dhiraj tiwari

A Project Report on

Treasury

&

Risk Management

(Implementation of VaR in G-SEC)

Submitted By

Mr. Dhiraj TiwariIndian Institute of Finance

Greater Noida

Dhiraj Tiwari Indian Institute of Finance1

http://www.bbkonline.com/BBK/EnBbk

Acknowledgement

Every nice work always begins with a systematic approach and this project work was not

an exception.

I would like to express my gratitude to the Chairman, Prof. J.D.Agarwal, and vice

Chairman, Prof. Aman Agrawal Indian Institute of Finance, New Delhi, for

encouraging me to do this project and for his expert guidance and kind support in

bringing out this project report.

My respective guide Mr. S.Raghunathan Head –Risk management Dept B.B.K. Mumbai

is the one whose expert guidance and kind support brought relevance on this project. I

would be thankful for this pleasing guidance and co-operation.

Mr. Ajay Singh Chief Dealer – Treasury Dept. Who was always there to provide me the

judicious judgment, logical thinking, procedure and in nut shell everything. His

inspiration and precious guidance did play a key role to complete my work at ease and

well within time. I wish my deepest gratitude and I am in deep debt to Mr. Prakash Rao

Head – Treasury Dept. for their valuable support .

I also express my deep sense of obligation to Mr. Kiran Jain, Ms. Sindhu, Ms. Harsha

and HR for giving me an opportunity to undergo this project in the esteemed organization

and I express my profound sense of respect and deepest gratitude to each and everyone.

I thank all my well-wishers who helped me directly or indirectly in carrying out this work

towards completion.

-Dhiraj Tiwari



Declaration

This is to certify that the project on“ Treasury and Risk management at B.B.K Mumbai

has been done by Mr. Dhiraj kumar Tiwari as a part of the requirement of the

Management of Business Finance (MBF) summer training program. This study is being

submitted for approval to Bank of Bahrain and Kuwait , Mumbai .

I declare that the form and contents of the above mentioned project are original

and have not been submitted in part or full, for any other degree or diploma of this or any

other Organization / Institute/ University.

Signature: --------------------

Name: Dhiraj kumar Tiwari

Enrollment No. 4107040040

MBF (2007-2009)

Indian Institute of Finance



Preface

Behind any of the systematic work there is some ample approaches after that it can reach

up to some decision. The project is not an exception. As a part of Management of

Business Finance (MBF) program, a student has to pursue a project duly approved by the

Director of the Institute. I had the privilege of undertaking project on the “Treasury and

Risk Management in BBK at MUMBAI

The project is divided in Two part as well the project has assigned the report has been

equipped.

Part 1- Treasury Management .

While starting the project the whole B.B.K. bank back ground as well as product

offering has been studied this has been explained in this part , similarly the most

important function of the treasury were highlighted in this section .

Part 2-Risk Management

Nowadays because of globalization , market is very volatile so risk involved are very

high , in this section the whole attention were given about the modern risk assessment /

methodology process which are used in bank .



EXECUTIVE SYNOPSIS

Trainee: Dhiraj Kumar Tiwari

Organization: Bank of Bahrain & Kuwait

Education Institute: Management of business finance (MBF) 2007-09

Indian Institute of Finance Delhi 110052

Address: Bank of Bahrain & Kuwait Jolly Maker Chamber -II

Nariman point Mumbai -21

Company Guide: Head – Risk Management

Topic: “Treasury & Risk Management of Foreign Bank ”.

Duration: 10 Weeks (15th April 07 –21th June 07)

Objective: To study the treasury & risk management dept workability in

Foreign bank , liquidity management , merchant banking ,

Proprietor trading, & importance of risk management dept ,

its methodology to monitor & control the risk .



Content

Preface 4

Executive synopsis 5

PAGE NO

Part -1 . Introduction 9 - 12

1.1. Introduction of B.B.K. 9

1.2. Overview of financial market 10

1.3. Treasury function 11

1.4. Government security market 12

Part – 2 . Investment 12- 22

2.1. Best investment practices 14

2.2. Primary issuance process 17

2.3. Type of Auction 18

2.4. Bidding process 22

Part -3. Secondary market 24 - 27

3.1. Secondary market trading 24

3.2. Role of primary dealer 27

Part -4 . Liquidity management 28 - 35

4.1. C.R.R. & S.L.R. maintenance 28

4.2. Call money market 33

4.3. Repo borrowing 34

4.4. Reverse Repo 35

Part – 5 Dealing accessory 36 - 38

5.1. Dealing system 36

5.2. Role of CCIL 38



Part 6 .FOREX Market 64 - 66

6.1. FORWARD contract. 64

6.2. SWAP contract 65

6.3. SPOT contract 66

Part – 7 . POLICY 116-118

7.1. Policy of B.B.K. 116

7.2. S.G.F. ( settlement Garantee fund ) 117

Part –II Mid office 130 - 134

8.1. Necessity of mid office . 130

8.2. Daily Monitoring, 131

8.3. Fortnightly Returns 132

8.4. Monthly Returns. 134

Part -9 . ALM management. 142 - 145

9.1. Structural Liquidity statement. 143

9.2. Interest rate sensitivity statement. 145

Part -10 . BASEL –II 152 - 165

Part -11. Important contribution made for bank 166 - 170

11.1. Fixing the deposits rates. 167

11.2. Implementation of VaR in G-sec portfolio. 170

Conclusion and suggestion 177

Bibliography 178-180



Part 1

Introduction

OF

B.B.K.



Bank Background:

BBK is very old & large bank in Bahrain and Kuwaiti market . this is single foreign bank

which is operating in Kuwaiti market , in Kuwait the main lending is mainly to corporates

who were doing the oil business.

In India this bank has come up in 1989 , currently it has two branch one is in Hyderabad,

Mumbai . Initially bank was continually facing the losses because of this in 2004 the

HDFC bank was bidded for the merger. but it was not taken place , in the last year the

bank profit has increased almost 4 time of the previous year .

BBK has lots of corporate product especially for the exporters , like pre-shipment , post-

shipment techniques , not only this treasury design the derivative techniques for the

clints.

The main important business in Hyderabad in LCBD i.e letter of credit and bill

discounting . the total turnover of the Indian operations is 460 crores. BBK has already

implemented the BASEL –II, as per the RBI it is now compulsory for all the foreign

banks to implement the BASEL -II from march 2008.

In India they are looking to open more branches , they are looking for the liberalization of

2009 , because in that case it will be easy for them to open new branches .

Head office of BBK is in Bahrain in Manama, in Indian operation total employees were

110 , this is very small bank in Indian operation , but in Bahrain it is very big in terms of

Indian bank comparison BBK is bigger then the DENA bank , the CAR i.e. capital

adequacy ration is about 21 % . which is much above the comfort level .



INTRODUCTION

Treasury management (or treasury operations ) refers to a management of an

enterprise holding in and trading in government and corporate bonds, currencies ,

financial futures , options and derivatives , payment system and associated

financial risk management .

In a nutshell its all about raising money , Managing money and protecting money

from the various risk such as currency , interest rate etc.

Financial Markets perform an important function of mobilization of savings and

channellising them into the most productive uses. The financial market in India can be

divided into four broad categories:

A) Money Market.

B) Debt Market

C) FOREX Market

D) Capital Market



Treasury in B.B.K. is divided in three parts –

The front office generates deals,

Dhiraj Tiwari Indian Institute of Finance

TREASURY

(B.B.K.)

FRONT OFFICE

(Dealing Room )

MID OFFICE

(Risk Mang.Dept)

BACK OFFICE

(Settlement Room)

11


The back office settles trades only after verifying compliance with the internal controls.

Mid office works Independently, monitors and manages the bank's Risk exposures.

FRONT OFFICE (DEALING ROOM)

Front office is the bank's interface with the financial market. The front office coordinates

and handles all the needs of the bank and its clients with respect to hedging and

financing.

In B.B.K. mostly dealing were in Government Security, Money market & FOREX

Market only & not in capital Market.

FUNCTION OF TRASURY:-

The most important function of the treasury department is as follows

1. Liquidity management: - In this depending upon the net outflow & inflow the

funding decision were taken i.e. borrowing or Lending.

2. Customer covering (Merchant transaction):- In this dealer does the hedging, i.e.

forward contract, swap for the client, or for bank itself.

3. Trading Proprietary: - When a firm trades for direct gain instead of commission

dollars, it is known as proprietary trading. In B.B.K. we have dealer they are

trading in G-SEC, call , FOREX Market .

Government security Market:-


http://www.fimarkets.com/pagesen/financial-terms-dictionary.htm


The government security market was further classified in to two categories:-

Normally the state issued government bond carries little risk weight , hence Return is also

little more then the centre issued government bond.

State Government Securities:

These are issued by the respective state governments but the RBI coordinates the actual

process of selling these securities. Each state is allowed to issue securities up to a certain

limit each year. The planning commission in consultation with the respective state

governments determines this limit. Generally, the coupon rates on state loans are

marginally higher than those of GOI-Secs issued at the same time.

The procedure for selling of state loans, the auction process and allotment procedure is

similar to that for GOI-Sec. State Loans also qualify for SLR status Interest payment and

other modalities are similar to GOI-Secs. They are also issued in dematerialized form.

State Government Securities are also issued in the physical form (in the form of Stock

Certificate) and are transferable. No stamp duty is payable on transfer for State Loans as

in the case of GOI-Secs. In general, State loans are much less liquid than GOI-Secs.

The best Practices:-


G-SEC MARKET

STATE G-SEC CENTRE G-SEC

13


The investments are classified into three categories —

Held-for-Trading (H.F.T.):-The investments made to earn profits from the short-term

price movements are classified under this Category.

Held-To-Maturity (HTM) :- The securities contracted basically on account of

relationship or for steady income and statutory obligations are classified under this

category.

Available-for-Sale:-The securities, which do not fall under above two categories, are

classified as Available-for-Sale.

The securities Held-for-Trading (HFT) and Available-for-Sale (AFS) are to be

marked-to-market periodically. As per the RBI, Trading Book includes HFT and

AFS and Banking Book refers to HTM. HFT is on daily basis , whereas the AFS is on

quarterly (90 days) basis.

The maximum duration up to which the G-Security can be hold under Available –for

–sale (AFS) is 90- days.

Held-to-Maturity


INVESTMENT

Available For Sale

(A.F.S.)

Held For Trading

(H.F.T.)

Held For Maturity

(H.T.M)

14


The risks inherent in the HTM portfolio:

Price risk if the acquisition cost is above par. The premium over the par value will be

amortised annually till maturity.

Re-investment risk due to reinvestment of high yielding security inflow at lower yields.

Held-for-Trading

Classification as HFT should be an explicit management decision considering the

intention, the trading strategies, the risk management capabilities, the capital position and

the manpower skills. Securities classified HFT are to be sold within 90 days (defeasance

period). Shifting of securities from HFT to AFS is permitted only under exceptional

circumstances such as tight liquidity

conditions, extreme volatility or exceptional market conditions. The shifting requires the

approval of Board of Directors/ALCO/Investment Committee.

Available-for-Sale

These assets in the Trading Book are held for generating profit on differential

interests/yields. Ideally, the securities held in the Trading Book are marked-to-market on

a daily basis

G-SEC Market:-

Why Government Issue Such Instruments

The government to finance its fiscal deficit floats the fixed income instruments. It

borrows by issuing G-Secs that are sovereign securities and are issued by the Reserve

Bank of India (RBI) on behalf of Government of India, in lieu of the Central

Government's market borrowing programme



Why one should invest in Debt Market

Fixed Income securities offer a predictable stream of payments by way of interest and

repayment of principal at the maturity of the instrument. The debt securities are issued by

the eligible entities against the moneys borrowed by them from the investors in these

instruments. Therefore, most debt securities carry a fixed charge on the assets of the

entity and generally enjoy a reasonable degree of safety by way of the security of the

fixed and/or movable assets of the company.

The investors benefit by investing in fixed income securities as they preserve and

increase their invested capital and also ensure the receipt of regular interest

income.

The investors can even neutralize the default risk on their investments by

investing in Govt. securities, which are normally referred to as risk-free

investments due to the sovereign guarantee on these instruments.

The prices of Debt securities display a lower average volatility as compared to the

prices of other financial securities and ensure the greater safety of accompanying

investments.

Debt securities enable wide-based and efficient portfolio diversification and thus

assist in portfolio risk-mitigation.

Determination of prices in Debt Markets :

The price of a bond in the markets is determined by the forces of demand and supply, as

is the case in any market. The price of a bond in the marketplace also depends on a

number of other factors and will fluctuate according to changes in

Economic conditions

General money market conditions including the state of money supply in the



economy

Interest rates prevalent in the market and the rates of new issues .

Credit quality of the issuer.

Types of Government Securities

Dated Government securities:.

These instruments are of the face value of Rs 100, which the buyer has to pay upfront.

The return is pre-decided. This is known as the coupon rate or the interest rate. The

interest rate indicates the amount that will be paid out by the government every year till

maturity. The time to maturity is also fixed.

For example, 12% GOI 2005 is a bond that matures on in the year 2005 and has an

interest rate of 12%. The buyer will have to pay Rs 100 to buy the instrument and will get

Rs 12 every year as interest. And when the security matures the face value will be

returned to the holder. As the interest rate is fixed the price of this instrument will

fluctuate depending on the lending rates that are offered by the central bank. If the RBI

lowers interest rates this instrument will become more expensive and if RBI hikes interest

rates then the instrument will become cheaper.

Features of Dated Securities:-

They are issued at face value.

1. Coupon or interest rate is fixed at the time of issuance, and remains constant till

redemption of the security.

2. The tenor of the security is also fixed.

3. Interest /Coupon payment is made on a half yearly basis on its face value

4. The security is redeemed at par (face value) on its maturity date.



Primary Issuance Process :

The Government of India issues securities in order to borrow money from the market.

One way in which the securities are offered to investors is through auctions. The

government notifies the date on which it will borrow a notified amount through an

auction. The investors bid either in terms of the rate of interest (coupon) for a new

security or the price for an existing security being reissued. Since the process of bidding

is somewhat technical, only the large and informed investors, such as, banks, primary

dealers, financial institutions, mutual funds, insurance companies, etc generally

participate in the auctions.

Participants

Primary dealers

Banks

Mutual Funds

Primary Dealers

Insurance Companies

Provident Funds

Non Competitive Bidders

Announcement of Auction :

RBI announces the auction of government securities through a press notification and

invites bids.

Submission of Bids :

The submission of bids is through Electronic Bidding System. NDS (Negotiated Dealing

System) facilitates the electronic submission of bids from all participants.



Allotment process :

After receipt of bids they are opened at pre determined time and allotted on the basis of

cut-off price. Successful bidders are those that bid at a higher price and lower yield than

cut-off price/yield.

Whoever bids at above the cut-off price or below the cut-off yield as the case may

be will be allotted the whole quantum submitted with the respective bid.

Whoever bids at the cut-off price/yield will be allotted on pro-rata basis i.e., he

might be given partial allotment.

Basis of Auction :

Yield Based Auction

Price Based Auction

Yield Based Auction :

If successful bids are decided by filling up the notified amount from the lowest bids

upwards. Such an auction is called yield based auction. Such auction creates a new

security every time a auction is completed.

Price Based Auction :

If successful bids are filled in terms of prices that are bid by participants from the highest

price downwards, such an auction is called price based auction. A price based auction

facilitates the reissue of existing security.

Two types auction widely known and used :

1. Discriminatory Price Auction / Multiple Price Auction (French Auction)

2. Uniform Price Auction (Dutch Auction)

Discriminatory Price Auction / Multiple Price Auction (French Auction) :



In discriminatory price auction successful bidder pays the actual price bided by him. It is

possible that different bidders bids at different price or yield as the case may be.

Therefore every successful bidder will be allotted the respective quantum for the

respective bids.

Bidder ‘A’ submits the following bids for the auction of 6.85% GS 2012 on 3rd June 2003

Sr. No. Quantum (in RS crores) Bid Price

1. 25 108.47

2. 25 107.54

3. 25 107.49

4. 25 107.47

Total 100

Cut-off Price Rs. 107.48

Bids Accepted 75 crores

In the above case only three bids are accepted as the 4th bid is below cut-off price.

Bidder has been allotted the quantum of 75 crores for the respective price bided by him.

i.e.;

25 crores 107.55

25 crores 107.54

25 crores 107.49

Uniform Price Auction (Dutch Auction) :



In uniform price auction successful bidder pays the uniform price. It is possible that

different bidders bids at different price or yield as the case may be. Therefore every

successful bidder will be allotted the respective quantum at the uniform price i.e.; cut-off

price.

Ex :

Bidder ‘A’ submits the following bids for the auction of 6.85% GS 2012 on 3rd June 2003

Sr. No. Quantum (in RS crores) Bid Price

5. 25 108.47

6. 25 107.54

7. 25 107.49

8. 25 107.47

Total 100

Cut-off Price Rs. 107.48

Bids Accepted 75 crores

In the above case only three bids are accepted as the 4th bid is below cut-off price.

Bidder has been allotted the quantum of 75 crores at the uniform price.

i.e.;

75 crores 107.48

Secondary market price that prevails after the auction, is uniform for all the bidders.

Therefore loss to a successful bidder is less in a Dutch auction than in a French Auction.

In our earlier example, assume the secondary market price for the security is Rs.106.98.

If the auction was Dutch the loss to all successful bidders is uniform, at 50 paise per

Rs100/-.

However if the auction was French, the highest successful bidder will incur a huge loss of

nearly Rs 1.49 per 100/-.



The discriminatory price auction thus creates a “winner’s curse” where a successful

bidder is the one who has priced his bid higher than the cut-off, but will immediately

suffer the loss in the market, if the after market price is closer to cut-off rather than his

bid.

There is loss in secondary market even in Dutch auction, if the after market price is lower

than the cut-off. The difference however is that the loss is same for all successful bidders.

Discriminatory price auctions are more common across treasuries of the world, than

uniform price auctions. 90% of the 42 countries surveyed by IMF, in a study of auctions,

used discriminatory price auctions. It is observed that participants would like to bid on

the basis of their valuations of the bond, rather than accept the consensus valuation of all

bids. An outcome that penalizes successful bidders to the extent of the actual distance

between their valuation and the cut-off, rather than uniform penalty for all are preferred.

Such auctions, therefore attract larger competitive participation. Research on the

efficiency of the alternate methods are largely inconclusive.

In Indian Markets, generally discriminatory price auction is used for bond

issuances.

The RBI has the discretion to reject bids when the yields at which bids are received are

higher than the rates at which RBI wants to place the debt. Depending upon the pricing

objective RBI wants to achieve and the bidding pattern of the participants, bidding

success and development takes place.

Non competitive Bids can also be submitted under treasury auctions. Allotment to these

bids will be first made from the notified amount, at the weighted average price of all

successful bids. RBI has announced that 5% of the notified amount in all the future

auctions to be reserved for non competitive bids for retail investors, who can apply

through Banks and Primary Dealers.



Non Competitive Bidding :

Meaning :

Non-competitive bidding means the bidder would be able to participate in the auctions of

dated government securities without having to quote the yield or price in the bid. Thus,

he will not have to worry about whether his bid will be on or off-the-mark; as long as he

bids in accordance with the scheme, he will be allotted securities fully or partially.

Eligible Investors :

Participation in the Scheme of non-competitive bidding is open to

Individuals

HUFs

Firms

Companies

Corporate bodies

Institutions

Provident funds

Trusts and

any other entity prescribed by RBI.

As the focus is on the small investors lacking market expertise, the Scheme will be open

to those who

a. do not have current account (CA) or Subsidiary General Ledger (SGL)

account with the Reserve Bank of India

b. do not require more than Rs two crore (face value) of securities per

auction

As an exception, Regional Rural Banks (RRBs), Urban Cooperative Banks (UCBs) and

Non-banking Financial Companies (NBFCs) can also apply under this Scheme in view of

their statutory obligations. However, the restriction in regarding the maximum amount of



Rs. two crore per auction per investor will remain applicable.

Eligible investors cannot participate directly. They have to necessarily come through a

Bank or Primary Dealer (PD) for auction.

Advantages of Non competitive Bidding Facility :

The non competitive bidding facility will encourage wider participation and retail

holding of government securities.

It will enable individuals, firms and other mid segment investors who do not have

the expertise to bid competitively in the auctions.

Such investors will have fair chance of assured allotments at the weighted average

yield in the auction.

Minimum Bidding Amount :

The minimum amount for bidding will be Rs.10,000 (face value) and in multiples of in

Rs.10,000.

Secondary Market Trading:

After the primary issue of government security through auction, they are traded in

secondary market.

Participants in Secondary Market :

Primary dealers

Banks

Mutual Funds

Primary Dealers

Insurance Companies

Provident Funds

Settlement :



Difference Between Face Value, Trade Value and the settlement value

Factor Affecting Interest rates in Debt market

Monetary policy

The government borrows money by issuing G-Secs (longer duration) and T-bills. The

interest the government pays on short-term instruments is the benchmark for all financial

activity in the country (this rate is considered to be close to risk free). After the rate cut in

March the benchmark interest rate in India is 7%.

Suppose the Reserve Bank feels that there is too much liquidity in the financial system

and there is a threat that inflation may rise. In such a scenario the Reserve Bank will

adopt a tight monetary policy. It therefore sells government bonds (and collects money),

reducing the money availability in the system. In case the central bank wants to ease the

monetary policy, it buys back the bonds, in effect infusing liquidity in the economy.

The central bank can therefore effectively control the short-term interest rates and the

lower end of the yield curve. When the markets expect the central bank to cut rates the

short-term instruments become expensive as they continue to offer higher interest or

coupon rates. Consequently, the yield declines, adjusting to the lower interest rate

environment (the yield curve steepens). On the contrary when the expectations are that

the central bank will increase interest rates the price of the debt instruments fall causing

the yield to increase (the yield curve flattens).

The central bank’s decision to cut interest rates or to increase it also depends on the

economic scenario in the country. The central bank has to keep in mind two objectives -

to promote economic growth and to keep inflation under control. If the growth prospects

of the economy are good then investment activity will be buoyant, resulting in demand

for money (to fund expansion). However, unchecked investment activity could lead to a

heating up of the economy, giving rise to inflationary pressures. In such a scenario, the

central bank needs to adjust the fast rise in demand to the slower growth in supply.



Economic growth

Economic growth and its prospects affect the yield curve. This is because the monetary

policy is largely influenced by the health of the economy.

The growth prospects of the economy affect the allocation of capital. If there are little or

no growth prospects, the demand for capital will be sluggish. Banks would be saddled

with surplus funds, which would probably diverted to the debt markets. Also, in a

slowing economy, banks themselves might not be comfortable giving loans to the

industry for fear of accumulating bad debts. Consequently, the investment avenue that

guarantees almost risk free returns is the G-secs and T-bills. This drives up demand for

debt instruments. Higher demand results in prices of debt instruments being marked up,

implying that yields decline.

On the other hand, when the growth prospects for the economy become brighter the

demand for these instruments weakens.

Fiscal policy

The fiscal policy controls the government’s earnings and spending. If a government

spends more than it earns it will incur a fiscal deficit. A higher fiscal deficit increases the

risk of default by a government. Therefore, the interest rates in these countries are higher.

Rising budget deficits cause the yield curve to be steep while falling budget deficits tend

to flatten the curve.

However, in case a fiscal situation of a country looks precarious the short-term interest

rates will tend to be much higher than long-term interest rates. The long-term interest

rates will be relatively lower on hopes that the situation improves in the future.

But if the fiscal deficit continues to rise then interest rates in the long term will be higher

because the government will continue to borrow to meet its fiscal deficit, increasing the

demand for money. The markets as a result would demand higher interest rates causing

the prices for instruments to decline.



Inflation

Inflation affects both the long term and the short term yields. If the inflation is around 7%

and the long-term yield is about 11%, the real rate of return is just 4%. Therefore, if

inflation rises the real rate of return would decline causing the price of the instrument to

head south and thereby increasing the yield. This causes the yield curve to flatten.

Attractiveness of debt markets

The investors who have invested in the stock markets have gone through a bad phase

considering that firstly there was the tech meltdown and then of course the scams that

were unearthed. Also, with the badla system being banned the investors have only one

avenue left where they can get almost risk free returns this has caused the demand for the

debt instruments and therefore their prices to move up. However, it remains to be seen

whether the demand is more of short-term instrument or for long-term instruments.

In the first quarter of FY02, the gross fiscal deficit at Rs 422 billion was almost double

compared to Rs 251 billion in the corresponding period in the previous year. The increase

in fiscal deficit was due to over 40% drop in revenue receipts. The decline in revenue

receipts was caused by a 54% dip in corporate tax collections, which was on account of

lower earnings by corporate. This clearly points to the slowing economy. Also, the actual

expenditure of the government at Rs 651 billion was higher by 14% compared to

1QFY01

Role of Primary Dealers

Primary Dealers are important intermediaries in the government securities markets

introduced in 1995.There are now 18 primary dealers.

The objectives of Primary Dealer System

The objectives of the PD system are:



To strengthen the infrastructure in the government securities market in order to

make it vibrant, liquid and broad based.

To ensure development of underwriting and market making capabilities for

government securities outside the RBI so that the latter will gradually shed these

functions

To improve secondary market trading system, which would contribute to price

discovery, enhance liquidity and turnover and encourage voluntary holding of

government securities amongst a wider investor base.

To make PDs an effective conduit for conducting open market operations (OMO).

C.R.R./ S.L.R.MAINTENANCE

According to banking regulation act 1949, all commercial banks are required to maintain

certain part of their Net Demand and Time Liabilities (NDTL) in the form of cash

balance in the Current Account of RBI.

At present CRR rate is 8.25 %

Working of CRR

Banks have to maintain minimum 70 % of CRR on daily basis. Every fortnight on an

average 4.5% of NDTL is to be maintained.

Fortnight is considered to be of 14 days (i.e. from Saturday to Friday). Reporting of

average CRR maintained on fortnight is to be done on alternate Fridays which is very

popularly known as Reporting Friday.



Interest payable by RBI

Out of 4.5%, 3% of NDTL is interest free. On the remaining balance of 1.5% RBI pays

the interest of 6% (i.e. at Bank Rate). RBI does not pay interest on any cash balance

maintained in excess of 4.5% of NDTL.

RBI pays the interest to Banks on monthly basis

Components of Net Demand and Time Liabilities

Demand Deposits

Current Account

Savings Account

Time Deposits

Fixed Deposits

Recurring Deposits

Interbank Deposits

Deposits placed by various banks

The basis (NDTL) to be taken for calculation of CRR, of the current fortnight is as of

the previous Reporting Friday.

Ex : Next Reporting Friday is on 27th June

Last Reporting Friday was 13th June

And Previous Reporting Friday was from 30th May.

Therefore calculation of CRR for the Fortnight

14th June – 27th June is done on the basis (NDTL) of

30th May



28th June – 11th July is done on the basis (NDTL) of 13th

June

12th July – 25th July is done on the basis (NDTL) of 27th June

TABLE for C.R.R. maintenance.

C.R.R SATAUS REPORT for the fortnight 7/06/08 to 20/06/08

CRR product required during the fortnight INR -5,189,765,700

Daily CRR requirement (100%) INR -370,697,550

Daily Minimum CRR requirement (70%) INR -259,488,285

Date

Daily

required Actual Bal Actual Bal Total CRR Total CRR Product



100%

per RBI

Stmt.

per RBI

Stmt. Maintained as % of covered

MUM HYD

daily

requir.

7/Jun/08 37.0698 30.7106 3.5756 34.2862 92.49% 34.2862

8/Jun/08 37.0698 30.7106 3.5756 34.2862 92.49% 68.5724

9/Jun/08 37.0698 26.2479 5.2560 31.5039 84.99% 100.0763

10/Jun/08 37.0698 43.6530 8.5285 52.1815 140.77% 152.2578

11/Jun/08 37.0698 25.5816 9.5565 35.1381 94.79% 187.3959

12/Jun/08 37.0698 28.2813 7.8222 36.1035 97.39% 223.4994

13/Jun/08 37.0698 31.0361 7.9574 38.9935 105.19% 262.4929

14/Jun/08 37.0698 31.6724 31.6724 85.44% 294.1653

15/Jun/08 37.0698 31.6724 0.0000 31.6724 85.44% 325.8377

16/Jun/08 37.0698 0.0000 0.00% 325.8377

17/Jun/08 37.0698 0.0000 0.00% 325.8377

18/Jun/08 37.0698 0.0000 0.00% 325.8377

19/Jun/08 37.0698 0.0000 0.00% 325.8377



20/Jun/08 37.0698 0.0000 0.00% 325.8377

TOTAL

518.976

6

325.83

77

S.L.R:-

According to Bank Regulation Act 1949 all commercial banks are required to maintain

25% of Net Demand and Time Liabilities in the form of securities on daily basis.

Components Of Statutory Liquidity Ratio :

Central Government Bonds

State government Bonds

PSU Bonds : Only those bonds which has been given SLR status by RBI.

Corporate Bonds : Only those bonds which has been given SLR status by RBI.

Reverse Repo: In case of reverse repo the ownership securities passes from to seller

buyer .Therefore such securities are eligible as SLR securities .

At present SLR rate is 25%. Therefore 25% of NDTL is supposed to be maintained in the

form of any of above mentioned securities on daily basis.

Whenever RBI increases SLR , Bank capacity to create credit reduces to that extent

affecting the money supply and the debt market.

The Indian Debt Market is mostly dominated by Banking System

International factors like recently the crude oil prices which is main responsible for the

inflation , to control the inflation the RBI uses the monetary tool by hiking the interest

rate, which is responsible for the portfolio value .



Call money market

Call Money Market refers to the market for short term funds. Call money is an amount

borrowed or lent on demand for a very short period i.e.; for one day. No collateral

security is required to cover these transactions. Intervening holidays and/or Sundays are

excluded for this purpose.

Call money transactions are essentially unsecured OTC transactions, with same day

settlement, and are preferred by participants for operational use, over most other short

term instruments including repos.

Features of Call Money Market :

The call market enables the banks and institutions to



square off their position (day to day deficits and surpluses of money)

Commercial banks, Co-operative Banks and are permitted to borrow and lend in this

market for adjusting their cash reserve requirements.

Specified All-India Financial Institutions, Mutual Funds and certain specified entities

are allowed to access Call/Notice money only as lenders. Interest rates in the call and

notice money market are market determined.

In view of the short tenure of such transactions, both the borrowers and the lenders are

obligated to have current accounts with the RBI.

It serves as a channel for deploying funds on short term basis to the lenders having

steady inflow of funds

Short-term liquidity conditions impact the call rates the most. On the supply side the call

rates are influenced by factors such as

Deposit mobilization of banks

Capital flows &

Bank reserve requirements

On the demand side call rates are influenced by :

Tax outflows

Government borrowing programme

Seasonal fluctuations in credit off take.

The external situation and behavior of exchange rates also have an influence on call

rates, as most players in the market run integrated treasuries that hold short term positions

in both rupee and forex markets, deploying and borrowing funds through call markets.



During normal times,

Call rates hover in between the repo rate and the reverse repo rate.

During easy liquidity,

Call rates are less than or equal to the repo rate.

During periods of tight liquidity,

Call rates move towards the reverse repo rate.

Repos

Repo is a money market instrument which enables collateralized short term borrowing

and lending through sale/purchase operations in debt instruments.

Under a repo transaction, a holder of securities sells them to an investor with an

agreement to repurchase at a predetermined date and rate.

The inflow of cash from the transaction can be used to meet temporary liquidity

requirement in the short term money market at comparable cost.

Repo thus represents a collateralized short term lending.

The lender of securities (who is the borrower of cash ) is said to be doing the repo, the

same transaction is a reverse repo in the books of lender of cash (who is the borrower of

securities).

Reverse Repo :

Reverse repo is the mirror image of repo. For in the reverse repo securities are acquired

with the simultaneous commitment to resell.

When the reverse repurchase transaction matures, the counter-party returns the security to

the entity concerned and receives its cash along with the profit spread.

Different instruments can be considered as collateral security for undertaking the ready



forward deals and they include Government dated securities, Treasury Bills

Eligible Participants :

Holding of SGL account with RBI

Holding of Current A/c with RBI

Advantages of Repos :

Repos can provide a variety of advantages to the financial market in general, and debt

market, in particular as under:-

An active repo market would lead to an increase in turnover in the money

market, thereby improving liquidity and the depth of the market.

Repos would increase the volumes in the debt market, as it is a tool for funding

transactions. It enables dealers to deal in higher volumes.

RBI are using repo with the objective injecting liquidity into or withdrawing from the

market and also to reduce volatility in short term in particular in call money rates.

Negotiated Dealing System :

Meaning :

Negotiated Dealing System (NDS) is an electronic platform for facilitating dealing in

Government Securities and Money Market Instruments.

NDS will facilitate electronic submission of bids/application by members for

primary issuance of Government Securities by RBI through auction and

floatation.



NDS will also provide interface to Securities Settlement System (SSS) of Public

Debt Office, RBI, thereby facilitating settlement of transactions in Government

Securities including treasury bills, both outright and repos.

Objective :

One of the basic objectives of NDS is dissemination of on-line price information of

transactions in government securities and money market instruments. In order to achieve

this objective, transactions not concluded over NDS will have to be necessarily reported

through the NDS.


NDS will use INFINET, a closed user group network as communication backbone.

Hence, membership to the NDS is restricted to members of INFINET. Membership of

INFINET entails holding SGL and/or Current Account with RBI or as may be

prescribed from time to time.

Types of Trades permitted to settle through NDS :

Presently instruments which are under the regulatory jurisdiction of RBI are envisaged

for trading over the NDS platform.

These include Government Securities and Money Market Instruments –

Call, Notice/Term Money

Coupon bearing bonds

Commercial Paper

Certificate of Deposit and

Repo in Government Securities.



Information required to facilitate transactions through NDS :

identity of the parties will not be 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)

will be disseminated to the market, through Market and Trade Watch.

Clearing Corporation of India Ltd (CCIL)

CCIL is an agency which will extend guaranteed settlement for trades done/reported on

NDS in government securities including Treasury Bills, both outright and Repos through

the process of Novation.

Novation is the process by which government securities transactions are settled through

CCIL. This means that CCIL will act as a buyer to the seller of security and

simultaneously will act as a seller to the buyer of the security. This will in effect remove

the credit risk faced by members vis-à-vis their counterparties.

Besides, CCIL provides the additional comfort of improved risk management practices

through daily marking to market of collateral, maintenance of daily margins by

members and through a Guarantee Fund.




Only NDS members can route their deals done among themselves for settlement through

the CCIL.

Method of Settlement of trades through CCIL :

Once a trade is done/reported over NDS it can be settled either though CCIL or directly

through RBI – SGL.

Settlement through CCIL will be on Delivery Versus Payment II (DVP II) mechanism.

DVP II refers to settlement of securities on gross basis (trade by trade basis) while funds

will settle on net basis.

Outright transactions in government securities and Treasury Bills should settle through

CCIL.

CCIL, however, will provide settlement guarantee for trades done/reported on NDS in

respect of government securities including treasury bills (both repo and outright).

Settlement Guarantee Fund

Settlement Guarantee Fund is a fund contributed by the members to meet the margin

requirements both initial and mark to market margins. The members’ contribution to the

Fund would be by way of cash (10%) and securities (90%).

Different cut off times

The processing of the trades is done in two batches i.e. Batch-1 and Batch-2.

The cut off time for accepting the trades for processing in batch-1 is 14:30 hrs/13

hrs on Saturday. i.e. all the trades captured in the NDS system between the

opening hours of trading i.e. 9:30 hrs and 14:30 hrs will be received from NDS

and processed by CCIL for settlement. These trades can be same day settlement,

next day settlement and till T+2 .



The cut off time for accepting trades for processing in batch-II is 17:30 hrs i.e. all

the trades captured in the NDS system between 14:30hrs and 17:30 hrs and till

14.00on Saturday will be downloaded from NDS and processed by CCIL for

settlement the next day and till T +2.

Default

Buyer

In case buyer defaults and there is no requisite balance in his current account to the extent

of securities purchased by him then CCIL will sell of the securities in the market and

remit the amount to the counterparty (seller)

Seller

In case if seller defaults i.e. he sells the security to the counterparty which he does not

possess in his SGL A/c then CCIL will utilize the current A/c of borrower and purchase

the securities from the market and reimburse the same to buyer.

If Seller does not possess the requisite balance in his account than CCIL will utilize the

Settlement Guarantee Fund to reimburse the buyer.

The important concept of treasuries

Analyzing Treasuries

Concept of Yield

Yield refers to the percentage rate of return paid on a stock in the form of dividends, or

the effective rate of interest paid on a bond or note.

The different kinds of yields measured depending on the investment scenario and the

characteristics of the investment in government securities:



Coupon Yield

Current Yield

Yield to Maturity

Coupon Yield :

Coupon yield refers to the fixed interest that the government bond carries. It is the fixed

return that the government commits to pay till maturity of the bond.

The coupon yield is always paid on the face value of the government security. Usually in

the case of government securities the coupon payments are made semi-annually.

Current Yield :

Current yield refers to the return that the holder of government bond gets on the market

price. It is calculated on the basis of market price.

Coupon Rate

Current Yield = ---------------- * 100

Market Price

The current yield does not take into account the reinvestment of future cash flows

including the interest earned on coupon payments. It should be noted that current yield is

never static. It changes with change in market price.

Yield To Maturity(YTM)

YTM is the most popular measure of yield in the Debt Markets and is the percentage rate

of return paid on a bond, note or other fixed income security if you buy and hold the

security till its maturity date.



The yield or the return on the instrument is held till its maturity is known as the Yield-to-

maturity (YTM). It basically measures the total income earned by the investor over the

entire life of the Security.

This total income consists of the following:

Coupon income: The fixed rate of return that accrues from the instrument

Interest-on-interest at the coupon rate: Compound interest earned on the

coupon income

Capital gains/losses: The profit or loss arising on account of the differ

Yield can also be termed as the internal rate of return that equates the present value of

total expected cash outflows with the present value of total expected cash inflows.

Mathematically yield on investment is the interest rate that will make the following

relationship hold :

C/2 C/2 C/2 + 100

P = -------------- + ----------------- + ……+ ------------------

(1+y/2) (1+y/2)² (1+y/2)²ⁿ

where

C is the (Coupon payment) cash flow received in period

P is the price of the bond

n is the number of years to maturity

y is the yield

The yield on the government securities is influenced by various factors such as

level of money supply in the economy



inflation

borrowing program of the government &

the monetary policy followed by the government.

Difference between coupon rate and yield

The difference between coupon rate and current yield arises because the market price of a

security might be different from the face value of the security. Since coupon payments

are calculated on the face value, the current yield is dependent on market price.

Relationship of Yield to Price :

Yields and Bond Prices are inversely related. So a rise in price will decrease the yield and

a fall in the bond price will increase the yield

There will be an immediate and mostly predictable effect on the prices of bonds with

every change in the level of interest rates.(The predictability here however refers to the

direction of the price change rather than the quantum of change).

When the prevailing interest rates in the market rise, the prices of outstanding bonds will

fall to equate the yield of older bonds into line with higher-interest new issues. This will

happen as there will be very few takers for the lower coupon bonds resulting in a fall in

their prices. The prices would fall to an extent till the same yield is obtained on the older

bonds as it is available for newer bonds.

When the prevailing interest rates in the market fall, there is an opposite effect. The

prices of outstanding bonds will rise, until the yield of older bonds is low enough to

match the lower interest rate on the new bond issues.

These fluctuations ensure that the value of a bond will never be the same throughout the

life of the bond and is likely to be higher or lower than its original face value depending



on the market interest rate, the time to maturity (or call as the case may be) and the

coupon rate on the bond.

Relationship between the Market Price, Coupon Rate, Current Yield and Yield to

Maturity(YTM):

If Market Price is equal to face value of the government security/bond,

then the current yield, coupon yield and yield to maturity will all be equal to the

coupon rate or interest payable on the government security / bond.

If Market Price is less than face value of the government security/bond,

then the coupon yield will all be equal to the interest payable on the government

security / bond and the current yield and yield to maturity will be higher than the

coupon yield.

If Market Price is more than face value of the government security/bond,

then the coupon yield would still be equal to the interest payable on the

government security / bond and the current yield and yield to maturity will be

lower than the coupon yield.

If Government security is selling at : Relationship

Par Coupon Yield = Current Yield = YTM

Premium Coupon Yield > Current Yield > YTM

Discount Coupon Yield < Current Yield < YTM

The Effect of Yield Level on Price Volatility :



YH Higher Yield Level PH Price corresponding to YH

YH' Decrease in YH PH' Price corresponding to YH'

YH'' Increase in YH PH'' Price corresponding to YH''

YL Lower Yield Level PL Price corresponding to YL

YL' Decrease in YL PL' Price corresponding to YL'

YL'' Increase in YL PL'' Price corresponding to YL''

Assumption

(YH'' – YH) = (YH - YH') = (YL'' – YL) = (YL – YL'')

Changes in Yields are assumed to be in Proportionate level.

Observation

(PL' – PL) > (PH' – PH)


PL'

PL

PL''PH'

PH PH''Price

45

YL' YL YL'' YH' YH YH''

Yield


(PL – PL'') > (PH – PH'')

Price increase is more in case when yield level is low than in case when yield level is

high for proportionate decrease in yield.

Interpretation

Price Volatility is not the same for all the bonds

Although price moves in the opposite direction with the change in yield, the percentage

price change is not the same for all the bonds.

Price Volatility is Higher when the yield level is Low

Price Volatility is huge for large change in yield.

Price increases are greater than decreases for proportionate changes in yield in

case

o When yield level is low or

o When there is large change in yield



When yield level is low, price increase is greater than price decrease. Any change

(proportionate increase or decrease) in yield, with lower yield level, will bring about

greater increase in price than decrease in price.

The investment implication is that capital gains are higher than capital losses when yield

level is low.

This is because at lower yield level the curve is steep and at the higher yield level the

curve become convex.

Price Volatility is Lower when the yield level is High

Price Volatility is approximately symmetric for small changes in yield


Price

P1

P

P2

Y1 Y Y2

47

Yield


Concept of duration

Duration is a measure of the average (cash-weighted) term-to-maturity of a bond. The are

two types of duration, Macaulay duration and modified duration. Macaulay duration is

useful in immunization, where a portfolio of bonds is constructed to fund a known

liability. Modified duration is an extension of Macaulay duration and is a useful measure

of the sensitivity of a bond's price (the present value of it's cash flows) to interest rate

movements

Macaulay Duration

The calculation of Macaulay Duration is shown below:


http://www.finpipe.com/cashflow.htm

http://www.finpipe.com/immune.htm


Modified duration is a measure of the price sensitivity of a bond to interest rate

movements. It is calculated as shown below:

Modified Duration = Macaulay Duration /( 1 + y/n), where y = yield to maturity and n =

number of discounting periods in year ( 2 for semi - ann pay bonds )

Then, % Price Change = -1 * Modified Duration * Yield Change

Modified duration indicates the percentage change in the price of a bond for a given

change in yield. The percentage change applies to the price of the bond including accrued

interest. In the section showing a bonds price as the present value of its cash flows, the

bond shown was priced initially at par (100), when the YTM was 7.5%, with a Macaulay

Duration of 4.26 years. The bond was repriced for an increase and decrease in rates of

2.5%. The Modified Duration for this bond will be: Dmod = -1 * 4.26 / (1 + .075/2) =

4.106 years. Therefore, a change in the yield of +/- 2.5% should result in a % change in

the price of the bond of: -/+ 4.106 * .025 = +/- 0.10265 (+/- 10.265 %). Since the bond

was initially priced at par, the estimated prices are : $110.27 at 5.00% and $89.74 at

10.00%. The actual prices were: $110.94 at 5.00% and $90.35 at 10.00%. The

discrepancy between the estimated change in the bond price and the actual change is due

to the convexity of the bond, which must be included in the price change calculation

when the yield change is large. However, modified duration is still a good indication of

the potential price volatility of a bond


http://www.finpipe.com/cashflow.htm


The previous percentage price change calculation was inaccurate because it failed to

account for the convexity of the bond. Convexity is a measure of the amount of "whip" in

the bond's price yield curve (see above) and is so named because of the convex shape of

the curve. Because of the shape of the price yield curve, for a given change in yield down

or up, the gain in price for a drop in yield will be greater than the fall in price due to an

equal rise in yields. This slight "upside capture, downside protection" is what convexity

accounts for. Mathematically Dmod is the first derivative of price with respect to yield

and convexity is the second (or convexity is the first derivative of modified duration)

derivative of price with respect to yield. An easier way to think of it is that convexity is

the rate of change of duration with yield, and accounts for the fact that as the yield

decreases, the slope of the price - yield curve, and duration, will increase. Similarly, as

the yield increases, the slope of the curve will decrease, as will the duration. By using

convexity in the yield change calculation, a much closer approximation is achieved (an

exact calculation would require many more terms and is not useful).

Using convexity (C) and Dmod then: % Price Chg. = -1 * D mod * Yield Chg. + C/2 *

Yield Chg * Yield Chg.



Using the previous example, convexity can be calculated and results in the expected price

change being: $111.02 at 5.00% and $90.49 at 10.00% The actual prices were: $110.94 at

5.00% and $90.35 at 10.00%



Characteristics of Bond that affect Price Volatility

There are two primary characteristics of treasuries that determine the price volatility. –

Coupon Rate

Term to Maturity

Liquidity

Lower the Coupon Rate, Greater the Price Volatility.

For a given term to maturity and the initial yield, lower the coupon rate, the greater the

volatility of the bonds

Practical illustration

Government

SecurityYield Price

Increase

in yield

New

price

%

Decline

in

Bonds

Price

Decrease

in yield

New

Price

%

Increase

in Bonds

Price

9.40% 2012 5.78 125.42 6.78 117.703 6.15% 4.78 134.0618 6.9%

11.03%2012 5.79 136.59 6.78 128.4094 5.9% 4.78 145.5111 6.53%

At the same time % Price increase is greater than price decrease in case of both the bonds

for same change in yield.

Price Volatility Increase with increase in Term to Maturity

For a given coupon rate and initial yield, the longer the term to maturity, the greater the

price volatility. The investment implication is that if an investor wants to increase a



portfolio’s price volatility because he expects the interest rates to fall, he should have

bonds with long maturities in the portfolio. To reduce a portfolio’s price volatility in

anticipation of a rise in interest rates, the investor should hold bonds with shorter

maturities.

Practical illustration

Government

SecurityYield Price

Increase

in yield

New

price

%

Decline

in

Bonds

Price

Decrease

in yield

New

Price

%

Increase

in Bonds

Price

6.25%2018 5.91 103.25 6.41% 98.50243 4.59% 5.41% 108.3691 4.96%

6.30%2023 6.02 103.12 6.52% 97.56204 5.39% 5.52% 109.3058 5.99%

% Price increase is greater in case of higher tenor bond than % Price decrease in case of

lower tenor bond for same change in yield.

Higher the Liquidity Higher the Price Volatility

Liquidity attribute plays a very important role in the price volatility. Bonds having

Liquidity characteristic indicates highest tradable security amongst the list of outstanding

bonds. Therefore liquid bonds are highly price sensitive than illiquid bonds.

Measuring Bond Price Volatility :

Price Value of basis point

Yield Value of a price change

Duration



Price Value of a Basis Point

The price value of a basis point is the rupee value of change in price of the bond for 1

basis point change in yield (1/100=.001).

This measure of price volatility indicates the rupee price volatility as opposed to price

volatility as a percentage of initial price.

Yield Value of Price Change :

Some investors use another measure of the price volatility of a bond – The change in the

yield for a specified price change.

This is computed by taking the difference between the initial yield and the yield of the

bond after a Rs x change in its price.

The smaller the yield value of a Rs x price change, the greater is the price volatility.

This is because it would take a larger Rs x price movement to change the yield a

specified no of basis points.

For ex

Government

SecurityYield Price

Increase

in price

New

Yield

Change

in Yield

6.85%2012 5.71 107.76 112.76 5.03 0.68

7.40%2012 5.71 111.6 116.6 5.05 0.66

Rs 5 change in price of both the bonds brings about lower change in yield in 7.40% 2012



Measuring Duration

According to Macaulay, Duration is elucidated in two ways :

Duration is the weighted average term to maturity of the bond

The weights in this weighted average are the present value of each cashflow as a

Percentage of bonds price.

Mathematically, Macaulay Duration can be computed as follows :

1 * PVCF + 2 * PVCF + 3 * PVCF +…….+ n * PVCF

1 2 3 n

-------------------------------------------------------------------------------

PVCTF

OR

1 + (y/2) (y/2) – (c/2)

---------- * w + ---------------- * n(1-w)

y/2 y/2

PVCF Present Value of cashflow

PVCF Present Value of cashflow in 1st semi annual coupon payment

1



PVCTF Present Value of total cashflow

w Ratio of Present Value of the Annuity of the coupon payments to the price

of the bond

Therefore the Present Value of the coupon Payments is

1

1 - ----------

(1+y)ⁿ

100 * c ------------------------

y

Duration is Approximate % change in Price to change in Yield

Though Macaulay computed the duration as a measure of length of time a bond

investment is outstanding.



The real significance and interpretation is linked to price volatility.

Duration assumes that for change in yield, change in price is symmetric.

The link between the bond price volatility and Macaulay duration can be shown as

follows:

1

= ---------- * Duration * Yield change

(1+y)

where is one half of yield to maturity

This product is called Modified Duration


Price

Y' Y Y''

Yield

P'

P

P''

Duration (Tangent Line)

(Estimated Price)

Gap

Actual Price

57


Macaulay Duration

Modified Duration = ----------------------------

(1+y)

The relationship can be expressed then be expressed as

Approximate percentage change in Price = Modified Duration * yield change

The above relationship holds only for small changes in yield. However this is not true for

large changes and duration is thus not a good measure for price volatility.

Higher the tenor, Greater the duration , Therefore higher the Price Volatility

Illustration

Government

SecurityYield Price Duration

6.85% 2012 5.71% 107.76 6.54

6.25% 2018 5.91% 103.25 9.27

6.30% 2023 6.02% 103.12 11.21

Within the same tenor bonds Lower the Coupon Higher the Duration

Illustration

Government

SecurityYield Price Duration

11.03% 2012 5.78 136.59 6.03

9.40 % 2012 5.79 125.42 6.36

7.40 % 2012 5.71 111.60 6.55



Interpretation

The investment implication is that if the dealer expects the interest rate to plunge down in

future then he may invest in bonds having higher duration as approximate % change in

price is higher (Capital gains are higher) in case of bonds having higher duration.

At the same time if dealer is of the view that interest rates will rise in future then he

include the bonds having shorter duration in his portfolio.

Measuring Convexity of Bonds

For small changes in yield approximate % change in price to change (increase or

decrease) in yield is almost the same. Therefore Duration assumes price yield

relationship as symmetric


Price

Y' Y Y''

Yield

P'

P

P''

Duration

Convexity

59


However this is not true for large changes in yield. Price Yield relationship in bonds is

not a straight line but convex. This means that change in price for every change in yield is

not symmetrical but convex.

Convexity Measure

The convexity measure of a bond is approximated using the following formula

V+ + V_ - 2Vo

Convexity measure = -------------------------------

2Vo (∆y)²

∆y = Change in yield in decimal

Vo = initial price

V+ = Price if yield declines by ∆y

V_ = Price if yield increases by ∆y

Convexity Adjustment Price Change

Approximate % change in price due to convexity

Convexity Adjustment = Convexity measure * (∆y)² * 100

For larger yield movements, a combination of duration and convexity gives a better

approximation to price change. Therefore the total % Price change would be

Duration Effect + Convexity Effect

i.e. Estimated change using duration + Convexity adjustment



Yield Curve :

The relationship between yield and yield to maturity is referred to as term structure of

interest rates. If we compute the yield of various government securities in relation to their

maturities, and the same is plotted graphically by plotting the “term to maturity” on the X

axis and the corresponding on Y axis a curve pattern emerges which is called as “yield

curve”.

The yield on the government security acts as a basis for determining yield against other

instruments like bonds, debentures etc:

The most traditionally observed types of yield curve are given below :

Upward Sloping Yield Curve

In an Upward Sloping Yield Curve the yield rises steadily as the maturity period of the


Yield

61

Term to Maturity


securities increases. This is also referred to as normal yield curve and it signifies the risk

return reward, i.e; the higher yield for the government security having a longer

maturity period. A longer maturity government security is subject to more interest

rate changes than a shorter term one

Downward Sloping Yield Curve

In a downward yield curve the yield declines steadily as the maturity period of the

securities rises. It is also referred to as inverted yield curve. In other words yields are

higher for shorter dates securities, or the securities maturing in the short term and decline

steadily over the period of time. This situation arises due to unstable liquidity conditions,

when short term funds are scarce. In such a situation investors tend to sell there short

term securities to meet there short term fund requirements, leading to a higher yield at the

shorter end.


Yield

Term to Maturity

62


Humped Yield Curve

In a humped yield curve, the yield peaks in the medium term and then declines steadily as

the maturity period of the securities increases. In the other words, the yield is upward

sloping up to a certain maturity period, after which yield starts declining.

Flat Yield Curve


Yield

Yield

63

Term to Maturity

Term to Maturity


In a flat yield Curve, any change in maturity period does not bring change in yields. In

such situation investments are made in short term securities, and the reinvestment in the

longer tenor is not preferred in the view of lack of return on the longer end.

Therefore Variation in CRR results in variation in money supply and hence authority can

vary money supply in accordance with the requirements of the economy.

Compared to Bank rate policy and OMO, CRR is the most effective and powerful

instrument in regulating credit and therefore it is described as most direct weapon to

control credit. In India CRR has certain drawbacks on account of

Excess cash reserves with the banking system.

As well as presence of unorganized money market.

However still it is the most effective instrument in the hands of the RBI to influence the

volume of credit in the economy.



Forex Market.

There are four types of market participants—banks, brokers, customers, and central

banks.

Banks and other financial institutions are the biggest participants. They earn profits by

buying and selling currencies from and to each other. Roughly two-thirds of all FX

transactions involve banks dealing directly with each other.

Brokers act as intermediaries between banks. Dealers call them to find out where they

can get the best price for currencies. Such arrangements are beneficial since they afford

anonymity to the buyer/seller. Brokers earn profit by charging a commission on the

transactions they arrange.

Customers, mainly large companies, require foreign currency in the course of doing

business or making investments. Some even have their own trading desks if their

requirements are large. Other types of customers are individuals who buy foreign

exchange to travel abroad or make purchases in foreign countries.

Central banks, which act on behalf of their governments, sometimes participate in the

FX market to influence the value of their currencies.

With more than $1.2 trillion changing hands every day, the activity of these participants

affects the value of every dollar, pound, yen or euro.

The participants in the FX market trade for a variety of reasons:

To earn short-term profits from fluctuations in exchange rates,

To protect themselves from loss due to changes in exchange rates, and

To acquire the foreign currency necessary to buy goods and services from other

countries



Currency Trading Between Banks

Banks are a major force in the FX market and employ a large number of traders. Trading

between banks is done in two ways—through a broker or directly with each other.

Brokers: If a U.S. bank trades with another bank, a FX broker may be used as an

intermediary. The broker arranges the transaction, matching the buyer and seller without

ever taking a position and charges a commission to both the buyer and seller. About a

third of transactions are arranged in this way.

Direct: Mostly banks deal with each other directly. A trader "makes a market" for

another by quoting a two-way price i.e. he is willing to buy or sell the currency. The

difference between the two price quotes (the spread) is usually no more than 10 pips, or

hundredths, of a currency unit.

Most currencies are quoted in terms of how many units of that currency would equal $1.

However, the British pound, New Zealand dollar, Australian dollar, Irish punt and the

Euro are quoted in terms of how many U.S. dollars would equal one unit of those

currencies.

The currencies of the world’s large, industrialized economies, or hard currencies, are

always in demand and are actively traded. In terms of trading volumes, the FX market is

dominated by four currencies: the U.S. dollar, the euro, the Japanese yen and the British

pound. Together these account for over 80 percent of the market.

It is not always easy to find a market for all currencies. The demand for currencies of less

developed countries, soft currencies, is a lot less than for the hard currencies. Weak

demand internationally along with exchange controls may make these currencies difficult

to convert



Types of Transactions

There are different types of FX transactions:

I. Spot transactions: This type of transaction accounts for almost a third of all FX

market transactions. Two parties agree on an exchange rate and trade currencies at

that rate

Spot Transaction: How it works

A trader calls another trader and asks for a price of a currency, say British pounds.

This expresses only a potential interest in a deal, without the caller saying whether he

wants to buy or sell.

The second trader provides the first trader with prices for both buying and selling

(two-way price).

When the traders agree to do business, one will send pounds and the other will

send dollars.

By convention the payment is actually made two days later, but next day settlements are

used as well.

Exchange Risks in Spot Transactions

Suppose a U.S. company orders machine tools from a company in Japan.

Tools will be ready in six months and will cost 120 million yen.

At the time of the order, the yen is trading at 120 to a dollar.

U.S. company budgets $1 million in Japanese yen to be paid when it receives the

tools (120,000,00 yen ¸ 120 yen per dollar = $1,000,000)

There is no guarantee that the rate will remain the same six months later.

Suppose the rate drops to 100 yen per dollar:



Cost in U.S. dollars would increase (120,000,000 ¸ 100 = $1,200,000) by

$200,000.

Conversely, if the rate goes up to 140 yen to a dollar:

Cost in U.S. dollars would decrease (120,000,000 ¸ 140 = $857,142.86) by over

$142,000

II. Forward transaction: One way to deal with the FX risk is to engage in a forward

transaction. In this transaction, money does not actually change hands until some

agreed upon future date. A buyer and seller agree on an exchange rate for any date

in the future and the transaction occurs on that date, regardless of what the market

rates are then. The date can be a few days, months or years in the future.

III. Swap: The most common type of forward transaction is the currency swap. In a

swap, two parties exchange currencies for a certain length of time and agree to

reverse the transaction at a later date.

In all of these transactions, market rates might change. However, the buyer and seller are

locked into a contract at a fixed price that cannot be affected by any changes in the

market rates. These tools allow the market participants to plan more safely, since they

know in advance what their FX will cost. It also allows them to avoid an immediate

outlay of cash.

Swap Transaction: How it works

Suppose a U.S. company needs 15 million Japanese yen for a three-month investment in

Japan.

It may agree to a rate of 150 yen to a dollar and swap $100,000 with a company

willing to swap 15 million yen for three months



After three months, the U.S. company returns the 15 million yen to the other

company and gets back $100,000, with adjustments made for interest rate

differentials.

International Finance features the best analysis of today's complex market and policy

issues, presented in a literate and engaging style. The only journal bridging the gap

between theory and policy in macroeconomics and finance, International Finance is a

vigorous intellectual forum for both economists and legal scholars. With a broad

readership encompassing national and corporate treasuries, central and investment banks,

international organisations and academic institutions, International Finance publishes

thought-provoking, policy-relevant analysis, particularly in the following areas:

exchange rates

political economy

monetary policy

financial markets

corporate finance

transition economics

Foreign Exchange (or Forex or FX) is the buying or selling of one currency against

another currency. All trades result in the buying of one currency and the selling of

another, simultaneously.

In forex trading, you place an order to buy (go long) or sell (go short) the first currency

in a currency pair at current exchange rates.

Buying

Buying a currency pair implies buying (longing) the first (base) currency and selling

(shorting) an equivalent amount of the second (quote) currency to pay for the base

currency. For example, buying EUR/USD means that you are buying Euros (EUR) using

US Dollars (USD).

It is not necessary for the trader to own the quoted currency prior to selling, as it is sold

short. A speculator buys a currency pair if she believes the exchange rate for the base


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currency will go up relative to that for the quote currency (that is, the value of the pair

will go up).

Selling

Selling the currency pair implies selling (shorting) the first (base) currency and buying

(longing) an equivalent amount of the second (quote) currency to buy the base currency.

For example, selling EUR/USD means that you are buying US Dollars (USD) using

Euros (EUR).

A speculator sells a currency pair if she believes the base currency will go down relative

to the quote currency, or equivalently, that the quote currency will go up relative to the

base currency.

Placing an Order

When you request to buy or sell a currency pair, you place an order (also called "opening

a trade") so that you "take a position") based on the exchange rate at the time. Right after

you place an order, the value of the position will be close to zero, because the value of

the base currency is more or less equal to the value of the equivalent amount of the quote

currency. (In fact, the value will be slightly negative, because of the spread involved.)

As time goes on and exchange rates change, the value of the position will evolve to be

profitable (or not). When you eventually decide to take a profit or stop a loss on the

position, you "close" the trade. When you close the trade, Profit/Loss is calculated from

the difference between the exchange rate at the time you opened the trade to the time

you closed it.

Examples

Suppose EUR/USD = 1.5000, and you sell 10,000:

Your base currency position is 10,000 EUR

Your quote or counter currency position is 10,000*1.5000=15,000.00 USD

Let's say, hypothetically, that there is political turmoil in Japan. If you believe that the

Yen will depreciate as a result of this turmoil, you have the following outlook:

It is a good time to be long (buy) USD

It is a good time to be short (sell) JPY


http://fxtrade.oanda.com/learn/basics/placing_orders.shtml


If you think the USD/CAD will move up:

You are bullish on the USD

You believe the USD/CAD is undervalued

You want to be long USD/CAD

Placing Orders

To take advantage of perceived market movements, you place an order to either short

or long a currency pair . This opens a new position (or trade) that can later be closed to

either take profit or stop loss. Orders can be closed manually at any time, or

automatically by a stop-loss or take-profit order.

Types of Orders for New Positions

There are two types of orders you can place to open new positions (trades):

Market orders open a position immediately at the current market rate.

Limit orders open a position at some point in the future should a currency pair

reach a specified threshold. There's a specified expiry date when, if the threshold

wasn't reached, the order is closed and no position is opened.

Specify Lower and Upper Bounds to Reduce Market Fluctuation Risk

The most current rates maintained at the OANDA servers are used when orders are

executed. Because of the continuously changing nature of exchange rates, these rates

may be higher or lower than expected.

For example, the rate of execution may not be the same as the rate shown at the time you

placed a market order, or the threshold amount you specified when you placed a limit

order. (A limit order is triggered when the exchange rate crosses its threshold, but there's

a mechanical time lag before the order is actually executed.)

The FXTrade platform lets you optionally specify lower and upper bounds when you

place a market order in the Buy/Sell Market Order window. The order will then be



executed only if the exchange rate to be applied is equal to or higher than the lower

bound, if specified (or equal to or lower than the upper bound, if specified).

If the most current exchange rate at the OANDA servers lies outside the range specified

by the lower and upper bounds, then the order is closed with no action being taken.

React to the Market 24/7 with Stop-Loss or Take-Profit Orders

You can place orders on open trades so they are automatically closed if certain market

conditions occur, even if you are not logged onto the trading platform. These orders let

you take advantage of positive market movements or limit your risk during negative

market movements, even if you're not at your computer at the time:

Take-Profit orders clear a position by buying (or selling) the currency pair of the

position when the exchange rate reaches a specified threshold. Take-Profit orders

are typically used to lock in a profit.

For example, if you are long USD/JPY at 118.48 and believe the price will continue

to rise until it reaches 120.00 but are unsure what it will do past 120.00, placing a

Take-Profit at 120.00 will automatically close your position around 120 (should the

market reach that rate) to lock in your profit .

Stop-Loss orders clear a position by buying (or selling) the currency pair of the

position when the exchange rate reaches a specified threshold. Stop-Loss orders

are typically used to limit losses and quantify risk.

For example, if you are long USD/JPY at 118.48 and set a Stop-Loss at 117, your

position will automatically be closed around 117 and you will be protected from a

further price decline.

Stop-Loss orders allow you a certain level of comfort when leaving a position open

while you are away from your computer and not actively following the markets.



Note: A stop-loss or take-profit order is triggered when an exchange rate crosses a

threshold, but the exchange rate used for executing the order is the most current

exchange rate at the time the order is executed and not necessarily the threshold

specified in the order. Thus, the rate applied for the execution of the order may be either

higher or lower than the specified threshold because of the continuously changing nature

of exchange rates.

Orders May Affect Your Other Open Positions!

When a market order is requested or a limit order is executed, the order closes out or

partially closes out any counter open trade should one exist (regardless of any stop-loss

or take-profit orders on that trade). A First-In-First-Out (FIFO) procedure is used, so

earlier trades are closed first. For previous trades that are partially closed out, any

associated Stop-Loss or Take-Profit orders are maintained for the remaining amount.

The following three examples illustrate this.

Example 1:

Existing open trades: Trade 1: Long $10,000 USD/JPY

Market or limit order: Sell $10,000 USD/JPY

Resulting open trades: none.

Example 2:

Existing open trades: Trade 1: Long $10,000 USD/JPY @ 120.00

Trade 2: Long $10,000 USD/JPY @ 121.00




Resulting open trades: Long $5,000 USD/JPY @ 121.00

(corresponding to half of Trade 2, which keeps any Take-Profit/Stop-Loss orders.)

Example 3:

Existing open trades: Trade 1: Long $10,000 USD/JPY


Resulting open trades: Short $5,000 USD/JPY

Margin Calculations

What is Margin?

To ensure that the speculator can carry the risk in the case where the position results in a

loss, banks or dealers typically require sufficient collateral to cover those losses. This

collateral is typically referred to as margin.

This topic explains how to calculate margin requirements on a trade. For more general

information, see the introductory information on margin trading and OANDA's margin policies.

Why are Margin Calculations Important?

As a trader, you are often faced with the following questions:

Given my account status, how much margin do I have available?

Given available margin, how large a trade can I make?

Given a potential trade size, how much available margin must I have?

How far away am I from a margin call?

Answers to these questions are provided to you automatically by the FXTrade Platform

and by the OANDA Margin Calculator. For example,

the Margin Available field in the Account Summary Table of the FXTrade user

interface tells you how much margin you have available;

the Buy/Sell window will always tell you the maximum number of units you can

trade, given your available margin. (also refer to the Units Available Calculator)


http://fxtrade.oanda.com/your_account/trading_practices/margin_rules.shtml


the Margin Calculator tells you how much margin you need for a particular trade;

and

the Account Summary of the User Interface indicates how far away from a margin

call you are with the “Margin Call” field.

Calculating Margin: Introduction

The calculations provided by the FXTrade Platform interface are sufficient for most

traders’ needs, and a quick review of OANDA’s margin call policy should help most traders

understand how to avoid a margin call. The rest of this document is intended for traders

or programmers who need to know how these values are calculated. The explanations get

quite involved (we’ve provided examples), and require the following steps:

1. Calculating the Net Asset Value

2. Calculating the Margin Used

3. Calculatng the Margin Available

4. Calculating the Margin Required for Opening New Trades

5. Calculating the Margin Call

Calculating the Net Asset Value

The term Net Asset Value represents the current value of your account. It includes your

account balance as well as all unrealized profit and losses associated with your open

positions. If you were to liquidate your account by closing all positions and withdrawing

all your funds, then the Net Asset Value indicates what that amount would be.

If you have no open positions, then the Net Asset Value is simply equal to your Account

Balance. (The Account Balance is equal to all of the funds ever deposited into your

Account, minus all of the funds ever withdrawn from your Account, adjusted for interest

and any profits or losses that have been realized through trading). The Account Balance

is displayed in the “Account Summary” section of the FXTrade User Interface.

If you have open positions then it gets just a bit more involved. The Net Asset Value is

equal to your account balance plus/minus any unrealized P/L.


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Unrealized P/L refers to the profit or loss held in your current open positions. This is

equal to the profit or loss that would be realized if all your open positions were to be

closed immediately.

Example:

If your account is in USD and you are currently long 10,000 units EUR/USD, which was

bought at 0.9136, and the current exchange rate for EUR/USD is 0.9125/27, then that

position represents 10,000 x (0.9125 - 0.9136) = 10,000 x (- 0.0011) = - 11, or an

unrealized loss of $11 USD.

Your Unrealized P/L continuously fluctuates with the current exchange rates if you have

open positions and is displayed in the "Account Summary" section of the FXTrade user

interface.

Net Asset Value is the sum of your Account Balance and your Account’s Unrealized

P/L. It represents the current value of your Account. The Net Asset Value of your

Account continuously fluctuates with the current exchange rates if you have open

positions and is displayed in the "Account Summary" section of the FXTrade user

interface.

Calculating Margin Used

Margin Used is equal to Position Value multiplied by Required Margin, summed up

over all open positions. Position Value is the size of the position (in units) converted

from the Base currency of the currency pair in question to your Account currency using

the ask rate if the position is long and the bid rate if the position is short.

Example:

You have a USD account and a short open position of 10,000 units EUR/USD.

If the current EUR/USD rate is 0.9134/36, then the EUR/USD Position Amount is equal

to (10,000 x 0.9134) = 9,134 USD.

Required Margin depends on the currency pair and the maximum leverage set for your

account:



Max. Leverage 10:1 20:1 30:1 40:1 50:1

Margin Requirement: 10% 5% 3.3333% 2.5% 2%

Margin for non-major currency

pairs:10% 5% 4% 4% 4%

Example:

You have the following open positions: 10,000 long EUR/USD and 20,000 short

EUR/CZK.

You have set your maximum leverage to 50:1. Your Account is in USD and the current

EUR/USD rate is 0.9134/36

The Position Value of 10,000 EUR/USD long is 10,000 EUR converted to USD, which

is equal to 10,000 x 0.9136, or $9,136. The margin requirement for EUR/USD is 2%

(when the account maximum leverage is set to 50:1). As a result, the margin required on

this EUR/USD position is equal to

$9,136 x 0.02, or $182.72.

The Position Value of 20,000 EUR/CZK short is 20,000 EUR converted to USD, which

is equal to 20,000 x 0.9134, or $18,268. The margin requirement for EUR/CZK is 4%

(when the account maximum leverage is set to 50:1). As a result, the margin required on

this EUR/CZK position is equal to $18,268 x 0.04, or $730.72.

The Position Value of your account is $9,136+$18,268 = 27,404. The Margin Used on

your open positions is equal to $913.44.

Example:

Same example as above but with maximum leverage set to 20:1.

The Position Values remain the same, but the margin required is equal to 5% of the

Position Value, which is ($9,136 x 0.05) + ($18,268 x 0.05) = $456.80 + $913.40.

Hence, the Margin Used on open positions is equal to $1,370.20.

Account Leverage 50:1 40:1 30:1 20:1 10:1



Margin for EUR/USD 2% 2.5% 3.3333% 5% 10%

Margin Used by 10,000 EUR/USD

9,136 x

0.02

= $182.72

9,136 x

0.025

= $228.40

9,136 x

0.0333

= $304.53

9,136 x

0.05

= $456.80

9,136 x

0.10

= $913.60

Margin for EUR/CZK 4% 4% 4% 5% 10%

Margin Used by 20,000 EUR/CZK

18,268 x

0.04

= $730.72

18,268 x

0.04

= $730.72

18,268 x

0.04

= $730.72

18,268 x

0.05

= $913.40

18,268 x

0.10

=

$1,826.80

Total Margin Used $913.44 $959.12 $1,035.25 $1,370.20 $2,740.40

Calculating Margin Available

We are finally at the point we can calculate the margin a trader still has available to

initiate new trades.

Margin Available is equal to the greater of $0 or “Net Asset Value” minus the “Margin

Used”. Note that this value continuously fluctuates if you have open positions: the Net

Asset Value changes with the value of your open positions, and Margin Used changes

over time as the exchange rates change. If Margin Available is $0, then you cannot open

new positions or increase existing positions.

Example:

If your Net Asset Value is equal to $12,000 USD, your maximum leverage is set to 50:1,

and:

(a) the Total Position Value is $100,000 USD for a position which is comprised of a

Major Currency Pair, then the Margin Available is equal to 12,000 - (0.02 x 100,000) =



12,000 - 2,000 = $10,000 USD. On the other hand, if Net Asset Value is equal to $1,990

USD, then the Margin Available is equal to $0, because 1,990 - 2,000 = - 10, which is

less than $0.

(b) the Total Position Value is $50,000 USD for a position which is comprised of an

Non-Major Currency Pair, then the Margin Available is equal to 12,000 - (0.04 x

50,000) = 12,000 - 2,000 = $10,000 USD. On the other hand, if Net Asset Value is equal

to $1,990 USD then the Margin Available is equal to $0, because 1,990 - 2,000 = - 10.

(c) the Total Position Value is $150,000 USD, made up of $100,000 USD for a position

which is comprised of a Major Currency Pair and $50,000 USD for a position which is

comprised of an Non-Major Currency Pair, then the Margin Available is equal to 12,000

– [(0.02 x 100,000) + (0.04 x 50,000)] = 12,000 - 4,000 = $8,000 USD. On the other

hand, if account equity is equal to $1,990, then the Margin Available is equal to $0,

because 1,990 - 4,000 = - 2,110.

Margin available is also displayed in the Account Summary section of the User

Interface.

Calculating the Margin Required for Opening New Trades

Calculating the Margin Required to open a new trade is relatively straightforward in

most cases. If you are creating a new position or are increasing an existing position, then

you can calculate the Margin Required for the new trade as described above. If the

Margin Required is less than or equal to the Margin Available, then you are allowed to

make the trade. If the Margin Required is greater than the Margin Available, then your

order will be rejected should you submit it.

You are always able to execute a trade if it reduces a position of your account. If your

trade reverses a position (that is, goes from long to short, or from short to long), then it is

easiest to consider the margin requirements of your positions immediately after

executing your order under the assumption your order is successfully executed. If the

margin requirements are less than the Net Asset Value under that assumption, then you

have sufficient margin to make the trade.



Calculating the Margin Call

The Margin Used (that is, the margin requirement of your open positions) divided by

two must always be less than the Net Asset Value of your account. If this requirement is

not met, then a margin call will occur without warning, and with that margin call, all

your open positions will be closed. You are responsible for monitoring your account to

see if a margin call may happen.

For your convenience, the “Margin Call” field in the Account Summary of the FXTrade

user interface is always set to the Margin Used divided by two. The closer this value is

to the Net Asset Value, also shown in the same table, the closer you are to a margin call.

For more information on what happens and what to do in the event of a margin call, go

to OANDA’s margin call policies.

Example:

The FXTrade Platform has determined, as described above, that for your open positions,

you have a margin requirement of $10,000 USD. You currently have $10,000 USD in

your Account and Unrealized P/L of $1,000 USD for a Net Asset Value of $11,000

USD.

The exchange rate moves unfavorably against your open position. When your

Unrealized P/L approaches -4,750 USD, your Net Asset Value has now declined to

$5,250 USD. Since this is within 5% of half the margin requirement, FXTrade will issue

a first warning. In our example,

($10,000 / 2 ) x 1.05 = $5,250

The exchange rate continues to move unfavorably against your position. When your

Unrealized P/L approaches -4,875 USD, your Net Asset Value has now declined to

$5,125 USD. Since this is within 2.5% of the margin requirement divided by two,

FXTrade will issue a second warning. In our example,

($10,000 / 2 ) x 1.025 = $5,125




The exchange rate continues to move unfavorably against your position. When your

Unrealized P/L exceeds -5,000 USD, your Net Asset Value has now declined to below

$5,000 USD. Since the Margin Requirement for your open positions (=$10,000) divided

by half (=$5000) is now higher than your Net Asset Value, and FXTrade will

automatically close all your open positions

OANDA Interest Rate Calculation

Continuously and Second-by-second

OANDA pays competitive interest rates on the account balances, and it pays and charges

interest rates on the currency pairs currently held in customer positions. Moreover,

OANDA calculates interest rates charged and paid continuously, second-by-second. This

is in contrast to other financial markets, where interest rate payments are made at daily

intervals with the shortest increment of one business day. This document describes how

interest rates are charged and paid.

Interest rates vary from currency to currency, and they can change on a daily basis.

There are two types of interest rates that come in to play in this context: lending (ask)

interest rates apply when OANDA lends you money to buy a currency, and borrowing

(bid) interest rates apply when OANDA holds your money. Lending rates are always

higher than borrowing rates (e.g., when the bank lends you money, it charges a higher

interest rate than it gives you on the money on your accounts).

Find out OANDA's bid and ask interest rates.

Calculate the interest you pay or earn when you hold a position over a period of time.

Interest Crediting and Debiting

OANDA interest crediting and debiting is performed daily at 4pm EST, and whenever

an open trade is closed. Hence, interest on the account balance is paid at 4pm EST each

day, with an appropriate entry in the transaction table of each account. Since the account

balance is held in USD, the USD borrowing rate is applied. To calculate the account

balance interest at 4pm, OANDA analyses the account balance held during each second

of the previous 24 hours and pays interest accordingly. For example, if the account

balance at 4pm is $10,000 and it changes to $12,000 at 10pm the same night and stays at


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$12,000 until 4pm the following day, then 6 hours worth of interest is paid on $10,000

and 18 hours worth of interest is paid on $12,000.

Calculating interest on open trades is more involved. An open trade, say 1000 units of

EUR/CHF, involves two currencies: the Euro and the Swiss Franc. If the open trade is

long (i.e., you bought Euro and sold Swiss Francs), then you effectively are long (i.e.,

you hold) 1000 Euro and OANDA pays you the borrowing interest rate on the 1000

EURO for the duration you hold the trade. At the same time, you are short on the

equivalent amount of Swiss Francs, so OANDA charges you the lending interest rate on

that amount for the duration of the trade. These interest rates are converted to USD

before they are credited/charged to your account.

If the open trade is short (i.e., you sold Euro and bought Swiss Francs), then you are

short EUR and OANDA charges you lending interest rates for that amount of EUR, and

you are long CHF and OANDA pays you borrowing interest rates for the corresponding

amount of CHF.

How Interest is Calculated

The specific algorithm used to calculate the interest on an open trade in XXX/YYY is as

follows:

For a long position:

1. calculate the borrowing interest on XXX for the duration in question and convert it to

USD

2. calculate the lending interest on YYY for the duration in question and convert it to

USD

3. subtract (2) from (1). If negative, then this is the interest you owe --- if positive, then

this is what OANDA will pay.

For a short position:



1. calculate the borrowing interest on YYY for the duration in question and convert it to

USD

2. calculate the lending interest on XXX for the duration in question and convert it to

USD

3. subtract (2) from (1). If negative, then this is the interest you owe — if positive, then

this is what OANDA will pay.

OANDA credits or debits interest on the account (with an appropriate transaction) for

trade that is open at 4pm, calculated for the time interval starting at 4pm the previous

day or the time the trade was made, whichever is later, and ending at 4pm. When a trade

is closed, OANDA credits or debits interest on the account for the trade, calculated for

the time interval starting at the previous 4pm or the time the trade was opened,

whichever is later, and ending at the time the trade is closed.

Let us consider two specific examples.

Example 1: Buy 1000 units EUR/JPY @ 91.7308 on Monday Jan 1, 2001 at 12:02

a.m.

Applicable interest rates

Assume that the following interest rates apply for Monday Jan 1, 2001:

EUR - 4.76 / 4.81%

JPY - 0.28 / 0.38 %

Note that the borrowing rate is quoted first, followed by the lending rate, and that

interest rates are quoted in percentage points per year.

Calculate duration of trade



Now assume that the trade is closed at 5:45am later the same day on Jan 1, 2001. The

amount of time the trade is held open is 20580 seconds (= 12:01am - 5:45am), or

0.00065214 years (20580 secs / 31557600 secs --- there are 31,557,600 seconds in a

year).

Calculate interest obtained on EUR

For calculating the interest obtained on our EUR position, we use the following formula:

units * lifetime (in years) * EUR borrowing interest rate (%/year) * conversion to USD

If we plug in the appropriate numbers, we obtain:

1000 * 0.00065214 * 4.76% * EUR/USD bid exchange rate

= 1000 * 0.00065214 * 0.0476 * 0.8423

= USD 0.0261

Calculate interest charged in JPY

For calculating the interest charged on our JPY position, we first note that we effectively

are short 1000 Euros worth of Japanese Yen, which, with the exchange rate of 91.7308

is 91730.8 units of JPY (= 1000 * 91.7308) on which interest is charged. We then use

the following formula similar to the one used above:

units * lifetime (in years) * JPY lending interest rate (%/year) * conversion to USD


91730.8 * 0.00065214 * 0.38% * JPY/USD ask exchange rate

= 91730.8 * 0.00065214 * 0.0038 * 0.00918

= USD 0.00209

Difference between the two interest amounts

The account will be credited by the difference between the interest to be credited and the

interest to be debited:

$0.0261 - 0.00209 = USD 0.02401

Note that in this case the customer is collecting significantly more money than they are

paying, due solely to the discrepancy in interest rates between the base and the quote



currencies. In this instance, the base currency (EUR) interest rate is higher than the

quote (JPY) interest rate, which is referred to as a "discount" quotation.

If the inverse were true (base currency interest rate lower than the quote currency

interest rate), the instrument would be said to be quoted at "premium".

Example 2: Sell 2000 units GBP/CHF @ 2.5882 on Monday Jan 1, 2001 at 04:02

a.m.

Applicable interest rates

Assume that the following interest rates apply for Monday Jan 1, 2001:

CHF - 3.18 / 3.28 %

GBP - 5.97 / 6.00 %

Note again that the borrowing rate is quoted first, followed by the lending rate, and that

interest rates are quoted in percentage points per year.

Calculate lifetime of trade

Assume that this trade is also closed at 5:45am later the same day on Jan 1, 2001. The

amount of time the trade is held open is 6180 seconds (= 04:00am - 5:45am), or

0.00019583 years (6180 secs / 31557600 secs)

Calculate interest obtained on CHF

For calculating the interest obtained on our CHF position, we first calculate the number

of CHF units the interest is applied to: 2000 GBP units worth of CHF with the exchange

rate of 2.5882 is 2000 * 2.5882 = 5176.4. Then we apply the following formula again:

units * lifetime (in years) * CHF borrowing interest rate (%/year) * conversion to USD


5176.4 * 0.00019583 * 3.18% * 0.5606



= USD 0.01807

Calculate interest charged in GBP

For calculating the interest charged on our GBP position, we again use the following

formula similar to the one used above:

units * lifetime (in years) * GBP lending interest rate (%/year) * conversion to USD


2000 * 0.00019583 * 6.00% * 1.4516

= USD 0.03411

Difference between the two interest amounts

The account will be credited by the difference between the interest to be credited and the

interest to be debited:

$ 0.01807 - $ 0.03411 = - USD 0.01604

Since the amount is negative, the aggregate interest is charged to the account

This tool calculates the interest gained or owed when buying or selling a specific

number of units of a currency pair. It calculates this value in the primary currency (as

chosen by the user).

It uses the following formulas.

For a long position:

1. Borrowed Interest = units * ({BASE} Interest Rate %) * (Time in years) *

({BASE}/Primary Currency)



2. Lent Interest = (converted units) * ({QUOTE} Interest Rate %) * (Time in

years) * ({QUOTE}/Primary Currency)

3. Total Interest = Borrowed Interest - Lent Interest

For a short position:

1. Borrowed Interest = (converted units) * ({QUOTE} Interest Rate %) *

(Time in years) * ({QUOTE}/Primary Currency)

2. Lent Interest = units * ({BASE} Interest Rate %) * (Time in years) *

({BASE}/Primary Currency)

3. Total Interest = Borrowed Interest - Lent Interest

Exchange Rates and Spreads

Exchange Rates

An exchange rate refers to the number of units of one currency needed to purchase one

unit of another, or the value of one currency in terms of another. Exchange rates,

influenced by real world events, change constantly.

Exchange rates are quoted in currency pairs. The first currency is referred to as the base

currency and the second as the counter or quote currency. For example, the exchange

rate quoted for the EUR/USD would tell you how many Euros (the base currency) would

be needed to buy USD (the quote currency).

If buying, an exchange rate specifies how much you have to pay in the quote currency to

obtain one unit of the base currency. If selling, the exchange rate specifies how much

you get in the counter or quote currency when selling one unit of the base currency.

Bid and Ask Prices

OANDA's FXTrade Platform uses the bid/ask (bid/offer) method for quoting prices. For

example, the exchange rate for EUR/USD might look like one of the following:

146.972/981

146.972 vs. 146.981



The first number is the bid price, or the rate used if you sell a currency. The next set of

numbers (after the slash) shows the last few digits of the ask price if you buy a

currency. For the EUR/USD example 146.972/981:

if you sold 100 Euros you would get 146.972 USD

if you bought 100 Euros you would pay 146.981 USD.

3-Letter Codes

A currency exchange rate is always quoted using standard International Standards

Organization (ISO) 3-letter code abbreviations. For example, USD/JPY refers to two

currencies: the U.S. Dollar and the Japanese Yen.

Here are some major ISO codes. (You can find the ISO code for any currency from

FXLookup.)

AUD - Australian Dollar CAD - Canadian Dollar CHF - Swiss Franc

EUR - Euro GBP - Great Britain Pound JPY - Japanese Yen

NZD - New Zealand Dollar USD - U.S. Dollar XAU - Gold

Spreads

The difference between the bid and the ask price is referred to as the spread. In the

example above (EUR/USD at 146.972/981), the spread is .009 or 9 pips.

Although a pip may seem small, a movement of one pip in either direction can translate

into thousands of dollars in gains or losses in the inter-bank market.

The smart trader pays close attention to spreads, because they are the cost of trading

(and the way the broker makes a profit). Find out more about OANDA's spreads.

Indirect rates

OANDA's FXTrade platform is designed for the speculative spot market, so all

transactions are roundtrip back to the currency of the trader's account (or subaccount).

This means that some trades may use indirect rates that don't involve the home account

currency.


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For trades involving indirect rates, there are several spreads to consider: the spread for

the traded pair, and the spread for the pair involving that pair's base currency and the

home account currency.

For example, if you make a trade involving the USD/MXN pair from a Euro account,

you need to consider the spread for both the USD/MXN pair and the EUR/USD pair.

The following examples illustrate how to calculate profit or loss when you close

particular trades. (Interest differentials are not considered.)

Example 1:

You see that the rate for EUR/USD is 0.9517/22 and decide to sell 10,000 EUR. Your

trade is executed at 0.9517.

10,000 EUR * 0.9517= 9,517.00 USD

You sold 10,000 EUR and bought 9,517.00 USD.

After you trade, the market rate of EUR/USD decreases to EUR/USD=0.9500/05. You

then buy back 10,000 EUR at 0.9505.

10,000 EUR *0.9505= 9,505.00 USD

You sold 10,000 EUR for 9,517 USD and bought 10,000 back for 9,505. The difference

is your profit:

9,517.00-9,505.00= $12.00 USD

Example 2:

You see that the rate for USD/JPY is 115.00/05 and decide to buy 10,000 USD. Your

trade is executed at 115.05.

10,000 USD*115.05= 1,150,500 JPY

You bought 10,000 USD and sold 1,150,500 JPY.

The market rate of USD/JPY falls to 114.45/50. You decide to sell back 10,000 USD at

114.45.



10,000 USD*114.45=1,144,500 JPY

You bought 10,000 USD for 1,150,500 JPY and sold 10,000 USD back for 1,144,500

JPY. The difference is your loss and is calculated as follows: 1,150,500-1,144,500=

6,000 JPY. Note that your loss is in JPY and must be converted back to dollars.

To calculate this amount in USD:

6,000 JPY/ 114.50 = $52.40 USD or

6,000 *1/114.50=$52.40

Currency Hedging Primer

Why Hedge?

More and more companies are faced with the problem of how best to deal with currency

exposure. This is no longer an issue faced only by large multinational corporations.

Increasingly, small firms and even individuals are faced with the same problem: signed

contracts or purchases in a different currency that take place in the future may result in

unplanned cost if the currencies fluctuate unfavorably. Smaller companies and

individuals are more than likely to ignore the issue and concentrate on the business at

hand. But it can become costly.

It is important to use a hedging strategy to eliminate currency exposure and the

attendant risk associated with currency movement. Luckily, a number of vehicles for

hedging forex risk exist. They all either involve finding a way to buy foreign currency

now at today's exchange rate (so you know what your costs are and have a sound basis

on which to set the price of your product/service), or finding a way to gain the right to

buy foreign currency at a later date at today's fixed exchange rate.

Hedging allows you to manage the risk and reduce potential risk. If you don't hedge, it's

tantamount to speculating that the foreign currency rate will stay the same. If the rate

ends up moving unfavorably, your speculation can be costly.



A Scenario

We'll go through several hedging vehicles using the following scenario:

Scenario: As a U.S.-based company, you sign a contract where you have to pay

EUR 500,000 in six months. Suppose the current EUR/USD rate is 1.50.

Remember that this scenario could equally apply to a contract due in six months, a parts

purchase delivered COD in six months, or a European property closing in six months.

The principles are the same, and could apply equally to both the payer and the payee.

How much is this EUR 500,000 really going to cost you in USD? It will depend on the

exchange rate fluctuations over the next 6 months. Using this scenario as an example,

we will briefly review five hedging solutions available today:

A: Euro Bank Account

B: Currency Forward Contract

C: Futures Contract

D: Currency Options

E: Carry spot trading using OANDA FXTrade

Solution A: Euro Bank Account

At a major bank:

Open a Euro account;

buy EUR 500,000 and deposit it into the Euro account

By buying the Euros up front, today's exchange rate is locked in, and future Euro

fluctuations do not affect the cost of the contract.

There are several problems with this approach:

1. It is unlikely you will get a good exchange rate or competitive interest rate at

the bank;

2. You need to pay roughly USD$750,000 or more to buy the Euros up front,

using scarce cash resources. You may not have these USD funds or an

available credit line.


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3. If you are using a credit line to fund the Euro bank account, the USD credit

line will likely have a higher rate of interest.

Solution B: Currency Forward Contract

At a major bank, ask for a currency forward contract. A currency forward contract is a

negotiated agreement between two parties to exchange specific amounts of currency at a

set rate on a particular day. The forward rate is priced based on the current exchange

rate, the interest differential for the contract time, a cost to cover potential negative

changes to the interest risk differential, and a flexible built-in commission for the

forward contract provider.

Currency forward contracts tend not to be very flexible, so there are several

disadvantages:

1. Often, the forward rate includes an uncompetitive exchange rate or high

built-in commission, making this solution quite costly;

2. You would require many forward contracts for more complicated scenarios

(such as monthly payments)

3. Since a forward contract is between two parties, there is no secondary

market for the purchase and sale of these contracts, making them rather

inflexible or expensive to extend or terminate early.

Solution C: Futures Contract

Buy a forex futures contract. Futures are similar to forward transactions, in that the cost

is based on the current exchange rate, the interest differential for the contract time, an

amount to cover potential negative changes to the interest risk differential, and a formal

commission.

The major advantage of futures contracts over forward contracts is the existence of a

liquid secondary market so they can be sold at any time on the open market and do not

have to be held until their maturity date. Futures contracts can be traded on organized

exchanges such as the Chicago Mercantile Exchange (CME) or London International

Financial Futures Exchange (LIFFE). These exchanges dictate contract specifications, such as


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expiration times (third Wednesday of March, June, September and December), face

amount, and margin requirements.

Disadvantages of futures contracts for the purpose of hedging include:

1. Futures contracts involve not just a spread, but also a commission;

2. Face value of futures contract are fixed. For example, British pound futures

are sold in GBP 62,500 and Euros are generally sold in lots of EUR 125,000,

making it difficult to make up the exact value of EUR 500,000;

3. A margin deposit must be posted and maintained daily;

4. Limited expiration times;

5. It is unlikely you will get a good exchange rate or competitive interest rate

on your margin account;

6. Futures contracts are typically speculative, so taking delivery of the money

at the end of the term is not expected and may cost commission.

Solution D: Currency Options

Buy a currency option at a bank. A currency option gives the holder the right, but not the

obligation, to sell or buy a face amount of currency at a set price, on or before a given

date. A currency option has a strike price, being the amount for which the currency can

be bought or sold for, and an expiration date. US options can be exercised any time up to

and including the expiration date, whereas European options can only be exercised on

the expiration date. There are two types of options. Call options give the holder the right

to buy a given amount of a currency at the strike price. Put options, on the other hand,

give the holder the right to sell a given amount of currency at the strike price.

Options are one-sided contracts (options, but not obligations) that are priced based on a

number of variables (exchange rates, interest differentials, duration of contract, historical

exchange rate volatility, and a built-in commission for the provider). They are a method



of speculating on future currency movements, and you pay a price for that right to

speculate.

Like futures, the major advantage of options over forward contracts is the existence of a

liquid secondary market. As a result, options can be sold at any time on the open market

and do not have held until their expiration date.

The disadvantages are also similar:

1. Options traded on formal exchanges must be purchased in fixed face values

and lot sizes. Some banks offer their own options with any notional amount,

but these options may cost you more as you will not be purchasing the

option in an open market.

2. The options have to be purchased. There is a cost involved, and premiums to

pay.

3. You will bear the risk and potential cost associated with the difference

between the amount to hedge and the fixed option amounts.

4. They have expiry dates.

Solution E: Carry spot trading using OANDA FXTrade

Currency hedging through online retail spot trading is surprisingly straightforward,

given the new generation of currency trading platforms such as OANDA's FXTrade. All

transactions can be completed over the Internet using a standard Web browser, at any

time, 365 days a year. No bank visits are required (until it comes time to arrange your

actual monetary transaction).

In the above scenario, you would open a USD-based FXTrade account, deposit margin

capital of, say, 10% or $75,000, and buy (long) 500,000 EUR/USD today. (That is, you

would open a trade whereby you buy 500,000 EUR and sell 750,000 USD.) You would

close this trade six months later when the payment is due and withdraw the margin

capital plus/minus profit/loss and the interest rate differential.

If the Euro went up over 6 months: If the new EUR/USD rate is 1.60 after 6 months,

your long position on FXTrade will be worth approximately:



1.6*500,000 - 1.5*500,000 = 800,000 USD - 750,000 USD = 50,000 USD

So the hedge would be worth 50,000 USD more when you close it (plus or minus the

interest rate differential). The original EUR 500,000 would now cost 800,000 USD

(500,000 x 1.6); however, you have made 50,000 USD on your hedge. Your hedging

strategy has ensured your total cash cost stays at 750,000 USD (800,000 - 50,000).

If the Euro went down over 6 months: If the new EUR/USD rate is 1.40 after 6

months, your long position on FXTrade would cost approximately:

1.4*500,000 - 1.5*500,000 = 700,000 - 750,000 = - 50,000 USD

So the hedge would cost 50,000 USD when you close it (plus or minus the interest

differential). The original EUR 500,000 would cost 700,000 USD (500,000 x 1.4, a

50,000 USD saving). Your hedging strategy has ensured your total cash cost stays at

750,000 USD (700,000 + 50,000).

What are the costs?

The cost of this type of hedging is the cost of the spread, which is typically 0.9 pips, or

around $22.50 for the example scenario, and the interest rate differential depending on

the two currencies you're trading. (You would still need to pay the unavoidable bank

fees and bank exchange rates when you make the actual payment, but only at the time

the payment is due.)

The disadvantage of this approach is that proper margin must be maintained at all times

to avoid margin calls. To reduce this possibility, you may wish to deposit more margin

in your FXTrade account. (OANDA pays competitive interest on all margin account

balances.)

Comparison Summary



Costs

A

Bank

Account

B

Forward

Contract

C

Future

Contract

D

Currency

Option

E

Carry

Spot

Overall Costs

Special Charges

Large Spreads

Large interest

differential

Interest risk

premium

Commissions

Volatility charge

Spreads: Bank accounts typically charge spreads 2% or 3% above interbank spreads.

Forward contracts, future contracts and currency options charge close to interbank

spreads, but do have the following built-in or explicit commissions and other special

charges:

Interest differential: All hedging methods charge an interest differential on the

currencies, either built into the rate offered or as a separate amount charged. Bank

accounts typically charge interest 2% to 3% above interbank rates for funds

borrowed to purchase the foreign currency (and pay much lower rates for funds

deposited).

Interest risk premium: Interest risk premium is a variable amount charged by the

issuing party for potential changes in interest rates.

Commissions: Forward contract and option contract suppliers build commissions



Costs

A

Bank

Account

B

Forward

Contract

C

Future

Contract

D

Currency

Option

E

Carry

Spot

into their products based upon how much they can charge the buyer. The commission

is built into the forward rate or included in the amount paid upfront for an option (it

is also called the premium).

Volatility charge: Options are one-sided contracts which cost an upfront premium to

purchase. Options offer the right, but not the obligation, to engage in a future

transaction. An estimate of the future volatility of the foreign currency over the life

of the option is built into the option pricing. While an individual option may incur a

large payout, other options will expire without being exercised.

Features

A

Bank

Account

B

Forward

Contract

C

Future

Contract

D

Currency

Option

E

Carry

Spot

Early Exit?

Extend beyond

expiry date?



Features

A

Bank

Account

B

Forward

Contract

C

Future

Contract

D

Currency

Option

E

Carry

Spot

Hedge exact

amount?

Change hedge

amount?

Early exit: Forward contracts require break costs if you exit early. You risk market

uncertainty by selling a future contract, or selling/exercising a currency option.

Extensions beyond expiry date: Bank accounts and currency spot have no expiry

dates. The other products will require you to enter into new hedging contracts or risk

currency fluctuations between the expiry date and when the foreign exposure is

settled.

Hedge exact amount: Contracts and options only offer fixed lot sizes. Currency spot

and bank accounts allow you to hedge to the nearest unit. Forward contracts in theory

may be structured to exact amounts, although often the amounts are not precise.

Change Amount: You can change the hedging amount by any amount for bank

accounts or currency spot. For contracts and options, you can only add or

sell/exercise a fixed lot size.



Credit Requirements

A

Bank

Account

B

Forward

Contract

C

Future

Contract

D

Currency

Option

E

Carry

Spot

Upfront Cash

Requirements

All hedging options require either upfront cash, or require necessary credit

arrangements with the counterparty. A bank account requires the largest amount of

upfront cash (the full hedge amount). Currency options must be purchased upfront

with cash. Forwards will only be offered as part of your overall credit arrangement

with the supplier, and any resulting forward contracts will reduce your available

credit lines. Future contracts and currency spot hedging will require adequate margin

amounts to cover the necessary credit requirements.

Benefits of Currency Trading vs. Equity Trading

Historically, currency trading has been a “closed” market, reserved primarily for major

banks, multi-national corporations, and other large organizations. These institutions

trade in large transaction sizes and high volumes and it has been next to impossible for

smaller-scale, individual investors to participate in an equal and competitive manner.

This all changed however, as new technologies such as OANDA's proprietary FXTrade

platform have made it possible for smaller investors to participate directly in the forex

market. By lowering these traditional barriers, the forex marketplace is now open to a

new group of forex investors.

Forex trading is rapidly winning favour as an alternative investment opportunity thanks

not only to new trading tools pioneered by OANDA, but also because forex trading has


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several inherent benefits when compared to equity trading. This page lists some of these

benefits.

Continuous, 24-hour trading

The currency exchange market is a true 24-hour market, operating five days a week.

Equity trading, on the other hand, is restricted to the operating hours of the various

equity exchanges. While after-hours trading for equities has become available to a

limited degree through some electronic communication networks (ECNs), there are no

guarantees that liquidity will be maintained after-hours or that trades can executed at

true “market prices”.

High liquidity and greater efficiency

Key to any efficient market is high liquidity. After all, as a trader, you want to know that

you have an active market with plenty of buyers and sellers looking to participate.

Trading volumes in the currency market can be one hundred times larger than that of the

New York Stock Exchange, and daily dollar amounts traded in foreign currency

approaches $3 trillion compared to less than $100 billion for the NYSE. High volumes

and “round-the-clock” trading ensures an active market for currency traders and greater

liquidity.

The incredible volumes traded in the FX market also contribute to the integrity of the

market—it is virtually impossible for an individual or group to manipulate prices.

Compare this to the equity markets, where large price movements can be triggered with

no warning should a major holder of a stock suddenly decide to reduce their holdings.

Intra-day volatility

FX trading is centered around a handful of currency pairs referred to colloquially as the

big seven. The high volume and liquidity combined with fewer active instruments

generates greater intra-day volatility than the equity markets where hundreds of stocks

are actively traded. It is this volatility that can be profitability exploited by forex traders.



Low spreads

Currency trading offers spreads that are much lower than what can be obtained when

buying or selling equities, especially during after-hours trading. Although exceptionally

tight currency spreads were previously reserved for transactions involving $1 million or

more, a shift towards tighter spreads for smaller transactions is gaining traction. Again,

OANDA's FXTrade is an industry leader in offering tight spreads regardless of the size

of the trade.

Margin-based leverage

Leverage—or margin based trading—makes it possible for FX market participants to

submit trades valued considerably higher than the deposits in their trading accounts.

Typically, margin ratios for trading currencies are higher than those permitted for

equities, and this is primarily attributable to the higher level of liquidity within the

currency markets.

To illustrate the power of leverage provided through the use of margin, consider a

margin ratio of 20:1 coupled with a trading account containing $10,000. This means that

you could trade amounts up to $200,000! Trading in larger volumes allows you to take

better advantage of even small price movements (but can also dramatically increases your

risk). Read about OANDA's margin policy.

Profit potential regardless of market direction

By definition, an investor with an open forex position is long one currency and short

another. If you determine that a currency is about to fall in value, then you can sell that

currency short and go long with another currency. No matter whether you buy or sell a

currency pair, however, every trade you make involves the buying of one currency and

the selling of another. Therefore, potential exists in the FX market regardless of whether

the market is moving up or down.

Short-selling is much less common in the equity markets and there are many rules and

regulations that you must abide by when shorting stock. This can make it difficult for

you to take advantage of a declining share price or market trend. These same restrictions



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do not apply to the FX market, thereby allowing you to gain no matter which direction

the market heads.

No commissions or transaction costs

A currency transaction typically incurs no commission or transaction fee outside of the

quoted spread. This is in stark contrast to the equity market, where commissions for

stock trades can range anywhere from $8 to $70 per trade, in addition to the quoted

spread.

Trading Styles

Currency traders make decisions by analyzing technical factors and economic

fundamentals. Traders must decide which style and/or combination of analysis works

best for them.

Technical Traders

Technical traders make their decisions using two primary tools:

Charting tools (trend lines, support and resistance levels, etc,)

Quantitive Trading Models (mathematical analysis to identify trading

opportunities).

The goal of a technical analysis is to study historical data or past behavior of the market

in order to predict future market movements. Traders may using their own charts and/or

models, or use those developed by third-party providers.

The FXTrade interface provides a variety of forex graphing features.

Fundamental Traders

Fundamental traders analyze key economic data, including news and government

reports, to evaluate trading opportunities. They believe that currency exchange rates are

affected primarily by economic and political conditions, and occasionally by central

banks intervening in the currency markets in an attempt to influence the value of their

currencies.


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Some of the key figures tracked by fundamental traders include interest rates, inflation,

trade balance, GDP (Gross Domestic Product), CPI (Consumer Price Index), PPI

(Producer Price Index), capacity utilization, factory orders, durable goods orders,

inventories, and employment statistics. They are also constantly evaluating the potential

impact of military conflicts, natural disasters, and changes in political leadership.

Another factor that often influences trading decisions is market sentiment. Traders often

read news, analyst reports, and Web site bulletin boards to get a sense of the general

market sentiment and then trade either with or against that sentiment.

All Forex trades result in the buying of one currency and the selling of another (currency

trading), simultaneously.

Buying ("going long") the currency pair implies buying the first, base currency and

selling an equivalent amount of the second, quote currency (to pay for the base currency).

It is not necessary to own the quote currency prior to selling, as it is sold short. A trader

buys a currency pair if he/she believes the base currency will go up relative to the quote

currency, or equivalently that the corresponding exchange rate will go up.

Selling ("going short") the currency pair implies selling the first, base currency, and

buying the second, quote currency. A trader sells a currency pair if he/she believes the

base currency will go down relative to the quote currency, or equivalently, that the quote

currency will go up relative to the base currency.

An open trade or position is one in which a trader has either bought or sold one currency

pair and has not sold or bought back an adequate amount of that currency pair to

effectively close the trade. When a trader has an open trade or position, he/she stands to

profit or lose from fluctuations in the price of that currency pair

What you need to know about Forex trading strategies and how to trade currency.

Simply put, Forex Trading is buying and selling of international currencies. The US

dollar is almost always the base currency against which other currencies are bought and



sold in real Forex trading. Of course, one's local currency can also be used as a base

currency. In such a case it will be called a CROSS TRADE. Cross trading is then an

exchange of two currencies where US dollar is not involved.

How to trade currency

Say, you got a tip or you suspect that the Japanese Yen might appreciate in value against

US dollar in near future. The current exchange rate is ¥ 120 to a US dollar. You go to the

bank and exchanged US$ 10,000 for ¥ 1,200,000.00

US$ 1.00 = ¥ 120.00

US$ 10,000.00 = (120*10,000)

You will get: ¥ 1,200,000.00

Profit

Later on, as expected, the Yen appreciates by Five Yen to ¥ 115 to a US dollar. You then

take your Yens back to the bank and exchanged them into US dollars. You will get US$

10,434.78. This extra US$ 434.78 will then be your profit on top of your initial

investment of US$ 10,000.

¥ 115.00 = US$ 1.00

¥ 1,200,000.00 = (1/115)*1,200,000 = US$ 10,434.78

Initial Investment was: = US$ 10,000.00

Your PROFIT: = US$ 434.78



Loss

On the other hand, instead of appreciating, the Yen further weakens. After all, it was only

an expectation that the Yen will appreciate, not a guaranty. Say, it weakens by Five Yen

to ¥ 125 to a US dollar. Of course you now have a choice to either hold on to your Yens

until it appreciates or exchange them back into US dollars. Suppose, you want to

exchange them back into dollars for fears of further Yen weakness. You then take your

Yens back to the bank and exchanged them into US dollars. You will get US$ 9,600.00.

Your loss is US$ 400.00. Now your initial investment of US$ 10,000 is reduced to US$

9,600.

¥ 125.00 = US$ 1.00

¥ 1,200,000.00 = (1/125)*1,200,000 = US$ 9,600.00

Initial Investment was: = US$ 10,000.00

Your LOSS: = (-US$ 400.00)

Forex Trading is neither gambling nor should it be perceived as such. In gambling, once

you place a bet you cannot withdraw from a losing situation. You either win or loose. On

the other hand, with Forex trading, you decide how much you are prepared to lose or wait

until you are in profit. Forex trading strategies provide several means to accomplish just

that.

Hence, one can trade Forex euphorically or in an organized manner. The tools and

techniques are there to help you learn how to trade currency, it's up to you to use them for

your best interest.



Many currency traders have made the switch from currency futures to spot foreign

exchange ("forex") trading. Spot foreign exchange offers better liquidity and generally a

lower cost of trading than currency futures. Banks and brokers in spot foreign exchange

can quote markets 24 hours a day. Furthermore, the spot foreign exchange market is not

burdened by exchange and NFA ("National Futures Association") fees, which are

generally passed on to the customer in the form of higher commissions. For these

reasons, virtually all professional currency traders and institutions conduct most of their

foreign exchange dealing in the spot forex market, not in currency futures.

The mechanics of trading spot forex are similar to those of currency futures. The most

important initial difference is the way in which currency pairs are quoted. Currency

futures are always quoted as the currency versus the US dollar. In Spot forex, some

currencies are quoted this way, while others are quoted as the US dollar versus the

currency. For example, in spot forex, EUR/USD is quoted the same way as Euro futures.

In other words, if the Euro is strengthening, EUR/USD will rise just as Euro futures will

rise. On the other hand, USD/CHF is quoted as US dollars with respect to Swiss Francs,

the opposite of Swiss Franc futures. So if the Swiss Franc strengthens with respect to the

US dollar, USD/CHF will fall, while Swiss Franc futures will rise. The rule in spot forex

is that the first currency shown is the currency that is being quoted in terms of direction.

For example, "EUR" in EUR/USD and "USD" in USD/CHF is the currency that is being

quoted

CURRENCY PAIRS

All currencies are assigned an International Standards Organization (ISO) code

abbreviation. In currency trading, these codes are often used to express which specific

currencies make up a currency pair. For example, USD/JPY refers to two currencies: the

US Dollar and the Japanese Yen.

EXCHANGE RATE

An exchange rate is simply the ratio of one currency valued against another. The first

currency is referred to as the base currency and the second as the counter or quote



currency. If buying, an exchange rate specifies how much you have to pay in the counter

or quote currency to obtain one unit of the base currency. If selling, the exchange rate

specifies how much you get in the counter or quote currency when selling one unit of the

base currency.

USD/JPY

base currency/quote currency

SPOT FOREX

Spot foreign exchange is always traded as one currency in relation to another. So a trader

who believes that the dollar will rise in relation to the Euro, would sell EUR/USD. That

is, sell Euros and buy US dollars. The following is guide for quoting conventions:

Currency Pairs - Exchange rate relationship between two currencies, where one

currency is expressed in terms of the other. For example, USD/DEM (US dollar against

German mark) is a currency pair.

Base Currency- The base currency is first currency in any conventionally quoted

currency pair. Thus in EUR-USD, Euro is the underlying currency; in USD/JPY it is the

US Dollar; while in EUR/JPY, it is again Euro.

Forex Symbol Guide

Symbol Currency PairTrading

Terminology

GBP/USD British Pound / US Dollar "Cable"

EUR/USD Euro / US Dollar "Euro"

USD/JPY US Dollar / Japanese Yen "Dollar Yen"

USD/CHF US Dollar / Swiss Franc"Dollar Swiss", or

"Swissy"

USD/CAD US Dollar / Canadian Dollar "Dollar Canada"



AUD/USD Australian Dollar / US Dollar "Aussie Dollar"

EUR/GBP Euro / British Pound "Euro Sterling"

EUR/JPY Euro / Japanese Yen "Euro Yen"

EUR/CHF Euro / Swiss Franc "Euro Swiss"

GBP/CHF British Pound / Swiss Franc "Sterling Swiss"

GBP/JPY British Pound / Japanese Yen "Sterling Yen"

CHF/JPY Swiss Franc / Japanese Yen "Swiss Yen"

NZD/USD New Zealand Dollar / US Dollar"New Zealand

Dollar" or "Kiwi"

USD/ZAR US Dollar / South African Rand

"Dollar Zar" or

"South African

Rand"

GLD/USD Spot Gold "Gold"

SLV/USD Spot Silver "Silver"

What is the “Foreign Exchange,” or “Forex” or “FX” for short? This is the largest

financial market in the world. Its daily average turnover is approximately US$1.5 trillion.

Foreign Exchange trading simply means the simultaneous buying of one currency, and

selling of another. The world's currencies are on a floating exchange rate. They are

always traded in pairs – for example, Dollar/Yen, Euro/Dollar, etc.

Is there a “central location” for this market? No. Unlike stock and futures markets, FX

trading is not centralized on any one exchange. It is considered to be an Over-the-Counter

(OTC), or 'Inter-bank,' market. This is because transactions are conducted between two

counterparts over the telephone, or via an electronic network.



Who are the “participants” in this market? 'Inter-bank market' means that it was

dominated by banks up until recently – i.e., central banks, commercial banks, investment

banks, etc. However, thanks to market makers brokers, other market players then entered

the market in record numbers. They include international money brokers, large

multinational corporations, registered dealers, global money managers, private

speculators, and futures and options traders.

When is this “market open” for trading? This is a true seamless 24-hour, seven-day-a-

week, market. Trading begins each day in Sydney, and then moves around the world, as

each financial center opens up – Tokyo, London, and then New York – in that order. The

big advantage to trading the forex market is that traders like you and I can respond to

currency fluctuations caused by economic, political or social events as they unfold – day

or night. This is much unlike other financial markets, as you well know.

Which “currencies” should I trade in this market? The most commonly traded are those

that are 'liquid' – i.e., those of countries with stable governments, low inflation, and

respected central banks. Over 85% of all trading activity revolves around the major

currencies – i.e., the Australian Dollar, British Pound, Canadian Dollar, Euro, Japanese

Yen, Swiss Franc, and the U.S. Dollar

Do I need a lot of “money” to trade this market? No. One market maker broker we

know of requires a minimum deposit of $500, although it is preferable that you start with

at least US$2,000 to US$5,000 in your trading account. You can execute margin trades

with up to 200:1 leverage, and you can also execute trades of $10,000 with an initial

margin requirement of $50, in some cases.

However, it is important to note that, while such leverage allows you to maximize your

profit potential, the potential for loss exists too. A more pragmatic margin trade for you,

if you are new to the FX markets, might be in the order of 20:1, but this ultimately

depends on your appetite for risk. The most common ratio is 100:1 for a standard

account, and that’s what we recommend when you open your account. Of course, you can

start with a mini account, and upgrade from there.



Concerning risk, our trading method has a 70% success rate, so you will not be “flying

blind,” as most traders do. We are here to help you get on the winning side of most of

your trades with our revolutionary Pivots Program that has captured the Forex market by

storm.

Don’t forget that you can open a demo account with most market maker brokers that we

deal with. This requires no capital outlay, and is risk-free.

We would be more than glad to recommend a market maker broker to you that would suit

your needs. We have thoroughly researched the offerings that are available out there, and

have come up with those that we are prepared to suggest you use.

What is “margin?” Margin is just that – collateral for a position. Your market maker

broker will request additional funds by way of a "margin call," if the market moves

against your position. It will immediately close out your open positions, if there are

insufficient funds in your account.

What are “long” or “short” positions? A long position is one in which you buy a

currency at one price, with the expectation of selling it later on at a higher price.

Obviously, you anticipate that the market will rise. A short position is one in which you

sell a currency with the expectation of buying it back at a lower price. Here, you expect

the market to fall. Every FX position you take automatically entails going long in one

currency, and short the other. If you buy one, by default you are shorting the other.

What is the difference between “intraday” and “overnight” positions? Intraday

positions are those positions you would take during the 24-hour period, after the market

maker broker’s normal trading hours open, but not hold after the close. Overnight

positions are those of your positions that are still on at the end of normal trading hours.

Your market maker broker rolls over your positions at competitive rates (based on the

currencies’ interest rate differentials) to the next day's price.

What “drives” currency prices? Currency prices are affected by a variety of economic

and political conditions – most importantly inflation, interest rates, large market orders,



and political climate. Furthermore, governments sometimes enter the Forex market to

influence the value of their currencies, either by flooding the market with their domestic

currency to lower its price, or conversely by buying it to give it a boost. This is

commonly called “central bank intervention.” Any of these factors can cause volatile

currency prices. However, the sheer size and volume of the Forex market makes it

virtually impossible for any one entity to "influence" the market for any length of time.

How should I “manage risk?” The most common risk management tools in Forex

trading are the limit and stop loss orders. A limit order restricts the maximum price to be

paid, or the minimum price to be received. A stop loss order ensures that your position is

automatically liquidated at a predetermined price, should the market move against you.

Limit order and stop loss orders can easily be executed due to the huge liquidity of the

Forex market.

What “trading strategy” should I use?

You could identify good trading opportunities, and execute your trades based on

economic fundamentals and/or technical factors. These factors typically include charts,

mathematical analyses, support and resistance levels, and trend lines, but we have our

own view on these technical considerations, as you will see in a minute.

Fundamentalists anticipate price movements by analyzing and interpreting a wide variety

of economic information, including government-issued indicators, news, rumors, and

reports. However, unexpected events instigate the most dramatic price movements. Such

events can include a central bank raising domestic interest rates, the outcome of a

political election, or even an act of war. Nonetheless, it is usually the expectation of the

event that drives the market, rather than the event itself.

From a purely technical perspective, there are many approaches to identifying buy/sell

levels for a tradable, but a great number of them are unreliable. Those approaches include

methodologies that utilize Fibonacci numbers and ratios, Gann concepts, moving

averages, and trend lines. They all have a very static view of the tradable. They assume

that the market will repeat past behavior and experience, and can therefore be viewed



linearly. They also use fixed intervals for inputs, which creates yet another dilemma.

The old maxim: “A study of the past does not tell you anything about the future.” The

exception here is our interest in the previous week’s levels, and those of the trading

session just past.

Watching price action without having something to go by will leave you directionless.

You should watch prices in relation to points-of-reference (a pivot point in combination

with buy/sell levels). It is perhaps the only way of knowing whether the market is moving

closer to, or further away, from a particular point. It also helps you develop a feel for the

market, once you put your position on. Your entry price will take on a whole new

meaning, as you track it in relation to these points-of-reference.

When watching price action, you will want to know three things: in what direction, how

far, and how fast. To do this measurement, you will need only observe current price in

relation to what we call the pivot point.

Our Pivots Program generates all the buy/sell signals for you automatically. All you have

to do is pull the trigger, and relax, when you combine these entry/exit points with other

indications, like significant bars (key reversal bars, inside bars, outside bars, price

rejection bars, railway tracks, etc.), MACD negative or positive divergence to price

action, trend line breakouts, etc.

How “often” should I trade? Market conditions will dictate your trading activity on any

given day. The average small-to-medium trader could conceivably trade up to 10 times a

day. However, because there are no commissions when you trade currencies on the

Forex, you can take long or short positions as often as you like, without worrying about

excessive transaction costs.

How “long” should I maintain my positions? In general terms, you will keep your

position on until, 1.) you realize sufficient profit from your position; 2.) your stop-loss is

triggered; or, 3.) another position with greater potential comes up, and you need to free

up funds from another trade to take advantage of it.



I like what I hear and see so far about foreign exchange trading, but I am still

“nervous” about getting involved. How can I “overcome my fears?” There is no better

way for you to get practical experience in this market than for you to open a demo

account with a market maker broker that we would recommend to you. That way, you

will get a feel for what it’s like to trade the Forex market, without actually risking any of

your hard-earned capital.

What is the “spot rate,” and what is the “spot market?” What “exchange” does it trade

on? In your daily newspaper, you will find quotations for the forward rate, options, and

the spot rate on currencies. The spot rate means that currencies can be exchanged for

delivery in two days – i.e., on the spot. The word market is misleading, in that there is no

central location where trading currencies takes place. The bulk of Forex trading is

conducted between approximately 300 large international banks, which process

transactions for large companies and governments. These institutions continuously

provide prices for each other, and their corporate and institutional clients. Forex trading is

not bound to any one trading floor, but takes place electronically within a network of

banks continuously over a 24-hour period.

What do the terms “bid/ask” and “spread” mean? Bid is the highest price that the seller

is offering for a particular currency at the moment; ask is the lowest price acceptable to

the buyer. Together, the two prices constitute a quotation; the difference between the two

is called the spread.

What is “price shifting?” Price-shifting is the practice of offering a client a buy or sell

price that does not reflect where the market is actually trading. The shift is always to the

advantage of the broker, and the purpose is obvious. The practice is common and,

unfortunately, legal.

Foreign Exchange (FOREX)

Foreign exchange is simply the exchange of one currency for another, but it can take

many forms.



At Standard Chartered Bank, SME Banking, there are 2 ways of booking an exchange

rate; either through Spot Rates or Forward Rates

Spot Rates

A spot contract is a binding obligation to buy or sell a certain amount of foreign currency

at the current market rate, for settlement in two business days. To enter into a spot deal,

you advise us of the amount, both currencies involved and which currency you would

like to buy or sell.

Purpose

All companies that have foreign currency exposure may use a spot deal, but companies

exposed to transactional risk most commonly use them.

Settlement

A spot deal will settle (in other words the physical exchange of currencies will take

place) within two working days after the deal is struck. This 'value date' reflects both the

need to arrange and transfer of funds and, in most cases, the time difference between the

currency centres involved, one or other of which may well be closed at the time of the

trade.

Summary

Forecasting exchange rates is very difficult - you cannot know for certain what the

exchange rate is likely to be by the end of today, let alone a few months. A company

using only the spot market for its foreign currency requirements, is using the simplest

method, but at the same time the most risky. If you placed an order for raw materials

from Canada for payment in three months, and use the spot market to meet the invoice

when it falls due, your company could lose significantly if rates move against you over

that three-month period.

Basic facts

Minimum deal size : No minimum

Maximum deal size : No maximum


http://www.standardchartered.com.my/sb/sb_forex.html#Forward%20Rates%23Forward%20Rates

http://www.standardchartered.com.my/sb/sb_forex.html#Spot%20Rates%23Spot%20Rates


Credit line : Not required

Currency pairs : In any currency pair where there is a liquid market

Forward Exchange Contracts

A forward exchange contract (or forward contract) is a binding obligation to buy or sell a

certain amount of foreign currency at a pre-agreed rate of exchange, on or before a

certain date. Contracts can be taken out for completion on an agreed date or at any point

between two pre-agreed dates (up to three months apart). To take out a forward contract

you need to advise us of the amount, the currencies involved, the expiry date and whether

you would like to buy or sell the currency on the expiry date or anytime during a pre-

agreed period.

Purpose

A forward contract is the simplest method that provides for exchange risk situations. This

overcomes one of the problems that you can experience when importing or exporting in

foreign currency, as you can now budget at a guaranteed rate of exchange.

Pricing

The price of a forward contract is based on the spot rate at the time the deal is booked,

with an adjustment that represents the interest rate difference between the two currencies

involved. For example, you need to buy US dollars in three months. Say US interest rates

are higher than RM interest rates. The pricing principal assumes that SCB buys US

dollars now, paying for the US dollars with Ringgit, in order to meet our obligation to

you under the contract in three months.

We pass on to you the benefit of the higher rate of interest we earn on the dollars. The

adjustment to the spot rate means that the forward contract rate would be more favourable

than a spot deal rate. The reverse would apply if US interest rates were lower than RM

rates.

Summary

A forward contract provides for situation of adverse movements in exchange rates



against your company.

You shall be meeting a budget rate for the transaction.

A forward contract is an obligation. Even if your requirements change over the term of

the forward contract, you are still obliged to deal.

A forward contract obliges you to deal at a specific rate - you are not in a position to

benefit from any favourable movements in exchange rates between booking the

contract and completing the deal.

No premium is payable.

Key facts

Minimum deal size : No minimum

Maximum deal

size

:No maximum

Period : Usually a period of two years - longer periods are available in

certain currencies

Credit line : A credit line is required for forward contracts

Currency pairs : In any currency pair where there is a liquid forward market



THE MAIN POLICY OF B.B.K.

INTEGRATED FOREIGN EXCHANGE POLICY

(I) INTRODUCTION:

Foreign exchange is essentially about exchanging one currency for another. Foreign

exchange position can be defined as the balance of contractual purchases and sales of a

foreign currency that has not been offset or closed. This foreign exchange position is

also called as net open position of a foreign currency. The risk in foreign exchange

arises from two factors - a) foreign exchange position and b) foreign exchange rate.

This foreign exchange policy is meant to deal with the foreign exchange risk

undertaken by the Bank.

(II) FOREIGN EXCHANGE RISK:

Foreign Exchange Risk may be defined as the risk that the Bank might suffer

losses in local currency, as a result of adverse exchange rate movements

(volatility in currency rates) in any individual foreign currency, during a period in

which it has a net open position, either spot or forward, or a combination of the

two.

Net open position is the degree to which the Bank is net long (positive / overbought)

or net short (negative / oversold) in a given currency. The net long exposure may

suffer a loss when the foreign currency falls in value against the local currency.

Similarly, the net short exposure may incur a loss when foreign currency gains in



value against the local currency. Thus, the bank will be exposed to fluctuations in the

exchange rate of a foreign currency against the local currency if it fails to maintain a

fully balanced position (bought and sold) in that given currency.

(III) SOURCES OF FOREIGN EXCHANGE RISK:

3.1 Foreign currency positions (Long or Short currency positions held during

the day / overnight) arising out of uncovered merchant transactions with

customers.

3.2 Bank’s net interest accruals (both payable / receivable) in foreign

currency.

3.3 Buying and selling currencies for FX trading (Proprietary FX trading

positions) in spot / forward markets based on trader’s / dealer’s view

on currency rate movements.

(IV) PRODUCTS IN FOREIGN EXCHANGE BUSINESS:

4.1 BBK-India venture into the following products in the foreign exchange

business:

- SPOT, Forwards and derivative products

However, for the purposes of trading, only SPOT and Forwards shall be

used.

4.2 The bank shall deal in the following currencies:

- USD, Euro, GBP, JPY, BHD for trading purposes.



- Any other currency for merchant transactions including the above

currencies.

(V) COUNTERPARTIES:

Credit risk (pre-settlement and settlement) is the risk of loss due to inability or

unwillingness of the counterparty to meet its obligation. This, risk can be effectively

managed through fixing of counter party limits, appropriate measurement of

exposures, ongoing credit evaluation and monitoring and following sound operating

procedures.

a) Pre-settlement Risk:

Pre-settlement risk is the risk of loss due to counterparty defaulting on a

contract during the life of a transaction. This exposure is also referred to as

the replacement cost. The level of this exposure varies through the life of

the hedging product and is known with certainty only at the time of

default. A key tool for effective management of this risk is the fixation of

exposure limits on counterparties.

b) Settlement Risk:

Settlement risk is the risk of loss arising when a bank performs on its

obligation under a contract prior to the counterparty does so. This risk

frequently arises in international transactions because of time zone

differences. The failure to perform may be due to operational breakdown,

counterparty default or legal impediments. Banks should, therefore,

monitor and control settlement risk very effectively.

In most of the trading transactions, the counterparties are banks / FIs. However,



merchant transactions are with corporates. The procedure for setting up of limits shall

be as follows:

5.1 Banklines Limits:

5.2 Corporate / Non-Corporate Limits:

For setting up limits for entities, which don’t fall under the purview of

Bank Lines, normal credit procedures should be followed. i.e. a proper

credit application shall be put up for approval at appropriate authority

levels and will be guided as per the H.O. Credit Policy norms.

(VI) RISK MONITORING:

The Foreign Exchange Risk could be controlled by establishing limits on – Open

foreign exchange positions (overnight and daylight), Stoploss and Value-at-Risk.

These limits are defined as follows:

6.1 Open Foreign Exchange Position Limits:

“Open Foreign Exchange Position Limit” is a major tool for managing

Foreign Exchange risk. The open position limits have two aspects –

“Overnight limits” and “Daylight limits”.

6.1.1 Overnight Limits:

- Individual Foreign Currency Net Open Position Limit

(Overnight):

The Bank’s exposure to foreign exchange risk in any currency is its net open position in



that currency, overnight, which is calculated by summing the following items:

A ) Net spot position:-

The net spot position is the difference between foreign currency assets and the

liabilities in the balance sheet. This should include all accrued income / expensess

The net forward position:

This represents the net of all amounts to be received less all amounts to be paid in the

future as a result of foreign exchange transactions, which have been concluded. These

transactions, which are recorded as off-balance sheet items in the bank’s books, would

include:

(i) spot transactions which are not yet settled

(ii) forward transactions

(iii) guarantees and similar commitment

denominated in foreign currencies which are

certain to be called

(iv) net of amounts to be received / paid in

respect of currency futures, and the principal

on currency futures / swaps.

a) The net options position (presently no approvals in

place to transact in options):

The options position is the “delta-equivalent” spot currency position as reflected in

the options risk management system, and includes any delta hedges in place which

have not already been included under (a) or (b) – (i) and (ii).

The report shall be generated and limits monitored by Mid-Office on a daily basis.



Presently, the limits are as follows:

Name of the Currency Overnight Limit

(000s)

BHD 1.00

EURO 525.00

GBP 275.00

JPY 33000.00

USD 2300.00

- Overall Overnight Position Limit:

This involves measurement of risks inherent in the Bank's mix of long and short

position in different currencies. It has been decided by RBI to adopt the “shorthand

method” which is accepted internationally for arriving at the overall net open

position. Bank should therefore calculate the overall net open position as follows:

a) Calculate the net open position in each currency (as

described above).

b) Calculate the net open position in gold (no such

exposures for bank, at present).

c) Convert the net position in various currencies and

gold into rupees in terms of existing RBI / FEDAI

guidelines.



d) Arrive at the sum of all the net short positions.

e) Arrive at the sum of all the net long positions.

Overall net foreign exchange position is the higher of d) or e). The overall net foreign

exchange position arrived at as above must be kept within the approved limit.

The report shall be generated and limits monitored by Mid-Office on a daily basis.

Presently, the limit is INR 176,500,000.

The excess, if any, shall be reported to RBI and an approval shall be sought for the

same.

For details of computation of the overnight positions, please refer to RBI A.P.(DIR

Series) Circular No. 92 dated April 4, 2003. The bank shall strictly follow the RBI

guidelines.

Capital Requirement:

Capital requirement will be as prescribed by RBI from time to time. At present the

risk weight is 100% of the net overnight position limit i.e. INR 176.5 MM.

6.1.2 Daylight Limits:

Computation of Daylight net open position is similar to Overnight position, but will

indicate the peak net open position of a foreign currency during the trading hours of

the day. The daylight limit could typically be substantially higher for two reasons -

(a) it is easier to manage exchange risk when the market is open and the bank is

actively present in the market and (b) the bank needs a higher limit to accommodate

client flows during business hours. Overnight position, being subject to more

uncertainty and therefore being more risky, should be much lower.

6.2 Stop Loss Limits:

The extent to which the currency trading spot position (exchange risk)



could lose in its value during the day and month-to-date is governed by the

Stoploss limits.

The stop loss limit for Indian Operations shall be 10% of the average

profits of last six months out of the foreign exchange business of Treasury.

The monitoring of the limits shall be done by Mid-Office.

6.3 Value at Risk (VaR):

Value-at-Risk is an important measure to monitor Foreign Exchange risk

(Forex risk) in foreign currency exposures.

Indian branches shall follow the FEDAI – VaR computation model to

monitor the VaR for its forex portfolio.

As per the VaR limits, as approved at H.O. ALM committee meeting,

USD 100,000 have been allocated for Indian Operations.

Daily VaR report shall be prepared by the Mid-Office and also

monitor the limits.

6.4 Gap Limits:

The Aggregate Gap Limit (AGL) for all currency positions should be

fixed after seeking appropriate approvals. (AGL is currently USD 69 MM)

Further, incase of USD, there should be an IGL for each tenor. At present

the limits are as follows,

Period USD MM

Spot 8.00

1 Month 7.00

2 Months 7.00

3 Months 7.00

4 Months 8.00



5 Months 8.00

6 Months 7.00

7 Months onwards 12.00

And for other currencies the IGL is as follows:

EURO 2.00

GBP 1.50

YEN 1.50

These individual miscellaneous currency limits will have flexibility under the overall

limit of USD 5 MM to cater to any large transactions that may occur in any

particular currency.

However, the limits as above are subject to following conditions:

(i) The tenor for which the limits are interchanged shall not exceed 1

month and

(ii) Only the unutilised amount for the particular month can be

sub-allocated to another month.

Any excess of the AGL shall be reported to RBI, and appropriate approvals shall be

sought.

6.5 Dealer-wise limits:-

BBK-India shall have a limit for each category of dealer.

Per Deal USD MM

Dealer I (Dy. Manager) 2.5 No upper limit per

day for forex

transactions.

Dealer II (Asst. Manager) 1.5

Manager (Treasury) 5.0



However in all the cases, Manager – Treasury shall countersign the

transactions. This will keep a check on the risk from human errors.

Transactions in excess of the limits of the Manager (Treasury) will

require the authentication of the GM & CEO – India.

(VII) For the procedural / operational aspect, the operations manual shall be referred

to i.e. Chapter 36 of the Operations Manual – Treasury – Forex. For other

corporate forex exposures, normal credit procedures shall be followed for

monitoring of the exposure.

(VIII) EVALUATION OF FOREIGN EXCHANGE PROFITS AND LOSSES:

Methods of Evaluation:

The Uniform Standard Accounting Procedure for evaluation of profit / loss of

foreign exchange transactions drawn up by FEDAI and approved by the RBI

should be strictly adhered and valuation undertaken at least at the end of each

month and on the balance sheet date.

The evaluation should disclose the actual profit / loss under different heads such

as exchange trading, interest income, commission / s, etc.

(XI) CLEARING CORPORATION OF INDIA LIMITED (CCIL):

CCIL’s operations cover only the inter-bank spot and forward US Dollar-Indian

Rupee (USD-INR) trades. Connectivity to the RBI’s INFINET network will be a pre-

requisite for members availing of CCIL’s services for settlement of their trades.

No settlement takes places on Saturdays, Sundays and such other days as are not

business days in either Mumbai or New York. There ought to be at the least one



settlement per Mumbai business day.

Bank should exchange deal confirmation files, over INFINET, among counterparts,

as well as with CCIL. The Rupee leg will be settled through the members’ current

accounts with RBI and the USD leg through CCIL’s account with the Settlement

Bank at New York.

Every eligible foreign exchange contract, entered into between members, will get

novated and be replaced by two new contracts for the same value date – between

CCIL and each of the two parties, respectively.

Following the procedure of multilateral netting, one net payable or receivable

amount, in respect of both USD and INR, will be arrived at.

Spot deals traded from the date of commencement and outstanding Forward deals

maturing thereafter shall be accepted for settlement by CCIL.

Settlement Guarantee Fund (SGF):

Bank shall be required to contribute to SGF in relation to its respective margin

obligations as advised by CCIL. The SGF is determined on the basis of Net Debit Cap

(NDC), as stipulated by CCIL from time to time. Currently, the NDC computation is

based on two factors, viz. The member’s credit rating and a surrogate for volatility in

the USD-INR exchange rate. Trades concluded by the bank will be accepted for

settlement only if the NDC limit is not violated, which shall mean that the net

obligation of the member to CCIL does not exceed the NDC stipulated.

For other relevant details / procedures, please refer to the Operations Manual –

Chapter – Forex Settlement through CCIL.

Front Office:

Dealer shall input the concluded deals in the ITMS system as per the existing

procedure and forwards duly signed copies of the deal tickets to Mid Office and Back



Office.

Mid Office:

Mid Office will view the deal ticket vis-à-vis the details in the conversation report

and confirm that the particulars are correct.

Further, Mid Office shall, on a daily basis, monitor the USD / INR transactions to be

settled through CCIL on Spot basis / contracts falling due vis-à-vis the Net Debit Cap

(NDC). In case any excess over the NDC is observed the matter should be at once

brought to the notice of the Manager – Treasury / Back Office in order for the latter to

take up the remedial measures immediately.

Back Office:

Back Office will view the deal vis-à-vis the deal ticket and after ensuring that the

particulars are correctly input, authorise the deal. Further, the trades data will be

transferred to CCIL through the Forex Deal Reporting (FDR) utility, which is similar

to FTP utility.

CCIL will provide all members with the list of all Member Ids along with their

correspondent Banks. Any change in the aforesaid list will be put on the message

board of the browser by CCIL.

Each bank / member would need to operate through only one correspondent bank for

CCIL operations as mentioned in the membership application form. In case,

subsequently, the correspondent bank needs to be changed, bank / member shall give

7 day’s notice to CCIL details of the new Correspondent bank and their SWIFT Code.

Back Office will further transfer the data relating to the outstanding forward contracts

to CCIL vide IFN 300 format. This will enable CCIL to obtain the confirmations of

the deals from the counter parties and also settle the transactions on the respective due

dates.

Back Office will generate the Net Position Report at the end of the day and tally the



position with the bank’s records.

Back Office shall verify the bank’s USD Nostro statement of account following

morning and confirm that the debit / credit amount appearing in the account matches

with the Net position. Correspondingly, Back Office shall confirm with Financial

Control that correct net INR amount is credited / debited in the bank’s account with

RBI.

(XII) RECONCILIATION OF NOSTRO BALANCES:

12.1 Importance:

Reconciliation of ‘Nostro’ Account balances is an essential control function and is

intended to ensure that every transaction undertaken by the bank in its Nostro account

has been correctly executed.

The basic records for reconciliation are the bank statements, which should be received at

least weekly, and the Mirror account. Reconciliation must be done choosing the same

date for Mirror accounts and foreign bank statements. Action on unreconciled items must

be taken on an on-going basis.

The records of reconciliation must be held under safe custody and preserved for a

sufficiently long period for reference.

It should be ensured that no set-off of debit and credit items has been

made / any unreconciled item written off or appropriated to profit and loss

except in terms of the authorisation in the Exchange Control Manual or the

prior approval of the Control.

12.2 Management Control:

A monthly report should be submitted by Reconciliation Department

indicating the progress made in reconciliation of Nostro account

balances highlighting special features such as large unreconciled

items, age-wise grouping of items, etc.



(XIII) MIS AND RETURNS:

Following is the list of reports / returns, required to be prepared and submitted

to the bank’s internal management / RBI:

(i) Daily Reports:

- VAR (Internal / RBI)

- Net Open Position (Internal / RBI)

- Foreign Exchange Mismatch – FEMIS (RBI)

- Foreign Exchange Data (RBI)

(ii) Monthly:

- Short Term Foreign Currency Loans (RBI)

- FCY Borrowing (RBI)

- Net Open Position (Internal)

(iii) Annual:

- 5% ceiling on Forex brokers (RBI).



Part – II

MID OFFICE

(RISK MANAGEMNET DEPT.)



MID OFFICE (Risk Management Dept)

Necessity of Mid –Office:-

Risk management is becoming an increasingly important issue for banks and other

financial institutions in the face of mounting regulation and the introduction of new

capital adequacy standards, such as the Basel II.

Banks need to identify and disclose their major sources of risk and the market factors

behind them. They need timely and consistent credit and limit information.

The bank middle office monitors and manages the bank's risk exposures. In order to

manage global market and credit risk, the middle office liaises closely with the front

office responsible for trading operations and also with the back office which handles the

administration associated with the settlement of trades.

Increases in cross-border trading, credit defaults, bankruptcies and globalisation have

made credit management a much more demanding and complex task for the bank middle

office. Maintaining and monitoring essential credit and market data risk in one place is a

major challenge facing the bank middle office. The most important element for an bank

middle office is data collection and consolidation from both the trading and banking

books.

Middle office do the analysis of Credit ,Market and Operational risk .

What is Risk :

The term ‘risk’ is a possible loss resulting from unexpected changes, which might lead to

adverse deviations from the bank’s projected asset development and its financial and



earnings performance.

MODERN STEPS FOR RISK

Risk Identification.

Risk Measurement

Risk Management (control)

Value at Risk, a category of risk measures, is widely used by the middle offices for forex

& G-Sec analysis.

Daily monitoring & checking

On daily basis there are some returns prepared and send to all dept heads,

These returns are prepared for monitoring purpose.

1) Net Open Position : The closing stock of all currency is valued at the FEDAI

indicative rate. The closing stock position report is generated from ITMS - option

The closing stock position should not exceed the limits set by RBI

2) Bank line Position: This report is generated from ITMS - option - Reports,. The

outstanding position of all banks for FOREX transaction is taken from this report.

The outstanding position of LCBD & FBN is taken from GL. The exposure should

not exceed the limits given by the H.O. a sub allocation can be given if any exposure

exceeds the limits. For FOREX transaction the sub allocation is given by front office

and for other the sub-allocation is given by Trade Finance.

3) SLR Valuation:

All the SLR investments portfolios are to be tallied with the book value from the GL.



Total SLR portfolio should be within the SLR required for the fortnight. Value the

securities with the market value (rates from FIMMDA) and see the

appreciation/depreciation calculated. If depreciation, provision has to be provided for

HFT-monthly and for AFS - quarterly.

4) Var Report:

The risks involved in holding the forward contracts are to be monitored. The maximum

amount of loss the bank could suffer in respect of the open position is indicated in this

report. The Var factors are determined by FEDAI. This report is generated from ITMS -

option - Reports, MIS, FOREX, General, Gap report, Gap Scan BBK. This report has to

be generated during the day after all the transactions have been inputted by F.O.

5) Stop loss

All the interbank FOREX transactions are to be valued by market rate(spot rate given by

FEDI). At the beginning of the month Front Office (FO) calculate the stop loss amount.

No single transaction should exceed the stop loss limit.

6) CRR maintenance

The daily RBI balance for both the branches are added and monitored for the CRR

maintenance. Daily the CRR maintained should not go below 70% of the CRR required

for the fortnight.

7) Call money lending and borrowing:

The daily call money lending’s and borrowings are monitored. Daily lending should not

exceed 50% of the Tier I & II as of March and borrowing should not exceed 125% of the

Tier I & II as of march.

Fortnightly Returns:

1) Special Fortnightly return VIA-Interest Rate wise break-up of advances



This return pertains to borrowers enjoying limits of Rs. 2 lakhs & above. The interest rate

given to the customers who enjoy limits of Rs. 2 lakhs and above are to be complied and

reported to RBI on fortnightly basis. as of every reporting Friday. The return has to be

consolidated for Indian Operations.

This statement is to be submitted within 10 days from the due date

(within 10 days from the fortnight)

2) Special Fortnightly Return CRR-SLR

These returns pertain to the cash reserves with RBI, Provisional data on maintenance of

Statutory Liquidity requirement, Money Market Operations. The return has to be

consolidated for Indian Operations.

This statement is to be submitted within 10 days from the due date (within 10 days from

the fortnight)

Balances with RBI, SLR maintained, cash on hand, balances with other bank, investment

with Govt. Sec., investment in treasury bills, other approved securities, call money

market transactions (borrowing and lending) for the fortnight has to be taken from daily

maintained file.

3) Statement of Structural Liquidity - (Asset - Liability Management)

This return pertains to the maturity structure of cash inflows and outflows. The statement

of structural liquidity has to be prepared on fortnightly basis as of reporting Fridays. The

statement of 1st reporting Friday has to be put up to ALCO and 2nd reporting Fridays to be

sent to RBI by 15th of next month.



4) Statement of Short term Dynamic Liquidity

This statement enables the banks to monitor their liquidity on a dynamic basis over a time

horizon spanning from 1-90 days. It has to be prepared as on each reporting Friday.

5) Statement of Interest Rate Sensitivity (IRS)

In IRS only rupee assets, liabilities and off-balance sheet positions should be reported.

The information collected in the statement will provide useful feedback on the interest

rate risk faced by the bank and the management would formulate corrective measures and

devise suitable strategies wherever needed.

The statement of IRS has to be prepared on fortnightly basis as of reporting Fridays. The

statement of 1st reporting Friday has to be put up to ALCO and 2nd reporting Fridays to be

sent to RBI by 15th of next month.

Monthly Returns:

1. Valuation of investments :

All the investments portfolio (SLR & Non SLR) is to be tallied with the book value

from the GL. Value the securities with the market value (rates from FIMMDA) and see

the appreciation/depreciation calculated.

If depreciation, provision has to be provided for HFT-monthly and for AFS - quarterly.

2. Report on open position

This report is sent to H.O. on the first of the month taking the net open position from

statement of position. Here we give the aggregate position currency wise. Rates are to be



taken from FEDAI.

3. Country wise exposure statement -

This statement is required to be sent to Risk Management Department (RMD) in HO by

the 7th of every month. A consolidated report for Indian Operations is to be sent after

getting the statement from Hyderabad.

This statement requires all our exposures like advances,LC's & Gty's, FOREX/settlement

contracts, Placements, Nostro balances & Investments to be classified country wise. The

details as on the month end are to be obtained as follows:

a) Bank wise outstanding Interbank FOREX contracts from FX back office dept.

b) Placements, Nostro balances & Investments from the month end GL.

c) Advances, LCs & Guarantee out standings from the MIS.

4. Industry-wise Concentration Report :

This report is required to be sent to Risk Management Department (RMD) at HO by the

5th of every month. A consolidated report for Indian Operations is to be sent after

getting the statement from Hyderabad.

The customer wise out standings under advances, investments, placements and Nostro

balances.



5. Top Ten Accounts:

This report is to be sent to FC department by 5 th of every month. Take the outstanding

balances of advances from MIS and sort it by grand total. Take top ten accounts

excluding NPAs and also including NPAs.

6. 5% ceiling on brokers

This report is prepared for internal purpose. The report is generated from ITMS. and see

whether any brokers are exceeding the 5

7. FCY borrowing

This report is to be generated as of last Friday of every month and is to be send to RBI by

10th.

This report is generated from ITMS. Option - Reports,

We can borrow 25% of Tier I or $ 10 MM, whichever is higher from HO.

8. Priority Sector advances

This report is prepared every month as of last day of the month for internal purpose.

Advances to agriculture (Direct and Indirect finance), Small Scale

Industries (Direct and Indirect Finance), Small Business / Service Enterprises, Micro

Credit, Education loans, Housing loans are considered under priority sector advances.



The Requirement for Foreign Banks is as follows:

Export credit as a % of net bank credit - 12%

(Includes SSI Exports)

Other priority sector credit as a % of net bank credit - 10%

(Includes SSI (including exports),

Investments in priority sector bonds,

other priority sectors)

Total priority sector advances as a % of net bank credit - 32%

CREDIT RISK :

In B.B.K. apart from the corporate banking dept (C.B.D.) , The risk management dept

work seprately for the credit risk control. The R.M.D. do the following documentary

analysis ;



1. Per borrower limit .

B.B.K. has set up the borrower limit as per the R.B.I. prudential norms :

INR MM

TIER I CAPITAL AS AT 31/03/2008 XXX

.

TIER II CAPITAL AS AT 31/03/2008 XXX

CAPITAL FUNDS AS AT 31/03/2008 XXX

MAXIMUM EXPOSURE TO -

INDIVIDUAL

INDIVIDUAL BORROWERS -15% OF CAPITAL FUNDS

INDIVIDUAL BORROWERS (INFRASTRUCTURE PROJECTS ) -

20% OF CAPITAL FUNDS

GROUP

BORROWER GROUP - 40% OF CAPITAL FUNDS

BORROWER GROUPS (INFRASTRUCTURE PROJECTS ) -

50% OF CAPITAL FUNDS



2. Lending to sensitive sector :

Real sector has been classified into sensitive sector; the limit has been fixed for this.

3. Sector wise risk analysis :-

In order to avoid the risk associated with different sector the limit has been fixed for

different sector as follows,

Sectors % of Net Limit (%) (Excess)%/

Assets Availablity%

Manufacture 13.88 22

8.

12

Mining 0.00 0 -

Agriculture 0.00 0.5

0.

50

Construction 5.14 18

12.

86

Financial -

Interbank** 39.79 35

(4.

79)

Financial - Others 1.22 3

1.

78

Trade 0.82 6

5.

18

Other Services 0.60 6.5

5.

90

Personal 7.24 12

4.

76

Government 22.75 30 7.



25

Total 91.45 133

41.

55

** Includes as

under :

BBK

(Bahrain/Kuwait) 0.00 -

Other Banks 39.79 35.00

(4.

79)

4. Country wise Risk analysis

Different exposure has been given according to the rating of country.

Country Name

Country Risk

classification

Austria A1

Australia A1

Bahrain A2

Brazil B1

Belgium A1

China A2

Canada A1

Cyprus A2

Denmark A1

Ethiopia C2

Egypt B1



5. Sanctioning Power Limit :

Different authorities have power to sanction different amount according to the grade

of borrower.

Total Aggregate Group Exposure Sub-limit for increases/ New Business

within Total

Grade 1-3 Grade 4-5

Grade

6-8 Grade 1-3 Grade 4-5

Grade 6-

8

Level I 1.58 1.05 0.53 0.59 0.40 0.20

Level II 4.73 3.15 1.58 1.58 1.05 0.53

Level III 11.81 7.88 3.94 3.94 2.63 1.31

Level IVa 39.38 26.25 11.81 11.81 7.88 3.94

Level IVb 47.25 31.50 15.75 19.69 13.13 6.56

Level V 78.75 52.50 42.00 39.38 26.25 21.00

Level VI

Any amount Maximum 78.75

Level VII Any amount



ASSET AND LIABILITY MANAGEMENT (ALM)

The ALM Committee was made in B.B.K. to take the necessary action once

the ALM process gets completed.

In the ALM Process consists of the following steps:

1. Risk identification, measurement and management.

2. Risk Policies and tolerance levels.

1. Liquidity Risk Management

This is very crucial & very important risk management. Liquidity needs are vital for

effective operation of banks. By assuring to meet the liabilities as they become due,

liquidity management can reduce the probability of adverse situations developing.

In B.B.K. Liquidity can be tracked by preparing following three statement,

Liquidity can be tracked through maturity or cash flows mismatches. For measuring and

managing net funding requirements, the use of maturity ladder and calculation of

cumulative surplus or deficit of funds, at select maturity dates can be adopted.


LIQUIDITY RISK

Structural Liquidity

StatementMAP Statement

Dynamic Liquidity

Statement

144


Structural Liquidity Statements.

The Structural Liquidity statement was prepared as per RBI guidelines as to the

classification into time buckets (all INR position and maturities).

This structural liquidity statement was prepared every fortnightly basis.

Mismatches in the shorter time buckets (say up to 1-year) were given attention as these

could provide early warning signals of impending liquidity problems.

Time buckets are to be divided into 8 ranges with the first time bucket 1 to 14 days and

the last, over 5 years.

Tolerance limits as mentioned below have been set:

(i) 1 to 14 days = -20%

(ii) 15 to 28 days = -20%

(iii) 29 days and up to 3 months = -30%

(iv) Over 3 months and up to 6 months = -30%

(v) Over 6 months and up to 1 year = -30%

(vi) Over 1 year and up to 3 years = -30%

(vii) Over 3 years and up to 5 years = -30%

(viii) Over 5 years = -30%

In the case of negative gaps, ALMC discuss liquidity / funding strategies.

Few of the options, the bank to resort to incase of short-term liquidity, are as follows:



1. Call-money borrowing.

2. Utilising Line of Credits (Forex swaps – if in foreign currency)

3. Repo transactions

4. Selling T-bills

Maturity and Position Statement (MAP) is prepared on a monthly basis, as per RBI

guidelines. This statement is similar to the Structural Liquidity Statement except that it

takes into account all foreign currency positions and maturities.

Dynamic Liquidity Statement is t prepared to monitor short-term liquidity on a dynamic

basis over a time horizon spanning from 1 to 90 days. The short-term liquidity profiles

are estimated on the basis of business projections and other commitments. If any negative

mismatch exists, the sources of funding need to be reviewed / looked at closely.

All the above statements were prepared on a monthly basis, taking into consideration the

present system and MIS capabilities. However it is the intention of the bank to move

towards fortnightly preparation of the statements, which will be possible only on

upgrading or implementation of new systems.

Apart form the above analysis the cap limit on lending & borrowing were made to have

control over the liquidity risk.

Cap on Call Money Borrowings:

Ceiling on call borrowing on a fortnightly average basis will be higher of:

100% now w.e.f April 03, 2004 of owned funds as at 31st March of the previous year.

OR



2.00 % of aggregate deposit as at 31st March of the previous year.

Ceiling for Call / Notice Lending on any day:

25% of Owned funds as at 31st March of the previous year.

And on any day, up to 50% of net owned funds as on 31st March of the previous year.

2. Interest Rate Risk

Interest rate risk is the exposure of earnings and equity to movements in market rate of

interest.

The immediate impact of changes in interest rates is on banks earnings (i.e. reported

profits), by changing its net interest income (NII) (i.e. earnings perspective). A long term

impact of changing interest rates is on the bank’s market value of equity (MVE) as the

economic value of banks assets, liabilities and off-balance-sheet positions, get affected

due to variations in market interest rates (i.e. economic value).

The objective of interest rate management is to develop a supportable framework for

measuring different types of risk

Three tools for analysing interest rate risks are:

1. Gap analysis

2. Duration and

3. Value at Risk

Gap Analysis:

The Gap is the difference between Risk Sensitive Assets (RSA) and Risk Sensitive



Liabilities (RSL) for each time bucket.

An asset or liabilities were classified as rate sensitive if it is able to generate interest

income or expense.

Interest rate sensitivity statement

An asset or liability will normally be classified as rate sensitive if:

(i) Within the time interval under consideration, there is a cash flow;

(ii) The interest rate resets / reprices contractually during the interval;

(iii) RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, Export

credit, Refinance, CRR balance, etc.) in cases where interest rates are administered; and

(iv) It is contractually prepayable or withdrawable before the stated maturities.

The gaps may be identified in the following time buckets:

(i) 1-28 days

(ii) 29 days and up to 3 months

(iii) Over 3 months and up to 6 months

(iv) Over 6 months and up to 1 year

(v) Over 1 year and up to 3 years

(vi) Over 3 years and up to 5 years

(vii) Over 5 years

(viii) Non-sensitive.

The statement was prepared as follows:

(i)All assets and liabilities in INR (Interest Rate Sensitivity Statement) and in addition

another statement of assets and liabilities which considers both INR and foreign currency.

(ii)All assets and liabilities in foreign currency, as per RBI guidelines (Sensitivity of



interest rates statement).

(iii)The above statements were prepared on a monthly basis and as per the RBI

guidelines, as classification per rate sensibility and time buckets.

With respect to the Interest Rate Sensitivity statement for RBI purposes, the limits set are

as follows:

Time Bucket -ve gap +ve gap

1-28 days 40 20

29days-3 months 30 20

3-6 months 30 20

6-12 months 30 20

1-3 years 30 30

3-5 years 30 30

Based on interest rate outlook, the gaps are discussed / reviewed at ALMC in order to

hedge / Minimise interest rate risk and start planning funding / replacement strategies on

a timely basis

Cost of Maturing Deposits:

The cost of maturing deposit statement is prepared by the Risk Management Department

with the intention to keep a track of the weighted average cost of deposits held. The

statement reflects the currency-wise, tenor-wise weighted average cost. This statement is

reviewed and discussed at every ALCO meeting.

The members are able to (i) mark out those funds, which prove to be a cost burden to the

bank and repayment of, which will help the bank in reducing its interest burden

especially in a falling interest rate scenario and (ii) plan out timing and quantum of



replacement strategies.

TO MONITOR INVESTMENTS EXPOSURE

BBK-India is guided by and follows the Bank’s global investment policy. However,

while carrying out investment transactions, they also follow the guidelines issued by RBI

from time to time as applicable to the Indian market including the prudential norms and

per party / group exposure

The present risk monitoring systems in Investments are as follows:-

Stop-loss limit

Incase of Government of India securities immediate disposal will be required to be made

if there is decline in value by 2% or more. Retention of the same will require approval of

the GM & CEO – India.

Incase of Indian Corporate Debt Issues, if the market value falls by 5% or more; or if the

rating falls one notch below the rating at the time of purchase, whichever is earlier, such

securities will be required to be disposed off. Retention of the same will require approval

of the GM & CEO – India.

The SLR investment valuation report is prepared by the Mid-office which tracks the

market prices of all the SLR securities. All the securities, which have a market rate lower

than its cost, by a substantial margin, are closely monitored.

Long-term investments limit:-

Long–term investments (Held to Maturity) are investments, which the bank intends to

hold for a period exceeding 12 months or until maturity of the particular security. There



is a cap on investments in long-term securities at 25% of the total investments. This

provides the bank a better flexibility to move according to the market perceptions and

further incase of a depressed market the valuation in respect of such securities will be at

cost and not marked to market thereby curtailing the net impact on the profit and loss

account.

The HTM securities as a % to total investments are calculated and circulated along with

the SLR valuation report.

Dealer-wise limits

SLR Transactions:

Per Deal INR MM Per Day INR MM

Dealer50 500

Manager (Treasury) As per PIAH Level I* 750

Security Limits

Investments in the Strategic SLR securities is capped at INR 2000 MM

An investment in the Trading SLR securities is capped at INR 500 MM.

Broker Limits:

As per extant RBI guidelines on Investment portfolio of Banks, a limit of 5% of total

transactions (both purchase and sales contracts) entered into by a bank during a year is

treated as the aggregate upper contract limit for each of the approved brokers.



TO MONITOR LIQUIDITY

Call money limits

As per the RBI guidelines, the cap on the call money borrowing and lending is as

follows:

Call money borrowing

Daily limit: - 125% of the owned funds as on the last day of the previous year. In B.B.K.

for the year 2008-09 is 675,818,750 crore.

Fortnight average limit

Higher of :

a) 100% of the owned funds as on the last day of previous year

OR

b) 2% of aggregate deposits as on the last day of previous year.

Call money lending

Daily limit: 50% of the owned funds as on the last day of the previous year.

In B.B.K. for the year 2008-09 is the maximum limit is 270,327,500 crore.

Fortnight average limit: 25% of the owned funds as on the last day of the previous year.



Cash Reserve Ratio (CRR) Maintainence

Cash Reserve Ratio (CRR) is the one which the banks have to maintain with itself in the

form of cash reserves or by way of current account with the Reserve Bank of India (RBI),

computed as a certain percentage of its demand and time liabilities.

The present percentage is 4.50% of the total liabilities as on the reporting Friday. This is

the CRR requirement for the succeeding fortnight.

The mid-office maintains an excel sheet which lists out the daily balances for CRR.

Before the end of the day, provisional figures are obtained from the Front-office / back-

office (who also monitor CRR) and input into the excel sheet.

Statutory Liquid Ratio (SLR) Maintenance:

Statutory Liquidity Ratio (SLR) is the one BBK-India has to maintain in the form of cash,

gold or unencumbered approved securities, an amount which shall not, at the close of

business on any day be less than such percentage of the total of its demand and time

liabilities in India as on the last friday of the second preceding fortnight, as the Reserve

Bank of India (RBI) may specify from time to time.

Presently the SLR is 25% of the Demand and time liabilities.

Presently, front-office keeps a track on the SLR maintenance by maintaining excel sheets

which are updated after every transaction. At the same time, mid-office prepares a daily

report, which reports the SLR maintenance.



BASEL –II

Basel II is the second of the Basel Accords, which are recommendations on banking

laws and regulations issued by the Basel Committee on Banking Supervision.

The purpose of Basel II, which was initially published in June 2004, is to create an

international standard that banking regulators can use when creating regulations about

how much capital banks need to put aside to guard against the types of financial and

operational risks banks face.

B.B.K. has implemented the BASEL II from March 2008.

Basel II uses a "three pillars" concept –

(1) Minimum capital requirements (addressing risk),

(2) Supervisory review ,

(3) Market discipline – to promote greater stability in the financial system.

FIRST PILLAR :-

The first pillar deals with maintenance of regulatory capital calculated for three major

components of risk that a bank faces: credit risk, operational risk and market risk.

The credit risk component can be calculated in three different ways of varying degree of

sophistication, namely Standardized approach , Foundation IRB and Advanced IRB. IRB

stands for "Internal Rating-Based Approach".

For operational risk, there are three different approaches - basic indicator approach or


http://en.wikipedia.org/wiki/Basic_indicator_approach

http://en.wikipedia.org/wiki/Operational_risk

http://en.wikipedia.org/wiki/Advanced_IRB

http://en.wikipedia.org/wiki/Foundation_IRB

http://en.wikipedia.org/wiki/Standardized_approach

http://en.wikipedia.org/wiki/Credit_risk

http://en.wikipedia.org/wiki/Market_risk

http://en.wikipedia.org/wiki/Operational_risk

http://en.wikipedia.org/wiki/Credit_risk

http://en.wikipedia.org/w/index.php?title=Financial_stability&action=edit&redlink=1

http://en.wikipedia.org/wiki/Market_discipline

http://en.wikipedia.org/wiki/Basel_Committee_on_Banking_Supervision

http://en.wikipedia.org/wiki/Basel_Accords


BIA, standardized approach or STA, and advanced measurement approach or AMA.

For market risk the preferred approach is VaR (value at risk)

SECOND PILLAR

The second pillar deals with the regulatory response to the first pillar, giving regulators

much improved 'tools' over those available to them under Basel I. It also provides a

framework for dealing with all the other risks a bank may face, such as systemic risk,

pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal

risk, which the accord combines under the title of residual risk.

THIRD PILLAR

The third pillar greatly increases the disclosures that the bank must make. This is

designed to allow the market to have a better picture of the overall risk position of the

bank and to allow the counterparties of the bank to price and deal appropriately.

In B.B.K. only the pillar pillar I has been implemented.

Credit risk

Credit risk is defined as the risk of loss due to a debtor's non-payment of a loan or other

line of credit (either the principal or interest (coupon) or both) . so in this regard in

BASEL II different risk weight has been assigned to differernt credit funding .

In BASEL II there are some set assumption that is any advances above 5 Cr. Will be


BASEL -II

CREDIT RISK

(Standardized)

OPERATION RISK

( BIA)

MARKET RISK

(Standardized)

155

http://en.wikipedia.org/wiki/Interest

http://en.wikipedia.org/wiki/Loan

http://en.wikipedia.org/wiki/Counterparty

http://en.wikipedia.org/wiki/Market

http://en.wikipedia.org/wiki/Disclosure

http://en.wikipedia.org/wiki/Legal_risk

http://en.wikipedia.org/wiki/Legal_risk

http://en.wikipedia.org/wiki/Liquidity_risk

http://en.wikipedia.org/w/index.php?title=Reputation_risk&action=edit&redlink=1

http://en.wikipedia.org/w/index.php?title=Strategic_risk&action=edit&redlink=1

http://en.wikipedia.org/wiki/Concentration_risk

http://en.wikipedia.org/w/index.php?title=Pension_risk&action=edit&redlink=1

http://en.wikipedia.org/wiki/Systemic_risk

http://en.wikipedia.org/wiki/Bank_regulation

http://en.wikipedia.org/wiki/Value_at_risk

http://en.wikipedia.org/wiki/Market_risk

http://en.wikipedia.org/wiki/Advanced_measurement_approach




consider as the corporate advances and any advances below this is taken as retail

advances .

Similarly any exposure above the 0.2 % of lending come under the corporates head qand

anu exposure below this is ttaken as retail advances. Accordingly the risk weightege were

assigned as shown below in table.

Mar-08

Particulars Risk Weight

Credit Portfolio Funded

Staff Loans 20%

Consumer Loans 125%

Retail 75%

Corporate 100%

NBFC 125%

NBFC – USD 145%

Shares 100%

LIC Policy 0%

LCBD Inland BBK 100%


ADVANCES

CORPORATE

(Above 5 Cr & 0.2 % of lending) 0.2% of le

RETAIL

(Below 5 Cr.)

156


LCBD Scheduled Banks 20%

Funded Exposure counter guaranteed by HO 50%

Foreign Bills Negotiated/Purchased 20%

ECGC Cover 20%

FCY LOANS 100%

REAL ESTATE EXPOSURE 150%

HOUSING LOANS EXPOSURE-MORE THAN 30 LACS 75%

HOUSING LOANS EXPOSURE LESS THAN 20 lacs 50%

NPA"S

Unsecured (<20%)- Corporate 150%

Unsecured (20-49%)- Corporate 100%

Unsecured (20-49%) - Retail 100%

Investments (50%) 50%

INVESTMENTS

Investments Corporate Priority Sector(NHB) 20%

Investments Gsec 0%

Housing loans 75%

Others 20%

Nostro 20%

50%

RBI Balance 0%

Cash 0%

Placements 20%

Other Assets

Acc. Int on G-Sec 0%

Adv.Tax 0%

Int Rec on CRR 0%



Fixed Assets 100%

OTHERS 100%

Int Rec on Lendings 20%

Non Funded

Market related off balance sheet items

Unutilized Retail Limits 75%

Unutilized Corporate Limits 100%

Capital Commitment 100%

Retail-L/C /Acceptances

BG- Financial

BG- Performance

Corporate L/C 100%

Acceptances 100%

BG- Financial 100%

Counter guaranteed 50%

BG- Performance 100%





Market risk:

Market risk is defined as the risk of losses in on and off –balance sheet positions arising

from the movement in market prices.

The market risk is derived from two subjects.

a) The risks pertaining to Interest rate related instruments i.e. G-SEC.

b) Foreign exchange risk

CAPITAL CHARGE FOR MARKET RISK -" Annexure -

I"

Risk Category Capital Charge

1.Interest Rate (a + b) 258.72

a. General Market Risk 258.72

I ) Net Position (parallel shift) 258.72

ii ) Horizontal disallowance (curvature) 0.00

iii) Vertical disallowance (basis) 0.00

iv) Options 0.00

b. Specific Risk 0.00

2.Equity ( a+b) 0.00

a. General Market Risk 0.00

b. Specific Risk 0.00

3.Foreign Exchange & Gold 101.87

4.Total Capital Charge for market risks( 1+ 2+ 3 ) 360.59



The above interest rate were derived from the G-SEC investment the desired i.e. taking

the trading book accounts (AFS & HFT) portfolio. The capital charges were calculated

from the Modified duration, yield & market value. The product of all tells us about the

capital charge of investment.

The capital charge of investment = Md * Yield * M.V.

Interest rate income arises from the G-SEC portfolio.

Security Cost Price Md Remaining

Maturity

Assumed

Change

in yield

Capital

charge

7.57%

FRB

2012

100.05 100.97 3.72 4.6 0.70 2.61 2630949.30

7.85 %

FRB

2013

99.99 102.68 4.34 5.4 0.70 3.04 6241506.22

7.86%

FRB

2014

101.48 101.51 4.68 6.1 0.65 3.04 6179254.44

7.83%

FRB

2016

99.36 101.34 5.73 8.1 0.60 3.44 6965098.20

7.99%

GOI

2017

102.85 100.32 6.41 9.3 0.60 3.84 3855502.66

TOTAL 25872310.82



Foreign Exchange & Gold

As on 31-Mar-08 (Rs. )

ZONE 1

TIME

BAND 0-1 mth 1-3 mths 3-6 mths 6m-1y Total

Bonds

-

FX forwards

(long)

20

0,391

740,43

2

100

,723

247,524

1,289,07

0.28

Derivatives

(long)

- -

-

-

-

Derivatives

(long)

20

0,391

740,43

2

100

,723

247,524

1,289,07

0.28

Derivatives

(short)

- -

-

-

-

FX forwards

(short)

(5

8,369)

(694,61

0)

(214

,722)

(

128,782)

(1,096,48

3.70)

Derivatives

(short)

(

58,369)

(694,61

0)

(214

,722)

(128,782)

(1,096,48

3.70)

Net Positions 14

2,022

45,82

2

(113

,999)

118,742

192,58

6.58

Vertical

Disallowance

(5%)

2,9

18.45

34,73

1

5,03

6.17

6,439.10

49,12

4.23

Horizontal

Disallowance

1(within the

(45

,600)

45,59

9.61



same zone)

Horizontal

Disallowance

2 (adjacent

Zones -

1&2,2&3)

-

Horizontal

Disallowance

3 (Zone 1&

3)

-

TOTAL

287,31

0.42

287,31

0.42

OPEN POSIITON

LIMIT

110,00

0,000.00

9,900,00

0.00

10,187,31

0.42 101.87

113,192,33

7.99

IF buying is greater then selling then it is called as long position. Like suppose I

have purchased more dollars in this month then that of selling so I am in a long

position.

If selling is more then buying then it is called as short position.



If the net position is long then it is applicable as vertical disallowance i.e. it

qualified under the 5 % disallowance.

If the net position is short it qualified as 40% horizontal disallowance.

Then 9 % on the net open position were taken as risk weightge.

Total of all is qualified as a value for the FOREX risk weight.

COMPONENTS OF MARKET RISK:

The risk that movements in equity and interest rate markets, currency exchange rates and

commodity prices will adversely affect the value of on-or-off-balance-sheet positions is

defined as market risk. The main components of market risk are therefore equity,

interest rate, forex and commodity risk.

In addition to market risk, the price of financial instruments may be influenced by the

following residual risks:

Spread Risk is the potential loss due to changes in spreads between two instruments.

For example, a foreign exchange trader who is hedging a short forward position with a

long spot position is taking spread risk. While the spot position is sensitive only to

changes in the exchange rate, the forward position is also affected by yield curve shifts.

Accordingly, the two positions do not perfectly hedge one another, and the trader is

taking spread risk.

Basis Risk is the potential loss due to pricing difference between equivalent instruments,

such as futures, bonds and swaps. Hedged portfolios are often exposed to basis risk.

For example, if the LIBOR decreases, all the LIBOR linked loans will yield lesser

interest, however the deposit rates will remain the same thereby reducing the margins.



Such exposure is known as Basis Risk.

Specific Risk refers to issuer specific risk (e.g., the risk of holding equity of a particular

entity.)

To determine the total risk of financial instruments, we aggregate market risk with

residual risk.

Diversification:

Risk is not additive. Total risk is less than the sum of its parts because of diversification

between different assets and risk components (i.e. correlation would never be 1). For

example, if a USD based investor holds INR denominated bond, he is exposed to rising

INR interest rates and devaluation of INR relative to USD. Clearly, his total risk is not

just the interest rate and Forex risk added together, because the likelihood that interest

and forex rates both moving out of his favour at the same time is less than 100%. This

effect is described as diversification benefit

Thus Diversification benefit is defined as total risk minus the sum of all individual risk

components.

Operation risk:


Market

Risk

Interest

FX

Equity

Residual Risk

Spread

Basis

Specifi

TOTAL PRICE + =


In as per the R.B.I. Norms last 3 year balance sheet figure were taken for the risk

analysis.

Computation of Capital Charge for operational risks (Basel II)

Rs in lakes

2006 2007 2008

Net Profit (669.82) (811.84) 1921.83

Add:

Provision & Contingencies 875.04 1,459.02 -647.43

Operating Expenses (Sch.16) 1,190.62 1,072.75 1218.51

Loss on HTM Investments -

Less:

Profit on sale of HTM

investments -

Income from insurance -

Extraordinary /Irregular

Income (43.75) (170.45) -388.42

Gross Income 1,352.09 1,549.48 2,104.49

Average Gross income 1,668.69

15% of gross Income 250.30

Summary of BASEL II



SUMMARY

RISK WEIGHTED ASSETS

Credit Risk 24252.24

Market Risk 4006.56

Operational Risk 2781.14

GRAND TOTAL 31039.94

TIER I CAPITAL 6341.83

TIER II CAPITAL 331.86

TOTAL CAPITAL 6673.69

Total CRAR 21.50

Core CRAR 20.43

TIER I Capital is the core measure of a bank's financial strength from a regulator's

point of view. It consists primarily of shareholders' equity but may also include preferred

stock that is irredeemable and non-cumulative and retained earnings. Head office

borrowing in foreign currency.

TIER II Capital is a measure of a bank's financial strength with regard to the second

most reliable form of financial capital, from a regulators point of view. It also include the

generaL PROVISION AND LOSS RESERVES , revaluation reserves ,these reserve often

serves as a cushion against unexpected losses , less permanent in nature & can not be

consider as Core Capital.


http://en.wikipedia.org/wiki/Retained_earnings

http://en.wikipedia.org/wiki/Preferred_stock

http://en.wikipedia.org/wiki/Preferred_stock

http://en.wikipedia.org/wiki/Regulator

http://en.wikipedia.org/wiki/Bank


IMPORTANT CONTRIBUTION

TO

BANK BY ME



Important contribution to bank

Fixing deposits rates

Fixing the deposits rates when s.b.i. hike its deposits rate . noemally in B.B.K. they keep

close watch over the s.b.i. activity fixing the deposits rate is one of them .

Deposit Interest Rates

1-2 2-3 3-5 5 & Above

Highest quoted 10.11% 10.0% 10.0% 10.0%

Lowest quoted 6.75% 7.5% 8.0% 7.50%

Quoted by S.B.I 8.25% 8.75% 8.85% 9.0%

Quoted by B.B.K 8.0% * 8.25% 8.25% -

Proposed Quote by

B.B.K

8.25% 8.75% 9.0% 9.25%

* for 13 months @ 9.0% & for 18 months @ 9.1 %

Highest quoted by Kotak , K.V.B. Kotak , Kotak,

Lowest quoted by ICICI , ICICI, UTI , J&K Bank.

Home Loan Interest Rates



Highest quoted by H.D.FC.

Lowest quoted by Citi Bank .

2. Implementation of VaR factor .

Value at Risk (VAR) calculates the maximum loss expected (or worst case scenario) on

an investment, over a given time period and given a specified degree of confidence.

With a given confidence level, it asks, "What is the maximum expected loss over a

specified time period?" There are three methods by which VAR can be calculated: the

historical simulation, the variance-covariance method, and the Monte Carlo simulation

The idea behind VaR

The most popular and traditional measure of risk is volatility. The main problem with

volatility, however, is that it does not care about the direction of an investment's

movement: a stock can be volatile because it suddenly jumps higher. Of course, investors

are not distressed by For investors, risk is about the odds of losing money, and VAR is

based on that common-sense fact. By assuming investors care about the odds of a really

big loss, VAR answers the question, "What is my worst-case scenario?" or "How much


Up to 5

year

( floating )

Above 5

years

( floating)

Up to 5

years

(fixed )

Above 5

years

(fixed)

Highest quoted 11.25% 11.25% 13.25% 13.25%

Lowest quoted 9.0% 9.0% 9.75% 9.75%

Quoted by S.B.I 10.75% 11.25% 12.25% 12.25%

Quoted by B.B.K - - - -

Proposed Quote by

B.B.K

11.25% 11.25% 13.25% 13.25%

169

http://www.investopedia.com/terms/v/volatility.asp


could I lose in a really bad month?"

Now let's get specific. A VAR statistic has three components: a time period, a confidence

level and a loss amount (or loss percentage). Keep these three parts in mind as we give

some examples of variations of the question that VAR answers:

What is the most I can - with a 95% or 99% level of confidence - expect to lose

in dollars over the next month?

What is the maximum percentage I can - with 95% or 99% confidence - expect to

lose over the next year?

You can see how the "VAR question" has three elements: a relatively high level of

confidence (typically either 95% or 99%), a time period (a day, a month or a year) and an

estimate of investment loss (expressed either in dollar or percentage terms).

Methods of calculating VaR :-

Institutional investors use VAR to evaluate portfolio risk, but in this introduction we will

use it to evaluate the risk of a single index that trades like a stock: the Nasdaq 100 Index,

which trades under the ticker QQQQ. The QQQQ is a very popular index of the largest

non-financial stocks that trade on the Nasdaq exchange.

There are three methods of calculating VAR: the historical method, the variance-

covariance method and the Monte Carlo simulation.

1. Historical Method:

historical method simply re-organizes actual historical returns, putting them in order from

worst to best. It then assumes that history will repeat itself, from a risk perspective.

The QQQ started trading in Mar 1999, and if we calculate each daily return, we produce a

rich data set of almost 1,400 points. Let's put them in a histogram that compares the


http://www.investopedia.com/terms/m/montecarlosimulation.asp

http://www.investopedia.com/terms/q/qqq.asp

http://www.investopedia.com/terms/i/index.asp


frequency of return "buckets". For example, at the highest point of the histogram (the

highest bar), there were more than 250 days when the daily return was between 0% and

1%. At the far right, you can barely see a tiny bar at 13%; it represents the one single day

(in Jan 2000) within a period of five-plus years when the daily return for the QQQ was a

stunning 12.4%!

Notice the red bars that compose the "left tail" of the histogram. These are the lowest 5%

of daily returns (since the returns are ordered from left to right, the worst are always the

"left tail"). The red bars run from daily losses of 4% to 8%. Because these are the worst

5% of all daily returns, we can say with 95% confidence that the worst daily loss will not

exceed 4%. Put another way, we expect with 95% confidence that our gain will exceed -

4%. That is VAR in a nutshell. Let's re-phrase the statistic into both percentage and dollar

terms:

With 95% confidence, we expect that our worst daily loss will not exceed 4%.

If we invest $100, we are 95% confident that our worst daily loss will not exceed

$4 ($100 x -4%).

You can see that VAR indeed allows for an outcome that is worse than a return of -4%. It

does not express absolute certainty but instead makes a probabilistic estimate. If we want



to increase our confidence, we need only to "move to the left" on the same histogram, to

where the first two red bars, at -8% and -7% represent the worst 1% of daily returns:

With 99% confidence, we expect that the worst daily loss will not exceed 7%.

Or, if we invest $100, we are 99% confident that our worst daily loss will not

exceed $7.

2. The Variance-Covariance Method

This method assumes that stock returns are normally distributed. In other words, it

requires that we estimate only two factors - an expected (or average) return and a

standard deviation - which allow us to plot a normal distribution curve. Here we plot the

normal curve against the same actual return data:

The idea behind the variance-covariance is similar to the ideas behind the historical

method - except that we use the familiar curve instead of actual data. The advantage of


http://www.investopedia.com/terms/s/standarddeviation.asp

http://www.investopedia.com/terms/e/expectedreturn.asp


the normal curve is that we automatically know where the worst 5% and 1% lie on the

curve. They are a function of our desired confidence and the standard deviation ( ):

The blue curve above is based on the actual daily standard deviation of the QQQ, which

is 2.64%. The average daily return happened to be fairly close to zero, so we will assume

an average return of zero for illustrative purposes. Here are the results of plugging the

actual standard deviation into the formulas above:

3. Monte Carlo Simulation

The third method involves developing a model for future stock price returns and running

multiple hypothetical trials through the model. A Monte Carlo simulation refers to any

method that randomly generates trials, but by itself does not tell us anything about the

underlying methodology.

For most users, a Monte Carlo simulation amounts to a "black box" generator of random

outcomes. Without going into further details, we ran a Monte Carlo simulation on the

QQQ based on its historical trading pattern. In our simulation, 100 trials were conducted.

If we ran it again, we would get a different result--although it is highly likely that the



differences would be narrow. Here is the result arranged into a histogram (please note

that while the previous graphs have shown daily returns, this graph displays monthly

returns):

To summarize, we ran 100 hypothetical trials of monthly returns for the QQQ. Among

them, two outcomes were between -15% and -20%; and three were between -20% and

25%. That means the worst five outcomes (that is, the worst 5%) were less than -15%.

The Monte Carlo simulation therefore leads to the following VAR-type conclusion: with

95% confidence, we do not expect to lose more than 15% during any given month.

Summary

Value at Risk (VAR) calculates the maximum loss expected (or worst case scenario) on

an investment, over a given time period and given a specified degree of confidence. We

looked at three methods commonly used to calculate VAR. But keep in mind that two of

our methods calculated a daily VAR and the third method cal

VALUE-AT-RISK

Financial institutions and corporate Treasuries require a method for reporting their risk

that is readily understandable by non-financial executives, regulators and the investment



public and they also require that this mechanism be scientifically rigorous. The answer to

this problem is Value-at-Risk (VaR) analysis. VaR is a number that expresses the

maximum expected loss for a given time horizon and for a given confidence interval and

for a given position or portfolio of instruments, under normal market conditions,

attributable to changes in the market price of financial instruments.

What does this mean in English? Suppose that we are investment managers with

positions in foreign exchange, fixed income and equities. We need an assessment of what

we can expect the worst case to be for the position overnight with a 95% degree of

confidence. The VaR number gives us this measurement. For example, the portfolio

manager might have 100 million dollars under management and an overnight-95%

confidence interval VaR of 4 million dollars. This means that 19 times out of 20 his

biggest loss should be less than 4 million dollars. Hopefully, he is making money instead

of losing money. You can also express VaR as a percentage of assets, in this case 4%.

VaR is also useful when we want to compare the riskiness of different portfolios. Let us

now consider two portfolio managers. Each of them starts the year with 100 million

dollars under management. Bob makes a return of 30%, handily beating his target of

20%. Jerry makes a return of 20%, coming in on target. Who is the better fund manager?

The answer is, as economists always say, it depends. To make an accurate judgment,

many people believe that we need to compare the risk involved.

Let's say that Bob's average overnight-95% VaR was 7 million dollars and Jerry's average

overnight-95% VaR was 2 million dollars. One way of calculating Bob's return on risk

capital is as follows: 30 million dollars/7 million dollars=428.6% Using the same

method, Jerry's return on risk capital is: 20 million dollars/2 million dollars=1000.0% It

could be reasonably argued that Jerry is a better fund manager in that he used his risk

capital more efficiently. How many people when they invest in mutual funds know

anything about the risk that their portfolio managers take in generating a return? Most

mutual funds do not report this kind of risk-adjusted number, although some of them

could use it to justify or explain their actions.



This is especially important when evaluating how closely a portfolio manager conformed

to the stated risk tolerance of his fund. If the fund is advertising itself as a very low-risk

investment vehicle suitable for widows and orphans, the average daily VaR as a

percentage of assets is an interesting number, especially when compared to the same

number for more openly risky investments. Corporate Treasuries and Banks use VaR for

the same purpose. They need to have an idea of how their market exposures behave under

normal market conditions. It is a risk management cliché but you know that you have a

bad risk management regime in place if you are surprised by the extent of any gains or

losses that you sustain.

CALCULATING VALUE-AT-RISK

Value-at-Risk is scientifically rigorous in that it utilizes statistical techniques that have

evolved in physics and engineering. VaR is questionable in that it makes assumptions in

order to use these statistical techniques. Chief among these assumptions is that the return

of financial prices is normally distributed with a mean of zero. The return of a financial

price may be thought of as the capital gain/loss that one might expect to accrue from

holding the financial asset for one day.

For example, in the case of foreign exchange, if I own one Canadian dollar against being

short 1 US dollar, I will earn a return overnight if the Canadian dollar appreciates against

the US dollar. One way of expressing the return is the difference between the current

price and the previous period's price, divided by the previous period's price. JP Morgan

has developed a methodology for calculating VaR for simple portfolios (i.e. portfolios

that do not include any significant options components) called RiskMetrics. The success

of RiskMetrics has been so great that Morgan has spun off the RiskMetrics group as a

separate company.

RiskMetrics forecasts the volatility of financial instruments and their various correlations.

It is this calculation that enables us to calculate the VaR in a simple fashion. Volatility

comes into play because if the underlying markets are volatile, investments of a given

size are more likely to lose money than they would if markets were less volatile.



Volatility here refers to the distribution of the return around the mean. A volatile market

is one in which the returns can vary greatly around the mean while a calm market is one

in which the returns vary little around the mean.

Correlation is important, too. Modern portfolio theory is familiar to many people who

intentionally diversify their investments. If we invest all of our money in a set of financial

instruments that move in the same direction and with the same relative speed, that is a

riskier portfolio than if we invest in a portfolio of financial instruments that move in

different directions at different speeds. If the instruments in the former portfolio all move

down, we will lose money on each of these instruments whereas we would expect to

make money on some instruments and lose money on the remaining instruments in the

latter portfolio. Hopefully, in the case of the latter portfolio, we make more money than

we lose, on average.

Earlier, we stated that volatility was both dynamic and persistent. That is to say, volatility

changes over time but it moves in a trending fashion. Correlation is dynamic, too.

Correlations move with less persistence than volatilities. It is easy to see how complex

the management of financial price risk can be with a portfolio containing more than two

or three instruments. For more information, visit the RiskMetrics web site at

http://www.riskmetrics.com. Once optionality is involved, it becomes computationally

difficult to calculate the VaR, in some cases requiring statistical simulation of the

portfolio. The reason for this is because of the convexity of option products.

Straightforward VaR calculation underestimates or overestimates the VaR, depending on

whether or not one is long or short convexity (i.e. whether one owns or has sold options).

SCENARIO ANALYSIS

In describing VaR, I have emphasized the fact that VaR is only good for calculating an

expected maximum loss under normal market conditions. Because of the generally

idiosyncratic nature of financial prices, we must have a way of understanding the

implications for our portfolio of abnormal market conditions. Scenario analysis is the tool

we use for this purpose. Consider the portfolio manager from our original example in this



article who has an overnight-95% VaR of 4 million dollars on underlying assets of 100

million dollars. The VaR number that our calculator generates describes his expected loss

under normal market conditions. An important, critical adjunct procedure to VaR

measurement is scenario analysis. In scenario analysis, the portfolio manager will

simulate various hypothetical evolutions of events in order to determine their effect on

the value of the portfolio.

For example, a Canadian bond portfolio manager in September 1995 would have been

engaging in some heavy-duty scenario analysis to determine at all times what the effects

of a Yes vote in the October 1995 Quebec separation referendum would have been. There

are an infinite number of possible scenarios that the portfolio manager or investor could

consider. However, it is possible to reduce this universe of possibilities to a set of

important tests of the stressors of a portfolio of financial instruments.

Any portfolio manager must understand what the weak spot is in his portfolio. Naturally,

this is the first set of scenarios to simulate. By determining the change in value of his

portfolio under stressful conditions (called "stress-testing"), the portfolio manager has a

better perception of where the risks in his portfolio lie. At that point, he can make trades

that reduce this risk to levels with which he is comfortable. At the very least, he has an

appreciation of what will happen so that if the worst-case does take place unexpectedly,

he can act more decisively and more quickly to manage his portfolio. Without this kind of

stress-testing, he will be forced to react in a moving market, a situation that can

exacerbate his market losses. In a complex derivatives portfolio, stress-testing that

reveals excessively risky exposures either to movements in the underlying cash rate or

shifts in implied volatility or interest rates (or combinations of these factors) is said to

identify "risk holes."

For example, an options portfolio that is short a great deal of short-dated options around a

particular strike is said to have a "gamma hole" around that strike and date (analogous to

space and time, in a physical sense). If the underlying rate were to move to the same level

as the strike price around the same time as the options were maturing or just before, the

portfolio would become very difficult to manage and the profitability of the portfolio



could become intolerably volatile. The bottom line here is that all of these ways of

measuring risk must be interpreted in terms of the preferences of the investor or the

institution managing the risk.

Conclus ion & Suggestion

In my view since in treasury there is no intraday trading option in G-SEC Market

that should be implemented; by intraday trade the trader will be able to take the

benefits of price appreciation and can able to make good profit.

Bank should do more lending to EXPORTER with this exposure there is double

benefits one is in term of priority sector lending , another is hedging of forward

fees can be taken.

Bank should also start looking investment in MUTUAL FUND , because

nowdays this is more preferable option then equity market.

Corporate banking lending should not be only on the basis of only tangible asset it

should be more on the basis of operating business prospective.

Bank should look for the counterparty businee with HDFC Bank , because in

India this is the second most leading bank , similar steps can be taken with YES

bank also.



Reference

Agarwal, J. D., “Equity investment and Economic Growth in India: 1970-1991”, Security

analysis & portfolio management, 2000, pp. 5-12.

Anthony Saunders & Cornett ., “ financial market and Institutions , financial market ,

2000, pp . 119 – 278.

Brigham & Ehrhardt, “Analysis of financial management” Financial Management, 2002,

pp. 74-84

Barealey & Myers, “Risk and Return” Principle of Corporate Finance, 2005, pp. 187-

221

Brigham & Ehrhardt, “Risk and Return: The Basis” Financial Management, 2002, pp.

225-229

Donald E. Fisher and Ronald J. Jordan, “Industry analysis”Security analysis and

Portfolio management, 2004, pp. 130 -157

India’s external financial openness and Economic Growth (1970-2000), Finance India,

Vol XX No. 3, September 2006, pp. 853-871

Reilly & Brown, “Industry Analysis” Investment analysis and portfolio Management,

2005, pp. 486-539



Statistic of Indian Economy, Finance India, Vol XX No. 4, December 2006, pp. 1547

Economic Aspects of Access to Medicines after 2005: Product Patent Protection and

Emerging Firm Strategies in the Indian Pharmaceutical Industry By Padmashree Gehl

Sampath, United Nations University-INTECH

Birrittier, Tony.Key Performance Indicators to Maintain Strategic Focus. from

http://www.businessintelligence.com/biarticles

Report on manufacturing sector from

http://www.equitymaster.com/research-it/sector-info/pharma/

Key Statistics of abrasive industry from

http://www.indiaoppi.com/keystat

Transforming India in Knowledge Power

http://chemicals.nic.in/pharma3.htm#pharma

Institute for International Research

http://www.ibclifesciences.com/index.xml

Sectoral reports: banking industry by Abn Amro, 2006Data for comparison:

www.bbkonline.com

www.google.com

www.investopedia.com

www.treasury.com

www.moneycontrol.com

www.rbi.org.in

www.sbi.com


http://www.sbi.com/

http://www.rbi.org.in/

http://www.moneycontrol.com/



http://chemicals.nic.in/pharma3.htm#pharma

http://www.indiaoppi.com/keystat


dhiraj tiwari

Documents

treasury management

liquidity management

project work

alm management

project report

mentioned project

education institute

dhiraj kumar tiwari