TreasuryOperations RiskMgt

TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT
Treasury Operations
and
Risk Management
$/ ¥/£
% £/
by
Trivedi & Hasan
Treasury Operations Treasury Operations

and
Risk Management
and
Risk Management
I III
About
the
Authors
FOREWORD BY :
Prof. M. Thomas Paul

National Institute of Bank Management
Pune.
2000, A. K. Trivedi & S. M. Hasan (Authors)
First Edition, September, 2000

Price : Rs. 290/-
Arun K. Trivedi,49, Head Global S. M. Hasan, 29, is with
£ 25
Banking, IndusInd Bank. background in Economics &
Former Faculty International Post Graduation in Foreign
All right reserved. © N o p a r t o f t h i s p u b l i c a t i o n m a y b e r e p r o d u c e d , Banking and Foreign Trade with Exchange and Risk Manage-
stored in a retrieval system, or transmitted in any form or by any National Institute of Bank ment, with specialization in
means, electronic, mechanical, photocopying, recording and/or Management, Pune. Prof- Financial Markets – with focus
otherwise, without prior permission of the authors. essional International banking on Derivatives – Futures &
experience includes Head Forex Options. He worked in the
Treasury, Vysya Bank and Chief past with reputed financial
PUBLISHED BY :
Forex Dealer, State Bank Institutions as a Forex Dealer
GENESIS Publishers of Patiala. Current research and Risk Manager. As a
3/52, Ohm Sainath Apartments, interest Risk Management freelancer he regularly
Linking Road Extension, Santacruz (W), Systems in Banks. Fellow of contributes articles to leading
Mumbai - 400 054. the Indian Institute of Bankers. financial newspapers and
Co-author of a book International journals on varied subjects
Phone :- 661 2890 Banking Operations published covering financial markets, risk
Fax :- 661 2035 by IIB Mumbai. Contributing management and economy
Email :- arunt11@bom5.vsnl.net.in regularly to Vinimaya, IIB related issues. He is an
www.genesispublishers.com journal, IBA Bulletin and Indian awardee of commendation by

Economic Panorama.Widely National Stock Exchange of
travelled and understanding of India for Derivatives product
PRINTED AT : international banking technique in the year 1999. Widely
and practices in India, Middle travelled and understanding of
WORK CENTER OFFSET PRINTERS (I) PVT. LTD.
A-2,32, Shah & Nahar Indl. Estate, East, South East Asia, North international Financial markets
Lower Parel, Mumbai-400 013. America and Canada. in India and South East Asia.
IV V
Contents
I Foreword XIII
II Preface XIV
1. Fundamentals of Foreign Exchange 1

Foreign Exchange 1
Exchange Rate 2
Evolution Of Exchange Rate System 2
The Gold Standard - (1880 - 1914) 2
Period From 1918 — 1939 3
Gold Exchange Standard 1944 - 1970 3
Smithsonian Agreement - 1971 4
Collapse of Bretton Woods - 1973 4
Euro Market 5
Euro – Yesterday, Today and Tommorrow 6
On the road to EMU 6
Exchange Rate Systems 7
Fixed Exchange Rates 7
Floating Exchange Rates 7
Managed / Dirty Float 8
Participants In The Foreign Exchange Market 8
Central Banks 8
Commercial Banks 8
Multinational Corporations, Importers, Exporters 9
Speculators 9
Foreign Currency Accounts 9
Nostro Account 9
Vostro Account 10
Loro Account 10
Foreign Exchange Transactions 10
Exchange Quotation 11
Direct Quotation 11
Indirect Quotation 12
Mechanism Of Currency Trading 13
Types Of Transactions 15
VI VII
Spot and Forward Transactions 15 Spreading risks among different institutions 44

Arbitraging Between Banks 17 Sub -contracting lending risks 44
Cross Exchange Rates 18 Examples of informal risks and maturity sharing... 45
Condition for cross exchange 19
Ready Exchange Rates 21 3. Forex Dealing Room – A Set-up 47
Basis For Merchant Rates 21 Genesis 47
Exchange Margin 22 Segregation 47
Principle Types Of Buying Rates 22 Dealing operations 48
T. T. Buying Rate 22 Selection and training of dealers 48
Bill Buying Rate 23 Electronic data processing (EDP) 49
Principal Types Of Selling Rates 25 Duties of Chief dealer 49
T. T. Selling Rates 25 Roles and functions of the dealers 51
Bills Selling Rates 26 Dealing procedure 53
Calculation Of Ready Rates Based On Cross Rates 27 Voice recording 54
Buying Rates 27 Rotation of dealers 54
Selling Rates 28 Code of Conduct 54
Card Rates 29 Back Office 54
Spread 30 Back office Management in practice 55
Forward Exchange Contracts 30 Profit budgeting 55
Date Of Delivery 30 Middle Office 56
Fixed and Option Forward Contracts 31
Exchange Control Requirement 31 4. Role of Brokers in Dealing Operations 57
Foreign Exchange Swap Deal 34 Exchange Brokers – Prohibitions 57
Roll Over Contract 37 Deals Through Brokers – Confirmation 57
Mechanics of Rollover cover 37 Nomination of Brokers 57
To Cover or not to Cover 38 Brokers’ Panel 57
Complaints 58
2. Interbank Forex Operations 39 Payment of Brokerage Claims 58
Genesis 40 Brokerage Statements 58
Inter bank dealing operations 40 Malpractices by Brokers 59
Position 40 Threat to Brokers 59
Balances abroad 41
Maturity mismatches 41 5. Forex Dealing Operations and
Interbank sales and purchases 41 Risk Management 61
Sales and purchase in overseas markets 41 Forex market in India 61
Inter bank foreign currency deposits 41 Risks in forex 61
Merchant transaction 41 RBI - Guidlines for Control 62
Inter bank transaction 42 Position or Rate Risk 62
Overseas transactions 42 Overnight Limit 63
Function of inter-bank market 42 Day Light Limit 64
Liquidity and risk management 43 Cut Loss Limit 64
Breaking up of maturity transformation 43 Credit risk 65
VIII IX
Contract risk 65 8. Forex and Money Market

Clean risk at settlement 65 - Integration Approach 99
Sovereign Risk 66 Genesis 99
Mismatched Maturates or Gap Risk 67 Riskless Arbitrage Mechanism 99
Operational Risk 68 Interest Rate Parity 100
Segregation of Dealing and Accounting Functions 68 Decomposition Of The Interest Differentials 104
Follow-up of Deal Slips and Contract Confirmations 68 Covered Interest Parity 109
Control Over Settlement of Local and Foreign Funds 69 Treasury Integration – An Essence 113
Branch Reports and Pipeline Transactions 69 Cash Flows and Fund Manager 113
Overdues Bills and Contracts 69 Methology 113
Nostro Reconciliation 69 Integrated Treasury – a definition 115
Skill and Expertise 71 Cost of capital 115
Conclusion 71 Return on investment 117
Inter bank products 117
6. De-Mystified Derivatives and Corporate products 117
Funds Management 73 By Historical perspective 118
Swaps 73 Upgrading of skills 118
Essential features of a Swap 76 Information flows. 119
Types of Swaps 76 Treasury head 119
Mechanics of Swap 77 Dealers 120
The factors that determines the Swap differentials 77 Mid-office 120
Using Swaps : What Managers Must Know 78 Infrasturcture 120
Derivatives – FRA, IRS, Futures, Options 79

Forward Rate Agreements ( FRAs) 79 9. Asset - Liability Management 123
Introduction 123
Interest Rate Swaps 83
Structure and Compositions of Assets and Liabilities 1 2 3
Currency Swap 85
Business Structure 124
Futures 86
Multi-Currency Balance Sheet 127
Options 87
Capital and Regulation 127
Basle committee 127
7. Money Market Operations 91
Objectives of Committee 128
Money Market : A Perspective 91
The Basle committee recommendations 128
Salient Features of the Money Market 92
Regulator’s Role 128
Money Market Instruments 93
Indian Scenario 128
Treasury Securities (Gilts) 93 Importance of Asset Liability Management 130
Financial Futures and Options market 94 Off-Balance Sheet Items 131
Government agencies securities 94 Off-balance Sheet risks 132
Certificates of Deposit (C.D.) 94 Asset/ liability and international banking operations 133
Commercial Paper (CP.) 95
Bankers Acceptances (B.A’s) 95 10. Risk Management Framework
Repurchase agreements 96 – Retrospect and Prospect 135
Municipal notes 97 Genesis 135
X XI
Enterprise Risk Management 136 CLS – operational changes 170

Culture 139 CLS – cultural change 170
Procedures 140 CLS – Impact on other Activities. 170
Technology In Perspective 142 Discussions with CLS – Back office 170
Data Aggregation 143 Monitoring Global Position 171
Risk Analysis 145 Liquidity and credit complications 171
Automated Oversight 147 CLS – Systems Improvement 171
Overcoming risks to systematic risk management 148 CLS – Better Customer Service 172
Risk management as a closed circle 149 CLS – Proactive Initiative By Banks in India 172
Risk strategy 149
Efficient risk management ... 150 12. Exposure Management 173
The banks risk policy ... 151 The Methodology 174
Risk Identification 152 The Economic Region 175
Efficient risk management... 153 Country Rating 175
Risk Measurement 154 Counter-Party Risk Rating 176
Management of interest rate risk 154 Total Capital 176
Policies and procedures 155 Exposure Assumable 177
Measurement and monitoring system 155
Independent controls 156 13. Value at Risk 179
Information for supervisory authorities 156 Genesis 179
Sound interest rate risk management practices 156 Methodology 180
Board of directors and senior management... 157 VaR : A Global Acceptance 180
Interest rate risk measurement systems 160 Limitations 181
Interest rate risk monitoring and reporting 161 VaR - Risk Manager’s View 182
Risk limitation... 161 VaR - Check and Balances 185
Limit system... 162
Conclusion 164 14. Role of Audit in Forex Operations 187
Internal audit 187
11. Settlement Risk and Concurrent audit 187
Continued Linked Settlement ( CLS ) 165 System audit 188
Settlement Risk 165
Committee on Payments and settlement Systems 165 15. Technical Analysis - A Tool to Forecasting 189
Bankhaus Herstatt :- Failure 166 Introduction 189
Retrospect 167 Objectives of technical analysis 190
CLS – Testing 167 Technical analysis is done from four point of view 191
CLS –16 shareholding Banks 167 Checklist of factors 191
Who comprise CLS shareholders ? 168 Isolating a Strong or Week Currency 192
CLS – Service to whom ? 168 Technical Analysisof Interest Adjusted Currencies 193
CLS – Benefits 168 Japanese Candlestick 194
Net Funding Mechanism 169 Bullish Patterns 195
CLS – Timing of fundamental criteria 169 Bearish Patterns 197
Settlement and User Members 169 Reversal Patterns 199
XII XIII
Neutral Patterns 200

Indicators 201
Relative Strength Index (RSI) 201 Foreword
Stochastics 202
Williams’ %R 204
Moving Averages 204 The growth in the volume of international trade and finance has
been tremendous in the recent times. The world economy is
16. Correspondent Banking 211 getting closer and integrated. In the present environment various
Genesis 211 financial markets, viz . forex, money and security markets are
Historical perspective 211 also growing in depth and liquidity and getting integrated. U.S.A’s
Services Bag 212 Federal Reserve ‘s interest rate policy affects the behaviour of
Correspondent Banker and International Banking 212 Foreign Institutional Investors, attitude towards emerging share
Control Documents 213 markets like india, and certainly it effects the forward premium
Advent of Euro 213 and discount in forex markets.
17. SWIFT Operations 215

The knowledge of the basics of the financial markets is a pre-
Background 215
requisite for practitioners in the markets, for academicians, students
SWIFT - A brief history 215
and enlightened layman. With de-regulation of various financial
User Friendly operations 216
markets, freedom of trading has increased. But this exposes to
Message Types (MT) 217
Mandatory and Optional Fields 219 risks and the knowledge of the risk management tools and
Straight Through Processing (STP) 219 techniques is a must. The concept of value-at-risk and its
Message Referencing 219 measurement is important, inspite of its limitations.
BIC Codes 220
Some Do’s 220 The book by Shri A. K. Trivedi and Shri S.M.Hasan on Treasury
SWIFT in India 221 Operations and Risk Management exposes the reader to all
Why to eliminate the telex? 222 these areas with tremendous skill and experience of international
Input 223 banking.
Reporting System 223
Output 224
Dr. M. Thomas Paul
Reporting System 224
Professor of International Banking
Disaster Recovery Plan 225
National Institute of Bank Management
SIBOS 225
Pune - 411048
Global SWIFT Utilisation (Table ‘A’ to ‘J’) 226
Glossary 231
Bibiliography 253
XIV X V
Preface
The economic challenge of globalization is presenting a new

set of problems and opportunities for several organizations. The
trade between the countries is virtually borderless with greater
emphasis on unrestricted capital flow between the countries.
Organizations are now having greater flexibility and alternatives
to raising finance at the comparatively economic cost. In
international finance were an event half away from the world can
have global consequences. In such circumstances, an organization
requires talents, new skills and fundamental knowledge of foreign
exchange, money market and related hybrid products for effective
management of treasuries.
This book is basically tailored for forex & treasury managers,

practitioners and students of international banking. Ultimate
success of all these professionals is visualised how profitably
they managed treasury function. Our objective is to provide a
broader outlook of the forex and treasury management functions.
The topics covered and the treatment of the more traditional
subjects are different. Conceptually the focus has been on the
‘control and operational’ aspects as well as the ‘evolution’ aspects
of the function;the evolutional aspect deals with the genesis
and the various inputs that go into it, the control and operational
aspect is more oriented to a ‘here and now’ situation to take
care of the problem quickly.
Substance for the more recently talked of topics in foreign

exchange and money market and their integration, which we
coined “Treasury Integration”, with concrete modus-operandi and
framework, has been objectively dealt with.
Besides, the book is to provide the reader with a framework for

Risk Management. Such a framework would include several
variables one needs to take into account for, a proper diagnostic
analysis, particularly from micro to macro level. It would enable
to get a broader view and a good ’feel’ of the several related
XVI XVII
TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Fundamentals of Foreign Exchange 1
subjects considered necessary for an understanding of the subject

of Risk Management. Chapter
1
We have attempted to add mix of topics covering necessity of
forecasting, correspondent banking and S.W.I.F.T etc. that could
escape catch of an Indian author to embody the relevant topics
in a single book comprehensively. Glossary cover various Fundamentals
terminologies used in forex business.
of
We do appreciate and thank our reader fraternity who are the
driving force to bring out a book comprehending the whole gamut
Foreign Exchange
of forex and treasury management. We welcome suggestions
and comments from readers. It will add value to refine the
subject matter further. Foreign Exchange
International trade refers to trade between the residents of two

different countries. Foreign exchange is the mechanism by which
A. K. Trivedi S. M. Hasan
the currency of one country is converted into the currency of
other country.
Each country functions as a sovereign State with its own set of

regulations and currency. The existence of a national monetary
unit poses a problem in the settlement of international transactions.
The exporter would like to get the payment in the currency of
his own country.
For instance if ‘A” of New York exports machinery to ‘B’, Mumbai,

the former would like to get payment in US$. Payment in Indian
rupee will not serve their purpose because Indian rupees can
not be used as currency in the USA. On the other hand, the
Importers in India have their savings and borrowings in India in
Rupees. Thus the exporter requires payment in the currency of
the exporter’s country whereas the importer can pay only in the
currency of importer’s currency. A need, therefore arises for
conversion of currency of the importer’s country in to that of
exporter’s country. Foreign exchange is the mechanism by which
the currency of one country is converted in to the currency of
the another country.
The conversions of currencies are done by banks that deal in

foreign exchange. These banks maintain stocks of foreign
XVIII
2 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Fundamentals of Foreign Exchange 3
currencies as balances with banks abroad. For instance, Indian (b) Unrestricted usage of gold by the holder.
Bank may maintain an account with Bank of New York, in which
(c) Unrestricted import and export of gold.
Dollar balances are held. In the earlier example, if ‘B’ pay the
equivalent Rupees to Indian Bank, it would arrange to pay ‘A’ at
2. The Gold Bullion Standard - Under the gold bullion standard
New York in Dollars from the Dollar balances held by it with
the money in circulation was either partly or entirely paper. Gold
Bank of New York.
served as a r e s e r v e a s s e t a n d p a p e r m o n e y c o u l d b e e x c h a n g e d
for gold at the bank of issue. It is fair to expect that the entire
Exchange Rate amount of paper money would not be converted into gold and
therefore the bank of issue need not hold full gold coverage.
The rate at which one currency is converted in to another currency Lower the coverage in gold the greater is the volume of money
is the rate of exchange between the currencies concerned. If in circulation and lower the rate of exchange in relation to other
Indian Bank exchanged US dollars for Indian Rupees at Rs currencies.
43.65 a dollar, the exchange rate between the rupee and dollar
can be expressed as US $ 1 = Rs 43.65.
Period From 1918 - 1939
The rate of exchange for a currency is known from the quotation

Enormous financing requirements of war time economies could
in the foreign exchange market. The banks operating at a financial
only be met by the creation of money and coupled with differing
centre, and dealing in foreign exchange, constitute the foreign
inflation rates between countries, lead to disparity in international
exchange market. As in any commodity or stock market, the
price relationships. Corrective action in the domestic and external
rates in the foreign exchange market are determined by the
economic sectors involved a number of countries in competitive
interaction of forces of demand for and supply of the commodity
devaluation of all important world currencies.
dealt in, viz., foreign exchange. Since the demand and supply
are effected by a number of factors, both fundamentally and
The need to introduce exchange control regulations to manage
transitory, the rates keep on changing frequently, and violently
foreign exchange reserves arose on account of inflation coupled
too.
with devaluation and the consequent flight of capital.
Evolution Of Exchange Rate System.

Gold Exchange Standard 1944 - 1970
The Gold Standard - ( 1880 - 1914)
It was a turbulent period in exchange markets during the second
Settlement of international trade using gold as reference gave World war which gave rise to the need for creating a free stable
rise to a system of fixed exchange rates whose parities were and multilateral monetary system. The American proposal accepted
set in relation to gold. There were two main forms of gold at the Bretton Woods conference in July 1944 was based on
standard— the gold standard and setting up of International Monetary

Fund (IMF) to monitor the operation of the new system.
1. The Gold Specie Standard - The payment of money is

fully backed by gold reserves of the government and therefore The objective of stable exchange rates within a range of
the essential conditions were- permissible parity fluctuation was achieved by each member of
the IMF setting a parity for its currency relative to gold or the
(a) Central bank had to buy or sell gold in unrestricted amounts USD and undertaking to keep rate fluctuations within + or -
at a fixed price. 1% of parity, by central bank market operation. No change in
parity could take place without the FUNDS approval, which Lira came under such a heavy pressure , that the pound was
could not be withheld if the change did not exceed 10%. allowed to float and Italian Lira went on a two tier exchange
market - commercial dealings and financial dealings.
To tideover the problems of deficit in balance of payments, a
credit fund was established and the quota of drawing allowed In spite of, USA revaluing gold in Feb 1973 to USD 42.22 and
based on Gross national product (GNP), currency reserves, and Swiss Francs and Japanese Yen getting revalued by 12% and
fluctuations in external trade was fixed. The limit is denoted in 7.5 % respectively, the inflow of capital to these two countries
terms of Special Drawing Rights (SDR). continued unabated and the European countries suspended their
obligation to intervene in the market signaling the collapse of
The first cracks in the international monetary structure appeared Bretton Woods system with fixed parities and the phenomena of
at the end of 1958 when all Western European currencies had floating exchange rates in major currencies came into existence.
become externally convertible. U.S.A. also recorded a massive
balance of payment deficit of USD 11.2 billion (for the years
Euro Market
1958 to 1960), and this started a run on gold pushing the market
price per ounce above the parity of USD 35, for the first time
The origin of the Euromoney market dates back to the fifties
since 1951.
and it was born more out of fear than confidence.
Smithsonian Agreement - 1971

The Governments of East European countries feared that the
deteriorating political relations with USA could lead to a freeze
Sharply declining interest rates, coupled with the strong rise in
of their dollar balances by the USA and decided to transfer their
the Balance-of-trade deficit sparked off a severe loss of
dollar assets from American to European banks setting the
confidence, resulting in massive flight of capital, and in August
stage for the Euro Dollar market.
1971 the USA was forced to abandon dollar- gold convertibility.
As a result most other countries joined Germany and Holland in
The growth of the Eurodollar market was also on account of
letting their currencies float, thereby bringing to an end official
Pound Sterling crisis in 1957, convertibility of Europe’s major
parities.
currencies in 1958 and the catalyst for the rapid growth being
the USA’s regulation ‘Q’ which forbade American banks from
A general return to fixed parities was concluded under Smithsonian
paying interest on domestic sight deposits with maturities upto
agreement, the salient features being –
30 days and placing of ceiling on interest rates for domestic
I) Rise in official gold price from USD 35 to USD 38, which time deposits.
tantamount to USD devaluation of 7.9 %.
II) Japan and European countries revalued their currencies by A Euro currency therefore is a currency in deposit or loan which
upto 7.66%. is held outside the country of origin of the currency. It is essential
to remember that the currency never leaves the country of
III) Intervention bands widened to + or - 2 1/4 % instead of origin, but is owned by a non-resident (Bank or Individual) of the
1%. country of the currency. The term “EURO” is associated with
these because of the origin of the market in Europe, and is
Collapse of Bretton Woods - 1973 not restricted in its operation to Europe alone. Thus we have
now Asian Dollars, Petro Dollars etc. The market has developed
Smithsonian agreement suffered on account of speculative in other currencies as well and we have Euro marks, Euro yen
movement of capital. First the British Pound and later the Italian etc,.
Euro – Yesterday, Today and Tommorrow fulfilled the criteria. Britain and Denmark have chosen to opt out
as of now.
Euro is the name of common single currency of the Economic

and Monetary Union (EMU). The idea of introducing the Euro Phase III: S t a r t e d January 1, 1999 during which the exchange
was that the single currency will increase Europe’s economic rates was fixed between the participating countries and the
clout and the Euro will become an international currency comparable single currency came into being. This phase will lasts upto
to the U.S. dollar. December 31, 2001. However during this period the legacy
currencies will also exist simultaneously. Euro will become a
parallel unit of accounting. All the cashless payments can be
On the road to EMU made in Euro. The European Central bank ( ECB ) starts functioning
which will be the central decision making body responsible for
In 1957 the famous treaty of Rome was signed which set up the the monetary policy of the participating countries. On the completion
European Economic Community (EEC) and the European Atomic of this phase Euro in form of notes and coins will be introduced.
Energy Community (EURATOM) covering France, Germany, Italy, The currency changeover will occur in all sectors by July 1,
Belgium, the Netherlands and Luxembourg. With the failure of 2002 at the latest. The national bank coins and notes will lose
the Bretton Woods system in 1973 the six member nations their legal tender but can still be exchanged for Euro.
decided to join the system. In 1979 all the member states
joined the Exchange Rate Mechanism (ERM) except UK. Greece,
Exchange Rate Systems
Spain and Portugal joined in soon (1981-86). 1987 saw Europe
Project 92 being launched which approved free circulation of
Fixed Exchange Rates
people, goods, services and capital. Delors plan in 1989 described
the transition to the EMU in three phases.
It is a system, where the parity for a country’s currency is fixed
against another country’s or a group of countries’ currencies.
Phase I: From July 1990 to December 31, 1993 with an aim
The exchange rate does not change on a day to day basis.
to strengthen Economic and Monetary co-operation in Europe.
Generally the central bank or the monetary authority undertake
The Maastricht treaty was signed on February 7, 1992 and
to maintain the parity by effecting sale and purchase of the
came into force 1993 transforming the countries of European
currency at the fixed price. A typical example of this is the Gold
Economic Community (EEC) as European Union (EU). The treaty
Exchange Standard adopted in the Bretton Woods conference in
sets out the convergence criteria which the potential EMU
1944, where the parity of USD/Gold was fixed at $ 35 an ounce
participants must fulfil.
and that of other currencies relative to Gold or USD .
Phase II: Began a January 1, 1994 ending on December 31,

1998. This phase is important because all the participants Floating Exchange Rates
make necessary technical changes for the introduction of Euro.
It was decided that if all the participants fulfill their criteria’s It is a system where the currency is allowed to find its own
then the date for the start of phase three will be set up otherwise price level, determined by the forces of demand and supply for
phase three would automatically and irrevocably commence on a currency against another currency.
January 1, 1999. As on date only 11 countries have fulfilled the
criteria and they are Austria, Belgium, France, Finland, Germany, In the short term the dominant factor will be balance of trade
Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain who and interest rates of the respective currencies and in the longer
will be participating in Euro. Britain, Sweden, Greece and Denmark term the factors of inflation, purchasing power parity and capital
will not be a part of Euro. Only Greece and Sweden have not funds flow have a greater influence on the rates.
Managed / Dirty Float (d) To undertake trading in FX, securities, etc., on their own
account.
Under this system the exchange rates are determined by the

Multinational Corporations, Importers, Exporters -
central banks and the monetary authorities with the primary
objectives being uncontrolled run on the currency, unnecessary
flight of capital ,violent fluctuations in exchange rates, maintenance Corporate clients and other customers use the forex market to-
of external reserves of the country, etc.

(a) To hedge their exposures and also to take advantage of
arbitrage opportunities,
The exchange rate system under the European Monetary Union
(b) Manage their foreign currency assets and liabilities in different
(EMU) is an ideal example of a managed float. Here the central
currencies,
or reference exchange rate of the currencies of member countries
are fixed and the maximum level of variation around that reference
(c) Effect remittance of funds from one country to the other,
rate is also fixed. If the rates move beyond this permissible
band, then the Central Banks undertake market operations to (d) Work out the pricing for imported goods and to quote prices
restore the exchange rate within the stipulated band. for exports.
In actual practice the floating exchange rate co-exists with Speculators -

managed float due to the actions of the concerned central banks.
They are one of the important element in the market which

Participants In The Foreign Exchange Market provides liquidity. Speculators are driven by the future expected
price change. They trade the market without any genuine trade
Central Banks - Functions are regulatory in nature. exposures. In today’s market major share of foreign exchange
dealings are by speculators and their speculative activities.
(a) They oversee the working of the FX market in the country.
(b) Manage the foreign currency assets and liabilities of the

Foreign Currency Accounts
country.
To facilitate dealings in foreign exchange, a bank in India may
(c) Manage cash/funds flow of the country. maintain accounts with banks abroad. Similarly, some foreign
banks may maintain accounts with banks in India. There are
Commercial Banks - Functions of a commercial bank are mainly three type of accounts:
(a) To provide service for exports, imports and remittances for

(1) Nostro Account
residents /non- residents .
(b) To manage the assets and liabilities in different currencies Nostro account is the account maintained by the bank concerned
with regard to deposits from customers, off shore lending, (in India) with the bank abroad. For example , State Bank of
deposits and placements with banks, borrowing on behalf India may maintain an account with Citibank, New York. Obviously,
of clients, etc. the account would be in US dollar. Similarly, it may have a Yen
account with Bank of Tokyo, Japan. While corresponding with
(c) To carryout central banks instructions from time to time. the foreign bank, State Bank of India would refer its account
1 0 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Fundamentals of Foreign Exchange 11
with former as Nostro account, meaning ‘Ours account with Therefore, while in purchase transaction the bank acquires foreign
you ’. So, for the State Bank of India, Nostro account means currency and parts with home currency and in a sale transaction
the bank account it maintains abroad in foreign currency. All it parts with foreign currency and acquires home currency. In
foreign exchange transactions are routed through Nostro accounts. purchase transactions the bank acquires foreign currency and
parts with home currency. In sale transaction the bank parts
(2) Vostro Account with foreign currency and acquires home currency. Following
chart summarises the explanation given.
A foreign bank, say Citibank, New-York, may open Rupee account
with Bank of India. While corresponding with Citibank, New- Foreign Exchange Transaction
Õ
York, maintaining an account with it, the Bank of India may
Õ
refer to the account as V
‘ ostro account’ m e a n i n g Y
‘ our account
with us ’.
Purchase Sale
Õ
(3) Loro Account
Bank Bank
Õ
Õ
Bank of India is having an account with Citibank, New York.
Õ
When the Canara bank of India likes to refer to this account
w h i l e c o r r e s p o n d i n g w i t h C i t i b a n k , i t w o u l d r e f e r t o i t a s L‘ oro
Acquires Parts with Acquires Parts with
account ’ , meaning ‘Their account with you ’.
foreign hom home foreign
currency currency currency currency
Foreign Exchange Transactions
Any transaction has two aspects- purchase and sale. A trader

Exchange Quotation
has to purchase goods from his suppliers, which he sells to his
customers. Likewise, the bank (which is authorised to deal in Exchange Quotation
Õ
foreign exchange) purchases as well as sells its commodity- the
Õ
foreign currency. Two points need be constantly kept in mind
while talking of foreign exchange transactions:
Direct Indirect
l The transaction is always talked from banks point of view;
Õ
and
Variable unit Variable unit
l The item referred to is foreign currency.
Õ
Therefore, when we say a purchase, we imply that Home currency Foreign currency
l The bank has purchased, and
l It has purchased foreign currency

Direct Quotation
Similarly, when we say sale, we imply that
The quotation in which exchange rates is expressed as the

l The bank has sold ; and
price per unit of foreign currency in terms of home currency, is
l It has sold foreign currency known as ‘Home Currency Quotation’ or ‘Direct Quotation’ . It
1 2 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Fundamentals of Foreign Exchange 1 3
may be noted that under direct quotation the number of units of units of foreign currency while selling. This principle is stated in
foreign currency is kept constant and any change in the exchange the form of a maxim : B
‘ uy High ; Sell Low ’.
rate will be made by changing the value in terms of rupees.
Indirect Quotation
Õ
Example - USD 1 = RS. 43.65
Õ
W i t h e f f e c t f r o m 2nd August. 1993, we have changed our system
Buy High SelfLow
of quoting exchange rates to Direct Quotation. By adopting this
Õ
system we have fallen in line with the International practice. It
has become more transparent for the Dealing public and it will Acquire more For a fixed Part with lesser
be easier for them to follow up the movement of exchange units of foreign Õ unit of home units of foreign
rates. currency currency currency
In direct quotation, the principle adopted by the bank is to buy

at a lower price and sells it at a higher price. This principle is The indirect quotation is used in London foreign exchange market
stated in the form of a maxim: ‘ Buy Low ; Sell High’. in the form of 1£ = USD 1.6500 $. In New York and other foreign
exchange market, including India, the direct quotation is mostly
used.
Direct Quotation
Õ
Mechanism Of Currency Trading

Õ
Õ
Buy low Sell high In the direct inter-bank market, which is the largest part of the
Õ
foreign exchange market, Bankers called foreign exchange dealer

at other banks and asks for the market. The caller does not say
Pay lesser For a fixed Receive more
units of home Õ unit of home units of foreign
whether he or she wants to buy or sell, nor does the caller state
the amount to be traded. The caller may say “ Your market in
currency currency currency
sterling please ”. Now a trader gives a two way quote, i. e. he
quotes two prices, a price at which he buys sterling in exchange
Indirect Quotation for dollars and at a price at which he will sell sterling for dollar.
Thus his quotation can be represented as
The quotation in which the unit of home currency is kept constant
and the exchange rate is expressed as so many units of foreign $/£ =1.5560 – 65 or 1.5560/5565
currency is known as ‘Foreign Currency Quotation’ or ‘I n d i r e c t
Quotation ’ . Under indirect quotation, any change in exchange The number on the left of the hyphen or slash is the amount of
rate will be effected by changing the number of units of foreign dollars the trader will pay to buy sterling. This is the traders B i d
currency. rate for a - sterling against dollar. The number on the right is the
amount of dollar the trader will require to sell a pound. This is
Example - RS.100 = USD 2.2910 the traders Ask rate also called as offered rate for a sterling
against dollars. The difference (ask - bid) is the b i d a s k s p r e a d
For a fixed unit of home currency the bank would like to acquire (or the bid - offer spread). In the above case bid - ask spread
more unit of foreign currency while buying and part with lesser is 0.0005 dollars per pound. This margin is the market maker’s
compensation for the cost incurred and normal profit on capital If the initial quotes was say DM/$ 2.0955-0965 he might move
invested in dealing function. it to 2.0965/0975 i.e. offer more marks per dollars sold to the
bank and change more marks per dollar bought from the bank.
In the normal two-way market a trader expects to be hit on both

sides of his quote in roughly equal amounts i.e. on the normal Types Of Transactions
business day a trader expects to buy and sell roughly equal
amount of pound/dollar. The bank margin would then be the bid In foreign exchange market settlement of transactions takes
- ask spread. But suppose during the course of trading a trader place by transfer of deposits between the two parties. The day
finds that he is being hit on one side of his quote much more on which transfer are effected is called settlement date or
often than other side i.e. from the above illustration it means value date . Depending upon the time elapsed between the
that he is either buying more pounds than he is selling and vice- transaction date and settlement date, foreign exchange transactions
versa. This leads to the trader building up a position. If he has can be categorized into spot, forward and swap transactions.
sold more pounds than he has bought he is said to have a net

short position (over-sold ) i n p o u n d s a n d i f h e h a s b o u g h t m o r e Spot and Forward Transactions
pounds than he has sold than he is said to have a net long
position (over-bought ) i n p o u n d s . G i v e n t h e v o l a t i l i t y o f e x c h a n g e The s p o t m a r k e t is the segment in which the two parties to a
rates maintaining a short or a long position for too long can be transaction arrange to conduct the exchange of currencies within
a risky proposition. For instance, suppose a trader has built up a relatively short-term horizon. More precisely, in a spot transaction,
a net short position in pounds of 1 million pounds. The pound the agreed payment date or “value date” for debiting and crediting
suddenly appreciates from 1.5560 $ to 1.5580 $. This means deposit balances is normally two business days after the transaction
that bank’s liability increases by 2000$ (0.0020$ per pound for is arranged, although banks often trade for the “next day” value.
1 million pounds). In this case, of course, pound depreciation The lag allows time for banks to confirm the details of the
would have resulted in gain. Similarly, a net long position leads transactions and properly execute the fund transfers. By contrast,
to a loss if it has to be covered at lower price and gains if it in an outright forward transaction, payment based on an agreed
is at a higher price. exchange rate takes place on a specified date more than two
business days in the future. The maturity of a forward contract
may be a few days, weeks, months, or even years.
The potential gains or loss from a position depend upon the size
of position and the variability of the exchange rates. Building
The transaction in which the delivery of foreign currency takes
and carrying such net position for long duration would be equivalent
place at a specified future date is known as the ‘f o r w a r d
speculation and banks exercise tight control over the traders to
transaction ’ . A forward transaction provides a way for an individual
prevent such activity. This is done by prescribing the maximum
or a business to arrange in advance to buy foreign exchange for
size of net position, a trader can build up during a trading day
the purpose of making a future international payment, or to sell
and how much can be carried overnight.
foreign exchange that will be available in the future. A large
proportion of outright forward transactions is undertaken to hedge
When a trader realises that he is building up an undesirable net currency exposures arising from international trade. In purchasing
position he will adjust his bid ask quotes designed to discourage or selling the foreign exchange forward, the exchange rate can
one type of deal and encourage the opposite deal. be agreed upon today. By contrast, under the alternative of
waiting to purchase or sell the foreign exchange spot at the time
For e.g. a trader who has overbought say Deutchemark against it is needed or available, the individual or business would remain
dollars, will want to discourage further selling of marks and uncertain about the exchange rate until the spot transaction
encourage buyers. took place.
Table 1 : Shares of global foreign exchange market activity, Arbitraging Between Banks
a
April 1992 & April 1995
It is not true that all banks will have identical quotes for a given
Geographical location 1992 1995
pair of currencies at a given point of time. The rates will be
United Kingdom 27 30 close to each other but it may be possible for a corporate
United States 17 16 customer to save some money by shopping around. Let us see
Japan 11 10 the possible relationships between quotes offered by different
Singapore 7 7 banks.
Switzerland 6 5
Hong Kong 5 6
(1) Suppose banks A and B are quoting :
Germany 5 5
All Others 22 21
By Type of Transactions A B
Spots 47 $/£ : 1.5560/1.5570 $/£ : 1.5540/1.5550
Forwards 46
Outright Forwards 7
Swaps 39
This can be represented as :
Futures 1
b
Options 5
By Currency c n ——————————— n A
US Dollar 82 83 bid ask

Deutsche mark 40 37
Japanese Yen 23 24
Pound Sterling 14 10 n ——————————— n B
Swiss Franc 9 NA
bid ask
All Others 32 46
Memorandum item: composition of forward contracts

Obviously such a situation gives rise to an arbitrage opportunity.
by maturity
Pounds can be bought from B at $1.5550 and sold at $1.5560
Up to seven days 64.3
for a net profit of $0.0010 per Pound without any risk or commitment
Eight days to one year 34.5
of capital.
Over one year 1.2
a
Notes: In Percent
One of the basic tenets of modern finance is that markets are
b
Includes both OTC and exchange traded options. efficient and such arbitrage opportunities will be quickly spotted
c
The total of currency traded is 200% representing the 2 way transaction and exploited by alert traders. The result will be, bank B will
have to raise its ask rate and/or A will have to lower its bid
Source BIS October 1993, & 1995
rates. The arbitrage opportunity will disappear very fast. In fact,
in the presence of profit- hungry arbitrageurs, such an opportunity
will rarely emerge in the first place.
(2) Now suppose the rates are as follows: dollar and the exchange rate between the pound and dollar. This
gives rise to the cross rates.
A B
$/£ : 1.5560/5570 $/£ : 1.5550/1.5560 In India, buying rates are calculated on the assumption that the
foreign exchange acquired is disposed of abroad in the international
bid £ ask £ market and the proceeds realised in the US dollars. The US
dollars thus acquired would be sold in the local interbank market
n ——————————— n A to realise the rupee. For example, if the bank purchased a DM
10,000 bill it is assumed that it will sell the DM at the Singapore
n ——————————— n B market and acquire US dollars there. The US dollars are then
sold in the interbank market against Indian rupee.
bid £ ask £
The bank would get the rate for US dollars in terms of Indian
Now there is no arbitrage opportunity as in (1). Thus the two
rupees in India. This would be the interbank rate for US dollars.
quotes must overlap by at least one point to prevent arbitrage.
It would also get the rate for US dollars in terms of Deutsche
However, now bank A will find that it is “being hit” on its bid side
marks at the Singapore market. The bank has to quote the rate
much more often while B will find that it is confronted largely
to the customer for Deutsche mark in terms of Indian rupee.
with buyers of pound sterling and few sellers.
The fixing of rate of exchange between the foreign currency and

From time to time, bank may deliberately move its quote in a
domestic currency through the medium of some other currency
fashion designed to discourage one type of deal and encourage
is done by what is known as ‘Chain Rule’ . T h e r a t e t h u s o b t a i n e d
the opposite deal. Thus bank A may have built large net short
is the ‘cross rate ’ between these currencies. For example let us
position in sterling and may now want to encourage sellers of
assume that in the interbank market dollar is quoted at
pound and discourage buyers. Bank B may be in a reverse
RS 43.65 and at Singapore market the Dollar is quoted at DM
position; it wants to encourage buyers and discourage sellers of
2.0653. With this information, the rate of exchange of Deutsche
sterling thus regular clients of bank A wanting to buy pounds
mark in terms of rupees may be calculated as follows:
can save some money by going to B and vice-versa.
?RS = DM 1
Cross Exchange Rates if DM 2.0653 = USD 1
and USD 1 = RS 43.65

With more than 150 different currencies in the world there are
over 22350 (150 x 149) different exchange rates. This is because The rate of exchange between Indian rupee and Deutsche mark
each of 150 different currencies has an exchange rate against can be calculated by dividing the product of right hand side by
the remaining 149 currencies. Fortunately for the people who the product of left hand side
work in the foreign exchange market, many of the more than
22, 350 possible exchange rates are redundant. The most obvious 43.65x1 + DEM 2.0653x1 = 21.1349 say Rs. 21.14 = DEM 1
case of redundancy is that once we know, for example, the
price of dollars in terms of pounds, this immediately gives the Condition for cross exchange to take place
price of pounds in terms of dollars. This reduces the number of
relevant exchange rate quotations by one-half. However there is Let us begin by defining the spot exchange rate between the
another cause of redundancy: it is possible, for example, to dollars and rupee as S($/RS) or more generally, S(i/j) is the
compute the exchange rate between the German mark and the numbers of currency i per unit of currency j in the spot exchange
British pound from the exchange rate between the mark and market.
First let us consider a person who wants to go from marks to indirect route. That is, for banks exchange rates to be effective
Rupee. In terms of the above figure this is shown by the dark, in attracting Deutschemark - Rupee business it must be such
rightward - pointing arrow along the base of the triangle between that
DM and RS. If a bank is to attract business by selling Rupee
S ( R S / D M ) 3S ( $ / D M ) • S ( R S / $ )
to Deutschemark, the exchange rate it offers directly between
the Deutschemark and Rupee must not be bad than that could
be achieved by going indirectly from the Deutschemark to dollar The exchange rates S(RS/DM) is a cross rate. More generally
and then from the dollars to the Rupee. In the above figure the cross rates are exchange rates directly between currencies when
indirect route involves travelling from Deutschemark to Rupee neither of the two currencies is the US dollars. From e. g.,
via dollars, that is, along the dark arrow from the Deutschemark S(Can$/£), S(Can$/DM), S(DM/SFr) are all cross rates.
to dollars, and then from dollars to Rupee.
What we have discussed above can be generalised for any
cross rates as:
$
S(i/j) = S(i/$) • S($/j)
S(RS/$)
Of course, since as $/j = 1/S(j/$), we can also compute the
S(DM/$)
cross rate S(i/j) from :
S(i/j) = S(i/$) / S(j/$)

S(DM/$) S($/RS)
Ready Exchange Rates

S(DM/RS)
DM RS The foreign exchange dealing of a bank with its customers is

known as ‘merchant business’ and the exchange rate at which
S(RS/DM)
the transaction takes place is the m
‘ erchant rate ’ . T h e m e r c h a n t
business in which the contract with the customer to buy or sell
foreign exchange is agreed to and executed on the same day
If a person buys Rupee directly from Deutschemark, the number
is known as ‘r e a d y t r a n s a c t i o n ’ o r ‘c a s h t r a n s a c t i o n ’ . I n p r a c t i c e ,
of Rupee received per Deutschemark is S(RS/DM) Rupees, the
the terms ‘ready’ and ‘spot’ are used synonymously to refer to
spot number of pounds per Rupee as shown on the side of the
transactions concluded and executed on the same day.
triangle with the dark arrow pointing from DM to RS. If instead
the indirect route is taken from DEM to RS via $, then on the
first leg of exchange, that going from Deutschemark to dollars, Basis For Merchant Rates
each Deutschemark buys S($/DM) dollars. Then on the second
leg, that going from dollars to Rupee, each of these S($/DM) When the bank buys foreign exchange from the customer, it
dollars buys S(RS/$) Rupees. Therefore, from the two legs, S($/ sells the same in the interbank market at a better rate and thus
DM)•S(RS/$) Rupee are received for each mark. makes a profit out of the deal. In the interbank market, the bank
will accept the rate as dictated by the market.
As we know, a bank offering to exchange Deutschemark directly
for Rupee at S(RS/DM) Rupee per Deutschemark must offer at The interbank rate on the basis of which the bank quotes its
least as larger number of Rupee as would be obtained via the merchant rate is known as the base rate.
Exchange Margin bank has the discretion to charge exchange margin at any rate
within the range prescribed.
If the bank quotes the base rate to the customer, it makes no

profit. On the other hand, there are administrative costs involved. Though the name implies telegraphic transfer, it is not necessary
Further the deal with the customer takes place first. Only after that proceeds of the transaction are received by the telegram.
acquiring or selling the foreign exchange from/to the customer, Any transaction where no delay is involved in bank acquiring
the bank goes to the interbank market to sell or acquire the the foreign exchange will be done at TT rate.
foreign exchange required to cover the deal with the customer.
An hour or two might have lapsed by this time. The exchange Nature of transaction where TT Buying Rate is applied are : -
rates are fluctuating constantly and by the time deal is concluded,
the exchange rates might have turned adverse to the bank. l Clean Inward remittance (TT, PO, MT, DD) for which cover
Therefore sufficient margin should be built into the rate to cover has already been provided in AD’s Nostro Account abroad.
the administrative cost, cover the exchange fluctuation and provide
l Conversion of proceeds instruments sent on collection basis.
some profit on the transactions to the bank. This is done by
(When proceeds are credited to Nostro Account)
loading exchange margin to the base rate. The margin that is
built into the rate is determined by the bank concerned within l Cancellation of outward TT, MT, PO, DD, etc.
the range prescribed by FEDAI.
l Cancellation of forward sale contract.
In the interbank market exchange rate is quoted upto four decimals

l Undrawn portion of an Export Bill realised.
in multiples of 0.0025. For customer the exchange rate is quoted
in two decimal places i.e. so many RS and paise
The formula for calculating TT buying rate is :
Principle Types Of Buying Rates

TT BUYING RATES
PARTICULARS Rs.
In a purchase transaction, the bank acquires foreign exchange
from customer and pays him in Indian Rupees. Some of the Dollar/Rupee market spot buying rate X
purchase transaction result in the bank acquiring foreign exchange
Less: Exchange margin X
immediately, while some involve delay in the acquisition of foreign
exchange. TT Buying rate (rounded off to the nearest paise) X X
Depending upon the time of realisation of foreign exchange by

(2) Bill Buying Rate : T h i s is the rate to be applied when a
the bank, two types of buying rates are quoted in India. They
foreign bill is purchased. When a bill is purchased, the proceeds
are :
will be realised by the bank after the bill is presented to the
drawee at the overseas centre. In the case of a usance bill the
(1) T. T. Buying Rate : (T.T. stands for Telegraphic Transfer):-
proceeds will be realised on the due date of the bill which
This is the rate applied when the transaction does not involve
includes the transit period and the usance period of the bill.
any delay in realisation of foreign exchange by the bank. In
other words, the Nostro accounts of the bank would already
have been credited. The rate is calculated by deducting from Two points need noting in loading the bill buying rate with forward
the buying rate the exchange margin. FEDAI has prescribed the margin. First, forward margin is normally available for periods in
exchange margin at 0.025% to 0.08% for T.T. buying rate. The multiples of a month and not for fifteen days etc. Secondly,
forward margin may be at a premium or discount. Premium is Nature of transaction where Bill Buying Rate is applied are : -
to be added to the spot rate and discount should be deducted
l Purchase/negotiation/discounting of export bills. (And other
from it. While making calculations, the bank will see that the
instruments)
period for which forward margin is loaded is beneficial to the
bank.
The formula for calculating the bill buying rate is given by :
Illustration: -
BILL BUYING RATES
PARTICULARS Rs.
Let the forward margin in respect of two currencies, French
Franc and Deutschemark, are as under: Dollar/Rupee market spot buying rate X
Add : - Forward Premium
French Franc Deutschemark (For Transit and usance: rounded off to lower month) X
1 month 0.05 discount 0.04 premium O R

2 months 0.10 discount 0.08 premium
Less:- Forward Discount
3 months 0.15 discount 0.12 premium (For Transit and usance: rounded off to higher month) X
X X
Let us further suppose the interbank buying rates for the currencies
are Rs.6.33 per Franc and Rs 21.25 per Mark. The banks want Bill Buying rate (rounded off to the nearest paise) X X
to calculate bill buying rate for the sight bill, say, 60 days.
If the bank buys a 60 days bill, the total of transit period (say, Principal Types Of Selling Rates
20 days) and usance period (60 days) involved is, 80 days. This
can be rounded of to 2 months or to 3 months. If the bank When a bank sells foreign exchange it receives Indian rupees
includes forward margin for 3 months into the rate, the base rate from the customer and parts with foreign currency. For all sales
for 60 days bill would be(Rs 6.33 - Rs. 0.15) Rs. 6.18 and for on ready/spot basis to the customer, the bank resorts to the
2 months would be Rs. 6.23. Of these two rates, the former is interbank market immediately and the base rate is the interbank
better for the bank as it pays lesser Indian rupees per unit of spot selling rate. However depending upon the work involved,
foreign currency. viz., whether the sale involves handling of documents by the
bank or not, two types of selling rates are quoted in India. They
In the case of Deutschemark, the forward margin is premium. are :
For 60 days bill, it can take forward margin for 3 months and
take the base rate at (Rs. 21.25 + RS. 0.12) RS. 21.37 and for (1) T. T. Selling Rates : This is the rate to be used for all
two months the base rate is Rs. 21.33 Of these two rates that transactions which do not involve handling of documents by the
of RS. 21.33 is beneficial to the bank. bank. Examples of sales for which this rate can be quoted are
issue of demand draft, mail transfers, telegraphic transfers, etc.
Now we can deduce the following rule: For calculating the bill
buying rate, if the forward margin is at discount round off the The T. T. selling rate is calculated on the basis of interbank
transit period and usance period to higher month and if the selling rate. The rate to the customer is calculated by adding
forward margin is at premium round off the transit and usance exchange margin to the interbank rate. The exchange margin
period to the lower month. allowed by FEDAI on T. T. selling rate is 0.125% to 0.150%.
Nature of transaction where TT Selling Rate is applied are : - The method used for calculating selling rates is :
l Outward remittance in foreign currency (TT, MT, PO, DD) SELLING RATES
(TT and Bills Selling)
l Cancellation of Purchase
PARTICULARS Rs.
l Bill Purchased earlier is returned unpaid
Dollar/Rupee market spot buying rate X
l Bill Purchased earlier is transferred to collection account. Add : - Exchange margin for TT selling rate X
TT Selling Rate * X X
l Inward remittance received earlier (converted into rupees) Add : - Exchange margin for Bills selling rate X
is refunded to the remitting bank. Bill Selling rate *
(rounded off to the nearest paise) X X
l Forward purchase contract cancelled
l Remittance relating to payment of import bills which are Calculation Of Ready Rates Based On Cross Rates:
directly received by the importer. The exchange rates for currencies other than the US$ are quoted
to customers based on the rates for the currency concerned
l Crystallisation of overdue export bills.
prevailing in the international foreign exchange market like London,
Singapore, and Hong-kong. These rates are available in terms
Note:- If the remitance is a clean remittance i.e. no
of US$. and they have to be converted into Rupee terms before
documents are to be handled by the banks. TT selling Rate
quoting to the customers.
will be applied.
(1) Buying Rates :

(2) Bills Selling Rates : This rate is to be used for all transactions
which involve handling of the documents by the bank; for example, In the case of foreign currency i.e. other than US$, being tendered
payment against import bills. by the customer, the bank should first get this foreign currency
converted to US$ in the international market. In other words, it
has to buy dollars in the international market against foreign
The bill selling rates is calculated by adding exchange margin
currency. The bank can do so at the market selling rate for
to the TT selling rate. That means the exchange margin enters
dollar. Therefore the customer rate for the foreign currency would
into the bills selling rate twice, once on the interbank rate and
be calculated by crossing the dollar selling rate against the
then other on the TT selling rate. The rate of margin allowed by
foreign currency in the international market and the dollar buying
FEDAI on bills selling rates is 0.175% to 0.200%.
rate against Rupee in the interbank market. The method of
calculating the ready rates thus is tabulated below :
Nature of transaction where Bill Selling Rate is applied are : -
TT BUYING RATES
l Transaction involving remittance of proceeds of import bill PARTICULARS Rs.
(except bills received directly by the importer) Dollar/Rupee market spot buying rate X
Less: E x c h a n g e m a r g i n X
Note:- Even if the proceeds of the import bills are to be remitted TT buying rate for dollar (1) X X
in foreign currency by way of DD, MT, TT, PO rate to be applied Dollar/foreign Currency market spot selling rate (2) X
will be Bill Selling rate. ( F C ) *TT Buying rate for foreign currency = (1) / (2)
(rounded off to the nearest paise) X X
l Crystallisation of overdue importexport bills. * Foreign Currency
BILL BUYING RATES SELLING RATES
PARTICULARS Rs. PARTICULARS Rs.
Dollar/Rupee market spot buying rate X Dollar/Rupee market spot selling rate X
Add : - Forward Premium Add: Exchange margin for TT selling X
(For Transit and usance:rounded off to lower month) X TT selling rate for dollar (1) X X
O R Add : Exchange margin for bill selling X
Bill selling rate for dollar (2) X X

Less:- Forward Discount
(For Transit and usance:rounded off to higher month) X
Dollar/foreign Currency market buying rate (3) X(FC)*
X X
TT Selling rate for foreign currency = (1) / (3) X X
(rounded off to the nearest paise)
Bill Buying rate for dollar (1) X X
Bill Selling rate for foreign currency = (2) / (3) X X
Dollar/Foreign currency market spot selling rate X(FC)* (rounded off to the nearest paise)
Add : - Forward Premium
(For Transit and usance:rounded off to lower m o n t h )X ( F C ) * * foreign currency
O R
Less:- Forward Discount Card Rates

(For Transit and usance:rounded off to higher m o n t h )X ( F C ) *
( 2 )X ( F C ) * Dealing Room of all banks as soon as open for that day’s
Bill buying rate for foreign currency = (1) / (2) X business, works out the exchange rate for all the major currencies
(rounded to nearest paise) and for all types of transactions. This rate will be communicated
to all AD branches of the bank. This rate will be the indicative
rate and this rate will be applicable only for the transaction upto
* Foreign currency
the prescribed level in some banks case it is USD 5000 or
equivalent. ( It may change from bank to bank). After applying
(2) Selling Rates the card rates for the transactions below USD 5000, branches
are advised to report these transactions to the dealing Room if
the transactions value is more than USD 1000 (USD 1000 may
When the bank sells foreign exchange (other than dollars) to the
change from bank to bank). The rate advised by the Dealing
customer, it has to acquire the required foreign currency in the
Room for the information of the branches is known as CARD
international market by selling the equivalent US$. The bank
RATE. It will be in two decimals.
can sell US$ in the international market at the market buying
rate for US$ against the foreign currency concerned. US$ required
to effect this sale has to be acquired in the interbank market at FEDAI has also prescribed that the spread between the Bank’s
the market selling rate. Therefore, in calculating the merchant buying and selling rate should not exceed the minimum level.
selling rate for foreign currency the relevant rates are dollar For all the transactions exceeding the limit, USD 5000, branches
buying rate against the foreign currency concerned in the should contact the Dealing Room and cover the transaction.
international market and the dollar selling rate against Rupee in Only after covering the transaction the branch will quote firm
the interbank market. rate to the customers.
Spread discounted, date of negotiation/purchase/discount and

payment of rupees to customer.
The spread is the difference between TT buying and TT selling 2. In case of bills/documents sent for collection; date of payment
rates. FEDAI has defined the spread as follows:- of rupees to the currency on realisation.
( (TT Selling – TT Buying) / (TT Selling + TT Buying) ) / 2 3. In case of retirement/crystallisation of import bills/documents;
the date of payment of retirement or crystallisation of liability,
FEDAI has suggested following minimum spread for the card
whichever is earlier.
rates for different currencies:-
Name of the Currency Spread limit by FEDAI Fixed and Option Forward Contracts
USD 1.00 % The forward contract under which the delivery of foreign exchange
s h o u l d t a k e p l a c e o n a s p e c i f i e d f u t u r e d a t e i s k n o w n a s ‘f i x e d
GBP, DEM< FFR, CHF, JPY 2.00 %
forward contract’ . In real situations, it is not possible for any
Other Currencies No Limit exporter to determine in advance the precise date on which he
will be tendering export documents. Besides internal factors
relating to production, many other external factors also decide
Authorised dealers are free to quote rates to customers which
the date on which he is able to complete shipment and present
are better than those warranted by the spread limits. The spreads
documents to the bank. At the most the exporter can only
are suggested and not mandatory.
estimate the probable date around which he would be able to
complete his commitment.
Forward Exchange Contracts
With a view to eliminating the difficulty in fixing the exact due
Forward exchange contract is a device, which can afford adequate date for delivery of foreign exchange, the customer may be
protection to an importer or an exporter against exchange risk. given a choice of delivering the foreign exchange during a given
Under a forward exchange contract a banker and a customer or period of days. An arrangement whereby the customer can sell
another banker enter into a contract to buy or sell a fixed or buy from the bank foreign exchange on any day during a
amount of foreign currency on a specified future date at a pre- given period of time at a predetermined rate of exchange is
determined rate of exchange. So the forward exchange rate is known as ‘Option Forward Contract’ . The rate at which the
the rate that is contracted today for the exchange of currencies deal takes place is the o p t i o n forward rate.
at a specified date in future.
Exchange Control Requirement

Date Of Delivery
While booking forward contract for customer banks are required
According to rule 7 of FEDAI, a ‘forward contract’ is deliverable to observe that the exchange control regulations are complied
at a future date, duration of the contract being computed from with. The regulations relating to forward contracts are summarized
the spot value date of transaction. as follows:
Date of delivery under forward contract will be :- 1. Forward contracts can be booked for residents customers
who are exposed to exchange risk in respect of genuine
1. In case of bills/documents negotiated, purchased or transactions permitted under current regulations.
2. Before entering into a forward contract, it should be ensured FORWARD BUYING RATE
that the customer is, in fact, exposed to exchange risk in
PARTICULARS RS.
a permitted currency in the underlying transactions.
Dollar/Rupee market spot buying rate X
3. Forward contract facility is available for genuine forex Add : - Forward Premium X
exposure only. (For Forward period, Transit period and Usance period
rounded off to lower month)
4. Exchange brokers are not authorised to book forward contract O R
as they are not authorised to purchase or sell foreign
exchange. Less:- Forward Discount X
(For Forward period, Transit period and Usance period
rounded off to higher month)
5. Exporter and importer in India can book forward contract
X X
only with those banks who are authorised to deal in foreign
exchange (Ads).
Forward Buying rate for dollar (1) X X
6. The bank should verify the underlying obligation contract
Dollar/Foreign currency market spot selling rate X (FC)*
as the forward contract is available for underlying commercial
Add : - Forward Premium X (FC)*
transactions which expose the merchants to exchange rate
(For Forward period, Transit period and Usance period
risks. The bank should ensure that the transactions for
rounded off to higher month)
which the forward contract is booked is a permissible one
under the Exchange Control Regulations India. O R
Less:- Forward Discount X (FC)*

CALCULATION OF FORWARD EXCHANGE RATES (For Forward period, Transit period and Usance period
rounded off to lower month)
The method of calculation of forward exchange rates is similar

(2) XX(FC)*
to that for ready rates. The only difference is that in the case
of forward rates, the forward margin that is included in the rate Forward buying rate for foreign currency = (1) / (2) X
will be for forward period as well. For instance, if the bank buys (rounded off to nearest paise)
a 30 days sight bill for 2 months forward, the total forward
discount will be for (30 days usance + 20 days transit + 2 *foreign currency
months forward, rounded off to higher month) 4 months.
FORWARD SELLING RATE
For selling rates, forward margins is not considered while calculating PARTICULARS RS.
ready rates. In the case of forward rates, the forward margin for Dollar/Rupee market spot buying rate X
the forward period will be included. In other respects, the calculation Add : - Forward Premium (for Forward period) X
is same as that of ready rates.
O R
Less :- Forward Discount (for Forward period) X

X X
Add : Exchange margin X
Forward TT Selling rate for dollar (1) X X A swap deal is done in the market which is different from the
ordinary deals; In the ordinary deals the following factors enter
Add : Exchange Margin for selling rate X into the rates:
Forward bills selling rate for dollar (2) X X
1. The difference between the buying and selling rates; and
Dollar/Foreign currency market spot buying rate X (FC)*
2. The forward margin, i. e, the premium or discount.
Add : - Forward Premium (for Forward period) X (FC)*
O R Thus, a swap - constitutes a simultaneous purchase and sale

of a specified amount of foreign exchange for two different
Less :- Forward Discount (for Forward period) X(FC)*
value dates. In a swap transaction, the amount of foreign exchange
XX(FC)*
purchased spot (or at a near term forward date) is simultaneously
Forward TT selling rate for foreign currency = (1)/(3) X sold forward (or at a more distant forward date). Swaps can
(rounded off to nearest paise) provide an attractive vehicle for corporations or institutional funds
to make temporary investments in a currency. Swaps also provide
Forward bill selling rate for foreign currency = (2)/(3)X
a mechanism for a bank to accommodate the outright forward
(rounded off to nearest paise when quoted to customer)
transactions executed with its customers, and more generally,
to modify the maturity profile of its outstanding spot and forward
*Foreign currency
contracts.
Foreign Exchange Swap Deal In a swap deal the first factor is ignored and both buying and
selling are done at the same rate. Only the forward margin
A ‘swap deal’ is a transaction in which the bank buys and sells enters into the deals as the swap difference. T h e nature of a
the specified foreign currency simultaneously for different maturities. swap deal is explained below with an example.
Thus a swap deal may involve:

When Bank A buys USD from Bank B against DEM value spot
1. Simultaneous purchase of spot and sale of forward or vice- and simultaneously sells back the same amount of USD to
versa; or Bank B against DEM value 1 month forward, then both the
banks have done a swap transaction. The spot rate and the 1
2. Simultaneous purchase and sale, both forward but for different
month forward rates will be different because the 1 month euro-
maturities. For instance, the bank may buy one month
rates for USD and DEM will be different. Let us assume that the
forward and sell two months forward. Such a deal is known
SPOT rate was 2.0653 and 1 month forward rate was 2.0663
as ‘forward to forward swap’.
and work out the Currency Position and Fund Position.
To be precise, a deal should fulfill the following conditions to be

USD/DEM Currency Position for Bank A:
called a swap deal:
D a y Particulars USD USD Value Position Rate

1. There should be simultaneous buying and selling of the Bought Sold Date Net
same foreign currency of same value for different maturities;
Day-1 T-1 1,000,000 - Spot 1,000,000 2.0653
2. The deal should have been concluded with the distinct Day-2 T-2 - 1,000,000 1mth. 0 2.0663
Forward
understanding between the banks that it is a swap deal.
The currency position is square at the end of Day-1 because Leg 1 Sell USD against DEM @ 2.0623 value today
there was a simultaneous purchase and sale of USD/DEM.
Leg 2 Sell USD against DEM @ 2.0643 value tomorrow
This is called an OVERNIGHT or a O/N Swap

Funds Position For Bank A :
USD Leg 1 Sell USD against DEM @ 2.0623 value tomorrow
DAY RECEIPT PAYMENT BALANCE Leg 2 Sell USD against DEM @ 2.0643 value spot
Spot 1, 000, 000 +1, 000, 000 This is called an TOM/NEXT or a T/N Swap
1 Month -1, 000, 000 0

A swap transaction thus basically results into an exchange of
cash flows between the two banks for an agreed period. The two
currencies involved may have different interest
DEM
DAY RECEIPT PAYMENT BALANCE Roll Over Contract

Spot -1, 560, 000 -1, 560, 000
The Indian forex market is yet to develop enough to provide a
1 Month 1, 561, 000 +1, 000
cover more than six months forward. This means that while we
can cover exposure upto six months in future be a simple
It will be seen from the funds position that bank A was in USD forward transaction, for exposure beyond six months we have to
funds for 1 month and was out of DEM funds for 1 month. The look at more complex hedging techniques. This is called a
surplus of DEM 1, 000-which has accrued in the DEM account Long-term Forward Cover or a Roll over Cover.
is out of the compensation that the bank A must receive for
paying out DEM (higher interest rate) funds and receiving USD Mechanics of Rollover cover
(lower interest rates) funds for a period of 1 month.
To understand how it works, let us take an example. XYZ Co.

There are, therefore, two legs of a foreign exchange swap. In has borrowed 5 million USD repayable in 5 instalments of one
the above example the two legs are: million each. Date of borrowing is 1/1/98 and the repayments
are every six month starting from 30/6/98. We are ignoring
Leg 1 Buy USD against DEM value spot @ 2.0623 interest payments. Let us assume forward premium to be 10%
annualised and rupee depreciation against the USD 15% annualised.
Leg 2 Sell USD against DEM @ 2.0643 value 6 months
forward
XYZ enters into a forward contract with the bank on Rollover
This is called a SPOT/FORWARD SWAP
basis. Bank will sell XYZ Co. five million value 30/6/98. On 30/
6/98 Bank will deliver one million USD for repayment at the
Leg 1 Buy USD against DEM @ 2.0623 value 3 months contracted rate. Balance of 4 million USD will be 31/12/98.
forward However, the contract rate does not change. This will be recovered
Leg 2 Sell USD against DEM @ 2.0643 value 6 months from the customer as extension charges. On 31/12/98, again
forward USD one million will be delivered at the original contracted rate
and balance 3 million extended. This will continue till all the
This is called a FORWARD /FORWARD SWAP repayments are made.
3 8 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Interbank Forex Operations 3 9
To Cover or not to Cover

Chapter
The decision to cover or not, will depend on the customer’s 2
appraisal of Rupee depreciation as compared to cost of forward
cover. If the customer does not cover, he leaves himself open
to any change in USD/Rupee price. His outflow will increase
with increasing depreciation of Rupee. If he covers on Rollover Interbank Forex
Basis, his exposure to Rupee depreciation is covered. However,
he opens himself to another risk – the Premium Risk. Higher the Operations
premium, higher the extension charges. He also cannot be sure
of the premiums prevailing in future. Even with Rollover cover
therefore he is not 100 % hedged, in the sense that he cannot
fix his Total Rupee out flow at the time of booking the contract.
Genesis
Customer, therefore, has to compare expected % depreciation
of Rupee with the expected % cost of forward cover. If the Bank to bank international business takes two basic forms:
former is much higher than the latter, COVER. If the If the latter
is much higher than the former, DO NOT COVER. The decision Interbank Deposits (placements) /Loans
to cover or not is always a difficult one to make. It should be
a part of the total exposure management strategy of the company In both instances the growth of the international inter-bank market
with clear understanding that the decision they take may not has been substantial over the years. Such an activity is conducted
turn out to be the best in such an uncertain scenario. not in any one country, but it is entered in the leading national
financial cities: Sydney, Tokyo, Singapore, Hong Kong, Dubai,
Mumbai, Amsterdam, Paris, Zurich, Frankfurt, Brussels, London,
New York, Toronto & others, i.e., right from Asia pacific to
America and Canada. Within each city, the market is further
decentralized. There are no opening and closing times in the
foreign exchange market. The day starts with the opening of the
Sydney followed by Japanese market then the market at Singapore
and Hongkong, then the European and then the American; by
the time the American market closes the Sydney and Japanese
start again on a fresh day the market operates round the clock,
thus as such the foreign exchange market never sleeps, one
can enter into a deal at any point of time. However, it is a
facilitating mechanism through which one country’s currency
can be exchanged i.e., bought or sold for the currency of another
country. It does not have any geographically locations.
The forex market comprises all the forex trades who are connected
to each other throughout the world by means of Tele
communications network. They deal with each other through
telephone, telex, and other electronic devices, With the advent of correspondent and branches in the country concerned. While
of possible technology like Reuters 2000-2, it is possible to transacting foreign exchange business, banks should ensure
access any trader in any corner of the world within a few seconds. that balances are not accumulated in their Nostros, which are
Deals can also be struck through electronic systems allowing in excess of immediate needs of such payments towards imports
scope of bid and offer rates to be matched automatically. or maturing deliveries under forward contracts or other remittances
etc.
By managing and arbitrating and hedging of their own and
customers, positions within each country and between currencies, Maturity mismatches
they provide the market with continuity and depth. The central
banks sometimes- control the movement of the market-‘ maintaining
Banks normally avoid outright forward or swap transaction, which
an orderly market’ by trading with commercial banks or by trading
will result in maturity mismatches in excess of the aggregate
among themselves. In countries without full convertibility, the
gap limits.
central banks often take a larger role by controlling the movement
of funds.
Interbank sales and purchases
Corporate buy and sell foreign exchange with banks to facilitate
the movement of their goods and funds, and also to hedge their Banks can freely buy and sell, for both spot and forward deliveries,
risks and exposures. This retail side of the market is where the any permitted currency to be settled against home currency.
long term supply and demand for currencies originate.

Sales and purchase in overseas markets.
Inter bank dealings operations
Bank can purchase and sell, for any permitted currency and to
Considering the nature of transaction, it is found that dealers in overseas banks and branch to cover a transaction with a customer
forex market deal with each other as per guidelines by regulatory, in home country
monetary authorities in the country concerned. A few aspects
are explained as under: - Inter bank foreign currency deposits.
Position Bank may freely place and accept deposits in permitted currencies
with and from other banks at the market related rate of interest.
The open position of banks at the close of business each day Various types of dealings that take place in forex markets are:-
in each foreign currency should be within overnight position limit
prescribed for that currency by their management. Before laying
Merchant transaction
down open position limits, banks should get it approved from
regulatory authority if required.
The bank buy/sell foreign exchange from/to exporters/importers
other customers. These are known as merchant transaction.
Balances abroad These transactions can be undertaken only on account of exposure
of the customers and speculation is not encouraged. These
Banks do maintain with overseas branches and correspondents, merchants can book and cancel forward contracts with bank in
balance in foreign currencies at levels, which are commensurate respect to their foreign exchange exposures. However, many
with their normal business needs having regard to the number central banks hence liberalized further and allowed NRI’s /FII’s/
OCB’s to book forwards contracts for certain accounts /investment Liquidity and risk management
by them abroad.
In addition, the inter bank market aids liquidity and risk management
in a number of ways. A major function of inter bank funds is to
Inter bank transaction
enable banks to cope up with the lumpiness of wholesale –sized
deposits and loans and plug up holes in the balance sheet.
When one bank deals with another bank, i.e. buys/sells foreign
Unwanted deposits can be laid of to other banks. Funds, needed
exchange, it is known as inter bank dealing. The banks are
to support lending can be bid for inter bank. In this way, the
allowed to deal freely amongst themselves. Most of the banks
need for resources as such is largely obviated. Inter bank and
are not market makers and are rather market user/takers. There
related funds market give confidence that funds to meet balance
is not much liquidity and depth in the foreign exchange market
sheet contingencies will be available. This confidence under
in many developing countries and even the small demand or the
pins banks willingness to issued stand by credit lines in of
market notices supply. In the Indian scenario, after rupee joined
balance sheet business. Banks go to considerable length to
the freely floating currencies there are days when exchange
maintain a market presence and to keep open inter bank credit
rates in inter-bank markets had been very volatile and RBI
lines. For unlike formal stand by lines of credit inter bank
intervened in the market on various occasions during such periods.
borrowing in never assured –‘ the market lives on lunch time
Market is skewed in consideration to business booked by a few
gossip’ (clarke). Bank adopts the habit of re-depositing a practice,
banks.
which incidentally inflates the statistic of market size. Trading
on both sides of the inter bank market prevents a bank from
Overseas transactions being seen as a perpetual taker of funds, so enhancing its
repute it also enables reciprocal relationships with other banks
to be formed. Most banks immediately re-deposit with other
When a bank buys/sells foreign exchange in the overseas markets,
banks over 40 percent of funds obtained in the market.
it is called an overseas transaction for the originating bank. In
Indian scenario, RBI liberalized and permitted banks to initiate
position in cross currencies in the overseas markets. Breaking up of maturity transformation
Inter –bank markets break up the maturity transformation process.

Function of inter-bank market In retail banking maturity transformation is normally undertaken
fully by the bank which accepts the deposit. On their way from
Linkages of regions and interest rates. end suppliers like OPEC countries, to end-users like the developing
countries funds in international banking may pass through several
The international inter-banks market performs many functions. chains of banks and--
It ties regions together much as money markets do domestically,
at the same time linking interest rates across markets. By maturity transformation can take place in any one of the chains.
standing between the suppliers in one location and end-users While the bank making the end placement is likely to carry the
elsewhere, the market performs an intermediary function in the largest share, each bank is still left with some share of the
global flow of funds. It provides for forward exchange covering transformation process. Taking positions in the inter-bank market
and enables banks to take speculative and/or hedging positions “mask” and thus facilitates the overall degree of maturity
against interest rate and exchange rate movements. Many transformation inherent in non-bank business. By their addition,
transactions are not inter-banks at all but are statistical images greatly mismatched non-bank business is “padded out” or diluted
of interbank arbitrages and transfer pricing motivated by bank’s in the total balance sheet. Each bank’s total balance sheet is
avoidance of tax and banking regulations. mismatched but not to a great extent.
Spreading risks among different institutions Illustrations
Finally, the inter-bank market enables the risks of lending to be Functionality of liquidity transformation can be illustrated as
spread amongst many different institutions. Loans risks are follows: -
backed not just by the capital of the lending bank but also
1. If a bank has arranged to make a loan of USD 1 Mio for
indirectly by the capital of the banks, which agree to lend to it.
one year, it is most unlikely that his customers will of their
The risk is known to participating bank and finds reflection in
own accord come forward with the effect of deposits to
the practices of interest rate “tiers” and lending limits. Banks
that amount and with a maturity that he can accept as
are classified into interest rate tiers according to perceived risk.
matching the loan atleast he cannot rely on this happening
The margin levied by the lending bank is in effect a premium
within the next two or three days. Instead the banker turns
paid by the borrowing bank for “insurance” against the default
to the inter-bank market for the deposits he needs to support
risk shared. In normal times, the range of rates for most banks
the loan. The chances of success are many times greater
is around ¼ of 1percent. But at times some banks have paid as
than if he relies on his customers because all that is
much as 2 % over LOBOR to get funds. Nearly all banks set
required is that somewhere in the secondary banking system
overall and daily limits on interbank placements of funds. Factors
deposits shall have been placed with the banks that have
governing the size of limits are the size and profitability of the
no immediate business in prospect.
institution, quality of management, evidence of over-trading in
the market and its access to lender of the last resort funds in
The same is the case of deposits. They do not arrive in
its national market.
“marginal” amounts that can be turned away so they are
lent out to other banks.
Whereas inter-bank dealings can be looked upon as in past as
informal means of risk-bearing banks do seek to protect themselves
against loan risks in more formal ways. These include co-financing Examples of informal risks and maturity sharing
with official lending institutions, credit insurance home government arrangements.
guarantees with national export banks or agencies. But by far,
the most important risk-sharing device is the syndication of 1. Wholesale bank “A” receives larger deposits. It seeks out
large loans. some non-bank customers and lends on the rest to bank
“B” via the inter-bank market. Bank “B” in turn lends out
Sub-contracting lending risks some to non-bank customers and the rest to bank “C”.
Loan syndication transaction are a formal sub-contracting of 2. Wholesale bank “X” is approached for a medium-term loan
lending risks, precisely equivalent to co-insurance and re-insurance by a non-bank customer on a 6-month roll over basis. On
arrangements in international insurance markets. Their purpose the interbank funds borrowed, bank “X” may want to go as
is the same; they enable the individual institutions to spread the long as possible but beyond 3 months, it is difficult. It thus
risks, avoiding too many exposures to individual cases. Because bids for 3-months interbank funds. Bank “Y” supplies 3-
of the arrangements institutions both individual and collectively month interbank loan, itself accepting 1-monthmoney from
take on greater risk than would otherwise be the case. bank “Z” which has a call deposits from a customer.
The first transaction can be seen as a form of informal risk

bearing. Given the normal maturity of deposits, bank “A” is
subject to the risks that the deposit may be withdrawn at short
4 6 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Forex Dealing Room - A Set-up 4 7
notice. In this case, the risk is spread across a number of

banks. As and when reinsurance arrangements exist a “claim” Chapter
by the customer against his option of withdrawal is meet in part
by the bank drawing upon its “contracts” with the other bank.
3
In the second example, another type of informal risk sharing is

illustrated. The interbank claims held by bank “Z” and “Y” are Forex Dealing Room
“backed” by the rollover loan which bank “X” has made to its
customers. Because the customer’s loan has default risk, so – A Set-up
does the inter-bank loan, though to a lesser extent because of
pooling. In principle at least the two banks should be assessing
the riskness of bank “X” asset portfolio and unlike non-banking
customers ought to be in a position to do so. Interest rate on
interbank transaction is to some extent “tiered” into quality classes,
as explains earlier. Genesis
Concludingly it is observed that with the vacuum between the Foreign exchange dealing operations though a profitable is a
cross-border diminishing, inter-dependence of countries on others high-risk activity. There are additional risks involved in this
is increasing, forex market is going to be more active and business that are not generally found in the routine banking
important. When the economies are on the way to further business. For a bank to be successful in forex operations the
liberalization, the gambit of banks has been expanded considerably. pre-requisite is a properly organized dealing room. It being a
The role of different banks is becoming more specific. Thus, highly specialized function has to be performed by well – trained
inter-bank business is of vital significance and an important personnel. Dealing department used to consist of dealers and
source of revenue to the banks. back office staff who is responsible for the follow-up of the
deals made by the dealers. With the passage of time, it is
understood and the need for effective control over the dealing
operations is envisaged as possibilities do exists for manipulation
of exchange rates, dealing positions, mismatches etc. the role
of mid – office has been in focus. As transactions relating to
forex are undertaken within the banks, on behalf of the bank in
the interbank market, in parallel markets, or with customers.
Segregation
The vital canon of operational procedures in the area of forex

activities is the clear functional separation of dealing, mid –
office, back office (processing scrutiny and control), accounting
and reconciliation. Some of banks being active trader and market
maker offer the whole range of product. Dealing activities are
segregated as under:
Dealing operations : Electronic data processing (EDP): (on line

processing)
Front office - dealing room (active operation)
The data processing systems in service needs to be appropriate
Mid-office - risk management and control, accounting policies to the nature and volume of business activities and programmed
and management information system specifically to ensure functional segregation. Rules for performing
distinct functions should be defined in detail and drawn up by
Back office - settlement, reconciliation, accounting, Recording persons unconnected with the forex dealing operations.
and reporting.
The data is recorded in an EDP system; it must be ensured that
dealers are enabled to enter transactions solely through
Selection and training of dealers : identifications. The trading date, time and transaction serial
number must be entered, automatically by the system, which
Dealers have to be selected carefully. The qualities that go in obviously will be impossible for the dealer to alter.
making of a dealer are :

In case of deviation from the specified norms when entering
a) broad understanding of the international scene transaction data, it must be approved in each case by an official
not connected with dealing office. When forex operations are in
b) ability to make quick decisions
extended dealing hours and the deals concluded after the back
c) ability to adapt to changing market conditions office has been closed recording for the day (late deals) are to
be marked as such and included in that day’s position. A late
d) ability to be calm in a crisis. deal slip must be processed immediately by an official unconnected
with the dealer so as to facilitate proper accounting of the deal
concluded and avoid scope for not carrying deals in the system
The usual requirement like integrity, commitments to the bank
on the same day basis.
are obvious. Thus heavy responsibility rests upon the dealers
as the manner of handling the inter-bank foreign exchange business
of the bank can make all the difference to the bank and its Duties of Chief dealer / dealer :
customers.
Chief dealer :
Adequate, and timely care therefore needs to be exercised while
The chief dealer has the most essential role in the dealing
selecting and grooming the dealers. Management should provide
room. He is a general who instills/morale and makes the team
opportunities to the dealing room staff to get continuously updated
function as efficiently and profitably as possible, by earning the
on global market trends in forex and derivatives trading and risk
respect of his other subordinate colleagues and extracting the
control aspects.
best from them. He is expected to use psychology and common
sense demanding maximum productivity, from his team, but
While drafting personnel from other banks or organizations as remaining keenly aware of staff problems and needs, and making
dealers their antecedents need to be care fully verified from the every effort to help them whenever possible. He operates as a
standpoint of integrity and background. When a dealer leave the liaison between management and the dealers, he implements
bank with bank’s interest in jeopardy, a reference heed be made policies and ensures compliance with those policies, and makes
to regulatory authority management aware of developments within the room. In this
fashion, he can be most efficient by following management Later he will monitor their progress, provide them with counsel
guidelines and code of ethics. and guidelines, and evaluate their performance. When
necessary he will recommend dismissal of those who fail
Chief dealer is totally responsible for everything that goes on in to maintain the proper standards. Such cases his authority
the dealing room. His job is to anticipate difficulties and find need to be given weight because of his ultimate responsibility
ways to solve them. His responsibilities do not disappear when for the overall performance of the dealing room.
he is away, before going on vacation or on a tour, he will take
all necessary proactive measures to ensure smooth functioning The dealer has to operate in the interbank market according to
of the room. the guidelines laid down by the management and the overall
control and supervision of chief dealer. Ideally dealers may
l Management provides the chief dealer with guidelines and confer before work starts, on the tend in the overnight markets
certain limits for the operation of the dealing room. He is in the light of the “newsbag” and the bank’s own business portfolio
expected, however to help management in reviewing and and arrive at tentative conclusions valid for the day. It is
refining such limits in line with market developments. essential that efficient communication channels be provided for
dealers to facilitate consolations with designate authorities in
addition to chief dealer.
l One of his most important functions consists of preparing
and monitoring a budget for the dealing room. This gives
management a better insight into the true profitability of his Roles and functions of the dealers.
operations. His input on current events is very important
to his superiors in providing them with an accurate picture l What makes a good dealer? Is there a standard answer to
of the markets. this question?. Besides the skills required for a successful
career are not taught in schools, because they are primarily
The keenness of his insights may be of valuable help in of a practical, rather than theoretical in nature.
determining new policies.
l A good dealer is above all a survivor. He needs a good

l Within the dealing room, the chief dealer is one of the understanding of the changing nature of things, and cannot
policy makers, determining broad strategies and monitoring afford to be obstinate. Certain psychological qualities are
their implementation. Within the framework provided by prerequisite: the ability to work under stress, willingness to
policies, his philosophy influences the style and methods accept responsibilities, the ability to make decisions quickly,
of dealing. good measure of aggressiveness, and above all a willingness
to recognize that one can be wrong.
l Not atleast among the functions of a chief dealer is
providing the proper training for his staff. Such training can l Dealers are entrusted with powers almost unparalleled in
be provided internally by holding classes and discussions banks. On the strength of the word ‘ done’, at a moment’s
after business hours, or by having junior dealers and notice, they are committing their institutions to sizeable
trainees participate in outside seminars. obligations. They deal with large sums of money, and are
often in danger of losing perspective: in the market, ‘five’
l Another important function is that of determining staff stands for five million.’ in a matter of minutes, a dealer
requirements, hiring or rotating. The chief dealer should be stands to gain or lose tens of thousands for the bank’s
best qualified to know what levels of skills are needed in money. The often-volatile nature of the markets aggravates
the dealing room, and interviews prospective members. this situation.
l There must thus exist an atmosphere of complete trust successful dealing, but it helps in developing strategies.
within a dealing room. The chief dealer is entrusted his News can be interpreted more easily, and decisions can be
team with his career, and must be confident that any problem reached in a better-rounded manner.
will be immediately brought to his attention. There can be
no effective way of operating if the chief dealer feels that l Among banks where foreign exchange is primarily a profit
his dealers are hiding something from him. Similarly, dealers center, dealers have two primary functions. The first is to
can only function effectively when they work in an environment, be able to manage currency positions by taking a view of
which allows them to concentrate fully on their work. They the market, and thereby to be profitable; the second is
cannot afford distractions, and problems not directly related to be able to make markets or prices on demand, in a
to their positions should be put off until such time as they manner which favourably reflects on their institution and
are not actively involved. which does not adversely affect them.
l One of the most difficult things for a dealer to learn is l The measure of success of a dealer is ultimately his
when to get out of a bad position. Even in the case of profitability. Whether he maintains a high or low profile and
experienced dealers, the desire to salvage something out how his colleagues in the market view him are secondary
of a bad position or the feeling that the rest of the market considerations. He is paid by his employers, who are best
is wrong, are difficult sentiments to fight. The fact remains able to judge his performance. A reliable level of profitability,
that dealers who were not willing to admit that their positions rather than an erratic performance, is most appreciated.
were wrong have incurred the great majority of all large
losses.
l The behavior of a dealer in the market place and the friends
he makes can also give him a good or bad reputation.
l Instinctive dealing can be defined as the ability to sense
Friends are of the most precious commodities in the business
the trends of the market. This important quality is the
– they will be glad to exchange information and express
result of experience, and is the best expressed by sensitivity
their views, and can provide valuable insights. After all,
to rate movements and to the liquidity of the markets, and
knowing what other market participants think helps in the
a flexibility of mind that allows a clear analysis of what is
knowledge of the market. On the other hand, behavior that
going on. Such experience is the result of a long presence
creates ill feelings is seldom profitable in the longer run.
in the - markets and learning from one’s mistakes. The
There is a little charity in the market, and few will help a
complexity of the markets always challenges the abilities
disliked dealer in trouble.
of the dealers, and it is impossible always to be right.
What is expected of dealers is that they will minimize
losses while maximizing profits. Dealing procedure :
l Theoretical knowledge of the foreign exchange markets is The dealers should have no accounting work of any kind to
powerful help for successful dealing, since it is as important perform. They should concentrate on the market by maintaining
to understand or predict basic trends as be aware of contact with other banks, brokers, as well as banks overseas.
day-to-day fluctuations. The two broad categories of theory Deals struck should be recorded on printed ‘deal slips’ free from
are background historical, geographical, political, economic all flaws. The deal slips should indicate the name of the broker
and financial understanding of countries whose currencies (if any), and the counterparty bank, currency, amount, time, rate
are dealt, and an awareness of how developments influence and due date, after authentication of the dealer. The deal slips
the markets. Knowledge does not necessarily guarantee a should be passed on without delay to the back office for further
correct understanding of the market nor are the key to processing.
Voice recording : l Develop core management skills to ensure the team is

involved, informed and motivated
Experience reveals that recourse to taped conversation proves l Operation area a key revenue protector
invaluable to the speedy resolution of differences. It is therefore
desirable to introduce voice recorders in the dealing rooms.
Back office Management in practice:
The tapes may be preserved for the time as per bank’s policy
and where a dispute has been raised, until the issue is resolved. l Confirmation of contracts is obtained for all deals from
Access to the equipment and tapes should be subject to strict counterparty banks and duly verified for correctness and in
control. no case the dealers sign the confirmation, (in regard to
cash/tom/spot contracts, confirmations may not be insisted
Rotation of dealers : upon, if the amounts thereof have been received in the
nostro accounts)
Dealers should not be kept for too long on dealing duties, a l Discrepancies noticed are rectified on the same day.
period of three to five years being considered reasonable for
effecting a change. Further a system of an annual compulsory l In respect of computer generated deal confirmations slips,
two-week break is suggested to be introduced so that no dealer which are not signed, banks issuing such confirmation
remains at the job continuously. execute a stamped agreement in favour of the counterparty
banks assuming responsibilities for errors/omissions.
Code of Conduct : l The evaluation of foreign exchange profits and loses are
undertaken at periodic intervals as per bank’s policy.
Dealers should furnish an undertaking to conform to the code of Trading profit and loss to be undertaken on the same day
conduct prescribed in Indian scenario by Foreign Exchange Dealers basis.
Association of India (FEDAI).
l A statement of true currency position is submitted to the
management after reckoning the effect of all transactions
Back Office : in the pipeline. The position and funds register are continually
updated on the basis of deal slips and there reports of
The back office should ensure increase control and improve business flowing from the branches, to assist the efficient
performance and productivity by implementing world class transmission of information to the dealing room and the
management techniques. management.
l Enhance the speed and efficiency of control, processing l Rate-scan reports are prepared quick regular intervals say
and settlement activities at least thrice a day (at opening hours, afternoon and closing
hours) and deals at wide variance with the on-going market
l Identify and evaluate new derivatives products and minimize rates if at all are questioned.
their inherent risks
l Create a pre-emptive control strategy and reduce Profit budgeting :

operating costs, errors, fines and losses
A realistic assessment is made taking into account the cost of
l Build and maintain an affective and supportive relationship infrastructure of the dealing room and reckon it for the annual
with the front and middle office profit planning. The projection profits must take into consideration
5 6 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Role of Brokers in Dealing Operations 5 7
the dealing style, skill of personnel in dealing room and lines

allocated to the dealing room. Chapter
4
Middle Office :
The essential role of an effective middle office operations to

ensure: Role of Brokers in
l A systematic approach to risk control for all products
Dealing Operations
l Understand the necessary legal , documentary and regulatory
frameworks
l Establish effective interaction with the front office and other

departments
Exchange Brokers – Prohibitions :
l Prepare for and support the introduction of new products
l Implement effective accounting, reporting and MIS Exchange brokers have a predominant role to play in forex
operations. However, as per exchange control, ethics and FEDAI
l Compare ‘best practice’ middle office operations
guidelines exchange brokers being intermediaries, are not to
act as principals and maintaining positions in foreign currencies.
Middle office Management Largely Practice: They should therefore refrain from doing anything which may
l The Middle office functions as a part of overall risk control result in the brokers taking over the function of the dealers.
l Structure
Deals Through Brokers – Confirmation :
l Reporting lines
l Responsibilities After the deal is concluded the broker record it and send a
broker’s note to the Bank. Brokers’ notes should be received
l The data control
promptly before the close of business on the day on which the
l P & L reconciliation deals are concluded and exceptionally and in no case after the
opening hours of the succeeding day. These should be checked
l The central control
meticulously and reconciled the same day.
l Portfolio controls
l Dealing with auditors feedback to top management Nomination of Brokers :
Middle Office and Expense Control Nomination of brokers for deals is not required and deals done
through their medium is not allowed.
l Pre-emptive
l Allocation problems Brokers’ Panel :

l Reporting
While recommending panel of brokers, bank ensures FEDAI
l Recognizing expense reductions/operations profitability approval, market report of the broker, market reach of the broker,
equipped with ideal infrastructure e.g., Reuters, screen, telex, any, in the panel of brokers are also to be indicated in the
fax, telephone, hotline to banks, voice recorder etc. and report.
professional, competitive quotes, financial analysis i.e. net worth,
and centres where located. It is to be ensured that none of the Malpractices by Brokers :
broker recommended for panel suffers any disciplinary action
from any regulatory authorities. As a general rule, authorized
To ensure good practice , complaints relating to malpractice’s
dealers should not discriminate between recognized brokers and
by brokers, if any required to be brought to the notice of the
others for business offered at competitive terms.
Foreign Exchange Dealers Association of India and the Exchange
Control Department of Reserve Bank of India, Central Office,
The panel should be revised/reviewed at periodic intervals, taking
Mumbai without any loss of time.
into account the nature and volume of business done through
the brokers, their market reputation, credit worthiness etc.
Threat to Brokers
Complaints :
Automation has made it possible to deal on the systems directly,
eliminating the traditional role of the brokers. Recently, Reuters
Complaint from any source against dealers is required to be
Dealing 2000-2 Electronic (Automated) Deal Matching System
promptly investigated and reviewed to higher authorities.
was launched, the wide use of it will virtually eliminate the
brokers role. As an intermediary because the deal with ones
Serious complaints alleging acceptance by the dealers of gifts own bid/offer rates would be matched automatically. Brokers
and other favours (or any other gratification) should be put up need to brush up their skills and display acumen to outbid such
to appropriate authorities for necessary action. All such cases challenges to their survival.
are required to be reported to Reserve Bank of India, Exchange
Control Department and the Department of Banking Operations
and Development, Central Office Mumbai.
Payment of Brokerage Claims :
The Foreign Exchange Dealers Association of India has decided

to do away with fixed brokerage on foreign exchange deals.
Banks are now free to negotiate with brokers on brokerage fee
and arrive at mutually acceptable rates. However, the accounting
desk maintains a broker-wise record showing details of the
exchange dealings made by the dealers. The dealing personnel
are not to attend anything with matters relating to the scrutiny,
passing or payment of brokerage claims.
Brokerage Statements :
Details showing broker-wise payments for the preceding twelve

months showed be reviewed to the management. Changes if
6 0 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Forex Dealing Operations and Risk Management 6 1
Chapter
5
Forex Dealing Operations

and
Risk Management
Forex market in India
The forex market in India is developed principally to facilitate

forex service to the customers. The RBI has allowed 86 banks
(ADs) to deal in forex, to trade among themselves in foreign
currencies directly or through forex brokers, the market operates
from major centers, viz. Mumbai, Calcutta, Delhi, Madras, Bangalore
and Kochi. Besides banks, financial institutions such as, IFCI,
IDBI, ICICI, etc., have also been given licenses to undertake
forex business incidental to their main business activities.
The forex market trades in spot and forward exchange contracts

in US$/rupee and cross currencies. The turnover is estimated
to be around US$ 3 bn per day .the India forex markets is a
skewed one with around 30 per cent of merchant business
emanating from a single player and a few foreign banks account
for 55 per cent turnover of inter-bank transactions. Business
turnover has been showing an increasing trend over the years.
Risks in forex
In view of the volume, volatility in currencies, market structure

liberalization in trade and exchange control, integration of the
Indian forex market to global market, sophistication of mechanism
and skill to handle dealing operations, we are to remember that
a risk does not vanish – one just prefers to ignore it. It is better
to face, quantify and manage risk exposure.
Forex business, however, place risks: the management of which l Merchant sales and purchases are not likely to match and
requires understanding and appreciation of controls separate the consequent over in the market may not be immediately
from those applicable to domestic operations. As these risks taken up.
arise as a consequence of certain unique features forex business
l Market participants deal in standard lots and it may not be
has given birth to various aspects:
worth while going for cover of small amounts.
l Operations are transnational –obviously subject to controls,
restriction, monetary and fiscal policies. l Transactions entered into by the branches effects the
exchange position but may come to the notice of the dealing
l Involve dealing in currencies whose value is volatile due room later.
to a variety of factors.
l Open position may be built up and held deliberately to the
l Operations are integrated with a vast global market spread advantage of prospective rate movements.
in all time zones.
Control over position risk generally is through currency wise
l Quick decentralized decision taking involving large values
limit on the size of the exposure (i.e. The mismatch between
without losing sight of the main theme of profits of earnings
assets and liabilities in that currency). The limit would generally
at acceptable risks levels.
be fixed on the following considerations:
l Requirement of compliance with exchange control in India.

While no empirical relationship is fixed, it is obvious that the
It is pertinent to note that forex trading by many a authorized first two deal with merchant generate exposure while the last
dealers is not seen freely as a source of foreign exchange two deal with the potential loss on exposure and the bank’s
earnings. ability to bear it, Separate limits are generally fixed for the
exposure during the trading hours—the daylight limit and the
exposure left at the closure of the day.
RBI - Guidlines for Control
The RBI has evolved a set of guideline for internal control on Overnight Limit.
forex transactions. The guideline are in no way unique to banks
in India while the RBI has, through its circulars and inspections, The Overnight Limit should necessarily be smaller, since the
endeavored to ensure compliance with these guidelines, it is exposure allowed is prone to a greater risk as it remains
imperative that the banks appreciate and understand the purpose unattended till the next trading day.
behind the controls and observe them truly as internal controls
rather than transform them into reserve bank requirements. RBI has permitted individual banks to have an open position at
the close of the day subject to approved by the board of the
Position or Rate Risk respective Banks. With the implementation of the Sodhani
committee, it is to be decided by the banks individually.
There are inherent risks involved in forex business. Dealing Consequently overnight limits should be conservatively set.
in forex involves acquisition of assets and liabilities denominated While fixing the overnight limit it is advisable to consider the
in foreigncurrencies whose values against the domestic currency impact of small value transactions effected at the branches-
change, the bank is exposed to a rate risk . A total quantitative the whole report will be received at the dealing room only after
match between assets and liabilities denominated in one currency the day is closed. Such transactions though individually small
is normally not practicable because of the following facts: could collectively distort the closing position of the bank. It is
hence suggested that banks periodically estimate the volume When so translating it, it is also essential to relate it to the size
of such small value transactions and their impact on the of the exposure. For instance, if a permissible amount of loss
exchange position. This would not only enable banks to review translates to a 50 point movement on the rate on a position of
the limits set for the branches to report transactions by telex/ US$ 1 million the cut loss should operate when 25 point movement
fax/phone but also give the dealer an indication of the extent affects a position of US$ 2 million.
of possible distortion so that the overnight exposure could
be managed to offset such distortion. Bank generally have the practice of consolidating the balance
in the different position accounts and tallying the net position
Day Light Limit with the closing position of the dealer. This is an operational
procedure to ensure no transaction has been omitted either
by the dealer or the accounting section .
Day Light Limit should allow for greater exposure constantly
and undertake market operation to maximize its returns on the
exchange position. Generally the exposure limit is fixed currency An attempt is also sometimes made to convert this position in
wise. Banks - also fix an overall exposure limit expressed in all the accounts and of all currencies into a single exposure
terms of a single currency, say US$ in Indian perspectives. against the local currency. This does not serve any purpose as
This limit functions as an over-ride to ensure that the exposure an exposure control device and only is an expression of the
is lower than the sum of all the currencywise limits. When bank’s exposure to the home currency.
cross currency positions are built, arguments are often advanced,
that is monitoring limits complementary position should be Credit risk
measured as an exposure only in currency, since the correction
of the position in the currency automatically squared the
Credit risk is a contingent risk which arises when the counterparty
complementary position. While there is substance in the argument
in a foreign exchange transaction fails to honor the commitment.
, it is preferable for easy monitoring , to have individual currency
exposure measured and limited. Complementary positions beyond
the limits. After all limits are not absolute bans on their Contract risk
transgression but are only meant to identify such transgression
for supervisory scrutiny. Where the failure of the counterparty is known prior to the
performance of bank’s commitment in the contract; the contract
has to be treated as cancelled and the risk is to the extent
Cut Loss Limit
of loss resulting from an adverse movement in exchange rates
while covering the transaction on going market rates.
The limit serves to restrict the quantum of loss a bank is willing
to risk on its open position during the day. The limit operates
within the exposure limit, i.e. The daylight limit, and is a function
Clean risk at settlement
of the exposure size as also the extent to which rates have
moved adversely. The moment the rates move adversely to Thought currencies are exchanged at settlement on the same
translate into a loss equivalent to the limit, the position has to value date, the time zone difference between different centers
be liquidated and the loss booked. This serves to avoid holding would result in one currency being paid before the other is
on to a position in anticipation of reversal of movement of rates. received. If the failure of the counterparty occurs after you
While the quantum of loss should be explicit, for easy monitoring have settled your portion of the commitment, it would result
it is better to translate it into the number of points on the in the loss of the entire value of the contract. The case of
exchange rate before an adverse movement can be accepted. bank herstatt in Germany, which failed in 1974 in the afternoon
after receiving Deutschemark funds but before delivering Mismatched Maturates or Gap Risk
counter value dollar funds, is a classic example of the clean
risk at settlement of funds. Control over credit risk is
Guided by asset liability management principles, we are inclined
exercised by fixing limits on aggregate value of outstanding
to know and find that the assets and liabilities constituting the
commitments for merchants as also inter bank counterparties.
exchange position would generally have different maturates and
The limits are constantly monitored and the dealing room suitable
mismatches in cash flows would also result. If uncorrected this
advised if the limits are closed to being branched. Limits are
would translate into problems of overdrafts or idle surpluses.
fixed on the aggregate outstanding commitments and separately
The deal situation would be a matching of assets and liabilities
for the amount of funds to be settled on a single day. The latter
not only in quantum but also in maturity. Despite these efforts
limit would be smaller and is intended to control the clean risk
it does not materialize because:
at settlement.
l Uncertainty attendant with merchant transaction. Option
periods available under forward contracts as also early/
The threat of settlement risk has haunted the global foreign
delayed receipt of export payments.
exchange industry since the 1974 collapse of Bank Herstatt.
But launch of continued Link Settlement Service ( CLS ) looks l Non-availability of matching forward cover in the market.
set to finally lay this spectre to rest.
l Even in inter bank contracts the buyer bank has option of
pick-up within the period of the contract.
In the Indian context, prior to computerization of the foreign
exchange operations not much attention was paid to credit risk l Deliberate attempt to hold gaps and covers them subsequently
and its control. to minimize swap costs or to earn swap gains.
This was perhaps due to the difficulty in monitoring the limits The risk the bank runs in carrying the gap is that when the
by a manual system and also a complacency that the possibility gap has to be covered by a suitable swap the forward differential
of any-participant in the Indian forex market failing is rather could go against the bank and costs more than provided for,
remote. In the interest of developing comprehensive control and could result. The Indian derivative market handles mainly forwards,
also computerization of dealing operations on ‘on-line’ basis swap and for options, it is quite thin and can move very sharply.
such complacency is not warranted. In the overseas market forex as well as money markets are
integrated and the swap differentials -
Sovereign Risk reflect interest rate differentials. Uniquely in the Indian context
forward margins are driven purely by demand and supply for
forward cover which could change quite dramatically and observed
Sovereign risk is the political side of the credit risk when a
that annualized 6 months premium for US$/rupee went up
country suspends or imposes restriction on payments . Thus,
approximately by 26 per cent also. This enhances the risk of
even if the counterparty is willing and able to honor commitments,
maintaining mismatches. RBI has thus placed restrictions on
sovereign action could frustrate the contract. This risk is present
banks maintaining mismatches.
not merely in dealing room activity but also the entire volume
of assets is prone to such a risk. The exposure limits for
different countries should take into consideration factors such Control of gap is exercised at monthly intervals by segregating
as political stability, health of the economy , possibility of state assets and liabilities maturity wise and quantifying the net
interference, availability of infrastructure for legal recourse, etc. inflow or out flow for each period. Banks thereafter take the
cumulative effects of these period wise mismatches to quantify up of the deal slip, the brokers note (where one is relevant) and
the cumulative inflow and outflow, on the quantum of which contract confirmations. In several cases mistakes in understanding
limits are placed. of any essential detail of the contract came to light so much
later that their correction become very painful. The guidelines
This is the way the net outflow or inflow is measured and do require banks to follow-up unconfirmed outstanding contracts.
subject to an individual mismatch or gap limit. For all the This aspect has been taken care of largely where dealing operations
periods, instead of the concept of cumulative outflow or inflow, are put on the dealing screen.
the individual gaps are grossed without set of and subject to
an aggregate limit. The rationale behind computing the Control Over Settlement of Local and Foreign
aggregate gap limit in the manner suggested in the guidelines Funds
is often questioned, since what is really relevant is cumulative
effect of inflows and outflows. However, RBI’s intent in fixing
A dealing decision can be totally frustrating if the funds are
the aggregate limit as above , seems to be not only risk control
not settled appropriately and marginal profits on exchange
but also to avoid excessive trading.
are likely to be more than loss by way of interest on delayed
settlement of funds. While executing funds transfer instructions
Operational Risk are to be prompt, the bank requires to be equally vigilant and
quick in locating and rectifying any delays in settlement of
Operational risk arise out of a wide variety of situation ranging funds.
from human errors to administrative inadequacies, provisions’
flaws in system and procedures, etc. It is essential that we Branch Reports and Pipeline Transactions
recognize them early and ensure that they are controlled and
corrected. We can identify some major areas of operations and
One of the major areas of operational difficulties is managing
the probable nature of operational errors that could occur.
of exchange cover for forex transactions committed at a large
number of branches. These transactions affect the bank’s position
Segregation of Dealing and Accounting Functions immediately notwithstanding the fact that they are advised by
the branch much later. Such an exposure has to be maintained
It is essential that the dealing decision and its execution be under control and any significant delay in a branch reporting
separated and performed by different functionaries. This ensures a transaction has to be followed-up.
that a check is maintained on the dealer’s activities and the
dealer of course cannot execute a dealing decision without Overdues Bills and Contracts
involving the accounts section. In some cases in India and
abroad huge dealing losses erupted from-concealed exchange
Export bills and forward contract have to be monitored to ensure
position, the situation largely arose because of the lack of functional
that they are delivered as per their tenor. Failing this the bank
segregation.
is likely to incur considerable swap costs in maintaining these
items in position.
Follow-up of Deal Slips and Contract Confirmations
Nostro Reconciliation
A dealing decision is taken orally by telephone or through
unauthenticated messages. It is essential to have this follow-up The Nostro account is the logical end of any forex transaction.
by written/authenticated confirmations. This requires the follow- When a transaction is ultimately transferred to the mirror account
in the books of the bank, it must find a corresponding entry in entry has to be responded promptly and where the customer
the statement of account sent by the correspondent bank. is not available the bank absorbs the charge.
Reconciliation of the entries and balances has to be done
periodically to identify and follow-up the outstanding items. Keeping l Set-off of unreconciled debits and unreconciled credits has
in mind a, b, c control reconciliation is required to be taken by to be totally avoided since while apparently reducing the
staff other than those who operate the accounts to avoid unreconciled items they will render reconciliation into further
possibilities of any cover up of errors or fraudulent transactions. disarray.
The problem often lies in situations considering the exercise
complete on reconciling the balance. The fact is that the job The RBI has required banks to have a vigorous follow-up of
begins with identification of the unreconciled entries which have reconciliation and submit periodical statements on the volume
to be followed-up with the concerned branches, counterparties of unreconciled items. While follow-up of unreconciled items
or the correspondents. Management are often lulled into could be quite laborious, it must be borne in mind that what is
complacency by considerations like: now difficult is only likely to become impossible, if postponed
further. Control over operational errors and failures would be
l Unreconciled debits and credits are in aggregate more or exercised through a system of record and follow-up of such
less equal and their reconciliation process will not result errors supported by concurrent or periodic audits. Periodic reports
in net outflows. need to be submitted to the management who could then review
the system in operation.
l Only unreconciled debits have to be followed-up. It is obvious

that such reasoning is shallow. Efforts towards improving Skill and Expertise
reconciliation include:
It has been observed that a number of Indian banks as of now,
(I) Where there is a large branch network allocation of separate do not generally deal in a big way in a number of sophisticated
Nostro accounts for specific groups of branches, convenience activities, particularly forex and money markets. It is mainly
on reconciliation obtaining from a limited number of branches due to the hesitations arising out of lack of appreciation of
operating on an account should of course be weighted operation of the products and skills to handle them. Efforts
against the cost of maintaining several nostro accounts. have already been initiated to break this vicious circle to be
able to expand our range of services and augment fee income.
(II) More than one account maintained with the same It will facilitate and enable Indian banks to handle derivative
correspondent often results in misdirection of transactions products beyond forward and swaps to futures, options and
by the correspondent and can be avoided. forward as within the ambit of forex dealing/trading operations
and also to ensure that the activity is in consonance with the
framework at the international level.
( I I I ) Responding entries remaining unreconciled to immediate
signal to an error and while following up the unreconciled
entries priority therefore has to be given to responding Conclusion
entries.
Indian Forex Market and Globalisation :
l Bank charges debited to the account has to be promptly
responded to.The problem often arises when the customer The progressive globalization of the economy has exposed
on whose account the charges arose is not making payment the Indian forex market to the volatility in international markets.
or is not available. Where the charges have been levied In order to appreciate the issues relating to products available
7 2 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT De-Mystified Derivatives and Funds Management 7 3
for hedging forex risk, scope for further development of the

market and introduction of new derivative products and other Chapter
related matters let us take stock of the situation, analyze and
accept tested devices, regulate efforts facilitating the process
6
to manage risk in the given situations. As the market develops
the cost of not taking an in-depth approach increases but the
benefits of an intelligent and well informed approach to the
De-Mystified Derivatives
system increases faster in the name of volatile forex market
and believing in “survival of the fittest” market players find and and
anticipate - further challenging task before. Surely it is high time
to herness the potential Indian forex market promise and to Funds Management
book advantage of available latent talent in activating the forex
market. The implementation of the Sodhani committee
recommendations on foreign exchange market in India is expected Swaps
to deepen and broaden the forex market and provide an
opportunity to integrate ultimately with the global activity still
Let us now understand the concept of Swaps. The underlying
further in the days ahead. Recent visit of president Bill Clinton
principle in foreign exchange trading is that purchases should
to India and followed by Indian Prime Minister’s visit to Washington
be offset by corresponding sales and vice versa, if a bank
added new dimensions to such a potential optimism to blossom
decides not to run the exchange rate fluctuations or indulge in
further.
speculation. It is an ideal situation in which a customer purchase
is offset by a customer sale for the corresponding maturity as
these transactions would give the highest profit margin to the
bank. In practice, such a situation may not exit. It is, therefore,
essential for banks to go for cover operations. For example , a
forward purchase from a customer would have been covered by
way of spot sale to another bank if the former does not want to
carry exchange rate risk. The reason for such a cover deal is
obvious; the forward rate quoted the customer was arrived at on
the basis of the ongoing spot market rate (which is likely to
fluctuate violently) and loading thereto the forward margin. It
does result in a mis-match in a cash flows. To match the cash
flows without any foreign exchange exposure, swap deals facilitate
achieving it.
A Swap transaction is a simultaneous buying and selling of

a foreign currency in equal amounts for two different value
dates.
The difference between the buying and selling rate is the SWAP
MARGIN. Since the buying and selling is done simultaneously,
the determining factor is the forward margin.
A Swap price is quoted as a margin (difference) over spot or Let us represent the above transaction in a flow chart -
any forward rate and when the transaction is done, it is confirmed
with respect to the spot price. Example Value spot 25/7/99 Value forward 28/8/99
Sell $ / Buy DEM Buy $ / Sell DEM
If ABC bank quotes 1 m $ /DEM swap as 20 30 and the
counterbank does a deal whereby they b u y a n d s e l l U S D / D E M USD USD
a t 2 0 ; and the $/ DEM spot rate is 1.6710/20, ABC bank would
confirm the deal as follows- - 1 mio ———- Sell USD Buy $ ——— + 1 mio
O.K. ABC bank sells and buys $ /DEM + 1 mio ——— Borrow $ Repay $ —— - (1mio + Iusd)
rates are 1.6720 and 1.6740

Net = nil Net = - Intt USD
val spot 25th July against 25th August, a n d f o l l o w i t u p w i t h
pay/receive instructions. DEM DEM
+ 1.6720 mio — Buy DEM Pay DEM — - 1.6720 mio

We see here that ABC Bank has an apparent ‘’exchange loss’’
- swap cost(20 pips)
or what is generally known as swap cost of 20 pips.
- 1.6720 mio — Lend DEM Rec. DEM — + 1.6720 mio
+ Intt on DEM
This is because ABC Bank sells SPOT and buys FORWARD
USD, and since USD is at a premium agt DEM, ABC Bank has
Net = nil Net =(+ I DEM- swap cost)
to pay more DEM. This ‘’swap cost’’ will be compensated by a
higher rate of interest in DEM.
Total funds (adding LHS & RHS) Nil = (-IUS$ + IDEM - swap
cost)
This can be represented as below-
25th July —sells $——

Therefore Swap cost = Intt on DEM - Intt on US$.
borrow $ for 3m——-
28th August buys $ (swap) — repays borrowing So we see that in an ideal situation the swap cost or the
difference in the exchange rate between spot & forward is offset
by the interest differential in the two currencies.
25th July. receives DEM——
deposit for 3m—— Therefore a bank which has requirements to fund assets in a
foreign currency say USD, would consider the following
28th August deposit matures——sells DEM(swap)
alternatives—
a) Direct borrowing of USD in the market,

The interest differential received between cost of borrowing USD
and interest received on DEM depo will offset swap cost (difference b) Borrowing in another currency say INR or DEM and swapping
in exchange rate). the funds so raised into USD
We observe from the above that swap operation links foreign The choice between the above modes of finance will be based
exchange with money market operations. on the net cost of funds.
Essential features of a Swap: Mechanics of Swap
I) The purchase and sale or sale and purchase should be

It is important to note that while we undertake swap deals, the
simultaneous;
exchange position of the bank is not altered. However, there is
II) Amount of one currency should be the same for both purchase a mismatch in the cash flows between the two value dates.
and sale; Further while under taking a swap deal, a cost is also involved.
This cost is known as ‘swap cost’ and this cost depends upon
III) Maturity dates should be different. on the swap rate. Swap rate is not an exchange rate, but it is
an exchange rate differential. It is the difference which buyer
and seller has to concede for swapping spot against forward or
Types of Swaps
near forward against forward depending upon the forward margins
for currencies. Forward rates depend on the currency being in
Banks may enter into swaps directly or through the medium of premium or discount against the other in the forward market. A
brokers. Where a broker arranges a swap, the counterparty bank currency is set to be ‘at par’ against the other if forward rate is
need not be the same for both the legs of the swaps. If the the same as spot rate. It occurs rarely. More often the forward
counterparty for both the legs of the swaps are different, then rates may be costlier or cheaper than the spot rate. The difference
such a swap is called “structured swap” or “engineered swap”. between the forward rate and the spot rate is known as ‘forward
If the counterparty to both the legs is one and the same, then margin’.
the swap is called “pure swap”.
We may say that forward rate- spot rate = margin (+) discount
Swaps can also be classified into two types depending upon the (–) premium.
delivery periods of the swap. They are:
The forward margin may be either at ‘premium’ or ‘discount’. A

A fixed date delivery swap is one in which the value dates for currency is said to be at premium if it is costlier in the forward
both the purchase and sales have been fixed at the time of market and is said to be at a discount if it is cheaper in the
concluding the swap. In international markets, normally fixed forward market. In-a swap deal, the overall position of the other
date swaps are undertaken. On the otherhand, option delivery party to the transaction also remains unchanged, and only risk
swaps are those for which the delivery of the contract can be involved would be the movement in the forward margins, which
done over a number of days. Option period in an Indian forex may usually be less volatile than movement in the value of the
market covers a calendar month or part of the calendar month currencies in the spot market. In the otherwords the mismatch
l i k e 1st w e e k , 2nd week, 1 st h a l f , 2 nd h a l f e t c . I n t h e I n d i a n f o r e x in the forward position are subject to interest rate risk it is,
market, option is prerogative of the customer (in the case of however, important to note that the settlement will be made on
interbank contract). gross basis.
For the purpose of payment of brokerage, swaps are classified The factors that determines the Swap differentials:
into two types : (a) short swap and (b) long swap. Short swap
is one on which both the legs of the transaction falls within the 1) Supply and demand for the currency for the settlement
spot period and long swap is one in which one leg of the transaction date. If there are more buyer for a particular date than
falls beyond the spot date. For example purchase of cash and seller, the forward point will be at a premium. If there are
sale of spot is a short swap and purchase of spot and sale of more sellers than buyers, the forward point will be at a
2 months is a long swap. discount.
2) Market expectations about the development in interest Derivatives – FRA, IRS, Futures, Options
differentials and exchange rates of the currencies on account
of various factors.
Uncertainty and volatility in foreign exchange rates, interest
rates and other financial markets had subjected banks and
3) Interest rate differentials between the currencies exchanged. corporations to risk. The need was felt to manage such uncertain
In fact,this is the only factor which affects the forward financial risks, such risk management efforts have given rise to
differentials provided capital flows are free from restrictions several instruments with different underlyings which popularly
came to be known as “derivatives”.
Using Swaps : What Managers Must Know The widely used derivatives are Forward rate agreements, Interest
rate swaps, Currency swaps, Cross Currency swaps, Futures
Why do managers need to understand about swaps and how and Options.
they work? Recognizing that most day-to-day decision involving
swaps will remain within the jurisdiction of corporate financial Forward Rate Agreements (FRAs)
operating Staff, what kind of specialized training and control
systems should banks be prepared to put in place ?.
Forward rate agreements They were introduced by the London
merchant banks as a new customer service designed to hedge
How should C.E.O. think about disclosures of their swap positions interest rate risks in a simple manner.
to control shareholders and directors? Obvious question by C.E.O.
how much can I actually delegate? An effort to address such FRAs and interest rate futures are both contracts on a rate of
a question is initiated based on practice in western world where interest f o r a loan, deposit or investment to apply from some
such operations are in volume and for a long time. Financial future date. They can be used by borrowers, lenders and investors
risk management is not just a theoretical nicety; it is practical to hedge their exposure to interest rate movements.
necessity. Used properly swaps don’t create surprises; they do
help minimize them. The current debate over the corporate use
An FRA is a contract between two parties and fixes a specific
of swaps needs to be put back on the track by focussing on the
rate of interest on a notional amount of principal for an agreed
strategic opportunities afforded by swaps. Going a step ahead
future lending period (3,6 or 9 months) starting from a agreed
we find that a simple rule can help managers distinguish hedging
settlement date. Therefore the contract must specify -
from speculation employ swaps to transfer risk, but never succumb
to the temptation to trade in risk-for its own sake. Manager do 1. The amount of notional principal
not need to become number crunchers but they do need to
under stand how swaps relate to the bank’s objectives structure 2. The date from which interest rate is to be fixed
and culture manager have to be caution about how they delegate
responsibility – the greater their concern about the effects of 3. The term for which it is fixed
swap the less discretion they should give operation personnel.
Concludingly it is interesting but pertinent to note when defining 4. The interest rate on the principal amount
a banks risk management policies board of directors should

consider broader business strategies and management expertise. An FRA is in fact a interest rate futures contract which is traded
In this way, CEO and board of directors can formulate consistence in the exchange. It is generally concluded for short term periods
and prudent policies relating to forex trading with reference to of 3 ,6, 9 or 12 months and it is possible to transact an FRA
swap operations. from any future start date to any future maturity date
Since an FRA locks in today ( the contract date ), an interest Selling an FRA would involve receipt of a fixed interest rate
rate to apply from a future start date ( settlement date), it can against payment of variable rate. Therefore FRAs can be sold
be used to fix the rate of interest on a future borrowing or to fix the interest income on variable rate lending or investments.
investment for either - It is therefore a hedge against a decrease in the market interest
rate between the contract date and the start of the time period
l A borrower who is paying floating interest rate on a loan, to which the FRA applies.
or
l An investor who is earning variable rate interest income . Example - If a company wishes to fix the income on its investment
which is placed on variable rate term with six- monthly fixing
FRA removes the borrower’s or lender’s exposure to the risk dates, and is due for roll-over in two month’s time then it can
from an adverse movement in interest rates between the FRA sell a 2 x 8 FRA and receive a fixed interest rate . If in two
contract date and the date of the future borrowing or investment. month’s time on the settlement date if the market interest rate
or reference interest rate (Libor) is lower, then the company
Banks use FRA for hedging short-term interest rate exposures would receive from the counter party to whom it sold the FRA,
for periods upto 2 years. a compensation which will be equal to the difference between
the contracted rate and the reference rate. It will continue to get
Notional Principal - An FRA guarantees an interest rate for a the variable rate on its direct investments thereby making the
borrower or investor on a specified sum of money and it is NOT total return equal to the contracted rate on the FRA.
an agreement to borrow or lend that amount of capital. No loan
principal is advanced or received under the terms of the
agreement. Calculation of compensatory payment —
FRAs can be bought and sold . Buying an FRA w o u l d i n v o l v e

The amount of compensatory payment should amount to the
payment of a fixed interest rate for the future period and receipt
difference between the FRA rate and the reference rate
of variable rate. Therefore FRAs can be bought to fix the interest
(Libor),applied to the notional principal for the notional term of
cost on future borrowing . It is therefore, a hedge against increase
interest.
in the market rate of interest between contract date and the
start of the time period to which FRA applies - (settlement date).
The settlement of FRA compensatory payment is on the first

Example - If on 1st November, a bank wants to fix the interest
day of the interest period to which the FRA relates (value date
rate for three months on its borrowing which is based on floating
for settlement). This contrasts with normal borrowing and lending
rate, from the next roll-over date say 1st Feb., then it can buy
for which the interest is paid at the end of the period.
an FRA for the period 3 x 6, for the notional amount of principal
with the settlement date as 1st Feb.
Therefore FRA payment which actually accrues during the full

If the rate quoted on 1st Nov for 3 x 6 FRA is say 5.5 - 5.25, term of the loan but paid upfront, should be discounted to account
then the FRA would be bought at 5.5% , so that the cost of for early settlement.
borrowing from 1st Feb for 3 months is fixed at 5.5%. This is
actually effected as a compensating payment between this fixed
rate and the reference rate say Libor prevailing on the settlement The discount rate used is the prevailing Libor rate on the settlement
day. date.
The formula for calculating compensatory payment is- 2) Bank ABC hedges its borrowing cost for a loan by buying
a 3 x 6 FRA at a rate of 5.5% . On the settlement date
If L > R the LIBOR for three months is 6.5%.the notional amount of
principal is US$ 5 Mio. Calculate the compensatory amount
( L – R ) x D x A payable by the counter bank.
( D x L ) + ( B x 100 )
compensatory payment with 90 days for three months and 360

If R > L days to year since it is in US$ is –
( R – L ) x D x A
( L – R ) x D x A
( D x L ) + ( B x 100 )
(D x L) + (B x 100)
Whereas
( 6.5 – 5.5 ) x 90 x 5000000
90 x 6.5 + 360 x 100
A is Notional Amount
L is Libor as on settlement date = USD 12300.12
R is Reference or Contract Rate

We will observe that this is nothing but the present value o f t h e
B is Basis for currency ( 365 days for rupee and sterling and interest differential or compensation discounted at the ongoing
360 days for USD ) market rate or Libor.
Example; Interest Rate Swaps
1) Your bank bought sterling 25 million 6.50% ,(25,000000 3/ An agreement between two parties to exchange stated interest
9 FRA) LIBOR on fixing date is 6.75%. The term of FRA obligations for a certain period in respect of a notional principal
is 181 days. How much amount payable or receivable on amount.
settlement date.
IRS are dealt for a variety of maturities ranging from one year
Solution : or less through to twenty-five years or more. The longer maturities
tend to be only available to the most credit-worthy counterparties,
LIBOR ( 6.75% ) on fixing date is more than contract rate as credit naturally becomes more of a concern with the longer
6.50%, your bank as a buyer of FRA will receive an amount i.e., dated transactions.
( L – R ) x D x A It must be stressed that the principal amount is purely “notional”.

( D x L ) + ( B x 100 ) It exists only to facilitate the calculation of interest. There is no
physical exchange of principal in single currency IRS.
( 6.75 – 6.50 ) x 181 x 25,000000
181 x 6.75 + 365 x 100 Interest Rate Swap is a product where neither party looses.
They successfully uses the counterparty’s creditworthiness to
= GBP 29989 their advantage.
Alternately, it can be termed as “credit rating swaps”, with one As can be seen from the diagram below, the 8.00% payments
party using its credit rating to access a source of funding on net out, in effect leaving B with its desired floating rate borrowing
attractive terms to the mutual benefit of all concerned. - at a rate of LIBOR flat, a saving of 25 b.p. (0.25% p.a.) on
the rate it would have paid if it had borrowed directly on this
There are two main types of Interest Rate Swaps : basis.
1) Floating rate exchanged for Fixed rate; e.g. LIBOR exchanged

Lender Lender
for 5 year Treasury.
2) Floating rate exchanged for floating rate with both different LIBOR + 50 bps 8.00 %
References; e.g. 90 days T-bills exchanged for 3 Months
LIBOR rate.
example :
LIBOR LIBOR
Company A can borrow :
Company A Intermediary Company B
Floating : 6 month floating rate at LIBOR + 0.50 bps
8.10 % 8.00 %
Fixed : 5 year fixed rate at 8.75%.
It would like a fixed rate borrowing, but at cheaper rates. Net Cost 8.60 % Net 10 bps Net Cost LIBOR
Saving 15 bps Saving 25 bps
Company B can borrow :
Floating : 6 month floating rate at LIBOR + 0.25 bps

A borrows at LIBOR + 0.50% and also enters into an IRS
Fixed : 5 year fixed rate at 8 % . transaction, making a fixed rate payment of 8.10%, in exchange
It would like to reduce its floating rate borrowing costs. for a floating rate LIBOR. The net effect is, A with its desired
fixed rate borrowing - at a rate of 8.60%, a saving of 15 bps.
The intermediary earns a net 10 bps for assuming the credit
Company B obviously has a higher credit rating . It has advantage
risks on both companies.
over A in both fixed and floating rate. It can however, only
borrow at 0.25% better in floating rate terms, whereas in fixed
rate its advantage is 0.75%. Currency Swap
In reality, there are normally far larger differences between the A “ Currency Swap” generally applies to transactions in which
rates that different credits will pay in medium or long term fixed two different counterparties exchange their long dated liabilities
rate borrowing than at short term. Therefore B should, borrow at that are denominated in two different currencies.
the fixed rate, in which it has the greatest comparative advantage,
even though it wishes to borrow at a floating rate. Currency swaps are generally used by Transnational Corporation
who need a different currency for financing assets but can raise
It thus borrows at 8.00% fixed and, independently of this process, resources in a different currency , in a different market at a
enters into an IRS paying LIBOR in exchange for receiving more competitive rates, these is because of a company might
8.00% fixed. be better know in its domestic market.
Main features of Currency Swaps are; 2. Energy futures - NYMEX offers contracts in crude oil ,
heating oil, leaded,gasoline and propane .
1) Exchange of equivalent amounts of different currencies.
3. Metals futures - Chicago mercantile exchange (CME) offers

2) Exchange of periodic interest payments.
futures in copper, silver, gold, etc. and palladium and
3) Re-exchanged of principal sum at a pre-determined rate at platinum are also offered byNYMEX.
maturity.
4. Stock index futures - Here the underlying commodity
is a portfolio of shares reflecting a stock market index,
Futures such as Standard and Poor’s 500 index, the NYSE index
and the FTSE 100 index.
A Future is a specialised contract to buy or sell a standard
quantity of an item at a specified future date and at a price 5. Currency Futures - CME is the main exchange for currency
that is agreed when the contract is made. Futures are traded on futures. The contract is for exchange of one currency
futures exchanges. to another.
6. Interest Rate Futures - It is a relatively new product in

As we see from the above definition a future is an exchange
vogue since 1970s. Here the volatility of interest rates
traded contract for a standard quantity to be settled / delivered
creates risk and uncertainty and it is this volatility that is
on a specified future date as determined by the futures exchange.
traded.
A future is very similar to forward contract in principle but differs

from the forward contract in the in the above three standardization’s. Options
A forward contract is an over-the-counter tailor made contract
with the amount and delivery date being decided by the Options can be defined as the right, but NOT the obligation to
counterparties to the contract. It is not traded in an exchange buy or sell an agreed amount of a commodity at an agreed price
but can be annulled by a reverse contract for the same amount on or before a specified future date.
and delivery date as the original contract.
It is somewhat similar to insurance - the buyer pays an amount

Forwards are contracts between two counterparties with inherent of money, known as the premium - for certain rights. These can
credit and delivery risk, whereas futures are contracts with be taken up if you wish, but there is no obligation to do so.
exchanges as the counterparties thereby almost eliminating
counterparty credit risk and non-delivery risk.
Unlike insurance, however, there is no limit on the amount “claimed”.
You have an option to, for example, buy at a certain price and
Futures had their origins in the 1860s in the US grain markets may do so, no matter how valuable the commodity in question
,and were introduced as a means to control price volatility and may become.
add liquidity to the trade.
Their modern origins were in agricultural commodities in the

Futures are traded in a wide range of items. These include : USA towards the end of the last century, although similar
transactions have been recorded thousands of years ago. Options
1. Agricultural futures - Futures in corn, wheat, Soya beans, on financial products only really developed during the last twenty
oil, broilerchickens, live cattle , live hogs, etc. years.
Buying an option protects against downside risk, but still gives The rate at which the buyer of the option has the right to buy,
upside potential. You establish the worst possible rate at which or sell, is the “strike” price. An option which can be “exercised”
you will buy/sell a commodity, but still have the possibility of at any time before it expires is described as an “American” style
improving on this rate. option. One which can only be exercised on the “expiry date”,
a “European” style option.
This is the most common underlying reason for using options,
an example of which follows: Another major difference to other instruments is the manner in
which they are priced. Supply and demand and the current
A US company is exporting to Germany and will be receiving levels of exchange and/or interest rates are only part of the
deutsche marks in six months’ time. It purchases an option picture.
giving it the right to sell those marks for dollars at a rate of
1.50. The mathematics used in the pricing of options is, by most
people’s standards, relatively complex. Unlike, for example, the
If the market rate at the time of receipt is better - say, 1.45 - formula for calculating interest on a deposit, they do not represent
than the rate to which it is entitled under the option (1.50), it certainty, but are based on probability theories. They are, in
simply discards the option, losing only the premium, and deals fact, research derived models.
in the market at 1.45. But if the market moves against it - to
1.70, 2.00 or even 10.00, it takes up (“exercises”) its rights There is no guarantee that the results obtained will be correct,
under the option and sells the marks at 1.50. although experience has shown that - within their limitations -
the most commonly used models appear to work the majority of
From this, you will appreciate that the party selling (“writing”) the time, in the majority of circumstances.
the option is in a very different position:
The degree of uncertainty involved can be easily appreciated
The buyer has a maximum possible loss - the amount of the from the fact that possibly the single most important factor is
premium - and a virtually unlimited possible profit (viewing the itself a prediction of future events.
option transaction in isolation).
The seller, on the other hand, has a virtually unlimited possible

loss and a maximum possible profit - the amount of the premium.
With that P/L profile, why should anyone ever be willing to sell
an option? The answer is quite simply that there will always be
someone who will take on - at a price - the risks that others do
not want.
They do so because they are confident that they have the

expertise to manage those risks and secure profits from doing
so. A knowledge of the basic terminology involved in options
can quickly be accumulated by reverting to the definition:
An option to buy is known as a “call” option, one to sell a “put”

option.
9 0 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Money Market Operations 9 1
Chapter
7
Money Market Operations
Genesis
Money Market : A Perspective
The money market is a wholesale market for low risk, highly

liquid, short term IOU’s. It is a market for various sort of debt
securities rather than equities. The stock in trade of the market
includes a large chunk of Treasury’s debt, government repos,
negotiable bank certificate of deposits, banker’ acceptances,
municipal notes and commercial paper.
Despite its frenzied and incoherent appearance to the outsider,

the money market efficiently accomplishes certain vital functions
everyday :
1. Shifting vast sums of money between banks.
2. It also provides a means by which surplus funds of cash-rich

corporations and other institutions can be funnelled to the
banks, corporations, and other institutions that need short
term money.
3. It provides a market from which the government treasury can

fund huge quantities of debt with ease.
4. It provides an arena to the central bank to carry out open

market operations destined to influence interest rates and
growth of money supply.
5. The activities of the money market (its participants) also

determines the short term interest rates.
Salient Features of the Money Market Money Market Instruments
1. It is not one market but a collection of markets for several Treasury Securities (Gilts)
distinct and different instruments, and the close interrelationships
that link these markets. To finance the national debt the treasury issues several types
2. It has numerous and varied cast of participants. Borrowers of securities. Those with maturity at issue of less than one year
include domestic and foreign banks, central bank, treasury, are known as Treasury bills. Treasury bills also known as T-bills
corporations of all types, dealers in money market instruments or just bills, they are a direct obligation of the government,
and many states and municipalities. The lenders include issued at maturity of three, six, twelve months period. They are
almost all the above and in addition the insurance companies, generally sold at auction, weekly or monthly and bear no interest.
pension funds and various other financial institutions. Treasury bills trade on a discount basis. An investor in bills
pays less than face value, and at maturity the treasury redeems
A money market may be defined as centre in which financial them at face value. This increase in value of the bill over a
institutions congregate for the purpose of dealing impersonally period of time provides the yield, usually called the rate of
in monetary assets. This serves to emphasise three essential return. Sometimes treasury bills are relatively unattractive compared
characteristics of such markets: to other short-term instruments on the basis of both the yield
curve and price improvement potential. But, there are many
1. The group of markets collectively described as ‘money markets’ occasions when it is possible to improve the rate of return on
is concerned to deal in particular type of asset, the chief the - treasury bill investments. The general factors that influence
characteristic of which is its relative liquidity (i.e. readiness the treasury bill market are the level of interest rates, new
with which it can be converted to cash without significant supply of treasury bills, expectations of future developments,
loss). unique position of these bills creating a fixed demand and the
operations of the central bank.
2. Such activities tend to be concentrated in some centre (or
centres) which serves (or serve) a region or area, the width
The treasury so issues interest bearing notes. These securities
of such area may vary considerably - some money markets
are issued at or very near face value and redeemed at face
like London or New York have become world financial centres,
value. Notes have original maturity of 1 to 10 years. Interest on
or atleast international in their scope.
treasury notes may be paid semi-annually or on an annual basis.
3. On a very strict definition, the relationships that characterise Notes like bills are also generally sold through auctions held by
a money market should be impersonal in character so that the central bank. In addition to the notes the treasury also may
competition will be relatively pure (in other words, dealings issue interest bearing negotiable bonds that have a maturity at
between parties should not be governed or influenced wholly issue of 10 years or more. The only difference between the
or in part by personal considerations) treasury bonds and notes is that the bonds are issued for longer
maturiries.
The above is too ‘pure’ a view. Even when money markets in
the real world are highly competitive, it is not unreasonable to Banks, other financial institutions, insurance companies, pension
expect that regularity of business, the amount of business and funds, and corporations are all important investors in the treasury
the trust in the individuals with whom one is dealing may give securities. The market for the government securities is largely
rise to a certain amount of discrimination in the matter of interest a wholesale market, and especially at the short end. Due to the
rate structures or the credit conditions. Certain other preconditions high volume of treasury debt outstanding generally, the market
relate to the kind of economy that a money market can be for treasury bills and short term government securities is most
expected to serve. active and most carefully watched sector of the money market.
The treasury securities market offer the investors several pay the beneficial holder or bearer the face value amount plus
advantages: interest at maturity. They are marketable as well as negotiable.
The CD’s may have maturities ranging from 14 days to 7 years.
The securities are generally constantly traded in the secondary The quantity of CD’s that the banks have outstanding depends
market in large volume and at narrow spreads between bid and on the loan demand. CD’s with variable rate are also being
ask prices (the spreads may differ from country to country, but are issued with roll-over of 30 days or six months. To facilitate
generally narrow), they are highly liquid. Repo’s on CDs, Discount CDs are also issued. In currencies
which are eurocurrency’s, than, other than the domestic CDs,
Eurocurrency CDs can also be issued. These CDs resemble the
Governments are considered free from credit risk.
domestic CDs except that, instead of the liability of a domestic
bank, they are the liability of a bank situated offshore. Another
Interest income from government securities is normally exempt
variety of a CD is the Yankee CD. Yankee as opposed to
from state taxation. Because of these advantages, treasury securities
domestic CDs are issued in the domestic market by the foreign
trade at yields below those of other money market instruments.
borrowers. They expose the investors to the extra risk of the
foreign name and are also generally less liquid than the domestic
Financial Futures and Options market CDs.
The market for the securities can be a cash market, i.e. the Commercial Paper (CP.)
market in which existing securities are traded for the same or
nest day delivery, or the futures market wherein the various
One of the source to the corporates to borrow is the loans from
money market instruments are traded for delivery at a future
the banks, but for large firms with good credit ratings an alternative
date. Futures market for financial instruments have grown at an
source of funds which is cheaper, is the commercial paper.
astonishing rate over the years.
Commercial paper is an unsecured promissory note issued for
a specific amount and maturing on a specific day. CPs are
Government agencies securities generally negotiable and have a short maturity period. They are
generally rolled over on maturity.
These securities are traded by the government securities dealers.
Positions vary in size, but the market in most of the larger Bankers Acceptances (B.A’s)
issues is active and liquid. Issues of short maturity may be
bought and sold in sizeable quantities. These securities are
An acceptance is a draft that the drawee bank has promised to
issued as a matter of policy to control as well as provide credit
honour at maturity. It constitutes an irrevocable obligation of the
to various sectors of the economy. Agencies are set up to
bank. Acceptances should be created to finance only real
provide credit to various sectors as per requirements.
transactions in - specific commodities or to facilitate exchange
transactions with foreign banks. The drawer of the draft and
Certificates of Deposit (C.D.) those who endorse the draft without qualification as well as the
accepting bank remain liable to the investor for the payment at
There are many corporations and other large investors that have maturity. The market for Bankers’ acceptances is capable of
huge sums of money that they could invest in bank time deposits. absorbing large amounts of selling in relation to the volume of
However by doing so they lose liquidity, this led the banks to items outstanding. Bankers’ acceptances closely resemble
invent the Negotiable certificate of deposits or just CD. Negotiable commercial paper in form. They are short-term non-interest bearing
certificate of deposit are the obligations of the issuing bank to notes sold at a discount and redeemed by the accepting bank
at maturity for the face value. The major difference is that the transaction is called depends upon who initiates it. Typically, if
payment on the commercial paper is guaranteed only by the a dealer hunting money does it is a RP, if a dealer hunting
issuing company. In contrast, bankers’ acceptances, in addition securities does it is a reverse.
to carrying the issuer’s pledge to pay, are backed by the
underlying goods being financed and also carry the guarantee of Municipal notes
the accepting bank.
Debt securities issued by state and local governments and their

Repurchase agreements (RPs or repos) and Reverse
agencies are referred to as municipal securities. Such securities
Repurchase agreements (Reverse RP or Reverse repo or
can be divided into two broad categories: bonds issued to finance
Reverse)
projects and short-term notes sold in anticipation of the receipt
of other funds. These notes are generally issued for a maturity
Speculation and risk are the inherent and important part of being
ranging from one month to one year or more. The major attraction
a dealer. While dealers have large amount of capital, the positions
of these notes is that the interest income from these notes is
they take are often several hundred times that amount. As a
generally exempt from state taxes.
result the dealers have to borrow and finance their positions.
One of the cheaper alternatives to borrow is by entering into a
repurchase agreements with investors. Much RP financing done
by dealers is on overnight basis. In such a case the securities
are sold by the dealers to the investors for repurchase of these
securities the next day at a slightly higher price. Thus, the
buyer of the securities is in effect making a one day loan
secured by the obligations sold to him. The difference between
the purchase and sale prices on the RP transaction is the
interest the investor earns on his loan. From the point of view
of the investors, overnight loans in the RP market offer several
attractive features. First by rolling overnight RPs, investors can
keep surplus funds invested without losing liquidity or incurring
price risk. Second, because RP transactions can are secured
by top-quality paper, investors expose themselves to little or no
credit risk. On term RP transactions the investors lose some
liquidity, but the rate offered is generally higher.
The most common technique to borrow securities is to enter in

a reverse RP transaction. To obtain securities through a reverse,
a dealer finds an investor holding the required securities, he
than buys these securities from the investor under an agreement
that he will resell the same securities to the investor at a fixed
price on some future date. In this transaction the dealer besides
obtaining the securities, is - extending a loan to the investor for
which he is paid some rate of interest.
An RP and a reverse are identical transactions. What a given

9 8 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Forex and Money Market - Integration Approach 9 9
Chapter
8
Forex and Money Market

- Integration Approach
Genesis
The interest parity theorem is the fundamental law of international

finance that links exchange rates and interest rates.
It is readily observable that interest rates vary widely across

countries. This is somewhat a puzzle. What would prevent capital
from flowing from one country to another until the entire interest
rate differential has disappeared? The reason this analysis is
wrong is that it does not consider exchange rate risk. Exchange
rate risk is unavoidable in such transactions. It acts as a barrier
of sorts. Exchange rate risk is what permits differentials in
interest to persist.
Riskless Arbitrage Mechanism
Although no riskless arbitrage mechanism exists to bring interest

rates around the world to one single level, there is a linkage
between interest rates and foreign exchange. The relationship is
called the interest parity theorem. Driving the interest theorem
is the basic principle that well-functioning financial markets generate
asset prices and exchange rates that preclude opportunities for
riskless profit taking.
An investor investing in the a high interest currency could use

the forward market to hedge the exchange rate risk and yet
retain some or all of the interest differential. The no risk arbitrage
rule here is enforced by the forward exchange rate, which is in
100 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Forex and Money Market - Integration Approach 101
effect the spoiler. It trades away from the spot by just enough assets, liabilities, or income flows are not uncertain. Risk also
to exactly capture in interest rates between the domestic and exists if there is uncertainty in the prices of what people buy,
foreign currencies. so called inflation risk, due to uncertainty in the buying power
of given amounts of money).
Interest Rate Parity

Now to see how an exchange-risk-free investment decision is
made. Let us take an example wherein if a firm puts its funds
There is an important condition that applies to the financial
in a US$ investment such as a bank deposit for 3 months, each
markets, the covered interest parity condition. It states that
dollar will provide :
when steps have been taken to avoid foreign exchange risk,
costs of borrowing and rates of return on financial investments
will be equal irrespective of the
currency borrowed. There is also need to consider the ‘frictions’
currency of investment or the { 1 +
r$
4
}
that must be absent for the covered interest parity condition to w h e r e r$ is the annualised US$ interest rate, and division by 4
hold. The frictions that must be absent include restrictions on gives the 3 month return. Suppose the firm considers investing
the movement of capital, transaction cost and taxes. in a rupees denominated bank deposit and that the spot dollar/
rupee exchange rate is S($/Rs), i.e. for each dollar the firm will
The approach to deriving the covered interest parity conditions obtain 1/ S($/Rs) in rupees, assuming that there are no transaction
begins by explaining how to make short-term investment and costs and full mobility of capital. If the annualised interest rate
borrowing decisions in the international context. Then it is shown o n 3 m o n t h r u p e e b a n k d e p o s i t s i s rRs t h e n f o r e v e r y d o l l a r t h e
how shopping around for the highest investment and borrowing firm will receive after 3 months:
decisions in the international context are made.
Moreover it is shown how shopping around for the highest

Rs.
S($
1
/ Rs)
{ 1 +
rRs
4
}
investment yield or lowest borrowing cost pushes yields and
cost in different currencies towards equality, thereby resulting in If at the time of buying the 3 month rupees denominated deposit,
the covered interest parity condition. Currency of denomination the firm sells forward the amount of rupees to be received
introduces foreign exchange risk while country of issue introduces at maturity (that is the amount derived from the above equation),
political risk, and for most countries and time periods, foreign the number of dollars that it will obtain is set by the forward
exchange risk is far larger concern than political risk. contract. Assuming the 3 month forward rate at the time of
investment to be F1/4 ( $ / R s ) , then the dollars itwillobtainwill be:
Short-term borrowing and investment take place in the money
market. This is the market in which short-term securities such
as
there
treasury
are
bills
actively
and
traded
commercial
forward
paper
contracts
are
with
traded.
relatively
Because
short-
$
F¼ ($ / Rs)
S($ / Rs)
{ 1 +
rRs
4
}
term money market maturities, the money market deserves special
treatment. Forward contracts allow the money market borrowers It is now simple matter to express the rule for deciding the
and investors to avoid foreign exchange risk and exposure. currency in which to invest. The investor should choose a 3
month US$ deposit, rather than rupees deposit, whenever,
For the time being we note that it is the result of uncertainty in

asset or liability values, or in income flows, due to unexpected
changes in exchange rates (risk can exist even if values of { 1 +
r$
4
} >
F¼ ($ / Rs)
S($ / Rs)
{ 1 +
rRs
4
}
The investor should select the rupees deposit than the US$ t i m e ‘n ’ forward; then they can buy rupees forward for less than
deposit whenever the reverse inequality holds, i.e. they expect to be able to sell them. This will force up the
f o r w a r d r a t e , F1 / 4($/Rs), until it is no longer less than the expected
future spot rate. Similarly, if S* n < F 1/4 ($/Rs) holds speculators
{ 1 +
r$
4
} >
F¼ ($ / Rs)
S($ / Rs)
{ 1 +
rRs
4
} w i l l s e l l r u p e e s f o r t i m e ‘n’ forward; they can sell forward rupees
for more than they expect to be able to buy them when they
honour their forward contract. Selling rupees forward pushes the
When, forward rate down until it is no longer more than the expected
future spot rate.
{ 1 +
r$
4
} >
F¼ ($ / Rs)
S($ / Rs)
{ 1 +
rRs
4
} Thus, to a close approximation, the uncovered interest parity
should hold in the form:
holds the investor is indifferent. If we allow the interest to compound
the indifference equation will be n n
n
n { 1 + r$
} >
S* n ($ / Rs)
S($ / Rs)
{ 1 + r Rs }
{ 1 + r$
} >
Fn ($ / Rs)
S($ / Rs)
{ 1 + r Rs }
This is only an approximate condition because uncovered interest
When the above equation holds good, no covered interest arbitrage parity involves risk. We have assumedS* n ($/Rs) = F 1/4 ($/Rs),
is profitable. The equation is the covered interest parity condition . this assumption is invalid if there is risk premium in the forward
When this condition holds there is no advantage to covered market.
borrowing or investing in any particular currency or from covered
interest arbitrage.
When put differently the above uncovered interest parity equation
y i e l d s rRs - r$ = S* i.e. the interest differential should approximately
The covered interest parity condition is the financial-market
equal the expected rate of change in the spot exchange rate.
equivalent of the law of one price, from the commodity market,
and follows from financial-market efficiency.
In reality, interest parity holds very closely (in efficient markets),
The equation above is the condition for hedged or covered interest but not precisely. The failure to achieve exact covered interest
parity because it involves the use of the forward market. it can parity could occur because in actual financial markets there are:
be argued that a very similar unhedged interest parity condition
should also hold. This follows because speculation will make l Transaction cost
the forward exchange rate approximately equal to the expected
future spot rate. If we define the expected spot exchange rate l Political risks
between the dollar and rupees in time ‘n’ as S* n ($/Rs) then it
follows that to a close approximation : l Potential tax advantages to foreign exchange gains versus
interest earnings
S* n ($/Rs) = F¼ ($/Rs)
l Liquidity differences between foreign securities and domestic
If S* n ($/Rs) > F 1/4 ($/Rs) holds, speculators will buy rupees for securities.
Decomposition Of The Interest Differentials equation, and the risk premium the second term in the equation
is the uncovered interest differential, or the expected difference
in rates across countries
It is well known that the elimination of barriers to the movement
of capital across national boundaries as reflected in covered
interest differentials is not enough to equalise interest rates
across countries.
Thus it is still a controversy as to which factor plays a more
important or dominant role as far as interest differentials are
concerned.
A analysis based on the above equation on the Indian condition

W h e r e ‘f p ’ i s t h e a n n u a l i s e d f o r w a r d p r e m i u m a n d i s the rendered the following results :
annualised depreciation of rupees against the foreign currency.
The first term, the covered interest differential, is associated Interest Covered Risk Actual Uncovered
with the country or political jurisdiction in which an asset is differen interest premium deprecia- interest
issued, not with the currency in which it is denominated. The tial differen- tor differen-
second and third terms, which are the exchange risk premium tial tial
and expected depreciation respectively, are associated with the
Mean 4.1842 -6.7548 19.9686 -9.0296 13.2138
currency of denomination, not with the political jurisdiction. Given
the high volatility of floating exchange rates, it is quite possible- Standard 2.6591 7.9943 23.5425 23.8521 24.8813
that the latter terms have a more impact on the interest differential. deviation
The conventional wisdom among the economists is that the

Note :
expected depreciation term is in small magnitude and variability,
and the risk premium term is larger in both magnitude and
1. The period under review is September 1995- April 1997
variability. This conventional wisdom emerges from the rational
theory of expectations. The rational expectations methodology
interprets it as evidence that there is no variation in expected 2. The interest differential is the difference between the US$
depreciation (the third term) and that all the variation in the LIBOR 1 month offer rate (annualised) and secondary market
forward premium represents variation in the exchange risk premium yields (annualised) of government securities with a 1 month
(the second term). (The rational expectations methodology infers balance maturity as on the first day of the month.
what investors must have expected e x ante from what actually
happened ex p o s t ). 3. The Forward premium rates are the month forwards
(annualised) for US$/Rs as on the first day of the month.
Frankel and Froot (1990b), report from the studies conducted by
t h e m t h a t t h e v a r i a t i o n i n e x p e c t e d d e p r e c i a t i o n i s large a n d t h e 4. Due to lack of availability of expected depreciation figure
variation in risk premium s m a l l precisely the reverse of the actual depreciation figures are used Actual depreciation is
conventional wisdom and even more strongly than did the earlier calculated by comparing the US$/Rs spot (FEDAI indicative)
results. rates as on the first day of the month and the last day of
the month. The depreciation so arrived is annualised and
The sum of the covered interest differential, the first term in the considered as the depreciation for the month.
So, the mathematical proof of the equations mentioned above the following prices-are available:-
are as follows:-
1 month USD 5.00 % p. a.
1) 1 month DEM 3.25 % p. a.
4.1842 = -6.7548 + 19.9686 + (-9.0296)

It will be noticed that even in the money market we have not
considered the bid-and-offered rates for the purpose of simplicity.
We will consider the effect later.
2)
-6.7548 + 19.9686 = 13.2138

A customer comes to you and asks for a one-month forward
USD/DEM rate. What options do we have?
The interest differential between the Rs and US$ based investments
when decomposed show the above result. The equation applied (a) Make an estimate of the likely spot rate that will be ruling
here, strictly speaking, cannot be used under Indian conditions 1 month later and quote.
(because of high variability of rupee depreciation (standard deviation
of 23.8521) and the forward premium rates), but still, the results
(b) Try to find out whether the money market can help us out.
show that the risk premium has played a dominant role over the
last two years as far as the interest differentials are concerned.
Obviously, the alternative (a) is a risky one since no one can
really estimate or predict the rate that will be ruling 1 month
The other important deduction is that the covered interest differential
later. We will then be running a currency risk. Alternative (b)
has been on an average negative, indicating that the 1 month
really works and produces a risk-free rate for 1 month forward.
premiums were generally higher than the interest differentials
We can do the following:
providing opportunities for riskless arbitrage. It also should be
noted that in the months when the rupee depreciation or appreciation
l Sell spot USD & buy DEM @ 1.4700
were high the same had played a dominant role as against the
risk premium.
l The DEM we will need only after 1 month so place them
on deposit for 1 month @ 3.25% p. a.
The results therefore show that as far as India is concerned the
risk premium which can be due to political risks, liquidity differences
l The USD we do not have since we will be getting the
and/or the high volatility of the exchange is the dominant factor
same from the customer only after 1 month. So borrow the
affecting the interest differentials.
USD for 1 month @ 5% p. a.
Now, let us see the integration of Forex and Money markets l After 1 month get the US dollars from the customer. Use
with the help of Illustration. this USD to repay the 1 month borrowing + interest. The
DEM that we will get from the maturing deposit along with
the interest be given to the customer.
ILLUSTRATION
Let us assume that the USD/DEM spot exchange rate is quoted l In order not to make any profit or loss on the trade, the
in the market at 1.4700. The bid-and-offered form is for the time rate for 1 month forward could then be worked out by
being left out of the discussion. Likewise in the money market dividing the DEM amount received by USD amount payable.
The above transactions can be shown in a diagramatically as As a consequence, we will be getting two forward prices and not
under. one. These will be the bid and offered prices for the forward
USD/DEM.
Buy spot DEM@

One more important factor that we have to remember here is
1.4700
that there is an interest income from the placement and there
is also interests out-go on the borrowal. So, in order to account
for this, we have to place only such amount in deposit as will
give us the desired forward amount dealt.
Borrow USD for 1 Lend DEM for 1

Covered Interest Parity
month @ 5% month @ 3.25%
In the above example, if we have to quote a price for 1 USD

on the 1 month forward, then we need to borrow not 1 USD but
an amount of USD 0.9958 so that after 1 month we will be
Pay USD 1.0042 Receive DEM
paying 1 USD inclusive of interest. The spot USD/DEM deal
after 1month 1.4740 after 1M
that we will be doing for an amount of USD 0.9958. This will be
equivalent to DEM 1.4639 and it will be this amount that we will
be placing in deposit for 1 month. The maturity amount inclusive
of interest will then be DEM 1.4678.
1 month forward
1.4740/1/0042 i.e.
We have seen how a forward exchange price can be worked out
1.4678
from the spot forex market and the money markets. This is
called the Covered Interest Parity . The resultant position was
completely risk-free and hence the name “covered”.
So, in the present market scenario, if we quote forward rate of
1.4678 to the customer, it will be a risk-free situation. Since we It will also be seen that forward price of a currency against
are fully hedged there will be no currency exposure at all. another currency will be dependent only on the following factors:
l Spot price of the currencies involved.

This process is at the heart of the forward market. The real
situation will be little more complicated. This is because we had l The interest rate differential for the currencies
earlier made certain assumptions. concerned.
l The term i.e. the period in future for which the price is
(a) We had assumed that there is no bid-and-offered price for calculated.
spot USD/DEM. In real situation we have a bid-and-offered
price.
Thus, the forward price is no indicator of the future trend
of a currency.
(b) We had assumed that there is no bid-and-offered price on
the money market quotes. Here also in real life we will That the forward price depends purely on interest rate differential
have bid and offered price. can also be seen in the context of the above example. Let us
assume that the forward price is same as the spot price. In equation from the base and offered currency angle. Consider,
other words we have the following market scenario. for example the following price,
A & B
Spot USD/DEM 1.4700
1 Month forward USD/DEM 1.4700 Here, A is the base currency and B is the offered currency. We
will have three possible scenarios in terms of the interest rates
1 Month deposit rates (USD) 5.00 % for the currencies A & B for a given term. These are,
1 Month deposit rates (DEM) 3.25 % A > B

A < B
The opportunity for profit lies in simultaneously buying spot
A = B
USD, borrowing DEM for 1 month, lending US dollars for 1
month and selling 1 month forward dollar. This is called the
process of arbitrage and the forex market is always looking for In 3rd possibility, the forward rate will be the same as the spot
such opportunity. rates since interest rate differential is zero.
Everyone in the market will do the arbitrage and then one or all However, the forward will be different in 1st possibility than the
of the following things can happen. forward rate in 2nd possibility. This is because the direction of
interest rate differential will be different.
l Spot USD/DEM rate will move in the direction of stronger
since everyone will be buying USD. The rate will move in We can also look at it from a different angle. In the 1st possibility
the direction of 1. 4710, 1. 4720. . . . above, if we are selling the currency A at the spot against B,
then for the period from spot date to the forward value date the
l There will be more people placing USD in deposits. So the
interest rate differential will be against us. The forward rate will
interest rates on USD will come down i.e. in the direction
have to be such as to compensate us for this loss.
of 4. 75, 4. 50. . . . . .
l There will be more people borrowing DEM and the interest While in the 2nd possibility, if we are selling the currency A
rates for DEM will firm up i.e. move in the direction of 3. spot, then for the period from spot date to the forward value
50, 3. 75. . . . . . date the interest rate-differential will be in our favour. The forward
rate will have to be such as will make us sacrifice for this gain.
l There will be more people selling 1 month forward USD so
the USD/DEM rate will move in the direction of a weaker
This compensation and sacrifice for the interest rate differential
USD i. e. 1.4690, 1.4680.... .
being paid or received, is called the premium and discount in
the forex market terminology. The terms have the same meaning
At some stage the market will come to an equilibrium and then as in the ordinary commercial sense.
it will no more be possible to make risk-free profit. This equilibrium
level will be the same level as calculated earlier based on A currency having higher rate of interest is said to be at a
interest rate differentials. We have thus that the forward rate will discount i n f o r w a r d r e l a t i v e t o t h e c u r r e n c y w i t h a lower rate
be an arithmetic function foreign the interest rate differential. of interest. Conversely, a currency having lower rate of interest
is said to be at a premium i n f o r w a r d r e l a t i v e t o t h e c u r r e n c y
It will be very useful at the stage if we look at the currency with a higher rate of interest.
A potential confusing situation can be avoided if we consider and not one. The forward rate is, therefore, always a combination
the fact that the premium and discount are different terms describing of the spot rate and the forward points. In an equation form this
the same situation but from a different angle. To achieve this, can be written as under:
we continue to stick to the spot market practice of talking in
terms of offered currency terms . For a given currency pair, Forward rate = Spot rate + Forward points
therefore, the premium or discount will be the premium or
discount of the offered currency. T h e premium of the offered
Treasury Integration – An Essence
currency is to be subtracted from the spot rate for arriving at the
forward rate. Likewise, discount of the offered currency is to be
added to the spot rate to arrive at the forward rate.One very “Indian rupees sharp fall triggers dollar selling”, “Indian call steady
important point that must be remembered here concerns the in early trade, bonds quiet”, “Rupee came under pressure”, “With
period for which interest rates are being considered. If one is the increase in volatility, bid/ offer spread have also widened,
talking of a premium or discount for 1 week, then the rates of forward premia have softened”.
interest for 1 week for both the currencies must be considered.

It will be completely wrong to consider rate of interest for 1 We do read these reports very often in the pages of financial
week for 1 currency and rate of interest for 1 month for the other and business newspapers without understanding much of it.
currency. What is integrated treasury? What is methology? Who are the
players? What is pre-requisite by way of forex markets? How to
In fact, when one says that a currency is at a premium or go about it as a process? Let us understand such like related
discount against other currency, the statement necessarily issues.
needs to be qualified by the period for which the relative
interest rates differential are considered. A precise statement Cash Flows and Fund Manager
will be - USD is at premium against DEM for the period of 1
week.
Funds manager is to manage the cash flows in various currencies
in the most efficient and profitable way with all concern and
The interest rate differential is always between the interest rates
compliance to the exchange control and business practices/
that are accessible. If the interest rates taken as basis is not
procedures. The management of cash flows involved making
accessible then the whole situation would look altogether different.
sure that payment are made when due and invested at the
In fact, a trader may be committing a gross error if he quotes
highest possible returns. Alternatly, finding optimal liability mix
a forward price based on those interest rates which he can not
for a given asset financing is part of role of the funds manager.
access and consequently will be exposing him to a loss situation.
When in international market/ the funds markets the funds manager
In the forex markets the eurocurrency interest rates are taken
do maintain the appropriate position in various currencies. The
as the benchmark for calculating the forward rates.
desired position depend on currencies of the cash flows involved
as well as managers views of the currency’s future value. It has
The forward rate will be different from the spot rate to he extent linkage to financial indicators, fundamental and technical analysis
of the interest rate differential. This differential can either be of the economic and political factor.
positive or negative for the offered and accordingly the forward
rate will be higher or lower compared to the spot rate. The
Methology
difference between the forward rate and the spot rate is called
the forward point . In the market there will always be bid &
offered prices for the spot rate as well as the corresponding Let us try to define an “Integrated Treasury” in the context of
euro-currency rates. There will, therefore, be two forward points modern banking system. From the definition, roles of such a
treasury are arrived at. Role clarity throws light on need for Integrated Treasury – a definition
integration of treasury . An organizational structure to fulfill the
roles in suggested in fig; “ A” This is followed by elaboration on The scope of defination is restricted to a banking company
infrastructural needs. The last section puts forth a plan for engaged in intermediation of investments and credit. It takes
phased implementation of the integrated process , where things into consideration a banking structure that is widely in place
are not likely to flow in a single go. and gaining increasing acceptance in the largest credit market,
the U.S. The latter is due to the dilution of the Glass–Steagall
Act that separated investment banking and commercial banking.
The integrated treasury is expected to serve a universal bank
ROLE TREASURY that encompasses both.
Integrated treasury in the new environment is expected to

manage all market risks associated with bank liabilities and
AUTONOMOUS INTERGRATED AUTONOMOUS assets. The market risks of liabilities pertain to floating interest
FX ROLE ROLE MONEY ROLE
rate risks and asset- liability mismatches. As for assets, market
risks is due to increasing levels of securitisation of assets ,
change in funding pattern of corporates from bank loans to debt
LIQUIDITY
issues and recent development of credit derivatives (a proxy of
ALM
CORPORATE CASH
DEALING MANAGEMENT participation certificates). While the credit risk assessment
continues to rest with credit function, the cash flow impact
TERM MONEY RESERVES
from change in asset prices due to interest rate changes would
be monitored by the treasury. Thus an integrated treasury apart
from short-term liquidity management is expected to provide
FCNR SWAP
policy inputs to strategic planing group on medium–term basis
PROPRIETORY SLR
TRADING MANAGEMENT INVESTMENTS with respect to the following aspect: funding mix (currency ,tenor
and cost), yield expected on credit and investment (yield and
classes of investment).
OVERSEAS
CORPORATE NON-SLR
FX TRADING
BORROWINGS
INVESTMENTS
Of the three roles identified under an integrated treasury viz.
INVESTMENT
Autonomous Forex, Autonomous Money and Integrated Role,
the last one gains pre-eminence in an era of liberalization.
GOVT. Specifically, this refers to freedom to corporate and banks to
DERIVATIVES SECURITIES structure multi–currency balance sheets and to take advantage
( NON-INR ) ARBITRAGE
TRADING
DEALING of strategic positioning. The expert Committee report on Capital
NON-GOVT.
Account Convertibility (CAC) dwelt at length on phase liberalization
INR
DERIVATIVES EQUITIES INV. on this count The report’s recommendation goes beyond the
DEALING AND TRADING
corporate sector to retail sector too. The relevance of integrated
Fig ‘A’ treasury is dwelt on to capitalise on the freedom envisaged.
Cost of capital
As per norms by Reserve Bank of India , it is possible for bank

to borrow up to 15% of tier 1 capital of the bank over and convertibility. At the long-end, bank choice of currencies in its
above FCNR funds, at the short end. Thus depending on call liabilities can be decided based on demand from customers. As
rates and swap rates at the short –end, it would be possible FCNR rates are fully freed by the Central bank, banks will have
for banks to save significantly- to hedge themselves against a floating LIBOR, in the absence
of interest –risk free landing opportunities.
FUNDING
Return on investment
Banks have also been given freedom to invest upto 15% of

CURRENCY TENOR COST
tier 1 capital of the i.e, Bank in overseas instruments (either
govt. T- bills or money market instrument of bank rated by
YIELD EXPECTED Moodys and S&P). As amount investible is enough increase
and / or the range of investment widened, this avenue would
compete with the current areas for short–terms and medium-
CREDIT INVESTMENT
terms (upto 1 year) investment of Indian banks. Further, floating
rates dollar liabilities would find a natural hedge in U.S. T–
Role of Treasury is given in flow chart as per Fig. ‘B’ bills (as for other currencies too) and obviate need to go in for
costly hedging programs.
FUNCTIONAL DEFINITION OF TREASURY ROLES
Inter bank products

COST REGULATORY CORPORATE TRADING
FUNCTION FUNCTIONS FUNCTIONS FUNCTION
Term-money market is likely to gain pace further with adoption
of Asset Liability Management (ALM) practices by the Indian
FIXED INCOME banks as it would increase demand for tenor funds to match
ALM CRR & & EQUITIES
CORP. FX
SLR MGT. duration of assets and liabilities. Reduction in Cash Reserved
DEALING
Ratio prompts augmentation in bank’s resources to be sizeable.
Term-market expected to receive a further boost . Forex forward
FCNR CORPORATE
SECURITIES rates would however be an indispensable index to quote term
SWAP MGT.
CURRENCY
DEALING rates. Expert are of opinion that only an integrated treasury
TRADING
can embark on such a task
ARBITRAGE Corporate products
Interest rates swaps call for counter parties with USD and INR
Fig ‘B’ TERM MONEY
liabilities. As and when FIIs and FDIs are allowed to operate in
Forward markets, more such matches could emerge. Bank could
earn fee-based income by intermediating such deals. As money
to meet short –term liquidity needs. These arbitrate opportunities and forex market integrate INR yield curve could mature and
may dwindle in quantum and exist for shorter period of time trigger of a wave of USD/INR forex and debt derivatives products.
but would continue to exist even beyond capital account Making a market in these products to bank and customers
would be made possible through an integrated treasury in a Some of the measures set out by the committee on CAC have
better way. been implemented in a phased manner.
By Historical perspective Information flows.
Expert committee on Capital Account Convertibility headed by To achieve the objective Organizational chart is found to be as
S. S. Tarapore recommended towards Risk Management as per fig ‘C’.
under:
l The RBI should prescribe prudential norms for mismatches Treasury head
i n the rupee books of the banks and FIs and prescribe a
l From MIS on micro level branch assets and liability
reporting system for monitoring mismatches .
statements representing liquidity position.
l The bank and FIs should be progressively to a 100
percent mark to market investment portfolio by the year l From Credit department on business projections for medium
2000. term.
l The best practices of risk management as outlined in the l From mid-office on Value At Risk and adherence by dealers
Report of the Expert Group on Forex Markets (Chairmain: to internal and external guidelines.
O. P.Sodhani) may be adopted by the entities including
l To Forex branch heads on currency market and money
corporates this will require strong internal control systems
market developments.
to identify, measure, monitor and manage all types of risks.
l Introduction of internationally accepted accounting and

disclosure norms for banks, financial institutions as also PROPOSED INTEGRATED
corporates simultaneous with the introduction of new
TREASURY STRUCTURE
instruments/products.
TOP MANAGEMENT
Upgrading of skills
TREASURY HEAD MID-OFFICE

The Committee underscores the need for strong initiatives on
the part of market participants to upgrade their human resource
skills by appropriate training inputs. In the long run, only skilled HEAD-MONEY
HEAD-FOREX
manpower can withstand vigorous competition and add value to
the products and services rendered. In order that they attract
CORPO- MONEY DEALER-
the best talent and expertise, individual banks and FIs should SEC.
TRADERS RATE MKT SLR &
TRADERS
have freedom to determine their personnel policies including DEALERS DEALERS C R R
recruitment and wages policies without being constrained by
any rigidities. The committee required that without appropriate
FOREX MONEY
changes in labour laws it will not be possible to create an B/O B/O
environment conductive to operational efficiency which is pre-
requisite for enabling Indian financial entities to compete .......INFO Fig ‘C’
meaningfully with their counterparts abroad.
Dealers sophisticated RMDS (Reuters Monitor Dealing System) to do

deals directly with banks globally. Further, hotlines with brokers
need to be established. Utilizing the services of information
Regular information flow between the dealers on money and
vendor Knight Ridder (now called Bridge) may also be considered
forex desk (swap side especially) is envisaged to exploit arbitrage
given their reputation in debt markets worldwide. This can be
opportunities at the short-end and medium term too as and
arranged/organised in view of the size of operation vis a vis
when a decision is taken to that effect.
cost benefit analysis.
Mid-office
Communication lines
A Mid-Office set up independent of the treasury unit could act

With integration, hotlines with money brokers need to be put in
as a risk monitoring and control entity reporting directly to top
place. A hotline video conferencing through ISDN connectivity
management. Keeping tab on Value at Risk, ensuring adherence
with top management at corporate office needs to be established.
to external and internal guidelines and evolving risk monitoring
The number of direct telephone lines can also be considered as
systems would be some responsibilities of such a set-up. Regular
per requirement i.e., considering the number of personnel in the
information flow from Treasury head to Mid-office chief is expected
dealing room. Money and Forex dealers can be equipped with
toward discharge of these responsibilities. To take real time
mobile phones/pagers to facilitate operations even when they
advantage the operation need to be on-line with sophisticated
are on the move.
need based information technology intervention. However, manual
intervention will suffice till switch over to sophisticated technology
Settlement
based control mechanism is feasible.
Rupee settlement for security operation and Forex operations

Infrasturcture
are done as an important event on day to day basis as a time
bound exercise. Considering the proximity of control place to
Location RBI and other banks, it is suggested that settlement continue
to operate from the same or around location in case these are
Considering that banks do have a well-established forex operation located at two different places due to - obvious unavoidable
at a place different to money operations, there would be proposal reasons. It is suggested to link the integrated treasury with the
to locate the integrated treasury at one place only. In case it is settlement office through modern automatically delivery instructions.
decided to go for integrated treasury in one go, it is suggested This would reduce transmission costs and also speed up the
that extensive planning go into designing the dealing room inputs. process of settlement of rupee funds.
Information vendors like Reuters & Bridge, MTNL engineers,
electricians and others also add value in such a layout design Treasury software
proposals. It has to be ideal location in view of cost benefit
analysis in short and long term. This is to ensure futuristic
At integrated treasury software that incorporates the compact
design of dealing room to be a state of the art operation.
i.e., current and future requirement is at the heart of the process.
Features like Transfer pricing mechanism to price deals involving
Information system the money and forex side of treasury would lead to a true
reflection of profitability on either sides. Talks with vendors of
Treasury needs to be equipped with information system viz from such software and bankers already using such software could
Reuters and Bridge and Bloomberg. The former includes the be a starting point towards acquiring it. Since treasury is considered
122 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Asset - Liability Management 123
to be a profit centre of the bank, advantage of Transfer Price

Mechanism (TPM) is all the same important and must to asses Chapter
true bottomline of operations.
9
Implementation of integration
Integration process is followed by well thought policy papers Asset - Liability

and well conceived / drawn action plan giving weightage right
from swapping the ideas / concept of money and forex operation Management
to integrated treasury operations with well defined roles and job
expectations by the management policy / goals sharing of market
information in the group within and by the team leader is a pre-
requisite. It will ensure smooth landing of proposal to launch as
an integrated treasury. Nuts and bolts have to be at place. Introduction
There has to be at place the communication devices to insure
internal and external access easy and pragmatic. The The inter-relationship between asset and liabilities relates to
implementation can be phased out by coordinating the present both domestic and international funding and lending. Funding
infrastructure, setting up the additional requirement and finally may derive from either domestic sources or the Eurocurrency
moving for functions. For it there is a need to have capacity markets. Lending likewise may relate to the domestic economy
and capability to absorb the shocks as a result of dilution in or take the form of international markets. Management of asset
the process. Thus need for standby or second line of defence and liabilities must operate within the framework of the prudential
can not be ruled out to ensure smooth succession and trouble controls and monetary policy laid down from time to time by the
free operation. authorities of the country concerned. Now, let us see the structure
and composition of asset and liabilities.
Risk management/ control
Structure and Compositions of Assets and
The MIS as per Guidelines for Internal Control over Foreign Liabilities
Exchange Business and Risk Management Systems in banks
by RBI has to be placed to the satisfactions of RBI and the
A good A/L managers understand structure and composition of
bank’s directions / policy frame work. It will ensure effective
asset and liabilities so as to ensure proper decision in the given
supervision and control over Treasury Operations viz over Daylight,
situation. The components of asset and liabilities can be categorized
Overnight limits, Stop loss limits, Individual Gap limits, Aggregate
into permanent natured assets and liabilities, long cycle time
Gap limits, Merchant, - Trading- positions nostro reconciliation,
assets liabilities, medium cycle time assets and liabilities, short
Cash management, Maturity Gaps, FCNR portfolio etc.
duration asset and liabilities and contingent asset and liabilities.
Such a segmented approach would enable banks to evolve
suitable specific strategies to manage asset and liabilities. This
would also give banks the totality rather than an aborted micro
view. Such segmentation would help identify the mismatches
according to maturity segments and help in planning to bank’s
advantage. Asset and liabilities of a branch/bank are regrouped
in chart as per Annexure ‘A’.
Business Structure Each of these “banks” has unique characteristics that influence
the structure of its ASSET LIABILITY position.
A non-exogenous factor that the A.L. manager has to take into Consumer Bank Coml. Bank (Domest) Intl Coml. Bank Invest (Mer) Bank
account is the bank’s own business structure. How the bank is
Capital -capital Capital requirement Capital requirement H i g h capital
structured determines largely: requirement depends depends on credit benefits from better requirement due to
on mix of consumer quality of customer diversification & may securities underwriting
finance and mortgage base and bank’s credit suffer from country risk a c t i v i t i e s and
l The scope, accuracy and speed that is required for ASSET loans m a n a g e m e n t inter alia m u l t i f a c e t e d
LIABILITY positioning and decision-making. capability. counterparty risks.
Liquidity -Liquidity at Liquidity primary L i q u i d i t y similar to All of balance sheet
l The scope, speed and quality of internal and external risk only in case of concern due to domestic c o m m e r c i a l turns over rapidly (not
confidence crisis; relatively rapid turnover bank at each national only transaction
information that thebank can provide to position ASSET Balance sheet turns of balance sheet level; better diversified; a c c o u n t s ) ;
LIABILITY , the bank’s “natural” positions and its over slowly need to preserve liquiditydepend on
bank’s liquidity i n marketability of
ability (often “size”) to conduct profitable treasury operations Eurocurrency market Inventory & availability
(positions, arbitrage). of borrowing facilities
IRR -Very vulnerable to -dueto high proportion -IRRM similar to -Interest rate risk
To understand it in depth the following classification is used: interest rate volatility; of low interest/interest- d o m e s t i c b a n k a t e a c h integral part of day-to-
especially mortgage free transaction national level day trading and
banks with t h e i r balances, tendency to c o m b i n e d with positioning activities;
l Consumer Banking (savings, consumer credit, mortgage tendency to negative develop positive (over m i s m a t c h aspects o f no natural positions
sensitivity (overlent) of borrowed) sensitivity of international treasury
lending, retail checking accounts, small time deposits/CDs) NII to interest rates. NII to interest rates trading activities.
Treasury Capabilities - -Treasury capabilities -Treasury c a p a b i l i t y -Highly developed

l Domestic Commercial Banking (commercial loans, checking Very limited treasury geared to activate highly developed at t r e a s u r y capabilities
accounts, medium-term credit, leasing, etc., large time capability; often limited participation i n n a t i o n a l & i n t e r n t i o n a l especially in the capital
access to equity domestic m o n e y level; bank usually also markets
deposits/CDs, some substitute products); market (legal structure); markets;usually limited a c t i v e participant in
typical client of financial capital markets national & international
markets capability (‘client’) capital markets; active
l International Commercial Banking, similar to Domestic & passive ability to
Commercial Banking (in domestic currency plus loans/ innovate
deposits in foreign currency, substitute products-swaps,

The consumer bank needs to rely on external resources; good
options, securitised products);
advice and risk management products to offset or hedge its
normally mismatched position. In contrast, the (small) domestic
l Investment Banking (underwriting/trading securities, making
bank is fairly self-sufficient, although normally sensitive to a
markets in securities, futures, exchange traded options,
general decline in interest rates. However the small domestic
etc., occasionally maintaining participation in non-
bank will normally not be able to run its treasury as a business
banking companies).
instead of a support function.
Both the international-commercial and the investment bank make

probably more on their treasury than they spend, and have an
interesting “captive” client in the bank or “house” itself.
Many large banks are hybrid and consist of several of these

four types and, for example, combine the treasury capabilities
of their international commercial bank with the risk management Multi-Currency Balance Sheet
needs and deposit base of their retail bank. A “universal” bank
would combine all four types.
When asset and liabilities are evaluated and held in more than
one currency, it is a case of multi-currency presentation of
International banks have different business mixes abroad than accounts. Local currency is converted into foreign currency.
they have in their home country, and problems in a given country Conversion rate would be the exchange rate ruling on the date
are often the result of an unfavourable business mix from an of evaluation of asset and liabilities. Many international banks
ASSET LIABILITY point of view (especially taking into account are presenting their Assets and Liabilities in multi currency. The
the regulatory/competitive profile of that market) that should be concept is yet to crystalise to usage in many countries including
addressed in a wider strategic context. India.
Guided by the business structure of an international banks, the Capital and Regulation
structure and compositions of asset and liabilities can be presented
in the balance sheet as follows:-
Capital is a central ingredient in the regulatory and supervisory
Amount in $ Mio process. It is the ultimate function and responsibility of bank
supervision to ensure that the business of banks is conducted
in a generally prudent manner and that depositors’ money is not
LIABILITIES Amount ASSETS Amount
put to unacceptable risk. Capital is essentially about a bank’s
ability to deal with risk. The maintenance of adequate capital is
Share Capital Fixed assets
a major part of the supervisory process. To elaborate specifically
Authorised Goodwill
we find that the Bank of England adopts a general approach
Issued Building
almost similar to that of the Comptroller of the Currency in the
Machinery
U.S. where the capital requirement is placed in a broader prudential
perspective known as the CAMELl system:
Reserves and Surplus Investment
l the adequacy of a bank’s capital;
P/L Account
General Reserve l the structure and quality of its assets;
l the quality of its management;

Current Assets
Secured Loans Cash/Bank l its earnings performance, and
S. Debtors l the liquidity structure of the balance sheet.

Unsecured Loans Stock
Term Deposits
While capital adequacy is an important issue, it cannot and is
Loans and Advances
not viewed independently of all aspects of the bank’s business.
Current Liabilities Loans
It is not set apart as an independent issue with rigidity established
S. Creditors Advances
requirements ignoring the particular position of individual institutions.
O/s Expenses
Misc. Expenditure
Provisions Basle committee
Proposed Dividend
There had been a couple of supervisory and regulatory initiatives,
which are in tune with recent time happenings and incidents. risk weights for calculation of capital adequacy, provisioning
Basle Committee on Banking Supervision - banking supervisory norms, exposure norms to be implemented over a period of time
authorities established by the central bank Governors. The stating from 31/3/99 to 31/3/2003. Thus, the bank has given a
committee is represented by senior functionaries from countries clear indication of the prudential norms for the future years also
viz. USA, UK, Japan, Germany, Canada, Bulgaria, France, Sweden, and advised the banks to gear up for implementing the measures
Switzerland, Netherlands Italy, Belgium and Luxembourg. A paper announced.
on Management of interest risk and measurement of banks
exposure to interest rate risk (IRR) is also submitted by the said Measures effective from 31/3/2000 and after as follows:-
committee.
EXISTING REVISED
Investment in government securities Risk Weight 0 % 2.5 % Risk Weight

Objectives of Committee w.e.f. 31/3/2000
l To emphasize that risk management practices are essential Investment in other approved securities Risk Weight 0 % 2.5 % Risk Weight
to prudent operation of banks. guaranteed by central/state government w.e.f. 31/3/2000
Investment in other securities where Risk Weight 0 % 2.5 % Risk Weight

l To promote stability in the financial system as a whole.
payment of interest and principal are w.e.f. 31/3/2000
guaranteed by State/Central
government
The Basle committee recommendations highlighted
the need:- Investment in other securities where Risk Weight 0 % 2.5 % Risk Weight
payment of interest and principal are w.e.f. 31/3/1999
l To re-assess the banks’ own systems not guaranteed by State/Central
government
l To provide a framework for obtaining information on IRR

Investment in government guaranteed Risk Weight 0 % 10 % Risk Weight
securities of government undertakings, in 2001-2002
l To define the principles of sound IRR for a bank
which do not form part of approved 10 % Risk Weight
market borrowings program. in 202-2003
l To propose capital charge specifically for IRR.
Investments in subordinate debts in the Risk Weight 100 % Risk Weight 100 %
form of Tier 2 capital
Regulator’s Role
All other investment Risk Weight 100 % No change in the
Credit and monetary policy by the regulator introduced ALM norm
system. The initial focus of the ALM function was to enforce Risk Weight for government guaranteed Risk Weight 0 % Govt. Gua. 20 %
the risk management discipline viz. Managing business and advances Risk Weight State
assessing the risks involved simultaneously. gua. 100 % Risk
Weight after 31/3/
2001
Indian Scenario
Reduction in time frame of sub-standard An asset is 31/0/99 - 50 5 Risk
assets classified as sub- W e i g h t
The Central bank of India has issued revised/changed guidelines standard if it has 31/3/2002 -
to all the banks on prudential norms. The measures announced been as NPA for a balance 50 %
period not Risk Weight
by the bank gave an indication that RBI directed implementing
exceeding two
the Narsimhan committee recommendations on banking sector years
reforms. The Central Bank has announced various measures on
EXISTING REVISED Off-Balance Sheet Items

Provisioning norm in respect of A d v a n c e 25 % each year
government guaranteed advances guaranteed by from 31/3/2000 to Cash deposits, advances, investment, etc. are reflected on balance
state government 3 1 / 3 / 2 0 0 3 sheet. Derivatives like forwards, swaps and also contingent
in respect of which
contracts like letter of credit and guarantee etc. are not shown
the guarantee has
been invoked are on balance sheet. Until the option is exercised, it is off-balance
treated as sheet item. Forwards and futures cannot be paid for the balance
standard assets sheet until the underlying assets are bought and paid for. Swaps
are the contractual commitment to exchange certain cash flows,
Provision for standard assets No provision 0.25 % Risk Weight
required which cannot really be treated as borrowings, and lending i.e.
from 31/3/2000
asset and liabilities for balance sheet purposes.
Importance of Asset Liability Management

Since there is no way of presenting or quantifying derivative on
the balance sheet as asset and liabilities, shareholders and
Asset liability management, one of the prime responsibilities of
regulators are integrated to know about it.
the treasury of the international bank which is primarily concerned
with three inter-related issues:-
Some of the off-balance sheet items are shown below for ready
l Cash Management reference:-
l Interest rate sensitivity

PARTICULARS 2000 1999
l Liquidity
Interest rate contracts
The major issues in this context are:-
Exchange Traded
l The mix of the asset and liabilities,
Futures
l The sources of liabilities Options Purchased

Options written
l External cash balances
Over the counter

l The pricing structure of both asset and liabilities
Forward Rate agreements
l Maturity and cash flows profits Swaps
l Liquifiable assets Options Purchased

Options written
l Mobilisation of deposits and the utilisation of internal liquid
resources Letter of Credit issued
l The funding of assets on the best possible terms

Letters of guarantee issued
l Balance sheet consideration
TOTAL
l Judicious use of the bank’s name
related only to assets currently on the balance sheet and observable.

PARTICULARS 2000 1999
This is a considerably more complex issue than the capital
requirements discussed above because the magnitude and nature
Foreign Exchange Contracts of the risks are less determinate.
Exchange Traded
Asset/ liability and international banking operations
Futures
Options Purchased
Asset liability management is crucial to both domestic and
Options written international banking. The basic objective is to ensure that the
bank’s profitability is not unduly exposed to changes in interest
Over the counter rates, which is a subject of importance to asset and liabilities
Spot and forward in home currency as well as in foreign currencies. The interest
Swaps rate exposure arises because the maturity patterns of the asset
Options Purchased and liabilities differ, they need to be priced at different points of
time, and therefore, changes in interests rates affect the cost
Options written
of liabilities and yields on assets and hence profitability. In
international banking, the major impact of asset liability management
Other Derivative Products
was felt in the pricing of the medium term loans, specific currency
denominated deposits i.e. foreign currency non-resident deposits
Exchange Traded
as in India, schemes.
Over the counter

With on the general subject of asset liability and its positioning,
TOTAL one ironic feature of the regulatory regime in some of the countries
including India is worth noting. While the supervisory authorities
Total notional Amount outstanding
have always been conscious of and controlled tightly the gaps
in the foreign exchange book, an equal emphasis needs to be
Off-balance Sheet risks placed on the gaps in the rupee book - whether by the supervisor
or by bank management. The major problem here is the mismatch
between relatively - shorter-term liabilities and the longer maturity
The final, though controversial, area to consider relates to Off-
assets held, particularly in the SLR proportion of a bank portfolio.
balance sheet risks. A bank is primarily in the business of
Since the latter still forms a significant proportion of banks’
financial intermediation: issuing assets and liabilities with different
assets and is increasingly requirement to be marked to market,
characteristics. This is reflected in the balance sheet. But the
the banking system runs a significant interest rate risk. The
bank is also exposed to risks for activities that do not count as
Reserve Bank of India should consider to evolve minimum standards
a definite asset on the balance sheet. In fact, Off-balance sheet
for securities settlement system and also reasonably enforceable
business has grown substantially in the 1980s and 1990s partly
systems especially relevant to emerging markets. It should cover
because of banks’ capital constraints. If business can be developed
broadly equity/equity related instrument/ Corporate bonds/govt.
without creating assets on the balance sheet, then profits rise
securities etc. It would indeed be a good initiative on the part
relative to capital and assets, and less capital is needed.
of regulators to plug the gap in control mechanism.
But much of this business does contain a contingent liability

and a bank would therefore be under-capitalized if capital were
134 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Risk Management Framework - Retrospect and Prospect 135
Chapter
10
Management Risk
Framework
- Retrospect and Prospect
Genesis
Competitive and regulatory pressures make it mandatory to have

an organization wide risk management framework in place.
Organizations that do not implement such a risk management
framework may be unable to compete effectively in the
marketplace.
Changing Scenario - Risk Management
A global marketplace characterized by the commonisation of

driven business, industry consolation, deregulation and technology
advances has heightened the level and nature of potential risks.
The current environment demands sophisticated and
comprehensive controls to quickly bring products to market,
The expectations of the Board of Directors, regulatory bodies,
rating agencies and shareholders regarding controls continue to
rise. Moreover, it goes beyond just “risk controls” market leaders
have evolved “ risk management” to the extent where they view
it as a core competency.
As a core competency, risk management empowers organizations

to control risk, but also measure performance more effectively,
determine capital allocations and realize a variety of other business
advantages. Thus, by being more proactive, an organization can
gain competitive edge and even enhance its business reputation.
Enterprise Risk Management management learned of the losses, they attempted to hide them
from the US regulators. Ultimately, Daiwa was forced to cease
its US operations and was $340 million in a plea agreement with
All organizations are in business of placing capital at risk in
the US prosecutors.
pursuit of ventures that are uncertain. This includes financial
institutions, governmental bodies, corporations and non-profit
organization. They all have goals, and they allocate resources l Sumitomo Corporation (June 1996)
to pursue them. Because all organizations face uncertainly in
achieving their goals, they all face risk. Enterprise risk management Sumitomo’s head copper trader, Yasuo Hamanaka, disguised
is about optimizing the process with which risks are taken.It losses totaling $ 1.8 billion over a ten year period. During that
became a critical issue for the 1990’s because organizations time, Hamanaka performed as much as $20 billion of unauthorized
have started suffering spectacular losses—often from risks they trades a years. He was able to hide his activities because he
never should have taken in the first place. headed his section and had trade confirmations sent directly to
him, bypassing the back office.
Examples include :
In recent years, numerous organizations have suffered staggering
l Orange County (November 1994) losses such as these. These four, however are some of the
most significant. They illustrate two common characteristics.
Orange County’s Investment Pool lost $ 1.7 billion from structured Each one :
notes and leveraged reposition. The treasurer, Robert Citron,
l Was directly caused by the actions of a single individual.
took the positions with oversight from the county’s five-person
board of supervisors. The risking of the pool’s investments was l Could easily have been prevented through appropriate
publicly discussed when Citron ran for, and won, reelection in oversight.
1994. Members of the board of supervisors claim that they did
not receive critical information, which have indicated the risks Losses such as these never used to occur. In the past,
that Citron wads taking. organizations might go bankrupt or suffer losses, but the forces
that caused them were macroscopic – competition,
l Barings Bank (February 1995) mismanagement or adverse conditions would bleed an
organization’s vitality. Today, an individual can pick up a phone
Barings Plc lost $ 1.5 billion because a Singapore-based trader, and deal with billions of dollars. This is new.
Nick Leeson, took unauthorized futures and options positions
liked to the Nikkei 225 and Japanese Government Bonds (JGBs). The risk does not come from derivative instrument alone. It
At the height of his activities, Leeson controlled 49% of the arises from the many sources of leverage, which are available
open interest in Nikkei 225 March 1995 contract. Despite having today. These include derivatives, repos, and securities lending
to finance margin call as the bank lost money, the Baring’s and structured notes. Such tools have increased liquidity in the
board and management claim to have been unaware of Leeson’s markets and enable institutions to efficiently manage many of
activities. their risk exposures. In the wrong hands, however, they can
devastate an organization.
l Daiwa Bank (September 1996)
The problem is not the financial tools, but the people who use
One of the Bank’s US-based bond traders, Toshihide lguchi, them. While many financial tools are new, the problem of people
concealed $1.1 billion losses over a ten-year period. When acting fraudulently, or just irresponsibly, has always existed. In
the past, risk were unleveraged, so trading losses were limited. needs of an organization. Each will, however, be important in
They might cost a few individuals their careers, but they would some sense or another.
rarely make it to the newspapers. Today, people take the same
types of risks, but they leverage them, and the losses burgeon. Culture
Leverage doesn’t only magnify market risk. As margins of error In the example of institutions that suffered dramatic losses,
contract, other risk increases, including credit risk liquidity risks, while the immediate cause for each loss was adverse market
operations risk and legal risk. Organizations are focussing on all moves, the fundamental problem was cultural. Each institution
these. Through enterprise risk management, they seek had a corporate culture that was incapable of confronting
comprehensive solutions – not because the problem is new, but irresponsible behavior.
because the consequences have become enormous.
In fact an organization will mange risk only if its members want

Regulators are also motivating a process of change. Awakened to manage risk. Regulators struggle with this each day. They
to the threat of leveraged risk, they are pursuing initiatives that: can force a bank to implement a savvy value at risk system.
They can also appoint a committee to implement hundreds of
l Enhance the disclosure of off – balance sheet risks.
pages of procedures.
l Promote corporate risks management.

But they cannot force an organization to effectively mange risk.
l Ensure that institutions are sufficiently capitalized for the It is individuals who decide whether or not they are going to
risks that they take. manage organizational risk. Unfortunately, there is a big incentive
from them not to.
l Reduce systemic risk.
While individual initiative is critical, it is corporate culture that

Finally, organizations are embracing enterprise risk management
facilitates the process. Corporate culture defines what behavior
because it makes good business sense. Today, they actively
the members of an organization will condone and what behavior
make this decision to change the way they take risks. They
they will shun. Corporate culture plays an important role in risk
implement innovative procedures. They install new technology.
management because it defines the risks that an individual
They actively reshape their corporate culture to facilitate better
must personally take if they are going to help manage
risk taking.
organizational risks.
Implementing an effective strategy of enterprise risk management

is not easy, and for each organization, it is different. There are, A positive risk culture is one that promotes individual responsibility
however, three fundamental elements that should compromise and is supportive of risk taking. Characteristics include:
any risk management strategy:
l Individual decision making
l Corporate culture.
l Procedures. Group decision making is bad risk management because no one

is accountable. When an individual makes a decision – possibly
l Technology. with the help or approval of others – that individual is personally
accountable. His reputation is on the line, so he will carefully
The importance of each of these will vary depending upon the analyze the issues before proposing a course of action.
l Questioning A lack of procedures increases the personal risk that individuals

must take if they are going to manage organizational risk.
In a positive risk culture, people question everything. Not Accordingly, - a lack of procedures tends to promote inaction.
only does this identify better way to do things, it also ensures
people understand and appreciate procedures. Effective procedures, on the other hand, empower people. They
lay out specifically what people should do – and what they
l Admissions of ignorance should not do – in a given situation. By reducing uncertainly –
individual risk – they promote action.
Admitting that we do not know entails significant personal

risk. A positive risk culture supports such honesty at every Examples of procedures include:
level of an organization. No risk culture is perfect. Fortunately,
few are beyond repair. The challenge of enterprise risk management l Board procedures
is to honestly assess an organization’s culture, and then work
to improve it. Every board of directors or governing body should operate
a set of procedures which address conflicts of interest,
clarify personal relationship and facilitate the discussion
Procedures
and resolution of difficult and contentious issues.
Procedures are a powerful t ool of enterprise risk management.

l Lines of reporting
The purpose of procedures is to empower people; they specify
how people can accomplish what needs to be down. It is only Everyone in an organization should to a signal person. The
when procedures are neglected or abused that they become an line of reporting should be explicit. A worthwhile illustration
impediment. for this the bank of England’s report on the Barings
collapses. That report identifies four different people who
The success of procedures depends critically upon a positive may have had oversight responsibility to any trader.
risk cuture. Procedures need not necessarily run into hundred
of pages. Even a simple set of procedures can make an enormous
l Trading authority
difference for an organization if people believe in them and take
personal responsibility for upholding them.
Whenever an organization engages in a new from of
market activity – such as the new from of transaction, a
Procedures systematize the process of risk management. They new hedging strategy or proprietary trading – there should
make explicit how much risk is too much risk for any given first be a formal review and approval process. Streamlined
segment of a portfolio. procedure should apply for granting new responsibility to
any trader.
Without risk limits, someone would have to risk the risks being
taken by individual traders and apply their own subjective judgement l Risk limits
that a trader is taking too much risk, the affected trader may
reasonably feel that the decision is arbitrarily or unfair. Market and credit limits represent procedures for
managing risk. There should also be procedures for
Whenever procedures do not exist, there is increased potential establishing and reviewing such limits in order to assure
for disagreement, misunderstanding and conflict. that the system of limits remains effective.
Also, every organization should have procedures for changing on technology, there is always a risk of technology becoming
procedures. Because procedures become outdated over time, it the focus of risk management.
is easy for organizations to change how they operate without
formally recognizing that the change is taking place. Informal More staged approach starts off by recognizing that risk
practices evolve out of habit, instead of a deliberate process. management is primarily about people- how they think and how
Because they may be adopted out of necessity or convenience they interact with one another. Technology is just a tool. In the
– without considering how they impact organizational risk – they wrong hands, it is worse than useless, but applied appropriately,
too, are a source of risk. it can transform an organization.
Often, periods first develop procedures for regulatory purposes. A good approach to implementing an enterprise risk management
Their regulators require them to implement certain procedures initiative is:
and so they do. As regulators are well aware, this can be a two-
edged sword.
l Initially allocate minimal funding for the initiative, but ensure
that board members, senior management or other supervisor
On the negative side, regulatory procedures are primarily intended are involved in the process.
to minimize risk, which is different from optimizing risk. Their
main purpose is to protect third parties or to control systemic l Start by planning a risk management strategy that involves
risk. no technology at all. This can be an empowering exercise.
It focuses participants on the procedural and cultural issues
Every organization should supplement regulatory with their own of risk management. Ultimately, it is these that determine
procedures that embrace a process of risk optimization. Indeed, the success of an initiative.
the more proactive an organization is in developing its own
procedures, the more effective that organization will be risk l Once you have decided on a strategy for managing risk,
management. then determine where technology needs to be incorporated
or where it can enhance the strategy.
Through such a process, an organization will not only implement
procedures that are in rune with its goals, it will also be
implementing procedures for the right reason. A useful analogy Data Aggregation
for this is drivers stopping their care whenever they see a red
light They may do so because they ear being caught running a Information is essential to enterprise risk management. However,
red light. A better situation, however, is if they stop out of before it can be processed, analyzed or acted upon, it must be
concern for their own safety. The best procedures are those that made available to the systems and individuals that needs it.
an organization wants to implement and promote.
In the examples of institutional losses – Orange County, Barings
Technology In Perspective Brothers, Daiwa Bank a Sumitomo Corporation - each could
have been prevented if decision- makers had the right information.
For many institutions, such as banks, investment management Three of these four cases involved fraudulent falsification of
firms or insurance organizations, technology will be a critical information.
component of any risk management initiative. For other
organizations, especially those that do not manage assets internally Accordingly, institutions should manage their information flows
technology is less important. For institutions that rely heavily with the assumption that individuals will attempt to corrupt or
undermine the process. Automation can play a valuable role by manage specific risks for which he or she was best qualified,
confirmations, reporting and funds transfers. This, however, is individuals were called upon to be generalists. Each would manage
just one benefit of automated data management. multiple risks. In this environment, each desk would be given
its own credit risk limit for each counterparty and its own market
Even without fraud or human error, data management has always risk trading limits.
been a bottleneck for enterprise risk management. Managing
such risks as an organization’s total yield curve exposure, or its Today, technology makes it possible to effectively communicate
total credit exposure to counterparty is impossible without information – across desks, across departments, around the
comprehensive information about those exposures. globe and in real time. That technology solution is data aggregation.
Credit exposure poses similar problem. Exposures to a single As the trading environment captured as it is generated – both
counterparty can arise throughout an institution. Lending, streamlining the process and avoiding errors or fraud. As data
underwriting, the derivatives desk, the foreign exchange desk – is captured, it can be posted to a central data repository. From
almost every functional unit may create exposures to a counterparty. there, all system, all desks and all departments that need it can
Those exposures can be highly varied and complex. access it.
Before an organization can attempt to manage risk on an enterprise This solves the communication problem. The need for human
– wide basis, it must first collect and communicate all necessary intervention – phones calls, memos, and meetings – is eliminated.
information relating to those risks. In the past, organization As information is generated, it is automatically posted. When
have had limited ability to do this. They have faced too many another desk or department needs that information, it is
different and complex risks – and professionals have had no automatically retrieved. Each desk and department needs just
convenient means of communicating exposures across an one line of communication – one with the data repository.
organization.
Data aggregation is not a new concept. Corporations have been
Consider the simple case of a bank, which has just two trading trying to aggregate data since the time when they installed the
desks. For these desks to co-operate in managing risks there first mainframe computers. Today, however, it is an achievable
would need to be just one line of communication. goal enterprise wide.
Suppose, however, that bank had not two desks, but ten. In this
case, the lines of communication would grow from one to as
Risk Analysis
forty-five. Trying to manage risk across these forty-five lines
would become a monumental task. For traders, communicating “How much risk are we taking?” the question is so simple – and
with other desks could become a full time job. Add to this the yet profound. In one form or another, it underlies enterprise risk
differing conventions that might exist on each desk, the need to management. In the past, organizations would look to their profit
the back office, credit department, sales risk management – the and loss statement to answer the question. Volatile profits meant
problem become insurmountable. high risk. You couldn’t ague with that.
In the past, this problem prevented organizations from managing A problem, however, is that profit and loss is a retrospective
risk on an enterprise-wide basis. Instead, each desk or department measure of risk. We all know that Barings Bank was taking a
would be given broad authority to manage those risks, which lot of risk in February of 1995. That brutally accurate fact,
arose from its own operations. Instead of having each professional however, arrived too late to avoid catastrophe.
Indeed, for many risks, the profit and loss statement may reveal Statistical measures for credit exposure is similar. Based upon
little or no information – even retrospectively. A credit loss the existing portfolio of contracts with a counterparty, they
might impact profit and loss years after an exposure is first summarize the potential credit exposure, taking into account all
taken. The profit and loss statement may provide no indication market volatilities and correlations.
whatsoever of liquidity risk. That risk tends to strike infrequently,
but with devastating effect. The first time a liquidity crisis impacts A shortcoming risk statistical risk measures is the fact that they
the profit and loss statement is often the last. can be extremely computer intensive. For this reason, institutions
are turning to ever more powerful computer systems to support
In order to manage risks, organizations need to be able to their risk analysis. Distributed systems, which parallel a simulation
measure those risks prospectively. They need to know based and run it simultaneously on multiple computers, offer much
on their positions today, how much risk they are actually taking. potential. When these are used in combination with the latest
This is a difficult question to answer. simulation techniques, many sophisticated forms of statistical
risk analysis can be performed in real time or near-real time.
Data aggregation does not solve this problem. It brings all the
necessary data together, but a list of contracts or catalogue of Automated Oversight
counterparties can not tell you where your risks lie. Somehow,
that wealth of data must be processed and converted into a With statistical risk measures, and the ability to assign a precise
measure of risk. number to risks, oversight can be automated. The process starts
by assigning each department, each desk and each trader explicit
Organizations are addressing this challenge with statistical risk authority to take specific risks. This authority is articulated as
measures. For market risk, they are using value at risk (VAR). risk limits.
For credit exposure, they are using expected exposure or maximum
exposure. Such risk measures are powerful because they can For example, a foreign exchange trader who trader’s three different
summarize a complete risk with a single number. currencies might be given a risk limits for each currency. Those
limits would be expressed in terms of value at risk. The risk
For example, value at risk incorporates all of a portfolio’s holdings management system would track the trader’s value at risk arising
as well as the volatilities and correlations of applicable risk from exposure to each of the currencies to ensure that they
factors. remained below the respective limits. The trader would also
have a total value at risk limit. This would cap the total risk he
was allowed to take, irrespective of source.
It then synthesizes this wealth of information to produce a
single number represents the upper bound on a confidence interval
In addition to trader-specific limits, there would be overall limits
for how much the portfolio could lose over a specified horizon.
for each desk and total limits for the entire trading operation.
Because value at risk is based on a portfolio’s current holdings, When a limit structure is supported by risk measurement technology,
it is a prospective measure of risk. It tells you how much you which can be precisely, measure utilization under each limit;
are taking now – not how much risk you trading risk oversight becomes automated. If a trader exceeds
a limit, it is immediately caught. The system then informs the
Were taking last week or a month ago. Furthermore, because it risk management unit, appropriate managers, the trader and the
takes into account market volatilities and correlations, it captures trader’s colleagues in the trading floor. In this way, a clear
all hedging and diversification effects. standard is set for appropriate behavior, and everyone knows if
someone violates the standard. The system becomes self-policing Risk management means the establishment of an organizational
because everything happens out in the open. framework for handling risks. All the processes, instruments,
resources and responsibilities needed to assure a systematic
and efficient risk management are to be clearly defined and
From overcoming risks to systematic risk
anchored into this framework.
management
A structured and systematic risk management replaces an adhoc
The assumption and handling of risks are an inseparable of problem solving with composed considerations. This also lends
banking. Against the background of competitive pressures, the support to the day-to-day business operations.
effective and efficient management of risk is a core competency
of the successful bank. Optimal risk management is a strategically
decisive factor in banking. Risk management as a closed circle
Spectacular cases of losses have the regulatory authorities The introduction and operation of a risk management system
worldwide to increase the demands they place on the bank’s form a circle. Risks are identified, measured and controlled.
risk management. The optimal integration of the regulatory They are monitored regularly to as certain whether the risks are
authorities in the bank’s internal risk management assures the still within the prescribed limits. If not, the circle starts again:
bank’s regulatory authorities in the bank’s internal risk management the excessive risks and their causes are identified, measured
assures the bank’s regulatory compliance, avoids duplication of and corrected.
effort and thus brings comparatives advantages.
Risk strategy
During the past decade, the banking industry worldwide has
made enormous efforts regarding risk management and has Within a bank’s risk management, the Board of directors and
achieved progress. At the same time, the regulatory requirements the senior management are responsible for the definition of the
have been extended and tightened both at the national and the objectives, priorities, principles and strategies. It is up to the
international level. The development of the best practice in risk Board of directors to approve the risk policy and thus the overall
management and also of the respective regulatory standards is framework of the bank’s risk management and to supervise its
placing in increasing demands on risk management. implementation.
The development of risk management has so far been isolated It is the responsibility of the Board and the senior management
in the individual business areas of banks and has therefore to ensure that structures and processes are implemented which
been relatively uncoordinated. The quick availability of solutions guarantee a systematic, efficient and effective risk management.
for limited areas was given priority. Systematic and structured They are also responsible for the establishment of an appropriately
overall concepts were, in comparison, given only secondary organized, properly staffed, technically equipped and methodical
attention. infrastructure.
Today’s efforts aim to embed a bank’s risk management into a Finally, the Board of directors and the senior management are
structures overall concept. A clear reference framework and a responsible for the supervision and the control of risk management,
solid and uniform basis need to be brought into line with each for the adherence to its principles and the global risk limits.
other and anchored within the organization. The relevant regulatory They must further ensure that the bank’s risk management is
standards also require an approach. being properly supervised and functions adequately.
It is, on the other hand, basically not the responsibility of the For a given objective, efficient risk management means that the
Board and the senior management to identify, measure / assess, bank will tailors entire risk management system strictly to that
steer and control the risks at the operational level. Direct interference objective. Good solutions fulfill the objectives defined by the
in these risk processes by the Board and senior management bank. Not more, but not less. The conception and realization of
should occur only exceptional cases. successful risk management are therefore based on clearly defined
and concrete objectives.
In practice, we see a certain tendency to concentrate the discussion
of risk management on technical and methodical aspects. High- Determining the objectives of the risk management is a decision
risk consciousness and adequate training of all persons involved of strategic importance. They have an ongoing influence on the
in risk management are, inspite of the advances at the system competitive of the bank. Therefore, setting the risk management
level, indispensable to successful risk management. Organizational objectives is part of the central responsibilities of the board of
aspects of risk nagement may also not be ignored: due attention directors and the top management. The senior bodies are
is to be given to the segregation of duties in particular. specifically responsible for the bank’s risk policy.
Efficient risk management as a means to an end The banks risk policy: systematic framework and
and not an end in itself communication instrument
The objective of risk management can be ambitious to varying

A bank’s risk policy sets the conceptual framework for the
degrees. Risk recognition, risk avoidance, risk limitation or even
operational risk management. The risk policy not only defines
the optimization of the risk income profile at the allocation of
the objectives, priorities and principles of the bank’s risk
the risk capital are example of objectives which a bank can
management, but also the instruments, resources and
pursue. Each of these objectives places differing demands on
responsibilities.
concepts, methods, systems and instruments.
Approval of the risk policy is clearly a responsibility of the board

To cite an example: limiting risks by means of risk limits is
of directors. It is also responsible for ascertaining that the desired
more demanding than risk avoidance, the reason being that
risk policy is in fact implemented. To that purpose, a catalogue
limitation requires that the risk can be quantified (measured and
of the measure – describing the change from the current situation
valued). The apparently harmless demand for the effective limitation
to the risk management system envisaged – is therefore an
of the overall risk of the bank through a global limit thus proves
indispensable component of bank’s risk policy.
to be a real challenge because it means, strictly speaking, that
the risks must be quantified in their entirety. Furthermore, all
risks must be quantified in a comparable way so that they can The bank must ensure that the risk policy is implemented at the
be aggregated to give the overall risk of the bank. appropriate levels and is adhered to in day-today operations.
Under no circumstances may the policy deteriorate to an overloaded,
The cost also increases with the increasingly ambitious objectives: abstract document with an alibi function and possibly simply
For example, if the bank not only wishes to limit risks but also disappear into a drawer. The risk policy is both the frame of
wants to optimize the potential for gains, then it will have to reference for the entire risk management and the basis for its
allocate and define the income and expense as well. continuing review and its systematic future development.
In general: the more ambitions the objective, the higher the The contradictory demands on the risk policy for comprehensive
necessary investments for the risk management system of a presentation on the one hand and easy accessibility and adaptability
bank. on the other can be achieved through a process-oriented structure
and through modular build-up. The resulting transparent structure risks. Risk identification is not a one-time exercise. On-going
of the risk policy simplifies not only communicate within the attention must be given to the possibility of new risks arising.
bank but also - reporting to third parties such as to regulatory
bodies, external auditors, owners and other interested parties. Efficient risk management means setting priorities
With our experience in formulating risk policies, we can provide

The process of structuring the risks as part of the risk identification
our customers with effective support. Seminars and workshops
process serves as the basis to set the priorities in risk management.
at attractive conditions assist in structuring the requirements,
Setting priorities means initially: adjust the investment of resources
identifying the core problem and establishing priorities.
in risk management according to the significance of the risks in
relation to the overall risk situation of the bank.
Our methodology for formulating the formulation of the risk policies
assures that a bank’s risk policy is oriented to its specific
Independent of the size of an individual risk, its effective
needs and covers optimally the regulatory requirements. At the
management presupposes that the particular risk can be measured
same time, it guarantees the timely conclusion of the project
and controlled at reasonable cost. It would be ideal if important
with the costs in line with the budget. Finally, we advise our
risks also happened to be risks that were easy to measure and
clients on how their desired risk management visions and goals.
to control. This is unfortunate rarely the case in practice.
Risk Identification
The extent of the human resources, the tools used and the
technical resources must be appropriate to the importance of
Risk identification means first of all that the bank systematically the individual risks. This principle applies not only to the risks
recognizes its risks, classifies them and assigns them to areas involved with the bank’s compliance with the regulatory requirements
of responsibility or to products/markets. This also includes the established for the protection of the creditors and the banking
operational definition of the risks. To this extent, risk identification system. In particular, where core areas concerned, risk
means sorting the risks, according to a certain structure. management’s purpose is not only to avoid acute danger: optimal
risk management also provides decisive assistance for strategic
The following factors have shown to be decisive in determining orientation. For this reason, smaller banks too may not dispense
the quality of risk identification : with the investments in risk management, which are necessary
to assure their future. Even a small bank has to control its risks
l Knowledge of the products, business areas and markets,
in the core areas effectively in order to survive.
the inherent in these areas and their causes
l A practical, appropriate and consistent order The real challenge the bank faces, however, is to find solutions,
which are geared to its individual requirements, characteristics
l Clear and operational definitions and possibilities. Risk management proves itself once again to
be a non-standardisable product.
If risk identification is incomplete, danger looms that the banks
will not cover unidentified risks risk management. There is the Significant improvements in managing a bank’s risks are often
further danger that the reduction of identified risks is accompanied achieved already by pragmatic measures and instruments. A
by the increase of unidentified risks. Such a shift of the risks bank is well advised to follow the adage: review what we have,
obviously does not reduce the overall risk position of the bank. retain what has proven practicable and close specific gaps.
Risk management systems improved in this pragmatic way usually
A further important point must be considered in identifying the show quick results and justify the effort.
Risk Measurement of the interest rate risk exposure of the bank.
l Senior management must ensure that the structure of the

Risk measurement must provide answers to two basic questions:
bank’s business and the level of interest rate risk it assumes
l How does the target figure (e.g. Profit, cash flow, value of are effectively managed, that appropriate policies and
an asset or the Bank as a whole) change when the risk procedures are established to control and limit these risks,
factors (interest prices, creditworthiness of the business and that resources are available for evaluating and controlling
partners etc.) change? interest rate risk.
l What changes in the risk factors must be reckoned with in l Bank should have a risk management function with clearly
the future? defined duties that reports risk exposures directly to senior
management and the board of directors and are sufficiently
In the recent years and decades, research and practice have independent from the business line of the bank. Larger
made great strides in both these areas. complex banks should have units responsible for the design
and administration of the bank’s interest rate risk
As to the valuation methods, the problem in practice is how the management system.
newly developed theoretical methodologies can be so simplified
that an adequate of accuracy can be achieved at a reasonable
cost. The sensitivity measures used in practice, such as the Policies and procedures
duration are a result of such efforts at simplification. Decisive
for measurement quality is the appropriateness of the measure l It is essential that bank’s interest rate risk policies and
for each single risk position and for the desired degree of accuracy. procedures be clearly defined and consistent with the nature
The evaluation of the most appropriate method of valuation of and complexity of their activities. These policies should
classic banking transactions which contain implicit options. This address the bank’s exposures on a consolidated basis and
applies especially to variable rate mortgages and saving deposits. as appropriate, also at the level of individual affiliates.
In determining the change in the risk factors, two methods in l It is important that the banks identify the risks inherent in
particular have established themselves in practice: probability- new products and activities and ensure these are subject
based methods and scenario-based methods. of adequate procedures and controls before being introduced
or undertaken. Major hedging or risk management initiatives
should be approved in advance by the board or its appropriate
MANAGEMENT OF INTEREST RATE RISK
delegated committee.
Sound risk management practices are essential to the prudent

operation of banks and to promoting stability in the financial Measurement and monitoring system
system as a whole.
l It is essential that the banks have interest rate measurement

The role of the board and senior management system that capture all materials sources of interest rate
risk and that assess the effect of interest rate change in
l In order to carry out its responsibilities, the board of directors ways that are consistent with the scope of their activities.
in a bank should approve interest rate risk management The assumptions underlying the system should be clearly
policies and procedures, and should be informed regularly understood by risk mangers and bank management.
l Bank must establish and enforce operating limits and other and off - balance sheet instruments:
practices that maintain exposures within levels consistent
l Appropriate boards and senior management oversight
with their internal policies.
l Adequate risk management policies and procedures

l Banks should measure their vulnerability to loss under
stressful market conditions – including the breakdown of l Appropriate risk measurement and monitoring systems
key assumptions—and consider those results when
l Comprehensive internal controls and independent external
establishing their policies and limits for interest rate risks.
audits
l Banks must have adequate information systems for

monitoring and reporting interest rate exposures to senior Board of directors and senior management
management and board of directors on a timely basis. oversight of interest rate risk
Independent controls Effective oversight by a bank’s board of directors and senior

management is critical to a sound interest rate risk, management
process. It is essential that these individuals are aware of their
l Banks must have adequate internal controls for their interest
responsibilities with regard to interest rate risk management and
rate risk management process and should evaluate the
that they adequate perform their roles on overseeing and managing
adequacy and integrity of those controls periodically,
interest rate risk.
Individuals responsible for evaluating control procedures
must be independent of the function that are assigned to
review. l Board of directors
l Banks should periodically conduct an independent review The board of directors has the ultimate responsibility for
of the adequacy and integrity of their risk management understanding the nature and the level of interest rate taken
processes. Such review should be available to relevant by the bank. The board should approve board business
supervisory authorities. strategies and significant policies that govern or influence
the interest rate risk of the bank. It should review the
overall objectives of the bank with regard to interest rate
Information for supervisory authorities
risk and should ensure the provision of clear guidance
regarding the level of interest rate risk acceptable to the
The banks need to furnish sufficient and timely information with
bank. The board should also approve policies and procedures
which to evaluate their level of interest rate risk. This information
that identify lines of authority and responsibility for managing
should take appropriate account of the range of maturities and
interest rate risk exposures.
currencies in each bank’s portfolio, as well as other relevant
factors, such as the distinction between trading and non-trading
Accordingly the board of directors is responsible for approving
activities.
the overall policies of the bank with respect to interest rate
risk and for ensuring that management takes the steps
Sound interest rate risk management practices necessary to identify, measure, monitor and control these
risks. The board or a specific committee of the timeliness
Sound interest rate risk management practices the application to allow it to understand and assess the performance of
of four basic elements in the management of assets, liabilities management in monitoring and controlling these risks in
compliance with the bank’s board approved policies, Such aggregate information as well as sufficient supporting management
reviews should periodically re-evaluate significant interest to assess the sensitivity of the institution to changes in market
rate risk policies and procedures as well as overall business conditions and other important risk factors.
strategies that affect the interest rate risk exposure of the
bank. Senior management should also review periodically the
organization’s interest rate risk management policies and
The board of directors should encourage discussions between procedures to ensure that they remain appropriate and sound.
its members and senior management—as well as between Senior management should also encourage and participate in
senior management and others in the bank—regarding the discussions with the members of the board and where appropriate
bank’s rate risk exposures and management process. Board risk measurement, reporting and management procedures.
member need nor have detailed technical knowledge of
complex financial instruments, legal issues, or of sophisticated Management should ensure that analysis and risk management
risk management techniques. They have the responsibility; activities related to interest rate risk are conducted by competent
however, to have risks incurred by the bank and that the staff with technical knowledge and experience consistent with
bank has personnel available who have the necessary the nature and scope of the bank’s activities and to accommodate
technical skills to control these risks. the temporary absence key personnel.
In order to carry out its responsibilities, the board of directors Senior management must ensure that the structure of the bank’s
in a bank should approve interest rate risk management business and the level of interest rate it assumes are effectively
policies and procedures, and should be informed regularly managed, that appropriate policies and available for evaluating
of the interest rate risk exposures of the bank. and controlling interest rate risk.
l Senior management Banks should establish a risk management function for monitoring
their interest rate risk. This function should provide reasonable
assurance that all activities and all aspects of interest rate risk
Senior management is responsible for ensuring that the
are covered by a bank’s risk management system. It should be
bank has adequate policies and procedures for managing
separated from and sufficiently independent of the business
interest rate risk on both a long-term and day-to–day basis
lines to avoid conflicts of interest and ensure adequate separation
and that maintains clear lines of authority and responsibility
of duties. The risk management function may be part of a more
for managing and controlling this risk.
general operation, audit, compliance, risk management or treasury
unit. Moreover, it should report risk exposures directly to both
Management is also responsible for maintaining:
senior level management and the board of directors. The personnel
charged with measuring and monitoring interest rate risk faced
l
l Appropriate limits on risks taking
throughout the bank. Compensation policies for these individuals
l
l Adequate systems and standards for measuring risks should be adequate to attract and retain personnel qualified to
assess the risk.
l
l A comprehensive interest rate risk reporting and interest
risk management review process Larger or more complex banks should have a unit for designing
and administering a bank’s interest rate risk management system.
l
l Effective internal controls The size and scope of such a unit should be in accordance with
the size and the structure of the bank and the complexity of its
Interest rate risk reports to senior management should provide transactions and commitments
Banks should have a risk management function with clearly Interest rate risk monitoring and reporting :
defined duties that reports risk exposures directly to senior
management and the board of directors and is sufficiently
An accurate, informative and timely management information
independent from the business lines of the bank. Larger or more
system is essential for managing interest rate mix exposure,
complex banks should have units responsible for the design and
both to inform management and to support compliance with
administration of the bank’s interest rate management system.
board policy. Reporting of risk measures should be regular and
should clearly compare current exposures to policy limits. In
Banks should have clearly defined policies and procedures for
addition, past forecasts or risk estimates should compare with
limiting and controlling interest rate risk. These policies should
actual results to identify any modeling shortcomings.
address the bank’s exposures not only on a consolidated basis
but also, appropriate, at specific affiliates or other units of the
The board on regular basis should review reports detailing the
bank.
interest rate risk exposure of the bank. While the types off
reports prepared for the board and for various levels of management
Such policies and procedures should delineate lines of responsibility
will vary based on the interest rate risk profile, they should at
and accountability over interest rate risk management decisions
a minimum include the following :
and should clearly define authorized instruments, hedging strategies
and position- taking opportunities. Interest rate risk policies should l
l Summaries of the bank’s aggregate exposure.
also identify quantitative parameters that define that level of
interest rate risk policies should also identify quantitative l
l Reports demonstrating the bank’s compliance with policies
parameters that define the level of interest rate risk exposure. and limits.
Individual and / or committees responsible for interest rate risk
l
l Summaries of the findings of review of interest rate risk
management decisions should be clearly identified. In addition,
policies, procedures and the adequacy of the interest rate
management should define the specific procedures and approvals
risk- measurement system, including any findings of internal
necessary for exceptions to policies, limits and authorizations.
and external auditors and retained consultants.
A policy statement identifying the types of instruments and

activities that the bank may employ or conduct is one means Risk limitation requires definition of the bank’s
whereby management can clearly identify permissible instruments, risk capacity appetite
either specifically or their characteristics and should also describe
the purposes or objectives for which they may bused. The The limitation of risk cannot take place in a vacuum. It must be
statement should also delineate a clear set of institutional related to the bank’s risk capacity.
procedures for acquiring specific instruments, managing portfolios,
and controlling the bank’s aggregate interest rate risk. The capacity to bear risk is an expression of the maximum
unexpected loss the bank could suffer without endangering its
Interest rate risk measurement systems should: existence. This definition rests on the assumption that appropriate
valuation provisions or reserves have already been built to cover
l
l Assess all material interest rate risk associated with a the expected losses. In practice, the limit of the risk capacity
bank’s assets, liabilities and OBS position. will probably be reached when the bank no longer meets the
regulatory minimum equity requirements.
l
l Utilize generally accepted financial concepts and risk
measurement techniques.
The definition of the risk appetite, the willingness to bear risk
l
l Have well documented assumptions and parameters. – within the bank’s capacity to bear risk – is the responsibility
of the bank’s board or top management. Under the going concern remains a significant disadvantage: volume limits cannot be
premise, this may under no circumstances exceed the bank’s aggregated to a risk limit for the entire bank.
risk capacity.
Where the link between the bank’s capacity to bear risk and the
The definition of risk appetite will only to a limited extent be limit system is not complete, the systems of limits can only
based on objective criteria. partially fulfill its objective. The aim must therefore be to make
possible the transition from volume to risk limits. This represents
a decisive step towards improving the limitation of risks.
Limit system should be critically examined as to
completeness and consistency
Effective risk monitoring starts with reporting and leads to measures
Once the bank has determined how much total risk it can bear,
Monitoring determines to what extent risk management goals
it faces the job of allocating this total to the individual risks,
have been attained and initiates necessary actions.
business areas and customers. The result is a limit system. Its
purpose is to assure that risk the bank engages in do not at nay
point in time exceed the bank’s defined risk appetite. Such As with every other kind of management reporting, reporting on
allocation requires that all risks are quantified appropriately and the risk situation will be appropriately tailored to the management
can be limited to set levels. level addressed. Only in this way can the bank make sure that
the information is, firstly, relevant for the proposed action, and
However, in practice not all risks can be quantified, or the secondly, that the information in fact reaches the persons
expense of quantifying them cannot be justified. Take the operating concerned.
risks, for example; they can be very significant in extent, but
can hardly be quantified. Therefore, non-quantifiable risks cannot Indispensable elements of risk, reporting are summarized data
be limited in amount and cannot be built directly into the limit comparing actual and plan, a brief analysis of the reasons for
system. The limitation of risk achieved with the risk limit system the variance and a list of problems. Optimal reporting requires
is therefore incomplete. that the reporting objectives be defined in advance as requirements.
One must define who must know what and when and who must
As a consequence, the limit for the bank as a whole must be deliver this information.One often observes in practice that the
set at an appropriate lower level. Otherwise, there is a danger senior supervisory body is burdened with information related to
that the risk appetite will be exceeded because of the non- daily business and is thereby induced to intervene directly. Direct
quantifiable risks. intervention by the bank’s top body should, however, be limited
to exceptional cases. Its primary concern should lie elsewhere,
The bank should encourage increased awareness of the assumption namely to review and ensure the correct functioning of the risk
of these risks among its employees. A clear segregation of management system.
responsibilities and duties is called for.
A further difficulty lies in the fact that problem are detected but
Limitation by means of a risk total for the bank a whole further do not induce the necessary reactions. The reason for this often
requires that the various risks be uniformly measured and limited. lies in that - the decision-makers underestimate the possible
Most limits systems are inconsistent in themselves. They often measures available to them. For example, the view is widespread
represent a combination of volume and risk limits. Even where that one can hardly do anything to remedy an unsatisfactorily
the volume limits are closely related to the inherent risk, there credit portfolio.
164 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Settlement Risk and Continued Linked Settlement (CLS) 165
Where the recognition of problems does not lead to decisive

corrective measures, this is often due to unsatisfactory segregation Chapter
between risk taking, risk control and risk monitoring. A clear
segregation between these functions in particular is of key
11
importance. The fact that such segregation is not always easy
for smaller institutions does not change the basic objections to
an accumulation of functions.
Settlement Risk
Conclusion and Continued Linked
A clear distinction should be made between risk management
Settlement (CLS)
and risk taking. Risk management oversees and ensures the
integrity of the process with which risks are taken. To maintain
Settlement Risk :
objectivity, risk management cannot be a part of the risk taking
process. Individuals who manage risk need to be completely
independent from individuals who are responsible for taking risk. Settlement risk is the risk that a settlement in a transfer system
does not take place as expected. Generally, this happens because
one party defaults on its clearing obligations to one or more
Enterprise risk management is a complex and multifaceted process
counterparties. As such, settlement risk comprises both credit
which from one organization to the next. It should be viewed as
and liquidity risks. The former arises when a counterparty cannot
an ongoing process, which needs continual oversight; planning
meet an obligation for full value on due date and thereafter
and modification as needs evolve.
because it is insolvent. Liquidity risk refers to the risk that a
counterparty will not settle for full value at due date but could
do so at some unspecified time thereafter; causing the party
which did not receive its expected payment to finance the
shortfall at short notice. Sometimes a counterparty may withhold
payment even if it is not insolvent (causing the original party to
scramble around for funds), so liquidity risk can be present
without being accompanied by credit risk.
Committee on Payments and settlement Systems

(CPSS) :
The risk that transactions cannot be settled affects every type

of asset and instrument which requires a transfer system to
pass from one party to another. But as a risk it figures most
prominently in currency trading because the daily settlement
flows in foreign exchange clearing dwarf everything else. Historically
also, the biggest problems in settlements have occurred in currency
trading. The Bank for International Settlements estimates that
the average daily turnover of global currencies in spot, outright
forward and foreign exchange swap contracts is US$1,230 billion. (irrevocable and unconditional). In the given background and
Since each trade could involve two or more payments, daily developments thereafter do we find a sense behind the Continued
settlement flows are likely to amount, in aggregate, to a multiple Linked Service as a pragmatic solution provider and viable to
of this figure especially on standard expiration dates. Even plug gaps in settlement risk.
more frightening, a report prepared by the Committee on Payment
and Settlement Systems (CPSS) of the central banks of the G- Retrospect
10 countries maintains that a bank’s maximum foreign exchange
settlement exposure could equal, or even surpass, the amount
Continuous Linked Settlement (CLS) : The continuos linked
receivable for three days’ worth of trades, so that at any point
settlement (CLS) project was initiated to eliminate foreign exchange
in time, the amount at risk to even a single counterparty could
settlement risk in participating currencies. It will initially focus
exceed a bank’s capital.
on five currencies – US dollar, Euro, Sterling, Swiss franc,
Canadian dollar, to be followed by the Japanese yen and the
Bankhaus Herstatt : - Failure
Australian dollar. The project hopes to pretty much eliminate the
systemic risks posed by forex settlement activities. But perhaps
The most well-known example of settlement risk is the failure
more significantly, CLS also represents a completely new way
of a small German bank, Bankhaus Herstatt in 1974. On 26 t h
of doing business, since its payment-versus-payment mechanism
June 1974, the firm’s banking license was withdrawn, and it was
ensures that payments for each leg of a forex trade settle
ordered into liquidation during the banking day; but after the
simultaneously through a bilateral arrangement between two
close of the German interbank payments system (3:30pm local
settlement members of the service. This replaces existing practice
time). Some of Herstatt Bank’s counterparties had irrevocably
where each leg settles separately, often in different time zones
paid Deutschemarks to the bank during the day but before the
and through multiple correspondent banking relationships.
banking license was withdrawn. They had done so in good faith,
believing they would receive US dollars later in the same day
in New York. But it was only 10:30 am in New York when CLS – Testing
Herstatt’s banking business was terminated. Herstatt’s New York
correspondent bank suspended all outgoing US dollar payments In gestation since the formation of CLS Services (CLSS) in July
from Herstatt’s account, leaving its counterparties fully exposed 1997, CLS Bank is finally approaching crunch time it is currently
to the value of the Deutschemarks they had paid the German undergoing integration testing at our CLSs shareholders level :
bank earlier on in the day. This type of settlement risk, in which Barclays Bank, HSBC, UBS and JP Morgan. Operational trials
one party in a foreign exchange trade pays out the currency it since begun in March 2000 involving 16 shareholders. The system
sold but does not receive the currency it bought, is sometimes is scheduled to finally go live in October 2000. CLSs anticipates
called Herstatt risk. It is however an inappropriate term since it that by the end of 2001, a further 44 or more participants will
has materialised in other cases and under differing circumstances. be ready to go.
The collapse of US investment bank Drexel Burnham Lambert
in 1990, Bank of Credit and Commerce International the following CLS –16 shareholding Banks
year and Barings in 1995 are all excellent case study material
for ‘Herstatt’ risk. The more appropriate name for ‘Herstatt’ risk The 16 shareholding banks aiming to be involved in the system’s
is foreign exchange settlement or cross-currency settlement launch are : ABN Amro Bank, Bank of America, Bank of New
risk. The amount at risk equals the full amount of currency York, Bank of Tokyo – Mitsubishi, Bank One, Barclays Bank,
purchased and lasts from the time that a payment instruction Chase Manhattan Bank, Canadian Imperial Bank of Commerce,
(for the currency sold) can no longer be cancelled unilaterally Citibank, Deutsche Bank, HSBC, Hypovereinsbank, JP Morgan,
until the time the currency purchased is received with finality Morgan Stanley, Paribas and UBS.
Going deep in the mechanism obvious question would be what challenges for financial institutions. The CLS mechanism demands
to achieve in critical mass ? a whole range of new systems and operational changes if
participants are to meet its strict processing requirement s and
CLS’s success or failure will hinge on whether the system attracts tight deadlines. Human resources will also be significantly affected.
a critical mass of forex transactions. Lack of volume led to the
demise of Echo, and earlier industry initiative at reducing settlement CLS promises other benefits aside from the near-elimination of
risk by using multilateral netting techniques. Consequently, CLS settlement risk. According to Bank of New York (BoNY) CLS
has been designed to attract significant proportion of transaction will simplify the liquidity management process associated with
volumes as quickly as possible. If all CLS’s shareholders used forex settlement activities. Their service will also lead to greater
the service to process all their forex trades in participating efficiency in the use of credit limits for forex dealing, since
currencies, more than 30 % of daily global forex volume would settlement members will effectively underwrite transactions
be achieved. processed on behalf of user members or third parties.
Who comprise CLS shareholders ? Net Funding Mechanism
At present, CLS’s shareholders comprise some 63 financial CLS’s net funding mechanism will also reduce the number of
institutions in 14 countries. CLS Bank will have three primary payment risk, enhancing payment efficiency and lowering
classes of participation : settlement members will hold a single transaction processing costs. Monitoring of forex settlement
multi-currency accounts and will be able to provide settlement exposures will also be improved, since the bank will provide a
service to both other classes. Transactions authorised by a single source of near real-time information on such exposures.
settlement members will be treated as that member’s own
obligations to CLS Bank, whether conducted on its own or on
CLS – Timing of fundamental criteria
another’s behalf.
Timing will be a fundamental criterion in determining the success

CLS – Service to whom ? or failure of CLS. The deadline for forex settlement will be
midnight of the day before settlement day, as this is when the
User members will be able to submit transactions for themselves, provisional pay-in schedule is published. Because CLS will allow
their affiliates and for third parties. However, they must settle only one account per settlement, regulated and reconciled by a
these transactions through the agency of a settlement member. nominated control branch, there must be agreements on the
Settlement and user members will both be able to offer CLS timings of pay-ins between all parties concerned to enable the
services to third parties. These third parties will only be able to transfer of funds to nostro accounts in advance of the five-hour
participate in CLS through their agency. Some CLS’s shareholder settlement cycle beginning at 8.00a.m. Central European Time
will also serve as liquidity providers to CLS Bank. (CET).
CLS – Benefits Settlement and User Members
However, everything may not be rosy in CLS garden. Though Settlement and user members may have to extend the working
CLS brings benefits in terms of reducing forex settlement risk, day to support messaging, funding and settlement activities
easing liquidity, management and lowering transaction processing during the early part of the CLS settlement day. “Because the
costs, getting the system up and running involves considerable payment schedule is published at midnight, operational staff
must be present to deal with any discrepancies or problems.” settlement members or user members. Third parties will also
need confirm transactions with their counterparties.
CLS – Operational changes

Monitoring Global Position
Though CLS brings benefits in terms of reducing forex settlement
risk, easing liquidity management and lowering transaction Global position monitoring will also be affected. CLS participants
processing costs, getting the system up and running involves with decentralised forex trading operations will need to provide
considerable challenges for financial institutions. The CLS a centralised mechanism for calculating and monitoring global
mechanism demands a whole range of new systems and operations currency positions. CLS’s impact on liquidity management also
charges if participants are to meet its strict processing involves operational challenges. The BoNY note the need for
requirements and tight deadlines. Human resources will also be access to liquidity through each currency’s RTGS systems.
significantly affected. CLSs shareholders aiming for direct participation in CLS will
need to assess their capacity to provide intraday liquidity in the
relevant currencies. It adds, particularly if they want to provide
CLS – Cultural change
third-party service.
Banks may decide to use same-day trading beginning after

midnight to reduce liquidity demands at the first payment deadline. Liquidity and credit complications
This will lead to a revised payment schedule being published at
6.30 am, revised settlement instructions and consequent human CLS settlement is restricted to spot / forward forex trades, but
resources and systems demands. This is a big cultural change the anticipated currency position of participants may include
for banks and their staff, at least as significant as the introduction settlements from securities same day forex trades, derivatives,
of the Euro. money market instruments and non-CLS currency transactions.
Depending on when these transactions settle, a CLS participant
CLS – Impact on other Activities may or may not be able to include the anticipated receipts in
calculating its daily currency positions. Funding of accounts
may be complicated if multiple operational nostro accounts are
Bankers are also concerned that some banks appear to
used.
underestimate the breadth of CLS’s impact. This goes far beyond
forex trading and settlements, bank TCA looked at CLS and
opined that it would have a significant impact on 14 different CLS – Systems Improvement
areas of the business ranging from IT, financial control, facility
management providers, software suppliers, business continuity Discussion with Italian bankers further revealed that the liquidity
planning through regulatory reporting. management issues raised by CLS create a new set of credit
risk considerations, since all CLS transactions authorised by a
Discussions with CLS – Back office settlement member considered as settlement obligations of that
member.
The BoNY also revealed that operational considerations for back
office workflow, noting that operations systems will need to be A group of bankers from Switzerland anticipate that this will
modified to route CLS messages internally for settlement and result in banks developing more sophisticated systems for
reconciliation purposes. Settlement instructions and confirmation measuring intraday overdraft exposures and associated credit
for CLS trades will need to flow between third parties and CLS risks. The upside of this is that CLS enables more efficient use
172 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Exposure Management 173
of credit limits. Moreover, its payment-versus-payment mechanism

allows for broader trading activities with counterparties. Chapter
12
CLS – Better Customer Service
It is clear that CLS participants will need to address these

challenges in order to experience the benefits that CLS offers. Exposure Management
Practicing bankers in USA stress that this task must not be
underestimated. Aside from reduced risk, CLS presents banks
with an opportunity to provide better levels of customer service
and gain competitive advantage, but this can only be achieved
if the transactions are smooth. CLS has the potential to become
the industry norm for forex settlement. Hopefully those who are
The long term health and survival of a financial service entity
among the first to go live will indeed be setting an industry
is critically dependent on its ability to understand , appreciate,
precedent – and will most definitely be under the spotlight to
quantify and manage the range of risks associated with its line
meet the deadlines during the coming months.
of business. The components of the risk spectrum are growing
in number as the regulators retreat and permit a freer play of
CLS – Proactive Initiative By Banks in India market forces. It is imperative that banks develops risk
management as one of its “Core Competencies” in view of the
As the product is still to be launched and also considering the liberalization and increasing globalization of the Indian economy-
fact that any bank from India is yet to join. Its compatibility or more specifically its financial risk.
otherwise to our systems and ultimately benefit in real terms to
offset/overcome problems of liquidity and cash management on The practice of risk management around the world has already
one hand and simultaneously risk free settlement of forex evolved into a complex domain. It incorporates sophisticated
transactions on the other. May be the time is a great healer. statistical techniques for forecasting, advanced mathematical
Nevertheless proactive effort in this direction will have special applications for managing analysis in a multi-variable context as
charm. w e l l a s c u s t o m m a d e 4th g e n e r a t i o n s o f t w a r e s o l u t i o n s . I t e n a b l e s
on-line decision support to anyone from the enterprise manger
to the front line user. Many a multinational bank has risk
management as its prime core competence.
The categories of risks any bank is exposed to in today’s context

are:
l Credit risk
l Market risk
l Interest rate risk
l Foreign exchange risk

l Liquidity risk l Rating assigned to banks by international rating agencies
l Operating risk l The total capital of the correspondent banks
l Margin or Basis risk l The asset size of the correspondent
l Legal Risk l The market leadership position ( measured in terms of

their ranking in the world as well as in their home currency
Each of the above categories encompasses more than one in terms of their capital )
activity group of a bank. For example credit risk arises from:
l Lending to a customer through bank’s credit function The Economic Region
l Assuming exposure on overseas correspondent banks through

This is the most general parameter of macro nature expected to
the international banking activities.
serve as an early warning indicator. Almost all credit rating
l Investing in a security of an issuer through bank’s treasury agencies as well as reputed international financial magazines
function like “ Institutional Investors”, “The Bankers”, “The Euromoney”

constantly forecast the emerging scenario of each region in
l Striking a forex deal with a counter-party through forex which our correspondent bank is located.
treasury operations
Through this parameter a bank may aim to time the triggering

For the purpose of our study we would focus on exposure on of a review for all the banks in the region in tune with the
overseas correspondent banks. The counter-party risk involved forecast of expected developments.
in forex dealings operations and understanding trade related
transactions necessitates a comprehensive exercise, for
establishing suitable exposure limits in respect of overseas Country Rating
correspondent banks with sub-limits for foreign exchange dealings
and other types of business. In consonance with the Reserve
The rating of the home country of a correspondent bank enable
Bank regarding risk management systems in banks a suitable
to estimate the probability of a delay or default that could occur
frame work has to be evolved to provide an over view of aggregate
due to the macro economic factors of that country. While the
exposure on other banks. Bank – wise exposure limits should
published rating of the rating agencies perform the role of a
be set on the basis of assessment of financial performance,
signpost, an actual assessment of the implications can be culled
operating efficiency, management quality, past experience etc.
out from various sources. These include the constant feedback
of the banks concerned.
from other correspondent banks, personal impressions gathered
as well as customer feedback on the case of securing payments
The Methodology from those territories.
To arrive at the optimum exposure limit ensuring avoidable high

However, for arriving at the exposure limit model suggested
risk the following building blocks have been deployed.
employs the signpost per se i.e., the country rating of the home
l The economic region to which the bank belongs country, as the parameter. For the purpose of this exercise the
country rating assigned by the reputed agency “Thomas Bankwatch”
l The specific country rating of its home currency can also be considered and adopted.
Counter-Party Risk Rating 1. Non-fund based exposure on contingent nature in Trade

finance by way of Letter of credit confirmation, guarantees
International credit rating agencies have evolved individual ratings as well as fund based facilities of all types except foreign
for indicating the risk level associated with various business exchange dealing and foreign exchange derivatives –
aspects of a major bank. Consequently, a plethora of ratings Weight 10%
explaining the risks associated with dealing in the various
2. Foreign Exchange dealing related exposure and exposure
instruments of a bank are available. Our exercise aiming to
on account of derivatives through outright purchase/ sale,
assess the counter-party risk arising out of our exposure through
swaps, options and other derivatives – Weight 10%
foreign exchange dealing, trade finance, guarantees and derivatives
covers short term as well as medium term tenors. Hence, the
counter-party risk rating assigned by Moody’s can be adopted A weight of 10% can be assigned to the exposure arising out
wherever available. In case of banks rated by Standard & Poor of foreign exchange dealing operations as the value at risk on
the financial strength rating can be adopted. a daily settlement basis which can be limited to the maximum
possible fluctuation in the exchange rate. While fluctuation would
normally be within 5% levels on any single day, a weight double
Total Capital
that figure of 5% can be assigned as a matter of abundant
caution. Simultaneously, it would ensure smooth functioning of
Globally banks build the absolute quantum of the correspondent
a bank’s foreign exchange dealing operations as well as its
exposure limits as a weighted fraction of the counter-party’s
expected growth in the year to come.
audited networth as on date. In the exercise we can adopt the
total capital of the correspondent bank which includes the sum
of shareholder’s equity and supplement capital. Supplement capital Taking a hypothetical case for e.g. Barclays bank
includes revaluation reserves, Long-term subordinated debt,
Region - Western Europe
subordinated capital debt ( dated & Perpetual ) and other supplement
capital, such as Capital certificates, participation- certificates Country - U.K.
and limited life preferred stock. The data can be culled out from
the published annual reports/financials. Country rating - AAA
Bank rating Moody’s - AAA

While the absolute quantum of exposure assumable in relation
to the networth of a counter-party banks is indicatively prescribed
Standard & Poor’s - A A
by the central authority of the respective country, it ranges
from 10 to 25% of the networth, when generalized. The period Total capital size - US$ 18,124 million
of exposure on a bank is estimated on the basis of its track
record and the length of the period of its existence. Banks may 15% of the capital - US$ 2719 million
intend to limit the assumption of long-term exposure only to the
Exposure Assumable
top banks in the ‘A’ rated countries.
Trade finance - US$ 1360 million

Coming to the absolute quantum in relation to the total capital,
it is suggested that exposure be limited to 15% of the total Foreign Exchange Dealing - US$ 13,1600
capital as per the practice followed by certain banks globally.
For ensuring the limits are not breached only 90% of the limits
The following weights are deployed to arrive at the consequent should be made available to the operating units. A buffer of 10%
maximum permissible exposure (MPE) on specific business areas. limits will ensure even emergencies or communication delays
178 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Value at Risk 179
which do not cause the breach of the counter-party limit already

approved. Chapter
13
The actual limits set can be altered taking into consideration the
ratings of the banks by applying the following multiplier
Rating multiplier Value at Risk

AAA 1
A A 0.75
A 0.50
BBB 0.25 Genesis
B B 0.15
Every financial corporation who trades in foreign exchange,
securities and derivatives are always exposed to the financial
Thus the exposure shown on above example will transform itself risk of the traded underlying. Financial risk can be defined as
into the following amounts if the bank currently enjoys any of the possible loss due to changes in the market rate of the
the ratings: underlying. Managing of such risks becomes even more important
when trading becomes corporations’ major source of revenue
Limit Rating Applicable Actual MPE MPE earner, if not managed prudently, it can have the potential of
15% of Assumed Multiplier Limit Forex Trade systemic risk which can break down the entire market.
Total Dealing 50% Finance
Capital Of sub-limit Weight
On a Weight 100% Taking it such into consideration, world over regulators have
Of 10% prescribed several tools for managing market rate risks such as
capital adequacy norms for charging margins. The quantifying
2,719 AAA 1 2,719 13,600 1,360 and managing such risks came to be known as “Value at Risk”.
2,719 A A 0.75 2,039 10,200 1,020

Value at Risk
2,719 A 0.50 1,360 6,800 680
2,719 BBB 0.25 680 3,400 340 Value at Risk can be defined as the expected maximum loss or
the worst loss given:
2,719 B B 0.15 408 2,040 204
l Specification of “normal” market conditions

However, the final limit arrived at needs to be toned down to
meet individual bank’s risk taking capacity. Ideally exposure to l Time horizon
even the best banks should be limited to 20%-30% of the bank’s
networth. Such exercises can be reviewed and recast with the l Probability level
change in scenario in the name of good practice for effective
exposure management l Measurement unit
VaR’s popularly aggregates several components of market risk credit risk and operational risks. Some even suppose that all
into a single number. the risks of an organization should be summarized with a single
risk measure.
Value at risk (VaR.) is a statistical measure which is used
extensively for measuring the market risk of portfolios of assets
Limitations
or liabilities. Value at risk in numerical terms can be defined as
follows:
It is, however, only a tool. Like all tools, it has limitations—
limitations that must be fully understood by any organization
The amount of money such that a portfolio is expected to lose
that might use VaR, actually estimating correct Value at Risk
less than that amount of money 99 days out of 100.
can be a challenge, but with the advent of Information Technology
such challenges have been greatly reduced.
The above definition is for 1-day value at risk measured at the
99% confidence level. Other horizons or confidence levels may
be used in practice. For example, if a portfolio’s 1-week, 95% Critics suggest that VaR may be ineffective for assessing risks
value at risk is $2MM, then the portfolio would be expected to other than market risk or that it fails even with market risk.
lose less than $2MM over 95 weeks out of 100. Such an estimate Others have noted disturbing inconsistencies between risk estimates
would be based upon the portfolio’s current composition and produced by different implementations of VaR.
recent market conditions.

To understand the limits of VaR, we need to explore what it
Methodology means to “quantify” risk. Let’s start by defining risk:
Various methods are used, to calculate VaR including: Risk is exposure to uncertainty.
l Closed form value at risk

Accordingly, risk has two components:
l Monte Carlo value at risk
l
l Uncertainty
l Historical value at risk
l
l Exposure to the uncertainty
l Delta-gamma value at risk
A synonym for uncertainty is ignorance. We face risk because
Each methodology has its own strengths and weaknesses. While we are ignorant about the future—after all, if we were omniscient,
the definition of value at risk is broad and encompasses—in there would be no risk. Because ignorance is a personal experience,
theory—all sources of market risk for a portfolio, Value at Risk risk is necessarily subjective. When we put a number on risk,
(VaR) offers tremendous opportunity for organizations that need that number says as much about us—how little we know—as it
to manage market related risk says about the world around us.
VaR : A Global Acceptance Let’s try to quantify our risk in this example. To characterize the
risk, we need to describe the uncertainty as well as our exposure
Value-at-Risk (VaR) is becoming somewhat of a revolution. Around to that uncertainty. Obviously, our exposure is $100. That is the
the globe, organizations are racing to implement the new amount we stand to lose. But what is our uncertainty—what is
technology. Experts propose extending VaR to other risks, including the probability that we will lose $100?
If we say it is one chance in six, I am sorry. We are wrong. day a trader takes on a sizable long position in the Japanese
Whenever we try to quantify risk, we are describing our own yen—exceeding his/her risk limit. He knows the markets and
understanding of a situation. Often, there will be aspects of a is aware of a combination of market factors—perhaps central
situation that we are simply unaware of. It is one thing to not banks are intervening in the markets—that are going to drive
know the answer to a question. It is another matter to not even the yen up in the short-term. He considers the position appropriate.
know the question exists. His risk manager disagrees. He doesn’t know about central
bank intervention—and he calls him on it.
Returning to our example, we still don’t know our probability of
losing $100. It is not one in ten. We are aware of the possibility, Reviewing the VaR number that indicates his limit violation, the
but it is difficult to place a number on that risk. Risk is subjective. trader retorts:
So what does this mean if we want to measure the financial “The model is wrong. I know the markets. I know what the
risks of an organization? To find out, let’s look at how risks are central banks are doing. I’m on the phone with FX professionals
quantified. It is a four step process: all day long. This VaR model is just a bunch of formulas. It
doesn’t know the yen is going up, but I do. There is zero risk
l
l Define the risk to be measured in my long position because any other market position, under
these circumstances, would be ridiculous.”
l
l Agree on a model for that risk
l
l Specify a risk measure that is compatible with that model Who is right, and who is wrong? The trader knows the markets.
It’s his job. By the same token, what is the point in having a
l
l Estimate the value of that measure implied by the model
risk manager who is going to be overruled by every trader with
a market view?
For example, the process might be as follows:
1) Risk: market risk of a specified portfolio Some might perceive that the answer is to build a better VaR
model—one that somehow captures the trader’s intuitive
2) Risk model: market variables are assumed to be jointly understanding of central bank intervention. Others may cling to
normally distributed with specified volatilities and correlations the existing VaR model, claiming that efficient markets and no
arbitrage conditions ensure its ultimate validity.
3) Risk measure: one-day 90% VaR
In fact, neither approach can possibly work. They both make a

It is the second step of the process that is pivotal. It is at this supposition that there is a “right” model—if only we can identify
point that we take the subjective notion risk and describe it in it. Markets, however, are too complex and ever changing for any
an objective manner. However, a group of individuals may agree model to fully describe. Selecting a model is a subjective process.
on a model, but retain their own subjective opinions about the
risk. In this sense, the model does not make risk an objective
Our FX trader and risk manager have a legitimate difference of
notion, it merely makes the measure of risk an objective notion.
opinion. To resolve such a situation, we have to get beyond the
simplistic notion that one is right and the other is wrong. In so
VaR - Risk Manager’s View : doing, we must challenge - the idea that every risk has a number—
that there is a “right” model that will find that number, and other
Let’s continue with the example of market risk. Suppose a models are “wrong.” We must embrace the notion that risk is
trading operation has implemented the above VaR system. One subjective.
We cannot manage market risk by having a risk manager forming— VaR - Check and Balances
and then enforcing—his own subjective opinions about the risking
of a trader’s position. This would be unfair to the trader, and it
Finally, VaR should be viewed as a necessary but not sufficient
would reduce the risk manager to being, in effect, just another
procedure for controlling risk. It must be supported by limits and
trader.
controls, by an independent risk management functions.
Instead, we implement an objective benchmark for risk in the

form of a VaR model. It may assume that market variables are
normally distributed despite some observers preferring the
lognormal assumption. It may not capture market leptokurtosis.
It probably won’t understand “sticky” volatilities. This is not
important.
If we had a perfect model, it would know everything there was

to know about the markets. It would eliminate the need for
traders. We could trade the portfolio based upon the model.
A VAR model, however, is limited because it is objective whereas

risk taking is subjective. If we deny that subjectivity, we deny
a role for human judgment. Rather than trade portfolios based
upon a model, we rely upon traders because we believe they
understand things the model cannot.
This leaves us with two—potentially inconsistent—market views:
l
l That of the model
l
l That of the traders
The question is: How can we use the objective VaR model to
manage the risk taking process, but not place arbitrary—or even
dangerous—restrictions upon the activities of traders? The answer
is risk limits. These represent explicit authority for traders to
take positions that differ from the model’s perception of the
markets. Risk limits enable an organization to manage risk
by limiting traders to taking positions within a specified range.
The role of the VaR model is to objectively define what that
range is. The trader’s role is to select the optimal position within
the range. In this context, VaR is just a tool for delimiting a set
of acceptable portfolios. We can call it a “risk measure” if we
like, but we don’t have to.
186 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Role of Audit in Forex Operation 187
Chapter
14
Role of Audit
in
Forex Operation
Internal audit :
Considering the complexities, volume and value of forex business

the nature and scope of audit has been widely accepted as a
check point. It has been designed to ensure that established
procedures/provisions are adhered to and are operating effectively.
Broadly audit and particularly internal audit is to review the
adequacy and timeliness of key management information reports,
such as those relating to limit exceeding, maturity periods, and
to ensure that appropriate action is initiated in response to this
information. In addition to it the tasks of the internal audit department
will include statutory and regulatory compliance reviews, data
processing, control reviews, and back– office efficiency reviews.
To attain benefit of internal audit it is essentials that necessary
MIS reports are submitted promptly to top management of the
bank.
The officers drafted for internal audit are expected to have the
requisite level of understanding of the subject, expertise, knowledge
and experience before taking up audit function.
Concurrent audit :
In addition to regular audit it is essential that the concurrent

audit is in place to curb scope for irregularities on day to day
basis and to initiate corrective/ remedial steps. Management
has to be ensured that internal/ concurrent auditor’s observations
are given due weightage.
188 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Technical Analysis - A Tool to Forecasting 189
System audit :
Chapter
Special audit of the Treasury and the systems in operation 15
has to be conducted at periodic intervals by an officer well
experienced and with requisite level of expertise in the subject.
The areas tested during this audit should include:
Technical Analysis
In Dealing room procedures to ensure that all deals executed
are promptly captured by the accounting system.
- A Tool to Forecasting
I. Reconciliation of foreign exchange positions between the
dealers’ records and the accounting system.
II. Review of incoming deal confirmations Market movement result from a complex web of fact, emotion
and money. Fact speaks. Emotion speak money speaks. The
III. Full scrutiny of sample deals . key is to determine how to get one’s arms around all these
factors, which are no longer of a local, but a global in nature.
Compliance with the requisite requirements is to be checked An effort is made in this chapter to study the technical analysis
at irregular, appropriate intervals by the system auditors. The of currencies, its impact and different methods.
main audit areas listed below should be subjected to a risk-
oriented audit at least once a year.
Introduction
l Exposure limit system
Technical analysis is the study of historical patterns of price
l Determination and reconciliation of position and results. behaviour and volume of trading that takes place on the forex
market. The input to the technical analysis is the sum of total
l Change in the EDP systems, if any.
of statistical information produced by the market, most of which
l Completeness, correctness and timeliness of the internal is in terms of volume of forex market transaction and level of
reporting system. quotes over a historical period.
l Functional separation
Technical analysis has to branches ; charting and trend analysis
the first, charting involves examining the history of price and
l Degree to which transactions are in line with market conditions.
volume movement in an attempt to discover pattern of movement
l Confirmations and counter confirmations. that will be repated in the future. Trend analysis is the mathematical
analysis of the historical price and volume data, in an attempt
l Stop loss triggered. to determine the under lying trends, which may be hidden by
more superficial price volatility.
l Skill of dealers to operate in a highly volatile market and
or managing intervention process by the Central bank.
Technical analysis is based on three fundamental premises;-
l Disaster management and contingency plan.

l All relevent factors are reflected in one number, the price.
l Concerns of supervisors/Top manager No one can know all things affecting a market at a given
time. The collective impact of all factors is known, however, forward market through the currency trading department of major
via the price mechanism. international banks.
l Prices move in one of three trends, upward, downward or Technical analysis is done from four point of view:-
sideways. Technical analysis tries to trend, so that one
can join the trend and profit from it.
1. Exchange Rate — c h a n g e i n e x c h a n g e r a t e reflect changes
in dealers attitude and demand for and supply of securities.
l History repeats itsself time and time again. Efficient markets
and random- walk theory suggest that there is no correlation 2. Time — the degree of movement in exchange rate is a
between the past and present. Beliver in technical analysis function of time. The longer it takes for a revesal in trend,
think otherwise. the greater the changes in exchange rate would follow.
3. Volume — the intensity of changes in exchange rate

Objectives of technical analysis
is reflected in the volume of transactions that accompany
the change.
The objectives that underlie analysis from a technical aspect
are basically the same as those used in any other financial 4. Breadth — the quality of changes inexchange rate is
market or for individual stocks. The major difference is that the measured by studing weather achange in trend spreads
price of a currency is always relative to the price of all other across currencies and countries or is concentrated in few.
currencies. Hence a rising trend in u.s. dollar –adjusted swiss
francs will be bullish for american and british for the swiss, but
when gold or equities are declining sharply, they are bearsh for
Checklist of factors
every one.
The time frames chosen determines which factors are more
There are two questions, which must be asked by any one who relevant. a spot trader is not worried about the factors affecting
invests or speculates in currencies. First, which currency should the currency over the next six months.He or she worried about
be bought for {sold}? In other words the first step is to establish the next few minutes or hours.the interbank spot trader has an
wheather a currency is generally strong against most other extremely short-time frame. keeping abreast of trading flows is
currencies, and then to try to identfy which cross rates or probably the most critical aspect, and traders work hard to
relation ship it will be strongest against. Investor with a longer determine what business is actually happening in the market.access
time horizon also need to take interest rate differentials with to information flows is critical to trading the spot market, and
consideration. This factor is discussed later. represent one reason why major banks and investment dealers
have a competitive advantage in spot and forward dealing
From a speculative point of view, there are only six currencies compareed with corporate and government entities.
that are actively traded out side the bank market; Canadian and
Australian dollars, British pounds, Swiss franc, German mark Forecasting is not a science.It is an art. A short list of popular
and Japanese yen all six are listed on the International Monetary inputs to the process follows:-
Market (IMM) in chicago and the last four also listed on the
l observed support and resistance levels
London International Financial Futures Exchange (LIFFE) in the
United Kingdom.
l relevant economic releases
These and other currencies can also be bought or sole in the l interest rates and forecast of future interest rates.
l pending deals hand, since relatively little trade is transacted between the united
states & switzerland, the changes in the swiss franc would have
l political events, politics and statements only a marginal effect on a TW index. TW indexes are constructed
by several institutions, including Morgan guarantee bank, bank
Market sentiments of england, and the ferderal reserve.
l elections, budgets,statements
Another technique which has proved useful in analysing the
l taxation overall technical structure of a currency is to compare its TW
index with an advance decline (AD) line. the comparison between
l fiscal policy AD line and TW index is useful because the two series do not
always move togather. when they are moving in concert the
Economic fundamentals prevailing trend is reaffirmed, but when they move in opposite
direction or one does’nt confirms the other, a warning of a
l economic activity probable reversal in trend is given.
l balance of payments
The discussion has so far be limited to U.S. dollar, but there is
l inflation nothing to preclude the construction of similar indicators for the
other currencies. indeed, it is useful to chart the TW indexes of
Others the major currencies as an important starting point for their
analysis.
l development in other market such as bond
l commodity, and equity markets Technical Analysisof Interest Adjusted Currencies
l developments elsewhere in the world

The level of short-term interest rates changes from country to
l central bank interventions country because of the differing monetary policies pursued by
the central banks of the different countries.
l gutt feeling
Cross currency rate for future delivery takes these interest-rate

Isolating a Strong or Week Currency differentials into considerations and are priced accordingly. For
instance U. K. short term money market instruments were yielding
The starting point involves the technical appraisal of analysis 15% in the early part of the 1990s, but U.S. rates started the
overall measure which acts as a proxy for general fortunes of decade at 8.5%. this meant that investor who bought pounds
a specific currency in a similiar way that a stock market average, and held them for 12 months would be ahead by 6.5% in
such as as the standard & poor’s ( s&p) is used as a proxy comparison to what they would have had if they held U.S.
measure for the market as a whole. the most convenient form dollars (i.e., they would have been ahead by the difference
is atrade weight (TW) index. TW indexes are constructed from between 15% & 8.5%) If you believed that there was not going
a basket of cross currency relationships, weighted according to to be any change in the value of the dollar/pound relationship
the volume of trade transaction with the country issuing the over the coming 12 months, it would make sense to convert
base currency. for example, Canada is the largest trading partner your US. cash to pounds, invest the money and sell the pound
of the united states; the TW (U.S. Dollar) index is therefore for future delivery. in this way you would obtain the interest
heavily weighted in favour of the Canadian dollar. On other differential without the currency risk by buying long pounds in
the cash market and short in the futures ( i.e., you would have any calculations. Each candlestick represents one period (e.g.,
a hedge ). however, because the sterling money market instrument day) of data. The Figure displays the elements of a candle.
would be paying 15%, you would earn additional 6.5% om your
money. there is a catch, however: other people have thought of Candlestick charts dramatically illustrate changes in the underlying
the same idea and the sterling you sell for 1 year future delivery supply/demand lines,because candlesticks display the relationship
is priced 6.5% below sterling for spot or cash delivery. In other between the open, high, low, and closing prices, they cannot be
words, a discount is built into the price of the currency to displayed on underlying that only have closing prices, nor were
compensate for the interest rate differential. they intended to be displayed on underlying that lack opening
prices. If you want to display a candlestick chart on a security
This market pricing mechanism can be turned to the advantage that does not have opening prices, We suggest that you use the
of the technician, for it a normal spot cross crrency relationship previous day’s closing prices in place of opening prices. This
is look ing strong technically and the interest - rate differential technique can create candlestick lines and patterns .
is also positive, the possibilities of a profitable trade or investment
are substantially increased. Highest price (upper shadow)
The importance of this market pricing mechanisim from a Opening or closing price which ever is
technical aspects is that if you can isolate a trend reversal is higher
unadjusted cross crrency rate and there is a significsnt interest
rate differential, you can achieve a form of build in insurance “real body” filled – in if the close is lower
against whipsaws. & vice- versa
The major problems occurs when if you are leveraged and the Opening or closing price which ever is
interest rate differntial gets substantially wider as the positions lower
goes against you in that situation the currency itself declines,
and because the differential widens, the discount for delivery
Lowest price (lower shadow)
also widens.
Now, let us study some of the selective technical analysis tools The interpretation of candlestick charts is based primarily on
and Indicators. patterns. The most popular patterns are explained below.
Japanese Candlestick
Bullish Patterns
Overview
A couple of centuries back, the Japanese developed a method Long white (empty) line . This is a
of technical analysis to analyze the price of agriculture contracts. bullish line. It occurs when prices open
This technique is called candlestick charting. near the low and close significantly
higher near the period’s high.
Candlestick charts display the open, high, low, and closing prices
in a format similar to a modern-day bar-chart. Candlestick charts
are simply a new way of looking at prices, they don’t involve
Hammer ( Takuri ). This is a bullish Bullish doji star . A “star” indicates a

line if it occurs after a significant reversal and a doji indicates indecision.
downtrend. If the line occurs after a Thus, this pattern usually indicates a
significant up-trend, it is called a Hanging reversal following an indecisive period.
Man. A Hammer is identified by a small You should wait for a confirmation (e.g.,
real body (i.e., a small range between as in the morning star, above) before
the open and closing prices) and a long trading adoji star. The first line can be
lower shadow (i.e.,the low is significantly empty or filled in.
lower than the open, high, and close).
The body can be empty or filled-in.
Bearish Patterns
Long black (filled-in) line . This is a

Piercing line ( kirikomi ). This is a bearish line. It occurs when prices open
bullish pattern and the opposite of a near the high and close significantly
dark cloud cover. The first line is a lower near the period’s low.
long black line and the second line is
a long white line. The second line opens
lower than the first line’s low, but it
closes more than halfway above the
first line’s real body. Hanging Man (Kubitsuri). These lines
are bearish if they occur after a
significant uptrend. If thispattern occurs
after a significant downtrend, it is called
a Hammer. They are identified by small
Bullish engulfing lines . This pattern real bodies (i.e., a small range between
is strongly bullish if it occurs after a the open and closing prices) and a long
significant downtrend (i.e., it acts as a lower shadow (i.e., the low was
reversal pattern). It occurs when a small significantly lower than the open, high,
bearish (filled-in) line is engulfed by a and close). The bodies can be empty
large bullish (empty) line. or filled-in.
Morning star. T h i s i s a b u l l i s h p a t t e r n Dark cloud cover (Kabuse). This is a

signifying a potential bottom. The “star” bearish pattern. The pattern is more
indicates a possible reversal and the significant if thesecond line’s body is
bullish (empty) line confirms this. The below the center of the previous line’s
star can be empty or filled-in. body.
Reversal Patterns
Bearish engulfing lines (tsutsuni). T h i s
pattern is strongly bearish if it occurs
after asignificant up-trend (i.e., it acts
as a reversal pattern). It occurs when Long-legged doji. This line often
a small bullish (empty) line is engulfed signifies a turning point. It occurs when
by a large bearish (filled-in) line. the open and close are the same, and
the range between the high and low is
relatively large.
Evening star. This is a bearish pattern

signifying a potential top. The “star”
indicates a possible reversal and the Dragon-fly doji. T h i s l i n e a l s o s i g n i f i e s
bearish (filled-in) line confirms this. The a turning point. It occurs when the open
star can be empty or filled-in. and close are the same, and the low is
significantly lower than the open, high,
and closing prices.
Doji star . A star indicates a reversal

and a doji indicates indecision. Thus,
this pattern usually indicates a reversa Gravestone doji. This line also signifies
l following an indecisive period. You a turning point. It occurs when the open,
should wait for a confirmation (e.g., as close, and low are the same, and the
in the evening star illustration) before high is significantly higher than the open,
trading a doji star. low, and closing prices.
Shooting star. This pattern suggests Star. Stars indicate reversals. A star
a minor reversal when it appears after is a line with a small real body that
a rally. The star’s body must appear occurs after a line with a much larger
near the low price and the line should real body, where the real bodies do not
have a long upper shadow. overlap. The shadows may overlap.
Doji star . A star indicates a reversal

and a doji indicates indecision. Thus,
Harami cross . This pattern also ndicates
thispattern usually indicates a reversal
a decrease in momentum. The pattern
following an indecisive period. You
is similar to a harami, except the second
should wait for a confirmation (e.g., as
line is a doji (signifying indecision).
in the evening star illustration) before
trading a doji star.
Candlesticks are highly useful in forecasting , it should be viewed

as a necessary tool, but their value can be further improved if
Neutral Patterns
used in conjunction to other technical indicatores such as explained
below;
Spinning tops . T h e s e a r e n e u t r a l l i n e s .
They occur when the distance between Indicators
the high and low, and the distance
between the open and close, are Relative Strength Index (RSI)
relatively small.
Definition :
Relative Strength Index (RSI), an oscillator introduced by J.

Welles Wilder, Jr., could be more appropriately called the internal
D o j i. T h i s l i n e i m p l i e s i n d e c i s i o n . T h e
strength index, for it compares the price of a security relative
security opened and closed at the same
to itself. The RSI is based upon the difference between the
price. These lines can appear in several
average of the closing price on up days and the average closing
different patterns. Double doji lines
price on down days over a given period, and is plotted on a
imply that a forceful move will follow
vertical scale of 0 to 100. An oscillator refers to a momentum
a breakout from the current indecision.
or rate-of-change indicator that is usually valued from 2 to +1
or 0 percent to 100 percent.
Wilder advocated a 14-day RSI, although shorter and longer

Harami (“pregnant” in English). This periods have gained popularity when the market exhibits certain
pattern indicates a decrease in characteristics. Generally, RSI is measured in a period between
momentum. It occurs whena line with 5 and 25 days.
a small body falls within the area of a
larger body. In this example, a bullish
(empty) line with a long body is followed Interpretation :
by a weak bearish (filled-in) line. This
implies a decrease in the bullish There are several possible interpretations for the Relative Strength
momentum. Index, any of which can be very powerful depending on the
market - conditions and trading/investment approach:
One interpretation is that buy signals are triggered when RSI is stochastics. When calculating fast stochastics, the raw value of
in an oversold (20-30) area, potentially meaning that the stock %K is the point at which the current price lies within the historical
is about to reach its low for this trend, and sell signals are price range of its given period, and the value of %D is the
triggered when RSI is in an overbought (70-80) area, potentially moving average of %K over a given number of periods.
signaling a market top.
When calculating slow stochastics, the value of %K slow is the
A second mode of interpretation is to look for support and %D-period moving average of the point at which the current
resistance lines or common chart formations such as a head price lies within the historical price range of its given period (or
and shoulders in the RSI itself, indicating potential reversals raw %K), and the value of %D slow is the moving average of
that the stock chart may not. the %K slow over a given number of periods.
A third mode of interpretation is to recognize divergences in the An oscillator refers to a momentum or rate-of-change indicator
RSI, such as when the price is moving up when the RSI is that is usually valued from 2 to +1 or 0 percent to 100 percent.
moving down, or vice versa. This can mean that the price is
going to “correct” and move in the direction of the RSI.
Interpretation :
A fourth mode of interpretation for the RSI is to view it as a
bullish or bearish signal when it crosses 50. When the RSI There are several major interpretations for stochastics, which
crosses above 50 it can be considered bullish, and when it may be more beneficial when combined with other indicators
crosses below 50 it can be considered bearish. that discern whether a market is in a trending or cyclical rotation
mode.
Stochastics
One interpretation (and the one Dr. Lane believes to be most
Definition : important) is to look for a divergence between %D and the
price. An overbought market occurs when %D makes a series
of lower highs while the price makes a series of higher highs.
The Stochastics oscillator, a popular and dynamic indicator
An oversold market occurs when the price makes a series of
developed by Dr. George Lane, is based on the premise that
lower lows while %D makes a series of higher lows.
during an upward trading market, prices tend to close near their
high, and during a downward trading market, prices tend to
close near their low. Stochastics measures at what point the A second interpretation is to receive signals based on a crossover
price of a security is within the entire price range of the security of the two lines. When the %K line rises above the %D line it
over a given period. is considered bullish, and when the %K line falls below the %D
line, it is considered bearish. You can eliminate some false
The stochastics indicator is plotted as two lines, %K and %D. signals by using only the signals that correspond to the direction
The range of the stochastics is between 0 and 100. With a price of the intermediate- to long-term trends.
range of 10 to 20, 10 would be given a 0 designation, 15 would
be at 50, and a price of 20 would be at the 100th percentile. The A third interpretation is that a buy signal is generated when
values of the stochastics calculations are dependent on the either line dips below and then rises above 20, and a bearish
parameters given to %K and %D. signal is generated when either line rises above and then dips
below 80. Many investors combine several of these interpretations
There are two types of stochastics: fast stochastics and slow as a major criterion used for making trading decisions. d i c a t o r s
Williams’ %R average value over a predetermined time period is made. As the

underlying’s price changes, its average price moves up or down.
Definition :
There are five popular types of moving averages: simple or
The main concept of Williams’ %R is “gravitation towards the arithmetic, exponential, triangular, variable, and weighted. Moving
mean.” If, within a given time period, the price is near the high averages can be calculated on any data series including a
end of a period’s range, the security tends to be overbought and underlying’s open, high, low, close, volume, or another indicator.
is vulnerable for a sell-off. Conversely, if the price is near the A moving average of another moving average is also common.
low end of a period’s- range, a potential rally could occur due
to oversold market conditions. An oscillator refers to a momentum The only significant difference between the various types of
or rate-of-change indicator that is usually valued from 2 to +1 moving averages is the weight assigned to the most recent
or 0 percent to 100 percent. data. Simple moving averages apply equal weight to the prices.
Exponential and weighted averages apply more weight to recent
Interpretation : prices. Triangular averages apply- more weight to prices in the
middle of the time period. And variable moving averages change
the weighting based on the volatility of prices.
If Williams’ %R moves above 80, it can be considered a signal
of an overbought market. When Williams’ %R moves below 20,
it can be considered a signal of an oversold market. The most popular method of interpreting a moving average is to
compare the relationship between a moving average of the
While Williams’ %R is a very powerful indicator used by many underlying’s price with the underlying’s price itself. A buy signal
market technicians, the following should be noted when using is generated when the underlying’s price rises above its moving
this indicator. Williams’ %R does have some tendencies to be average and a sell signal is generated when the underlying’s
a leading indicator (in other words, to bottom out or peak before price falls below its moving average.
the price does). But some suggest that one might not consider
buying in an oversold market until the price actually begins to This type of moving average trading system is not intended to
turn upward, or sell in an overbought market until the price get you in at the exact bottom nor out at the exact top. Rather,
actually begins to turn downward. This is due to potentially it is designed to keep you in line with the underlying’s price
prolonged overbought/oversold periods. It suggests that %R should trend by buying shortly after the underlying’s price bottoms and
be confirmed with other indicators that may be able to selling shortly after it tops.
distinguish between the two circumstances.
The critical element in a moving average is the number of time
The optimal period for %R is the cycle length of the underlying, periods used in calculating the average. The key is to find a
although periods of 10 and 20 are also commonly used. moving average that will be consistently profitable. The most
popular moving average is the 39-week (or 200-day) moving
average. This moving average has an excellent track record in
Moving Averages
timing the long-term market cycles.
Introduction
The length of a moving average should fit the market cycle you
A Moving Average is an indicator that shows the average value wish to follow. For example if you determine that a underlying
of a underlying’s price over a period of time. When calculating has a 40-day peak to peak cycle, the ideal moving average
a moving average, a mathematical analysis of the underlying’s length would be 21 days calculated using the following formula:
Trend Moving Average Simple
Very Short Term 5-13 days

A simple, or arithmetic, moving average is calculated by adding
the closing price of the underlying for a number of time periods
Short Term 14-25 days
(e.g., 12 days) and then dividing this total by the number of time
periods. The result is the average price of the underlying over
Minor Intermediate 26-49 days
the time period. Simple moving averages give equal weight to
each daily price.
Intermediate 50-100 days
Long Term 100-200 days For example, to calculate a 21-day moving average of USD/
INR: First, you would add USD/INR ‘s closing prices for the
most recent 21 days. Next, you would divide that sum by 21;
You can convert a daily moving average quantity into a weekly
this would give you the average price of USD/INR over the
moving average quantity by dividing the number of days by 5
preceding 21 days. You would plot this average price on the
(e.g., a 200-day moving average is almost identical to a 40-
chart. You would perform the same calculation tomorrow: add up
week moving average). To convert a daily moving average quantity
the previous 21 days’ closing prices, divide by 21, and plot the
into a monthly quantity, divide the number of days by 21 (e.g.,
resulting figure on the chart.
a 200-day moving average is very similar to a 9-month moving
average, because there are approximately 21 trading days in a
month). Exponential
An exponential (or exponentially weighted) moving average is

Moving averages can also be calculated and plotted on indicators.
calculated by applying a percentage of today’s closing price to
The interpretation of an indicator’s moving average is similar to
yesterday’s moving average value. Exponential moving averages
the interpretation of an underlying’s moving average: when the
place more weight on recent prices. For example, to calculate
indicator rises above its moving average, it signifies a continued
a 9% exponential moving average of USD/INR, you would first
upward movement by the indicator; when the indicator falls below
take today’s closing price and multiply it by 9%. Next, you
its moving average, it signifies a continued downward movement
would add this product to-the value of yesterday’s moving average
by the indicator.
multiplied by 91% (100% - 9% = 91%).
One thing to keep in mind is the shorter the time period, the Because most analyst feel more comfortable working with time
more reactionary a moving average becomes. A 10-day moving periods, rather than with percentages, the exponential percentage
average is much more sensitive to moves than a 50-day moving can be converted into an approximate number of days. For
average. However, a shorter period also means that you may example, a 9% moving average is equal to a 21.2 time period
have a greater number of false moves within an existing trend, (rounded to 21) exponential moving average.
what is considered “market noise” or a “whipsaw.”
Formula :
Calculation
The formula for an exponential moving average is as follows:
The following sections explain how to calculate moving averages
of a underlying’s price using the various calculation techniques. Exponential Percentage = 2/Time Period + 1
Therefore, a 50-day EMA will have a 3.9 percent exponential more sensitive the smoothing constant used in the moving average
average. .039 = 2/50 + 1 This means that the most recent day calculation. Sensitivity is increased by giving more weight given
will be weighted 3.9 percent of the value of the EMA. For a 50- to the current data.
day simple moving average, each day has precisely a 2-percent
weight.
Most moving average calculation methods are unable to
compensate for trading range versus trending markets. During
Triangular trading ranges (when prices move sideways in a narrow range)
shorter term moving averages tend to produce numerous false
Triangular moving averages place the majority of the weight on signals. In trending markets (when prices move up or down over
the middle portion of the price series. They are actually double- an extended period) longer term moving averages are slow to
smoothed simple moving averages. The periods used in the react to reversals in trend. By automatically adjusting the
simple moving averages varies depending on if you specify an smoothing constant, a variable moving average is able to adjust
odd or even number of time periods. its sensitivity, allowing it to perform better in both types of
markets.
The following steps explain how to calculate a 12-period triangular

moving average.
Weighted
1. Add 1 to the number of periods in the moving average
(e.g., 12 plus 1 is 13). A weighted moving average is designed to put more weight on
recent data and less weight on past data. A weighted moving
2. Divide the sum from Step #1 by 2 (e.g., 13 divided by 2 average is calculated by multiplying each of the previous day’s
is 6.5). data by a weight. The following table shows the calculation of
a 5-day weighted moving average.
3. If the result of Step #2 contains a fractional portion, round

the result up to the nearest integer (e.g., round 6.5 up to 5-day Weighted moving average
7).
Day # Weigh Price Weighted Average

4. Using the value from Step #3 (i.e., 7), calculate a simple
moving average of the closing prices (i.e., a 7-period simple
1 1 * 21.00 = 42.00
moving average).
2 2 * 24.00 = 48.00
5. Again using the value from Step #3 (i.e., 7) calculate a
simple moving average of the moving average calculated
3 3 * 29.00 = 87.00
in Step #4 (i.e., a moving average of a moving average).
4 4 * 28.00 = 112.00
Variable
5 5 * 32.00 = 160.00
A variable moving average is an exponential moving average
that automatically adjusts the smoothing percentage based on
the volatility of the data series. The more volatile the data, the Totals : 15 134.00 = 449.00 /15 = 29.93
210 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Correspondent Banking 211
Interpretation:
Chapter
There are two major ways moving averages are used. 16
First, the moving average can be compared to the price. If the
price rises above the moving average it can be considered a
bullish signal, and if the price dips below the moving average it Correspondent
can be considered a bearish signal. This “crossover” or “penetration”
will not be at the top or bottom, but normally shortly after the
Banking
price bottoms out or tops out.
Second, longer-term and shorter-term moving averages can be

compared to each other, and generate signals when they cross.
When a shorter-term MA moves across a longer-term MA and
both slopes go up, it can be considered a bullish signal. When
Genesis
a shorter-term MA moves across a longer-term MA and both
slopes go down, it can be considered a bearish signal.
Correspondent banking in a broad sense means relations with a
bank. It is a practice whereby a bank establishes a presence in
an overcostly or othewise inaccessible market by means of a
relationships with a local bank. Bank takes advantage of the
business opportunities abroad while minimizing its operating cost.
Historical perspective
There had been a shift in approach in the field of correspondent

banking since the early 1980s. Until the 1980s the major banks’
main earning in these area used to be from the current account
balances of their correspondents. With the rise in interest rates
in the late 1970s and early 1980s many minor banks started
to economize on their holdings of non-earning assets, resulting
in a consequent decline in the level of nostro balances held.
Correspondent banking increasingly came to depend on other
financial services as a source of income and many major banks
began to offer a wide range of new credit and consulting
advisory services to their correspondents. Consequently, there
has been a change from balance income to fee income. Each
service relating to activity or otherwise now carry a price tag-
either by way of fees or by means of peg balances or combination
of both.
212 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Correspondent Banking 213
Services Bag Control Documents
Correspondent banking services include: Swift authenticated keys and Bilateral keys or Telex Testing
keys and other control documents are exchanged between the
- Clearing house functions. two banks including agency arrangement. For such services
banks quote strategic pricing and tactical pricing depending on
- Payments and collections. the business ties, volume and relationship.
- Letters of credit and bankers acceptances.

Advent of Euro
- Trade developments and referrals .
- Credit services – loans and placements. With the advent of the Euro there has been a dramatic effect
on correspondent b a n k i n g , a s a f t e r 1st January 1999, banks are
- Foreign exchange services. able to offer a service whereby non-European banks can open
a single account in Europe to clear all their transactions
- Travel services.
denominated in the Euro. Banks will have fewer counterparts
and they will choose only the best based on service standards,
- Cash management facilities.
activity service cost and other relationship factors.
- Automated balance reporting .
- Nostro account investment scheme.
- Securities facilities.
- Futures and options.
- New issue management and advisory services.
- Insurance trust.
- Advisory services on mergers and acquisitions.
Correspondent Banker and International Banking
Correspondent banks are not only customers but in the main are
an essential cornerstone in the provision of international banking
services for all other customers of the bank. It is essential
therefore to maintain an efficient and cordial working relationship.
The relationship can be :
l Account based.
l Non-account based.
214 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT SWIFT Operations 215
Chapter
17
SWIFT
Operations
Background
Information technology brings people and places closer to each

other besides facilitating decision making. SWIFT is a concrete
example of the way in which the world has been condensed to
a global village by information technology. SWIFT stands for
Society for Worldwide Interbank Financial Telecommunications.
SWIFT is a Co-operative Society registered in May 1973
headquartered at Brussels (Belgium). SWIFT offers unique
message processing services and facilitates to the international
financial community. The Society operates a Computerised
Telecommunication System which allows rapid, economical, secure
and accurate transmission of the essential data relating to a
broad range of financial transactions i.e. Customer transfers,
Bank transfers, Forex loans/deposits collections, securities,
precious metals and syndication, documentary credits/guarantees,
and special messages etc. besides providing facilities like Interbank
file transfer.
SWIFT - A brief history
About 239 banks from Europe, North America and Asia came
together and decided to form a non-profit co-operative society
named Society for Worldwide Interbank Financial Telecommunication
(SWIFT) in May 1973 at Brussels (Belgium) mainly with the
clear objectives to standardise the funds transfer, delivery of
payment instructions, enhance the security level of such
transactions, cut down the cost of message transmission Payment/
Settlement System round the clock, seven days a week and
fifty two weeks a year. In fact SWIFT also advises its users to Of these Message Categories 1,2,4,7 and 9 are in formatting
follow the same in response in 1977 and by the end of the year while sending messages from designated branches. Except
15 founder countries with 586 banks were live on the SWIFT Category - 9 messages, all other Categories used by the designated
system. Over the years, the society evolved to meet the rapid branches (1,2,4 and 7) require authentication On the other hand
changes well within the international financial environment. SWIFT all messages of these categories viz., 1,2,4 and 7 received
has not only added new dimensions as under but also provided through SWIFT network are authentic and need not be separately
the forum within which institutions around the world met in order tested. Messages in these categories can be sent to only those
to resolve international financial issues relating to the activity banks with which there was a bilateral agreement to that effect
and to ensure that trade and finance is conducted troublesfree known as Bilateral Key Exchange (BKE). Category 9 messages
and swiftly. require no authentication and can be sent/received to/by any
SWIFT member (blue-inked codes in Bank Identifier Code Directory).
SWIFT provides Bank Identifier Code (BIC) directory is supplied by SWIFT.
Message Types (MT) :

N e w N e w New Standards New category Forums viz.
Services Message Types of users SIBOS

There can be any number of message types in each Category,
and each message is identified by a three-digit number. The
The data/ activity as per table ‘A’ to ‘J’ reveals that the SWIFT first digit of each message type represents the category it belongs
has grown to a size equal to none in quality and quantity of to.
funds settlement and related interbank message traffic. The
amazing figure substantiates the statement of facts.
To facilitate the understanding let us refer the commonly used
message types in each Category:
User Friendly operations :
To ensure uniformity in international standards, SWIFT devised Category 1

ten categories of messages from 0 to 9.
MT 100 - Customer Transfer
Category No. What it represents
MT 111 - Request for Stop Payment of a Cheque
0 System Messages
1 Customer Payments & cheques

Category 2
2 Financial Institution Transfers
MT 202 - General Financial Institution Transfer
3 Financial Trading
MT 203 - Multiple General Financial Institution Transfer
4 Collections & Cash letters
5 Securities
Category 4
6 Precious Metals & Syndications
MT 400 - Advice of Payment
7 Documentary Credits & Guarantees
8 Travellers Cheques MT 410 - Acknowledgement
9 Cash Management & Customer Status MT 412 - Advice of Acceptance

MT 416 - Advice of Non-Payment/Non-acceptance Mandatory and Optional Fields

MT 420 - Tracer
Since, the messages routed through SWIFT are formatted, correct
MT 422 - Advice of Fate and Request for Instructions usage of fields forms an indispensable part in the transmission
as well as processing of messages. In the PC-Connect application
MT 430 - Amendment of Instructions each field is identified by a code work Mandatory Field/Optional
Field (MF/OF), indicating the Mandatory or Optional usage of
MT 456 - Advice of Dishonor
the concerned field.
Category 7 Straight Through Processing (STP)
MT 700 and MT 701 - Issue of Documentary Credit

Most of the banking applications in different parts of the world
MT 705 - Pre-Advice of a Documentary Credit are automated and require minimal manual intervention. STP is
one where there is no need to handle the messages manually
MT 707 - Amendment to a Documentary Credit and thereby ensures faster processing and reduction in costs.
Using BIC codes wherever possible (instead of typing the full
MT 730 - Acknowledgement address of the banks in the fields 57D/56D); usage of Field 72
only with allowed code words etc., will help in STP.
MT 734 - Advice of Refusal
MT 740 - Authorization to Reimburse Message Referencing
MT 742 - Reimbursement Claim

While replying to any of the SWIFT-received messages, the
MT 756 - Advice of Reimbursement related reference of our reply (Field 21) should contain the
transaction reference of the received message (Field 20 of other
MT 760 - Guarantee bank), so that messages can be identified easily and passed on
to the respective desks. In automated systems usage of these
fields helps in data message matching.
Category 9
(Mis) Use of Field 72 (Sender to Receiver Information)
MT 986 - Status Report
Common Group Messages In remittances (MT 100,202,203) this field when used should
always be adhered to the correct coding rules.
n92- Request for Cancellation
Many banks have experienced it that incorrect use of this field

n95-Queries
is resorted to. Some information on it is hereby provided.
n96-Answers
a) The first line of field 72 should start with a code word sandwiched
n99-Free Format Message
between two slashes, and the code word represents the information
to which it is directed. Any subsequent extension in lines say
Where‘n’ can be any number in any of the said categories. 2 nd , 3 r d e t c s h o u l d b e f o l l o w e d b y a d o u b l e s l a s h ( / / ) .
Most Commonly used words are l Ensure ‘ACK’ Copy of each message sent which is the
proof of the message that has been transmitted. ‘NAK’
/ b e n /- instruction to beneficiary
represents that the network has not accepted the message
/ a c c /- instruction to the account with institution sent because of improper formatting, and the message
again needs to be sent after proper formatting. Since ‘NAK’ed
/int/ - instruction to the intermediary bank etc.
messages are extra charged users to avoid ‘NAK’s as far
as possible.
(For elaborations/details reference to message standards is
suggested)
l Pass on the messages to the respective branches directly,
in case they have been sent to the wrong addressee (using
BIC Codes wrong SWIFT Code e.g. VYSAINBBNPT in place of
VYSAINBBMDV)
Bank Identifier Code (BIC) is an eight or eleven-digit code assigned
to each SWIFT registered financial institution. The first four l See that your Overseas Correspondent Banks use your
letters of the code represent the name of the bank, next two correct and full SWIFT Code, so the addressee can directly
letters the country code and the next two location code. Last receive those messages. For it banks can include in their
three letters in an eleven digit BIC represent the branch code, letterhead their exclusive SWIFT code.
as well.
l Make the updates like BIC Updation, loading of Software

For example the SWIFT code of VYSAINBBCAL is a formation Patches on time and in consonance with the instructions
of supplied along with the software by the SWIFT.
VYSA -Which represents the Vysya Bank

SWIFT is highly sensitive area, therefore operate it from a
IN - Country Code (India in this case) secure and restricted entry area and keep it dust free and virus
B B - Mumbai (Location Code) free. Passwords are to be kept confidential and change them at
regular intervals or as and when required.
CAL - Our OSB Calcutta Code
As a good practice Main and Remote locations, contact persons

W h i l e s e n d i n g m e s s a g e s , t h e 9t h Character of a BIC Code which
and their phone/fax numbers can be circulated among the users.
represents the logical terminal should be left untouched (Default
It will facilitate in case of any clarification or additional information.
value X is valid)
SWIFT in India
Utilizing BIC Directory is useful not only for referring SWIFT
Codes, but also for the Cut Off times of each country, Country
Turning the pages of history we find that the Indian Bank’s
Codes etc. It is updated quarterly by the SWIFT.
Association (IBA)/Reserve Bank of India, CMC and Mahanagar
Telephone Nigam Ltd. and member banks took the initiative in
Some Do’s 1982. To start SWIFT in India it took more than ten years to
translate dreams to reality when SWIFT was formally inaugurated
l Ensure that the queues RTSQ, TBVQ, TBAQ, REJQ are on 2 nd December 1991 as a result of persistent efforts by IBA.
empty before shutting your system down so that no message Mr.Richard Frohlich the then Chairman of Board of Directors,
is left in the queue inadvertently. SWIFT made himself available to Banking Industry in India.
Thirty-one banks joined the network in India. It is fascinating to Is telex costly?

note that India’s message transmission traffic is now improving
when comparing with countries connected to SWIFT. There are Telex is expensive; manual processing, handling of the test
totally 64 financial institutions/banks enacted on SWIFT in India keys and communication all contribute to inflated costs. By
but 58 are connected. comparison, a SWIFT message is considerably cheaper. Two
recent surveys by French and UK banks show that the cost
On examining participation in message traffic we find that majority difference between SWIFT and telex processing ranges from
of the traffic is sent by foreign/private sector banks, say about USD 8.5 to USD 14 per telex message.
49% of the total messages inputed.
In a bank in India the schematic presentation of SWIFT input

There is greater surmounting to earlier inhibitions and restrictions
and output (messages) can be understood as under:
by Deptt. Of Telecommunication on connecting other parts of
India to the ‘SWIFT’ CBT modes in Mumbai. SWIFT with its
SAP (Swift Access Point) at Mumbai receives messages from INPUT :
the CBT (Computer Based Terminals) erected at each member
bank’s SWIFT center and delivers the same in seconds to the Branches Interbank Back-up Reconcillation
desired destination country following the transmissions traffic
route via SWIFT’s processors.
SWIFT
Why to eliminate the telex?

REPORTING SYSTEM
There are questions viz. why to eliminate the telex? The obvious
reply is the cost of message is lower compared to the earlier 1. Outward messages Register showing the following details:-
available modes viz. telex, telegram and courier services. At
the same time SWIFT ensures reliable, secure, speedy and Date; Branch; Type of Message (MT700, 707,Remittance, Others);
standardized transmission. SWIFT accorded ISO 9000 certification IB; Misc; Pending;
on account of standards assured and accepted universally.
Remarks.
Increasingly, institutions are under pressure to reduce costs,
better manage risk and improve service. One of the most attractive
SWIFT charges that have to be debited to branches are arrived
solutions is to be able to process messages straight through
at from this table.
(STP) from one end of the transaction chain to the other.
2. IB Payments register showing the following details: -

Studies by SWIFT show that even institutions connected to the
network exchange telexes even though appropriate message
Date; Type (IBdeal settlement, Nostro Transfer, Depo Placement);
standards exist.
Currency; Amount; No.of items; Transmitted; ACK Received;
In brief, telex is a barrier to automation that generates costs Remarks; Initial.
and delays, and increases the chance of fraud. Eliminating it

from the message processing chain can help banks meet three 3. FLCs sent Register: -
of their most fundamental objectives: mitigation of risks, reduction
in costs and improvement in customer service. Hard Copies for Verification/Authentication before transmitting.
4. SWIFT Charges for Branches Register: - Disaster Recovery Plan
Periodical Register, showing charges levied on branches for Inspite of elaborate disaster recovery plans something may still
transmitting their messages. Register also gives details regarding fail to work. The purpose of every disaster recovery plan is to
the total number of messages sent during the period under minimize impact of the most unavoidable disaster. A bank may
consideration and type of messages sent. be forced to give value dates on a particular day. There could
be many reasons for this and some could be beyond control of
the bank such as war, general power failure, strikes etc. However
General: -
it is suggested that the banks do make disaster recovery plans
wherever it is within their control. Some of the situations can
SWIFT Center LogBook: - Registering the time the Center was be: (I) Electric power/Air conditioning, (ii) Hardware (iii) Systems
opened and closed each day. and application software (iv) Telecom equipment and lines dedicated
leased or dial up (v) Personnel. It is admitted that if something
is to go wrong, it will go wrong and at the most inopportune
System Log Book: - Gives details for Upgradation Software
time. Such events can be remedied with a little pro-active disaster
loaded date and also Backup taken date and period for which
planning to reduce the impact.
taken.
OUTPUT : SIBOS (SWIFT INTERNATIONAL BANKING

OPERATIONS SEMINAR)
SWIFT
Doing business in a borderless world through SWIFT is a unique
Branches Back-office Interbank SWIFT MISC. Vostro experience. Forums like SIBOS explore how the banking and
MSG financial industries will meet the challenges of this new borderless
world.
REPORTING SYSTEM : How the banks will really balance the issues of round-the-clock
performance with round-the-world security.
1.ELC Register showing the following details: -
Experience reveals that participation in such forums from India

Date; Branch; Received from; LC no.; Beneficiary; LC Type and
is not much. M/s. SSI and Indigo Technologies as aservice
Value. LCs are dispatched to respective branches after filling up
provider in India with responsibility to provide service support
the proforma.
and to impart cost effective training in SWIFT related issues to
the users right from operators to control level: can play a significant
2. Received and ACK Registers: - In serial order role. They may think/plan pre or post SIBOS meets in India as
well to spread more awareness and to facilitate transfer knowledge
to those who are not able to participate in SIBOS. Such an
3. Vostro Register
effort would prompt further utilization of SWIFT network and to
admit that SWIFT operations are certainly a step beyond mere
telecommunication.
GLOBAL SWIFT UTILISATION (TABLE ‘A’ to ‘J’): Netherlands 36.4 58.8%
Italy 33.6 62.0%

(Source: SWIFT bulletin February 2000 - #13) Hong Kong 31.4 64.9%
Luxembourg 24.7 67.3%

A : TRAFFIC In messages
Australia 22.1 69.3%
Total number of messages 1,058,836,425
Spain 20.9 71.3%
Message growth 13.0%
Singapore 19.6 73.2%
Average daily traffic 4,208,412
Sweden 17.7 74.8%
Latest peak day: 30 November 1999 5,151,884
Canada 16.6 76.4%
Austria 16.1 77.9%

B : FIN AVAILABILITY
Korea 11.8 79.0%
FIN Systems 99.998%
Denmark 11.4 80.1%
Transport network 99.991%
South Africa 10.6 81.1%
Overall service 99.989%
E : TOP 20 NATIONAL & INTERNATIONAL ROUTES

C : CUSTOMER BASE
Live countries 189 Between And Traffic (million)
Live members 2,214 United Kingdom United States 45.3
Live sub-members 2,763 United States United States 41.7
United Kingdom United Kingdom 39.1

Live participants 1,820
Germany United Kingdom 21.3
Live users 6,797
Japan United States 18.5
D : TOP 20 COUNTRIES Germany United States 17.2
Traffic Distribution France France 16.8

(Million) cumuli.
Hong Kong United States 16.5
United States 182.6 17.2% Switzerland United States 16.2
United Kingdom 139.2 30.4% France United Kingdom 14.5
Germany 73.9 37.4% United Kingdom Italy 13.3
France 59.0 42.9% France United States 12.6
Switzerland 48.4 47.5% Belgium United Kingdom 12.1
Belgium 45.6 51.8% Switzerland United Kingdom 11.1
Japan 37.3 55.3% Switzerland Switzerland 10.2

United Kingdom Netherlands 10.1 G : TRAFFIC DISTRIBUTION BY MARKET (In millions of

messages)
Switzerland Germany 9.6
Traffic Distribution
Netherlands United States 9.3
Switzerland Switzerland 8.8 Payment 668.7 63.2%
Belgium Belgium 9.3 Securities 224.3 21.2%
Treasury 97.0 9.2%
F : MOST USED S.W.I.F.T (FIN) messages Trade Finance 39.7 3.8%
Message type Message sent(million) Distribution Total 1,058.8
100 210.2 19.4%

H : TRAFFIC DISTRIBUTION BY REGION (in millions of
202 135.2 12.7%
messages)
950 78.5 7.3%
Traffic Distribution
300 68.1 6.5%
Americas 213.4 20.2%
910 47.3 4.4%
Asia-Pacific 162.8 15.4%
940 39.0 3.6% Europe, Middle-East,
940 39.0 3.6% Africa 638.9 60.3%
571 29.7 2.7% Total 1,058.8
521 24.2 2.2%

I : TRAFFIC GROWTH BY MARKET
534 22.8 2.0%
Payment 9.7%
523 22.2 2.0%
Securities 49.8%
900 22.1 2.0%
573 21.3 2.0% Treasury -17.0%
Trade Finance 2.9%

210 20.9 1.9%
198 20.6 1.9% Total 13.0%
531 19.6 1.8%

J : TRAFFIC GROWTH BY REGION
999 18.9 1.8%
Americas 10.6%
533 18.2 1.6%
Asia-Pacific 7.9%
199 14.4 1.3%
Europe, Middle-East, 3.3%
320 13.7 1.3% Africa
Others 192.9 17.9% Total 13.0%
230 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Glossary 231
Glossary
Actuals
Refers to debt securities, currencies, physical commodities and

equity securities (versus derivatives)
All or Nothings
The option payout is a predetermined amount, which is paid out

only if a trigger point is reached.
American Style Option
An option that can be exercised any time during its life up to

and including the last trading day.
Accreting Swap
A swap with a notional principal amount which decreases over

time.
Arbitrage
The simultaneous purchase and sale of the same (or equivalent

or related) securities to take advantage of price differences
prevailing in separate markets. A pure arbitrage involves trading
effectively the same instruments for different prices at the same
time. The term is now used widely in connection with concurrent
purchases and sales of securities of proposed acquiring and
acquired companies in pending tender offers and other acquisitions.
Asset-Liability Management goes bankrupt.
Matching the amounts of assets and liabilities by term and Barrier Options
interest rate type. Financial institutions carry out asset-liability
management when they match the maturity of their deposits These options operate in the same way as standard options,
with the length of their loan commitments to keep from being except that payout or receipt only occurs if certain thresholds
adversely affected by rapid changes in interest rates. in the related reference rate or index are or are not exceeded
during the exercise period. Barrier options include Knock-in options
and Knock-out options.
At-the-Market
An order to buy or sell a financial instrument (eg. futures, options, Basis

etc.) at whatever price the contract is trading when the order is
The difference between a futures contract price for an item and
executed.
the current spot price of the same item.
At-the-Money
Benchmarking
An option whose exercise price is equal to the market price of
Comparing information of one entity to like information of another
the underlying stock, index or other security.
entity or composite group for the purpose of determining areas
for potential improvement and to identify the best practices.
Average-Style (or Asian) Options
Black-Scholes Formula
The payoff of Average-Style options is based on the average
price of the underlying interest over a period relative to the An option valuation formula based on the principle that an option
strike price. This contrasts with American and European style can be priced by combining it with its underlying asset into a
options which pay off based on a prices as at a single date riskless hedge portfolio.
relative to the strike price.
Call Option
Backwardation
The buyer of a call option has the right to buy an underlying
A market situation where the spot price trades at a premium to instrument at a predetermined price during a determined period.
the forward price. Opposite of contango. The seller of a call option has the obligation to sell, if the option
is exercised.
Bankers Acceptances
Cap
A time or sight draft drawn on a commercial bank by a borrower,
usually in connection with a commercial transaction. The borrower A contract between a borrower and a lender where the borrower
is liable for payment, as is the bank, which is the primary is assured that he will not have to pay more than some maximum
obligor, to pay the draft at its face amount on the maturity date. interest rate on borrowed funds.
Bankruptcy Risk Cash Flow Forecasting
The risk that a counterparty, which owes your institution money, The process of identifying and/or estimating all known future
cash receipts and obligations, and calculating cash balances for Convexity Risk
each future date in order to cover shortfalls and invest surpluses.
The risk of adverse changes in the price of a position due to
changes in the yield.
Cash Settlement
A way of settling some futures and options contracts. The seller Correlation
pays the buyer the cash value of the underlying interest.
A measure of the degree to which returns on two risky assets
Collar move in tandem. A positive correlation means the returns move

together. A negative correlation means they vary inversely.
A floating rate debt contract that establishes a maximum and a
minimum interest rate to be paid by the borrower.
Correlation Risk
Commodity Swap The risk that the actual correlation between two risk assets is
not equal to the estimated or expected correlation.
Commodity swaps can either swap a fixed and a floating price
for the underlying commodity, or can swap two different
Costless Collar
commodities.
Is made up of two options, one purchased and one written,

Competitive Risk structured so that the value of the two premiums are equal and
offsetting.
Occurs due to nature of the business the company is in and the
type and location of its competition. It is the risk that the
Covered Call Option Writing
demand for a company’s goods and services will decline due to
the actions of competitors.
A call option seller is covered if he owns the underlying actuals
(Naked Call Option Writing) for the call option contract.
Contango
A condition in a futures market where the more distant delivery Credit Risk
months trade at a premium to the near term delivery months.
The risk of loss from a counterparty who is unwilling or unable
to settle its side of a transaction.
Convergence criteria
Entry criteria which an EU member country must meet in order Credit Support Providers
to participate in EMU. The five criteria are: price stability, budgetary
discipline (budget deficit and public debt), low interest rates, Are typically party to swap agreements where one of the
currency stability and a central bank independent of the government counterparties is a member of a corporate group in which other
members of the group are stronger credits.
Convexity
Currency Swap
The rate of change in price of a position for a given change in
yield. An exchange of equal initial principal amounts of two currencies
at the spot exchange rate. Over the term of the agreement, the ECOFIN
counterparties exchange fixed or floating rate interest payments
in - their swapped currencies. At maturity, the principal amount is the Council of Economics and Finance Ministers of the fifteen
is reswapped at a predetermined exchange rate so that the EU countries. This Council also meets if decisions need to be
parties end up with their original currencies. taken concerning an excessive deficit within the parameters of
the planned stability pact
Current Exposure
ECU
Represents the current replacement cost of financial instrument
transactions, that is, their market value. The ECU is the European accounting and currency unit in use
until the start of monetary union. It is based on a currency
basket in which the weighted currencies of the EU member
Customs union
countries are integrated.The ECU is a key component of the
European Monetary System. It serves as a basis and reference
A customs union is a merger of several customs zones into one
with which deviations among the EU currencies can be calculated
single customs zone. Customs between the member states are
abolished. The members of a customs union have common
customs duties towards non-member countries. A customs union ECU Banking Association
was introduced in the EC in 1968 example, it is EAF (Elektronische
Abrechnung Frankfurt) and in France TBF (Transfer Banque de The ECU Banking Association (EBA) is a private company which
France) has operated a cross-border ECU clearing system since 1986.

49 banks currently participate in this system. Earlier Swiss
Bank Corporation ( now UBS ) has been a clearing member
Delta since 1987 via its London Office. On December 13, 1996, the
report of the EBA’s Future Development Group was approved
The ratio of the change in the price of the option to the change
by the clearing committee thus making it possible to expand the
in the price of the underlying.
current ECU clearing system into a euro clearing system. The
EBA expects a share of 30% of all euro payments to be handled
Derivative by its new system, especially as the transaction costs will be
lower than those for Target. Unlike the national RTGS systems,
A generic term often used to categorize a wide variety of financial
the EBA system is a net settlement system
instruments whose value “depends on” or is “derived from” the
value of an underlying asset, reference rate or index.
EEA
Documentation Risk The European Economic Area is an association consisting of

the 15EU countries and the EFTA countries Liechtenstein, Iceland
The risk that the legal agreements between two institutions is and Norway. This economic area, which has existed since January
insufficient or incomplete. 1, 1994, is a de facto geographic expansion of the EU single
market to these EFTA countries
Duration
Embedded Options
A measure of the sensitivity of the price of an interest rate
instrument to a change in interest rates. Securities, which contain call or put features. For example, a
“callable bond” contains provisions that allow the issuer to buy European Economic Community
back the bond at a predetermined price at specified times in the
future. A “putable bond” contains provision that allow the holder The European Economic Community (EEC) was established under
to demand early redemption at a predetermined price at specified the Treaties of Rome (1957) and its name was changed to
times in the future. European Community (EC) under the Treaty on European Union
(Maastricht treaty)
Equity Swap
European Monetary Institute
A contract between two counterparties to exchange two different
The Frankfurt-based European Monetary Institute (EMI) is
cash flows over time. During the life of the swap one party
responsible for the transition to the third stage of economic and
agrees to pay the rate of return on an equity or the equity index
monetary union.This includes supporting and monitoring the
while the other party agrees to pay a floating or fixed rate of
economic convergence of the countries involved as well as
interest.
promoting and facilitating use of the single currency. In addition,
the EMI is preparing the tasks of the European Central Bank
(ECB)
European Style Option
An option that can be exercised only on the expiration date. If European Monetary System
investors do not want to wait until the expiration date, they can
close the position with an offsetting trade. The European Monetary System (EMS) was created in 1979 as
a reaction to major fluctuations between the currencies of the
EC member states in the 1970s. The aim is to prevent the
Euro process of European integration from failing. The EMS has two
main features: the exchange rate mechanism and the ECU. The
Name of the new European currency which is available as book exchange rate mechanism is a system of fixed but adjustable
money as of January 1, 1999 and as cash as of January 1, exchange rates. A key rate is defined for each community currency.
2002. The official abbreviation is EUR, and the ISO code is 978 The result is bilateral key rates for the community currencies,
from which the exchange rates may deviate within certain
bandwidths and which may- be changed only with the unanimous
EUR
approval of the member countries. If the exchange rates reach
the upper or lower intervention point, the central banks involved
The official abbreviation for Euro, the ISO code is 978
must intervene on the currency market (by buying and selling
currencies). At first the bandwidths were +/- 2.25% for most
European Central Bank countries participating in EMS. In August 1993 the bandwidths
were set at +/- 15% so that the current exchange rates are de
The European Central Bank (ECB) and the European System of facto flexible ones
Central Banks will take up their work with the launch of economic
and monetary union. Monetary policy will be determined by the euroSIC
Governing Council of the ECB, comprising the national central
bank governors and the Executive Board of the ECB. The European euroSIC is a system currently being established to settle euro
Central Bank is completely independent of directives issued by payments in Switzerland. It is based on the Swiss clearing
governments or other centralized bodies system SIC, which is being expanded to include the functions
needed for payments in euros Foreign payments
At present, payments between the banks of the individual countries

European System of Central Banks
are settled using standardized SWIFT messages via correspondent
The central banks (ESCB) of the member states will continue banks, foreign branches and private clearing systems. The SWIFT
to exist even after the transition to the single currency and, organization (Society for Worldwide Interbank Financial
together with the European Central Bank, will form the European Telecommunication) began operating in 1977. The SWIFT system
System of Central Banks. The main goal of the ESCB is to provides the participating banks with a computerized
maintain price stability of the European currency communications network which can be used to transmit
standardized messages concerning international banking
transactions rapidly, securely andelectronically
European Union
The European Union (EU) is an association of 15 independent Forward Contracts

countries acting jointly in many areas relating to politics and the
A simple forward-based contract obligates one party to buy and
economy. In other areas, however, the countries retain their
the other party to sell a financial instrument, a currency, an
sovereignty. EU member countries are Belgium, Denmark, Germany,
equity or a commodity at a future date. Examples of forward-
Finland, France, Greece, Britain, Ireland, Italy, Luxembourg, the
based contracts include forward contracts, futures contracts,
Netherlands, Austria, Portugal, Sweden and Spain
FRAs and swap transactions.
Exchange Traded Contracts

Forward or Delayed Start Swap
Futures and options offered by an exchange. They are standardized
Interest rate swaps that are structured so that they start at
contracts subject to the rules and regulations of the exchange.
some time in the future.
Exercise Price
Forward Pricing
(see Strike Price)
The pricing of financial instruments for a value date in the
future.
Exotic Derivatives
Forward Rate Agreements (FRAs)
Generic term for the more sophisticated derivative strategy which
has features over and above the basic contracts. FRAs are over the counter contracts on forward interest rates
typically for periods of less than two years.
Expiration Date
Futures Contracts
The day the option contract expires and becomes worthless.
An exchange traded variant of over the counter forwards.
Floor
Gamma
An aspect of a floating rate debt contract that specifies a minimum-
interest rate for an investor. Measures the change in the delta for a given change in the
price of the underlying. is above the strike price of the option. For a put, it is when the
market prices of the underlying interest is below the strike price
of the option.
Gap position Monitoring
A component of asset/liability management during which the Index-Amortizing Swaps

mismatched positions are reviewed and managed.
These swaps generally operate as basis swaps for an initial
period (the lock-out period), after which time the notional principal
Gross domestic product balance is amortized or extended based on a schedule linked to
interest rate changes or some other index during the lock-out
Gross domestic product (GDP) refers to the newly created total-
period.
value of the goods and services produced in a country over a
certain period (usually one year). By adding the incomes earned
by nationals of that country abroad and subtracting the incomes
Interest Rate Swap
earned by foreigners in that country, one arrives at the gross
The exchange between counterparties of a fixed interest rate
national product (GNP)
and a floating interest rate in a single currency.
Hedge International Swaps and Derivatives Association

(ISDA) Agreements
A transaction that reduces the price risk of an underlying security
or commodity position by making the appropriate offsetting Standardized legal documents used by institutions entering into
derivative transaction. over the counter derivative contracts.
Historical Volatility Intrinsic value
To estimate volatility empirically, prices are observed at fixed The economic value of an option if it is exercised immediately.
time intervals and used to calculate volatility for that period. The intrinsic value cannot be less than zero.
Hybrid Security Knock-in Option
An option which pays nothing at expiry unless it is first “activated”

A complex security consisting of a combination of two or more
as a result of the underlying variable reaching a pre-determined
risk management building blocks - bond or note, forward, future,
level.
option or swap.
Knock-out Option
Implied Volatility
Begins life as a standard option but is “killed off” if an underlying
The volatility implied by the option price observed in the variable touches a pre-determined level.
marketplace.
Legal and Regulatory Risk

In-The-Money
The effect on a company due to new or changing laws affecting
For a call, it is when the market price of the underlying interest its normal course of business.
Legal Risks banks. A payment in Swiss francs to a foreign recipient will be

credited to the Swiss franc account of the client’s bank at the
These risks result when companies transact with counterparties respective correspondent bank. In this case, it is called a loro
in foreign countries, which are subject to different legal and account. If the amount is to be paid in a foreign currency, it will
regulatory frameworks. be debited to the respective Swiss bank’s foreign currency account
at the correspondent bank abroad. From the point of view of the
Leverage bank in Switzerland, this is a nostro account
The minimizing of actual cash exposure while attempting to Margin

maximize (eg. trading on margin) upside opportunity.
Minimum deposit of cash or negotiable instruments to guarantee
Leverage Swaps a position.
These swap arrangements can be structured in a variety of

Mark to Market
ways but have as a common characteristic a variable rate payment
stream that adjusts at a multiple of the actual change in market A procedure to adjust the carrying value of a security or derivative
rates. contract to its current market value.
LIBOR Market Liquidity

(“London Interbank Offer Rate”). The rate of interest offered on The ability of market participants to easily enter into or unwind
deposits from other banks in eurocurrency markets. a particular type of transaction.
Limits
Market Risk
Arbitrary price and/or quantity barriers imposed on traders or
The risk of loss resulting from changes to foreign exchange
positions.
rates, interest rates, commodity prices, or equity prices or indices.
Liquidity Risk
Market Value
The risk of a company’s working capital becoming insufficient
The value of an asset based on current market prices.
to meet near term financial demands.
Look-Bank Options Market-Maker
The payout is based on the lowest in the case of a put, or A financial intermediary which will provide both bid and offer
highest, in the case of a call, level reached by the underlying prices.
instrument during the exercise period.
Naked Call Option Writing

LORO accounts
Options sold, without owning the actual underlying product (versus
Payments are settled via reciprocal accounts maintained by the covered call option writing).
Netting Option on Futures
Calculating the total exposure to a counterparty by offsetting Are exchange traded option which give the holder the right, but
the receivables and payables, in the same currency, for the not the obligation, to enter into a long or short futures position.
same dates. This exposure is less than if a gross total calculation
is used. Out-of-the-money Option
For a call, it is when the market value of the underlying interest

Nominal Measures
is below the strike price of the option. For a put, it is when the
The most basic of methodologies for risk management and market price of the underlying interest is above the strike price
represents a risk position based on the nominal amount or face of the option.
amount of the transactions.
Over-the-Counter
NOSTRO accounts Term used to describe a financial instrument that is traded
through principals rather than on an exchange.
Payments are settled via reciprocal accounts maintained by the
banks. A payment in Swiss francs to a foreign recipient will be
credited to the Swiss franc account of the client’s bank at the Parallel Shift
respective correspondent bank. In this case, it is called a loro
With reference to yield curve movements, is an equal shift of
account. If the amount is to be paid in a foreign currency, it will
the whole curve either upwards or downwards.
be debited to the respective Swiss bank’s foreign currency account
at the correspondent bank abroad. From the point of view of the
bank in Switzerland, this is a nostro account Path-Dependent Options
These options (“up and in”, “down and out”, etc.) only become
Open Interest effective if the value of the underlying interest moves above or
below specified “trigger” points.
The number of outstanding long or short positions for a given
exchange-traded futures or option contract. A measure of the
Performance Measurement
liquidity of the contract.
The comparison of actual returns against a pre-specified benchmark.

Operational Risk
Physical settlement
The risk of loss resulting from breakdown in administrative
procedures and controls or any aspect of operating procedures. With reference to futures contracts, the actual receipt or delivery
of the underlying product or commodity.
Option
Potential Credit Risk
An option provides the holder with the right, but not the obligation,
to buy or sell an underlying bond, equity, currency or commodity, Is in addition to the current risk exposure amount calculated,
or to receive a payment based on the movement of such underlying and reflects the risk that the contract may move further “into the
interest. The holder of the option pays a premium for this right. money”, increasing the credit exposure.
Potential Exposure Reinvestment Risk
An estimate of the future replacement cost of these transactions. The risk that interest rates will decrease as investments or
bond coupons come due.
Premium
Rho
The cost which the buyer of an options pays to the writer of
The sensitivity of the option price to a change in the interest
seller of the option; normally only a very small fraction of the
rate.
notional value of the underlying product commodity.
RTGS
Price Risk
(Real-Time Gross Settlement) Under this system, each payment
The risk of adverse movements in prices. order is entered individually and irrevocably on a real time basis,
i.e. the account at the instructing bank is debited at the same
Puts Option time as the account at the beneficiary bank is credited, as long
as the instructing bank has sufficient cover. This represents a
An option that gives the right to the buyer to deliver to the seller considerable improvement in risk management, especially versus
the underlying instrument at a predetermined price within a specified other, older net settlement systems
period. The seller of a put option has the obligation to accept
delivery if the option is exercised. Segregation of Duties
A key operational control to ensure that one individual does not

Put-Call Parity Theorem participate in more than one key trading or operational function.
An equation representing the proper relationship between put Settlement Risk

and call prices. Violation of a parity allows arbitrage opportunities.
This risk occurs when a payment is required by a counterparty
and it is unable or unwilling to effect it.
Quanto Option (guaranteed exchange rate option)
An option in which foreign exchange risks in an underlying security Speculation
have been eliminated.
Trading for the explicit purpose of making profits.
Realized Profits and Losses

Spot Deferred Forward Contracts
A profit or loss realized from the sale of capital assets, such as
A forward sale of a commodity at a specified future date at a
portfolio securities.
specified price. The holder has the option to postpone the maturity
date of the contract, in return for the payment of the premium.
Regulatory Risk
Spot
The risk that regulators will change the current rules or impose
new rules, and negatively impact positions already on the books. The current price or rate.
Spread payments, financial trading, securities and trade finance. These

standards greatly facilitate transactions between banks, allowing
The difference between the bid and asked prices of a security messages to be processed almost entirely automatically. SWIFT
and to the dealer’s commission on a security offering. currently has around 2600 full members worldwide
Spread Position Systemic Risks

A combination of a put and call options at different prices, one The risk that a specific large counterparty (such as a country),
below and the other above the current market price. a certain market or a settlement system should experience a
crisis, and that there will be a widespread spillover into the
Stress Testing financial markets as a whole.
Assists in identifying and measuring the effects on a portfolio

or a position of changes in market prices, volatility levels, shifts TARGET
in the yield curve and correlations between two or more market
is the overall system for settlement of electronic payments in
factors.
Europe, created by linking the national RTGS systems of the
EU countries via an interface. The system, which came into
Strike Price operation on January 1, 1999, is a decentralized one, meaning
that payments are recorded, processed and forwarded by the
The price specified in the option contract at which the option
national systems. Only the exchange is made via a central unit.
holder may buy or sell the underlying interest.
Settlement is handled by the central banks of the two countries
involved. The system is only process payments in euros and
Structured Notes
serves in particular to implement an effective Europe-wide
Structured notes are debt securities in which the repayment of monetary policy
interest, and sometimes principal, is tied to movements in an

underlying index. Examples include range bonds, step-up notes Theta
and inverse floaters.
The sensitivity of the option price to time decay.
Swap Spread
Time Value
The number of basis points to be added to the appropriate
market bond yield. The time value is equal to the difference between the premium
of an option and its intrinsic value. This portion of the premium
Swaptions is attributable to the amount of time remaining to expiration and

the fact that components that determine the value of the contract
Are over-the-counter options on swaps. may change in that time.
SWIFT Translation Risk
(S o c i e t y for Wo r l d w i d e Interbank Fi n a n c i a l Te l e c o m m u n i c a t i o n ) An accounting or financial reporting risk. It is the risk that the
SWIFT is a supplier of an exclusive network. It also offers consolidated earnings of a company will be negatively impacted
products in the form of standardized messages in the areas of due to the method of accounting for foreign operations.
252 TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT Bibiliography 253
Unrealized Profits and Losses Bibiliography
Profits and losses resulting from the mark-to-market process.

i) A Manual of Foreign Exchange by H. E. Evit
Value at Risk (VaR)

ii) Exchange Airthmetic by H.C.F. Holgate
This calculation focuses on the probability of loss from a position,

typically calculated using a 95 or 99% confidence interval over iii) International Banking Vol. I, II, III by the Indian Institute of
a holding period of one to ten days. Bankers
Value of a Basis Point iv) The Banker’s Handbook edited by William H. Baughn and
Charles E. Walker
Methodology which calculates the change in present value of a
financial instrument or portfolio of instruments due to a one v) EMU, EURO and India by Deptt. Of Economic Analysis &
basis point change in interest rates. Policy by the Reserve Bank of India
Vega vi) The European Monetary Union. The Countdown is Running

by the Dresdner Bank
The sensitivity of the option price to a change in volatility.
vii) Foreign Exchange Handbook by H. P. Bhardwaj

Volatility
v i i i ) Managing Foreign Exchange Risk by Nick Touch
The rate of change in the price of the underlying commodity.
ix) Vinimaya-National Institute of Bank Management (Vol. XVI

Warrant
No.4)
An option to purchase or sell an underlying instrument at a
given price and time or series of prices and times. It is ordinarily x) Risk Management Systems in Banks guidlines by the Reserve
issued for longer than a year. Bank of India
Yield Curve xi) Conference of Chairmen of Banks - Banking in the New

Millennium at National Institute of Bank Management, Pune
The plotting of investment yields against maturity periods.
xii) SWIFT solutions, Feb. 2000

Yield Curve Risk
x i i i ) Exchange Control Manual (1993 edition) Vol. I
The risk of losses due to adverse changes or shifts in the yield
curve.
x i v ) Rules Book by Foreign Exchange Dealer’s Association of
India
Zero Coupon Yield Curve
The plotting of zero coupon rates against maturity dates.

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TR E A S U RY O PERAT I O N S AND R I S K M ANAGEMENT

Treasury Operations Treasury Operations

Prof. M. Thomas Paul

2000, A. K. Trivedi & S. M. Hasan (Authors)

First Edition, September, 2000

Fax :- 661 2035 by IIB Mumbai. Contributing management and economy

Email :- arunt11@bom5.vsnl.net.in regularly to Vinimaya, IIB related issues. He is an

www.genesispublishers.com journal, IBA Bulletin and Indian awardee of commendation by

1. Fundamentals of Foreign Exchange 1

Spot and Forward Transactions 15 Spreading risks among different institutions 44

Contract risk 65 8. Forex and Money Market

Using Swaps : What Managers Must Know 78 Infrasturcture 120

Derivatives – FRA, IRS, Futures, Options 79

Enterprise Risk Management 136 CLS – operational changes 170

Neutral Patterns 200

17. SWIFT Operations 215

The economic challenge of globalization is presenting a new

This book is basically tailored for forex & treasury managers,

Substance for the more recently talked of topics in foreign

Besides, the book is to provide the reader with a framework for

subjects considered necessary for an understanding of the subject

International trade refers to trade between the residents of two

Each country functions as a sovereign State with its own set of

For instance if ‘A” of New York exports machinery to ‘B’, Mumbai,

The conversions of currencies are done by banks that deal in

The rate of exchange for a currency is known from the quotation

Evolution Of Exchange Rate System.

standard— the gold standard and setting up of International Monetary

1. The Gold Specie Standard - The payment of money is

Smithsonian Agreement - 1971

Euro is the name of common single currency of the Economic

Phase II: Began a January 1, 1994 ending on December 31,

Under this system the exchange rates are determined by the

of external reserves of the country, etc.

In actual practice the floating exchange rate co-exists with Speculators -

They are one of the important element in the market which

(b) Manage the foreign currency assets and liabilities of the

(a) To provide service for exports, imports and remittances for

Any transaction has two aspects- purchase and sale. A trader

l The bank has purchased, and

l It has purchased foreign currency

The quotation in which exchange rates is expressed as the

In direct quotation, the principle adopted by the bank is to buy

Mechanism Of Currency Trading

foreign exchange market, Bankers called foreign exchange dealer

In the normal two-way market a trader expects to be hit on both

sold more pounds than he has bought he is said to have a net

US Dollar 82 83 bid ask

Memorandum item: composition of forward contracts

The fixing of rate of exchange between the foreign currency and

Cross Exchange Rates if DM 2.0653 = USD 1

and USD 1 = RS 43.65

S(i/j) = S(i/$) / S(j/$)

Ready Exchange Rates

DM RS The foreign exchange dealing of a bank with its customers is

If the bank quotes the base rate to the customer, it makes no

In the interbank market exchange rate is quoted upto four decimals

Principle Types Of Buying Rates

Depending upon the time of realisation of foreign exchange by

1 month 0.05 discount 0.04 premium O R

(1) Buying Rates :

BILL BUYING RATES SELLING RATES