Unit 19 : Treasury Risk Management Treasury risk management assumes for two reasons:- (a) Nature of treasury activity is such that profit are generated out of market opportunity and market risk is present at every step. (b) Treasury is also responsible for balance sheet management, i.e. market risk generated by other operational department. Potential loss in loan assets is known as credit tisk. Treasury on the other hand, has a very low funding requirement, which we call as high leverage. Traders are generally not allowed to hold open positions for long, as the risk of loss increase with time. The variability of the price, upward or downward is known as the Volatility. In case of currency, it is known as volatility of exchange rate and in case of the securities, it is volatility of interest rate(security prices have inverse relationship with interest rate movement).Liquidity involves the managing of cash flow mismatch, and if the liquidity is not readily maintained, interest costs will go up, sometime threatening the viability of banking operations. Liquidity and interest rate risk are two sides of same coin, but the risks are dealt separately, as banks are highly sensitive to liquidity risk. Treasury risks are primarily managed by the conventional control & supervisory measure, mostly in the nature of preventive steps, which may be divided into three parts: * Organisational Controls + Exposure Ceiling + Limits on trading positions and stop-loss limits Organisational ControlsOrganisational Controls :- Treasury is basically divided into three parts: the front office, back office and the Mid office. Front office is headed by Chief Dealer, assisted by other dealers in foreign exchange, securities market and money market. Larger banks may have dealers specializing in specific activities, such as corporate dealers, cross-currency dealers, equity traders etc. Back office is responsible for confirmation, accounting and settlement of the deals. The back office obtains independent confirmation of each and every deal from the counterparty and settles deal only if it is within the exposure limits allowed for the counterparty. Mid Office is responsible for risk management and management information system (MIS). Some of the key responsibilities of Mid-office are: monitoring compliance with risk limits set in respective policy, ensuring compliance with the regulatory requirement, daily mark to market (MT) valuation of Treasury position,verification of pricing of treasury product, include derivative, and periodic reports to top management.The trading limit in context of foreign exchange are of three kinds: (i) limits on deal size (ii) limits on open positions (iii) stop-loss limits. Limits on deal size prescribe maximum value for a buy/sell transaction. The limit generally corresponds to marketable size of transaction, and applies only to trade deals (and not to the merchant deals). Open positions refer to the trading positions, where buy/sell position are not matched. Limit in foreign exchange trade are defined as day light and over night - the day light limits pertain to intra day positions, say if dealer purchase currency in the morning and sells it in the afternoon. The overnight limits are smaller as dealers may continue to hold the position for next day and during the night forex market would be active but no one would be tracking the position.The Risk in forward position is measured by ‘gaps’ (residual time for completion of the transaction) which are then capped with a gap limit - akin to position limits on spot trading positions. Gap limits are internally approved by the management. Position limits and gap limits attract capital requirement,prescribed by RBI. Stop Loss Limit :- It represent the final stage of controlling trading operations. The stop-loss limits are prescribed per deal, per day, per month as also an aggregate loss limit per year. Exposure Ceiling Limits :- They are kept in place to protect bank from credit risk. Credit risk in Treasury may be split into default risk and settlement risk. Default risk is typically when the bank lends in money market (mainly to other banks), the borrowing bank may fail to repay amount on due date. Default risk is there in repo transactions also.The settlement risk refers to possible failure of the counterparty to the transaction (which is generally a bank or a financial institution) to deliver/settle their part of transaction. While ideally all deals should take place in DvP (Delivery vs. Payment) mode, it is not always possible to achieve standard, either for want of institutional mechanism, or due to physical barriers (such as different time zones). Exposure limits are fixed on the basis of the counterparty's net worth, market reputation, track record and/or credit rating. Limits also take into account size of treasury's operations, so that the business is spread over several counterparty & there is no concentration of risk. RBI has imposed a ceiling of 5% of the total business in a year for individual broker, subject to exceptions being reported to the bank's management for ratification. All limits are to be reviewed at least once in a year.Market Risk :- Market risk is a confluence of liquidity risk, interest rate risk, exchange rate risk, equity risk & commodity risk. Consider, all these factors, Bank for InternationalSettlements (BIS) defines market risk as "the risk that the value of on- or off-balance sheet position will be adversely affected by movement in equity and interest rate market, currency exchange rates and commodity prices". Market risk is also known as price risk. Liquidity Risk :- It refers to cash flow gaps which could not be bridged. It translates into interest rate risk. Interest Rate Risk :- It refers to rise in interest costs (of a liability) or fall in interest earnings (from assets) eroding the business profits. The interest rate risk is present wherever there is a mismatch between assets (cash inflows) and liabilities (cash outflows).Currency Risk(Exchange Risk):- Interest rate is domestic cost of currency, while exchange rate is External cost of currency. Forward exchange rate of the two currencies actually reflect the interest rate differentials of the respective currencies. Exchange rates are influenced more by External trade, global interest rates and capital flows. DvP: Delivery versus payment means one account is debited and another account is credited at the same time, one of the accounts necessarily being a funding account. In case of securities purchase, funding account is debited & security account is credited simultaneously. Cost of Carry :- It refers to the interest cost of funds locked in a trading position. Marked to Market: It is valuation of trading position applying current market value as at the end of the day. Often the valuation rates are provided by FEDAI/FIMMDA.Mismatch: It refers to differences in duration of assets and liabilities, or, sources and uses of funds with different payment terms. Off-balance sheet: Items such as interest rate swaps and guarantees which may not appear on balance sheet. Speculation: Purchase or sale of an asset or a currency, not for an end-use but only for resale or repurchase of the same asset with a profit - all trading is speculative activity. Volatility: It refers to degree of fluctuation of markets, with reference to variables such as interest rates and exchange rates; measured as standard deviation from mean of the variable. Yield curve: It is a line where yields of risk-free securities for different maturities at a given point of time are graphically plotted. Swap: It refers to exchange of an asset or cash flows at preset points of time. Macro-hedging: The hedging duration gap (difference between aggregate assets and aggregate liabilities of a Bank (instead of hedging individual assets and liabilities)