The document discusses asset liability management, capital markets, approaches to capital account convertibility, interest rate risk hedging techniques, value at risk, and integrated treasury management. It provides definitions and explanations of these topics. For asset liability management, it notes the objectives are to achieve a perfect match of assets and liabilities and deal with changes in present asset and liability values. It also discusses various interest rate hedging tools like FRAs, interest rate futures, options, swaps, caps and floors. Value at risk components include market factors, factor sensitivity, market volatility and defeasance period. Integrated treasury functions include reserve management, liquidity management, risk management and derivative products development.

1. MF0016 TREASURY MANAGEMENT
Q1. Analyse the significance and objectives of asset liability management.
Ans: Asset liability management refers to the strategic balance involving risk caused due to the changes in
interest rate, exchange rates and liquidity position in the organization. The credit risk and contingency
risk are the roots of ALM.
The changing environment in assets and liabilities has brought the following significances:
a)Volatility – The globalization scenario has led to increase in number of economies. This has paved way
for market driven economies due to the changing dynamics of the financial markets. These changes are
reflected in interest rate structures, money supply, and credit position of the market, exchange rates and
price levels. Hence the organization experiences low market value, net interest income etc.
b) Product innovation – The innovation in financial products has grown rapidly. Some of the innovations
are repacked with existing products with slight modifications. These have major impact on the risk profile
in the organization enhancing the need for ALM.
c) Regulatory environment – The integration of domestic and international market has enabled the
regulatory bodies of financial markets to initiate number of measures. These measures prevent major
losses that occur due to market impulses.
d) Management recognition – The top management in the organization realised that asset liability is
neither a franchise for credit disbursement nor it’s a place for retail deposit base. It must be considered to
relate and link the asset with liability. Hence the need for efficient asset liability management came into
existence.
The objective of ALM is to achieve perfect match in assets and liabilities. The match is related to the
changes in the present value of assets and liabilities. The importance of ALM has led to the change in the
functional environment. The ALM objectives are divided into micro and macro levels.
The macro level objectives deal with formulation of critical business policies, efficient allocation of
capital and designing of products with suitable pricing strategies. At macro level, the ALM aims at
obtaining profits through price matching while ensuring liquidity by maturity matching. The process of
price matching ensures deployment of liabilities which are greater than costs.
Q2. What are the features of a capital market?
Ans. A capital market is an organization where securities like debt and equity are traded to raise long-
term funds in the economy. The capital market is fragmented into stock market which trade equity
securities and the bond market which trade debt securities. Various financial instruments like equity,
insurance, derivative instruments and so on are traded in capital market to enhance liquidity.
The features of capital market are as following:
a) The Capital markets deal with primary securities like equities and bonds .

2. b) The trading in capital market occurs without intervention of financial intermediaries.
c) The information structure is complex.
d) The security prices are volatile in nature.
e) Mobilization of savings & acceleration of capital formation.
f) Promotion of industrial growth.
g) Raising long term capital.
h) Proper channelization of funds.
Q3. Describe the approaches of CAC.
Ans. The decade of the 1990s witnessed a spate of financial crises in several countries across the world
with risks emanating mainly from the capital account of balance of payments. Consequently, the capital
account has come to receive increasing attention in policy making. The crises of the 1990s underscored
the inadequacy of erstwhile theories in explaining the sharp volatility in capital flows. The benefits and
costs of an open capital account appear more ambiguous now than what many researchers and policy
makers had perceived earlier. Moreover, the international financial community is hard put to provide a
conclusive set of prescriptions for containing the ill-effects of such capital movements, particularly during
episodes of sudden reversal in flows. The debate assumes a critical dimension in respect of developing
countries and emerging market economies (EMEs). While these economies can potentially benefit
enormously from larger volumes of capital inflows, their relatively shallow and underdeveloped
institutions render them more vulnerable to crises as compared with the developed economies.
The East Asian crisis of 1997 amply demonstrated the need to proceed with caution in opening the capital
account. Not surprisingly, the pace and content of opening up of the capital account has slowed down in
many EMEs with a view to limiting their vulnerability to crises. It has been recognized that capital
account liberalization needs to be undertaken as an integral part of macroeconomic and structural
reforms and be synchronized with appropriate macroeconomic, exchange rate and financial sector
policies. The issue relates as much to the sequence of reforms as to their speed. It is argued that a
combination of sound macroeconomic policies, a well-regulated financial system and restrictions on
short-term speculative flows is likely to create a system wherein the benefits of external capital could be
reaped without its adverse effects.
In India, capital account liberalization is treated as a process rather than an event (Reddy, 2000a). India
adopted a cautious approach while initiating a process of gradual capital account liberalization in the early
1990s. The Report of the Committee on Capital Account Convertibility (Chairman: S.S. Tarapore)
provided the framework for liberalization of capital account and served as the basis for undertaking
further liberalization during the late 1990s. Initial reform measures on the heels of the balance of
payments crisis in 1991 were predominantly directed at current account convertibility leading to
acceptance of obligations under Article VIII of the International Monetary Fund’s (IMF) Articles of
Agreement by August 1994.
The different ways of implementing CAC are as follows:
Open the capital account for residents and non- residents.
Initially open the inflow account and later liberalise the outflow account.
Approach to simultaneously liberalise control of inflow and outflow account.

3. Q4. Explain the IRR hedging techniques.
Ans. There are several methods of hedging the interest rate risk. These include the use of:
a) Forward rate agreement (FRAs)
b) Interest rate futures
c) Interest rate options (borrowers’ and lenders’ interest rate options, interest rates caps and
floors options, and interest rate collars options)
d) Interest rate swaps
FORWARD RATE AGREEMENT (FRAS)
Forward rate agreement is a forward contract that can be used to fix an interest rate for a future
short-term loan or deposit. A FRA is not an actual short-term loan or deposit. The interest rate
fixed by the FRA is on an agreed notional amount of principal, rather than an actual loan or
deposit. The selected interest rate fixed by a FRA can be any benchmark rate of interest, but is
usually the LIBOR rate for the term of the loan or deposit.
In a FRA the buyer of the FRA agrees to pay a fixed rate of interest on the notional loan and in
return to receive interest at the current market rate prevailing at the start of the notional loan
period. Conversely, the seller of the FRA agrees to receive interest on the notional loan at the
fixed FRA rate, and in return to pay interest at the current market rate prevailing at the start of
the notional loan period. A FRA therefore involves an exchange of interest payments, with the
FRA buyer paying the fixed rate and the FRA seller paying the current market rate, whatever this
happens to be when the settlement date for the contract arrives.
A company can buy one or more FRAs to hedge the risk due to an increase in short-term interest
rates. If the interest rates do rise, the company will have to pay the higher interest rates on its
loan, but the higher interest cost will be offset by the receipt of compensation under the FRA
agreement. On the other hand, if the market interest rates move favorably (down), the benefit
will be offset by having to make a compensation payment to the other party to the FRA.
SHORT-TERM INTEREST RATE FUTURES (STIRS)
Short-term interest rate futures (STIRs) are standardized exchange traded forward contracts on a
notional deposit of a standard amount of principal, starting on the contract’s final settlement date.
A hedge with STIRs offers protection against the downside risk of borrowing or investing (i.e.
against risk of higher borrowing costs or lower yield). A STIRs is bought or sold such that, if the
underlying cash market rate moves in an adverse direction, there will be a gain on the futures
position that largely offsets the loss in the cash market. For example, if futures are used to hedge
the risk of a rise in short-term interest rates on a future loan, a rise in interest rates would add to
the interest cost loan, but this would be offset by a gain on the future position (as the company
sales at one price to open the position and then buying at a lower price to close the position).
Conversely, if the cash market interest rate moves favorably, there will be an offsetting loss on
the future position. This is the case because if the interest rate falls, the price of a future will rise.
INTEREST RATE OPTIONS
An interest rate option grants the option holder the right, but not the obligation, to deal at an
agreed interest rate (the option strike rate) at a future maturity date.
Interest rate options are tailor-made over-the-counter instruments. They can be purchased from
major banks, with principal amounts, the length of the interest period, the currency, the

4. exercise/expiry date and the strike rate (i.e. the rate of interest) all subject to negotiation and
agreement.
Interest rate options can be arranged to hedge a series of future interest periods or for a single
interest period of up to one year, which is known as interest rate guarantee. Alternatively, the
terms borrower's option and lender's options are used to describe single interest period interest
rate options and interest rate caps and floors to describe a series of payments or receipts.
Exposure to long-term interest rate risks can be hedged using:
a) Interest Rate Swap
b) Interest rate caps and floors
c) Interest rate collars
INTEREST RATE SWAP
An interest rate swap is an agreement to exchange interest payments on a notional loan, normally
at regular intervals for the term of the swap. Swaps are over-the-counter instruments and an
important instrument for large companies to manage long-term interest rate risk and long-term
currency risk.
INTEREST RATE CAPS AND FLOORS
An interest rate cap is a series of call options (borrowers’ options) on a notional amount of
principal, exercisable at regular intervals over the term to expiry of the cap. The cap holder has
the right to exercise the option at each interest fixing date or rollover date for the loan. The
effect of cap is to place an upper limit on the interest rate to be paid, and therefore useful to the
borrower of funds who will be paying interest at a future date.
An interest rate floor is a series of put options (lender’ options) that sets a minimum interest rate
(the strike rate) on deposit. The floor holder has the right to exercise the option at each interest
fixing date or rollover date for the loan.
INTEREST RATE COLLARS
An interest rate collar option reduces the premium cost by limiting the possible benefits of favorable
interest rate movement. A collar involves the simultaneous purchase and sale of options. For instance,
when a borrower buys a collar, he is buying cap at one strike rate but at the same time is selling a floor at
a lower rate. Hence, the cost of a collar is the difference between the premium payable on the cap and the
premium receivable from selling the floor.
Q.5. Define VaR and illustrate its components.
Ans. The Value at Risk measures the potential loss in value of a risky asset or portfolio over a defined
period for a given confidence interval. The measure is sometimes defined more narrowly as the possible
loss in value from “normal market risk” as opposed to all risk, requiring that we draw distinctions
between normal and abnormal risk as well as between market and non-market risk.
The components of VaR are market factors, factor sensitivity, market volatility and defeasance period.
a. Market factors

5. Any external factor that brings changes in the price of an instrument is a market factor. VaR
methodologies differ with respect to the simulation and changes in transformation of market rates. Large
institutions require simulation of thousands of general and specific market factors to compute VaR.
b. Factor sensitivity
It is the impact of movements of portfolio of assets in the relying risk parameter of an individual asset. To
estimate the component VaR of factor, its marginal VaR should be multiplied with the evaluated factor
sensitivity.
c. Market volatility
The factors or events which cannot be predicted are market volatility. It illustrates the investment
opportunities in the future. Previous studies regularly and strongly support the relationship between the
stock market volatility and the priced factors.
d. Defeasance period
It is the time consumed to liquidate the position on the basis of liquidity in the secondary market. This
period increases VaR. Defeasance period is vibrant and fluctuating. It also experiences changes on
account of product-specific or general market conditions.
Q6. What are the functions and benefits of integrated treasury?
Ans. The need for integration of Forex dealings and domestic treasury operations has arisen in the
backdrop of interest rate deregulations, liberalization of Exchange control, development of Forex market,
introduction of derivative products and technological advancement in settlement systems and dealing
environment. The major functions of treasury unit are as follows:
a) Reserve Management and Investment: It involves meeting CRR/SLR obligations having an
appropriate mix of investment portfolio to optimize yield and duration.
b) Liquidity and Fund management: It involves analysis of major cash flows arising out of asset
liability transactions, providing a balanced and well diversified liability base to fund the various
assets in the balance sheet of the bank, providing policy inputs to strategic planning group of the
bank on funding mix and yield expected in credit and investment.
c) Asset Liability Management and Term Money: It calls for determining the optimal size and
growth rate of the balance sheet and also prices the Assets and Liabilities in accordance with
prescribed guidelines.
d) Risk Management: Integrated treasury manages all market risks associated with a bank’s
liabilities and assets.
e) Transfer Pricing: Treasury is to ensure that the funds of the bank are deployed optimally, without
sacrificing yield or liquidity. An integrated treasury unit has an idea of the bank’s funding needs
as well as direct access to various markets .
f) Derivative Products: Treasury can develop Interest rate Swap and other Rupee based/ cross
currency derivative products for hedging bank’s own exposures and also sell such products to
customers.

6. g) Arbitrage: Treasury units of banks undertake this by simultaneous buying and selling of the same
type of assets in two different markets to make risk less profits.
Treasury is the backbone of financial institutions and banks. Integrated treasury helps banks and
financial institutions to effectively manage the resources and comply with the regulatory
requirements. The benefits of integrated treasury are as following:
a) Improves cash planning and monitors the cash position of the organization.
Prepares the financial statement and other financial reports for analysis, financial control and
budgeting.
b) Allows greater financial control by integrating budget and budget execution data.
c) Enhances the quality of data for budget execution.