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CHAPTER 1: INTRODUCTION1.1 Meaning & Definition
In general terms and from the perspective of commercial banking, treasury refers to the fund
and revenue at the possession of the bank and day-to-day management of the same. Idle
funds are usually source of loss, real or opportune, and, thereby need to be managed,
invested, and deployed with intent to improve profitability. There is no profit or reward
without attendant risk. Thus treasury operations seek to maximize profit and earning by
investing available funds at an acceptable level of risks. Returns and risks both need to be
managed. If we examine the balance sheets of Commercial Banks, we find
investment/deposit ratio has by far overtaken credit/deposit ratio. Interest income from
investments has overtaken interest income from loans/advances. The special feature of such
bloated portfolio is that more than 85% of it is invested in government securities.
The reasons for such developments appear to be as under:
Poor credit off-take coupled with high increase in NPAs.
Banks' reluctance to cut-down the size of their balance sheets.
Government's aggressive role in lowering cost of debt, resulting in high inventory
profit to commercial banks.
Capital adequacy requirements.
The income flow from investment assets is real compared to that of loan-assets, as
the latter is size ably a book-entry.
In this context, treasury operations are becoming more and more important to the banks and
a need for integration, both horizontal and vertical, has come to the attention of the
corporate. The basic purpose of integration is to improve portfolio profitability, risk-
insulation and also to synergize banking assets with trading assets. In horizontal integration,
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dealing/trading rooms engaged in the same trading activity are brought under same policy,
technological and accounting platform, while in vertical integration, all existing and diverse
trading and arbitrage activities are brought under one control with one common pool of
funding and contributions.
Meaning:
Treasury is the glue binding together liquidity management, asset/liability management,
capital requirements and risk management. It has an increasingly important job to do. At one
end of the spectrum it manages balance sheets and liquidity, and does good things to
enhance the yield on assets and minimize the cost of liabilities, mostly through the clever
and intelligent use of derivatives. At the other end of the spectrum, treasury can help
restructure the balance sheet and provide new products.
All banks have departments devoted to treasury management, as do larger corporations.
Treasury management modules are available for many larger enterprise software systems.
Banks do not disclose the prices they charge for Treasury Management products.
Definition:
Treasury management is the management of an organizations liquidity to ensure that the
right amount of cash resources are available in the right place in the right currency and at the
right time in such a way as to maximize the return on surplus funds, minimize the financing
cost of the business, and control interest rate risk and currency exposure to an acceptable
level.
In other words,Treasury management (or treasury operations) includes management of an
enterprise' holdings in and trading in government and corporate bonds, currencies, financial
futures, options and derivatives, payment systems and the associated financial risk
management.
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1.2 Objectives of Study
To have in-depth knowledge about the meaning of Treasury Management.
To know about the functions, organizational structure and objective of Treasury
Management in Banks.
To understand the elements of Treasury Management and the functions of treasurer.
To understand the risk associated with Treasury Management and their mitigation.
To know what are the RBI guidelines formulated for Treasury Management.
To know the future scope involved in Treasury Management.
To have an in-depth knowledge of how SBI Bank & CITI Bank manages its treasury.
1.3 Scope of Study
Treasury management includes the management of cash flows, banking, money market and
capital-market transactions; the effective control of the risks associated with those activities;
and the pursuit of optimum performance consistent with those risks. This definition is
intended to embrace an organizations use of capital and project financings, borrowing,
investment, and hedging instruments and techniques.
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1.4 Review of Literature
Abstract 1:
http://www2.warwick.ac.uk/fac/soc/wbs/subjects/finance/fof2012/programme/managing_of_
treasury_transactions_and_e.pdf /
Managing of Treasury transactions in banking SystemWithin a multi currency
economy
Author: Nidal Rashid Sabri (2012)
Diama K. Abulabn (2012)
Dima W. Hanyia (2012)
The Palestinian economy has no national currency which led to having three currencies in
use for deposits, saving, wealth measurement and trade transactions. Thus leads to make
challenges to the management of banking treasury activities and balances of each single
currency in the Palestinian economy. Therefore, this research aimed to target this issue,
using three research instruments. Three research instruments were used including:
Examining the related laws, imposed by the PMA on banks working in Palestinian economyas well as individual banking regulations, structures interviews with banks treasurers, and a
relevant questionnaires was directed to a selected samples of treasury staff and employees
regarding challenges to the management of banking treasury and closeting of foreign
currency positions. The study found that management of the banks working in the
Palestinian economy imposed more strict levels then that imposed by PMA and decreased it
to 1% to 3%, of the total owner equity instead of 5%, while others (42%) reduced the
maximum permitted surplus of a currency to a value ranged between 200,000 US$ and
500,000 US$. For closing the surplus of currencies, the majority of banks close it in the last
hour of working day. The majority of treasuries' staff strongly agreed that there is a need for
additional legislation to cover all related transactions to facilitate the work of the treasury.
The study recommended to relaxing the maximum ratio of 5% imposed on each single
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http://www2.warwick.ac.uk/fac/soc/wbs/subjects/finance/fof2012/programme/managing_of_treasury_transactions_and_e.pdf/http://www2.warwick.ac.uk/fac/soc/wbs/subjects/finance/fof2012/programme/managing_of_treasury_transactions_and_e.pdf/http://www2.warwick.ac.uk/fac/soc/wbs/subjects/finance/fof2012/programme/managing_of_treasury_transactions_and_e.pdf/http://www2.warwick.ac.uk/fac/soc/wbs/subjects/finance/fof2012/programme/managing_of_treasury_transactions_and_e.pdf/ -
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currency to be hold more than blatancies, keeping the 20% level from owner equity to the
total of currencies, extending the time of work including Fridays, reducing the restrictions on
investments outside Palestine, permitting trading in options and future transactions including
duke deposits and margins
Abstract 2:
http://www.tanzaniabankers.org/TBA%20-%20Currency%20Risk%20Management.pdf
A STUDY ON THE ROLE OF TREASURY MANAGEMENTON CURRENCY RISK
MANAGEMENT: THE CASE OF SELECTED COMMERCIAL BANKS
Author: Moremi Marwa: (2005)
The increased volatility of the international foreign exchange market generates increased
financial risk especially to commercial banks. Exchange rate change is one of the financial
risks where the increased volatility is reflected to the greatest extent. Therefore, if banks are
to measure, price, and control currency risk, they must establish an appropriate unit
responsible for currency risk management. This paper attempts to show that, commercial
banks in Tanzania have the necessary resources to curb risks associated to currency risks.This paper briefly provide some highlights on the research findings as regards to the role of
treasury management in currency risk management and then poses recommendations and
challenges on the magnitude of sustainability of the registered best practice for currency risk
management in commercial banks. The study employed both primary and secondary data
with a comparative case study orientation. Published financial statements and other desk
materials were collected principally from selected banks. Interviews were also conducted
with responsible treasury managers. There are various ways (economic, translation and
transaction), that the bank can utilize in analyzing and setting the exchange rate risk
management. In this study, transaction and translation exposure were the chosen methods of
analysis.
1.5 Research Methodology
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http://www.tanzaniabankers.org/TBA%20-%20Currency%20Risk%20Management.pdfhttp://www.tanzaniabankers.org/TBA%20-%20Currency%20Risk%20Management.pdf -
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1.5.1 Formation of problem:
To study the various treasury management operations & risk management techniques.
1.5.2 Methods of Collection of data:
Gathering primary data through meeting key officials from the related area of
Treasury Management, collecting view points from them to arrive at meaningful
conclusion.
Gathering secondary data from books, periodicals, publications, newspaper, survey
reports, journals, websites, and internal website.
Conducting interview with appropriate officials relating to the field of Treasury
Management by designing appropriate questionnaires.
1.5.3 Research Limitation:
Time allotted for making the project is very limited.
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CHAPTER 2: TREASURY
2.1 Organizational structure of treasury
There is no standard structure for treasury department of a bank. Depending on the
responsibilities assigned and power delegated, it can be aptly structured. Typically, banks
maintain three independent tiers at the functional/operational level-
Tier I Dealing Desk (Front Office): The dealers and traders in different markets- money,
stock, debt, commodity, derivatives and forex- operate in their respective areas. They are the
first point if interface with other participants in the market. The number of dealers depends
on the size and frequency of the operations. In case of larger in each bank, operations would
be carried out by separate and independent set of dealers in each market. But, for a relatively
smaller treasury, operations would be done by one or more dealers jointly in all the markets.
Tier II Settlement Desk (Back Office): Once the deals are concluded, it is for the back
office to process and settle the deals. Indeed, the back office undertakes settlement and
reconciliation operations.
Tier III Accounting, Monitoring and Reporting Office (Audit group): This department
looks after the activities relating to accounting, auditing and reporting. Accountants record
all deals in the books of accounts, while auditors and inspectors closely monitor all deals and
transactions done by the front and the back office, and send regular reports to authorities
concerned. This department independently inspects daily operations in the treasury
department to ensure internal/regulatory system and procedures.
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The three departments should be compartmentalized and they act independently. The heads
of each section reports directly to the Head of the Treasury. A treasury can have more
functional desk depending on the size and structure of the bank, and activities undertaken by
the bank.
2.2 Functions of treasury department
8
Head of Treasury
Chief Dealer
MarketIntelligence
Research andanalysis
Head ofSettlements
Head of AccountingMonitoring and
Reporting
Manager-Funds/Reserve Manager
SettlementsCustodian
Manager-Settlements
Documentation
Accounts/Monitoring
Audit/Reporting
Dealer- RupeeMoneyMarket.
Department
Dealer- Forex.Currency/Investment
Dealer- CorpoMerchant/
Service
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Since 1990s, the prime movers of financial intermediaries and services have been the
policies of globalization and reforms. All players and regulators had been actively
participating, only with variation of the degree of participation, to globalize the economy.
With burgeoning forex reserves, Indian banks and Financial Institutions have no alternative
but to be directly affected by global happenings and trades. This is where; integrated
treasury operations have emerged as a basic tool for key financial performance.
A treasury department of a bank is concerned with the following functions:
a) Reserve Management & Investment: It involves (i) meeting CRR/SLR obligations,
(ii) having an appropriate mix of investment portfolio to optimise y ield and duration.
Duration is the weighted average life of a debt instrument over which investment in
that instrument is recouped. Duration Analysis is used as a tool to monitor the price
sensitivity of an investment instrument to interest rate charges.
b) Liquidity & Funds Management: It involves (i) analysis of major cash flows
arising out of asset-liability transactions (ii) providing a balanced and well-
diversified liability base to fund the various assets in the balance sheet of the bank
(iii) providing policy inputs to strategic planning group of the bank on funding mix
(currency, tenor & cost) and yield expected in credit and investment.
c) Asset Liability Management & Term Money: ALM calls for determining the
optimal size and growth rate of the balance sheet and also prices the Assets and
liabilities in accordance with prescribed guidelines. Successive reduction in CRR
rates and ALM practices by banks increase the demand for funds for tenor of above
15 days (Term Money) to match duration of their assets.
d) Risk Management: integrated treasury manages all market risks associated with a
banks liabilities and assets. The market risk of liabilities pertains to floating interest
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rate risk for assets & liability mismatches. The market risk for assets can arise from
(i) unfavorable change in interest rates (ii) increasing levels of disintermediation (iii)
securitization of assets (iv) emergence of credit derivates etc. while the credit risk
assessment continues to rest with Credit Department, the Treasury would monitor the
cash inflow impact from changes in assets prices due to interest rate changes by
adhering to prudential exposure limits.
e) Transfer Pricing: Treasury is to ensure that the funds of the bank are deployed
optimally, without sacrificing yield or liquidity. An integrated Treasury unit has as
idea of the banks overall funding needs as well as direct access to various market
( like money market, capital market, forex market, credit market). Hence, ideally
treasury should provide benchmark rates, after assuming market risk, to various
business groups and product categories about the correct business strategy to adopt.
f) Derivative Products: Treasury can develop Interest Rate Swap (IRS) and other
Rupee based/ cross- currency derivative products for hedging Banks own exposures
and also sell such products to customers/other banks.
g) Arbitrage: Treasury units of banks undertake this by simultaneous buying andselling of the same type of assets in two different markets to make risk-less profits.
h) Capital Adequacy: This function focuses on quality of assets, with Return on Assets
(ROA) being a key criterion for measuring the efficiency of deployed funds. An
integrated treasury is a major profit centre. It has its own P&L measurement. It
undertakes exposures through proprietary trading (deals done to make profits out of
movements in market interest/ exchange rates) that may not be required for general
banking.
i) Coordination: Banks do operate at more than one money market centers. All the
centers undertake similar transactions with differing volumes. There is a need to
coordinate the activities of these centers so that aberrations are avoided (situations
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where one center is lending and the other one is borrowing at the same time). The
task of coordination of foreign exchanges positions is no different.
j) Control and Development: Treasury operates as the focal point of dealing
operations. Dealing operations could include cash/spot, forward, futures, options,
interest and currency liability swaps, forward rate agreements and the like. Treasury
is the sole owner and performer of these transactions.
k) Fraud Protection: The decade of nineties has witnessed more frauds in trading than
banking books. The amount and variety of such embezzlements have been directly
relatable to the operational level. The ground level task of this kind is to be
undertaken at the treasury.
2.3 Elements of treasury management
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2.3.1 Cash Reserve Ratio (CRR)
The core business of banks is mobilizing the deposits and utilizing the same for credit
accommodation. However, it should be taken into consideration that the banks are not
allowed to use the entire amount for extending credit. In order to promote certain prudential
norms for healthy banking practices, most of the developed economies require all banks to
maintain minimum liquid and cash reserves. As such, banks are required to ensure that these
statutory reserve requirements are met before directing on their credit plans.
Maintenance of CRR
As per the RBI Act 1934, Scheduled Commercial Banks are required to maintain with RBI
an average cash balance, the amount of which shall not be less than three per cent of the total
of the Net Demand and Time Liabilities (NDTL) in India, on a fortnightly basis and RBI is
empowered to increase the said rate of CRR to such higher rate not exceeding twenty
percent of the Net Demand and Time Liabilities (NDTL) under the RBI Act, 1934. At
present, effective from October 2,2004, the rate of CRR would be 5 per cent of the NDTL.
Thus, all Scheduled Commercial Banks are required to maintain the prescribed Cash
Reserve Ratio based on their NDTL as on the last Friday of the second preceding fortnight.
With a view to providing flexibility to banks in choosing an optimum strategy of holding
reserves depending upon their intra period cash flows, all Scheduled Commercial Banks are
required to maintain minimum CRR balances upto 70 per cent of the total CRR requirement
on all days of the fortnight with effect from the fortnight beginning December 28, 2002. If
any Scheduled Commercial Bank fails to observe the minimum level of CRR on any day/s
during the relevant fortnight, the bank will not be paid interest to the extent of one fourteenth
of the eligible amount of interest, even if there is no shortfall in the CRR on average basis.
Computation of Demand & Time Liabilities
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Liabilities of a bank may be in the form of demand or time deposits or borrowings or other
miscellaneous items of liabilities.
'Demand Liabilities' include all liabilities which are payable on demand and they include
current deposits, demand liabilities portion of savings bank deposits, margins held against
letters of credit/guarantees, balances in overdue fixed deposits and cumulative/recurring
deposits, outstanding Telegraphic Transfers (TTs), Mail Transfer (MTs), Demand Drafts
(DDs), unclaimed deposits, credit balances in the Cash Credit account and deposits held as
security for advances which are payable on demand.
Time Liabilities are those which are payable otherwise than on demand and they include
fixed deposits, cumulative and recurring deposits, time liabilities portion of savings bank
deposits, staff security deposits, margin held against letters of credit if not payable on
demand, deposits held as securities for advances which are not payable on demand and Gold
Deposits.
Money at Call and Short Notice from outside the Banking System should be shown against
Liability To Others. Loans/borrowings from abroad by banks in India will be considered as
'liabilities to others' and will be subject to reserve requirements. When a bank accepts fundsfrom a client under its remittance facilities scheme, it becomes a liability (liability to others)
in its books. The liability of the bank accepting funds will extinguish only when the
correspondent bank honors the drafts issued by the accepting bank to its customers.
Other Demand and Time Liabilities (ODTL) include interest accrued on deposits,
bills payable, unpaid dividends, suspense account balances representing amounts due to
other banks or public, net credit balances in branch adjustment account, any amounts due to
the "Banking System" which are not in the nature of deposits or borrowing.
Liabilities not to be included for NDTL computation
The under-noted liabilities will not form part of liabilities for the purpose of CRR:
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a) Paid up capital, reserves, any credit balance in the Profit & Loss Account of the bank,
amount availed of as refinance from the RBI, and apex financial institutions like Exim Bank,
IDBI, NABARD, NHB, SIDBI etc.
b) Amount of provision for income tax in excess of the actual estimated liabilities. Amount
received from DICGC (Deposit Insurance and Credit Guarantee Corporation) towards
claims and held by banks pending adjustments thereof.
d) Amount received from ECGC (Export Credit Guarantee Corporation) by invoking the
guarantee.
e) Amount received from insurance company on ad-hoc settlement of claims pending
Judgment of the Court.
f) Amount received from the Court Receiver.
g) The liabilities arising on account of utilization of limits under Bankers Acceptance
Facility
h) Inter bank term deposits/term borrowing liabilities of original maturity of 15 days and
above and upto one year with effect from fortnight beginning August 11, 2001.
Change in CRR as RBI's Strategy
In case of any shortfall banks generally tend to borrow from the call money market to meet
the cash reserve ratio (CRR) requirements, which they should maintain with the Reserve
Bank of India (RBI) every fortnight.
When the Reserve Bank of India (RBI) cuts the CRR rates, the general expectation is that
bankers would greet the news warmly as it provides them an opportunity to retain more
funds, which could be used productively. However, taking into consideration the recent
banking scenario the bankers consider it as a not very fruitful exercise, as the investment
avenues are very minimal and highly risky in nature. Moreover, a decrease in CRR resultsinto lesser funds to be locked up in RBIs vaults and further infusing greater funds into a
system.
When there is a fall in CRR, it increases money with the banks, which could then be used for
productive purposes. However, the question that one needs to ask is "Why infuse more
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money into a system which is already flush with liquidity? The main reason for high
liquidity is increasing number of customers approaching banks to open up deposit accounts.
Moreover, credit risk has always been present in the banking industry because of its very
nature of business. This has gathered momentum in the recent past due to mounting non-
performing assets (NPAs). Almost all the banks are facing the problem of bad loans,
burgeoning non-performing assets, thinning margins, etc. as a result of which, banks are
little reluctant in granting loans to corporates.
This results into a good liquidity position of commercial banks as deposits are showing a
continuous increase whereas, mobilization of funds for productive purposes is much more
restrictive in nature. Also, the bankruptcy of major corporates in recent past has added to
their fear of possible non-recovery of advances.
As such, as and when Reserve Bank of India (RBI) reduces the CRR, it further enhances
loanable funds with the banks and reduces their dependence on the call and term money
market. This will in turn reduce the call rates and the borrowing cost of the government.
Thus the Impact of CRR cut as RBIs strategy creates a terribly uncomfortable situation
from the banks point of view and Reserve Bank of India (RBI) further enhances its liquidity
position, with no productive avenues available for investment purposes.
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2.3.2 Statutory Liquidity Ratio (SLR)
As per the B.R. Act, 1949 all Scheduled Commercial Banks, in addition to the average daily
balance which they are required to maintain u/s 42 of the RBI Act, 1934, maintain1
a) In cash, or
b) In gold valued at a price not exceeding the current market price, or
c) In approved securities valued at a price as specified by the RBI from time to time an
amount of which shall not, at the close of the business on any day, be less than 25 per cent or
such other percentage not exceeding 40 per cent as the RBI may from time to time, by
notification in gazette of India, specify, of the total of its demand and time liabilities in India
as on the last Friday of the second preceding fortnight.
At present, all Scheduled Commercial Banks are required to maintain a uniform SLR of 23%
of the total of their demand and time liabilities in India.
Computation of demand and time liabilities for SLR
The procedure to compute total NTDL for the purpose of SLR is similar to the procedure
followed for CRR purpose. However, it is clarified that Scheduled Commercial Banks are
required to include inter-bank term deposits/ term borrowing liabilities of original maturitiesof 15 days and above and up to one year in 'Liabilities to the Banking System'. Similarly
banks should include their inter-bank assets of term deposits and term lending of original
maturity of 15 days and above and up to one year in 'Assets with the Banking System'
Penalties
If a banking company fails to maintain the required amount of SLR, it shall be liable to pay
to RBI in respect of that default, the penal interest for that day at the rate of 3 per cent per
annum above the bank rate on the shortfall and if the default continues on the next
succeeding working day, the penal interest may be increased to a rate of 5 percent per annum
above the Bank Rate for the concerned days of default on the shortfall.
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CHAPTER 3: INVESTMENTS
3.1 Classification of investments
The entire investment portfolio of the banks (including SLR securities and non-SLR
securities) should be classified under three categories viz. Held to Maturity, Available for
Sale and Held for Trading. However, in the balance sheet, the investments will continue to
be disclosed as per the existing six classifications viz. a) Government securities, b) Other
approved securities, c) Shares, d) Debentures & Bonds, e) Subsidiaries/ joint ventures and f)
Others (CP, Mutual Fund Units, etc.).
Banks should decide the category of the investment at the time of acquisition and the
decision should be recorded on the investment proposals.
3.1.1 Held to Maturity
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The securities acquired by the banks with the intention to hold them up to maturity
will be classified under Held to Maturity.
Investment classified under Held to Maturity category need not be marked to marketand will be carried at acquisition cost unless it is more than the face value. In such a
case, the premium should be amortized over a period remaining to maturity.
The investments included under 'Held to Maturity' should not exceed 25 per cent of
the banks total investments. But Sept 2004 onwards, RBI has revised this norm
allowing banks to park up to 25% of their NDTL in the HTM category.
The following investments will be classified under Held to Maturity but will not be
counted for the purpose of ceiling of 25% specified for this category:
Re-capitalization bonds received from the Government of India towards their
re-capitalization requirement and held in their investment portfolio. This will
not include re-capitalization bonds of other banks acquired for investment
purposes. (The funds that banks received in lieu of equity issued by the
government were invested in government bonds i.e. recapitalisation bonds.
The government serviced these bonds paying interest and banks, in turn, paid
dividends to the government. recapitalisation bonds)
Investment in subsidiaries and joint ventures. [A joint venture would be one
in which the bank, along with its subsidiaries, holds more than 25% of the
equity.]
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3.1.2 Available for Sale & Held for Trading
The securities acquired by the banks with intention to trade by taking advantage of
the short-term price/interest rate movement will be classified under Held for Trading.
The investments classified under Held for Trading category would be those from
which the bank expects to make a gain by the movement in the interest rates/ market
rates. These securities are to be sold within 90 days.
The individual scrips in the Held for Trading category will be revalued at monthly or
at more frequent intervals and net appreciation/depreciation under each classification
will be recognized in income account. The book value of the individual scrip will be
changed with revaluation.
The securities which do not fall within the above two categories will be classified
under Available for Sale
The investments classified under Available for Sale category should be held for
minimum period of 90 days.
Individual scrips in the Available for Sale category will be marked to market at the
year-end. The net depreciation under each classification should be recognized and
fully provided and any appreciation should be ignored. The book value of the
individual securities would not undergo any change after the revaluation
The banks will have the freedom to decide on the extent of holdings under Available
for Sale and Held for Trading categories. This will be decided by them after
considering various aspects such as basis of intent, trading strategies, risk
management capabilities, tax planning, manpower skills, capital position.
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3.1.3 Shifting among categories
1. Banks may shift investments to/from Held to Maturity category with the approval of
the Board of Directors once a year (beginning of the year).
2. Banks may shift investments from Available for Sale category to Held for Trading
category with the approval of their Board of Directors/ ALCO/ Investment
Committee.
3. Shifting of investments from Held for Trading category to Available for Sale
category is generally not allowed. However, it will be permitted only under
exceptional circumstances like not being able to sell the security within 90 days due
to tight liquidity conditions, or extreme volatility, or market becoming unidirectional.
Such transfer is permitted only with the approval of the Board of Directors/ ALCO/
Investment Committee.
4. Transfer of scrips from one category to another, under all circumstances, should be
done at the acquisition cost/ book value/ market value on the date of transfer,
whichever is the least, and the depreciation, if any, on such transfer should be fullyprovided for.
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3.1.4 Investment Fluctuation Reserve (IFR)
With a view to building up of adequate reserves to guard against any possible reversal of
interest rate environment in future due to unexpected developments, banks are advised to
build up Investment Fluctuation Reserve (IFR) of a minimum 5 per cent of the investment
portfolio within a period of 5 years. IFR should be computed with reference to investments
in two categories, viz., Held for Trading and Available for Sale.
RBI GUIDELINES FOR NON- SLR INVESTMENTS
Banks should prescribe minimum disclosure standards as a policy with Board
approval, with regards to the investments made by the treasury department.
Banks should ensure that their investment policies duly approved by the Board of
Directors are formulated after taking into account the following aspects:
The Boards of banks should lay down policy and prudential limits on investments
in bonds and debentures including cap on unrated issues and on private
placement basis, sub limits for PSU bonds, corporate bonds, guaranteed bonds,
issuer ceiling, etc.
Banks should make their own internal credit analysis and rating even in respect
of rated issues and should not entirely rely on the ratings of external agencies
The investments should be well diversified and there should be no concentration
of risk.
The banks should put in place proper risk management systems for capturing and
analysing the risk in respect of these investments and taking remedial measures
in time.
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Due caution should be taken by the bank while investing in bonds, debentures of
companies and should not invest in companies whose name appear in the Defaulters
list. In case a director of a company, in which the bank wants to invest in, is in the
Defaulters list, prior approval from the Board is required.
Direct investment in shares, convertible bonds and debentures etc: Banks are free to
acquire shares, convertible debentures of corporates and units of equity-oriented
mutual funds, subject to a ceiling of 5 per cent of the total outstanding domestic
credit (excluding inter-bank lendings and advances outside India) as on March 31 of
the previous year. Within the overall ceiling of 5 per cent for total exposure to
capital market, the total investment in shares, convertible bonds and debentures and
units of equity-oriented mutual funds by a bank should not exceed 20 per cent of its
net worth. While making investment in equity shares etc., whose prices are subject to
volatility, the banks should keep in view the following guidelines:
Underwriting commitments taken up by the banks in respect of primary issues
through book building route would also be within the above overall ceiling.
Investment in equity shares and convertible bonds and debentures of corporate
entities.
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3.2 Investment Options
A large portion of the banks investment is made in debt instruments i.e. to the extent of 90-
95 % while investment in Equity amounts to hardly 5 % of banks portfolio.
3.2.1 Equity Market
The Banks are permitted to invest in Equity within a limit set up by the RBI, the limit as of
now is 5%. Though the cap is 5% many or almost all banks hardly invest 2-3% in equity.
Now a days banks are also exploring investment opportunities in capital market through
Mutual Funds.
Investing in equity markets include areas like:
Individual companies scrips
Index
Derivatives (Futures, Options, Interest rate swaps, currency rate swaps, commodity)
Mutual Funds offer various products with varied risk levels related to capital market, which
includes options like:
Equity Funds
Growth Funds
Sectoral Funds
Balanced Funds
Value Funds
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3.2.2 DEBT MARKET
Role of Debt Market
The key role of the debt markets in the Indian Economy stems from the following reasons:
Efficient mobilization and allocation of resources in the economy
Financing the development activities of the Government
Transmitting signals for implementation of the monetary policy
Facilitating liquidity management in tune with overall short term and long-term
objectives.
Since the Government Securities are issued to meet the short term and long term financial
needs of the government, they are not only used as instruments for raising debt, but have
emerged as key instruments for internal debt management, monetary management and short
term liquidity management.
The returns earned on the government securities are normally taken as the benchmark rates
of returns and are referred to as the risk free return in financial theory. The Risk- Free rate
obtained from the G-sec rates are often used to price the other non-govt. securities in the
financial markets.
Participants in the Debt Market
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Debt markets are mainly wholesale markets dominated by institutional investors, namely,
Banks
FIs
Mutual funds
Provident funds
Insurance companies &
Corporates.
Many of these participants are issuers of debt instruments.
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VARIOUS DEBT INSTRUMENTS
Debt instruments represent contracts whereby one party lends money to another on pre-
determined terms with regard to rate of interest to be paid by the borrower to the lender. In
India, we use the term bond for debt instruments issued by central & state governments
and public sector organizations and the term debentures issued by private corporate sector.
Short Term Debt Instruments
CALL MONEY
The call money market is a part of money market, where day-to-day surplus funds, mostly of
banks, are traded. The call money market comprises an interbank call market, and the market
between banks on one hand and security brokers and dealers on the other hand. The call
money market is most liquid of all the money market segments and it is also the most
sensitive barometer measuring the liquidity conditions prevailing in the financial markets.
The call money is the money repayable on demand. The maturity of call loans varies
between 1 to 14 days. The money that is lent for one day in the call money market is alsoknown as overnight money. The term notice money also refers to the money lent in the
call market, but a notice is served by the lender for payment in a day or two before payment
date. Duration of notice money is similar to that of call money i.e. upto 14 days. The money
that is lent for more than 14 days is referred to as term money. In call money market any
amount could be lent or borrowed at an interest rate, which is acceptable to both borrower
and lender. These loans are considered as highly liquid; as they are repayable on due date.
Initially, banks were only permitted to deal in this market; it was then referred as Inter bank
market. RBI acts as a regulator of the call money market, but neither borrows from nor
lends to it.
Participants
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Scheduled commercial Banks (private sector, public sector and cooperative banks)
Discount and Finance House of India (DFHI)
Securities Trading Corporation of India Limited (STCI)
Primary Dealers
Financial Institutions
Mutual Funds
Purpose
The short-term mismatches arise due to variation in maturities.
The banks borrow from this market to meet the Cash Reserve Ratio requirements,
which they should maintain with RBI every fortnight.
Money is borrowed in the call/notice market for short periods to discount
commercial bills.
Call Rates
The interest paid on call loans is known as the call rates. Though the rate quoted in themarket is annualized one, the rate of interest on call money is calculated on a daily basis.
These rates vary from day to day, often from hour to hour. High rates indicate a tightness of
liquidity in the financial system while low rates indicate an easy liquidity position in the
market. The rate is largely subjected to influence by the forces of demand and supply for
funds.
TREASURY BILLS
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Government issues Treasury bills (T-bills) and dated securities as a means to raise funds, in
the short term and long term markets respectively. T-bills constitute a major portion of short-
term borrowings by the Government of India.
T-bills are issued in the form of promissory notes or finance bills (a bill which does not arise
from any genuine transaction in goods is called a finance bill) by the government to tide
over short-term liquidity shortfalls. These short-term instruments are highly liquid and
virtually risk free as they are issued by the government. They are the most liquid instruments
after cash and call money, as repayment guarantee is given by the central government. T-
bills do not require any grading or further endorsement like ordinary bills, as they are claim
against the Government. These instruments have distinct features like zero default risk,
assured yield, low transaction cost, negligible capital depreciation and eligible for inclusion
in SLR and easy availability, etc. apart from high liquidity.
Issuer
The RBI acts as a banker to the Government of India. It issues T-bills and other government
securities to raise funds on behalf of Government of India, by acting as an issuing agent.
Investors
Though various groups of investors including individuals are eligible to invest, the main
investor found in T-bills are mostly banks to meet their SLR requirements. Other large
investors include:
Primary Dealers
Financial Institutions (for primary cash management)
Provident Funds (PFs)
Insurance Companies
Non-banking Finance Companies (NBFCs)
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Foreign Institutional Investors (FII)
State Governments.
NRIs and OCBs are allowed to invest only on non-repatriable basis.
Purpose
T-bills are raised to meet the short-term requirements of Government of India. As the
Governments revenue collections are bunched and expenses are dispersed, these bills
enable the Government to manage cash positions in a better way. T-bills also enable the RBI
to perform Open Market Operations (OMO), which indirectly regulate money supply in the
economy.
Banks prefer T-bills because of high liquidity, assured returns, no default risk, no capital
depreciation and eligibility for statutory requirements.
Size
The T-bills are issued for a minimum amount of Rs. 25000 and in multiples of 25000. T-
bills are issued at discount and redeemed at par.
Types
T-bills are issued at various maturities, generally upto one year. Thus they are useful in
managing short-term liquidity. They are:
91-day T-bills - 91-day T-bill- maturity is in 91 days. Its auction is on every
Wednesday of every week. The notified amount for this auction is Rs. 250 cr.
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364-day T-bills - 364-Day T-bill- maturity is in 364 days. Its auction is on every
alternate Wednesday (which is a reporting week). The notified amount for this
auction is Rs. 750 cr.
Categorization of T-Bills based on the nature of issue
Ad hoc Treasury bills: These are issued in favor of the RBI when Government needs
cash. They are neither issued nor available to the public.
On Tap Treasury bills: RBI issues on-tap T-bills to investors on any working day.
They have a maturity of 91 days.
Auctioned Treasury bills: Various T-bills are auctioned on different days. The RBI
issues a calendar of T-bill auctions. RBI also announces the exact date of auction,
the auction amount and the dates of payment. The bids are tendered and accepted at
the auction.
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T-Bills Issuance
Treasury bills are sold through an auction process, in which banks and primary dealers are
major bidders. Non-competitive bids are allowed in the auction, in which provident funds
and other investors can participate. Non- competitive bidders need not quote the rate of yield
at which they desire to buy the T-bills. The Reserve Bank of India allots bids to the non-
competitive bidders at the weighted average yield arrived at, on the basis of the yield quoted
by accepted competitive bid at the auction. Allocation to non-competitive bids is outside the
amount notified for sale. Non-competitive bidders therefore do not face any uncertainty in
purchasing the desired amount of T-bills from the auctions. The RBI issues a calendar of T-
Bills auctions.
The system of underwriting the T-bills by the PDs has been replaced by a system of
minimum bidding commitment. Each PD is required to make a minimum commitment for
auction of T-bills so that they together absorb 100% of the notified amount. Both
discriminatory and uniform method is used for issuance. Auctions for 91-day T-bills are
uniform price auctions where all successful bidders have to pay the cut-off price. Therefore,
in 91-day T-bill auctions, the weighted average is same as the cut-off price.
In case of all other bills, discriminatory auction is followed, where all the successful biddershave to pay the prices at which they had bid for.
Subsidiary General Ledger (SGL) A/C:
SGL A/C is a facility provided by RBI to large banks and financial institutions to hold their
investments in Government securities and T- bills in electronic book entry form. Such
entities can settle their trades in securities held in SGL a/c through delivery versus payment
(DVP) mechanisms, which ensures moment of funds and securities simultaneously .As all
investors do not have access to the SGL system, RBI has permitted such investors to hold
their securities in physical certificate form. They may also open an SGL a/c with any such
entity approved by RBI for this purpose, and thus avail of the DVP settlement system. Such
client accounts are also referred as Constituent SGL A/C.
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Both buyer and the seller have to maintain a Current a/c with the RBI and no overdraft
facility will be provided.
RBI GUIDELINES
All the transactions put through by a bank, either on outright basis or ready forward basis
and whether through the mechanism of Subsidiary General Ledger (SGL) Account or Bank
Receipt (BR), should be reflected on the same day in its investment account and,
accordingly, for SLR purpose wherever applicable. Purchase/ sale of any securities will be
done through SGL A/c under the Delivery Versus Payment (DVP) System.
All transactions in Govt. securities for which SGL facility is available should be putthrough SGL A/cs only.
Under no circumstances, a SGL transfer form issued by a bank in favour of another
bank should bounce for want of sufficient balance of securities in the SGL A/c of
seller or for want of sufficient balance of funds in the current a/c of the buyer.
The SGL transfer form received by purchasing banks should be deposited in their
SGL A/cs. immediately i.e. the date of lodgement of the SGL Form with RBI shall
be within one working day after the date of signing of the Transfer Form.
SGL transfer forms should be signed by two authorised officials of the bank whose
signatures should be recorded with the respective PDOs (Public Debt Office) of the
Reserve Bank and other banks.
Any bouncing of SGL transfer forms issued by selling banks in favour of the buying
bank, should immediately be brought to the notice of the Regional Office of
Department of Banking Supervision of RBI by the buying bank.
If a SGL transfer form bounces for want of sufficient balance in the SGL A/c, the
following penal action against it is taken:
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In case of any default arising in the current a/c, such amount will be penalised
by the RBI @ of 3 % above the Discount and Finance House of Indias
(DFHI) call money lending rate of that day. And if this rate is lower than the
PLR than the penal rate would be 3 % above the current PLR.
If the bouncing of the SGL form occurs thrice, the bank will be debarred from
trading with the use of the SGL facility for a period of 6 months from the
occurrence of the third bouncing. If, after restoration of the facility, any SGL
form of the concerned bank bounces again, the bank will be permanently
debarred from the use of the SGL facility in all the PDOs of the Reserve
Bank.
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COMMERCIAL PAPERS (CPs)
Commercial Papers (CPs) are short-term unsecured usance promissory notes issued
at a discount to face value by reputed corporates with high credit rating and strongfinancial background. Companies issue CPs typically to finance accounts receivable
and inventories at a discount reflecting the prevailing market interest rates.
Issuers: private sector Co., public sector unit, non-banking Co., primary dealers.
Commercial Papers are open to individuals, corporates, NRIs and banks, but NRIs
can invest on non-repatriable / non-refundable basis. FIIs have also been allowed to
invest their short-term funds in Commercial Papers.
CPs have a minimum maturity of 15 days and a maximum maturity of 1 year. They
are available in the denomination of Rs. 5 lakh and multiples of 5 lakh and a
minimum investment is Rs. 5 lakh per investor.
Secondary market trading takes place in the lot in lots of Rs.5 lakh each usually by
banks. The transfer is done by endorsement and delivery.
CPs are issued only if the total cost is lower than PLR of banks.
The features of CPs are:
1. They do not originate from specific trade transactions like commercial bills.
2. They are unsecured.
3. Involve much less paper work.
4. Have high liquidity.
CPs are issued at a discount to the face value. The issue price is calculated as below.
P = Face value / (1 + D * (N / 365))
Where, F= Face/Maturity value P = Issue price of the CP
D= Discount Rate N = Usance period (No. of days)
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Types of Papers
Commercial paper can be issued either directly or through a dealer.
If the paper is issued by the company directly to the investors without dealing withan intermediary, it is referred as direct paper.
If CPs is issued by an intermediary (i.e. dealer / merchant banker) on behalf of its
corporate client, it is known as dealers paper.
In India, the CPs are usually placed with the investors with the help of Issuing & Paying
Agents (IPA). Only scheduled banks can act as IPAs.
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CERTIFICATE OF DEPOSIT (CDs)
Certificate of Deposit (CDs) are usance promissory notes, negotiable and in
marketable form bearing a specified face value and number. Scheduled commercial banks and the major financial institutions can issue CDs
within the umbrella limit fixed by RBI.
Individuals, corporate, companies, funds, associations, trusts and NRIs are the main
investors in the CDs (on non-repatriable basis).
CDs are issued for a period of 14 days to one year (normally one to three years by
the financial institutions) at a minimum amount of Rs. 5 lakh and in multiples of Rs.5
lakhs thereafter with no upper limit.
There is no specific procedure to issue CDs. It is available, on tap, with the bankers.
CDs are the largest money market instruments traded in dollars. They are issued by
either banks or depository institutions, mostly in bearer form enabling trading in the
secondary market.
The features of CDs are:
It is title document to a time deposit, riskless, liquid and highly negotiable
and marketable.
It is issued at a discount to the face value.
It is freely transferable by endorsement and delivery.
CDs are maturity-dated obligations of banks forming a part of time
liabilities, and are subjected to usual reserve requirements.
It does attract stamp duty.
CDs issued are within the limit as specified by Reserve Bank of India (in
case of FIs only).
CDs are also issued in demat forms. Thus various advantages of
dematerialization can be availed.
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The benefits of issuing CDs to the bank are:
Interest can be determined on a case-to-case basis.
There is early maturity of a CD
Rates are more sensitive to call rates.
Discount
CDs are issued at a discount to the face value. Bank CDs are always discount bills, while
CDs of DFIs (Development Financial Institutions) can be coupon bearing as well. The
discount rate is calculated as follows:
DR = F
1 + (I * N)
100*365
Where: DR =Discounted Rate N=Issuance period
F=Face Value I=Effective Interest rate per annum
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BILL FINANCING
Monetary policy and Bill financing refers to the use of the official instruments under
the control of the Central Bank of the country to regulate the availability, cost anduse of money and credit.
The bank standard rate is the rate at which the bank is prepared to buy or rediscount
bills of exchange or other commercial paper eligible for purchases.
A bill of exchange has been defined as an instrument in writing containing an
unconditional order, signed by the maker, directing a certain person to pay a certain
sum of money only to, or to the order of, a certain person or to the bearer of the
instrument.
Bills of exchange can be classified as demand or usance bills, documentary or clean
bills, D/A or D/P bills, inland or foreign bills, supply bills or government bills or
accommodation bills.
Bills can also be classified as traders bills, bills with co-acceptance, bills
accompanied by letter of credit and drawee bills.
Originally discounted bills can be rediscounted by banks for their corporate clients
with financial institutions, as long as such bills arise out of genuine trade
transactions.
RBI has instructed the banks to restrain from rediscounting bills outside the
consortium of banks and initially discounted by finance companies and merchant
bankers. Further discounting should be only for the purpose of working capital /
credit limits and for the purchase of raw materials / inventory. Accommodation bills
are not to be discounted under any circumstances.
The specific features of a negotiable instrument are:
There must be three parties to the exchange, namely drawer, drawee and
payee.
found in the bills of exchange
It should be duly signed by the drawer and presented to the drawee for
acceptance.
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REPOS & REVERSE REPOS
Repo is a money market instrument, which enables collateralized short term borrowing and
lending through sale/ purchase of debt instruments. Under a repo transaction, the seller of
the instrument enters into an agreement with the buyer to repurchase the instrument at a
predetermined price and date. A repo is also called as a Ready Forward transaction as it is a
means of funding by selling a security on spot and repurchasing the same on a forward basis.
The main objective of trading in Repos is to meet temporary short-term liquidity
requirements in the short-term money market.
For the lender of cash, the securities offered by the borrower serve as a collateral; whereas
for the lender of securities, the cash borrowed serves as a collateral. Repos, thus are called as
collateralized short term borrowings.
The lender of the securities (borrower of cash) is said to be doing a repo, whereas the lender
of cash (borrower of securities) is said to be doing a reverse repo.
A reverse repo is a mirror image transaction of a repo. In this transaction, the investor
purchases with an agreement to resell the securities. Hence, whether a transaction is a repo
or a reverse repo depends on who initiated the first leg of the transaction. One factor whichencourages an organization to enter into a reverse repo is to earn some extra income on its
idle cash.
Though there is no restriction on the maximum duration for a repo, generally repo
transactions do not exceed 14 days. It is essential for the participants of the repo market to
hold SGL & current accounts with the RBI. Repo transactions are also reported on the
WDM segment of the NSE.
Consider the following eg:
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Trade date: 13th July 2004
Trade price: 108.5
Total Face value: Rs.100 *1000 = 100000
Security: 9.5 %, maturing on 22nd March 09
Repo rate: 4.5 %
Repo term: 2 days
First leg:
On 13th July the seller of the repo (borrower of cash) receives the following amount:
Value of the security: 108.5/100*100000 =108,500.00
Accrued interest: 9.5/100 * 100000* 112 / 360 = 2955.56
Settlement amount: 108500 + 2955.56 = 111455.56
Second leg:
On 15th July (repo term is 2 days), the seller returns the following amount:
Original borrowing: 108,500.00
Accrued interest: 9.5/100 * 100000 * 114 / 360 = 3008.33
Repo interest: 4.5 /100 * 100000 * 2/360 = 25Settlement amount: 108500 + 3008.33 + 25 = 111533.33
RBI GUIDELINES
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Ready forward contracts may be undertaken only in (i) Dated Securities and
Treasury Bills issued by Government of India and (ii) Dated Securities issued by
State Governments.
Ready forward contracts in the securities specified above may be entered into by
a banking company, a co-operative bank or any person maintaining a Subsidiary
General Ledger Account with Reserve Bank of India, Mumbai.
Such ready forward contracts shall be settled through the Subsidiary General
Ledger Accounts of the participants with Reserve Bank of India or through the
Subsidiary General Ledger Account of the Clearing Corporation of India Ltd.
with Reserve Bank of India, and
No sale transaction shall be put through without actually holding the securities in
the portfolio.
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LONG-TERM DEBT INSTRUMENTS
By convention, these are instruments having a maturity exceeding one year. The main
instruments are Government of India dated securities (GOISEC), State Government
securities (state loans), public sector bonds (PSU bonds), corporate debentures etc.
Most of these are coupon bearing instruments i.e. interest payments (called coupons) are
payable at pre specified dates called "coupon dates". At any given point of time, any such
instrument has a certain amount of accrued interest with it i.e. interest, which has accrued
(but is not due) calculated at the "coupon rate" from the date of the last coupon payment.
E.g. if 30 days have elapsed from the last coupon payment of a 14% coupon debenture with
a face value of Rs 100, the accrued interest will be
100*0.14*30/365 = 1.15
Whenever coupon-bearing securities are traded, by convention, they are traded at a base
price with the accrued interest separate; in other words, the total price would be equal to the
summation of the base price and the accrued interest.
A brief description of these instruments is as follows:
Government of India dated securities (GOISECs):
Like treasury bills, GOISECs are issued by the Reserve Bank of India on behalf of the
Government of India. These form a part of the borrowing program approved by Parliament
in the Finance Bill each year (Union Budget). They are issued in dematerialized form but
can be issued in denominations as low as Rs 100 in physical certificate form. They have
maturity ranging from 1 year to 30 years. Very long dated securities i.e. those having
maturity exceeding 20 years were in vogue in the seventies and the eighties while in the
early nineties, most of the securities issued have been in the 5-10 year maturity bucket. Very
recently, securities of 15 and 20 years maturity have been issued.
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Like T-Bills, GOISECs are most commonly issued in dematerialized form in the "SGL"
account although it can be issued in physical certificate form on specific request. Tradability
of physical securities is very limited. The SGL passbook contains a record of the holdings of
the investor. The RBI acts as a clearing agent for GOISEC transactions by being the
custodian and operator of the SGL account. GOISECs are transferable by endorsement and
delivery for physical certificates. Transactions of securities held in SGL form are effected
through SGL transfer notes. Transfer of GOISECs does not attract stamp duty or transfer
fee. Also no tax is deductible at source on the coupon payments made on GOISECs.
Like T-Bills, GOISECs are issued through the auction route. The RBI pre specifies an
approximate amount of dated securities that it intends to issue through the year. However, it
has broad flexibility in exceeding or being under that figure. Unlike T-Bills, it does not have
a pre set timetable for the auction dates and exercises its judgement on the timing of each
issuance, the duration of instruments being issued as well as the quantum of issuance.
Sometimes the RBI specifies the coupon rate of the security proposed to be issued and the
prospective investors bid for a particular issuance yield. The difference between the coupon
rate and the yield is adjusted in the issue price of the security. On other occasions, the RBI
just specifies the maturity of the proposed security and prospective investors bid for the
coupon rate itself. In either case, just as in T-Bills, the auction is conducted on a French
auction basis. Also, the RBI has wide latitude in deciding the cut off rate for each auction
and can end up with unsold securities, which devolve on itself.
Apart from the auction program, the RBI also sells securities in its open market operations
(OMO), which it has acquired in devolvements or sometimes directly through private
placements. Similarly, it also buys securities in open market operations if it feels fit.
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New types of GOISECs
Earlier, the RBI used to issue straight coupon bonds i.e. bonds with a stated coupon payable
periodically. In the last few years, the RBI has been innovative and new types of instruments
have also been issued. These include:
Inflation linked bonds: These are bonds for which the coupon payment in a particular
period is linked to the inflation rate at that time the base coupon rate is fixed with the
inflation rate (consumer price index-CPI) being added to it to arrive at the total coupon rate.
Zero coupon bonds: These are bonds for which there is no coupon payment. They are
issued at a discount to face value with the discount providing the implicit interest payment.
State government securities (state loans): 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, which is decided in consultation
with the planning commission. Though there is no central government guarantee on these
loans, they are deemed to be extremely safe since the RBI debits the overdraft accounts of
the respective states held with it for payment of interest and principal. Generally, the coupon
rates on state loans are marginally higher than those of GOISECs issued at the same time.
The procedure for selling of state loans, the auction process, allotment procedure & transfer
is similar to that for GOISEC. They also qualify for SLR status and interest payment and
other modalities are similar to GOISECs. They are also issued in dematerialized form and no
stamp duty is payable on transfer. In general, state loans are much less liquid than GOISECs.
Primary Issuance Process of G-Secs
RBI announces the auction of G-Secs through a press notification and invites bids. The
sealed bids are opened at an appointed time, and the allotment is based on the cut-off price
decided by the RBI. Successful bidders are those that bid at a higher price than the cut-off
price.
The two choices in treasury auctions widely used are:
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1. Discriminatory Price Auctions (French Auction)
2. Uniform Price Auction (Dutch Auction)
In both these type of auctions, the winning bids are those that exhaust the amount on the
offer, beginning at the highest quoted price (or lowest quoted yield). However, in a uniform
price auction, all successful bidders pay a uniform price, which is usually the cut-off price.
In case of the discriminatory price auction, all successful bidders pay the actual price they
had bid for.
If successful bids are decided by filling up the notified amount from the lowest bid upwards,
such an auction is called a yield-based auction. In such an auction, the name of the security
is the cut-off yield. Such auction creates a new security with a distinct coupon rate every
time an auction is completed. For example, a 10.3% G-Sec 2010 derives its name from the
cut-off yield i.e. 10.3%, which becomes the coupon payable on the bond. The coupon
payment and redemption dates are unique for each security depending on the deemed date of
allotment of the securities auctioned.
If successful bids are filled up in terms of the prices bid by the participants, from the highest
bid downwards, such an auction is called a price-based auction. A price-based auction
facilitates the re-issue of an existing security. The coupon rate and the dates of payment of
coupons and redemption are already known.
RBI moved from the yield-based auction to price-based auction in 1998, in order to enableconsolidation of G-Secs through re-issue of existing securities. The RBI has the authority to
shift to yield-based auctions and notify the same in the auction notification.
GUIDELINES ON TRANSACTIONS IN GOVERNMENT SECURITIES
In the light of fraudulent transactions in the guise of Government securities transactions in
physical format by a few co-operative banks with the help of some broker entities, it has
been decided to accelerate the measures for further reducing the scope of trading in physical
forms. These measures are as under:
For banks, which do not have SGL account with RBI, only one CSGL account can be
opened.
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In case the CSGL accounts are opened with a scheduled commercial bank, the
account holder has to open a designated funds account (for all CSGL related
transactions) with the same bank.
The entities maintaining the CSGL / designated funds accounts will be required to
ensure availability of clear funds in the designated funds accounts for purchases and
of sufficient securities in the CSGL account for sales before putting through the
transactions.
No transactions by the bank should be undertaken in physical form with any broker.
Banks should ensure that brokers approved for transacting in Government securities
are registered with the debt market segment of NSE/BSE/OTCEI.
Public Sector Undertaking Bonds (PSU Bonds): These are long-term debt instruments
issued by Public Sector Undertakings (PSUs). They have maturities ranging between 5-10
years and they are issued in denominations (face value) of Rs1000 each. Most of these issues
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are made on a private placement basis to a targeted investor base at market determined
interest rates.
These PSU bonds are transferable by endorsement and delivery and no tax is deductible at
source on the interest coupons payable to the investor (TDS exempt). In addition, from time
to time, the Ministry of Finance has granted certain PSUs, an approval to issue limited
quantum of tax-free bonds i.e. bonds for which the payment of interest is tax exempt in the
hands of the investor. This feature was introduced with the purpose of lowering the interest
cost for PSUs which were engaged in businesses which could not afford to pay market
determined rates of interest e.g. Konkan Railway Corporation was allowed to issue
substantial quantum of tax free bonds.
Bonds of Public Financial Institutions (PFIs): Apart from public sector undertakings,
Financial Institutions are also allowed to issue bonds, that too in much higher quantum.
They issue bonds in 2 ways through public issues targeted at retail investors and trusts and
also through private placements to large institutional investors. Usually, transfers of the
former type of bonds are exempt from stamp duty while only part of the bonds issued
privately have this facility. On an incremental basis, bonds of PFIs are second only to
GOISECs in value of issuance.
Corporate debentures: These are long-term debt instruments issued by private sector
companies. These are issued in denominations as low as Rs 1000 and have maturities
ranging between one and ten years. Long maturity debentures are rarely issued, as investors
are not comfortable with such maturities. Generally, debentures are less liquid as compared
to PSU bonds and the liquidity is inversely proportional to the residual maturity.
Bond Issuance
Board meeting and approval of issue as an ordinary resolution at the AGM
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Credit rating of the issue (mandatory in case of a public issue)
Creation of security for the bond /debenture through appointment of debenture
trustees (period greater than 18 months)
Appointment of advisors and investment bankers for issuance management
Finalizations of the initial terms of the issue
Preparation of the offer document (for public issue) and Information memorandum
(for private placement.)
SEBI approval for the offer document of the issue
Listing agreement with Stock Exchanges
Offer the issue to prospective investors and/or book-building
Acceptance of the application money/advance deposit for the issue
Allotment of the issue
Issue of letters of allotment and certificate / Depository conformation
Collect final amount from the investors
Refund excess application money / interest on application money.
A key feature that distinguishes debentures from bonds is the stamp duty payment.
Debenture stamp duty is a state subject and the quantum of incidence varies from state to
state. There are two kinds of stamp duties levied on debentures viz issuance and transfer.
Issuance stamp duty is paid in the state where the principal mortgage deed is registered.
Over the years, issuance stamp duties have been coming down and are reasonably uniform.
Stamp duty on transfer is paid to the state in which the registered office of the company is
located. Transfer stamp duty remains high in many states and is probably the biggest
deterrent for trading in debentures resulting in lack of liquidity.
Pass Through Certificates (PTCs): Pass through certificate is an instrument with cash
flows derived from the cash flow of another underlying instrument or loan. Most commonly,
they have been issued by foreign banks like Citibank on the basis of their car loan or
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mortgage/housing loan portfolio. The issuer is a special purpose vehicle, which just receives
money from a multitude of (may be several hundreds or thousands) underlying loans and
passes the money to the holders of the PTCs. This process is called securitization. Legally
speaking PTCs are promissory notes and therefore tradable freely with no stamp duty
payable on transfer. Most PTCs have 2-3 year maturity because the issuance stamp duty rate
of 0.75% makes shorter duration PTCs unviable.
RBI GUIDELINES FOR INVESTMENT BY BANKS
The Reserve Bank of India has issued guidelines on classification, valuation and operation
of investment portfolio by banks from time to time as detailed below:
Investment Policy
i) While framing the investment policy, the following guidelines are to be kept in view by
the banks;
(a) No sale transactions should be put through without actually holding the security
in its investment account. However, banks successful in the auction of primary
issue of Government securities, may, enter into contracts for sale of the allotted
securities.
(b) The brokerage on the deal payable to the broker, if any, should be clearly
indicated on the notes/ memoranda put up to the top management seeking
approval for putting through the transaction and a separate account of
brokerage paid, broker-wise, should be maintained.
For engagement of brokers to deal in investment transactions, the banks
should observe the following guidelines
Transactions between one bank and another bank should not
be put through the brokers' accounts.
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If a deal is put through with the help of a broker, the role of the broker
should be restricted to that of bringing the two parties to the deal together.
While negotiating the deal, the broker is not obliged to disclose the
identity of the counterparty to the deal. On conclusion of the deal, he should disclose
the counterparty and his contract note should clearly indicate the name of the
counterparty.
With the approval of their top managements, banks should prepare a
panel of approved brokers which should be reviewed annually, or more often if so
warranted
A disproportionate part of the business should not be transacted through
only one or a few brokers. Banks should fix aggregate contract limits for each of the
approved brokers. A limit of 5% of total transactions (both purchase and sales)
entered into by a bank during a year should be treated as the aggregate upper contract
limit for each of the approved brokers. However, if for any reason it becomes
necessary to exceed the aggregate limit for any broker, the specific reasons therefore
should be recorded, in writing, by the authority empowered to put through the deals.
Further, the board should be informed of this, post facto. However, the norm of 5%would not be applicable to banks dealings through Primary Dealers.
The concurrent auditors who audit the treasury operations should
scrutinize the business done through brokers also and include it in their monthly
report to the Chief Executive Officer of the bank
(c) Banks desirous of making investment in equity shares / debentures should
observe the following guidelines:
Formulate a transparent policy and procedure for investment in shares, etc.,
with the approval of the Board.
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The decision in regard to direct investment in shares, convertible bonds and
debentures should be taken by the Investment Committee set up by the
banks Board. The Investment Committee should be held accountable for
the investments made by the bank.
(d) A copy of the Internal Investment Policy Guidelines, duly framed by the bank
with the approval of its Board, should be forwarded to the Reserve Bank
certifying that the same is in accordance with the RBI guidelines and that, the
same has been put in place.
While laying down such investment policy guidelines, banks should strictly observe Reserve
Bank's detailed instructions on the following aspects :
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CHAPTER 4: YIELD
Yield is the return you actually earn on the bond-based on the price you paid and the interest
payment you receive. 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. There are many different
kinds of yields depending on the investment scenario and the characteristics of the
investment.
T-bills do not carry a coupon rate, but they are issued at a discount. Though the yields on T-
bills are less when compared to other money market instruments, the risk averse banks
prefer to invest in these securities.
Yields on T-bills are considered as benchmark yields. It is considered as a representative of
interest rates in the economy in general, while arriving at the interest rate or yield or any
short-term instruments.
Eg: The yield is calculated on the basis of 365 days a year. If the face value of a 364-day T-
bills is Rs.100, and if the purchase price is 88.24 for a T-bills, then the yield is calculated as
below:
Days * Yield + 1 Face value=
365 Price
Yield = 100 1 365
* = 13.36 %88.24 364
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4.1 Types of yield
There are basically three types of bond yields you should be aware of: current yield, yield to
maturity & yield to call.
Current yield (CY)
Current yield is the yield on the debt instrument based on the current market price. It is
actually the return you earn on the instrument, if you purchase the instrument at the current
market price. It is calculated as follows:
CY = Coupon payment----------------------Current market price
Current Yield is the coupon divided by the Market Price and gives a fair approximation of
the present yield.
Again the thumb rule is that if the CY is more than the required rate of return, invest in the
instrument otherwise not.
Therefore,
Current Yield = Coupon of the Security (in %) x Face Value of the Security-----------------------------------Market Price of the Security
Eg: Suppose the market price for a 10.18% G-Sec 2012 is Rs.120. The current yield on the
security will be (0.1018 x 100)/120 = 8.48%
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Yield to maturity (YTM)
The current yield calculation shows us the return the annual coupon payment gives the
investor, but this percentage does not take into the account the time value of money, or,
more specifically, the present value of the coupon payments the investor will receive in the
future.
Yield to maturity tells you the total return you will receive by holding the bond until it
matures. It also enables you to compare bonds with different maturities and coupons. Yield
to maturity equals all the interest you receive from the time you purchase the bond until
maturity (including interest on interest at the original purchasing yield), plus any gain (if you
purchased the bond below its paR) or loss (if you purchased it above its par value).
It is the discount rate, which equals all the cash flows (coupon payments and the debt
repayment) arising from the instrument with the purchase price. The concept of YTM is
based on following implicit assumptions:
The instrument is held till maturity
The intermediate cash flows are reinvested at the rate of YTM
There is no put and call facility available to investors or the issuers
Given a pre-specified set of cash-flows and a price, the YTM of a bond is that rate which
equates the discounted value of cash flows to the present price of the bond. It is the internal
rate of return of the valuation equation.
For example, if a 11.99% 2009 bond is being issued at Rs.108 and the coupons are paid
semi-annually, we can state that:
108 = 5.995 + 5.995 + + 105.995------- ------- -----------
(1 + r) (1 + r)2 (1 + r)18
The value of r, which solves the equation, will be the YTM of the bond.
The value of r in the above equation is found to be 5.29%, which is the semi-annual rate
and hence YTM of the bond would be 10.58%
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YTM of a Zero Coupon Bond
In case of a zero coupon bond, since there are no intermittent cash flows in the form of
coupon payments, YTM of the bond is the rate that equates the present value of the maturity
or redemption value of the bond to the current market price. For example, if a zero coupon
bond sells at Rs.93.76 issued on February, 5 2001 and matures on 1 st January 2002, its YTM
is computed as
93.76 = 100------------
(1 + YTM) 330/365
= 7.39%
One can compare the YTM with one's required rate to take investment decisions. If the YTM
is more than the required rate of return of an investor, he should invest in the instrument
otherwise not.
Yield-to-Call
Yield to ca