Treasury management

Definition
Treasury management is the process of administering to the
financial assets and holdings of a business. The goal of most
treasury management departments is to optimize their company's
liquidity, make sound financial investments for the future with
any excess cash, and reduce or enter into hedges against its
financial risks.
Another word treasury management is the financial center of the
organization, Which Protect and Stewardship of financial assets and the
management of financial liabilities.
Generally Treasury refers to the funds and revenue at the disposal of the
bank and day-to-day management of the same. So the treasury acts as the
custodian of cash and other liquid assets.
Hence the art of managing, within the acceptable level of risk, the consolidated fund of the
bank optimally and profitably is called Treasury Management.
IF WE HAVE TO DESCRIBE TREASURY MANAGEMENT, THEN WE CAN
STATE THAT IT IS THE MANAGEMENT OF CASH, FUND, CURRENCY, BANK
AND FINANCIAL RISK. SO, IT IS AN IMPERATIVE TOOL OF FINANCE. IN
THIS MANAGEMENT, FINANCE MANAGER CHECKS THE CASH INFLOW AND
OUTFLOW. HE MAKES THE LIST OF ALL RECEIVABLE AMOUNTS WHICH
WILL INCREASE TREASURE HOUSE OF COMPANY. HE ALSO TRACKS THE
DATES IN WHICH HE HAS TO RECEIVE THE FUND FROM DEBTORS.
UNDER THIS MANAGEMENT, HE ESTIMATES ALL FINANCIAL RISK FOR
INVESTMENT OF CASH. ALL INVESTMENT IS ON THE BASIS OF
INVESTMENT POLICY. MANY ORGANIZATIONS HAVE SEPARATE TREASURY
DEPARTMENT. IF COMPANY DEALS WITH FOREIGN CURRENCY, THEN
MANAGEMENT OF FOREIGN CURRENCY RISK IS THE DUTY OF TREASURY
DEPARTMENT.
FINALLY UNDER THE BASIS OF ABOVE DISCUSSION WE CAN CONCLUDE
THAT THE treasury department of a bank is responsible for
balancing and managing the daily cash flow and liquidity of funds
within the bank. The department also handles the bank's
investments in securities, foreign exchange, asset/liability
management and cash instruments.
FUNCTION/ROLE OF TREASURY DEPARTMENTS:-
The Treasury department in a bank is very critical. The basic trading
product for the banks is money. Simply stated, banks are intermediates
between the borrower and the saver or Investor. Irrespective of how good
the products offered to the customer are and whether there is top notch
customer service in the bank, if the bank is not able to satisfy the investors
and borrowers, then it is not in business.

It ensures that the investors and borrowers needs are met. Fundamentally the Treasury
department plays a very important role in the continual functioning of a bank. Some of
the important roles it plays are:

Reserve and Investment Management

Liquidity and Funds Management
Asset-Liability Management
Risk Management
Transfer Pricing
Derivatives Trading
Arbitrage
Minimize Currency Risk
Capital Adequacy

Liquidity and Funds Management

It ensures that the liquidity position of the bank is sound. One of the
conditions of the Central Bank as a regulatory authority to Banks is that
banks maintain a deposit account with it. The basic function of this account
is to ensure that the banks are able to settle their interbank obligations, as
and when they fall due. This usually means cheque payment and funds
transfer.

So Treasury department in the bank ensures that the account has sufficient
money to meet its obligations, even through overnight borrowing from
other banks. This quick loan in most cases charges high interest rate.

It is the main function of treasury management to maintain the liquidity of

business. Without proper liquidity, it is risk for business to operate

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smoothly. By using cash flow analysis and working capital management.
Treasury officer make good ratio of liquid assets and liquid liability.
Reserve and Investment management:-
Every commercial/Scheduled bank in Nepal has to keep certain minimum
amount of cash reserves with central bank of Nepal (NRB). Nepal rastra
bank uses CRR as a tool to increase or decrease the reserve requirement
depending on whether NRB wants to increase or decrease in the money
supply. An increase in CRR will make it mandatory for the banks to hold a
large proportion of their deposits in the form of deposits with the NRB. This
will reduce the amount of Bank deposits and they will lend less as they
have fewer amounts as their reserve. This will in turn decrease the money
supply. If NRB wants to increase Money supply it may reduce the rate of
CRR and it will allow the banks to keep large amount of their deposit with
themselves and they will lend more money. It will increase the money
supply. For example: When someone deposits Rs.100 in a bank, it increase
the deposit of banks by Rs100, and if the cash reserve ratio is 9%, the
banks will have to hold additional Rs. 9 with NRB and Bank will be able to
use only Rs 91 for investments and lending / credit purpose. Therefore,
higher the ratio (i.e. CRR), the lower is the amount that banks will be able
to use for lending and investment. NRB uses CRR to control liquidity in the
banking system.

Minimize Currency Risk

We have already explained that it is the function of treasury management
to minimize the currency risk. For this, treasury managers touch with
currency market of world. They analyze the reason of crisis in currency
market. Sometime this crisis will be benefited for them because they have
to pay less to other country for getting their service at cheap rates.
Asset-Liability Management
AS WE KNOW THAT BANK HAVE HUGE AMOUNT OF PUBLIC DEPOSIT AND
FINANCIAL INSTRUMENTS THOSE BELONGS TO ASSETS AND
OBLIGATIONS, NOW EVERY BUSINESS ORGANIZATIONS SHOULD
PROPERLY MANAGED THEIR ASSETS AND LIABILITIES. HERE WE CAN
CONSIDER FOLLOWING MAJOR TYPES OF ASSETS AND LIABILITIES.
CASH MANAGEMENT

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 CASH TRANSFER METHODS
CASH FORECASTING
CASH CONCENTRATION

WORKING CAPITAL MANAGEMENT

CREDIT MANAGEMENT
RECEIVABLES MANAGEMENT
INVENTORY MANAGEMENT
WORKING CAPITAL METRICS

FINANCING
DEBT MANAGEMENT
EQUITY MANAGEMENT

SOME OTHER MAJOR ROLE PLAYING BY TREASURY DEPARTMENT IS

MENTION BELOW:-
CASH FORECASTING
WORKING CAPITAL MANAGEMENT
CASH MANAGEMENT
INVESTMENT MANAGEMENT
TREASURY RISK MANAGEMENT
MANAGEMENT ADVICE
CREDIT RATING AGENCY RELATIONS
BANK RELATIONSHIPS
FUND RAISING
CREDIT GRANTING
OTHER ACTIVITIES (I.E. MERGER, ACQUISITION, SYSTEM
INTEGRATION)

TREASURY MANAGEMENT SYSTEM (TMS)

IT WILL AUTOMATE ALL STANDARD DAY TO DAY CORPORATE TREASURY
PROCESSES FROM FRONT THROUGH TO BACK AND MIDDLE OFFICE
THE SYSTEM WILL ALLOW THE CORPORATE TREASURER TO MANAGE THE
ORGANIZATIONS FINANCIAL RISKS AND LIQUIDITY PROFILE IN A

4
TRANSPARENT AND CONTROLLED ENVIRONMENT BY PROVIDING TIMELY
AND RELIABLE DATA.
(DIAGRAM AVAILABLE IN THE READER SLIDE)

TIME VALUE OF MONEY (TVM)

Time value of money is the idea that money available at the present time is worth
more than the same amount in the future due to its potential earning capacity. This
core principle of finance holds that, provided money can earn interest, any amount of
money is worth more the sooner it is received.

Everyone knows that money deposited in a savings account will earn

interest. Because of this universal fact, we would prefer to receive money
today rather than the same amount in the future.
For example, assuming a 5% interest rate, $100 invested today will be
worth $105 in one year ($100 multiplied by 1.05). Conversely, $100
received one year from now is only worth $95.24 today ($100 divided by
1.05), assuming a 5% interest rate.

Time value of money is the concept that the value of a dollar to be

received in future is less than the value of a dollar on hand today.
One reason is that money received today can be invested thus generating
more money. Another reason is that when a person opts to receive a sum
of money in future rather than today, he is effectively lending the money
and there are risks involved in lending such as default risk and inflation.
Default risk arises when the borrower does not pay the money back to the
lender. Inflation is the rise in general level of prices.
Time value of money principle also applies when comparing the worth of
money to be received in future and the worth of money to be received in
further future. In other words, TVM principle says that the value of given
sum of money to be received on a particular date is more than same sum
of money to be received on a later date.

Few of the basic terms used in time value of money calculations

are:
Present Value
When a future payment or series of payments are discounted at the given
rate of interest up to the present date to reflect the time value of money,
5
the resulting value is called present value. Present Value of a Single Sum of
Money and Present Value of an Annuity

Present Value of a Single Sum of Money

Present value of a future single sum of money is the value that is obtained
when the future value is discounted at a specific given rate of interest. In
the other words present value of a single sum of money is the amount
that, if invested on a given date at a specific rate of interest, will equate
the sum of the amount invested and the compound interest earned on its
investment with the face value of the future single sum of money.
Formula
The formula to calculate present value of a future single sum of money is:
Future Value (FV)
Present Value (PV) =
(1 + i)n
Where,
I is the interest rate per compounding period; and n are the number of
compounding periods.
Examples
Example 1: Calculate the present value on Jan 1, 2011 of $1,500 to be
received on Dec 31, 2011. The market interest rate is 9%. Compounding is
done on monthly basis.
Solution
We have,
Future Value FV = $1,500
Compounding Periods n = 12
Interest Rate i = 9%/12 = 0.75%
Present Value PV = $1,500 / (1 + 0.75%) ^12
= $1,500 / 1.0075^12
$1,500 / 1.093807
$1,371.36
Example 2: A friend of you has won a prize of $10,000 to be paid exactly
after 2 years. On the same day, he was offered $8,000 as a consideration
for his agreement to sell the right to receive the prize. The market interest
rate is 12% and the interest is compounded on monthly basis. Help him by
determining whether the offer should be accepted or not.
6
Solution
Here you will compute the present value of the prize and compare it with
the amount offered to your friend. It will be good to accept the offer if the
present value of the prize is less than the amount offered.
So,
Future Value FV = $10,000
Compounding Periods n = 2 12 = 24
Interest Rate i = 12%/12 = 1%
Present Value PV = $10,000 / (1 + 1%) ^24
= $10,000 / 1.01^24
$10,000 / 1.269735
$7,875.66
Since the present value of the prize is less than the amount offered, it is
good to accept the offer.
Present Value of an Annuity
An annuity is a series of evenly spaced equal payments made for a certain
amount of time. There are two basic types of annuity known as ordinary
annuity and annuity due. Ordinary annuity is one in which periodic
payments are made at the end of each period. Annuity due is the
one in which periodic payments are made at the beginning of each
period.
The present value an annuity is the sum of the periodic payments each
discounted at the given rate of interest to reflect the time value of money.
Alternatively defined, the present value of an annuity is the amount which
if invested at the start of first period at the given rate of interest will
equate the sum of the amount invested and the compound interest earned
on the investment with the product of number of the periodic payments
and the face value of each payment.
Formula
Although the present value (PV) of an annuity can be calculated by
discounting each periodic payment separately to the starting point and
then adding up all the discounted figures, however, it is more convenient
to use the 'one step' formulas given below.
1 (1 + i)-n
PV of an Ordinary Annuity = R
I
PV of an Annuity Due = R 1 (1 + i)-n (1 + i)
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 i
Where,
i is the interest rate per compounding period; n are the number of
compounding periods; and R is the fixed periodic payment.
Examples
Example 1: Calculate the present value on Jan 1, 2011 of an annuity of
$500 paid at the end of each month of the calendar year 2011. The annual
interest rate is 12%.
Solution
We have,
Periodic Payment R = $500
Number of Periods n = 12
Interest Rate i = 12%/12 = 1%
Present Value PV = $500 (1-(1+1%)^(-12))/1%
= $500 (1-1.01^-12)/1%
$500 (1-0.88745)/1%
$500 0.11255/1%
$500 11.255
$5,627.54
Example 2: A certain amount was invested on Jan 1, 2010 such that it
generated a periodic payment of $1,000 at the beginning of each month of
the calendar year 2010. The interest rate on the investment was 13.2%.
Calculate the original investment and the interest earned.
Solution
Periodic Payment R = $1,000
Number of Periods n = 12
Interest Rate i = 13.2%/12 = 1.1%
Original Investment = PV of annuity due on Jan 1, 2010
= $1,000 (1-(1+1.1%)^(-12))/1.1% (1+1.1%)
= $1,000 (1-1.011^-12)/0.011 1.011

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 $1,000 (1-0.876973)/0.011 1.011
$1,000 0.123027/0.011 1.011
$1,000 11.184289 1.011
$11,307.32
Interest Earned $1,000 12 $11,307.32
$692.68
Future Value
Future value is amount that is obtained by enhancing the value of a
present payment or a series of payments at the given rate of interest to
reflect the time value of money.
Future Value of a Single Sum of Money and Future Value of an Annuity

Future Value of a Single Sum of Money

Future value of a present single sum of money is the amount that will be
obtained in future if the present single sum of money is invested on a
given date at the given rate of interest. The future value is the sum of
present value and the compound interest.

Formula
The future value of a single sum of money is calculated by using the
following formula.

Future Value (FV) = Present Value (PV) (1 + i)n

Where, i is the interest rate per compounding period; and n are the
number of compounding periods.
Examples

Example 1: An amount of $10,000 was invested on Jan 1, 2011 at annual

interest rate of 8%. Calculate the value of the investment on Dec 31, 2013.
Compounding is done on quarterly basis.
Solution
9
We have,
Present Value PV = $10,000
Compounding Periods n = 3 4 = 12
Interest Rate i = 8%/4 = 2%
Future Value FV = $10,000 (1 + 2%) ^12
= $10,000 1.02^12
$10,000 1.268242
$12,682.42
Example 2: An amount of $25,000 was invested on Jan 1, 2010 at annual
interest rate of 10.8% compounded on quarterly basis. On Jan 1, 2011 the
terms or the agreement were changed such that compounding was to be
done twice a month from Jan 1, 2011. The interest rate remained the
same. Calculate the total value of investment on Dec 31, 2011.
Solution
The problem can be easily solved in two steps:
STEP 1: Jan 1 - Dec 31, 2010
Present Value PV1 = $25,000
Compounding Periods n=4
Interest Rate i = 10.8%/4 = 2.7%
Future Value FV1 = $25,000 (1 + 2.7%) ^4
= $25,000 1.027^4
$25,000 1.112453
$27,811.33
STEP 1: Jan 1 - Dec 31, 2011
Present Value PV2 = FV1 = $27,811.33
Compounding Periods n = 2 12 = 24
Interest Rate i = 10.8%/24 = 0.45%
Future Value FV2 = $27,811.33 (1 + 0.45%) ^24
= $27,811.33 1.0045^24
$27,811.33 1.113778
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 $30.975.64
Future Value of an Annuity

The future value of an annuity is the value of its periodic payments each
enhanced at a specific rate of interest for given number of periods to
reflect the time value of money. In other words, future value of an annuity
is equal to the sum of face value of periodic annuity payments and the
total compound interest earned on all periodic payments till the future
value point.
Formula
There are two types of annuity. The one in which payments occur at the
end of each period is called ordinary annuity and the other in which
payments occur at the beginning of each period is called annuity due. Both
types have different formulas for future value calculation:
(1 + i)n 1
FV of Ordinary Annuity = R
I
(1 + i)n 1
FV of Annuity Due = R (1 + i)
i
In the above formulas, i is the interest rate per compounding period; n are
the number of compounding periods; and R is the fixed periodic payment.

Examples
Example 1: Mr. A. deposited $700 at the end of each month of calendar
year 2010 in an investment account of 9% annual interest rate. Calculate
the future value of the annuity on Dec 31, 2011. Compounding is done on
monthly basis.
Solution
We have,
Periodic Payment R = $700
Number of Periods n = 12
Interest Rate i = 9%/12 = 0.75%
Future Value PV = $700 {(1+0.75%) ^12-1}/1%

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 = $700 {1.0075^12-1}/0.01
$700 (1.0938069-1)/0.01
$700 0.0938069/0.01
$700 9.38069
$6,566.48
Example 2: Calculate the future value of 12 monthly deposits of $1,000 if
each payment is made on the first day of the month and the interest rate
per month is 1.1%. Also calculate the total interest earned on the deposits
if the whole amount is withdrawn on the last day of 12th month.
Solution
Periodic Payment R = $1,000
Number of Periods n = 12
Interest Rate i = 1.1%
Future Value = $1,000 {(1+1.1%)^12-1}/1.1% (1+1.1%)
= $1,000 {1.011^12-1}/0.011 (1+0.011)
= $1,000 (1.140286-1)/0.011 1.011
$1,000 0.140286/0.011 1.011
$1,000 12.75329059 1.011
$12,893.58
Interest Earned $12,893.58 - $1,000 12
$893.58
Interest
Interest is charge against use of money paid by the borrower to the lender
in addition to the actual money lent.

Simple vs. Compound Interest Calculation

Interest is the charge against the use of money by the borrower. The same
is profit earned by the lender of money. The amount which is invested in a
bank in order to earn interest is called principal. The interest rate is
normally expressed in percentage and represents the dollar interest
earned per $100 of principal in a specific time, usually a year. Simple
12
interest and compound interest are the two types of interest based on the
way they are calculated.
Simple Interest
Simple interest is charged only on the principal amount. The following
formula can be used to calculate simple interest:
Simple Interest (Is) = P i t
Where,
P is the principle amount; i is the interest rate per period; t is the time
for which the money is borrowed or lent.
Compound Interest
Compound interest is charged on the principal plus any interest accrued till
the point of time at which interest is being calculated. In other words,
compound interest system works as follows:

1. Interest for the first period charged on principle amount.

2. For the second period, its charged on the sum of principle amount
and interest charged during the first period.

3. For the third period, it is charged on the sum of principle amount

and interest charged during first and second period, and so on ...

It can be proved mathematically, that the interest calculated as per above

procedure is given by the following formula:
Compound Interest (Ic) = P (1 + i) n
P
Where,
P is the principle amount; i is the compound interest rate per period;
n are the number of periods.

VALUATION OF SECURITIES:-
UNDER VALUATION OF SECURITIES WE ARE CONSIDER ON STOCK
VALUATION AND BOND ANALYSIS.
STOCK VALUATION:-
BOND ANALYSIS:-
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ANALYSIS OF FINANCIAL INSTITUTIONS:-
In financial economics, a financial institution acts as an agent that provides
financial services for its clients. Financial institutions generally fall under
financial regulation from a government authority.
ANOTHER WAY WE CAN SAY FINANCIAL INSTITUTION ARE THOSE
ORGANIZATIONS WHICH ARE PLAYING THE ROLE OF INTERMEDIARIES
BETWEEN TWO OR MORE THAN TWO PARTIES (SAVER AND BORROWER)
FOR THE MOBILIZATION OF FUND.
IN THE CASE OF NEPAL WE HAVE SEEN FOLLOWING MAJOR TYPES OF
FINANCIAL INSTITUTIONS
DEPOSITORY INSTITUTIONS
NON-DEPOSITORY OR CONTRACTUAL INSTITUTIONS
SIMPLY DEPOSITORY INSTITUTIONS BELONG TO THOSE ORGANIZATIONS
WHO ACCEPT THE DEPOSIT FROM THE MARKETS. ALL THE DEPOSITORY
ORGANIZATIONS ARE REGULATED BY GOVERNMENTAL AUTHORITY OR
CENTRAL BANK.
Banks
A bank is a commercial or state institution that provides financial services,
including issuing money in various forms, receiving deposits of money,
lending money and processing transactions and the creating of credit.
UNDER THE ACT OF CENTER BANK DEPOSITORY INSTITUTIONS ARE
CLASSIFIED ON FOUR GROUPS.
Types of Bank NO. of Banks
Central Bank 1
A Class (Commercial) 28
bank
B Class Financial institutions 79
C Class Financial institutions 50
D Class financial 36
institutions
www.nrb.org.np/monetaryPOLICY (2015/2016)

Central Bank
A central bank, reserve bank or monetary authority, is an entity
responsible for the monetary policy of its country or of a group of member

14
states, such as the European Central Bank (ECB) in the European Union,
the Federal Reserve System in the United States of America, State Bank in
Pakistan, Nepal rastra bank in Nepal.
Its primary responsibility is to maintain the stability of the national
currency and money supply, but more active duties include controlling
subsidized-loan interest rates and acting as a lender of last resort to the
banking sector during times of financial crisis
Commercial Banks
A commercial bank accepts deposits from customers and in turn makes
loans, even in excess of the deposits; a process known as fractional-
reserve banking. Some banks (called Banks of issue) issue banknotes as
legal tender.
Commercial banks comprise the largest group of depository institutions in
size. In Nepal Commercial banks are dominant financial institutions. Nepal
Rastra Bank (Central Bank of Nepal) licensed them as A" class. Currently
there are 30 commercial banks in Nepal. Few names and
respective websites are given below.
S. No. Name of Commercial Bank Website (URL)

1 Nepal Bank Ltd. www.nepalbank.com.np

2 Rastriya Banijya Bank Ltd www.rbb.com.np

3 Agricultural Development Bank Ltd. www.adbl.gov.np

4 Nabil Bank Ltd. www.nabilbank.com

5 Nepal Investment Bank Ltd. www.nibl.com.np

6 Standard Chartered Bank Nepal Ltd. www.standardchartered.com/np/

7 Himalayan Bank Ltd. www.himalayanbank.com

8 Nepal SBI Bank Ltd. www.nepalsbi.com.np

9 Nepal Bangladesh Bank Ltd. www.nbbl.com.np

10 Everest Bank Ltd. www.everestbankltd.com

15
DEVELOPMENT Banks
DEVELOPMENT banks help companies and governments and their
agencies to raise money by issuing and selling securities in the primary
market. They assist public and private corporations in raising funds in the
capital markets (both equity and debt), as well as in providing strategic
advisory services for mergers, acquisitions and other types of financial
transactions.

FINANCE COMPANIES IN NEPAL

Finance company is an organization that originates loans for both

businesses and consumers. Much like a bank, a typical finance company
acts as a lending entity by extending credit. However, the main difference
between a bank and a finance company is that, unlike a bank, a finance
company does not accept deposits from the public. Instead, a finance
company may draw funding from banks and various other money market
resources. But in case of Nepal, finance companies also a depository
institution. They are licensed by Nepal Rastra Bank "C" class.
Micro Finance Banks
For the purpose of poverty reduction program, such kinds of banks are
working in the different countries with the contribution of UNO or World
Bank.
In Nepal 17 Micro Finance Banks are providing services under the central
bank regulation.
NON- DEPOSITORY OR CONTRACTUAL FINANCIAL INSTITUTIONS
UNDER THIS SECTION WE HAVE CONSIDER FOLLOWING TYPES OF
ORGANIZATIONS.
Insurances Companies
Insurance companies may be classified as
1. Life insurance companies, which sell life insurance, annuities and
pensions products.
2. Non-life or general insurance companies, which sell other types of
insurance.
Mutual Fund
16
 An investment which is comprised of a pool of funds collected from many
investors for the purpose of investing in securities such as stocks, bonds,
money market securities and similar assets.
Mutual funds are operated by money managers, who invest the fund's
capital and attempt to produce capital gains and income for the fund's
investors. A mutual fund's portfolio is structured and maintained to match
the investment objectives stated in its prospectus.
Brokerage Houses
Stock brokers assist people in investing, online only companies are called
'discount brokerages', companies with a branch presence are called 'full
service brokerages' or 'private client services.

FINANCIAL STATEMENT ANALYSIS

What is Finance?

Term "finance" in our simple understanding it is perceived as equivalent to 'Money'. But

finance exactly is not money; it is the source of providing funds for a particular activity.
Thus finance does not mean the money with the Government, but it refers to sources of
raising revenue for the activities and functions of a Government.

Financial system

Financial system can be defined as the global, regional and firm specific level.

The firm's financial system is the set of implemented procedures

that track the financial activities of the company.

On a regional scale, the financial system is the system that

enables lenders and borrowers to exchange fund.

The global financial system is basically a broader regional system

that encompasses all financial institutions, borrowers and lenders
within the global economy.

17
 Financial markets

Financial System: Financial system consists of financial institutions, such as banks and
credit unions; financial markets; and payment system.

It is the channel through which savings become the investments and money and financial
claims are transferred and settled.

FINANCIAL INSTITUTIONS/INTERMEDIARIES

In financial economics, a financial institution acts as an agent that

provides financial services for its clients. Financial institutions generally
fall under financial regulation from a government authority.

Common types of financial institutions include banks, Insurance Co,

Leasing Co, Investment Co, Mutual Funds

Segment of financial system/market:-

Generally in financial system fund can be flow in two ways, those are
mention below.

Direct finance:-

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In direct finance system borrowers borrow directly from lenders in financial
market by knowing each other or basis on trust as well as selling financial
instruments which are claims on the borrowers future income or assets.

Indirect finance:-

Here borrowers borrow indirectly from lenders via financial intermediaries

(established to source both loan able fund and loan opportunities) by
issuing financial instruments which are claims on the borrowers future
income or assets.

FINANCIAL MARKETS
Market where entities can trade financial securities, commodities,
at low transaction costs and at prices that reflect supply and
demand. Securities include stocks and bonds, and commodities
include precious metals or agricultural goods.

KINDS OF FINANCIAL MARKET

Money
market
As per RBI
definitions
A market
for short
terms financial assets that are close substitute for money,
facilitates the exchange of money in primary and
secondary market.
The money market is a mechanism that deals with the lending
and borrowing of short term funds (less than one year).
It is the segment of the financial market in which financial
instruments with high liquidity and very short maturities are
traded.
19
It doesnt actually deal in cash or money but deals with substitute of cash
like trade bills, promissory notes & government papers which can convert
into cash without any loss at low transaction cost. It includes all individual,
institution and intermediaries.

Features of Money Market

It is a market purely for short-terms funds or financial assets called
near money.
It deals with financial assets having a maturity period less than one
year only.
In Money Market transaction cannot take place formal like stock
exchange, only through oral communication, relevant document and
written communication transaction can be done.
Transaction has to be conducted without the help of brokers.

It is not a single homogeneous market, it comprises of several

submarket like call money market, acceptance & bill market.
The component of Money Market is the commercial banks,
acceptance houses & NBFC (Non-banking financial companies).
Objective of Money Market
To provide a parking place to employ short term surplus funds.

To provide room for overcoming short term deficits.

To enable the central bank to influence and regulate liquidity in the

economy through its intervention in this market.
To provide a reasonable access to users of short-term funds to meet
their requirement quickly, adequately at reasonable cost.
Importance of Money Market
o Development of trade & industry.
o Development of capital market.
o Smooth functioning of commercial banks.
o Effective central bank control.
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 o Formulation of suitable monetary policy.
o Non inflationary source of finance to government.
Composition of Money Market
Money Market consists of a number of sub-markets which collectively
constitute the money market. They are,
Call Money Market

Commercial bills market or discount market

Acceptance market

Treasury bill market

Instrument of Money Market

A variety of instruments are available in a developed money market. Some
of them are mention below:-
Treasury bills
Money at call and short notice in the call loan market. Commercial
bills, promissory notes in the bill market.
New instrument
Now, in addition to the above the following new instruments are
available:
Commercial papers.

Certificate of deposit.

Bankers Acceptance

Repurchase agreement

Money Market mutual fund

21
 CAPITAL MARKET
The market where investment instruments like bonds, equities and
mortgages are traded is known as the capital market. The primal role of
this market is to make investment from investors who have surplus funds
to the ones who are running a deficit.

Capital markets are markets for buying and selling equity and
debt instruments. Capital markets channel savings and
investment between suppliers of capital such as retail investors
and institutional investors, and users of capital like businesses,
government and individuals. Capital markets are vital to the
functioning of an economy, since capital is a critical component
for generating economic output. Capital markets include primary
markets, where new stock and bond issues are sold to investors,
and secondary markets, which trade existing securities.

The capital market offers both long term and overnight funds. The different
types of financial instruments that are traded in the capital markets are:
> Equity instruments
> Credit market instruments,
> Insurance instruments,
> Foreign exchange instruments,
> Hybrid instruments and
> Derivative instruments.

Nature of capital market

The nature of capital market is brought out by the following facts:
It Has Two Segments

It Deals In Long-Term Securities

It Performs Trade-off Function

It Creates Dispersion In Business Ownership

22
 It Helps In Capital Formation

It Helps In Creating Liquidity

Significance of Capital Market

Link between savers and investors

Stability in security prices

Speed up economic growth and development

Helps in capital formation

Helps in creating liquidity

Types of capital market:-

There are two types of capital market:
Primary market,

Secondary market

Primary market:-

23
It is that market in which shares, debentures and other securities are sold
for the first time for collecting long-term capital.
This market is concerned with new issues. Therefore, the primary market is
also called new issue market/initial markets. In this market, the flow of
funds is from savers to borrowers (industries), hence, it helps directly in
the capital formation of the country. The money collected from this market
is generally used by the companies to modernize the plant, machinery and
buildings, for extending business, and for setting up new business unit.
Features of Primary Market
It Is Related With New Issues

It Has No Particular Place

It Has Various Methods Of Float Capital: Following are the methods of

raising capital in the primary market:

Public issue
Private placement
Euro issues
Government securities
Offer for sale
Right issue
Electronic initial public offering
It comes before Secondary Market

Secondary Market
The secondary market is that market in which the buying and
selling of the previously issued securities is done.
The transactions of the secondary market are generally done through the
medium of stock exchange. The chief purpose of the secondary market is
to create liquidity in securities.
If an individual has bought some security and he now wants to sell it, he
can do so through the medium of stock exchange to sell or purchase

24
through the medium of stock exchange requires the services of the broker
presently, there are 24 stock exchanges in India.
Features of Secondary Market
It Creates Liquidity

It Comes After Primary Market

It Has A Particular Place

It Encourages New Investments

Help in determining fair prices based on demand and supply forces

and all available information
Participants in the Secondary Market
Stock Exchange

Clearing Corporation

Depositories/ DP

Trading Member (Stock Broker)/ Clearing Member

Registrar to an Issue and Share Transfer Agent

What are the products deals in Secondary Markets?

Equity shares

Debentures

Government securities

Bonds

Stock exchange
The history of securities market began with the floatation of shares by
Biratnagar Jute Mills Ltd. and Nepal Bank Ltd. in 1937. Introduction of the
Company Act in 1964, the first issuance of Government Bond in 1964 and
the establishment of Securities Exchange Center Ltd. in 1976 were other
significant development relating to capital markets.

25
Securities Exchange Center was established with an objective of facilitating
and promoting the growth of capital markets. Before conversion into stock
exchange it was the only capital markets institution undertaking the job of
brokering, underwriting, managing public issue, market making for
government bonds and other financial services. Nepal Government, under
a program initiated to reform capital markets converted Securities
Exchange Center into Nepal Stock Exchange in 1993.
The Nepal Stock Exchange Limited (abbreviated as NEPSE) is the only
Stock Exchange of Nepal. It is located in Singha Durbar Plaza, Kathmandu
Nepal. On March 23, 2014 the equity market capitalization of the
companies listed on NEPSE was approximately US$7896 million.
The basic objective of NEPSE is to impart free marketability and liquidity to
the government and corporate securities by facilitating transactions in its
trading floor through member, market intermediaries, such as broker,
market makers etc. NEPSE opened its trading floor on 13 January 1994. As
on April 4, 2013, the number of listed companies is 334, which includes
Commercial Banks, Hydro Power Companies, Insurance Companies and
Finance Companies among others. The Exchange has 50 registered brokers
as of April 2013. The NEPSE Index is primary all equity market index of
NEPSE. It is regulated by the Securities Board of Nepal.
Members of NEPSE are permitted to act as intermediaries in buying and
selling of government bonds and listed corporate securities. At present,
there are 50 member brokers and 2 market makers, who operate on the
trading floor as per the Securities Act, 2007, rules and bye-laws.
Trading System
NEPSE operates on the NEPSE Automated Trading System (NATS), a fully
screen based automated trading system, which adopts the principle of an
order driven market. Purchase & Sell of Physical as well as dematerialized
securities is done through NATS.
Market Timing
Trading on equities takes place on all days of week (except Saturdays and
holidays declared by exchange in advance). On Friday only odd lot trading
is done.
The market timings of the equities are: - Market Open: - 12:00 PM Market
Close: - 15:00 PM
26
Odd Lot Trading is done on Fridays. For Odd Lot Trading Market Timings are
Market Open: - 12:00 PM Market Close: - 13:00 PM
Note: - The exchange may however close the market on days other than
schedule holidays or may open the market on days originally declared as
holidays. The exchange may also extend, advance or reduce trading hours
when it deems it necessary.
Here some major exchange markets in the world are shown below.
1. New York Stock Exchange (NYSE) - Headquartered in New York City,
Market Capitalization (2011, USD Billions) 14,242; Trade Value (2011,
USD Billions) 20,161.
NYSE IS the largest stock exchange in the world by both market
capitalization and trade value. NYSE is the premier listing venue for the
worlds leading large- and medium-sized companies. Operated by NYSE
Euro next, the holding company created by the combination of NYSE
Group, Inc. and Euronext N.V., NYSE offers a broad and growing array of
financial products and services in cash equities, futures, options,
exchange-traded products (ETPs), bonds, market data, and commercial
technology solutions. Featuring more than 8000 listed issues it includes
90% of the Dow Jones Industrial Average and 82% of the S&P 500 stock
market indexes volume.
2. NASDAQ OMX - Headquartered in New York City, Market Capitalization
(2011, USD Billions) - 4,687; Trade Value (2011, USD Billions) 13,552.
It is the Second largest stock exchange in the world by market
capitalization and trade value. The exchange is owned by NASDAQ OMX
Group which also owns and operates 24 markets, 3 clearinghouses and 5
central securities depositories supporting equities, options, fixed income,
derivatives, commodities, futures and structured products. It is a home to
approximately 3,400 listed companies and its main index is the NASDAQ
Composite, which has been published since its inception. Stock market is
also followed by S&P 500 index.
3. Tokyo Stock Exchange - Headquartered in Tokyo, Market Capitalization
(2011, USD Billions) 3,325; Trade Value (2011, USD Billions) 3,972.
It is the third largest stock exchange market in the world by aggregate
market capitalization of its listed companies. It had 2,292 companies which
are separated into the First Section for large companies, the Second
27
Section for mid-sized companies, and the Mothers section for high growth
startup companies. The main indices tracking Tokyo Stock Exchange are
the Nikkei 225 index of companies selected by the Nihon Keizai Shimbun,
the TOPIX index based on the share prices of First Section companies, and
the J30 index of large industrial companies. 94 domestic and 10 foreign
securities companies participate in TSE trading. The London Stock
Exchange and the Tokyo Stock Exchange are developing jointly traded
products and share technology.
4. London Stock Exchange - Headquartered in London, Market
Capitalization (2011, USD Billions) 3,266; Trade Value (2011, USD Billions)
2,871.
Located in London City, it is the oldest and fourth-largest stock exchange
in the world. The Exchange was founded in 1801 and its current premises
are situated in Paternoster Square close to St Pauls Cathedral. It is the
most international of all the worlds stock exchanges, with around 3,000
companies from over 70 countries admitted to trading on its markets. The
London Stock Exchange runs several markets for listing, giving an
opportunity for different sized companies to list. For the biggest companies
exists the Premium Listed Main Market, while in terms of smaller SMEs the
Stock Exchange operates the Alternative Investment Market and for
international companies that fall outside the EU, it operates the Depository
Receipt scheme as a way of listing and raising capital.
5. Shanghai Stock Exchange - Headquartered in Shanghai, Market
Capitalization (2011, USD Billions) 2,357; Trade Value (2011, USD Billions)
3,658.
It is the worlds 5th largest stock market by market capitalization and one
of the two stock exchanges operating independently in the Peoples
Republic of China. Unlike the Hong Kong Stock Exchange, the SSE is not
entirely open to foreign investors. The main reason is tight capital account
controls by Chinese authorities. The securities listed at the SSE include the
three main categories of stocks, bonds, and funds. Bonds traded on SSE
include treasury bonds, corporate bonds, and convertible corporate bonds.
The largest company in SSE is PetroChina (market value 3,656.20 billion).
Credit market

The broad market for companies looking to raise funds through debt
issuance, the credit market encompasses investment-grade bonds and
28
junk bonds, as well as short-term commercial paper. The market for debt
offerings as seen by investors bonds, notes and securitized obligations
such as mortgage pools and collateralized debt obligations (CDOs).

The credit markets dwarf the equity markets in terms of dollar value. As
such, the current state of the credit markets tells us the relative health of a
large portion of the financial community if we examine the prevailing
interest rates and look at investor demand for various grades of credit -
from "riskless" (as in Treasury Bonds) to junk bonds that carry high default
risks. More demand from investors will prompt companies and lenders to
issue more bonds, the effects of which will spill over into the equity
markets.

There are broad classes of mutual funds and ETFs that invest solely in the
credit markets, allowing investors to add fixed-income exposure to their
portfolios without purchasing individual securities.

Financial market in Nepal

Already we discussion about the basic concept of financial market, now in
this section we are looking to the context of Nepalese scenario.
The growth of the financial market is gaining importance to every
interested professionals and investor in general both from domestic
perspective and international context. The role of financial sector had
made everyone to have their specific goals attuned to take tangible
financial benefits from the efficient functioning of the financial system. In
broader understanding, prosperity and development of every nation
depend much on the manner how financial market plays a role in the
transfer of funds from savers to users. Financial market now became an
integrating factor in creating the linkage of the various sectors of the
economy. Development of real sector is proving significant in financial
market. Taking the case of Nepal, financial system is slowly bringing
significant macro-economic policy transformation effect as well as
multiplying financial fortunes of the individual investors actively
participating in financial markets. Moreover, the governments role is
proving vital to the growth of financial institutions and financial market.
29
altogether, there exist at present 28 commercial banks that comprise 2
local commercial banks that include Rural Development Banks as well and
79 development bank. Then, in the chain of development, financial system
covers 50 finance companies, 25 insurance companies, 36 saving and
credit cooperatives having permission to operate with Nepal Rastra Bank
license and 47 Non-Government Organizations licensed to perform limited
banking functions in addition to micro credit development banks under the
supervision and monitoring of NRB.
In Nepal there is no long history of financial markets after the development
of Nepal bank limited (1937), lead to the development of modern banking
and financial market. Now at the present we have seen following major
type of financial market in Nepal.
Insurance market
Security market
Derivative market
Commodity market

ASSET-LIABILTY MANAGEMENT (ALM)

Concept of ALM
ALM is concerned with strategic management of Balance Sheet by giving
due weight- age to market risks viz. Liquidity Risk, Interest Rate Risk &
Currency Risk.
ALM function involves planning, directing, controlling the flow, level, mix,
cost and yield of funds of the bank. ALM builds up Assets and Liabilities of
the bank based on the concept of Net Interest Income (NII) or Net Interest
Margin (NIM).
Definition
It is a dynamic process of Planning, Organizing & Controlling of
Assets & Liabilities- their volumes, mixes, maturities, yields and
costs in order to maintain liquidity and net interest income (NII).
ALM is a series of management tools designed to minimise risk exposure of
banks, hence, loss of profit and value of banks. ALM comprises all areas
related to banking operations loans, deposit, portfolio investment, capital
management etc.

30
Asset-liability management models enable institutions to measure and
monitor risk, and provide suitable strategies for their management. An
effective Asset Liability Management Technique aims to manage the
volume, mix, maturity, rate sensitivity, quality and liquidity of assets and
liabilities as a whole so as to attain a predetermined acceptable
risk/reward ratio

ALM is the process involving decision making about the

composition of assets and liabilities including off balance sheet
items of the bank / FI and conducting the risk assessment.
ALM Strategies
There are three ALM techniques
Asset Management Strategy (AMS) this is a strategy concerns with
control of incoming funds through the determination of loans/credits
allocation and their interest rates.
Liability Management Strategy (LMS) deals with controlling of
sources of funds and monitoring of the mix and cost of deposit and non
deposit liabilities by controlling price, interest rate.
Fund Management Strategy (FMS) this approach of ALM that
incorporates both AMS and LMS. The basic objectives of FMS are:

-The control of volume, mix, and return or cost of both assets and
liabilities for the purpose of achieving a banks goals.
- The coordination of asset and liability management as a means of
achieving internal consistence and maximizing the spread between
revenue and costs, and minimization of risk exposure.
-Maximization of returns and minimization of costs from supplying
services.

Significance of ALM
Volatility
Product Innovations & Complexities

31
 Regulatory Environment
Management Recognition

WHY ALM?
Globalization of financial markets.

Deregulation of Interest Rates.

Multi-currency Balance Sheet.

Prevalence of Basis Risk and Embedded Option Risk.

Integration of Markets Money Market, FOREX Market, Government

Securities Market.

Narrowing NII / NIM.

Purpose & Objective of ALM

An effective Asset Liability Management Technique aims to manage the
volume, mix, maturity, rate sensitivity, quality and liquidity of assets
and liabilities as a whole so as to attain a predetermined acceptable
risk/reward ration.
ALM Objectives
Liquidity Risk Management.

Interest Rate Risk Management.

Currency Risks Management.

Profit Planning and Growth Projection.

It is aimed to stabilize short-term profits, long-term earnings and long-

term substance of the bank. The parameters for stabilizing ALM system
are:
1. Net Interest Income (NII)
2. Net Interest Margin (NIM)
3. Economic Equity Ratio (EER)
ALM Process
32
 R i s k P a r a m e t e r s

R i s k I d e n t i fi c a t i o n

R i s k M e a s u r e m e n t

R i s k M a n a g e m e n t

R i s k P o l i c i e s a n d T o l e r a n c e L e v e l

The Asset - Liability Committee (ALCO)

A risk-management committee in a bank or other lending
institution that generally comprises the senior-management
levels of the institution. The ALCO's primary goal is to evaluate,
monitor and approve practices relating to risk due to imbalances
in the capital structure.

For example, the ALCO will have responsibility for setting limits on the
arbitrage of borrowing in the short-term markets, while lending long-term
instruments. Among the factors considered are liquidity risk, interest rate
risk, operational risk and external events that may affect the bank's
forecast and strategic balance-sheet allocations. The ALCO will generally
report to the board of directors and will also have regulatory reporting
responsibilities.

Asset-Liability Committee ALCO is a senior management level

committee responsible for supervision/management of Market
Risk (mainly interest rate and liquidity risks). The committee
generally comprises of senior managers from treasury, Chief Financial

33
Officer, business heads generating and using the funds of the bank, credit,
and individuals from the departments having direct link with interest rate
and liquidity risks. The CEO or any senior person nominated by CEO is the
head of the committee. The size as well as composition of ALCO depends
on the size of each bank, business mix and organizational complexity. To
be effective ALCO should have members from each area of the bank that
significantly influences liquidity risk.

Major responsibilities of the committee include:

Monitoring the structure /composition of banks assets and liabilities

Identifying balance sheet management issues like balance sheet gaps,
interest rate gap/profiles etc. that are leading to under- performance.

Developing maturity profile and mix of incremental assets and liabilities.

Determining interest rates the bank and deciding on the future business
strategy.

Reviewing and documenting bank's funding policy.

Deciding the transfer pricing policy of the bank.

Evaluating market risk involved in launching of new products.

Reviewing deposit-pricing strategy for the local market.

Receiving and reviewing reports on liquidity risk, market risk and capital
management

Reviewing liquidity contingency plan for the bank.

ALCO should ensure that risk management is not limited to collection of

data only. Rather, it will ensure that detailed analysis of assets and
liabilities is carried out so as to assess the overall balance sheet structure
and risk profile of the bank. The ALCO should cover the entire balance
sheet/business of the bank while carrying out the periodic analysis.

ALCO, consisting of the bank's senior management (including

CEO) should be responsible for ensuring adherence to the limits
set by the Board
34
 Is responsible for balance sheet planning from risk - return
perspective including the strategic management of interest rate
and liquidity risks
The role of ALCO includes product pricing for both deposits and
advances, desired maturity profile of the incremental assets and
liabilities,
It will have to develop a view on future direction of interest rate
movements and decide on a funding mix between fixed vs
floating rate funds, wholesale vs retail deposits, money market
vs capital market funding, domestic vs foreign currency funding
It should review the results of and progress in implementation of
the decisions made in the previous meetings
FUNCTIONS OF ALCO
The major functions of ALOC are mention below
- Implementation of ALM System
- Monitor the risk levels of the Bank.
- Articulate the Interest Rate Position & fix interest rate on Deposits &
Advances.
- Fix differential rate of interest rate on Bulk Deposits.
- Facilitating and coordinating to put in place the ALM System in the
Bank.
COMPONENTS OF A BANK BALANCE SHEET
Assets Liabilities
Cash and balance with Capital
NRB Reserves and
Bal. with banks and surplus
money at call and short Deposits
notices. Borrowings
Investments Other liabilities
Advances
Fixed assets

35
 Other assets

Contingent liabilities

Liabilities:-
Liability is an obligation that legally binds an individual or company to
settle a debt. When one is liable for a debt, they are responsible for
paying the debt or settling a wrongful act they may have committed.
In the case of a company, a liability is recorded on the balance sheet
and can include accounts payable, taxes, wages, accrued expenses, and
deferred revenues. Current liabilities are debts payable within one year,
while long-term liabilities are debts payable over a longer period.
Components of Liabilities
1. Capital:-
Capital represents owners contribution/stake in the bank.
- It serves as a cushion for depositors and creditors.
- It is considered to be a long term sources for the bank.
2. Reserves & Surplus
Reserve and surplus has includes following components.
I. Statutory Reserves
II. Capital Reserves
III. Investment Fluctuation Reserve
IV. Revenue and Other Reserves
V. Balance in Profit and Loss Account

3. Deposits
This is the main source of banks funds. The deposits are classified as
deposits payable on demand and time. They are reflected in balance
sheet as under:
I. Demand Deposits
II. Savings Bank Deposits
III. Term Deposits

36
4. Borrowings
(Borrowings include Refinance / Borrowings from NRB, Inter-bank & other
institutions)
I. Borrowings in Nepal
i) Nepal rastra bank
ii) Other Banks
iii) Other Institutions & Agencies
II. Borrowings outside Nepal
5. Other Liabilities & Provisions
It is grouped as under:
I. Bills Payable
II. Inter Office Adjustments (Net)
III. Interest Accrued
IV. Unsecured Redeemable Bonds
(Subordinated Debt for Tier-II Capital)
V. Others (including provisions)

Assets:-
Current assets
A balance sheet item which equals the sum of cash and cash
equivalents, accounts receivable, inventory, marketable securities,
prepaid expenses, and other assets that could be converted to cash in
less than one year
Fixed Asset
A long-term tangible piece of property that a firm owns and uses in the
production of its income and is not expected to be consumed or
converted into cash any sooner than at least one year's time
Components of Assets
1. Cash & Bank Balances with NRB
I. Cash in hand

37
 (Including foreign currency notes)
II. Balances with Nepal Rastra bank
In Current Accounts
In Other Accounts
2. Balances with banks and money at call & short notice
I. In Nepal
I) Balances with Banks
a) In Current Accounts
b) In Other Deposit Accounts
ii) Money at Call and Short Notice
a) With Banks
b) With Other Institutions
II. outside Nepal
a) In Current Accounts
b) In Other Deposit Accounts
c) Money at Call & Short Notice
3. Investments
A major asset item in the banks balance sheet, Reflected under 6
buckets as under:
I. Investments in Nepal
I) Government Securities
ii) Other approved Securities
iii) Shares
iv) Debentures and Bonds
v) Subsidiaries and Sponsored Institutions

38
 VI) Others (UTI Shares, Commercial Papers, COD &Mutual Fund Units
etc.)
II. Investments outside Nepal
In Subsidiaries and/or Associates abroad
4. Advances
The most important assets for banks are:-
A.) Bills Purchased and Discounted
ii) Cash Credits, Overdrafts & Loans repayable on demand
iii) Term Loans
B. Particulars of Advances:
i) Secured by tangible assets
(Including advances against Book Debts)
ii) Covered by Bank/ Government Guarantees
iii) Unsecured
5. Fixed Asset
I. Premises
II. Other Fixed Assets (Including furniture and fixtures)
6. Other Assets
I. Interest accrued
II. Tax paid in advance/tax deducted at source
(Net of Provisions)
III. Stationery and Stamps
IV. Non-banking assets acquired in satisfaction of claims
V. Deferred Tax Asset (Net)
VI. Others
Contingent Liability
39
Banks obligations under LCs, Guarantees, and Acceptances on behalf of
constituents and Bills accepted by the bank are reflected under this
heads.

Risk management in banking and financial institutions:-

Risk is defined as anything that can create hindrances in the way of
achievement of certain objectives. It can be because of either internal
factors or external factors, depending upon the type of risk that exists
within a particular situation. Exposure to that risk can make a situation
more critical.
A better way to deal with such a situation; is to take certain proactive
measures to identify any kind of risk that can result in undesirable
outcomes. In simple terms, it can be said that managing a risk in
advance is far better than waiting for its occurrence.
Risk Management is a measure that is used for identifying, analyzing
and then responding to a particular risk. Risk Management is the
application of proactive strategy to plan, lead, organize, and control
the wide variety of risks that are rushed into the fabric of an
organizations daily and long-term functioning. Like it or not, risk
has a say in the achievement of our goals and in the overall success
of an organization. Present paper is to make an attempt to identify the
risks faced by the banking industry and the process of risk
management.

40
 W CIL n i u q ti er l l
rur ee i d sn ti
n tcR y o y a t
w eR i s k
R i s k
b e
d i s c
u s s
e d
i n
d e t
a i l
PROCESS OF RISK MANAGEMENT:
To overcome the risk and to make banking function well, there is a need
to manage all kinds of risks associated with the banking. Risk
management becomes one of the main functions of any banking
services risk management consists of identifying the risk and controlling
them, means keeping the risk at acceptable level. These levels differ
from institution to institution and country to country. The basic objective
of risk management is to stakeholders; value by maximizing the profit
and optimizing the capital funds for ensuring long term solvency of the
banking organization. In the process of risk management following
functions comprises:
Risk management process

Risk organization with in the bank

Liquidity risk
Credit risk
Exchange risk

41
 Risk identification
Identify risk
Understand and analyze risk

Risk assessment and measurement

Assess the risk impact
Measure the risk impact

Risk control
Recommendation for risk control
Risk mitigation through control technique
Deputation of competent officers to deal with
the risk

Risk monitoring
Supervise the risk
Reporting on progress
Compliance with regulations follow-up

Risk-return trade-of
Balancing of risk against return

Liquidity Risk
Liquidity risk arises from funding of long term assets by short term
liabilities, thus making the liabilities subject to refinancing

42
 FTC uia m nl l de R i rni si gs k k r i s k
Liquidity Risk Management
Banks liquidity management is the process of generating funds to
meet contractual or relationship obligations at reasonable prices at all
times
Liquidity Management is the ability of bank to ensure that its
liabilities are met as they become due
Liquidity positions of bank should be measured on an ongoing basis

A standard tool for measuring and managing net funding

requirements, is the use of maturity ladder and calculation of
cumulative surplus or deficit of funds as selected maturity dates is
adopted
Credit Risk
Credit Risk is the potential that a bank borrower/counter party fails to
meet the obligations on agreed terms. There is always scope for the
borrower to default from his commitments for one or the other reason
resulting in crystallization of credit risk to the bank.
The objective of credit risk management is to minimize the risk and
maximize banks risk adjusted rate of return by assuming and

43
maintaining credit exposure within the acceptable parameters. The
management of credit risk includes
a) Measurement through credit rating/ scoring
b) Quantification through estimate of expected loan losses
c) Pricing on a scientific basis and
d) Controlling through effective Loan Review Mechanism and Portfolio
Management.
TOOLS OF CREDIT RISK MANAGEMENT
The instruments and tools, through which credit risk management is
carried out, are detailed below:
a) Exposure Ceilings: Prudential Limit is linked to Capital Funds say
15% for individual borrower entity, 40% for a group with additional 10%
for infrastructure projects undertaken by the group, Threshold limit is
fixed at a level lower than Prudential Exposure; Substantial Exposure,
which is the sum total of the exposures beyond threshold limit should
not exceed 600% to 800% of the Capital Funds of the bank (i.e. six to
eight times).
b) Review/Renewal: Multi-tier Credit Approving Authority, constitution
wise delegation of powers, Higher delegated powers for better-rated
customers; discriminatory time schedule for review/renewal, Hurdle
rates and Bench marks for fresh exposures and periodicity for renewal
based on risk rating, etc are formulated.
c) Risk Rating Model: Set up comprehensive risk scoring system on a
six to nine point scale. Clearly define rating thresholds and review the
ratings periodically preferably at half yearly intervals. Rating migration
is to be mapped to estimate the expected loss.
d) Risk based scientific pricing: Link loan pricing to expected loss.
High-risk category borrowers are to be priced high. Build historical data
on default losses. Allocate capital to absorb the unexpected loss. Adopt
the RAROC framework.
e) Portfolio Management The need for credit portfolio management
emanates from the necessity to optimize the benefits associated with
diversification and to reduce the potential adverse impact of

44
concentration of exposures to a particular borrower, sector or industry.
Stipulate quantitative ceiling on aggregate exposure on specific rating
categories, distribution of borrowers in various industry, business group
and conduct rapid portfolio reviews. f) Loan Review Mechanism this
should be done independent of credit operations. It is also referred as
Credit Audit covering review of sanction process, compliance status, and
review of risk rating, pickup of warning signals and recommendation of
corrective action with the objective of improving credit quality. It should
target all loans above certain cut-off limit ensuring that at least 30% to
40% of the portfolio is subjected to LRM in a year so as to ensure that all
major credit risks embedded in the balance sheet have been tracked.

Foreign exchange management

Foreign exchange risk is the risk of negative effects in the financial
result and capital of the bank caused by changes in exchange rates. It is
the current or prospective risk to earnings and capital arising from
adverse movements in currency exchange rates. It refers to the impact
of adverse movement in currency exchange rates on the value of open
foreign currency position. As a result, banks may suffer losses due to
changes in discounts of the currencies concerned.
The foreign exchange positions arise from the following activities:
trading in foreign currencies through spot, forward and option
transactions as a market maker or position taker, including the
unheeded positions arising from customer-driven foreign exchange
transactions;
holding foreign currency positions in the banking book (e.g. in the form
of loans, bonds, deposits or cross-border investments); or
engaging in derivative transactions that are denominated in foreign
currency for trading or hedging purposes.
In the foreign exchange business, banks also face the risk of default of
the counter parties or settlement risk. Thus, banks may incur
replacement cost, which depends upon the currency rate movements.
Banks also face another risk called time-zone risk, which arises out of
time lags in settlement of one currency in one center and the settlement
of another currency in another time zone. The foreign exchange
transactions with counter parties situated outside Nepal also involve
sovereign or country risk.
45
Derivative
A product whose value is derived from the value of one or more basic
variables called bases (underlying asset, index or reference rate), in a
contractual manner.
Introduction/concept:-
The growth in the financial derivatives market over the last thirty years has
been quite extraordinary. Derivatives contracts today have grown to
several trillion dollars, now derivatives grown up under the consideration
of following factor. This phenomenal growth can be attributed to two
factors.
The first, and most important, is the natural need that the products
fulfill.
The second factor is the parallel development of the financial
mathematics needed for banks to be able to price and hedge the
products demanded by their customers.
NATURAL NEED
Any organization or individual with sizeable assets is exposed to
moves in the world markets.
Manufacturers are susceptible to moves in commodity prices;
multinationals are exposed to moves in exchange rates; pension
funds are exposed to high inflation rates and low interest rates.
Financial derivatives are products which allow all these entities to
reduce their exposure to market moves which are beyond their
control.
DEVELOPMENT: FINANCIAL MATHEMATICS
The breakthrough idea of Black, Merton and Scholes, that of pricing
by arbitrage and replication arguments.

46
 It is only because of work in the field of pure probability in the
previous twenty years that the theory was able to advance so rapidly.
Stochastic calculus and martingale theory were the perfect
mathematical tools for the development of financial derivatives.
Models based on Brownian motion turned out to be highly tractable
and usable in practice.
Definitions:-
Derivatives are financial contracts, or financial instruments,
whose values are derived from the value of something else
(known as the underlying).
A product whose value is derived from the value of one or more
basic variables called bases (underlying asset, index or reference
rate), in a contractual manner.
The underlying value on which a derivative is based can be an asset (e.g.,
commodities, equities (stocks), residential mortgages, commercial real
estate, loans, and bonds), an index (e.g., interest rates, exchange rates,
stock market indices, consumer price index (CPI)), weather conditions, or
other items.
A derivative is a financial instrument that derives or gets it value from
some real good or stock. It is in its most basic form simply a contract
between two parties to exchange value based on the action of a real good
or service. Typically, the seller receives money in exchange for an
agreement to purchase or sell some good or service at some specified
future date.
The largest appeal of derivatives is that they offer some degree of
leverage. Leverage is a financial term that refers to the multiplication that
happens when a small amount of money is used to control an item of much
larger value. A mortgage is the most common form of leverage. For a small
amount of money and taking on the obligation of a mortgage, a person
gains control of a property of much larger value than the small amount of
money that has exchanged hands.
Derivatives can be used to mitigate the risk of economic loss arising from
changes in the value of the underlying.
hedge risks
47
 reflect a view on the future behavior of the market, speculate
lock in an arbitrage profit
change the nature of a liability
change the nature of an investment
A derivative is a financial instrument whose value is derived from
the value of another asset, which is known as the underlying.
When the price of the underlying changes the value of the
derivative also changes.
A Derivative is not a product. It is a contract that derives its value from
changes in the price of the underlying.
Example:
The value of a gold futures contract is derived from the value of the
underlying asset i.e. Gold.
Traders in Derivatives Market
There are 3 types of traders in the Derivatives Market:
HEDGER
A hedger is someone who faces risk associated with price movement of an
asset and who uses derivatives as means of reducing risk. They provide
economic balance to the market.

Derivatives can be used to mitigate the risk of economic loss

arising from changes in the value of the underlying. This activity
is known as hedging.
Derivatives can be used by investors to increase the profit arising
if the value of the underlying moves in the direction they expect.
This activity is known as speculation.

Wheat

48
 Both parties have reduced a future risk, for the wheat farmer the
uncertainty of the price and for the miller the availability of wheat.
There is still the risk that no wheat will be available due to causes
unspecified by the contract, like the weather, or that one party will
renege on the contract.
Hedging also occurs when an individual or institution buys an asset (like a
commodity, a bond that has coupon payments, a stock that pays
dividends, and so on) and sells it using a futures contract. The individual or
institution has access to the asset for a specified amount of time, and then
can sell it in the future at a specified price according to the futures
contract.
SPECULATOR
A trader who enters the futures market for pursuit of profits, accepting risk
in the endeavor, they provide liquidity and depth to the market.
Derivatives can be used to acquire risk, rather than to insure or hedge
against risk. Some individuals and institutions will enter into a derivative
contract to speculate on the value of the underlying asset, betting that the
party seeking insurance will be wrong about the future value of the
underlying asset. Speculators will want to be able to buy an asset in the
future at a low price according to a derivative contract when the future
market price is high, or to sell an asset in the future at a high price
according to a derivative contract when the future market price is low.
ARBITRAGEUR
A person, who simultaneously enters into transactions in two or more
markets to take advantage of the discrepancies between prices in these
markets, Arbitrage involves making profits from relative mispricing.
Arbitrageurs also help to make markets liquid, ensure accurate and
uniform pricing, and enhance price stability they help in bringing about
price uniformity and discovery.
Economic benefits of derivatives
Reduces risk
Enhance liquidity of the underlying asset
Lower transaction costs
Enhances liquidity of the underlying asset

49
 Enhances the price discovery process.
Portfolio Management
Provides signals of market movements
Facilitates financial markets integration

Types of derivative contract:-

Forwards/Futures
Options
Swaps

Forward contract:-
A forward is a contract in which one party commits to buy and the other
party commits to sell a specified quantity of an agreed upon asset for a
pre-determined price at a specific date in the future.
It is a customized contract, in the sense that the terms of the contract are
agreed upon by the individual parties. Hence, it is traded OTC.
It is a contract negotiated between two parties for the delivery of a
physical asset (e.g., oil, gold, currency) at a certain time in the future for a
certain price fixed at the inception of the contract. No actual transfer of
ownership occurs in the underlying asset when the contract is initiated.
Instead, there is simply an agreement to transfer ownership of the
underlying asset at some future delivery date.
The forward exchange market is a market for contracts that
ensure the future delivery of a foreign currency at a specified
exchange rate. The price of a forward contract is known as the
forward rate.
The forward exchange rate is the rate that is contracted today for
the exchange of currencies at a specified date in the future
Forward Contract Example

50
 Rs.20,000

Risks in Forward Contracts

Credit Risk Does the other party have the means to pay?

Operational Risk Will the other party make delivery? Will the other
party accept delivery?
Liquidity Risk Incase either party wants to opt out of the contract,
how to find another counter party?
Terminology
Long position - Buyer

Short position - seller

Spot price Price of the asset in the spot market.(market price)

Delivery/forward price Price of the asset at the delivery date.

Future contract:-
A futures contract is an agreement between two parties to buy or sell an
asset at a certain time in the future at a certain price. But unlike forward
contracts, the futures contracts are standardized and exchange traded. To
facilitate liquidity in the futures contracts, the exchange specifies certain
standard features of the contract.
51
Unique Features of Futures Contracts
Some futures contracts have daily price limits.
Some futures contracts (Euro$, T-bills, stock index futures, currencies)
have one specific delivery date; others (T-bonds, crude oil) give the
short the option of choosing which day (usually in the delivery month)
to make delivery.
Some futures contracts (e.g., T-bonds) let the seller choose the
quality of good to deliver, within a specified quality range.
Some futures contracts (Euro$, stock index futures, feeder cattle) are
cash settled.
Note that a futures contract is like a portfolio of forward contracts
(time series).
Futures/Forwards are contracts to buy or sell an asset on a future date at a
price specified today, A futures contract differs from a forward contract in
that the futures contract is a standardized contract written by a clearing
house that operates an exchange where the contract can be bought and
sold, while a forward contract is a non-standardized contract written by the
parties themselves .
Futures Contract Example

Market Price/Spot Price

D1 $10
D2 $12
D3 $14

52
DIFFERENCES BETWEEN FORWARDS & FUTURES CONTRACTS

Nature Forwards Futures

Primary market Dealers Organized Exchange

Secondary market None the Primary market

Contracts Negotiated Standardized

Delivery Contracts expire Rare delivery

Collateral None Initial margin, mark-

the-market

Credit risk Depends on parties None [Clearing

House]

Market participants Large firms Wide variety

Options:-
An option is the right to buy or sell, for a limited time, a particular
good at a specified price.
Option is the Contracts that give the holder the option to buy/sell
specified quantity of the underlying assets at a particular price on
or before a specified time period.
The word option means that the holder has the right but not the
obligation to buy/sell underlying assets.
For example, if IBM is selling at $120 and an investor has the option to buy
a share at $100, this option must be worth at least $20, the difference
between the price at which you can buy IBM ($100) through the option
contract and the price at which you could sell it in the open market ($120).

53
Options are contracts that give the owner the right, but not the
obligation, to buy (in the case of a call option) or sell (in the case
of a put option) an asset. The price at which the sale takes place
is known as the strike price, and is specified at the time the
parties enter into the option.
In addition, options offer a very high degree of gearing or leverage, which
makes them attractive for speculative purposes too. Prior to 1973, options
of various kinds were traded over-the-counter. In 1973, the Chicago Board
Options Exchange (CBOE) began trading options on individual stocks. Since
that time, the options market has experienced rapid growth, with the
creation of new exchanges and many kinds of new option contracts.

Types of option:-
Options are classified in two ways those are mention below.

Call option
Call option gives the owner the right to buy a particular asset at a
certain price, with that right lasting until a particular date.
Call option is the right to buy an asset at a predetermined price
(strike price) on or before a specific date.
Call option give the buyer the right but not the obligation to buy a
given quantity of the underlying asset, at a given price on or
before a particular date by paying a premium.

If asset price is higher than the strike price Option is In The Money

If asset price is exactly at the strike price Option is At The Money

If asset price is below the strike price Option is Out Of The Money

Call Option Example

54
 Expiry date

Put option:-
Put option is the right to sell an asset at a predetermined price on
or before a specific date.
Puts give the buyer the right, but not obligation to sell a given
quantity of the underlying asset at a given price on or before a
particular date by paying a premium.
If asset price is lower than the strike price Option is In The Money

If asset price is exactly at the strike price Option is At The Money

If asset price is higher than the strike price Option is Out Of The
Money
Ownership of a put option gives the owner the right to sell a particular
asset at a specified price, with that right lasting until a particular date.

Put Option Example

55
Expiry date

At the same time call and put option further classified in two ways under
the basis on American and European style.
European style options can be exercised only on the maturity date
of the option, also known as the expiry date.
American style options can be exercised at any time before and on
the expiry date.

Features of Options
A fixed maturity date on which they expire. (Expiry date)

The price at which the option is exercised is called the exercise price
or strike price.
The person who writes the option and is the seller is referred as the
option writer, and who holds the option and is the buyer is called
option holder.
The premium is the price paid for the option by the buyer to the
seller.

56
 A clearing house is interposed between the writer and the buyer
which guarantees performance of the contract.
Options Terminology
Underlying: Specific security or asset.

Option premium: Price paid.

Strike price: Pre-decided price.

Expiration date: Date on which option expires.

Exercise date: Option is exercised.

Open interest: Total numbers of option contracts that have not yet
been expired.
Option holder: party who buys option.

Option writer: party who sells option.

Option class: All listed options of a type on a particular instrument.

Option series: A series that consists of all the options of a given class
with the same expiry date and strike price.
Put-call ratio: The ratio of puts to the calls traded in the market.

Moneyness: Concept that refers to the potential profit or loss from

the exercise of the option. An option maybe in the money, out of the
money, or at the money.

Decision Call Option Put Option

57
 Spot price > strike Spot price < strike
price price
In the money

Spot price = strike Spot price = strike

At the money
price price

Out of the
Spot price < strike Spot price > strike
money
price price

Swaps:-
It is an agreement between two parties to exchange sequences of
cash flows for a set period of time.
Another word in a swap, two counterparties agree to a contractual
arrangement wherein they agree to exchange cash flows at
periodic intervals.
Most swaps are traded Over the Counter. Some are also traded on
futures exchange market.
A swap is an agreement between counter-parties to exchange cash
flows at specified future times according to pre-specified conditions.
A swap is equivalent to a coupon-bearing asset plus a coupon-bearing
liability. The coupons might be fixed or floating.
A swap is equivalent to a portfolio, or strip, of forward contracts--each
with a different maturity date, and each with the same forward price.
Swaps are contracts to exchange cash (flows) on or before a specified
future date based on the underlying value of currencies/exchange rates,
bonds/interest rates, commodities, stocks or other assets.
The Swap Bank
A swap bank is a generic term to describe a financial institution
that facilitates swaps between counterparties.
The swap bank can serve as either a broker or a dealer.
58
As a broker, the swap bank matches counterparties but does not
assume any of the risks of the swap.
As a dealer, the swap bank stands ready to accept either side of a
currency swap, and then later lay off their risk, or match it with
counterparty.

The Swaps Market Unlike most standardized options and futures contracts, swaps
are not exchange-traded instruments. Instead, swaps are customized contracts that
are traded in the over-the-counter (OTC) market between private parties. Firms and
financial institutions dominate the swaps market, with few (if any) individuals ever
participating. Because swaps occur on the OTC market, there is always the risk of a
counterparty defaulting on the swap.

Swap market Quotations

Swap banks will tailor the terms of interests rate and currency swaps
to customers needs. They also make a market in generic plain
vanilla swaps and provide current market quotations applicable to
counterparties with Aa or Aaa credit ratings.
Consider a basic U.S. dollar fixed-for- floating interest rate swap
indexed to dollar LIBOR. A swap bank will typically quote a fixed-rate
bid-ask spread (semiannual or annual ) versus three-month or six-
month dollar LIBOR flat, that is , no credit premium.
Suppose the quote for a five-year swap with semiannual payments is
8.50-8.60 percent against six-month LIBOR flat. This means the swap
bank will pay semiannual fixed-rate dollar payments of 8.50 percent
against receiving six-month dollar LIBOR, or it will receive semiannual
fixed-rate dollar payments at 8.60 percent against paying six-month
dollar LIBOR.
Swap banks will tailor the terms of interest rate and currency swaps
to customers needs
They also make a market in plain vanilla swaps and provide quotes
for these. Since the swap banks are dealers for these swaps, there is
a bid-ask spread.

59
 3.823.85 means the swap bank will
pay fixed-rate euro payments at
3.82% against receiving euro LIBOR
or it will receive fixed-rate euro
payments at 3.85% against receiving
euro LIBOR

Types of Swaps
There are 2 main types of swaps, those are mention below.
Plain vanilla, fixed for floating swaps

Or simply interest rate swaps.

Fixed for fixed currency swaps

Or simply currency swaps.

Interest rate swap:-

A company agrees to pay a pre-determined fixed interest rate on a
notional principal for a fixed number of years. In return, it receives interest
at a floating rate on the same notional principal for the same period of
time. The principal is not exchanged. Hence, it is called a notional amount.
In the basic fixed-for-floating rate interest rate swap, one counter
party exchanges the interest payments of a floating-rate debt
obligation for the fixed-rate interest payments of the other
counterparty. Both debt obligations are denominated in the same
currency. Some reasons for using an interest rate swap are to better match
60
cash flows (inflows and outflows) and/or to obtain a cost savings. There are
many variants of the basic interest rate swap, some of which are discussed
below.
LIBOR London Interbank Offered Rate

It is the average interest rate estimated by leading banks in London.

It is the primary benchmark for short term interest rates around the
world.
Similarly, we have MIBOR i.e. Mumbai Interbank Offered Rate.

It is calculated by the NSE as a weighted average of lending rates of a

group of banks.

An Example of an Interest Rate Swap

Example:-1

Notional Amount = 5 million

Using a Swap to Transform a Liability

Firm A has transformed a fixed rate liability into a floater.

A is borrowing at LIBOR 1%

A savings of 1%
61
 Firm B has transformed a floating rate liability into a fixed rate
liability.
B is borrowing at 9.5%

A savings of 0.5%.

Swaps Bank Profits = 8.5%-8% = 0.5%

Example:-2
Consider this example of a plain vanilla interest rate swap.

Bank A is an AAA-rated international bank located in the U.K. and

wishes to raise $10,000,000 to finance floating-rate Eurodollar loans.
Bank A is considering issuing 5-year fixed-rate Eurodollar bonds
at 10 percent.
It would make more sense to for the bank to issue floating-rate
notes at LIBOR to finance floating-rate Eurodollar loans.
Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance
an investment with a five-year economic life.
Firm B is considering issuing 5-year fixed-rate Eurodollar bonds
at 11.75 percent.
Alternatively, firm B can raise the money by issuing 5-year
floating-rate notes at LIBOR + percent.
Firm B would prefer to borrow at a fixed rate.

The borrowing opportunities of the two firms are:

62
Bank
A

63
LIBOR %

LIBOR %

64
 Bank
A

A saves %

Currency swaps

65
A currency swap is a foreign-exchange agreement between two institute
to exchange aspects (namely the principal and/interest payments) of a
loan in one currency for equivalent aspects of an equal in net present
value loan in another currency. A currency swap should be distinguished
from a central bank liquidity swap.
In a currency swap, one counterparty exchanges the debt service
obligations of a bond denominated in one currency for the debt
service obligations of the other counterparty denominated in
another currency.
The basic currency swap involves the exchange of fixed-for-fixed rate debt
service. Some reasons for using currency swaps are to obtain debt
financing in the swapped denomination at a cost savings and/or to hedge
long-term foreign exchange rate risk. The International Finance in Practice
box The World Banks First Currency Swap discusses the first currency
swap.
It is a swap that includes exchange of principal and interest rates
in one currency for the same in another currency. It is considered to
be a foreign exchange transaction. It is not required by law to be shown in
the balance sheets. The principal may be exchanged either at the
beginning or at the end of the tenure. However, if it is exchanged at the
end of the life of the swap, the principal value may be very different. It is
generally used to hedge against exchange rate fluctuations.

Uses of currency swaps:-

To secure cheaper debt (by borrowing at the best available rate
regardless of currency and then swapping for debt in desired currency
using a back-to-back-loan).
To hedge against (reduce exposure to) exchange rate fluctuations

To convert a liability in one currency into a liability in another

currency.
To convert an investment (asset) in one currency to an investment in
another currency.
Direct Currency Swap Example
Example:-1

66
 Firm A is an American company and wants to borrow 40,000 for 3
years.
Firm B is a French company and wants to borrow $60,000 for 3 years.

Suppose the current exchange rate is 1 = $1.50.

40th

Comparative Advantage
Firm A has a comparative advantage in borrowing Dollars.

Firm B has a comparative advantage in borrowing Euros.

This comparative advantage helps in reducing borrowing cost and

hedging against exchange rate fluctuations.
Example:-2
Suppose a U.S. MNC wants to finance a 10,000,000 expansion of a
British plant.
They could borrow dollars in the U.S. where they are well known and
exchange for dollars for pounds.

67
 This will give them exchange rate risk: financing a sterling
project with dollars.
They could borrow pounds in the international bond market, but pay a
premium since they are not as well known abroad.
If they can find a British MNC with a mirror-image financing need they
may both benefit from a swap.
If the spot exchange rate is S0($/) = $1.60/, the U.S. firm needs to
find a British firm wanting to finance dollar borrowing in the amount
of $16,000,000.
Consider two firms A and B: firm A is a U.S.based multinational and firm B
is a U.K.based multinational.

Both firms wish to

finance a project in each others country of the same size. Their borrowing
opportunities are given in the table below.

68
12%

69
B saves $.6%

$224,000
$160,000
$64,000

The QSD

70
 The Quality Spread Differential represents the potential gains from
the swap that can be shared between the counterparties and the
swap bank.
There is no reason to presume that the gains will be shared equally.

In the above example, company B is less credit-worthy than bank A,

so they probably would have gotten less of the QSD, in order to
compensate the swap bank for the default risk.

A pays .4% less to borrow in pounds

than B:

71
 B pays only .4% more to borrow in
pounds than A:

A has a comparative advantage in borrowing in dollars.

B has a comparative advantage in borrowing in pounds.
If they borrow according to their comparative advantage and then swap,
there will be gains for both parties.

Arbitrage
Arbitrage can be defined as capitalizing on a discrepancy in
quoted prices to make a risk-free profit. The effect of arbitrage on
demand and supply is to cause prices to realign, such that risk-free profit is
no longer feasible.
In economics and finance, arbitrage is the practice of taking
advantage of a price differential between two or more markets:
Striking a combination of matching deals that capitalize upon the
imbalance, the profit being the difference between the market prices.
When used by academics, an arbitrage is a transaction that involves
no negative cash flow at any probabilistic or temporal state and a
positive cash flow in at least one state; in simple terms, a risk-free
profit.
International Arbitrage

72
International Arbitragers play a critical role in facilitating
exchange rate equilibrium. They try to earn a risk-free profit
whenever there is exchange rate disequilibrium.
As applied to foreign exchange and international money markets,
international arbitrage (i.e., taking risk-free positions by buying and selling
currencies simultaneously) takes three major forms:
locational arbitrage
triangular arbitrage
covered interest arbitrage

Interest Rate Arbitrage:-

When you are able to borrow at a short term lower interest rate and invest
with higher interest rates long term, you are practicing arbitrage. Most
people arent able to take advantage of this because these types of
arbitrate most exists in inter-country rates. For example, many people for
years have been taking advantage of the low interest rates in Japan loans
to invest in the stock market.

We can define interest rate arbitrage as the way to profit between the
difference in borrowing and lending rates. This type of arbitrage only
happens when money markets funds and lending institutions trade at a
steady differential to each other.
Covered interest arbitrage
Covered interest arbitrage is an arbitrage trading strategy whereby an
investor capitalizes on the interest rate differential between two countries
by using a forward contract to cover (eliminate exposure to) exchange rate
risk. Using forward contracts enables arbitrageurs such as individual
investors or banks to make use of the forward premium (or discount) to
earn a riskless profit from discrepancies between two countries' interest
rates. The opportunity to earn riskless profits arises from the reality that
the interest rate parity condition does not constantly hold. When spot and
forward exchange rate markets are not in a state of equilibrium, investors
will no longer be indifferent among the available interest rates in two
countries and will invest in whichever currency offers a higher rate of
return.

73
Covered interest arbitrages the process of capitalizing on the interest rate
differential (on assets of similar risk and maturity) between two countries
while covering for exchange rate risk. Covered interest arbitrage tends to
force a relationship between forward rate premium and discount
(difference between the forward and spot rate) and

interest rate differentials.

For example, as per the chart at right consider that an investor with
$5,000,000 USD is considering whether to invest abroad using a covered
interest arbitrage strategy or to invest domestically. The dollar deposit
interest rate is 3.4% in the United States, while the euro deposit rate is
4.6% in the euro area. The current spot exchange rate is 1.2730 $/ and
the six-month forward exchange rate is 1.3000 $/. For simplicity, the
example ignores compounding interest. Investing $5,000,000 USD
domestically at 3.4% for six months ignoring compounding, will result in a
future value of $5,085,000 USD. However, exchanging $5,000,000 dollars
for euros today, investing those euro at 4.6% for six months ignoring
compounding, and exchanging the future value of euros for dollars at the
forward exchange rate (on the delivery date negotiated in the forward
contract), will result in $5,223,488 USD, implying that investing abroad
using covered interest arbitrage is the superior alternative.
For example, suppose that the U.S. dollar (USD) deposit interest rate is 1%,
while Australia's (AUD) rate is closer to 3.5%, with a 1.5000 USD/AUD
exchange rate.

74
Investing $100,000 USD domestically at 1% for a year would result in a
future value of $101,000. However, exchanging USD for AUD and investing
in Australia would result in a future value of $103,500.
Using forward contracts, investors can also hedge out the exchange rate
risk by locking in a future exchange rate. Suppose that a 1-year forward
contract for USD/AUD would be 1.4800 - a slight premium in the market.
The exchange back to dollars would therefore result in $1,334 loss on the
exchange rate, which still yields an overall $2,169 gain on the position.

International Banking
International banks can be characterized by the type of services
they provide that distinguish them from domestic banks
Major Functions:
Facilitate imports and exports of their clients trade financing
Arrange for foreign exchange cross-border transactions and foreign
investments
Assist in hedging exchange rate risk
Trade foreign exchange products for their own account
Borrow and lend in the Eurocurrency market
Participate in international loan syndicate lending to MNCs- project
financing and to sovereign governments economic development
Participate in underwriting of Eurobonds and foreign bonds issues
75
 Provide consultancy and advice on hedging strategies, interest rate
and currency swap financing and international cash management
services.
Banks providing all the above are commonly known as universal
banks or full service banks

CORRESPONDENT BANKING

Correspondent banking relationship involves the provision of banking

services by one financial institution to another financial institution which is
located in a different jurisdiction.

Two banks maintain a correspondent bank account with one another, which Helps MNCs
clients to conduct business worldwide through his local bank or its contacts.

Banks located in different countries establish accounts in other bank,

Provides a means for a banks MNC clients to conduct business worldwide
through his local bank or its contacts.

It Provides income for large banks Smaller foreign banks that want to do
business ,say in the U.S., will enter into a correspondent relationship with a
large U.S. bank for a fee

Foreign financial institutions maintain correspondent accounts at U.S.

banks to gain access to the U.S. financial system and access services such
as Cash management, International payments or funds transfers, Check
clearing, FOREX trading, overnight placements, Payable through accounts,
Pouch activities, Loans and Trade finance etc.

Correspondent banking relationships are vulnerable to money laundering

and terrorist financing because they involve a bank carrying out
transactions on behalf of another banks customers where information on
those customers is very limited.

Correspondent banking sometimes called relationship banking now it can

be defined as a strategy used by banks to enhance their profitability. They
accomplish this by cross-selling financial products and services to
strengthen their relationships with customers and increase customer
loyalty. Relationship banking involves offering customers a broad array of
76
financial products and services that go beyond simple checking and
savings accounts.

In addition to these two basic products, relationship-banking products may

include certificates of deposit, safe deposit boxes, insurance, investments,
credit cards, loans and business services (e.g., credit card processing).
They may also include specialized financial products designed for specific
demographics, such as students, seniors or the wealthy.

RISK IN CORRESPONDENT BANKING:-

CHALLENGES FOR CORRESPONDENT BANKING:-

IDENTIFICATION OF CUSTOMERS

Obtaining a full understanding of the Correspondent Banks customers

would be a challenge as all customers may not be involved in transactions
through the Nepalese banks. Even for customers that do transact, the
information on those customers is very limited. It would however be
prudent for the Nepalese bank to identify customers customer that are
most active based on transaction history and collect as much information
from public sources, external databases and the foreign correspondents.

LACK OF FULL PICTURE OF TRANSACTIONS

The Nepalese bank would not be in a position to see all the transactions
performed by the foreign correspondents customers. This limits the ability
to perform any meaningful behavioral profiling on those customers. The
pattern analysis will be limited to the transactions that pass through the
Nepalese bank.

CROSS BORDER PRIVACY ISSUES

Ability to obtain further information on the customers customer even in

cases of suspicious activity may be a challenge due to privacy issues or
reluctance of the correspondent to divulge full KYC information available to
them.

RFI RESPONSE DURATION

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Even when the foreign banks provide information in response to RFIs, there
may be large or unacceptable delays due to protocol, communication
issues and other challenges of cross border information sharing.

LIMITED ACCESS TO DOCUMENTATION ON SPECIFIC TRANSACTIONS

During investigation of suspicious activity related to correspondent

banking activity, there is usually not much documentation to go by except
the wire instruction that came through the payment system. For example a
copy of check related to a domestic transaction is easily available but the
original wire form is rarely available.

TYPOLOGIES

Certain typologies or rules may be applied by financial institutions to

specifically target the risks associated with correspondent banking activity.
These need to be applied in conjunction with policies, procedures and a
robust due diligence program for correspondent banking that manage the
risk by incorporating appropriate account-opening procedures, risk
assessment and its use in monitoring, understanding of the foreign
correspondents customer base, usage of the correspondent account, their
AML controls and customer due diligence processes.

Following are some of the useful typologies applicable to correspondent

banking.

HIGH RISK JURISDICTIONS AND HIGH RISK CORRIDORS

Transactions involving one or more High Risk jurisdictions should be

analyzed for suspicious activity. Transactions related to high risk corridors
(a set of one or more countries to another set of one or more high risk
countries) are of more interest. For example transactions originating from
countries with high corruption indices to tax havens or transactions from a
Drug Consumption jurisdiction to Drug production jurisdiction can be
monitored.

MULTIPLE JURISDICTIONS

Transactions involving multiple jurisdictions can be detected by counting

the number of countries of each party including the intermediary banks
involved in the transaction. Most transactions involve 2 or 3 jurisdictions
78
and is not a cause for concern. When the number of jurisdictions gets to 4
or higher they would need to be reviewed.

STRUCTURING

Structuring refers to the breaking down of a larger transaction into multiple

smaller transactions that are under a threshold amount (typically $10,000)
to avoid reporting requirements. Though the reporting limit of $10,000 is
for cash or cash equivalents, people try to structure transactions below
that amount even for wires and other types of transactions.

Micro-structuring is a similar concept with much smaller amounts.

Typically, the number of transactions tends to be larger.

NESTING

Nesting can be detected by looking for keywords referencing a Bank in the

originator or beneficiary name. The originator or beneficiary on a wire
payment is usually an individual or a business. Additionally Nesting can be
detected through transactions to jurisdictions in which the foreign financial
institution has no known business activities or interests. Nesting may also
be indicated when a single account or customer of the
correspondent bank has an unusually large number of transactions
sometimes with further information in the instructions identifying the
nested banks customers.

STRIPPING

Stripping is challenging to detect but some instances may be detected by

using a proactive approach to watch for transactions following an OFAC
reject. The correspondent bank or their customer may attempt to process
the transaction again wherein the offending name has been removed or
obfuscated. The transaction amounts and other information may remain
the same.

LAYERING

Layering of transactions (mainly across borders) can be detected by

identifying transactions where the originator name and beneficiary name
are the same but with different addresses. Such a detection mechanism is
more useful for transactions by individuals but can result in a large number
of false positives on businesses due to inter-company transfers.
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U-TURN

Transactions originating and terminating in the same country after passing

through multiple jurisdictions would be of interest due to lack of business
reason for doing so in many cases. Note: Iranian U Turn transactions are no
longer permitted

KEYWORDS

Keywords can be used to analyze several different risks. For example,

keyword searches on names of parties using words like Charity,
Charitable, Foundation can be used to find such entities. Additionally,
keyword searches on instructions can be used for detecting MT 202 abuse
to trade in high risk commodities. It is important to build a comprehensive
list of keywords to be searched and maintain it.

AUTHENTICATION
Authentication is the act of confirming the truth of an attribute of a single
piece of data (a datum) claimed true by an entity. In contrast with
identification which refers to the act of stating or otherwise indicating a
claim purportedly attesting to a person or thing's identity, authentication is
the process of actually confirming that identity.
It might involve confirming the identity of a person by validating their
identity documents, verifying the validity of a Website with a digital
certificate, tracing the age of an artifact by carbon dating, or ensuring that
a product is what its packaging and labeling claim to be. In other words,
authentication often involves verifying the validity of at least one form of
identification.
Authentication is defined as the process by which a computer,
computer program, or another user attempts to confirm that the
computer, computer program, or user from whom the second
party has received some communication is, or is not, the claimed
first party.
In other words, someone has the need to verify that someone else is who
they Say they are. Authentication can be completed via the use of many
different methods. Some of these methods are far superior to others, but
are more difficult to implement and fund.

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BANKS ARE ORGANIZATIONS THAT MUST TAKE THE AUTHENTICATION
PROCESS VERY SERIOUSLY. BANKS ARE STOREHOUSES OF CRITICAL
PERSONAL IDENTIFIABLE INFORMATION. THIS INFORMATION MAY INCLUDE:
SOCIAL SECURITY NUMBERS, PHYSICAL ADDRESSES, PHONE NUMBERS,
EMAIL ADDRESSES, ACCOUNT NUMBERS, CREDIT HISTORIES, EMPLOYMENT
HISTORIES, AND OTHER INFORMATION PERTAINING TO THE
ORGANIZATIONS CLIENTS AND THE EMPLOYEES.

Remittance arrangement
Remittance is the act of transmitting money to a distant location to fulfill
an obligation.
An international remittance business may follow the conventional banking
model or any of the non banking models.
Conventional banking model
In this model an end-to-end remittance transaction involves following
parties.
Remitters bank: - the bank where the remitter has an account that is
debited for transferring money to the beneficiary.
Beneficiarys bank: - the bank where the beneficiary of the remittance
has an account that is created for the remittance money received.
Correspondent bank: - (only in case where the above mentioned entities
do not have a direct business tie-up)- an intermediary bank which has
associated with various banks globally, through which remittance
transactions are routed.

Trade finance and bills discount financing:-

Trade finance:-
There are many types of financial tools and packages designed to facilitate
the financing of trade transactions. Here we will only introduce three types,
namely:

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 Trade financing Instruments
Export Credit Insurances
Export Credit Guarantee

The main types of trade financing instruments are as follows:

a) Documentary Credit
This is the most common form of the commercial letter of credit. The
issuing bank will make payment, either immediately or at a prescribed
date, upon the presentation of stipulated documents. These documents
will include shipping and insurance documents, and commercial invoices.
b) Countertrade
As mentioned above, most emerging economies face the problem of
limited foreign exchange holdings. One way to overcome this constraint is
to promote and encourage countertrade.
Todays modern counter trade appears in so many forms that it is difficult
to devise a definition. It generally encompasses the idea of subjecting the
agreement to purchase goods or services to an undertaking by the supplier
to take on a compensating obligation. The seller is required to accept
goods or other instruments of trade in partial or whole payment for its
products.
Some of the forms of counter trade include:
Barter This traditional type of countertrade involving the exchange of
goods and services against other goods and services of equivalent value,
with no monetary exchange between exporter and importer.
Counter purchase The exporter undertakes to buy goods from the
importer or from a company nominated by the importer, or agrees to
arrange for the purchase by a third party. The value of the counter
purchased goods is an agreed percentage of the prices of the goods
originally exported.
Buy-back The exporter of heavy equipment agrees to accept products
manufactured by the importer of the equipment as payment.
c) Factoring
This involves the sale at a discount of accounts receivable or other debt
assets on a daily, weekly or monthly basis in exchange for immediate cash.
82
The debt assets are sold by the exporter at a discount to a factoring house,
which will assume all commercial and political risks of the account
receivable. In the absence of private sector players, governments can
facilitate the establishment of a state-owned factor; or a joint venture set-
up with several banks and trading enterprises.
d) Pre-Shipping Financing
This is financing for the period prior to the shipment of goods, to support
pre-export activities like wages and overhead costs. It is especially needed
when inputs for production must be imported. It also provides additional
working capital for the exporter. Pre-shipment financing is especially
important to smaller enterprises because the international sales cycle is
usually longer than the domestic sales cycle. Pre-shipment financing can
take in the form of short- term loans, overdrafts and cash credits.
e) Post-Shipping Financing
Financing for the period following shipment, the ability to be competitive
often depends on the traders credit term offered to buyers. Post-shipment
financing ensures adequate liquidity until the purchaser receives the
products and the exporter receives payment. Post-shipment financing is
usually short-term.
f) Buyers Credit
A financial arrangement whereby a financial institution in the exporting
country extends a loan directly or indirectly to a foreign buyer to finance
the purchase of goods and services from the exporting country. This
arrangement enables the buyer to make payments due to the supplier
under the contract.
g) Suppliers Credit
A financing arrangement under an exporter extends credit to the buyer in
the importing country to finance the buyers purchases.

2. Export Credit Insurance

In addition to financing issues, traders are also subject to risks, which can
be either commercial or political. Commercial risk arises from factors like
the non-acceptance of goods by buyer, the failure of buyer to pay debt,

83
and the failure of foreign banks to honor documentary credits. The types
of export credit insurance used vary from country to country and depend
on traders perceived needs. The most commonly used are as follows:
Short-term Export Credit Insurance Covers periods not more than 180
days. Protection includes pre-shipment and post-shipment risks, the former
covering the period between the awarding of contract until shipment.
Protection can also be covered against commercial and political risks.
Medium and Long-term Export Credit Insurance Issued for credits
extending longer periods, medium-term (up to three years) or longer.
Protection provided for financing exports of capital goods and services.
Investment Insurance Insurance offered to exporters investing in
foreign countries.
Exchange Rate Insurance Covers losses as a result of fluctuations in
exchange rates between exporters and importers national currencies over
a period of time.
3. Export Credit Guarantees
Export credit guarantees are instruments to safeguard export-financing
banks from losses that may occur from providing funds to exporters. While
export credit insurance protects exporters, guarantees protect banks
offering the loans. They do not involve the actual provision of funds, but
the exporters access to financing is facilitated. An export credit guarantee
is issued by a financial institution, or a government agency, set up to
promote exports.

Role and function of Nepal Rastra Bank

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Nepal Rastra Bank, the Central Bank of Nepal, was established in 1956
under the Nepal Rastra Bank Act 1955, to discharge the central banking
responsibilities including guiding the development of the
embryonic(developing) domestic financial sector.
The new Nepal Rastra Bank Act 2002 which replaces the erstwhile Act has
ensured operational autonomy and independence to the Bank.
Key objectives of the Bank are to achieve price and balance of payments
stability, manage liquidity and ensure financial stability, develop a sound
payments system, and promote financial services. The Board of Directors,
chaired by the Governor, is the apex body of policy making and the
Governor also discharges his duty as the chief executive of the Bank.
A central bank is a public institution that manages a state's currency,
money supply, and interest rates. Central banks also usually oversee the
commercial banking system of their respective countries. In contrast to a
commercial bank, a central bank possesses a monopoly on increasing the
nation's monetary base, and usually also prints the national currency,
which usually serves as the nation's legal tender.

Functions of central bank

Issuing notes and coins:-
The central bank has the sole monopoly of note issue in almost every
country. The currency notes printed and issued by the central bank
become unlimited legal tender throughout the country.
The main advantages of giving the monopoly right of note issue to be:
(i) Brings uniformity in the monetary system of note issue and note
circulation.
(ii) Increases public confidence in the monetary system.
(iii) Enables the central bank to exercise control over the creation of credit
by the commercial banks.
Banker, Agent and Adviser to the Government:-
The central bank functions as a banker, agent and financial adviser to the
government,
85
a) As banker to government, the central bank maintains the accounts of
the central as well as state government, receives deposits from it, makes
short-term advances and collects cheques and drafts deposited in the
government account.
b) As an Agent to the government, the central bank collects taxes and
raises loans from the public and thus manages public debt.
c) As a financial adviser to the lent, the central bank gives advice to the
government on economic, monetary, financial and fiscal matters.
Bankers' Bank:-
The central bank acts as the bankers' bank in three capacities:
(a) Custodian of the cash preserves of the commercial banks;
(b) As the lender of the last resort; and
(c) As a clearing agent.
In this way, the central bank acts as a friend, philosopher and guide to the
commercial banks
Lender of Last Resort:-
In case if the commercial banks are not able to meet their financial
requirements from other sources, they can, as a last resort, approach the
central bank for financial accommodation.
- It increases the elasticity and liquidity of the whole credit structure of the
economy.
- It provides financial help to the commercial banks in times of emergency.
- It enables the central bank to exercise its control over banking system of
the country.
Clearing Agent:-
The function of clearing house in the central bank has the following
advantages:
(i) It economies the use of cash by banks while settling their claims and
counter-claims.

86
(ii) It reduces the withdrawals of cash and these enable the commercial
banks to create credit on a large scale.
(iii) It keeps the central bank fully informed about the liquidity position of
the commercial banks.
Credit control:-
- The significance of the function has increased so much that for property
understanding. The central bank has acquired the rights and powers of
controlling the entire banking.
- Central bank can adopt various quantitative and qualitative methods for
credit control such bank rate, open market operation, changes in reserve
ratio selective controls, moral situation etc.
Collection of Data:-
Central bank collects statistical data regularly relating to economic aspects
of money, credit, foreign exchange, banking, economic growth etc.

Role of Central Bank:-

Control of the money supply:-
Central bank plays several important roles in a modern economy. The most
important role is control of the money supply.
To control the inflation

To change the economic activity

To influence the growth rate of economy as a whole

Stabilizing the money and capital markets:-

Another important role of central bank is stabilizing the money and capital
markets. If the financial markets are unruly, with more fluctuation in
interest rates and securities prices or financial institutions are prone to
frequent collapse, public confidence in the financial system might be lost.
Maintaining and improving the payments mechanism:-
This involves clearing check

87
 Providing adequate currency

Wiring funds

Preserving confidence in the value of monetary units

Maintaining a sound banking and financial system:

By serving as a lender of last resort

By providing reserves to depositary institutions

Carrying out monetary policy:

Various tools are used to carry out the monetary policy:
Deposit reserve requirement

Discount rates

Open market operation etc

Providing information to the public:

Information related current economic and financial developments and
changes in policies etc.
Daily, weekly, monthly, quarterly etc.

To formulate rules regulation and policies:-

Monetary Policy for 2015/16

Background
The devastating earthquake of 25 April 2015 and the subsequent
aftershocks have caused an enormous loss of lives and properties. More
than 8800people lost their lives and more than 22000 were injured in the
earthquake. According to the post disaster needs assessment (PDNA)
report by the government of Nepal (GON), the earth quake has caused a
total loss of Rs. 706 billion. Nepal rastrs bank (BRB) pays deep tributes to
those losing lives in the natural disaster and wishes for the speedy
recovery of injured sisters and brothers. The NRB, keeping in view the risk
of the banking service disruption, made necessary provisions for smooth
operation immediately after the earthquake. A number of situation easing
88
measures such as the simplified provision of computing the reserve
requirement, interest free refinancing facility to banks and financial
institutions (BFIs) aimed at promoting the housing loan at a 2 percent
concessional interest to the earthquake affected families, and the transfer
of money only to the Prime Ministers Disaster Relief Fund by earmarking
the funds collected in the accounts opened for the relief of the earthquake
victims were introduced. This last provision was intended to provide the
relief amount, given by individuals and organization from home and
abroad, to the real victims. Additional provisions were also made for
restructuring and rescheduling the loans of the earthquake affected
borrowers, and allowing victims to open bank account with their
earthquake victim identity card in case they have lost their citizenship
certificate in the disaster. The April 25 earthquake has posed challenges in
maintaining macroeconomic stability as envisaged in the Nepal Rastra
Bank Act, 2002. The monetary policy for 2015/16 aims at maintaining
price as well as financial stability along with achieving balance of
payments surplus so as to support the overall economic development of
the country. The monetary policy focuses on supporting the economy and
buttress the post-earthquake reconstruction process through a
competitive, inclusive and production oriented financial development.
Though the macroeconomic indicators relating to price, credit
disbursement, deposit collection and external sector remained in good
shape, the economy saw a growth squeeze in 2014/15. The fiscal year
2015/16 is considered to be important in devising the long-term
development course of the country. This is followed by the expectations of
the promulgation of new constitution along with the efforts to rejuvenate
the earthquake embattled economy. The investment climate is expected to
be favorable due to the ease in the political transition as well as the
implementation of the timely announced governments budget. These
along with the expected improvement in agriculture output citing the
opportune monsoon are assumed to be supportive in attaining the
governments targeted economic growth of 6 percent in 2015/16.
Domestic Economic Situation
The GDP growth remained lower in 2014/15 compared to the previous year
because of the contraction in the growth rate of agriculture sector due to
delayed monsoon and the negative impact of the April 25 earthquake and
subsequent aftershocks. According to the preliminary estimates of the
Central Bureau of Statistics, the real GDP grew by 3.0 percent at basic
89
price and 3.4 percent at producers' price in the review year. Such growth
rates were 5.1 percent and 5.4 percent respectively in the previous year. In
the review year, the growth rate estimates for agriculture and non-
agriculture sectors are 1.9 percent and 3.6 percent respectively. Such
growth rates were 2.9 percent and 6.3 percent respectively in the previous
year. As monetary expansion has been at the expected level, price of
petroleum products has fallen and inflation is contained in the neighboring
economy; the annual inflation is estimated to have remained around 7.5
percent in 2014/15, lower than the target.
On the basis of the cash flow data available as of 11 July 2015, total
government spending increased by 18.9 percent to Rs. 440.99 billion. In
the corresponding period of the previous year, such expenditure had
increased by 9.6 percent. Out of the total expenditure, recurrent
expenditure stood at Rs. 300.42 billion, capital expenditure at Rs 56.63
billion and financing expenditure at Rs. 83.94 billion. Likewise, total
resource mobilization of the government increased by 10.2 percent to Rs.
433.98 billion in the review year compared to an increase of 19.5 percent
in the previous year. Out of total resources the revenue collection
increased by 12.8 percent to Rs. 380.64 billion. Since the government
budget remained at surplus due to low government expenditure relative to
resource mobilization in the review period, the cash balance of the
government at the NRB stood at Rs 72.04 billion.
The overall BoP was in a surplus of Rs. 127.20 billion in the eleven months
of 2014/15. The BoP surplus had stood at Rs. 109.56 billion in the
corresponding period of the previous year. Under the current account, net
service income accumulated a surplus of Rs. 24.32 billion and remittance
inflow increased by 12.4 percent to Rs. 551.74 billion. In USD terms,
remittance inflow increased by 11.2 percent to USD 5.55 billion in this
period.

In the review period, total trade deficit expanded by 8.7 percent to Rs.
612.87 billion. Such deficit had increased by 28.6 percent during the same
period of the previous year.
The gross foreign exchange reserves increased by 21.7 percent to Rs.
809.48 billion in mid-June 2015 from Rs. 665.41 billion in mid-July 2014. In
USD terms, foreign exchange reserves increased by 14.2 percent to USD
7.92 billion in mid- June 2015 compared to mid-July 2014.
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Financial Market
The total number of BFIs stood at 195 including 30 commercial banks ("A"
Class), 79 development banks ("B" Class), 50 finance companies ("C"
Class), and 36 microfinance institutions ("D" Class) in mid-June 2015.
The NRB has been monitoring the provision of maintaining 5 percent
spread rate on an average in loan and deposit for "A" Class, "B" Class and
"C" Class BFIs. The average base rate of commercial banks stood at 7.69
percent in mid-June 2015, which was 8.36 percent in mid-July 2014.
Likewise, base rate of "B" Class financial institutions is also monitored.
Credit-to-deposit ratio (including capital fund) of commercial banks,
development banks and finance companies stood at 75.21 percent, 75.36
percent and 73.38 percent respectively in mid-April 2015. The credit-to-
deposit ratios of such BFIs had remained at 71.61 percent, 71.02 percent
and 76.55 percent respectively in mid-July 2014. There has been some
improvement in the non-performing loans (NPL) of the BFIs. In mid-June
2015, the average NPL ratio of commercial banks stood at 2.67 percent
and of development banks at 3.76 percent whereas such ratios of
commercial bank and development banks had remained at 2.92 percent
and 4.16 percent respectively in mid-July 2014. Likewise, NPL of finance
companies decreased to 13.85 percent in mid-June 2015 from 14.33
percent in mid-July 2014.
Among the government-owned commercial banks, the NPL ratio of Nepal
Bank Ltd. stood at 4.64 percent, Rastriya Banijya Bank remained at 3.95
percent and Similarly, NPL ratio of Agriculture Development Bank stood at
5.62 percent in mid-April 2015.
As of mid-June 2015, the number of listed companies in Nepal Stock
Exchange Ltd. was 232.
Altogether 26 insurance companies established under the Insurance Act,
2049 are in operation as of mid-April, 2015. Of these, 9 companies are life
insurance and 17 are non-life. According to the ownership structure, 3 are
in foreign investment, 3 are in foreign joint-venture investment, 18 are in
domestic private ownership, and 2 in the Government ownership. Total
assets/liabilities of these companies increased by 15.3 percent to Rs.
116.58 billion in mid-April 2015 from Rs. 101.01 billion in mid-July 2014
As per the data from the Department of Cooperatives, the number of
saving and credit cooperatives reached 13,413 in mid-June 2015.
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Monetary Situation
Broad money supply (M2) increased by 15.1 percent in the eleven months
of 2014/15 compared to an increase of 13.5 percent in the corresponding
period of the previous year. Narrow money supply (M1) grew by 11.9
percent in the review period compared to a growth of 11.6 percent in the
same period of the previous year. The y-o-y growth in M2 and M1 was 20.6
percent and 18.0 percent respectively in mid-June 2015. Domestic credit
increased by 10.6 percent in the eleven months of 2014/15 compared to a
growth of 6.8 percent in the same period of the previous year. On y- o-y
basis, domestic credit increased by 16.7 percent in mid-June 2015.
Deposits at BFIs increased by 15.4 percent (Rs. 216.41 billion) to Rs.
1623.18 billion in the review period compared to an increase of 12.5
percent (Rs. 148.23 billion) in the corresponding period of the previous
year. Deposits at commercial banks, development banks and finance
companies increased by 17.0 percent, 5.0 percent and 3.0 percent
respectively in the review period. On y-o-y basis, deposits at BFIs
expanded by 21.5 percent in mid-June 2015.
Loans and advances of BFIs increased by 15.3 percent, compared to a
growth of 13.2 percent in the corresponding period of the previous year.
Credit to the private sector from BFIs increased by 17.8 percent (Rs.
198.47 billion) in the review period compared to an increase of 15.7
percent (Rs. 147.42 billion) in the same period of the previous year. Private
sector credit from commercial banks, development banks and finance
companies increased by 20.0 percent, 10.3 percent and 6.5 percent
respectively. On y-o-y basis, the credit to the private sector from BFIs
increased by 20.9 percent in mid-June 2015.
BFIs' credit exposure to the industrial production, construction, wholesale
and retail trade shows a remarkable growth in the review period. Credit to
the industrial production sector increased by Rs. 30.62 billion (13.7
percent) in the review period. Likewise, credit to the wholesale and retail
trade sector increased by Rs. 46.17 billion (18.9 percent); construction
sector by Rs. 32.72 billion (27.4 percent) and the transportation,
communication and public service sector by Rs. 10.55 billion (22.3

92
percent) during the review period. In the review period credit to the
agriculture sector increased by Rs. 11.71 billion (23.0 percent).

Liquidity Management
The NRB has been using Open Market Operations (OMOs) as a major
instrument for maintaining monetary aggregates and interest rates at a
desired level. In 2014/15, the NRB absorbed liquidity of Rs. 155.0 billion
through deposit auction, Rs. 315.80 billion through reverse repo auction
and Rs. 6.0 billion through outright sale auction on cumulative basis. In the
previous year, Rs.602.50 billion was mopped up through reverse repo and
Rs. 8.50 billion through outright sale auction In 2014/15, BFIs managed
short-term liquidity through interbank transactions and standing liquidity
facility (SLF) provided by this bank. In the review period, inter- bank
transactions of commercial banks stood at Rs. 374.70 billion and those of
other financial institutions (excluding transactions among commercial
banks) amounted to Rs. 226.91 billion. These were Rs. 200.76 billion and
Rs. 171.06 billion respectively in the previous year. The BFIs used SLF of
Rs. 10.31 billion in the review period. In 2014/15, the NRB injected net
liquidity of Rs. 396.72 billion through the net purchase of USD 4.03 billion
from foreign exchange market (commercial banks). Net liquidity of Rs.
343.46 billion was injected through the net purchase of USD 3.52 billion in
the previous year. The NRB purchased Indian currency (INR) equivalent to
Rs. 348.09 billion through the sale of USD 3.50 billion in the review period.
INR equivalent to Rs. 307.98 billion was purchased through the sale of USD
3.14 billion in the previous year.
Monetary Policy and Financial Sector Programs for 2015/16
The economy is in need of mobilizing huge resources for reconstruction
and rehabilitation to recover human and physical losses caused by the
earthquake. Equally important is to consider the possible effect emanating
from the expansion of loans and advances along with the increased
government spending on macroeconomic stability. In addition, challenges
such as managing excess liquidity in the banking sector, expanding credit
to the productive sector, promoting access to finance and financial
inclusion, among others are still there. The monetary policy and financial

93
sector programs for 2015/16 are designed taking the existing needs and
challenges of the economy into account.
The monetary policy stance is designed considering the effect of possible
excess demand on price, external and financial sector stability arising from
reconstruction driven private investment and the implementation of fiscal
policy.
Monetary policy for 2015/16 aims at containing annual average CPI
inflation at 8.5 percent and maintaining foreign exchange reserves
sufficient to cover the imports of goods and services at least for 8 months.
Likewise, the monetary policy is geared to facilitating the economic growth
of 6 percent.
With the above mentioned economic targets; the broad money, as an
intermediate target of monetary policy, is projected to increase by 18
percent in 2015/16. Giving continuity to the excess liquidity of BFIs as an
operating target of monetary policy, the liquidity management will be
made more effective.
The private sector credit is projected to grow by 20 percent considering the
targeted economic growth and inflation for 2015/16. Credit disbursement
will be encouraged towards productive sector to support the targeted
growth, without any adverse upshot on price and external stability.
Despite the significant mop-up drive through open market operations, the
liquidity remained higher than expected in 2014/15. Considering the
adverse effects from prevailing excess liquidity and higher demand arising
from post-disaster reconstruction efforts, the existing provision of
mandatory cash reserve ratio of 6 percent for "A" class, 5 percent for "B"
class and 4 percent for "C " class, is kept unchanged.
The statutory liquidity ratios (SLR) for BFIs are also kept unchanged at 12
percent for "A" class; and 9 percent and 8 percent respectively for "B" and
"C" class institutions, which accept current and call deposits.
Financial Sector Reform, Regulation and Supervision
The objective of the financial sector program is to maintain overall
financial stability and subsequently assist economic prosperity through
effective regulation and supervision of the financial sector including self-
regulation, market monitoring and financial literacy.

94
A special policy provision will be made in order to provide the license for
the establishment of a national level infrastructure bank, as mentioned in
the governments budget speech. In addition to other provisions specified
by this bank, the infrastructure bank can be established entirely with
domestic investment or jointly with foreign investors, and the minimum
paid up capital of such bank will be Rs. 20 billion.
BFIs will be required to increase the minimum paid up capital in order to
promote the financial stability and mobilize the resources needed for the
long-term development. Commercial banks will be required to increase
paid-up capital to Rs. 8 billion, national level development banks Rs. 2.5
billion, development banks operating in 4 to 10 districts Rs. 1.20 billion
and the development banks operating in 1 to 3 districts Rs. 0.50 billion.
Similarly, national level finance companies and finance companies
operating in 4 to 10 districts will require Rs. 0.80 billion paid- up capital
and those operating in 1 to 3 districts Rs. 0.40 billion paid up capital. BFIs
are required to meet this provision by mid-July 2017. In addition, BFIs will
be further encouraged for merger and acquisition.
BFIs will not require the prior approval of this bank to open branches in
certain areas of the country. These areas include 114 Village Development
Committees and 4 municipalities of Parsa, Bara, Rautahat, Sarlahi,
Mahottari, Dhanusha, Siraha and Saptari districts adjoining the southern
border having relatively high severity of poverty; 10 previously specified
districts with higher level of poverty in the hilly region; and districts
severely affected by the earthquake, except Kathmandu Valley.
A provision will be made whereby the BFIs on the basis of repayment
capacity of borrowers can extend loan up to Rs. 1 million against the
collateral of arable land that is not linked to roads. This is expected to
encourage the commercial farming and livestock, small and medium size
enterprises as well as the income generating activities in the earthquake
affected areas.
The provisions relating to the capital fund will be implemented in
commercial banks in accordance with the schedule of gradually
implementing provisions relating to BASEL-III.
The deprived sector lending requirement for BFIs has been increased by
0.5 percentage point. The new provision requires commercial banks to
disburse 5 percent, development banks 4.5 percent and finance companies
4.0 percent of their total loan in the deprived sector. In addition, the
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deprived sector lending will be redefined by including the commercial
agriculture lending.
Foreign Exchange Management
The process of transferring remittance from India will be made simple and
easier by solving the existing difficulties.
In order to broaden the area and scope of the foreign exchange
investment, the diversification and expansion of such investment will be
made after studying the possibilities of the foreign exchange investment in
SAARC countries.
The high level mechanism formed recently under the initiation of this bank
for controlling the illegal transactions of foreign exchange and silver/gold
will be mobilized effectively.
In order to make the gold/silver imports and distribution effective,
necessary revisions will be made on the existing policy provisions after
conducting a study.
Additional measures relating to capital account convertibility will be
undertaken after amendment in the Foreign Exchange Regulation Act and
the Act Restricting Investment Abroad. This will provide timely revisions in
the capital account convertibility in context of the increasing integration of
the national economy into the global financial market.
The foreign investors desiring to operate business fully under their own
investment will be allowed to bring the registration fee and other
reasonable preliminary expenses through banking channel. This amount
will be counted as investment along with other investment inflow after the
completion of the firm registration at the Company Registrars Office.
The provision of making payment for imports from third country (except
India) through draft/TT will be increased from a maximum amount of USD
35,000 to USD 40,000 each time.
Indian tourist travelling to Mansarobar Kailash through Nepalese tour
operators will be given exchange facilities of convertible foreign
currencies. The tour operator can request up to USD 500 for such
exchange facilities to make payment in Tibet by incorporating the VAT
invoice of certain expenses made by the tourists in the Nepalese hotel and
the proof of the transfer of Indian currency through the banking channel.

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INR exchange facility required for a week will be provided to commercial
banks based on their monthly transactions to maintain the stock of Indian
currency for making payment of commercial and card transactions.
The list of products that can be imported from India by making the
payment at the convertible foreign currency will be updated by including
additional commodities in consultation with the stakeholders.
The purchase/sale of the USD and the market intervention process by this
bank will be automated.
A prior approval from this bank will be required for the foreign exchange
facility if the Nepalese companies take consulting services of more than
USD 50,000 in a year from foreign companies. This is in case of the
absence of the regulatory agencies or unavailability of recommendations
from such agencies.
The existing provision of providing license of foreign exchange transactions
to the hotels and travel-tours operators located in the remote areas will be
further simplified.
The limit of the exchange facility in INR to the Indian transport companies,
which transport goods from India to Nepal or from Nepal to India and third
countries, will be increased to INR 75,000; from the existing INR 50,000.
NRB directives:-
Directive No. 1
Provisions Relating to Capital Adequacy Ratio
The following Directives with regard to the capital adequacy ratio to be
maintained by a licensed institution have been issued having exercised the
powers conferred by Section 79 of the Nepal Rastra Bank Act, 2002.
1. The capital adequacy to be maintained
Based on its risk-weight assets, a licensed institution shall have to
maintain the following capital adequacy ratio: -
Institutions Minimum capital fund to be maintained
based on the
risk-weight assets (percent)
Core capital Capital fund

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A class 6.0 10.0
B and C class 5.5 11.0
D class 4.0 8.0

2. Capital fund
Capital fund means the aggregate of core capital and supplementary
capital.
3. Classification of capital fund
For the purpose of calculation of capital fund, the capital fund of a licensed
institution shall have to be classified in two categories as follows:-
1. Core capital 2. Supplementary capital

Capital Fund Ratio Determination Formula

The capital fund ratio has to be determined as follows:
(a) Core capital ratio = core capital/total of the risk-Wight assets *100

(b) Capital fund Ratio = Core capital + Supplementary capital/ Total of the
risk-weight assets x 100
Total of risk-weight assets = Total risk-weight assets within the balance-
sheet + total risk-weight transaction outside the balance sheet.
Directive No. 2
Provisions Relating to Classification of Loans/advances and Loan
Losses
Having exercised the powers conferred by Section 79 of the Nepal Rastra
Bank Act, 2002, the following Directives have been issued with regard to
classification of credit/advances and provisions to be made for its possible
loss by the institutions obtaining licenses from this Bank to carry out
financial transactions.
1. Classification of loans/advances:

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 Entire loans and advances extended by a licensed institution have to be
classified as follows based on expiry of the deadline of repayment of the
principal and interest of such loans/advances:-
(a) Pass: Loans/advances which have not overdue and which are overdue
by a period up to three months.
(b) Sub-standard: Loans/advances which are overdue by a period from
three months to a maximum period of six months.
(c) Doubtful: Loans/advances which are overdue by a period from six-
months to a maximum period of one year.
(d) Loss: Loans/advances which are overdue by a period of more than
one year.
The loans which are in pass class and which have been
rescheduled/restructured are called as "the performing loan, and the sub-
standard, doubtful and loss categories are called non-performing loans.
Directives No. 3
Provisions relating to Single Obligor and Limitation of the Sectors
Credit and Facilities
1. Fixation of Limit on Credit and Facilities
(1) For "A", "B" and "C" Class licensed institutions
Licensed Institution may extend to a single borrower or group of related
borrowers the amount of fund-based loans and advances up to 25 percent
of its Core capital. Having regard to aspects including production,
employment, the single borrower limit of the loans to be provided to export
sector, small and medium industries, pharmaceutical industries,
agricultural sector, tourism, cement industries, iron industries and other
production-oriented industries has been fixed at 30 percent in the
maximum.
2. Special Provisions Relating to Investment in Hydropower
Projects
The licensed institutions may advance to the projects relating to
hydropower project the fund-based loan and non fund-based facilities not
exceeding an amount of 50 percent of its core capital.

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Provided that in the event of advancing more than 25 percent of the core
capital, there shall have to be concluded power purchase agreement with
the concerned Organization.
Provisions relating to Housing Land and Real Estate Loans:
(a) The amount of loan to be extended against the security of housing land
and real estate shall not be more than 60 percent of the fair market value
of the housing land and real estate under collateral security.
Directives No. 5
Provisions relating to Mitigation of Risks in Transactions of
Licensed Institutes
The following Directives have been issued with regard to minimizing the
risks associated with liquidity, interests rate, foreign exchange in
transactions of licensed institutions having exercised the powers conferred
by Section 79 of the Nepal Rastra Bank Act, 2002.
1. Classification of Risks
For the purpose of monitoring the risks relating to banking and financial
activities by licensed institutes, the risks have been classified into the
following groups:
(a) Liquidity risks
(b) Interest Rate risks
(c) Foreign Exchange risks
(d) Credit and Investment risks
Directives No. 12
Provisions Relating to Credit Information and Blacklisting
Provisions relating to Credit Information
Credit Information Bureau Ltd., having been incorporated and in operation
under the Companies Act, 2006, has been named as Credit Information
Bureau Ltd.
Returns to be filed with the Bureau relating to Borrowers
(Customers)

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 Licensed institution shall furnish to the Bureau the following loan details
within fifteen days of the completion of every month:
a) Credit facilities of 2.5 million rupees and above it have approved.
b) Credit facilities of one million or more rupees and below 2.5 million
rupees that is overdue.
Directives No. 13
Provisions Relating to Compulsory Reserve/Statutory Liquidity
Provisions relating to Compulsory Reserve:
1. For "A", "B", "C" And "D" Classes Micro-Banking Institutions
Collecting Deposits of General Public
It shall be mandatory for class "A" institutions licensed by this bank and
for the "B" and "C" classes institutions licensed by this Bank and
accepting the current/calls accounts to maintain a deposit of 5.5 percent
of the total deposit liabilities at this Bank.
Provided that, "B" and "C" class licensed institutions accepting deposits
other than the "Current Deposit and "D" class micro-banking institutions
collecting deposits of general public shall have to maintain mandatory
balance at 2 percent of their total deposit liabilities.

OPEN MARKET OPERATIONS OMO

Open market operation is the buying and selling of government
securities in the open market in order to expand or contract the
amount of money in the banking system. Purchases inject money
into the banking system and stimulate growth while sales of
securities do the opposite.

One must understand that when there is excess liquidity in the market, the
NRB intervenes and sucks it by issuing bonds among other means. At the
same time if the liquidity starts to dry up in the markets. The NRB
intervenes once again and infuses liquidity by buying back the bond that is
with the investors.
When the NRB buys bond from the markets and infuses liquidity the
consequences are:-

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 - It tends to soften the interest rates.
- It enables corporate to borrow at favorable interest rates.
- It prevents the rupee from strengthening unnecessarily and there by
protects the interest of exports.
- It may tend to increase inflation.
Thus OMOs are an important instruments of credit control through which
the Nepal rastra bank purchases and sell securities.
It helps to regulate interest rates and foreign exchange rates.
Open-market operation refers to any of the purchases and sales of
government securities and sometimes commercial paper by the central
banking authority for the purpose of regulating the money supply and
credit conditions on a continuous basis. Open-market operations can also
be used to stabilize the prices of government securities, an aim that
conflicts at times with the credit policies of the central bank. When the
central bank purchases securities on the open market, the effects will be
(1) to increase the reserves of commercial banks, a basis on which they
can expand their loans and investments; (2) to increase the price of
government securities, equivalent to reducing their interest rates; and (3)
to decrease interest rates generally, thus encouraging business
investment. If the central bank should sell securities, the effects would be
reversed.
Open-market operations are customarily carried out with short-term
government securities (in the United States, frequently Treasury bills).
Observers disagree on the advisability of such a policy. Supporters believe
that dealing in both short-term and long-term securities would distort the
interest-rate structure and therefore the allocation of credit. Opponents
believe that this would be entirely appropriate because the interest rates
on long-term securities have more direct influence on long-run investment
activity, which is responsible for fluctuations in employment and income.
Interbank money market:-
In recently globalization era, financial markets enhance growth and
continue to grow up therefore many financial institutions are concern
about the risk which can transfer between countries and markets, Now the
interbank money market which concerning borrow and lend money
between banks.

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As money became a commodity, the money market became a
component of the financial markets for assets involved in short-term
borrowing, lending, buying and selling with original maturities of one year
or less. Trading in money markets is done over the counter and is
wholesale.
There are several money market instruments, including treasury bills,
commercial paper, bankers' acceptances, deposits, certificates of deposit,
bills of exchange, repurchase agreements, federal funds, and short-lived
mortgage-, and asset-backed securities. The instruments bear differing
maturities, currencies, credit risks, and structure and thus may be used to
distribute exposure. Money markets, which provide liquidity for the global
financial system, and capital markets, make up the financial market.
Money market that is short term and allowing a large financial institution to
borrow or loan money at interbank rates, These institutions can include
banks, corporations, and mutual fund companies. These loans are typically
short and last only approximately one week. They are made primarily to
assist banks in meeting their reserve requirements.
The money market consists of financial institutions and dealers in money
or credit who wish to either borrow or lend. Participants borrow and lend
for short periods, typically up to thirteen months. Money market trades in
short-term financial instruments commonly called "paper". This contrasts
with the capital market for longer-term funding, which is supplied by bonds
and equity.
The core of the money market consists of interbank lendingbanks
borrowing and lending to each other using commercial paper, repurchase
agreements and similar instruments. These instruments are often
benchmarked to (i.e., priced by reference to) the London Interbank Offered
Rate (LIBOR) for the appropriate term and currency.
The interbank lending market is a market in which banks extend loans
to one another for a specified term. Most interbank loans are for maturities
of one week or less, the majority being overnight. Such loans are made at
the interbank rate (also called the overnight rate if the term of the loan
is overnight).
Banks are required to hold an adequate amount of liquid assets, such as
cash, to manage any potential bank runs by clients. If a bank cannot meet
these liquidity requirements, it will need to borrow money in the interbank

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market to cover the shortfall. Some banks, on the other hand, have excess
liquid assets above and beyond the liquidity requirements. These banks
will lend money in the interbank market, receiving interest on the assets.

The interbank rate is the rate of interest charged on short-term loans

between banks. Banks borrow and lend money in the interbank lending
market in order to manage liquidity and satisfy regulations such as reserve
requirements. The interest rate charged depends on the availability of
money in the market, on prevailing rates and on the specific terms of the
contract, such as term length. There is a wide range of published interbank
rates, including the federal funds rate (USA), the LIBOR (UK) and the
EURIBOR (Euro zone).

Foreign exchange transactions:-

Foreign exchange transaction refers to the buying and selling of foreign
currencies, generally the trade done through foreign exchange market. The
foreign exchange market is the mechanism, by which a person of firm
transfers purchasing power from one country to another, obtains or
provides credit for international trade transactions, and minimizes
exposure to foreign exchange risk.
A foreign exchange transaction is an agreement between a buyer
and a seller that a given amount of one currency is to be delivered
at a specified rate for some other currency.
A foreign exchange rate is the price of a foreign currency. A foreign
exchange quotation or quote is a statement of willingness to buy or sell at
an announced rate. Generally foreign exchange rate set by central bank of
the country, the rate is determine by several factor like; balance of
payment, inflation, GDP, growth of economy.
The foreign exchange market consists of two tiers: the interbank or
wholesale market, and the client or retail market. Participants include
banks and nonbank foreign exchange dealers, individuals and firms
conducting commercial and investment transactions, speculators and
arbitragers, central banks and treasuries, and foreign exchange brokers.
Foreign exchange interventions
Currency intervention, also known as foreign exchange market
intervention, or currency manipulation, occurs when a government buys or
sells foreign currency to push the exchange rate of its own currency away
104
from equilibrium value or to prevent the exchange rate from moving
toward its equilibrium value.
Generally, central banks intervene in foreign exchange markets in order to
achieve a variety of overall economic objectives: controlling inflation,
maintaining competitiveness, or maintaining financial stability. The precise
objectives of policy and how they are reflected in currency manipulation
depend on a number of factors, including the stage of a countrys
development, the degree of financial market development and integration,
and the countrys overall vulnerability to shocks.
Purposes
There are many reasons why a country's monetary and/or fiscal authority
may want to intervene in the foreign exchange market.
Central banks are in a general consensus in regard to the primary
objective of foreign exchange market intervention: to adjust the volatility
or changing the level of the exchange rate. Governments prefer to stabilize
the exchange rate because excessive short-term volatility erodes market
confidence and affects both the financial market and the real goods
market.
Today, forex market intervention is largely used by the central banks of
developing countries, and less so by developed countries. There are a few
reasons why most developed countries no longer actively intervene:
Research and experience suggest that the instrument is only effective (at
least beyond the very short term) if seen as foreshadowing interest rate or
other policy adjustments. Without a durable and independent impact on
the nominal exchange rate, intervention is seen as having no lasting power
to influence the real exchange rate and thus competitive conditions for the
tradable sector.
Large-scale intervention can undermine the stance of monetary policy.
Private financial markets have enough capacity to absorb and manage
shocks - so that there is no need to guide the exchange rate.
Developing countries, on the other hand, do sometimes intervene,
presumably because they believe the instrument to be an effective tool in
the circumstances and for the situations they face. Objectives include: to
control inflation, to achieve external balance or enhance competitiveness

105
to boost growth, or to prevent currency crises, such as large
depreciation/appreciation swings.
Types of Intervention
Direct intervention
Direct currency intervention is generally defined as foreign exchange
transactions that are conducted by the monetary authority and aimed at
influencing exchange rate. Depending on whether it changes the monetary
base or not, currency intervention could be distinguished between
sterilized intervention and non-sterilized intervention, respectively.
Sterilized intervention
Sterilized intervention is a policy that attempts to influence the exchange
rate without changing the monetary base. The procedure is a combination
of two transactions. First, the central bank conducts a non-sterilized
intervention by buying (selling) foreign currency bonds using domestic
currency that it issues. Then the central bank sterilizes the effects on the
monetary base by selling (buying) a corresponding quantity of domestic-
currency-denominated bonds to soak up the initial increase (decrease) of
the domestic currency.

Non-sterilized intervention
Non-sterilized intervention is a policy that alters the monetary base.
Specifically, authorities affect the exchange rate through purchasing or
selling foreign money or bonds with domestic currency.
Indirect intervention
Indirect currency intervention is a policy that influences the exchange rate
indirectly. Some examples are capital controls (taxes or restrictions on
international transactions in assets), and exchange controls (the restriction
of trade in currencies). Those policies may lead to inefficiencies or reduce
market confidence, but can be used as an emergency damage control.
Value Date
A future date used in determining the value of a product that fluctuates in
price. Typically, you will see the use of value dates in determining the
payment of products and accounts where there is a possibility for
106
discrepancies due to differences in the timing of valuation. Such products
include forward currency contracts, option contracts, and the interest
payable or receivable on personal accounts.
In banking, value date is the delivery date of funds traded. For
spot transactions it is the future date on which the trade is
settled. In the case of a spot foreign exchange trade it is normally
two days after a transaction is agreed upon.
For example, in the case of savings bonds, the interest is compounded
semi-annually so the value date is every six months. This removes any
uncertainty for investors because their calculations of interest payments
will be the same as the governments.
A Value Date or maturity date is the date on which counterparties to a
financial transaction agree to settle their respective obligations by
exchanging payments and ownership rights. The typical Value Date for a
Spot forex trade is two business days. A Spot Trade in Forex is a purchase
or sale of a foreign currency in the Spot Market at the Spot Rate for
immediate delivery or delivery "on the spot", as opposed to a date in the
future. Spot contracts are typically cleared and settled electronically. A
Spot Trade in foreign currencies is typically transacted with a "2-day value
date", an international convention due to time zone differences and the
need for banks to communicate cross-border to perform the transaction.
Occasionally a "1-day value date" can be achieved when the complete
trade is near or within the same time zone, as with USD trades for the
Canadian Dollar of the Mexican Peso. If a position is left open overnight, a
forex broker will typically reset the value date two business days out by
closing and reopening the position at the same price, thereby preventing
the actual delivery of currency to take place. The Spot Market accounts for
nearly 35% of the total volume exchanged on the foreign exchange market
Pegged Exchange Rate
In foreign exchange terminology, currency pegging involves a country not
allowing the value of its currency to change significantly versus another
currency. Often, the countrys central bank will intervene as necessary to
sustain the fixed rate and to take up any excessive supply and demand so
that the exchange rate maintains a narrow range.
A pegged, or fixed system, is one in which the exchange rate is set and
artificially maintained by the government. The rate will be pegged to some

107
other country's dollar or rupees. The rate will not fluctuate from day to
day. Developing nations can use this system to prevent out-of control-
inflation. The system can backfire, however, if the real world market value
of the currency is not reflected by the pegged rate.
Advantages of Fixed Exchange Rates
The main arguments advanced in favour of the system of fixed or stable
exchange rates are as follows:
1. Promotes International Trade:
Fixed or stable exchange rates ensure certainty about the foreign
payments and inspire confidence among the importers and exporters. This
helps to promote international trade.
2. Necessary for Small Nations:
Fixed exchange rates are even more essential for the smaller nations like
the U.K., Denmark, Belgium, in whose economies foreign trade plays a
dominant role. Fluctuating exchange rates will seriously affect the process
of economic growth in these economies.
3. Promotes International Investment:
Fixed exchange rates promote international investments. If the exchange
rates are fluctuating, the lenders and investors will not be prepared to lend
for long-term investments.

4. Removes Speculation:
Fixed exchange rates eliminate the speculative activities in the
international transactions. There is no possibility of panic flight of capital
from one country to another in the system of fixed exchange rates.
5. Necessary for Small Nations:
Fixed exchange rates arc even more essential for the smaller nations like
the U.K., Denmark, Belgium, in whose economies foreign trade plays a
dominant role. Fluctuating exchange rates will seriously disturb the
process of economic growth of these economies.
6. Necessary for Developing Countries:

108
Fixed exchanges rates are necessary and desirable for the developing
countries for carrying out planned development efforts. Fluctuating rates
disturb the smooth process of economic development and restrict the
inflow of foreign capital.
7. Suitable for Currency Area:
A fixed or stable exchange rate system is most suitable to a world of
currency areas, such as the sterling area. If the exchange rates of the
countries in the common currency area are flexible, the fluctuations in the
leading country, like England (whose currency dominates), will also disturb
the exchange rates of the whole area.
8. Economic Stabilization:
Fixed foreign exchange rate ensures internal economic stabilization and
checks unwarranted changes in the prices within the economy. In a system
of flexible exchange rates, the liquidity preference is high because the
businessmen will like to enjoy wind fall gains from the fluctuating
exchange rates. This tends to Increase price and hoarding activities in
country.
9. Not Permanently Fixed:
Under the fixed exchange rate system, the exchange rate does not remain
fixed or is permanently frozen. Rather the rate is changed at the
appropriate time to correct the fundamental disequilibrium in the balance
of payments.

10. Other Arguments:

Besides, the fixed exchange rate system is also beneficial on account of
the following reasons.
o It ensures orderly growth of world's money and capital markets
and regularises the international capital movements.
o It ensures smooth functioning of the international monetary
system. That is why; IMF has adopted pegged or fixed exchange
rate system.

109
 o It encourages multilateral trade through regional cooperation of
different countries.
o In modern times when economic transactions and relations
among nations have become too vast and complex, it is more
useful to follow a fixed exchange rate system.
Disadvantages of Fixed Exchange Rates
The system of fixed exchange rates has been criticized on the following
grounds:
1. Outmoded System:
Fixed exchange rate system worked successfully under the favourable
conditions of gold standard during 19th century when
(a) The countries permitted the balance of payments to influence the
domestic economic policy;
(b) There was coordination of monetary policies of the trading countries;
(c) The central banks primarily aimed at maintaining the external value of
the currency in their respective countries; and
(d) The prices were more flexible. Since all these conditions are absent
today, the smooth functioning of the fixed exchange rate system is not
possible.
2. Discourage Foreign Investment:
Fixed exchange rates are not permanently fixed or rigid. Therefore, such a
system discourages long-term foreign investment which is considered
available under the really fixed exchange rate system.
3. Monetary Dependence:
Under the fixed exchange rate system, a country is deprived of its
monetary independence. It requires a country to pursue a policy of
monetary expansion or contraction in order to maintain stability in its rate
of exchange.
4. Cost-Price Relationship not reflected:
The fixed exchange rate system does not reflect the true cost-price
relationship between the currencies of the countries. No two countries
follow the same economic policies. Therefore the cost-price relationship
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between them goes on changing. If the exchange rate is to reflect the
changing cost-price relationship between the countries, it must be flexible.
5. Not a Genuinely Fixed System:
The system of fixed exchange rates provides neither the expectation of
permanently stable rates as found in the gold standard system, or the
continuous and sensitive adjustment of a freely fluctuating exchange rate.
6. Difficulties of IMF System:
The system of fixed or pegged exchange rates, as followed by the
International Monetary Fund (IMF), is in reality a system of managed
flexibility.
It involves certain difficulties, such as deciding as to
(a) When to change the external value of the currency,
(b) What should be acceptable criteria for devaluation; and
(c) How much devaluation is needed to re-establish equilibrium in the
balance of payments of the devaluing country?

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