TDLin Eligible Liquid Assets

1. Treasury Bills2. FIBs/PIBs Not More Than 5% of TDL3. Reverse Repos - Repos4. Other Approved Assets i.e. NIT, Cash in Vault, Foreign Currency Held, Excess in SCR etc.

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MARKET TYPESMARKET TYPES

Primary MarketPrimary Market This constitutes all securities issued for This constitutes all securities issued for

the first time. the first time.

Secondary MarketSecondary Market The securities issued in the primary The securities issued in the primary

market are then traded in the secondary market are then traded in the secondary market among banks, investors etc. market among banks, investors etc.

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MARKET PARTICIPANTSMARKET PARTICIPANTS

Commercial Banks /NBFIs.Commercial Banks /NBFIs.

State Bank of Pakistan.State Bank of Pakistan.

Corporate Treasuries.Corporate Treasuries.

Public Sector/Government.Public Sector/Government.

Inter-Bank Brokerage Inter-Bank Brokerage Houses-Houses-Playing the role of facilitators.Playing the role of facilitators.

Exchange CompaniesExchange Companies

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PRIMARY DEALER SYSTEMPRIMARY DEALER SYSTEM

The PDs are Price makers, quoting two-way The PDs are Price makers, quoting two-way prices reflective of market sentiment and actively prices reflective of market sentiment and actively participating in trading of all marketable securities.participating in trading of all marketable securities.

PD must be a Band/ DFI/ Investment Bank/ Listed PD must be a Band/ DFI/ Investment Bank/ Listed Brokerage House.Brokerage House.

The PD status is assigned by the SBP. The PD status is assigned by the SBP.

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Money Market ActivitiesMoney Market Activities

Money Market TransactionsMoney Market TransactionsCall/Term lending/borrowingCall/Term lending/borrowing

Clean lending/borrowing among banks. Clean lending/borrowing among banks.

Providing KIBOR as a benchmark for term Providing KIBOR as a benchmark for term lending to the corporate sector.lending to the corporate sector.

Less developed as compared to other Less developed as compared to other countries because of the presence of more countries because of the presence of more developed REPO/Reverse REPO market.developed REPO/Reverse REPO market.

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Money Market Transactions Money Market Transactions Cont’dCont’d.. REPO/Reverse REPOREPO/Reverse REPO

Repurchase of securities. Introduced in Repurchase of securities. Introduced in early 80s. early 80s. Akin to Collateralized lending Akin to Collateralized lending borrowing borrowing andand Governed by Master REPO Governed by Master REPO Agreement.Agreement.

Securities usually repurchased are T Bills, Securities usually repurchased are T Bills, FIBs, PIBs etc.FIBs, PIBs etc.

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Money Market Transactions Money Market Transactions Cont’dCont’d.. Outright Purchase/Sale of SecuritiesOutright Purchase/Sale of Securities

Purchase of government securities i.e. Purchase of government securities i.e. Treasury Bills and Pakistan Investment Treasury Bills and Pakistan Investment Bonds (PIBs) for portfolio management.Bonds (PIBs) for portfolio management.

Purchase/Sale of securities is based on the Purchase/Sale of securities is based on the portfolio strategy and market conditions.portfolio strategy and market conditions.

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Major Money Markets instrumentsMajor Money Markets instruments..

Market Treasury Bills.Market Treasury Bills. 3, 6 and 12 months maturity, zero coupon 3, 6 and 12 months maturity, zero coupon

instruments priced at discount.instruments priced at discount. Issued by Govt. to finance current expenditure.Issued by Govt. to finance current expenditure. Sold by SBP through auctions.Sold by SBP through auctions. Risk free, highly liquid and reserve eligible.Risk free, highly liquid and reserve eligible.

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Federal Investment BondsFederal Investment Bonds.. Half yearly coupon bonds. 3,5 & 10 years Half yearly coupon bonds. 3,5 & 10 years

maturity. maturity. Discontinued in the Primary MarketDiscontinued in the Primary Market Issued by GoP, these bonds are only traded Issued by GoP, these bonds are only traded

in the secondary market.in the secondary market. Are SLR eligible security.Are SLR eligible security.

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Pakistan Investment BondsPakistan Investment Bonds.. Launched in the year 2000 to replace FIBs as Launched in the year 2000 to replace FIBs as

a long term investment.a long term investment. Half yearly coupon bonds. 3, 5, 10, 15 & 20 Half yearly coupon bonds. 3, 5, 10, 15 & 20

years maturity. Are sold to Primary Dealers years maturity. Are sold to Primary Dealers through auction.through auction.

Active secondary market catering to banks Active secondary market catering to banks and institutional investors etc.and institutional investors etc.

Are SLR eligible securities up to 5% of DTL.Are SLR eligible securities up to 5% of DTL.

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Outstanding StockOutstanding Stock

T-BillsT-Bills PKR 274.6 billionPKR 274.6 billion

PIBsPIBs PKR 278.9 billionPKR 278.9 billion

DTLDTL PKR 2,090 billionPKR 2,090 billion

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MARKET YIELDSMARKET YIELDS

T-BillsT-Bills

TenorTenor W.A.Rate(%)W.A.Rate(%) Cut-Off (%)Cut-Off (%) Mkt.Yield%Mkt.Yield%

3-Months3-Months 3.91613.9161 3.94623.9462 3.75-3.60%3.75-3.60%

6-months6-months 3.73213.7321 3.84263.8426 4.10-3.90%4.10-3.90%

1-Year1-Year 4.42904.4290 4.49464.4946 4.70-4.50%4.70-4.50%

2020

MARKET YIELDSMARKET YIELDS PIBsPIBs

TenorTenor Coupon Rate(%)Coupon Rate(%) Cut-Off (%)Cut-Off (%) Mkt.Yield(%)Mkt.Yield(%)

3-Year3-Year 6.006.00 4.35004.3500 5.60-5.40%5.60-5.40%

5-Year5-Year 7.007.00 5.35005.3500 6.70-6.50%6.70-6.50%

10-Year10-Year 8.008.00 7.37007.3700 7.75-7.65%7.75-7.65%

15-Year15-Year 9.009.00 8.99888.9988 8.85-8.70%8.85-8.70%

20-Year20-Year 10.0010.00 9.99429.9942 9.85-9.70%9.85-9.70%

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BENCHMARK RATESBENCHMARK RATES

Discount RateDiscount Rate The SBP discount window facility offer funds to banks The SBP discount window facility offer funds to banks

as the lender of last resort.as the lender of last resort. Current rate is 7.5%.Current rate is 7.5%.

Karachi Inter-bank Offer Rate (KIBOR):Karachi Inter-bank Offer Rate (KIBOR): Lending rate for 1, 2 weeks and 1, 3, 6, 9 and 12 Lending rate for 1, 2 weeks and 1, 3, 6, 9 and 12

months.months. Recently established as a benchmark rate for all Recently established as a benchmark rate for all

corporate term lending.corporate term lending.

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BONDSBONDS

Investments for period of more than 1 Investments for period of more than 1 year.year.

Currently, PIBs are auctioned by SBP Currently, PIBs are auctioned by SBP (traded in Primary Market).(traded in Primary Market).

FIBs are no more auctioned and are FIBs are no more auctioned and are traded in the secondary market.traded in the secondary market.

Riskier than T-Bills because of longer Riskier than T-Bills because of longer maturity and presence of coupons.maturity and presence of coupons.

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Bonds’ PricingBonds’ Pricing

A Bond’s price is simply the present value of its:A Bond’s price is simply the present value of its: Coupons to be received during life of the bond, andCoupons to be received during life of the bond, and Principal repayment at the maturity.Principal repayment at the maturity.

Price = C1 + C2 + .…………………+ Cn + FV

1+ i (1+ i)2 (1+ i)n (1+ i)n

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Issued / traded at Premium or Discount Issued / traded at Premium or Discount depending upon the coupon rate and the depending upon the coupon rate and the market yield for the tenors.market yield for the tenors.

Bond trades at Premium when:Bond trades at Premium when:

Coupon Rate > Market YieldCoupon Rate > Market Yield

and vice versa.and vice versa.

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Bonds’ price (whether at premium or at Bonds’ price (whether at premium or at discount) converges to its par value as the discount) converges to its par value as the bond reaches its maturity.bond reaches its maturity.

Par Value

Premium Bond

Discount Bond

Maturity

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Sensitivity Measures for BondsSensitivity Measures for Bonds

DurationDuration

Price Value of a Basis Point (PVBP or PVPrice Value of a Basis Point (PVBP or PV0101))

ConvexityConvexity

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DurationDurationMeasures the Interest Rate Risk or Price Risk.Measures the Interest Rate Risk or Price Risk.

Measures the change in price of the bond w.r.t Measures the change in price of the bond w.r.t change in the yield. change in the yield.

Price

Yield

3% 4%

Change in Price as the yield drops by 1%

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DurationDuration

Higher for papers with longer maturity.Higher for papers with longer maturity.

Lower for bonds with higher coupon rate.Lower for bonds with higher coupon rate.

For a zero coupon bond, duration is For a zero coupon bond, duration is approx. equal to life of the bond.approx. equal to life of the bond.

However, duration of a zero coupon However, duration of a zero coupon security is higher compared to that of security is higher compared to that of coupon bonds.coupon bonds.

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PVBPPVBP

Calculates the change in price as a result Calculates the change in price as a result of 1 basis point (0.01of 1 basis point (0.01%%) change in yield.) change in yield.

As Duration measures the change in price As Duration measures the change in price for 100 basis point change in yield, PVBP for 100 basis point change in yield, PVBP is:is:

PVBP = Duration (PVBP = Duration (for 1%for 1%) / 100) / 100

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ConvexityConvexityThe change in duration for a change in yield.The change in duration for a change in yield.

Convexity adjusts the flaw in the price estimated Convexity adjusts the flaw in the price estimated by duration, especially for larger changes in the by duration, especially for larger changes in the yield.yield.

Price

Yield

1% 4%

Convexity Adjustment

Price estimated through Duration

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ConvexityConvexity

Duration underestimates the increase in Duration underestimates the increase in Bond’s price and overestimates the Bond’s price and overestimates the decline.decline.

Therefore, Convexity adjustment is to be Therefore, Convexity adjustment is to be added to the duration estimate in both the added to the duration estimate in both the cases of price increase or decrease.cases of price increase or decrease.

3232

Interest Rate DerivativesInterest Rate Derivatives

Interest Rate Swap (IRS)Interest Rate Swap (IRS)

Forward Rate Agreement (FRA)Forward Rate Agreement (FRA)

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The Derivatives MarketThe Derivatives Market

A Derivative transaction is a contract whose value A Derivative transaction is a contract whose value depends on (or derives from) the value of an underlying depends on (or derives from) the value of an underlying asset, reference rate or index. (Group of Thirty, Global asset, reference rate or index. (Group of Thirty, Global Derivatives Study 1993).Derivatives Study 1993).Underlying asset may refer to:Underlying asset may refer to:

CurrencyCurrency Interest RateInterest Rate Stock PriceStock Price CommodityCommodity

Derivatives are sometimes referred to as ‘contingent Derivatives are sometimes referred to as ‘contingent claims’.claims’.Derivatives contracts are of two types:Derivatives contracts are of two types:

Exchange traded contracts.Exchange traded contracts. OTC (Over the Counter) Contracts.OTC (Over the Counter) Contracts.

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Forward Rate Agreement (FRA)Forward Rate Agreement (FRA)

An agreement to fix interest rate for a future transaction An agreement to fix interest rate for a future transaction based on a certain benchmark.based on a certain benchmark.Agreement to borrow/lend an amount of money (nominal Agreement to borrow/lend an amount of money (nominal principal)…principal)…

At a specified future date (‘settlement date’)At a specified future date (‘settlement date’) For a specified tenorFor a specified tenor For a specified interest rate (‘forward rate’)For a specified interest rate (‘forward rate’)

FRA buyer hedges against rising interest rates.FRA buyer hedges against rising interest rates.Buy a 6-over-9M FRA for PKR10 Million at 9%Buy a 6-over-9M FRA for PKR10 Million at 9%

Agreement to…...Agreement to…...Borrow PKR 10 Million for 3MBorrow PKR 10 Million for 3MAt a date 6M from todayAt a date 6M from todayAt 9% costAt 9% cost

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FRAs – A Practical ExampleFRAs – A Practical ExampleA bank needs to fund a six month fixed rate Dollar Loan.A bank needs to fund a six month fixed rate Dollar Loan.Two choices are available:Two choices are available:

Borrow for six months at KIBOR, 8 3/8%. Borrow for six months at KIBOR, 8 3/8%. Fund the first three months using its own funds at a cost of 8 Fund the first three months using its own funds at a cost of 8

1/16%.1/16%.

In choosing option 2 the runs the risk that interest rates will rise within In choosing option 2 the runs the risk that interest rates will rise within three months and that overall funding cost will be above 8 3/8%three months and that overall funding cost will be above 8 3/8%

To guard against this risk, the bank could buy a three against six FRATo guard against this risk, the bank could buy a three against six FRAwhich is being quoted at 8 ¼ - 8 ½ ..which is being quoted at 8 ¼ - 8 ½ ..

By buying a 3/6 FRA at 8 ½ % the bank locks in a borrowing cost of 8By buying a 3/6 FRA at 8 ½ % the bank locks in a borrowing cost of 8½ % from the third to the sixth month. The overall cost of borrowing in½ % from the third to the sixth month. The overall cost of borrowing inthis fashion is 8.36% almost exactly the same as borrowing for sixthis fashion is 8.36% almost exactly the same as borrowing for sixmonths at 8 3/8 %.months at 8 3/8 %.

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Forward Rate Agreements - SettlementForward Rate Agreements - SettlementSuppose after three months, three month KIBOR has risenSuppose after three months, three month KIBOR has risento 10 ½ %. The bank receives the difference between theto 10 ½ %. The bank receives the difference between thecurrent KIBOR and the agreed FRA rate (10 ½ - 8 ½ = 2%).current KIBOR and the agreed FRA rate (10 ½ - 8 ½ = 2%).

Suppose FRA bought had been for a notional principal ofSuppose FRA bought had been for a notional principal ofPKR 10 M. Settlement would be as under:PKR 10 M. Settlement would be as under:

The buyer of the FRA would gain 2% on PKR 10 M forThe buyer of the FRA would gain 2% on PKR 10 M forthree months, discounted to take account of the fact that itthree months, discounted to take account of the fact that itis being paid at the start rather than the end of the threeis being paid at the start rather than the end of the threemonth period. This comes to :month period. This comes to :PKR 10,000,000 * 2 * 0.25 = PKR 48,721.07PKR 10,000,000 * 2 * 0.25 = PKR 48,721.07 1+ (10.5*0.25)1+ (10.5*0.25)

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Interest Rate SwapsInterest Rate Swaps

An Interest Rate Swap is an agreement between counter An Interest Rate Swap is an agreement between counter parties in which each party agrees to make a series of parties in which each party agrees to make a series of payments to the other on agreed future dates until maturity of payments to the other on agreed future dates until maturity of the agreement. Each party’s interest payments are calculated the agreement. Each party’s interest payments are calculated using different benchmarks by applying the agreement terms using different benchmarks by applying the agreement terms to the notional principal amount of the swap.to the notional principal amount of the swap.

An agreement to exchange:An agreement to exchange: Floating rate payments for fixed rate payments (or vice-versa)Floating rate payments for fixed rate payments (or vice-versa) At regular intervals over a pre-specified periodAt regular intervals over a pre-specified period On a certain principal amountOn a certain principal amountTypical features:Typical features: Payments denominated in the same currencyPayments denominated in the same currency Payments are nettedPayments are netted Principal in not exchangedPrincipal in not exchanged Tailor madeTailor made Off Balance SheetOff Balance Sheet

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IRS Floating to Fixed SwapIRS Floating to Fixed Swap

ABC Ltd

5 year

Floating rate

Loan

Bank

6m KIBOR

Current 2.25%

Fixed 3.8%

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IRS - ApplicationsIRS - Applications

If the borrower’s view is that PKR interest rates If the borrower’s view is that PKR interest rates will go higher an IRS synthetically converts a will go higher an IRS synthetically converts a floating rate loan into a fixed rate loan (or vice floating rate loan into a fixed rate loan (or vice versa).versa).Users may be able to better match assets and Users may be able to better match assets and liabilities using an interest rate swap; matching liabilities using an interest rate swap; matching dates, floating or fixed interest rates.dates, floating or fixed interest rates.Exchange certainly for uncertaintyExchange certainly for uncertaintySynthetically convert a fixed rate liability into a Synthetically convert a fixed rate liability into a floating rate liability if the borrower’s view is that floating rate liability if the borrower’s view is that PKR interest rates will move lower.PKR interest rates will move lower.

treasury division & its functions

Documents

market typesprimary

market conditions

market treasury bills

government securities

marketable securities

slr eligible securities

pakistan investment

yearly coupon bonds