Integrated Treasury Management

Integrated Treasury Management

By

Satyadev PGDM 146

Under the guidance of

Mr. Ashok Madaan Chief Manager Bank of India

Mr. Deva D Dubey Assistant Professor K J SIMSR

K J Somaiya Institute of Management Studies & Research

July, 2012

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Declaration
I, Mr. Satyadev hereby declare that this project report is the record of authentic work carried out by me during the period from May, 2012 to June, 2012 and has not been submitted to any other University or Institute for the award of any degree / diploma etc.

Signature

(Satyadev) PGDM 146

Certificate from Faculty Guide

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This is to certify that Mr. Satyadev, a student of the Post-Graduate Diploma in Management, has worked under my guidance and supervision. This Summer Project Report has the requisite standard and to the best of our knowledge no part of it has been reproduced from any other summer project, monograph, report or book.

Mr Deva D Dubey Assistant Professor K J SIMSR 10 July, 2012

Acknowledgement
Between the conception and the creation. Between the emotion and the response. Between the hard work and the result, lies my gratitude to you.

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I would like to thank my reporting authority Mr.Anil Waingankar, Assistant General Manager and Mr R C Thakur, Assistant General Manager for their kind co-operation and encouragement which help me in completion of this project. I would also thank my company guide Mr.Ashok Madan, Chief Manager, DealerInvestment treasury for extending their continuous support and assistance in achieving my project goals. I would like to take the opportunity to express my gratitude to my faculty guide Mr. Deva D Dubey ,SIMSR, Vidyavihar for his continuous guidance and valuable support and for being responsible for bringing the best out of me. I am highly indebted to Chief Manager Mr.R.C.Behra, Risk Management; Chief Manager Mr. K.V. Gurjar, Investment Back Office; Senior Manager Mr.D.G.Joshi, Nostro Department; Senior Manager Mr. Naveen Singla, Forex back office; Senior Manager Mr. G.S. Patra, treasury mid office, for their guidance and constant supervision as well as for providing necessary information regarding the project & also for their support in completing the project. Also, this project would not have been possible without the support of my parents and friends, who were my inspiration throughout. Last but not the least, my colleagues and fellow interns for their valuable comments and suggestions for making this a cherish able experience for me.

Table of Contents
Chapter Page/Section Cover Page Fly Leaf
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Page No
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1 1.1 1.2 1.3 2 2.1 2.2 2.3 2.4 3 3.1 3.2 3.3 3.4 4 4.1 4.2 4.3 4.4 5 5.1 5.2 5.3 5.4 5.5 5.6 5.7 6 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 7 7.1 7.2 7.3

Title Page Declaration from Student Certificate from Summer Project Guide Acknowledgement Chapter Secheme List of Figures List of Tables Executive Summary Introduction to Treasury Introduction Integrated Treasury Management Objectives of Treasury Department Bank of India Introduction The Emblem BOIs Mission BOIs Vision Bank of India Treasury Mission Objective Nature of Treasury Assets and Liabilities List of BOIs Treasury Products Organizational Structure Introduction Front Office Mid Office Back Office Investment & Money Market Objective Cash Reserve Ratio (CRR) Statutory Liquidity Ratio Non SLR Securities Government Securities Negotiated Dealing System (NDS) Money Market Forex Investments Foreign Exchange History Participants in Foreign Exchange Forex Hierarchy Exchange rate Types of Transactions Merchants Transactions Proprietary Trading Nostro Account Introduction Nostro Reconciliation Vostro Accounts
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ii iii iv v vi viii ix x 1 1 1 2 4 4 5 5 6 7 7 7 8 8 11 11 14 14 15 16 16 17 18 19 21 21 25 32 32 33 35 37 39 40 43 48 49 49 50 55

10

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7.4 Loro Accounts Derivatives 8.1 Derivatives Market 8.2 History 8.3 Classification of Derivatives 8.4 Forwards 8.5 Futures 8.6 Options 8.7 Terminology of Derivatives 8.8 Participants in Derivative Markets Valuation 9.1 Held to Maturity 9.2 Held for Trade 9.3 Available for Sale 9.4 Method of Valuation Risk Management 10.1 Introduction 10.2 Risk Identification 10.3 Types of Risk Conclusion & Recommendations 11.1 Career Prospect 11.2 Recommendations 11.3 Conclusion Bibliography Appendices

55 56 56 56 59 59 61 63 64 67 72 72 72 73 73 75 75 76 80 83 83 84 85 86 87

Table of Figures

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Figures 4.1 6.1 7.1 7.2 7.3 8.1 8.2

Title Organizational Structure Forex Market Hierarchy Nostro Accounts Interface of Nostro Software Mirror Account Screen Shots Classification of Derivatives Futures Transctions

Page No.
13 37 49 51 52 59 62

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List of Tables

Tables 5.1 6.1 7.1

Title T-Bills Types of Transactions SWIFT Settlement

Page No. 28 40 53

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Executive Summary
This is the report of my 2 month Summer Internship Program at the Treasury Department of Bank of India, Mumbai. This project covers the Management of Integrated Treasury Operations. Treasury refers to the fund and revenue at the possession of the bank and day to day management of the same. Treasury channelizes the movement of the funds within the organization for profit maximization. Treasury is basically concerned with managing BOIs liquidity and managing cash resources so as to ensure that right amount of money is available at the right time. It is used to manage the funds of BOI as far as optimizing the profits on deployment of surplus funds and finding the cheapest source of resources for funding deficits while complying with the norms of RBI. The treasury branch is a profit centre within BOI and is not allowed to make a loss. The treasury at BOI has business presence in: Investments in SLR and Non SLR Forex Market Money Market Derivatives Market Equity Market

The advantage of an Integrated Treasury is that at any point of time the bank has a wide array of opportunities to choose from derivatives, forex, equity, government securities and hence profits can be optimized by careful deployment of resources. Banks face intense competition in mobilizing resources and deployment of resources, resulting in rising costs and falling yields. The competition comes from not only the Mutual Funds but also from the Private sector banks and foreign banks that have lower operating costs and better technology. It is hence imperative that BOI has sound investment policies which provide for expeditious decision making and efficient risk management.

As a part of my program, I was exposed to the following policies and guidelines:

Investment Policy Derivative Policy Dealing Room Operations and Forex policy Operational Guidelines

This was the first stage of my learning at BOI and the knowledge base developed through these readings was immensely helpful throughout the program. In this report the statistics are not revealed as directed by my company guide, however, the report describes these policies succinctly. BOI has divided its Treasury Operations into Dealing Section (Front Office) and Settlement (Back Office) for the purpose of exercising internal control. Mid office has been established for conducting research and analysis. Risk Management System (RMS) has been entrusted to the back office for the same purpose. As a part of the summer internship, I was exposed to the functions of Back office and mid office and partly to the functions of front office due to restricted entry inside the front office. In this report I have tried to provide the information of Integrated Treasury Management of BOI to the best of my knowledge.

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1. Introduction to Treasury
1.1 Introduction Treasury management is the management of an organizations liquidity to ensure that right amount of cash resources are available in the right place in the right currency at the right point of time in such a way that as to maximize the financing cost of the business and control interest rate risk and currency exposure to an acceptable level. Treasury management includes management of enterprise holdings in and trading in government and corporate bonds, currencies, financial futures, options and derivatives, payment systems and the associated financial risk management. In general terms and from the perspective of commercial banking, treasury refers to the fund and revenue at the possession of the bank and day to day management of the same. Idle funds are usually source of loss, real or opportune, and thereby need to be managed, invested and deployed with intent to improve profitability. There is no profit or reward without attendant risk. Thus treasury operations seek to maximize profit and earning by investing available funds at an acceptable level of risks. Returns and risks both need to be managed. 1.2 Integrated Treasury Management Traditionally, the role of the Treasury in Indian banks was limited to ensuring the maintenance of the RBI-stipulated norms for CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio). Activity in foreign exchange was confined to meeting merchants and customers requirements for imports, exports, remittances and deposits.
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The reforms that were initiated in 90s made domestic markets closely linked to Global markets. The deregulation of financial markets began with the shift to market determined exchange rates and moved ahead with the freeing of bank deposit and lending rates. The need of Integration of forex dealings and domestic treasury operations has arisen on account 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. Post-liberalization, deregulation and financial market reforms, a vibrant bond market has evolved in the country. This has enhanced the relative importance of investments and the investment portfolio in the balance sheet of banks. Investments are now viewed as an alternative to credit, the historical source of profit for banks. The volatility in interest rate is at the heart of the transformation of bank treasuries from mere CRR and SLR keepers to a profit centre. The basic objective of integration is to improve portfolio profitability, risk insulation and synergize banking assets with trading assets. 1.3 Objectives of Treasury Department To take the advantage of the attractive trading and arbitrage opportunities in the bond and forex markets. To deploy and invest the deposit liabilities, internal generation and cash flows from maturing assets for maximum return on a current and forward basis with the banks risk policies/appetite. To fund the balance sheet on current and forward basis as cheaply as possibly taking into account the marginal impact of these actions. To effectively manage the forex assets and liabilities of the bank. To manage and contain the treasury risks of the bank within the approved and prudential norms of the bank and regulatory authorities. To adopt the best practices in dealing, clearing, settlement, and risk management in treasury operations.

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To maintain statutory reserves-CRR and SLR as mandated by the RBI on current and forward planning basis. To identify and burrow on the best terms from the market to meet the clearing deficit of the bank. To offer comprehensive value added treasury and related services to the banks customer.

To achieve above objectives, individuals banks have to follow policies linked to overall business strategies and plans. Specific Treasury Policies and goals. Specific guidelines for managing and various risks. Specific guidelines to build I.T. and analytical capabilities. Specific earning targets on ROE & ROA and acceptable risk levels and limits. Specify internal structure and decision making tools.

Deposits mobilized by banks are required to be deployed either in loans & advances or in investments. While doing this every bank has to take care of credit risk and market risk. The portions of such deposits which are not lent are invested Non-SLR securities. Since SLR securities are more risk free and there is compulsion to invest their return is generally low. Non-SLR security investments are to be shuffled both within and between them taking into account the interest rate movements and connected price movements.

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2. Bank of India
2.1 Introduction Bank of India (BOI) was founded on 7th September, 1906 by a group of businessman from Mumbai. The promoters incorporated the Bank under Act VI of 1882, with an authorized capital of Rs. 1 crore divided into 100,000 shares each of Rs. 100. The promoters placed 55,000 shares privately, and issued 45,000 to the public by way of IPO on 3 October 1906; the bank commenced operations on 1 November 1906. Earlier Bank of India was under private ownership and control, that is, till 1969.In the year 1969, it was nationalized. Bank of India has a strong national presence and sizeable international operations and also good business volume. It has 4157 branches as on 21/04/2012, including 29 branches outside India, and about 1679 ATMs. All the branches are controlled through its 48 zonal offices and 27 branches /offices approach (Including 3 representative offices) and 1 joint venture abroad. Bank of India came out with its public issue in 1997 and follow on Qualified Institutional Placement in February 2008.It established its fully computerized branch and ATM facility in 1989.It is a founder member of SWIFT in India. It pioneered the introduction of Health Code System in 1982, for evaluating/ rating its credit portfolio. Bank of India formed an association with BSE and founded BOI Shareholding Ltd. to extend depository services to stock broking community. The Bank's association with the capital market goes back to 1921 when it entered into an agreement with the Bombay Stock Exchange (BSE) to manage the BSE Clearing House. It is an
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association that has blossomed into a joint venture with BSE, called the BOI Shareholding Ltd. to extend depository services to the stock broking community. Bank of India was the first Indian Bank to open a branch outside the country, at London, in 1946, and also the first to open a branch in Europe, Paris in 1974. The Bank has sizable presence abroad, with a network of 29 branches (including five representative offices) at key banking and financial centres viz. London, New York, Paris, Tokyo, Hong-Kong and Singapore. The international business accounts for around 17.82% of Bank's total business.

While firmly adhering to a policy of prudence and caution, the Bank has been in the forefront of introducing various innovative services and systems. Business has been conducted with the successful blend of traditional values and ethics and the most modern infrastructure. The Bank has been the first among the nationalized banks to establish a fully computerized branch and ATM facility at the Mahalaxmi Branch at Mumbai way back in 1989.

2.2 The Emblem The Banks corporate personality and philosophy are fully reflected in the emblem, which is a five-pronged Star-a harmonious blend of tradition and function. The elongated prong pointing upward conveys the banks drive to achieve ascending goal s. The star is a beacon and guide to those in need of direction. 2.3 BOIs Mission

"To provide superior, proactive banking services to niche markets globally, while providing cost-effective, responsive services to others in our role as a development bank, and in so doing, meet the requirements of our stakeholders".

2.4 BOIs Vision

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"To become the bank of choice for corporate, medium businesses and up market retail customers and to provide cost effective developmental banking for small business, mass market and rural markets"

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3. Bank of India Treasury

3.1 Mission

To be a proactive player in bond, forex, equities and derivatives in the domestic and offshore markets and earn significant profits for the bank.

3.2 Objectives

To maintain statutory reserves- Cash Reserve Ratio (CRR) and SLR(Statutory Liquidity Ratio) as mandated by RBI. To take advantage of the attractive trading and arbitrage opportunities in the bond and forex markets. To maintain and provide sufficient liquidity at all times to meet the banks commitments. To deploy and invest the deposit liabilities, internal generation and cash flows from maturing assets for maximum return on appropriate maturities either current or forward basis consistent with BOIs risk policies.

To fund the balance sheet as cheaply as possible taking into account the marginal impact of these actions. To effectively manage the forex assets and liabilities of the bank. To manage and contain the treasury risk of the bank within the approved and prudential norms of the bank and regulatory authorities. To assess advice and manage the financial risks associated with the nontreasury assets and liabilities of the bank. To adopt the best practices in dealing, clearing, settlement and risk management in treasury operations.

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To deploy profitably and without compromising liquidity the clearing surplus of the bank. To identify and borrow on the best terms from the market to meet the clearing deficits of the bank. To offer comprehensive value-added treasury and related services to the banks customers. To act as a profit centre for the bank.

3.3 Nature of Treasury Assets and Liabilities The banks balance sheet consists of treasury assets and liabilities on one hand and non-treasury assets and liabilities on the other hand. There is a clear distinction between these two groups. In general, if a specified asset or liability is created through a transaction in the interbank market and/or can be assigned or negotiated, it becomes part of treasury portfolio of the bank. Treasury assets are generally marketable or tradable instruments. Another usual characteristic of a treasury asset is that it is required to be marked to market. An example of a treasury asset/liability which is created by corporate/treasury action/decisions on funding/deployment, but is not tradable is Inter-bank Participation Certificate. Again, Loans and advances are specific contractual agreements between the bank and its borrowers and do not form a part of treasury assets, although they are obligations to the bank. They can, however, be securitised and traded in the market).But an investment in G-Sec can be traded in the market. It is, therefore, a treasury asset. 3.4 List of BOIs Treasury Products

A. Domestic Treasury 1. Asset Products/Instruments Call/Notice Money Lending Term Money lending/Inter-bank deposits Investments in Certificates of Deposits Commercial Paper
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Inter-bank Participation Certificates Reserve Repos/CBLO-backed lending through CCIL SLR Bonds (notified as such by RBI) o Issued by the Government of India o Issued by State Government o Guaranteed by Government of India o Guaranteed by State Government

Non-SLR Bonds (guaranteed/non-guaranteed) o Financial Institutions o Banks/NBFCs(Tier II Capital) o Corporate o State-Level Enterprises o Infrastructure Projects o Asset-backed Securities o Preference Shares o Equity o Mutual Funds

2. Liability Products/Instruments Call/Notice Money Borrowing Term Money Borrowing Certificate of Deposit Issues Inter-bank Participation Certificates Repos/CBLO-backed borrowing through CCIL Refinance(RBI, SIDBI, NABARD, Exim Bank, NHB) Tier II Bonds Swaps(INR borrowing, forex assets)

B. Foreign Exchange 1. Interbank Spot Cash

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Tom Forward and Forward-Forward(simultaneous purchase and sale of a currency for two different forward maturities) Swaps Foreign Currency Placements, Investments and Borrowings(in accordance with RBI guidelines) Cross Currencies o Spot o Forward

2. Merchant(initiated by branches, arranged by Forex Treasury) Pre-shipment Foreign Credit(PCFC) Foreign Currency Bills Purchased(FCBP) Foreign Currency Loans(FCLs)/FCNR(B) Loans Post Shipment Credit in Foreign Currency(PSCFC) External Commercial Borrowing(ECB)

C. Derivatives Interest Rate Swaps(IRSs) Forward Rate Agreement(FRAs) Interest Rate Futures Interest Rate Options Currency Options

D. Certain Corporate Assets such as investments in subsidiaries and joint ventures are reckoned as treasury assets although they are not traded and are permanent in nature.

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4. Organizational Structure
4.1 Introduction Organizations structure of a commercial bank treasury should facilitate the handling of all markets operations, from dealing to settlement, custody and accounting in both domestic and foreign exchange markets. In view of voluminous and complex nature of transactions handled by a treasury, various functions are segregated as follows: Front Office:-Dealing-Risk taking Mid Office:-Risk management and Management Information Back Office:-Confirmations, Settlements, Accounting and Reconciliation.

The organization of a treasury depends on the volume of activities handled. It is important that the above three functions are distinct and work in water tight compartments. The dealers are not supposed to handle settlements or accounts. The Back Office should not perform dealing but may perform accounting function and accounting section should not perform dealing but may perform Back Office function. The treasury is headed by an appropriate senior executive who directs controls and coordinates the activities of the treasury. He/she also coordinates the work between the chief dealer, the Head of Back office, Head of Research and is totally responsible for management of funds, investments and forex activity. Banks which have separate forex operations will have dealers for forex operations. Treasury will have a separate research division. Heads of Research will be assisted to carry out research activities/analysis in various types of securities. Research department may be common for money market, debt, equity and forex. Market analysis would also be provided by the research department. Appropriate Information technology (process, package and infrastructure) is necessary for the treasury management as the operations are distinct from branch banking and are also very critical. The fund manager looks into the liquidity position, fund flows, and

maintenance of reserve requirements. Risk manager should be posted in treasury for

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facilitating the evaluation of scenarios, independent review of line /limit excess, reviews of transactions to ensure compliance with regulations, monitor risk factorscredit risk, liquidity risk, interest risk, operational risk in the transactions and give guidance to the front line, viz. Dealers to remain in touch with the product and market developments. DIAGRAM 4.1 Organizational Structure

CMD

Executive Director

General Manager (Treasury)

Deputy General Manager

Chief Dealer/AGM

AGM (Back Office)

Chief Manager (Dealing)

Chief Manager (Mid Office)

Chief Manager (Forex Back Office)

Chief Manager (Admin/Investment Back Office)

Senior Manager (Mid Office) Senior Manager (G-Secs)

Chief Manager (IT)

Senior Manager (IT) Senior Manager (Money Market & Derivatives) Senior Manager (Forex) Senior Manager (Administration) Senior Manager (Investment Back Office)

Senior Manager (Forex backup)

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Senior Manager (Nostro Recon.)

4.2 Front Office The front office of a treasury has a responsibility to manage investment and market risks in accordance with instructions received from the banks ALCO. This is undertaken through the Dealing Room which acts as the bank interface to international and domestic financial markets. The dealing Room is the centre for market and risk management activities in the bank. It is the clearing house for risk and has the responsibility to manage the treasury risks taken in all areas of the bank, on behalf of customers, on behalf of the bank, within the policies and limits prescribed by the Board and Risk Management Committee. For this reason the significant authority is given to the Treasure and the Dealing Room staff to commit the banks to the market. Treasury also functions as the profit centre of the bank. It is therefore important that the treasury is managed efficiently. In view of this, control over the activities of the treasury and its staff are critical to ensure that the bank is protected from undue market risk. 4.3 Mid Office Mid Office is responsible for onsite risk measurement, monitoring and management reporting. The other functions of Mid Office are: Limit setting and monitoring exposures in relations to units. Assessing likely market environments based on internal assessments and external /internal research. Evolving hedging strategies for assets and liabilities. Interacting with the banks Risks Management Department on liquidity and market risk. Monitoring open currency position. Calculating and reporting VAR. Stress testing and back testing of investment and trading portfolios. Risk return analysis Marking open positions to market to assess unrealized gain and losses.
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4.4 Back Office The key functions of the back office are: Deal slip verification Generation and dispatch of interbank confirmations Monitoring receipt of confirmations of forward contracts Effective/ receiving payments Settlement through CCIL or direct through nostro as applicable. Monitoring receipt of forex funds in interbank contracts Statutory reports to RBI Management of nostro funds to advice latest funds positions to enable the F/O to take the decision for the surplus/ short fall of funds Reconciliation of nostro/vostro accounts Monitoring approved exposure and position limits Accounting

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5. Investment & Money Market

Within the prudential and regulatory norms issued by RBI from time to time and the Banks own Investment policy guidelines, BOI has been investing in both SLR and Non SLR portfolios in order to deploy funds more profitably. 5.1 Objective The investment business may be oriented to achieve the following objectives: Liquidity Management Profit maximization Supplementary Service

5.1.1 Liquidity Management To satisfy reserve requirements i.e. SLR To deploy surplus resources arising out of gaps in credit utilization, with reasonable liquidity. Under liquidity management meeting SLR requirements is the primary objective and profits are to be optimized within available range of G securities by making use of market opportunities in the secondary market. 5.1.2 Profit maximization To function as a profit centre and to build a diversified investment portfolio with in the policy norms.
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To engage in securities trading by active participation in primary and secondary markets. To enter retail market. To invest in securities with special status which help in saving tax, reducing capital burden and reach priority sector targets. To expand treasury activity into related areas such as syndications, assets swaps, asset sales, underwriting commitments etc.

5.1.3 Supplementary service: Planning and executing strategic investments. Investment in subsidiaries and associates. Absorbing investments resulting from devolution under corporate commitments such as undertaking commitments, compromise

arrangements in audit department etc. Investing funds on behalf of Terminal benefit and other staff related funds of the bank on no profit no loss basis. 5.2 Cash Reserve Ratio (CRR) In terms of Section 42(1) of the RBI Act 1934, Scheduled Commercial bank are required to maintain with RBI an average cash balance, the amount of which shall not be less than three percent of the total of the Net Demand and Time Liabilities (NDTL) in India, on a fortnightly basis and RBI is empowered to increase the said rate of CRR to such higher rate not exceeding 20% of the NDTL under the RBI Act 1934. At present CRR prescribed by the Reserve bank of India is 4.75% of a banks total of demand and time liabilities. The sources of borrowing for the purpose of CRR requirement are: Call/Notice money RBI Liquidity Adjustment facility Market Repo Collaterized Burrowing and Lending (CBLO)

Each of the sources will be explained in detail in the following section.

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Maintenance of CRR on a daily basis In order to provide flexibility to banks and enable them to choose an optimum strategy of holding reserves depending upon their intra period cash flow, scheduled PCBs are presently required to maintain on average daily balance, a minimum of 70% of the prescribed CRR balance based on their NDTL, as on the last Friday of the second preceding fortnight. Net demand & Time Liabilities (NDTL) Demand Liabilities include all liabilities which are payable on demand and they include current deposits, demand liabilities portion of savings bank deposits, margins held against letters of credit/guarantees, balances in overdue fixed deposits, cash certificates and cumulative/recurring deposits, outstanding Telegraphic Transfers (TTs), Mail Transfer (MTs), Demand Drafts (DDs), unclaimed deposits, credit balances in the cash Credit account and deposits held as security for advances which are payable on demand. Time Liabilities are those which are payable otherwise on demand and they include fixed deposits, cash certificates, cumulative and recurring deposits, time liabilities portion of savings bank deposits, staff security deposits, margins held against letters of Credit if not payable on demand, deposits helps as securities for advances which are not payable in demand and Gold deposits. 5.3 Statutory Liquidity Ratio (SLR) In terms of section 24 (1) and 24 (2A)(a) of Banking Regulation Act, 1949 (AACS), every bank is required to maintain , on daily basis, liquid assets, the amount of which shall not be less than 24% or such other percentage not exceeding 40%, as may be notified by RBI, of its demand and time liabilities in India as on the last Friday of the second preceding fortnight. The liquid assets may be maintained:1. Cash 2. In Gold valued at a price not exceeding the current market price.

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3. Unencumbered approved securities valued at a price as specifies by the RBI from time to time. At present SLR prescribed by RBI is 24% of a Banks total of demand and time liabilities. However, usually a higher quantum is invested in government approved securities , mainly as a buffer for any change in SLR and also enables the bank to trade in SLR securities and to optimize the yield. 5.4 Non SLR Securities Any investment which does not qualify to be a SLR security will be treated as a non SLR security. Main types covered are Commercial Papers (CPs), Non Convertible Bonds/ Debentures, Equity Issues, Pass through Certificates (PTCs), Units of Mutual Funds, Units of Venture Capital Funds, etc. Non SLR investments help to diversify Banks Exposure to various sectors/ industries, thereby providing an alternative to credit portfolio, optimizing profit and reducing risk. Investments in non SLR securities, however, are less lucrative then credit, but are much more selective and liquid in nature. Optimum level of non SLR investments is limited to twice the Net Worth of the bank or 10% of the advances of the Bank as per the last annual balance sheet, whichever is higher. All investments should be in Dematerialized (Demat) form. Treasury also deals with book entry of securities, provided: 1. It is issued by well known PSUs and not corporate. 2. The issue is rated not below AAA or A1+ or other equivalent ratings by a recognised Rating Agency like CRISIL, CARE, ICRA, or FITCH ratings India Pvt. ltd and the tenor is up to 12 months. 3. At times, corporate securities, structured obligations or negotiated deals may not have ready secondary market, but all investments preferably are potentially tradable. However, no investment/ deal/ transaction undertaken by treasury should be by way of issue and/ or receipt of BRs. No investment should be made in unrated non SLR securities. Only exceptions are investments in securities issued directly by the Central and State

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Governments, which are not reckoned for SLR purpose; Equity shares; Units of Equity Oriented Mutual Fund schemes. Equity Shares are exempted from rating requirements by Reserve bank of India. Back to back deals from part of trading activity, and are exempted from credit rating requirements. All other debt securities should carry a credit rating of not less than investment grade from a credit rating by a recognised Rating Agency like CRISIL, CARE, ICRA, or FITCH ratings India Pvt. Ltd as directed by RBI. For Medium & Long term Bonds: [AA-] or equivalent rating by any of domestic credit rating agencies. [AAA] or equivalent rating by any of domestic credit rating agencies in case of debt instrument issued by NBFCs. OR [A] or equivalent rating by international rating agencies for domestic issues. OR Rating equivalent to sovereign rating of India, for international issues, by any of the international rating agencies. For Short Term Debts: All short term debt instruments with maturity with maturity/ residual maturity of 1 year or less. A1/P1 or equivalent rating by any domestic credit rating agencies; A1+/P1+ or equivalent rating by any one of domestic credit rating agencies in case of debt instruments issued by NBFCs. 5.5 Government Securities Market The Government securities market consists of securities issued by the State government and the Central government. Government securities include Central Government securities, Treasury bills and State Development Loans.

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They are issued in order to finance the fiscal deficit and other short and long term funding requirements of the Government. The securities are issued at par value (Rs 100) and have a coupon rate which is decided at the time of issue by auction technique. These securities pay interest at the coupon rate on a half yearly basis and are redeemed at par values on maturity. These are called dated securities because these are identified by their date of maturity and the coupon. e.g.6.49% GOI 2015 is a central Government security maturing in 2015, which carries a coupon of 6.49% payable half yearly. Government securities are highly liquid instruments available both in the primary and secondary market. In the primary market Government securities are issued through auctions (yield based or price based auction) which are conducted by the Reserve bank of India. There is a scheme of non competitive bidding in these auctions where in retail investors can participate for small accounts ranging from Rs 10,000 to Rs 2 cr face value. The tenor of these securities ranges from 1 year to 30 years. The secondary market consist of both a telephonic market where in brokers provide quotes to market participants which has to be reported to NSE/BSE and the electronic trading system operated by the Reserve bank of India known as Negotiated Dealing Systems Order Matching (NDS-OM). The instruments traded on the NDS-OM include G-secs, T Bills, etc. The settlement of all such trades takes place through the Clearing Corporation of India Limited (CCIL) which guarantees the settlements. The market trades from 9 am to 3:30pm from Monday to Friday. 5.6 Negotiated Dealing System (NDS) Negotiated Dealing System (NDS) is an electronic platform for facilitating dealing in Government securities and money market instruments. The Indian debt market has witnessed significant transformation with the introduction of the NDS which is used for trading of the instruments like Government of India Date Securities, State Government securities, Call/Notice/Term Money, Commercial paper, Certificate of Deposits (CD), Repos/Reverse Repos.
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Membership of the NDS is open to all institutions which are members of Indian Financial Network (INFINET) and have Subsidiary Ledger Accounts (SGL) with the RBI.

NDS facilitates electronic submission of bids/application by members for primary issuance of government securities by RBI through auction and flotation. The system of submission of physical SGL transfer for deals done between members on implementation of NDS has been discontinued. NDS also provides an interface to Securities Settlement System (SSS) of public debt office, RBI thereby facilitating settlement of transactions in Government Securities including T Bills, both outright and repos.

With effect from August 2005, another platform has been made available through the medium of CCIL called as the NDS-OM (Order Matching) system. This system is an order matching system as the name suggests. The members like bank of India put in their orders for purchase and sale of government securities and the system matches the trades on a price/time priority basis (Just like the Stock Exchange mechanisms), Irrespective of whether the trade has taken place over the NDS or NDS-OM, the information is made available to CCIL for further processing as explained later.

No identity of the parties is disclosed to the market. Only the vital information of a transaction viz., ISIN of the security, nomenclature, amount (face value), price rate and /or indicative yield, in case applicable, is disseminated to the market, through Market and Trade Watch.

Steps involved in the G-sec settlement process through CCIL In order to facilitate a better understanding of the securities settlement system, as also the role of CCIL in the SSS 1. The Deal details are taken into the PDO-NDS system based on the transactions taking place in the g-sec market between members. These deals could be actually negotiated over the NDS itself or could be entered into by members outside the system and thereafter reported over the NDS. 2. At the cut-off time, 2.30 pm for T+0 (same day only for repo transactions) settlement and 5.30 pm for T+1 (next working day) settlement, the deal information is extracted from the PDO-NDS system and sent to CCIL.

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3. At CCIL, the deal information so received from NDS will be validated for preliminary details such as NDS membership id, CCIL membership id, membership status, instrument details etc. 4. Simultaneously, CCIL also receives the trade details from the NDS-OM (Order Matching) platform which also need to be accounted in further steps for the purpose of risk assessment, clearing and settlement with the guarantee extended by CCIL. 5. The next step at CCIL involves verification of exposures of the members. For each member, the trades which are to be settled on that day are taken, margin factors applicable to the security are applied and the initial margin for all trades for each member is calculated. The total Initial Margin thus arrived for each member is verified against that members contribution in the SGF. If the margin requirement is within the members contribution in the SGF, all the trades are taken up for settlement with settlement guarantee by CCIL. However, if the margin requirement exceeds the members balance in the SGF, a suitable report is generated and the member will be advised to make additional contribution within a stipulated time, failing which the deals which are in excess of the SGF balance are sent for settlement without the settlement guarantee given by CCIL. A suitable report to this effect is sent to the concerned member. 6. The next step is that of Novation. Novation is a process by which the contract between the original trading counterparties is replaced by a standard contract each party has with CCIL. In other words, CCIL replaces the single original contract with two contracts where CCIL acts as the buyer to the seller and as seller to the buyer. Thus the bilateral counterparty risk which existed in the deal stands replaced by a standard risk which each party has with CCIL. 7. Thereafter, the settlement obligations are arrived at by CCIL by netting the securities as well as funds obligations so as to enable final settlement on DvP-III basis. (DvP-I is where both funds and securities are settled on gross basis; DvP-II where funds are settled on net basis while securities are settled on gross basis and DvP-III is a process by which funds are settled on net basis and securities obligations is also netted security wise). 8. The final settlement position thus arrived at are sent to RBI (PDO-NDS system) by CCIL so as to facilitate actual settlement of transactions.

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9. The settlement data received from CCIL is taken up for further processing by Public Debt Office, Mumbai where the investments of all major players in the government securities market is held in the form of centralized SGL accounts as well as Constituent SGL accounts of NDS members under the Securities Settlement System component of the PDO-NDS. 10. The settlement data thus obtained from CCIL is processed by PDO and Deposit Accounts Department, Mumbai under the Delivery versus Payment mechanism. For this purpose, the Securities Pay-in takes place first wherein the members who have a net obligation to pay securities will pay the securities to CCIL (because of Novation). The members balance for respective loans will be debited in their SGL account and the account of CCIL will credited. 11. Where members do not have sufficient balance of any security in their SGL account, the entire settlement file will be sent back to CCIL. At CCIL, the deal status for settlement guarantee will be verified and thereafter, CCIL will change the settlement details in such a manner as to debit the SGF account for the concerned security where default has occurred. In case the security is not available with CCIL, the Securities Line of Credit arrangement entered into by CCIL with a few members will be invoked and securities pay-in details will be altered so that the required securities are taken from these accounts. In either case, the funds to be paid to the defaulting member will be withheld. In case the transaction is not under the umbrella of CCIL guarantee, it may be withdrawn from settlement by CCIL, in which case it will be treated as SGL bouncing and any arbitration arising out of such a situation will be settled outside the NDS system. 12. After the securities pay-in at PDO, the next step is to ensure payment of funds by the members who have a net payment of funds obligation before the securities are released by PDO. For this purpose, the funds obligation details are sent to DAD Mumbai 13. The funds pay-out takes place with net paying members paying funds from their current accounts to the CCIL account (because of Novation). 14. In case of funds shortage, the CCIL has made arrangements for funds Line of Credit with a few members having current account with Mumbai DAD and standing instructions have been given to RBI to make use of these lines of credit so as to complete the settlement.

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15. The next step is that of Funds Pay-out wherein the funds are paid out from CCIL current account to those members who are net receivers of funds in that settlement. (Here of course, in case of securities default by any member, funds are suitably withheld by CCIL and the corrected settlement instructions sent to RBI as explained above) 16. DAD Mumbai then forwards the completed settlement instructions to PDO Mumbai where the utilization of lines of credit, if any, are automatically recognized by the securities settlement system. In such instances, the status is reported to CCIL for appropriate measures (of withholding securities to members who have defaulted in funds) at their end. 17. In case of no default in funds or after receiving the corrected instructions from CCIL, PDO Mumbai then proceeds with Securities Pay-out whereby the securities held in CCIL account during the securities pay-in are credited to members SGL account who have to receive securities as their net position for the settlement. 18. The final status of the deal after settlement has to be updated in the deal related information in the NDS system. For this purpose, the status update of each deal takes place based on the settlement completion information received from PDO Mumbai (SSS module). 19. The updated deal status is also made available to the concerned members so that they can verify the deal status as well as available balances in their SGL accounts directly from the SSS.

5.7 Money Market The money market in that part of a financial market which deals in the borrowing and lending of short term loans generally for a period of less than or equal to 365 days. It is a mechanism to clear short term monetary transactions in an economy. According to the RBI, "The money market is the centre for dealing mainly of short character, in monetary assets; it meets the short term requirements of borrowers and provides liquidity or cash to the lenders. It is a place where short term surplus investible funds at the disposal of financial and other institutions and individuals are bid by borrowers, again comprising institutions and individuals and also by the government."

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Functions of Money Market:Money market is an important part of the economy. It plays very significant functions. As mentioned above it is basically a market for short term monetary transactions. Thus it has to provide facility for adjusting liquidity to the banks, business corporations, non-banking financial institutions (NBFs) and other financial institutions along with investors. The major functions of money market are given below:1. To maintain monetary equilibrium. It means to keep a balance between the demand for and supply of money for short term monetary transactions. 2. To promote economic growth. Money market can do this by making funds available to various units in the economy such as agriculture, small scale industries, etc. 3. To provide help to Trade and Industry. Money market provides adequate finance to trade and industry. Similarly it also provides facility of discounting bills of exchange for trade and industry. 4. To help in implementing Monetary Policy. It provides a mechanism for an effective implementation of the monetary policy. 5. To help in Capital Formation. Money market makes available investment avenues for short term period. It helps in generating savings and investments in the economy. 6. Money market provides non-inflationary sources of finance to government. It is possible by issuing treasury bills in order to raise short loans. However this does not leads to increases in the prices. Apart from those, money market is an arrangement which accommodates banks and financial institutions dealing in short term monetary activities such as the demand for and supply of money The most commonly used Money markets instruments are as follows 5.7.1 Call/ Notice Money

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The call/notice/term money market is a market for trading very short term liquid financial assets that are readily convertible into cash at low cost. The money market primarily facilitates lending and borrowing of funds between banks and entities like Primary Dealers. An institution which has surplus funds may lend them on an uncollateralized basis to an institution which is short of funds. The period of lending may be for a period of 1 day which is known as call money and between 2 days and 14 days which is known as notice money. Term money refers to borrowing/lending of funds for a period exceeding 14 days. The interest rates on such funds depend on the surplus funds available with lenders and the demand for the same which remains volatile. 5.7.2 Collateralized Borrowing and Lending Obligation (CBLO) CBLO is a money market instrument by Cleaning Corporation of India in January 2003. It is a discounted instrument with maturity ranging from 1 day up to 1 year, backed by collaterals, and redeemable at par. CBLOs are traded electronically, on line, on an anonyms order matching system facilitating price discovery and transparency. Banks, financial institutions, primary dealers, mutual funds, NBFCs and corporate can be members. 5.7.3 Treasury Bills Treasury bills are money market instruments offered to finance short term debt obligation of the Government of India. Three types of T bills are issued, namely 91day, 182-day and 364-day Treasury Bills, through a competitive bidding process of auction. Only a few institutions like state governments and Central Bank of Nepal are allowed to participate in the T-Bills auctions on a non-competitive basis whereby full amount of security is allocated at the yield determined at the auction.

The table as under describes the types of T-Bills, day of auction and payments, and the notified amount of auction. Table 5.1

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The instrument is quoted at a discount price to the par value of Rs 100. It is quoted in the secondary market on a yield basis with the minimum tradable amount of Rs. 25000. The instrument is redeemed at par value with the difference between the issue price and par value being the return on the instrument. Bills are quoted in Yield Terms. In order to convert it to price terms per Rs 100: PRICE=100/ (1+ (YIELD % * (No. of days to maturity/365))). 5.7.4 Certificate of Deposit Certificate of deposit is a negotiable money market instrument issued in dematerialised form or as a Usance Promissory Note by scheduled commercial banks excluding Regional Rural Banks (RRBs) and local Area Banks (LABs); and select all-India Financial Institutions that have been permitted by RBI to raise short-term resources.

CDs are discounted instruments and are issued at a discounted price and redeemed at par value. The tenor of issue can range from 7 days to 1 year, however most CDs are issued by banks for 3, 6 and 12 months.

CDs can be issued to individuals (other than minors), corporations, companies, trusts, funds, associations, etc. Non Resident Indians may also subscribe to CDs. However they are mainly subscribed to by banks, mutual funds, provident and pension funds and insurance companies. The minimum amount of a CD should be Rs. 1 lakh i.e., the minimum deposit that can be accepted from a single subscriber should not be less than Rs 1 lakh and in multiples of Rs 1 lakh thereafter.

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There exists an active secondary market for CDs which witnesses an average volume of Rs 200-300 crore per day with demand and supply determined by the liquidity conditions in the market. 5.7.5 Commercial Paper A Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. Corporate and primary dealers (PDs), and the all-India financial institutions (FIs) that have been permitted to raise short-term resources by Reserve Bank of India are eligible to issue CP. A corporate would be eligible to issue CP provided:

(a) the tangible net worth of the company, as per the latest audited balance sheet, is not less thanRs.4crore; (b) company has been sanctioned working capital limit by bank/s or all-India financial institution/s and (c) the borrowable account of the company is classified as a Standard Asset by the financing bank/s/institution/s. All eligible issuers are required to obtain a credit rating for issuance of Commercial Paper from a credit rating agency as may be specified by the Reserve Bank of India from time to time. The minimum credit rating should be P-2 of CRISIL or such equivalent rating by other agencies. CP can be issued for maturities between a minimum of 7 days and a maximum up to one year from the date of issue and can be issued in denominations of Rs.5 lakh or multiples thereof. CP may be issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by FIIs would be within the limits set for their investments by Securities and Exchange Board of India. Mutual Funds, Banks, Insurance companies etc are the dominant investors in the CP market. Secondary market trading takes place through the interbank broking market between institutional participants. CPs is issued at a discount to face value, as may be determined mutually by the issuer & investor.

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5.7.6 Repo Repo is a repurchase agreement entered into between eligible counterparties for borrowing and lending of funds on a collateralized basis. A repo involves selling of a security with the agreement to repurchase the same at a future date for a predetermined price. The seller of the security receives funds while the buyer of the security receives collateral for the funds he has lent. The rate at which the security will be repurchased in the 2nd leg of the repo is derived from the rate of interest payable on the funds lent and is known as repo rate.

Repo transactions are permitted between counterparties and in instruments permitted by the Reserve Bank of India. At present repo able securities include Central Government dated securities, Treasury Bills, State Development Loans and Govt of India Special Securities like Oil bonds, Food bonds, and Fertiliser bonds. The entities permitted to undertake repo transactions include Scheduled Commercial Banks, Cooperative Banks, Primary Dealers, Mutual Funds, Insurance Companies and corporate entities. Repo transactions facilitate banks to invest surplus cash for adjusting CRR position and also for adjusting SLR positions.

A Reverse repo transaction involves the buying of securities and lending of short term surplus in the 1st leg and selling the security at a predetermined rate in the 2nd leg. A repo transaction for one counterparty becomes a reverse repo transaction for the the other counterparty. The calculation of the first leg is the same as an outright sale transaction. Total consideration =Deal rate* Face value + Accrued Interest; In the Second leg, interest paid for borrowing, i.e. the Repo Rate is adjusted with the interest earned on the securities during the holding period to arrive at the reversal price. Computation of repo interest based on Actual /365 days convention is applicable to Money market instruments. Total Consideration for second leg= Consideration for first leg + Repo Interest;

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5.7.7 Liquidity Adjustment Facility A tool used in monetary policy that allows banks to borrow money through repurchases agreements. This arrangement allows banks to respond to liquidity pressures and is used by governments to assure basic stability in the financial markets. Liquidity adjustment facilities are used to aid banks in resolving any short-term cash shortages during periods of economic instability or from any other form of stress caused by forces beyond their control. Various banks will use eligible securities as collateral through a repo agreement and will use the funds to alleviate their short-term requirements, thus remaining stable. Presently Reserve Bank of India conducts Overnight Reverse Repo auctions @7% (for absorption of liquidity) and Overnight Repo auctions @8% (for injection of liquidity) on a daily basis from Monday to Friday once a day. All Scheduled Commercial Banks and PDs having Current and SGL account with RBI are eligible to participate in the auction. Reverse Repos/ Repos will be undertaken in all SLR-eligible GOI dated Securities/ Treasury Bills and SDLS. A margin will be uniformly applied in respect of the above eligible securities i.e. 5% for GOI/TB and 10% for SDLs. RBI has the right to accept or reject the bids under LAF either wholly or partially. Securities received under Reverse Repo will count for SLR purpose and vice versa.

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6. Forex Investments
6.1 Foreign Exchange Residents in need of home currency but having receipts in foreign currency and vice versa have to convert their receipts to suit their needs Parity between two currencies Example: An importer of Goods and services in Japan, would base his profit assessments in Yen, while an exporter of the same in India would base his profit assessment of the consignment in Rupees. Out of this demand /supply dynamics emerges parity between the two currencies. Foreign Exchange as defined in Foreign Exchange Management Act, 1999 means all deposits, credits, balances payable in any foreign currency and any drafts, travellers cheque, letter of credit and bills of exchange expressed or drawn in Indian Currency and payable in foreign currency. In currency conversion the foreign currency is always treated as a commodity and the home currency as the purchasing power. Foreign exchange does not involve only trade .Trade constitutes only a small portion of foreign exchange market .The cross border capital movements means transfer of capital between countries wither by the import or export of securities, dividend payments or interest payments constitute the major portion. Happenings in the foreign exchange market (forex market) form the essence of the international finance. The foreign exchange market is not limited by any geographical boundaries. It does not have any regular market timings, operates 24 hours 7 days week 365 days a year, characterized by ever-growing trading volume, exhibits great heterogeneity among market participants with big institutional investor buying and

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selling millions of dollars/or any other currency at one go to individuals buying or selling less than 100 dollar/any other currency.

Foreign Exchange being a commodity likes any other commodities the exchange rates tend to fluctuate from time to time. There are various factors that cause the fluctuation in the rates of exchange. These factors can be divided into several following groups. These groups can affect the exchange rates on a short term as well as long-term basis. 6.2 History Before July 1944 the world currency system was different. It was based on the principal that a sum of money could buy you what it was worth in gold. Of course, not every country agreed to accept any currency in international exchange. The majority of money was not convertible into gold and was only used for internal payments in a country. Without having a noticeable influence on the world economy, these currencies were not convertible (convert meaning exchange). Only the banknotes of certain large countries were convertible into gold: Great Britain (pound sterling) and the USA (US dollar). In order to buy something abroad, for example, gold, equipment or even Chinese fur-coats, a businessman or bank had to exchange their money into US dollars or pounds first. The situation then changed. By July 1944, the Second World War had shattered the economies of most war participants except the USA, which had incurred the smallest relative losses. Countries had to decide how to reconstruct trading relationships between them and what they would be after the horrible war was over. Not long before the end of the war, representatives of 41 countries gathered together in Bretton Woods (a tiny city in the USA with a population today of 600 people) to discuss the reformation of the traditional system of gold standards. It is worth saying that by 1944 the USA had taken into possession two-thirds of the worlds gold reserves. Most likely that was the reason why the US dollar became the only reserve currency in the world after the Bretton Woods meeting. In other words, 41 countries confirmed that only gold could be more reliable than US dollars. After the Bretton Woods system lost its power in December 1971, the US dollar naturally
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devalued and in reaction the price of gold rose. A Troy ounce of gold cost 38 US dollars and a year later it cost 42.2 dollars. Japan and nearly all the European countries decided to ignore the agreement and left it in 1973, as they felt there was little support for countries in trouble. At that very moment, the system of fixed rates was dead and its place was taken by an unpublished system of floating rates with decisive interference from Central Banks. In January 1976 in Kingston, Jamaica IMF participant countries gathered once again to sign a new document to control international trading. The meaning of this document can be summarized in the following statements:

Gold was no longer an equivalent to money and there was no need for the golden cover anymore. So gold gradually drifted to the category of goods or raw materials. One could buy any amount of gold in any country and the US dollar exchange rate would have nothing to do with it;

Since that moment, countries became responsible for the destiny of their currency: whether it should have floating, fixed or other limited rate;

A new international currency SDR (Special drawing rights) was introduced. It was a type of absolute money of the IMF that existed in some special accounts of certain countries. Balances of these accounts corresponded with the contribution of a given country to the IMF;

Central Banks of different countries were allowed to shape their own policy.

The Jamaican meeting was not only meant to bring joy to its participants but to mark the beginning of a new flexible system of international trading which would help to make it more simple for new countries to adapt to the situation. Nevertheless, the US dollar remained the major currency for all international payments. The Forex market is the place where trading is conducted at market prices dictated by the law of supply and demand. There are exchange and overthe-counter (interbank, OTC) currency markets. Stock exchanges, such as the New York Stock Exchange, are hives of business activity, where traders work in one building (exchange house) and all day long the cries of Buy! Sell! can be heard. In contrast, the over-the-counter Forex market is when traders sit at the office or even at their apartments and use special

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software to buy or sell currencies. Most Forex brokers will allow you to deal through the interbank market. 6.3 Participants in Foreign Exchange The major participants in the foreign exchange market include: Central Banking Institutions Commercial banks Investment Banks Merchant Banks Foreign Exchange Brokers Merchants including Brokers Merchants including Corporations

Out of these stated above ,commercial banks became the vehicle for conversion as normally a majority of foreign exchange operations take place through the accounts ,maintained with commercial banks. Commercial banks in India require specific authorization from Reserve Bank of India for undertaking foreign exchange transactions under FEMA, 1999. Banks which have been approved are known as Authorized Dealer banks in foreign exchange and they are required to be members of FEDAI (Foreign Exchange Dealers Association of India).

6.3.1 Foreign Exchange Dealers

Banks, and a few nonbank foreign exchange dealers, operate in both the interbank and client markets. They profit from buying foreign exchange at a bid price and reselling it at a slightly higher ask price. Worldwide competitions among dealers narrows the spread between bid and ask and so contributes to making the foreign exchange market efficient in the same sense as securities markets.

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Dealers in the foreign exchange departments of large international banks often function as market makers. They stand willing to buy and sell those currencies in which they specialize by maintaining an inventory position in those currencies.

Participants in Commercial and Investment Transactions: Importers and exporters, international portfolio investors, multinational firms, tourists, and others use the foreign exchange market to facilitate execution of commercial or investment transactions. Some of these participants use the foreign exchange market to hedge foreign exchange risk.

6.3.2 Speculators and Arbitragers Speculators and arbitragers seek to profit from trading in the market. They operate in their own interest, without a need or obligation to serve clients or to ensure a continuous market. Speculators seek all of their profit from exchange rate changes. Arbitragers try to profit from simultaneous exchange rate differences in different markets.

6.3.3 Central Banks and Treasuries:

Central banks and treasuries use the market to acquire or spend their country's foreign exchange reserves as well as to influence the price at which their own currency is traded. In many instances they do best when they willingly take a loss on their foreign exchange transactions. As willing loss takers, central banks and treasuries differ in motive and behaviour form all other market participants.

6.3.4 Foreign Exchange Brokers:

Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction. For this service, they charge a small commission, and maintain access to hundreds of dealers worldwide via open telephone lines.

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It is a broker's business to know at any moment exactly which dealers want to buy or sell any currency. This knowledge enables the broker to find a counterpart for a client quickly without revealing the identity of either party until after an agreement has been reached. The other major providers of foreign exchange are: Full fledged money changers Travel agents, hoteliers, reputed departmental stores who are permitted to buy and sell foreign currency notes, cheques etc. Restricted Money Changers Those who are authorised to buy notes & cheques. 6.4 Forex Hierarchy Even though the forex market is decentralized, it isn't pure and utter chaos! The participants in the FX market can be organized into a ladder. To better understand what we mean, here is a neat illustration: Figure 6.1

At the very top of the forex market ladder is the interbank market. Composed of the
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largest banks of the world and some smaller banks, the participants of this market trade directly with each other or electronically through the Electronic Brokering Services (EBS) or the Reuters Dealing 3000-Spot Matching. The competition between the two companies - the EBS and the Reuters Dealing 3000Spot matching - is similar to Coke and Pepsi. They are in constant battle for clients and continually try to one-up each other for market share. While both companies offer most currency pairs, some currency pairs are more liquid on one than the other. For the EBS platform, EUR/USD, USD/JPY, EUR/JPY, EUR/CHF, and USD/CHF are more liquid. Meanwhile, for the Reuters platform, GBP/USD, EUR/GBP, USD/CAD, AUD/USD, and NZD/USD are more liquid. All the banks that are part of the interbank market can see the rates that each other is offering, but this doesn't necessarily mean that anyone can make deals at those prices. Like in real life, the rates will largely dependent on the established CREDIT relationship between the trading parties. Just to name a few, there's the "B.F.F. rate," the "customer rate," and the "ex-wife-you-took-everything rate." It's like asking for a loan at your local bank. The better your credit standing and reputation with them, the better the interest rates and the larger loan you can avail. Next on the ladder are the hedge funds, corporations, retail market makers, and retail ECNs. Since these institutions do not have tight credit relationships with the participants of the interbank market, they have to do their transactions via commercial banks. This means that their rates are slightly higher and more expensive than those who are part of the interbank market. At the very bottom of the ladder are the retail traders. It used to be very hard for us little people to engage in the forex market but, thanks to the advent of the internet, electronic trading, and retail brokers, the difficult barriers to entry in forex trading have all been taken down. This gave us the chance to play with those high up the ladder and poke them with a very long and cheap stick. 6.5 Exchange Rate

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The rate at which one currency is converted into another currency is called Exchange Rate. Exchange Rate can be quoted in two ways: 1) Direct Quote A given number of units of local currency per unit of foreign currency Example: US$1= INR 55.3900

2) Indirect Quote A given number of units of foreign currency per given units of local currency. Example: INR 100=US $ 1.8070 In India it was the practice to use the indirect method of quotation. However from 2nd August 1993, direct quotation is being used in India. Two way quotes Another development in the market is the adoption of two- way rate quotations(simultaneous buying and selling rates).In keeping with the basic motivation of the AD category I banks to deal in the interbank market to cover their merchant transactions only one-way rates were being used. However, now-a days active banks quote two way prices .Such quotations help not only in adding depth and liquidity but also in developing expertise in the dealers to quote rates in tune with market development and currency position emerging in their book. Base Currency For example, if you were looking at the USD/INR currency pair, INR would be the base currency and the U.S. dollar would be the quote currency. The price represents how much of the quote currency is needed for you to get one unit of the base currency.

Purchase and Sale

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From the Authorized Dealers point of view conversion of foreign currency on behalf of an exporter into Indian Rupees would involve a purchase and conversion of domestic currency into foreign currency on behalf of an importer would be a sale. Likewise outward remittance would involve sale of foreign currency while inward remittance would involve purchase of foreign currency. Purchase and sale are not affected at the same rate. A dealer in foreign exchange like any other trader would like to make profit from the differentials. For example, Authorized dealer would buy US$ @ INR 55.3700 and sell US$ @ 55.3900. He would buy at a lower rate and sell at a higher rate.

The maxim applied is: Buy low-Sell high Or Give less-Take more

6.6 Types of Transactions

Outright-Cash / ready TOM (Tomorrow) Spot Forward

Same day value Next working/business day Settlement made two working or business days from today. All deals over two working/business days from today, fixed at the time of dealing.

Swap

The simultaneous purchase and sale of identical amounts of a currency for different value dates

6.6.1 Spot Market:

The term spot exchange refers to the class of foreign exchange transaction which requires the immediate delivery or exchange of currencies on the spot. In practice the settlement takes place within two days in most markets. The rate of exchange effective for the spot transaction is known as the spot rate and the market for such transactions is known as the spot market. 6.6.2 Forward Market: The forward transactions is an agreement between two parties, requiring the delivery at some specified future date of a specified amount of foreign currency by one of the parties, against payment in domestic currency be the other party, at the price agreed upon in the contract. The rate of exchange applicable to the forward contract is called the forward exchange rate and the market for forward transactions is known as the forward market. The foreign exchange regulations of various countries generally regulate the forward exchange transactions with a view to curbing speculation in the foreign exchanges market. In India, for example, commercial banks are permitted to offer forward cover only with respect to genuine export and import transactions. Forward exchange facilities, obviously, are of immense help to exporters and importers as they can cover the risks arising out of exchange rate fluctuations be entering into an appropriate forward exchange contract. With reference to its relationship with spot rate, the forward rate may be at par, discount or premium. If the forward exchange rate quoted is exact equivalent to the spot rate at the time of making the contract the forward exchange rate is said to be at par. The forward rate for a currency, say the dollar, is said to be at premium with respect to the spot rate when one dollar buys more units of another currency, say rupee, in the forward than in the spot rate on a per annum basis. The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot rate when one dollar buys fewer rupees in the forward than in the spot market. The discount is also usually expressed as a percentage deviation from the spot rate on a per annum basis. The forward exchange rate is determined mostly be the demand for and supply of forward exchange. Naturally when the demand for forward exchange exceeds its
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supply, the forward rate will be quoted at a premium and conversely, when the supply of forward exchange exceeds the demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand for forward exchange, the forward rate will tend to be at par. 6.6.3 Futures While a focus contract is similar to a forward contract, there are several differences between them. While a forward contract is tailor made for the client be his international bank, a future contract has standardized features the contract size and maturity dates are standardized. Futures cab traded only on an organized exchange and they are traded competitively. Margins are not required in respect of a forward contract but margins are required of all participants in the futures market an initial margin must be deposited into a collateral account to establish a futures position. 6.6.4 Options While the forward or futures contract protects the purchaser of the contract from the adverse exchange rate movements, it eliminates the possibility of gaining a windfall profit from favourable exchange rate movement. An option is a contract or financial instrument that gives holder the right, but not the obligation, to sell or buy a given quantity of an asset as a specified price at a specified future date. An option to buy the underlying asset is known as a call option and an option to sell the underlying asset is known as a put option. Buying or selling the underlying asset via the option is known as exercising the option. The stated price paid (or received) is known as the exercise or striking price. The buyer of an option is known as the long and the seller of an option is known as the writer of the option, or the short. The price for the option is known as premium. Types of options: With reference to their exercise characteristics, there are two types of options, American and European. A European option cab is exercised only at the maturity or expiration date of the contract, whereas an American option can be exercised at any time during the contract. 6.6.5 Swap operation
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Commercial banks who conduct forward exchange business may resort to a swap operation to adjust their fund position. The term swap means simultaneous sale of spot currency for the forward purchase of the same currency or the purchase of spot for the forward sale of the same currency. The spot is swapped against forward. Operations consisting of a simultaneous sale or purchase of spot currency accompanies by a purchase or sale, respectively of the same currency for forward delivery are technically known as swaps or double deals as the spot currency is swapped against forward. 6.6.5 Arbitrage Arbitrage is the simultaneous buying and selling of foreign currencies with intention of making profits from the difference between the exchange rate prevailing at the same time in different markets. 6.7 Merchants Transactions

Retail transactions involve bank and customers as two parties where bank sell foreign currency or buy foreign currency from the customers. Merchant transactions could be of cash, tom spot and forward types involving forex receipts and payments. Rates are provided by corporate dealer, depending upon deal size. It involves: TT(telegraphic Transfer) buying/TT selling Bill Buying/Bill Selling TC(Travellers Cheque) buying/selling FC (Foreign Currency) buying/selling

Is base rate available for retail transactions? No, base rates are meant for inter-bank transactions alone. Transactions relating to non-bank customers involve additional work. Say for example, a customer calls on you for a DD in US $ 300. Similarly, an importer calls on you for arranging payment of his import bills designated in dollars. No doubt, these two are foreign currency sale transaction, but work involved for the Dealer is different i.e. issuing DD is a simple transaction of
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recovering equivalent rupees from a customer and issue a DD in foreign currency. Secondly, rupee equivalent is received from the customer while issuing DD itself and the same remained with the Dealer till DD is actually en cashed abroad. Whereas, in case of import bill, work involved is not that simple for the bill has to be scrutinized on receipt of documents; recorded; acknowledged; presented to the drawee; followed up for payment; etc. Hence, a Dealer naturally likes to be compensated for the additional work being undertaken by him. So, he sells the currency a little costlier i.e. at a worse rate to the importercustomer as compared to the remittance-customer. Thus, Dealers quote different kinds of rates for undertaking different kinds of transactions of their non-bank customers by loading different rates of profit margins and such rates are known as Merchant Rates. Member banks are now free to load exchange margins at their discretion for the transactions, subject to compliance of maximum spreads and other provisions relating to calculation of exchange rates as prescribed by FEDAI from time to time. Are these margins mandatory? A dealer uses his discretion to load margins on various quotes, keeping in view: Size of transaction - a sale of 1 lac dollars would be at a finer rate than the sale of 100 dollars; Customer relationship - a regular customer, giving large volumes, obviously commands finer margins.

Customer awareness - customer knowing as to what is happening across the Dealing Rooms, both domestic and overseas, obviously enjoys a better rate.

Are there different Merchant Rates? Yes, there are different rates meant for different transactions, for example: 6.7.1 Merchant TT Buying Rates: It is meant for:
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Purchase of TT/MT/DD for which cover has already been credited to ADs nostro account. Converting proceeds of bills/cheques under collection as soon as nostro account is credited. Cancellation of an outward TT/MT/DD/PO etc. Cancellation of forward sale contract (forward rate to be used when delivery is in future).

The rate is quoted as: Base Rate - Exchange Margin

Select appropriate Base Rate (market buying rate) Ex. US $ 1 = Rs.55.5000

(-) exchange margin Rs 0.0500 --------------------Rs.55.4500 6.7.2 Merchant TT Selling Rate It is meant forRemitting foreign currency in the form of DD/TT/MT/PO etc. Paying import bills received by importer directly.

Cancelling purchases already made

Eg: Bills purchased earlier returned unpaid; Bills purchased earlier transferred to collection account Cancelling forward purchase contract (forward rate to be used when delivery is in future);

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Generally, TT Selling Rate is applied to all clean remittances i.e. no documents are to be handed by the bank.

The rate is quoted = Base Rate + Exchange Margin Choose an appropriate Base Rate; (Market Selling Rate) Ex. US $ 1 = Rs.55.50/51 (+) Margin 4 paisa Rs.55.5100 +Rs. 0.0400 --------------Rs.55.5500 Rounded off up to two digits in multiples of 1 paisa. Rs.55.55

6.7.3 Merchant Bill Buying Rate It is meant for Purchasing/discounting/negotiating of Export Bills; as it involves extra labour by way of handling the documents, etc., cost of handling is loaded to the base rate; The rate is quoted - Select appropriate Base Rate; Add/deduct on-going forward premium / discount depending upon the transit period, tenor of the bill such as sight, usance and grace period, etc. Deduct appropriate exchange margin. And resultant rate rounded off as per FEDAI Guidelines. 6.7.4 Merchant Bill Selling Rate It is meant for Remittance of Import Bills proceeds.(received through banks) The rate is quoted = TT Selling Rate + Exchange Margin Arrive at Merchant TT Sale Rate (as determined above); Rs.55.55 (+) appropriate exchange margin 5 paisa; That is ; Rs.55.55

Rs. 0.05

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Rs.55 How Travelers cheques in foreign currency purchased/sold? Buying Banks first month forward rate of the currency of travelers cheques is taken as base rate and crossed with appropriate dollar/currency rates abroad. From this crossed rate, an all-inclusive margin not exceeding 1% is deducted to arrive at the amount in rupees to be paid for every unit of foreign currency. The resultant rate is rounded up to the nearest 5 paisa.

Selling Clean TT Selling Rate is 1 unit of the base rate. To this, 0.5% margin is added at the option of ADs. A commission not exceeding 1% may be charged on the rupee equivalent of the value of foreign currency cheques sold to the customer. The resultant rate rounded off to the nearest 5 paisa. How Foreign Currency Notes bought/sold?

Buying - TC Buying Rate less 0.5% Selling - TC Selling Rate plus 0.5%

6.8 Proprietary Trading Dealers are also involved in proprietary trading .Dealers also trade foreign exchange as part of their own proprietary trade. In proprietary trading, dealers invest their own capital and undertake currency trading. Unlike the smaller margin received by dealers
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from the bid-ask spread, in proprietary trades, dealers expect a larger profit margin. They mainly undertake trades based on directional view about a currency depending on interest rate change, major policy movement.

Banks cut proprietary trades in forex as volatility mounts

MUMBAI: Banks have reduced proprietary trades in foreign exchange in view of the extreme volatility in recent days. Several treasury heads said they are squaring off their forex position by the end of the day to avoid any risk on their books. Over the past few days, the rupee has witnessed wide swings of 50 to 80 paise in a single day against dollar. The wild swings in the exchange rate are largely because of the precipitous fall of the euro against the dollar. The flight of investment into the dollar has resulted in most currencies weakening against the greenback. These include even Asian currencies whose economies are outperforming those in the West.

6.9 OTHER MERCHANT TRANSACTIONS (initiated in branches, arranged by Forex Treasury) Refer Appendix 1 6.10 Deal Authorization Refer Appendix 2

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7. Nostro Account
Figure 7.1

7.1 Introduction The above diagram shows when X (Buyer) a trader in Base Country (India) wants to purchase $5000 worth of goods by paying cash. Mr. X deposits the cash in his local bank (Importers Bank) in the country's currency (Ex.INR) for the corresponding amount ($5000). An importer of Goods and services in India, would be able to make his payment only in INR(his countrys currency) either by issuing an Cheque/Demand Draft or i n any other mode as per his convenience, while an exporter of the same in USA would base his profit assessment of the consignment in US$. The needs of the counterparties can be achieved by Nostro account which is normally used in the context of foreign exchange transactions done by the banks or during

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currency settlement .An account at a foreign bank where a domestic bank keeps reserves of a foreign currency. A bank keeps a nostro account so that it does not have to make a currency conversion (which brings with it foreign exchange risk) should an account holder make a deposit or a withdrawal in that foreign currency. It is also called our account with you

For example: BOI has around 30 Nostro Accounts*(Next page)

7.2 NOSTRO RECONCILIATION Mr. X, an importer of India imports goods from USA, he has an account with ABC, and Bandra Kurla Complex branch which is one of the 200 authorized dealers of ABC. Mr. X has to make payment to his exporter as agreed by both the parties while entering into contract, that is, it can be either demand bill or Usance bill. The importer either issues a Cheque/DD/any other mode of payment for the equivalent USD to his banker (importers bank) and thus ABC, Bandra Kurla Complex branch account holders account gets debited with the same amount. In the books of ABC, Bandra Kurla Complex branch the entry will be: Mr. Xs A/c..dr. This transaction will then pass on to Treasury H.O, wherein the Nostro and Nostro Reconciliation departments desktop screen looks like: Figure 7.2

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Here, this department will credit their Mirror account * (notionally) from forex authorised dealer branch, here, ABC Bandra Kurla Complex branch and also Treasury H.O branches Nostro Account gets debited because ABC has a nostro account with their New York Branch or for the case ABC, India can have nostro account with any other banks also, for example: XYZ,New York In the books of ABC, India, treasury, H.O the entry will be: Mirror A/c.cr. Nostro A/c.dr. *Mirror Account: A contra-account which reflects a nostro account with another bank. For having an account with XYZ, NY or any other foreign bank can charge fees to ABC, India for maintaining and undertaking a transaction.ABC, India has a current account with the foreign bank. Charges depend upon their countries central bank policy. And in the books of ABC, NY or any other bank where ABC, India has a nostro account with them, the entry will be: ABC, India Nostro A/cdr.
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Thus, Reconciliation of NOSTRO account becomes necessary because of the fact that ABC, treasury, H.O maintains NOSTRO account and its replica account (mirror account) which results in difference of balance in the overseas bank account andthe mirror account. Figure 6.3

There are three types of Reconciliation: 1) Nostro to Mirror: If credit in Nostro then debit in Mirror and vice-a versa 2) Nostro to Nostro Example: A businessman receives credit against exports to a country and at the same imports from the same country. In order to reduce the complexes and complications involved in separate debit and credit, there can be net settlement for the two transactions. 3) Mirror to Mirror Example: Mr. A, in India has issued a Cheque to his friend in Mr.B, USA; this transaction shows effect in his branch account details and also shows effect in Treasury H.O (in their mirror account); but his friend Mr. has boarded a flight and landed in India and he asks Mr. A to not transfer the money to his US

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account. In such cases the in Treasury H.O there is no Nostro account effect but there are two effects on Mirror Account. This process is also possible when the importer wants to make a L/C (Letters of Credit), remittances etc. The settlement of the above transactions takes place through Society for Worldwide Interbank Financial Telecommunication ("SWIFT") which provides the network that enables financial institutions worldwide to send and receive information about financial transactions in a secure, standardized and reliable environment. Procedure of SWIFT SETTLEMENT EXAMPLE In cross currency deal of USD/JPY where bank of India bought JPY and sell USD at a certain rate. Then the swift settlement will be in the following manner. Table 6.1 ABC, Treasury, Mumbai would send swift to Citibank, New York (all banks have swift codes) in codes

Citibank would send swift message to DBTC, New york which would forward that to DBTC, London

In action of the message DBTC, London would credit DBTC, New york

On the other side through swift message DBTC, London would message DBTC, Tokyo to credit ABC with the JPY

There are n number of types of SWIFT messages like MT 940 /950 statements, MT910, MT 103/202/700/701/199/192/195 etc. for various transactions, for example, funds transfer, L/C, remittances, refund etc.

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ABC, NY or any other foreign bank where ABC, India has a nostro account sends MT 940/950 on a daily basis through SWIFT.

MT 940/950 messages are The MT940/950(a still detailed message type) (MT = Message Type) electronic account statement is an international standard that was developed by S.W.I.F.T. in Brussels for the paperless transmission of account information. This standard is used by banks all over the world. In particular, MT940 is used to provide bank information to clients' cash management, treasury systems and accounting applications. The MT 103 is a specific message format used mainly for transferring information about money between customers of different banks or other similar financial institutions. A MT700 is the SWIFT format for a Documentary Letter of Credit, but it is also possible to issue a Standby Letter of Credit using the same SWIFT message type. An MT 192 is sent to the beneficiary bank requesting to cancel a payment.

The above stated were few types of MT messages used on a regular basis. Sometimes, there may be chances that the entries are not reconciled which is known as un reconciled entries which may be possible due to: Human errors(wrong reconciliation) Exporter might have ask his bank to make the payment at his favourable future date Chances of the transaction being cancelled Refund transactions etc.

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All the reconciled entries have to be reconciled as soon as possible .And this is possible if Nostro and Nostro Reconciliation department is entirely automated, increase in the number of employees and follow the internal guidelines of the bank. 7.3 Vostro Accounts An account at a domestic bank where a foreign bank keeps reserves of a home currency. A bank keeps a Vostro account so that it does not have to make a currency conversion (which brings with it foreign exchange risk) should an account holder make a deposit or a withdrawal in that home currency. It is also called your account with us 7.4 Loro Accounts (1) An ISO term. An account serviced by a bank on behalf of an account owner bank. (2) An account held by a bank in our books on behalf of another (=correspondent) bank. In principle, a liability account representing balances maintained with the reporting entity for another bank. (3) Loro accounts are also known as "Vostro Accounts" and "Due To Accounts".

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8. Derivatives
8.1 Derivatives Market Derivatives are securities whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. 8.2 History

Derivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the worlds largest futures industries. In 1952 the government banned cash
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settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created. In the equity markets, a system of trading called badla involving some elements of forwards trading had been in existence for decades.6 However, the system led to a number of undesirable practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared securities. This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999.

The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. A system of marketdetermined exchange rates was adopted by India in March 1993. In August 1994, the rupee was made fully convertible on current account. These reforms allowed increased integration between domestic and international markets, and created a need to manage currency risk.

The use of derivatives varies by type of institution. Financial institutions, such as banks, have assets and liabilities of different maturities and in different

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currencies, and are exposed to different risks of default from their borrowers. Thus, they are likely to use derivatives on interest rates and currencies, and derivatives to manage credit risk. Non-financial institutions are regulated differently from financial institutions, and this affects their incentives to use derivatives. Indian insurance regulators, for example, are yet to issue guidelines relating to the use of derivatives by insurance companies.

In India, financial institutions have not been heavy users of exchange-traded derivatives so far, with their contribution to total value of NSE trades being less than 8% in October 2005. However, market insiders feel that this may be changing, as indicated by the growing share of index derivatives (which are used more by institutions than by retail investors). In contrast to the exchangetraded markets, domestic financial institutions and mutual funds have shown great interest in OTC fixed income instruments. Corporations are active in the currency forwards and swaps markets, buying these instruments from banks.

Why do institutions not participate to a greater extent in derivatives markets? Some institutions such as banks and mutual funds are only allowed to use derivatives to hedge their existing positions in the spot market, or to rebalance their existing portfolios. Since banks have little exposure to equity markets due to banking regulations, they have little incentive to trade equity derivatives. Foreign investors must register as foreign institutional investors (FII) to trade exchange-traded derivatives, and be subject to position limits as specified by SEBI. Alternatively, they can incorporate locally as a broker-dealer. FIIs have a small but increasing presence in the equity derivatives markets.

Retail investors (including small brokerages trading for themselves) are the major participants in equity derivatives, accounting for about 60% of turnover, according to NSE. The success of single stock futures in India is unique, as this instrument has generally failed in most other countries. One reason for this success may be retail investors prior familiarity with badla trades which shared some features of derivatives trading. Another reason may be the small size of the futures contracts, compared to similar contracts in other countries. Retail investors also dominate the

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markets for commodity derivatives, due in part to their long-standing expertise in trading in the havala or forwards markets.

8.3 Classification of Derivative Contracts (Diagram 8.1)

DERIVATIVES

FORWARD CONTRACT

OPTIONS

SWAP

CALL/OPTION

PUT OPTION

INTEREST RATE SWAP

CURRENCY SWAP

There are various types of derivatives traded on exchanges across the world. They range from the very simple to the most complex products. The following are the three basic forms of derivatives, which are the building blocks for many complex derivatives instruments.

Forwards Futures Options

8.4 Forwards

A forward contract or simply a forward is a contract between two parties to buy or sell an asset at a certain future date for a certain price that is pre-decided on the date of the contract. The future date is referred to as expiry date and the pre-decided price is referred to as Forward Price. It may be noted that Forwards are private contracts and their terms are determined by the parties involved. A forward is thus an agreement between two parties in which one party, the buyer, enters into an agreement with the other party, the seller that he would buy from the seller an underlying asset on the
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expiry date at the forward price. Therefore, it is a commitment by both the parties to engage in a transaction at a later date with the price set in advance. This is different from a spot market contract, which involves immediate payment and immediate transfer of asset. The party that agrees to buy the asset on a future date is referred to as a long investor and is said to have a long position. Similarly the party that agrees to sell the asset in a future date is referred to as a short investor and is said to have a short position. The price agreed upon is called the delivery price or the Forward Price. Forward contracts are traded only in Over the Forward contracts are traded only in Over the Counter (OTC) market and not in stock exchanges. OTC market is a private market where individuals/institutions can trade through negotiations on a one to one basis.

8.4.1 Settlement of forward contracts

When a forward contract expires, there are two alternate arrangements possible to settle the obligation of the parties: physical settlement and cash settlement. Both types of settlements happen on the expiry date and are given below.

Physical Settlement

A forward contract can be settled by the physical delivery of the underlying asset by a short investor (i.e. the seller) to the long investor (i.e. the buyer) and the payment of the agreed forward price by the buyer to the seller on the agreed settlement date. The main disadvantage of physical settlement is that it results in huge transaction costs in terms of actual purchase of securities by the party holding a short position and transfer of the security to the party in the long position. Further, if the party in the long position is actually not interested in holding the security, then she will have to incur further transaction cost in disposing off the security. An alternative way of settlement, which helps in minimizing this cost, is through cash settlement.

Cash Settlement
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Cash settlement does not involve actual delivery or receipt of the security. Each party either pays (receives) cash equal to the net loss (profit) arising out of their respective position in the contract. So, in case of Scenario I mentioned above, where the spot price at the expiry date (ST) was greater than the forward price (FT), the party with the short position will have to pay an amount equivalent to the net loss to the party at the long position. In our example, A will simply pay Rs. 5000 to B on the expiry date. The opposite is the case in Scenario (III), when ST< FT. The long party will be at a loss and have to pay an amount equivalent to the net loss to the short party. In our example, B will have to pay Rs. 5000 to A on the expiry date. In case of Scenario (II) where ST = FT, there is no need for any party to pay anything to the other party. Please note that the profit and loss position in case of physical settlement and cash settlement is the same except for the transaction costs which is involved in the physical settlement.

8.4.2 Default risk in forward contracts

A drawback of forward contracts is that they are subject to default risk. Regardless of whether the contract is for physical or cash settlement, there exists a potential for one party to default, i.e. not honour the contract. It could be either the buyer or the seller. This results in the other party suffering a loss. This risk of making losses due to any of the two parties defaulting is known as counter party risk. The main reason behind such risk is the absence of any mediator between the parties, who could have undertaken the task of ensuring that both the parties fulfil their obligations arising out of the contract. Default risk is also referred to as counter party risk or credit risk.

8.5 Futures

Like a forward contract, a futures contract is an agreement between two parties in which the buyer agrees to buy an underlying asset from the seller, at a future date at a price that is agreed upon today. However, unlike a forward contract, a futures contract is not a private transaction but gets traded on a recognized stock exchange. In addition, a futures contract is standardized by the exchange. All the terms, other than the price, are set by the stock exchange (rather than by individual parties as in the case of a

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forward contract). Also, both buyer and seller of the futures contracts are protected against the counter party risk by an entity called the Clearing Corporation. The Clearing Corporation provides this guarantee to ensure that the buyer or the seller of a futures contract does not suffer as a result of the counter party defaulting on its obligation. In case one of the parties defaults, the Clearing Corporation steps in to fulfil the obligation of this party, so that the other party does not suffer due to non-fulfilment of the contract. To be able to guarantee the fulfilment of the obligations under the contract, the Clearing Corporation holds an amount as a security from both the parties. This amount is called the Margin money and can be in the form of cash or other financial assets. Also, since the futures contracts are traded on the stock exchanges, the parties have the flexibility of closing out the contract prior to the maturity by squaring off the transactions in the market. The basic flow of a transaction between three parties, namely Buyer, Seller and Clearing Corporation is depicted in the diagram below: Figure 8.2

For further Information on Forward Refer Appendix 3.

8.6 Options
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An option is a derivative contract between a buyer and a seller, where one party (say First Party) gives to the other (say Second Party) the right, but not the obligation, to buy from (or sell to) the First Party the underlying asset on or before a specific day at an agreed-upon price. In return for granting the option, the party granting the option collects a payment from the other party. This payment collected is called the premium or price of the option. The right to buy or sell is held by the option buyer (also called the option hold er); the party granting the right is the option seller or option writer. Unlike forwards and futures contracts, options require a cash payment (called the premium) upfront from the option buyer to the option seller. This payment is called option premium or option price. Options can be traded either on the stock exchange or in over the counter (OTC) markets. Options traded on the exchanges are backed by the Clearing Corporation thereby minimizing the risk arising due to default by the counter parties involved. Options traded in the OTC market however are not backed by the Clearing Corporation. There are two types of optionscall options and put options.

Call option

A call option is an option granting the right to the buyer of the option to buy the underlying asset on a specific day at an agreed upon price, but not the obligation to do so. It is the seller who grants this right to the buyer of the option. It may be noted that the person who has the right to buy the underlying asset is known as the buyer of the call option. The price at which the buyer has the right to buy the asset is agreed upon at the time of entering the contract. This price is known as the strike price of the contract (call option strike price in this case). Since the buyer of the call option has the right (but no obligation) to buy the underlying asset, he will exercise his right to buy the underlying asset if and only if the price of the underlying asset in the market is more than the strike price on or before the expiry date of the contract. The buyer of the call option does not have an obligation to buy if he does not want to.

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Put option

A put option is a contract granting the right to the buyer of the option to sell the underlying asset on or before a specific day at an agreed upon price, but not the obligation to do so. It is the seller who grants this right to the buyer of the option. The person who has the right to sell the underlying asset is known as the buyer of the put option. The price at which the buyer has the right to sell the asset is agreed upon at the time of entering the contract. This price is known as the strike price of the contract (put option strike price in this case). Since the buyer of the put option has the right (but not the obligation) to sell the underlying asset, he will exercise his right to sell the underlying asset if and only if the price of the underlying asset in the market is less than the strike price on or before the expiry date of the contract. The buyer of the put option does not have the obligation to sell if he does not want to.

8.7 Terminology of Derivatives

8.7.1 Spot price (ST)

Spot price of an underlying asset is the price that is quoted for immediate delivery of the asset. For example, at the NSE, the spot price of Reliance Ltd. at any given time is the price at which Reliance Ltd. shares are being traded at that time in the Cash Market Segment of the NSE. Spot price is also referred to as cash price sometimes.

8.7.2 Forward price or futures price (F)

Forward price or futures price is the price that is agreed upon at the date of the contract for the delivery of an asset at a specific future date. These prices are dependent on the spot price, the prevailing interest rate and the expiry date of the contract.

8.7.3 Strike price (K)

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The price at which t he buyer of an option can buy the stock (in the case of a call option) or sell the stock (in the case of a put option) on or before the expiry date of option contracts is called strike price. It is the price at which the stock will be bought or sold when the option is exercised. Strike price is used in the case of options only; it is not used for futures or forwards.

8.7.4 Expiration date (T)

In the case of Futures, Forwards, Index and Stock Options, Expiration Date is the date on which settlement takes place. It is also called the final settlement date.

Types of options Options can be divided into two different categories depending upon the primary exercise styles associated with options. These categories are:

European Options: European options are options that can be exercised only on the expiration date. American options: American options are options that can be exercised on any day on or before the expiry date. They can be exercised by the buyer on any day on or before the final settlement date or the expiry date.

8.7.5 Contract size

As futures and options are standardized contracts traded on an exchange, they have a fixed contract size. One contract of a derivatives instrument represents a certain number of shares of the underlying asset. For example, if one contract of BHEL consists of 300 shares of BHEL, then if one buys one futures contract of BHEL, then for every Re 1 increase in BHELs futures price, the buyer will make a profit of 300 X 1 = Rs 300 and for every Re 1 fall in BHELs futures price, he will lose Rs 300.

8.7.6 Contract Value

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Contract value is notional value of the transaction in case one contract is bought or sold. It is the contract size multiplied but the price of the futures. Contract value is used to calculate margins etc. for contracts. In the example above if BHEL futures are trading at Rs. 2000 the contract value would be Rs. 2000 x 300 = Rs. 6 lacs.

8.7.7 Margins

In the spot market, the buyer of a stock has to pay the entire transaction amount (for purchasing the stock) to the seller. For example, if Infosys is trading at Rs. 2000 a share and an investor wants to buy 100 Infosys shares, then he has to pay Rs. 2000 X 100 = Rs. 2,00,000 to the seller. The settlement will take place on T+2 bases; that is, two days after the transaction date. In a derivatives contract, a person enters into a trade today (buy or sell) but the settlement happens on a future date. Because of this, there is a high possibility of default by any of the parties. Futures and option contracts are traded through exchanges and the counter party risk is taken care of by the clearing corporation. In order to prevent any of the parties from defaulting on his trade commitment, the clearing corporation levies a margin on the buyer as well as seller of the futures and option contracts. This margin is a percentage (approximately 20%) of the total contract value. Thus, for the aforementioned example, if a person wants to buy 100 Infosys futures, then he will have to pay 20% of the contract value of Rs 2,00,000 = Rs 40,000 as a margin to the clearing corporation. This margin is applicable to both, the buyer and the seller of a futures contract.

8.8 Participants in the Derivatives Market

As equity markets developed, different categories of investors started participating in the market. In India, equity market participants currently include retail investors, corporate investors, mutual funds, banks, foreign institutional investors etc. Each of these investor categories uses the derivatives market to as a part of risk management, investment strategy or speculation. Based on the applications that derivatives are put to, these investors can be broadly classified into three groups: Hedgers
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Speculators, and Arbitrageurs

8.8.1 Hedgers

These investors have a position (i.e., have bought stocks) in the underlying market but are worried about a potential loss arising out of a change in the asset price in the future. Hedgers participate in the derivatives market to lock the prices at which they will be able to transact in the future. Thus, they try to avoid price risk through holding a position in the derivatives market. Different hedgers take different positions in the derivatives market based on their exposure in the underlying market. A hedger normally takes an opposite position in the derivatives market to what he has in the underlying market. Hedging in futures market can be done through two positions, viz. short hedge and long hedge. Short Hedge A short hedge involves taking a short position in the futures market. Short hedge position is taken by someone who already owns the underlying asset or is expecting a future receipt of the underlying asset. For example, an investor holding Reliance shares may be worried about adverse future price movements and may want to hedge the price risk. He can do so by holding a short position in the derivatives market. The investor can go short in Reliance futures at the NSE. This protects him from price movements in Reliance stock. In case the price of Reliance shares falls, the investor will lose money in the shares but will make up for this loss by the gain made in Reliance Futures. Note that a short position holder in a futures contract makes a profit if the price of the underlying asset falls in the future. In this way, futures contract allows an investor to manage his price risk. Similarly, a sugar manufacturing company could hedge against any probable loss in the future due to a fall in the prices of sugar by holding a short position in the futures/ forwards market. If the prices of sugar fall, the company may lose on the sugar sale but the loss will be offset by profit made in the futures contract.

Long Hedge
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A long hedge involves holding a long position in the futures market. A Long position holder agrees to buy the underlying asset at the expiry date by paying the agreed futures/ forward price. This strategy is used by those who will need to acquire the underlying asset in the future. For example, a chocolate manufacturer who needs to acquire sugar in the future will be worried about any loss that may arise if the price of sugar increases in the future. To hedge against this risk, the chocolate manufacturer can hold a long position in the sugar futures. If the price of sugar rises, the chocolate manufacture may have to pay more to acquire sugar in the normal market, but he will be compensated against this loss through a profit that will arise in the futures market. Note that a long position holder in a futures contract makes a profit if the price of the underlying asset increases in the future. Long hedge strategy can also be used by those investors who desire to purchase the underlying asset at a future date (that is, when he acquires the cash to purchase the asset) but wants to lock the prevailing price in the market. This may be because he thinks that the prevailing price is very low.

8.8.2 Speculators

A Speculator is one who bets on the derivatives market based on his views on the potential movement of the underlying stock price. Speculators take large, calculated risks as they trade based on anticipated future price movements. They hope to make quick, large gains; but may not always be successful. They normally have shorter holding time for their positions as compared to hedgers. If the price of the underlying moves as per their expectation they can make large profits. However, if the price moves in the opposite direction of their assessment, the losses can also be enormous.

8.8.3 Arbitrageurs

Arbitrageurs attempt to profit from pricing inefficiencies in the market by making simultaneous trades that offset each other and capture a risk-free profit. An arbitrageur

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may also seek to make profit in case there is price discrepancy between the stock price in the cash and the derivatives markets. For example, if on 1st August, 2009 the SBI share is trading at Rs. 1780 in the cash market and the futures contract of SBI is trading at Rs. 1790, the arbitrageur would buy the SBI shares (i.e. make an investment of Rs. 1780) in the spot market and sell the same number of SBI futures contracts. On expiry day (say 24 August, 2009), the price of SBI futures contracts will close at the price at which SBI closes in the spot market. In other words, the settlement of the futures contract will happen at the closing price of the SBI shares and that is why the futures and spot prices are said to converge on the expiry day. On expiry day, the arbitrageur will sell the SBI stock in the spot market and buy the futures contract, both of which will happen at the closing price of SBI in the spot market. Since the arbitrageur has entered into off-setting positions, he will be able to earn Rs. 10 irrespective of the prevailing market price on the expiry date. There are three possible price scenarios at which SBI can close on expiry day. Let us calculate the profit/ loss of the arbitrageur in each of the scenarios where he had initially (1 August) purchased SBI shares in the spot market at Rs 1780 and sold the futures contract of SBI at Rs.1790. Scenario I: SBI shares closes at a price greater than 1780 (say Rs. 2000) in the spot market on expiry day (24 August 2009) SBI futures will close at the same price as SBI i n spot market on the expiry day i.e., SBI futures will also close at Rs. 2000. The arbitrageur reverses his previous transaction entered into on 1 August 2009. Profit/ Loss () in spot market = 2000 1780 = Rs. 220 Profit/ Loss () in futures market = 1 790 2000 = Rs. (--) 210 Net profit/ Loss () on both transactions combined = 220 210 = Rs. 10 profit.

Scenario II: SBI shares close at Rs 1780 in the spot market on expiry day (24 August 2009) SBI futures will close at the same price as SBI in spot mar ket on expiry day i.e., SBI futures will also close at Rs 1780. The arbitrageur reverses his previous transaction entered into on 1 August 2009. Profit/ Loss () in spot market = 1780 1780 = Rs 0 Profit/ Loss () in futures market = 1790 1780 = Rs. 10 Net profit/ Loss () on both transactions combined = 0 + 10 = Rs. 10 profit.

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Scenario III: SBI shares close at Rs. 1500 in the spot market on expiry day (24 August 2009) Here also, SBI futures will close at Rs. 1500. The arbitrageur reverses his previous transaction entered into on 1 August 2009. Profit/ Loss () in spot market = 1500 1780 = Rs. () 280 Profit/ Loss () in futures market = 1790 1500 = Rs. 290 Net profit/ Loss () on both transactions combined = () 280 + 290 = Rs. 10 profit. Thus, in all three scenarios, the arbitrageur will make a profit of Rs. 10, which was the difference between the spot price of SBI and futures price of SBI, when the transaction was entered into. This is called a risk less profit since once the transaction is entered into on 1 August, 2009 (due to the price difference between spot and futures), the profit is locked. Irrespective of where the underlying share price closes on the expiry date of the contract, a profit of Rs. 10 is assured. The investment made by the arbitrageur is Rs. 1780 (when he buys SBI in the spot market). He makes this investment on 1 August 2009 and gets a return of Rs. 10 on this investment in 23 days (24 August). This means a return of 0.56% in 23 days. If we annualize this, it is a return of nearly 9% per annum. One should also note that this opportunity to make a risk-less return of 9% per annum will not always remain. The difference between the spot and futures price arose due to some inefficiency (in the market), which was exploited by the arbitrageur by buying shares in spot and selling futures. As more and more such arbitrage trades take place, the difference between spot and futures prices would narrow thereby reducing the attractiveness of further arbitrage.

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9. Valuation
The RBI stipulates that the entire investment portfolio of a bank should be classified into following three categories: 9.1 Held To Maturity The securities acquired with an intention to hold them up to maturity are classified under Held to maturity category. Banks may hold the following securities under HTM category: SLR securities up to 25% of their DTL as on the last Friday of the second preceding fortnight. Fresh re-capitalization bonds received from the Government of India towards their re-capitalization requirement and held in their investment portfolio. Fresh investments in the equity of subsidiaries and joint ventures (A joint venture would be one in which bank, along with its subsidiaries, holds more than 25 % of the equity.) RIDF/SIDBI Deposits.

9.2 Held For Trading The securities acquired with the intention to trade by taking advantage of the short term price/interest rate movements will be classified as under Held For Trading (HTF). The investments classified under HTF category would be those from which the bank expects to make a gain by the movement in the interest rate/ market rates. These securities are to be sold within 90 days. In case securities acquired under HFT category cannot be sold within 90 days due to market volatility , market turning unidirectional, etc, it can be transferred to the Available for Sale category subject to the depreciation if any applicable on the date of transfer and with the approval of the Investment committee. 9.3 Available For Sale
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The securities which do not fall within the above two categories are classified under Available For Sale Category. The banks will have the freedom to decide on the extent of holdings under Available for Sale and Held for trading categories. This will be decided by them after considering various aspects such as basis of intent, trading strategies, risk management capabilities, tax planning, manpower skills, capital position. Profit or loss on sale of investments in both the categories will be taken to the Profit and Loss account. 9.4 Method of Valuation For Investments According to Their Category Held To Maturity Category Investments classified under Held to Maturity category need not be marked to market and will be carried at acquisition cost, unless it is more than face value, in which case the premium should be amortised over the period remaining to maturity. Banks should recognize any diminution, other than temporary, in the value of their investments in subsidiaries /joint ventures which are included under Held to maturity category and provide therefore. Such diminution should be determined and provided for each investment individually. Held For Trading Category The individual scrip in the Held for trading category will be marked to market at monthly or at more frequently intervals and provided for as in in the case of those in the Available for Sale category. Consequently, the book value of the individual securities in this category would also not undergo any change after marking to market. Available for Sale category The individual scrip in the Available for sale category will be marked to market at quarterly or at more frequent intervals. Securities under this category shall be valued scrip-wise and depreciation/appreciation shall be aggregated for each classification. Net depreciation, if any should be ignored. Net depreciation required to be provided for in any one classification should not be reduced on account of net appreciation in

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any other classification. The book value of the individual securities would not undergo any change after the marking of market.

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10. Risk Management

10.1 Introduction Risk is a potential future loss. When we take an insurance cover, what we are hedging is the uncertainty associated with future events. Time and again we have seen people paying insurance premium for many years without any claim for loss and then discounting the cover, only to face a loss thereafter and regretting the decision. It is the same situation in the commercial world as well, managers end up taking such decisions only to regret later .There are many cases of huge commercial losses due to excessive speculation or being too confident of the movement of prices in a given direction. When the future does not turn out the way it was expected, the losses hit the organization so badly that it often ends up in the liquidation block. Risk management principle will help in avoiding such embarrassment. Risk management calls for certain discipline and if this is violated losses can be huge. Thus risk management merely means, We cant do anything about the past, but we can do something about the future. Risk is closely associated with the risk. Higher the risk, higher is the return. Thus the aspects to be understood are: a) What is return? b) What drives return? c) What uncertain factors can impact return? d) How do plan for it, expect its movements and take actions to protect against adverse movements? e) What can you do if the returns do deviate?

Risk is inherent in any walk of life in general and in financial sectors in particular. It cannot be avoided, but can be only managed. If all risk were to be managed and eliminated it is not running a business. A risk management system includes various policies, procedures and practices that work in unison to identify, analyze, evaluate, address and monitor risk. Risk
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management information is used along with other corporate information, such as feasibility, to arrive at a risk management decision. Transferring risk to another party, lessening the negative effect of risk and avoiding risk altogether are considered risk management strategies. Treasury mid office looks after the risks associated with the forex treasury and its operations and analyze and manage the risks. Managing foreign exchange risk is a fundamental component in the safe and sound management of all institutions that have exposure in foreign currencies. It involves prudently managing foreign currency positions, in order to control, within set parameters the impact of foreign exchange rates on the financial position of the institution. Generally, a companies Board of Directors needs to have a means of ensuring compliance with the foreign exchange risk management program, this is done normally through periodic reporting by inspectors/auditors. These risk management practices are widely used in public and private sectors, covering a wide range of activities or operations. It is now an integral part of business planning. 10.2 Risk Identification The risks to which traders in foreign exchange are exposed are: 10.2.1 Measuring the Market or Price Risk

The risks arising out of open positions should be looked upon. If one is overbought in a currency and it weakens, one would be able to square the overbought position only by selling the currency at a loss. The same would be the position if one is oversold and the currency appreciates. Given the magnitude of fluctuations witnessed in recent years, the possibilities of substantial losses can hardly be overlooked. Some of the measures traditionally adopted by bank managements in order to limit the risks are: (a) Limits on intra-day open positions in each currency (b) Limits on overnight open positions in each currency; these would be smaller than (a)

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(c) Limit on aggregate open position for all currencies taken together, which would be less than the total of the currency-wise limits. (d) A turnover limit on total daily transaction volume for all currencies; this is more important for banks that are active in market making or trading. In India, the Reserve Bank of India has prescribed Internal Control Guidelines to be followed by banks. While open position and stop loss limits are the traditional methods of measuring and controlling risks, more and more banks active in trading are now using the Value at risk (VaR) approach. 10.2.2 Gap Limit Gap limits are not usually set for all time periods in banks. It depends upon the overall structure of the bank. Gap analysis is a procedure that illustrates how quickly an individual asset or liability reacts to a change in market rates. Furthermore, gap analysis associates the rate sensitivity of assets with the rate sensitivity of liabilities and measures the difference between their respective rate sensitivities at a particular period of time. If the gap is positive, assets are more re pricing with market rates compared to liabilities. When this occurs, the bank is considered to be positively rate-sensitive. Positive rate sensitivity is directly proportional to the exchange rates and profits. If rates move up, profits also rise and if rates drop, profits will also shrink. If the gap is negative, liabilities are more re pricing with market rates compared to assets. In such a situation, the bank is considered to be negatively rate-sensitive. Negative rate sensitivity is inversely proportional to the exchange rates and profits. If rates move up, profits fall and if rates drop, profits will increase. The various types of gap limits in foreign exchange risk management are as follows: Day light limit- Day light open positions are the exposures that are opened in the course of a trading day and will invariably be closed (squared) before the close of the day. Daylight exposures may last only for a few seconds or

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minutes but also hours and arise when dealers try to take advantage of volatility during a trading session, either in the domestic (USD/INR) market or Far East, European or U.S markets, if trading in the cross. However, higher day light limits allow the bank to undertake large merchant operations/deals with RBI enabling the bank to maximize profit on exchange position. Overnight limits- Exposures left at the close of business day are regulated by overnight limits. Over- night limits are smaller than day-light limits because of the exposure to higher risk since the position is left attended till the next trading day. Dealers can exceed day light limit subject to prior approval by the chief incumbent of PMB but in no case can a PMB exceed over-night limit. Individual gap limit This is the limit placed on mismatches in the currency bought and sold by the banks. Aggregate gap limit This is the limit for all the gaps, both bought and sold by the banks, for all the individual months for a particular currency. Total aggregate gap limit This is the total of the aggregate gap limit of all currencies taken together. Take profit limit- Take profit limits ensure that a dealer books a certain minimum profit once the position moves in the favorable territory. Stop Loss Limit - Stop loss limit is the most common way to minimize risks related to forex trading. A stop loss limit contains instructions to withdraw the present market position if the price reaches a certain level. When a stop loss order is placed in banks, an exit point is set in case the trade losses reach a specific value. Liquidity of the forex market ensures stop loss limits to be easily implemented. Stop loss in forex lowers the risks in banks and enables more profit gain in forex trade. For this, banks need to set up strict stop-loss limits for losing trades to reduce the losses. If the market starts going in the wrong direction, banks should cancel the order instead of closing that position. By placing stop loss limits, banks remove the risk of being impatient and taking profit too early. 10.2.3 Credit Risk

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Credit risks are very important in foreign exchange transactions. These can arise when a counterparty, whether a customer /bank fails to meet his obligation and the resulting open position has to be covered at the going rate .If the rates have moved against you, a loss can result. An example would clarify the nature of the risk. Assume that you have sold forward dollars to a customer at, say, Rs.50 per $.Before the contract matures, the customer fails. You are now faced with the problem of having to dispose of the dollars earmarked for delivery under the contract in the market going rate. If the current forward rate for the appropriate delivery is Rs.45 per$, a loss would obviously result. If, on the other hand, the rate has moved to Rs.55, the profit on cancellation would have to be paid out. This example is of credit risks before maturity of a transaction. How to mitigate the credit risks? Netting Netting of forex transactions for settlement purposes has become increasingly common in foreign exchange markets. There are two types of netting: Settlement day and close out. Settlement day netting is of two types Simple payment netting merely replaces a number of receipts and payments due on a given settlement day, by a single transaction, but does not alter the rights and obligations under the individual contracts; Netting by novation involves that all deals being netted are cancelled and replaced by a new (nova) legally binding deal. In both the above methods; there is no difference between the amounts that would change hands on the settlement day. Close-out netting is a credit risk management tool at the pre-settlement stage, in the event of occurrence of default. In this case, the non-defaulting party has the legal right
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to liquidate and set off all outstanding transactions between them. Close out netting involves the calculation of the replacement cost/gain of each transaction to the nondefaulting counterparty; the amounts are then aggregated and netted. 10.3 Different Types of Risk Settlement Risk

This is the risk of counterparty failure during settlement, because of the time differences in the markets in which cash flows in the two currencies have to be paid and received. Settlement risk is the risk of a counterparty failing to meet the obligations in a financial deal after the bank has fulfilled the obligations on the date of settlement of the contract. Settlement risk exposure possibly exists in foreign exchange business. Settlement risk arises mainly due to the way foreign currency deals are settled. Settlement necessitates a cash transfer from one banks account to the others for the currencies involved in the transaction. Settlement risk appears in case of spot, forward, asset rollovers and currency swaps. There are two factors which could be responsible for this risk: Different time zones Different time zones implies that there is a risk that the bank paying rupees to the counterparty in India during Indian business hours may not get payment from the counterparty in the United States when the US banks open. Cable in factors Cable in factors occur mainly in continental countries such as West Germany where cables for transfer of funds have to be done previous to opening hours whereas in countries such as the United States cables reaching up to 12 noon local time or near to business hours are accepted and acted upon. In some other countries such as West Germany messages have to be delivered on the day previous to the settlement day. The probability of payment against non-receipt of the counterparty funds could result in the loss of the entire face value of the contract. A certain amount of settlement risk has now been eliminated as a result of Society for Worldwide Interbank Financial Telecommunication (SWIFT). SWIFT does not enable
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funds transfer, it sends payment orders, which must be settled by correspondent accounts that the institutions have with each other. Each financial institution must have a banking relationship by either being a bank or affiliating itself with one so as to enjoy particular business features such as exchange of banking transactions. The SWIFT-messaging network run by the Society for Worldwide Interbank Financial Telecommunication has operational centers located in the Netherlands and the U.S. These protected messaging centres share real-time information with each other so that if one of them runs into a problem, the other centre can take over the operations of the entire network. SWIFT conducts most of its messaging services in areas such as payments and cash management, treasury, securities and trade services. Several other major initiatives have been taken or are in the pipeline to reduce the payment and settlement risk. Some national payment systems have already shifted to Real time gross settlements (RTGS). This means that each payment instruction is executed as soon as it is received and is not clubbed together with other transactions during the day on a batch processing basis. Also CCIL (Clearing Corporation Of India Limited.) runs a multilateral netting system for forex inter-bank transactions that nets the members payments and receipts in a currency, though they are due to or from different counterparties and settles the net position in both the legs of the transactions. The matched and accepted Forward deals are guaranteed for settlement from S-2 day and the Spot, Tom, Cash deals are guaranteed for settlement from the trade date as the CCIL becomes the central counterparty to every accepted trade through the process of Novation.

Liquidity Risk

This arises when, for whatever reason, markets turn illiquid and positions cannot be liquidated except at a huge price concession. Indeed, in volatile markets, the bid offer spreads tend to widen and often positions cannot be reversed within the stipulated stop loss levels, thus increasing losses beyond the magnitude considered acceptable.
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Consider the USD: INR market in India. In normal conditions, the interbank bid offer spread is 0.25 to 0.5 paisa .When there is volatility or illiquidity due to demand: supply imbalance, the spread often widens to 2,3 or 5 paisa. In such cases, managements would be wise to reduce open position limits. Operational risk

Operational risks do not have any relations with the dealer. Operational risk is affected by the manner in which transactions are settled or handled operationally. Some of the operational risks are as follows Dealing and settlement Functions related to dealing and settlement should be properly separated. If dealings are not differentiated from each other, it will cause split up of related duties which may cause operational risk. Confirmation In confirmation, dealing is usually done by

telephone/telex/Reuters or some other system. It is necessary that confirmation deals are set by written confirmations. There is a risk of miscalculations related to amount, rate, value, date and the likes. Pipeline transaction Sometimes there are faults in communication and often protection is not available for pipeline transactions handled by the branches of the banks. There can be delays in transmitting details of transactions to the dealer for a cover resulting in the actual position of the bank being unlike from what is shown by the dealers position statement. The collective effect may be large divulging the bank to the risks associated with open positions. Overdue bills and forward contracts The trade finance department of banks generally control the maturity of export bills and forward contracts. A risk occurs if the monitoring is not done appropriately.

Sovereign risk

One more kind of risk which banks and other agencies that deal in foreign exchange face is sovereign risk. Sovereign risk is based on the government of a country. Although an importer in the country agrees to pay for his imports, the central bank of the country may not allow the importer to do so. This has happened in a number of

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African and South American countries on account of economic volatility and political uncertainties. Legal Risks

In forex transactions legal risk can arise because of inability to enforce closeout netting in the event of default. Documentation is therefore very important. For Value at Risk Refer Appendix4 Country Risk Rating Refer Appendix 5

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11. Future Scope and Challenges in Treasury Management

Treasury Management is increasingly being viewed as a specialization function in many corporate companies, and has already been assigned a separate status from the general financial functions. Treasury management asks for expertise on capital markets, money markets, instruments and investment avenues, treasury and risk management and related areas. In this increasingly integrated and interdependent financial environment, the links between money and capital markets have become extremely close. To better understand this inter linking and manage business in a better way, films are hiring persons who can handle Treasury Management and forecast rates accurately. 11.1 Career Prospects in Treasury Management India is changing from an economy with strong socialistic leanings to a free market one where the barriers to trade, both domestic and international, are fast vanishing. The transformation process that began in the early 1990s has been put into overdrive. While foreign firms are busy trying to get a foothold on Indian sol, Indian companies do not lag behind in attempting to penetrate foreign markets. There has been an unexpected rise in exports as well as imports, which has resulted in volatile exchange rates and more financial constraints. Given the inconsistency of exchange rates, the corporate and banking worlds are paying greater attention to treasury and foreign exchange management. Careers in treasury and forex management have suddenly been pitch forked into the limelight. Banks have been scouting campuses of Indian B schools with a view to recruiting for their treasury and forex functions.

11.2 Recommendation
Domestic Treasury & Forex treasury is currently running on a programme based on Oracle database E-Treasury (TCS). Bank has implemented 100% Core Banking Solution (CBS) with Finacle Version 7.0.25 (Domestic) and finacle version 10.X (Overseas) of M/s Infosys Technologies Ltd. in 4029 branches as on 31st March 2012,
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across India. But still, there are many areas like in Risk Management where works are done manually and which consume more time than actually needed. Thus, bank should go for the solution that should also take care of the growth in business with passing years. Apart from it, I found out that there is something wrong with the Country Risk Policy. While calculating the country risk we assign 40% weightage to rating by ECGC and after summing up all the 4 values, we compare it against the standards of ECGC to give final rating to country. So here the fallacy lies that the country rating is 40% dependent on ECGC rating. The software companies say the software should be updated on regular basis for the better performance as technology changes very fast. Therefore, support of the software should be done in an interval with consultation of the service provider.

11.3 Conclusion
The association with Bank Of India for the project has been an enriching and educational experience. This project helped me to understand the operations, functions and risks involved in the most sensitive area of bank-Treasury Management.

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If cash is the lifeblood of any organization, the treasury is the heart where all cash of the bank is circulated. Post financial reforms the treasury management has taken the central stage. The investments are now viewed as an alternative to credit, the historical source of profits for banks. With the increasingly volatile financial market conditions it is the need of the hour to adopt new hedging instruments. All financial institutions need to have a thorough understanding of various operations of its assets, liabilities etc , which will enable the financial institution to identify and unbundled the risks and further aid in adopting and developing appropriate risk management models to manage risks.

Bibliography
Books

IIBF : Treasury Management, Macmillan Publishers India, 2010. A V Rajwade: Foreign Exchange International Finance Risk Management, 4th Edition,2008

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Reference RBI Guidelines : http://www.rbi.org.in Bank of India Treasury Manual Bank of India, Dealing Room Policy and Domestic policy

Appendix1
OTHER MERCHANT TRANSACTIONS (initiated in branches, arranged by Forex Treasury)

Pre-shipment/Post Shipment Foreign Credit (PCFC)

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FCNR (B) Loans Exchange Earners Foreign Currency (EEFC) account Resident Foreign Currency (RFC) account Foreign Currency Loans (FCLs)

6.9.1 Pre-Shipment/Post-Shipment Credit in Foreign Currency to Exporters PCFC in foreign currency to the exporters enables them to fund their procurement, manufacturing/ processing and packing requirements. These loans are available at very competitive international interest rates covering the cost of both domestic as well as import content of the exports. The PCFC can be availed in US$, Euro, GBP and Japanese Yen. The corporations/ exporters with a good track record can avail of a running account facility with the Bank for PCFC. To qualify for this purpose, the exporters overdue bill should not exceed 5% of the average annual export realization during the preceding -3- years. Key Benefits

In case of cancellation of export order, the PCFC can be closed by selling equivalent amount of foreign exchange at TT selling rate prevalent on the date of liquidation.

The forward covers can be booked in respect of future PCFC drawings. The PCFC drawings are also permitted in cross currency subject to exporter bearing the risk in currency fluctuations.

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PCFC in foreign currency is available for a maximum period of 180 days from the date of first disbursement, similar to the case of Rupee facility. PCFC is to be repaid with the proceeds of the export bill submitted after shipment. Multi-currency drawings against the same orders are not permitted due to operational inconvenience.

Cross-country drawings are restricted to US dollars. In case, the export order is in a non-designated currency like Swiss Franc etc. PCFC will be given only in US$. For orders in Euro, Pound Sterling and JPY, PCFC can be availed in the respective currencies or US$ at the choice of exporter.

6.9.2 FCNR (B) Loans Corporates can avail this type of loan. Key Benefits FCNR (B) loans are beneficial to the corporates on account of following:

At times, it may entail lesser interest cost vis--vis Rupee borrowings. The borrower is not required to go to the International market for raising the funds as foreign currency funds are made available in India reducing the cost of raising such funds.

Broad purpose of loans Corporate are allowed to obtain foreign currency denominated loans in India under the above scheme for the following purposes: 1. For meeting working capital requirements in Indian Rupees. 2. By way of pre-shipment advances/ post shipment advances to the exporters. 3. Import of raw materials.

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4. Import of capital goods. 5. Purchase of indigenous machinery. 6. Repayment of the existing Rupee Term Loan. 7. Repayment of any existing ECB's with the permission from RBI, Govt. of India. Foreign currency loan can be disbursed in -4- currencies viz US$, Sterling, Euro and Japanese Yen.

Minimum amount of the loan US$, GBP, Euro: 100,000 Japanese Yen: 10 million.

6.9.3 Exchange Earners Foreign Currency (EEFC) account The EEFC account is a special type of current account aimed at exporters / individual professionals who receive eligible remittances in foreign currency as per FEMA regulations. The account is maintained in foreign currency, shielding accountholders from exchange rate fluctuations. EEFC accountholders are required to open a current account in INR for crediting the INR leg of the transaction / converting the balance held in the EEFC account into INR as well as for paying the applicable charges. Features & benefits

Zero balance account, so no need to maintain any average or minimum balance in the EEFC account

Available in four currencies: US Dollars, Japanese Yen, Pound Sterling (GBP) and EURO

Comprehensive range of Doorstep banking services

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Wide range of trade services available at attractive rates

6.9.4 Resident Foreign Currency Account

A Resident Foreign Currency account in India can be maintained by a Non-resident Indian who has returned home for permanent settlement, after staying abroad for a minimum period of one year. An RFC account can be opened without any regulatory approval from the Reserve Bank of India .RFC accounts can be maintained in USD/EUR/GBP/JPY/AUD/CAD in the form of Savings / Term Deposit.

Credits to the account can in any of the following means:

(i) Balances standing to the credit of NRE and FCNR accounts at the time of return. (ii) Income from overseas assets or sales proceeds from overseas assets. (iii) Entire amount of pension received from abroad. (iv)Balance in the account can be remitted abroad for bona fide purposes either for yourself or your dependents.

Interest earned on RFC account is subject to tax. 6.9.5 Foreign Currency Loan Eligibility

Exporters for working capital needs Importers for meeting import obligations Importers of capital goods Those customers who have earlier raised medium-term FC Loans for meeting capital expenditure from overseas financial institutions, so that these loans can be foreclosed (subject to RBI guidelines)

Loan to JV/WOS entities of Indian companies. High value corporate clients with a good track record, to meet working capital requirements in substitution of WCDL

Those customers who are looking for conversion of rupee term/cash credit.

Period

Working capital for exporter/importer- 6 months to one year. Importers of capital goods-3 years (subject to availability of funds) Substitution of WCDL/Cash Credit 6 months to one year. In case of Term Loan Conversion- 6 months to 3 years (subject to availability of funds)

Quantum/Currency

On transaction to transaction basis within the existing credit facilities Minimum USD 0.50 mn (Rs. 2.00 Crore) equivalent. Normally in US$, FC Loans can also be availed in Pound Sterling or in Euros subject to availability of funds

Rate of Interest

Bench marked to relevant LIBOR rates.

Appendix2
Deal Authorization Deal authorization is one of the main functions of Back Office in forex department. At one shot the dealer crack a deal but its authencity is checked by the authorization procedure of back office.
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The following things are checked by the back office during authorization: Check the deal ticket bears the serial number/s, which is in line with the current running numbers. Ensure that the deal ticket is received in the back office promptly after the deal is struck. In case of interbank deals, verify from the deal time mentioned on the Reuters Conversation Details print out and the deal ticket that the ticket is captured within a reasonable time after the deal is struck.

Ensure that the deal is undertaken within the business hours fixed for the dealing room operations by the bank. In case the deal is undertaken at a time other than the business hours, ensure that it is authorized by the designated non-dealing official.

Check that the deal ticket is signed by the concerned dealer. Check the deal ticket for its completeness. In case of interbank deals, check the transaction details on Reuters conversation details print out with those of the deal ticket. Check details of counterparty name, amount, currency, dealing date, settlement details and rate of deal. Ensure that the deal is in accordance with Exchange control directives, risk management policies, operating guidelines and control measures of the bank, including various limits stated above.

After the scrutiny is over, initial on the deal ticket is required at appropriate place. After scrutiny, the concerned official should authorize the deal in the system. In case of interbank transactions the underlying Reuters deal conversation or broker note should be verified with the deal ticket during authorization.

In respect of merchant transactions, the particulars should be verified with the reporting confirmation sent by the concerned branches. At the end of the day, the number of deals, amount and the position should be tallied between the records of the front office and back office (E-treasury)

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In case of deals through the brokers contract notes and counterparty banks confirmation should be verified for correctness. It should also be ensured that counterparty banks communication seeking confirmation of deal is received for all the deals .The authorized official of the bank should sign these confirmations. The bank shall this against the counterparty banks authorized signatory list. Such confirmations need not be insisted for Cash and Tom contracts where the amounts of contract are received in our nostro accounts.

And after the deal detail is authorized the back office person in charge of the same put a counter signature on the deal report and sends it for settlement.

Appendix3
Forward Premium: Indicates the costliness of currency vis--vis spot rate for a future date delivery. Premium is added to both selling and buying spot rates (under direct quotes). Forward Discount: Indicates the cheapness of currency vis-a-vis spot rate for a future delivery. The discounts are subtracted from both selling and buying spot rates.

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Forward Rate consists of two components Spot Rate plus Forward points reflecting the interest differentials adjustment for different settlement dates. Forward points are determined by the factors like Supply and demand for currency for the settlement date Market view Interest rate differential between the countries of respective currencies. Interest rate differential An interest rate differential is the difference in interest rate between two currencies in a pair. If one currency has an interest rate of 3 percent and the other has an interest rate of 1 percent, it has a 2 percent interest rate differential. If you were to buy the currency that pays 3 percent against the currency the pays 1 percent, you would be paid on the difference with daily interest payments. Interest Differential explained 6 m interest rate in USA = 5%; 6 m interest rate in UK = 6.5% If spot rate is 1 GBP = 1.6500 USD; Borrow in USD, deposit in UK; Borrow USD 1.65 million for 6 m

Convert that into GBP 1 mio at 1.65; Deposit GBP 1 mio for 6 m Currency at higher rate of interest is at a discount Currency at a lower interest rate is at a premium

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Calculation of Forward Points =Spot rate x interest rate differential x forward period/100 x No. of days in the Year (usually 360) First figure in the Forward Points being lower than the second figure indicates that the base currency is at a premium in forwards. Reverse indicates that base currency is at a discount in forwards.

How forward rates calculated and quoted Take an appropriate spot rate Arrive at the base rate at which the cover transaction can be undertaken in the market Add/deduct forward premium/ discount Add/deduct profit margin to the base rate and round it off as permitted under FEDAI rules What is Chain Rule? (Determination of cross currency rates)

Let us try to understand the concept of Chain Rule by taking an example Suppose a customer calls on us to purchase EURO against payment in Indian Rupees, to meet his requirement we have to first buy US Dollars in the local market against rupees; and then sell them in London/outside markets to purchase EURO .

But then how to quote a rate to customer?

Let us say the local market quotes for USD/INR as: US $ 1 = Rs 55.49/51 and

London quotes 1 EURO = USD 1.2635/37

Now, by using this relationship, we can build up the chain rule as under:
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Step 1 - Write the question to be answered, that is, how many Rs. = EUR 1 Step 2 - The second equation begins with currency in which first equation ended i.e. if EUR 1 = 1.2637 USD Step 3 - The third equation begins with the currency in which the second equation ended i.e. US $ 1 = Rs. 55.51 Therefore, EUR 1 = 55.51 x1.2637 = 70.1479 = INR 70.1479 Then add your own margins and quote different rates for different transactions

Appendix4
Value at Risk Approach The Value at Risk (VaR) approach is a comprehensive indicator for measuring foreign exchange risks. VaR approach incorporates all the assets and liabilities of the national financial system, along with the contingent liabilities, thus permitting rapid comparison among different countries and the analysis of the evolution over time for a country.

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Value at risk method is used to set market position limits for traders and to decide how to allocate minimum capital resources. VaR allow creation of a common denominator to compare risky activities in varied markets. The total risk of the banks can also be decomposed into incremental VaR to reveal positions that increases total risk. On the other hand, VaR can be used to regulate the performance of risk. Performance assessment of risk is vital in banks, where traders have a natural tendency to take on extra risk. Risk capital charges based on VaR approach provides corrected incentives to the traders. The VaR approach has a number of practical advantages and disadvantages. The advantages of VaR are as follows: The potential losses are computed in simple terms. VaR approach is approved by various regulatory bodies concerned with the risks faced by banks such as RBI (Reserve Bank of India) and SEBI (Securities and Exchange Board of India). VaR acts as a versatile tool for forex risk measurement. The limitations of VaR are as follows: VaR faces some difficulties in risk estimation and is sensitive to the estimation methods used.

VaR approach may create a false sense of security. VaR may miscalculate the worst-case outcomes for a bank. The VaR of a specific market position is not always the same for the VaR of the overall portfolio of the bank. VaR fails to incorporate positive results, thus painting an incomplete picture of the situation.
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Appendix5
Country rating of Greece by using Balance Sheet of any bank of Greece? Answer:-We cant do the rating of the country by using the balance sheet of any bank of Greece. So we will see here the procedure of Country Rating by using ratings of Euro money, D&B, ECGC. The main factors which should be considered are: Economical factors:-includes GDP, BOP, Terms of Trade, Capital Flows, etc. Social factors:-Includes HDI, natural resources, Human resources, etc. Political Factors:-Include system of governance, political stability, etc.
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GDP growth in Greece is -6.2% (Q1 2012 compared with Q1 2011). BOP decreased from 2.9 to 2.7Billion US $. No change in value of HDI (0.861) which is very good stands at 29 out of 187. Political crisis: There was election on May 6th, 2012 and no party has won enough seats to govern alone, and they failed to reach a coalition deal. So there will be re election on 17 June, 2012. FITCH has already cut Greece rating from B- to CCC. And if new govt. Is not able to continue to be part of EU, then there will be bankruptcy. Following weightings has been assigned:-

Ratings by ECGC Other parameters by Euro Money Grades by D&B Credit Ratings by Euro Money

10% 20% 30% 40%

1. Euro Money Country Risk evaluates the investment risk of a country, such as risk of default on a bond, risk of losing direct investment, risk to global business relations etc. Factors included are: Political Risk (30%) Economic Performance (30%) Structural Assessment (10%) Debt Indicators (10%) Credit Ratings (10%) Access to Bank Finances/Capital markets (10%)

Ratings By EURO Money is

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http://www.euromoney.com/Article/2773235/Country-risk-March-2011-Countryrankings-and-acknowledgements.html

2. Grades by D&B:-D&B divides the countries into 26 grades and according to grades marks are assigned. Ex.- DB1a30marks etc. A document has been provided by D&B which will help in giving rating to agencies based on financial strength. Ratings by D&B is http://www.dnbcountryrisk.com/

3. Ratings by ECGC:- It grades various countries in 7 levels based on marks scored. Its ratings are based on following factors and weights as follows: Economic Risk Political risk Economic & Political Relations Experience with other Forecast By ECGC 20% 15% 10% 10% 35%

ECGC has recently changed the buyer underwriting policy for Greece. i.e. Exporters will now have to take larger risk cover from ECGC; Jan 17,2012. Presently A2 is rating given to Greece. Ratings by ECGC are A2 Country.

So, Following is the Country Rating for Greece:-

Criteria Credit rating by EURO

Rating/Weight 40%

Marks 15.84

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Money Other Parameters by 20% 9.68

EURO money Grades by D&B(DB5a) Grades by ECGC(A2) Total 30% 10% 13.00 8.50 47.02

So, Total Score comes out to be 47.02 out of 100. And by ECGC classification it lies in the range of 45-60 and it has Category of Risk is High.

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