Treasury Management Fundamentals

Treasury Management
(Finance)
Subject Code:
MF 0016
Revised Edition: Spring 2010
BKID B1814
Sikkim Manipal University

Directorate of Distance Education
Department of Management Studies
Board of Studies
Chairman
HOD Management Studies
SMU DDE
Mr. Pankaj Khanna

Director
HR, Fidelity Mutual Fund
Additional Registrar
SMU DDE
Mr. Shankar Jaganathan

Former Group Treasurer
Wipro Technologies Limited
Dean
SMU DDE
Mr. Abraham Mathew

Chief Financial Officer
Infosys BPO
Dr. T. V. Narasimha Rao

Adjunct Faculty and Advisor
SMU DDE
Ms. Sadhna Dash

Ex Senior Manager, HR
Microsoft India Corp. (Pvt.) Ltd.
Prof. K. V. Varambally
Director
Manipal Institute of Management, Manipal
Revised Edition: Spring 2010
Printed: July 2013
This book is a distance education module comprising a collection of learning
materials for our students. All rights reserved. No part of this work may be
reproduced in any form by any means without permission in writing from Sikkim
Manipal University, Gangtok, Sikkim. Printed and Published on behalf of Sikkim
Manipal University, Gangtok, Sikkim by Manipal Global Education Services
Manipal 576 104. Printed at Manipal Technologies Limited, Manipal.
Authors Profile
Prof. V. S. Kumar holds PDGBA from IIM Ahmedabad, AICWA from the Institute of
Cost and Works Accountants, and ACS from the Institute of Company Secretaries
of India. He has worked as CEO, Chief Compliance Officer, Company Secretary,
Chief Financial Officer, and General Manager in varied organizations over 35 years.
He is a specialist in the field of Financial & Accounting Controls, Reporting & MIS,
Disclosure, and Decision Support Systems. He conducts programmes in leading
corporations like Infosys and Ford, and in premier institutions.
Peer Reviewers Profile
Shankar Jaganathan is a Chartered Accountant (1985) and Law graduate (1984),
with over 25 years of experience in corporate, academic and social sectors. He
worked with Wipro Limited for 18 years between 1985 2003. The last position he
held was as Corporate Treasurer from 1995 2003. As Corporate Treasurer, he
was heading the Investor Relations, Treasury operations, Financial planning and
Accounting functions for Wipro Limited reporting to the Chief Financial Officer.
During his tenure, Wipro Limited was listed in the New York Stock Exchange in
October 2000. From 2003 to 2006, Shankar headed the Technology Initiatives
Program and Academic and Pedagogy function in Azim Premji Foundation. Shankar
is currently focused on research, writing, consulting and teaching. Shankar is a
Guest faculty in Corporate Finance in leading management institutes. His recent
book wisdom from the ants is a popular history of economics.
In House Content Review Team
Dr. Sudhakar G. P.
HOD
Dept. of Management Studies
SMU DDE
Dr. Sireesha Nanduri

Assistant Professor
Dept. of Management Studies
SMU DDE
Contents
Unit 1
Introduction to Corporate Treasury Management
Unit 2
Financial Markets The Money Market
21
Unit 3
Financial Markets Capital Market
39
Unit 4
Treasury Products
60
Unit 5
RBI and the Foreign Exchange Market
81
Unit 6
Liquidity Planning and Managing Cash Assets
99
Unit 7
Business Risk Management
117
Unit 8
Corporate Liquidity Risk Management
138
Unit 9
Interest Rate Risk Management
154
Unit 10
Financial Risk
176
Unit 11
Foreign Exchange Risk Management
199
Unit 12
Working Capital Management
225
Unit 13
Treasury Risk Management
245
Unit 14
Integrated Treasury
260
MF 0016
Treasury Management (Finance)
Course Description
Corporate Treasury Management (CTM) is the subject of organising the
finance required by a company and managing the liquidity and risks
associated with the finance sourced and used. CTM is the responsibility of
the Treasury function or department of a company.
CTM is a specialised function and involves application of financial expertise.
It studies financial market happenings and their impact on a business,
exposure of the business to a variety of financial risks, and explores
avenues to cope with the risks and keep the business as far as possible free
of adverse impact of the risks.
The core of CTM is management of liquid assets meaning cash and cash
equivalents, and this subject has taken on an international flavour especially
in India after economic liberalisation. In this revised environment, Treasury
has to contend with several varieties of risks, including foreign exchange
fluctuation, interest rate changes, financial market turbulence, business
vagaries and of course risks inherent in the treasury function itself.
For effective management of these risks, market has generated and
continues to generate and use several products such as forward contracts,
futures, options, swaps and other variants of these products that are (all
together) referred to as the derivatives family.
Apart from these products, Treasury has to work with effective strategies
that emanate from sensible, well-structured treasury policies. CTM can be
successful only when policies relating to the different aspects of the treasury
function, particularly the measurement and management of the plethora of
risks are properly evolved and tightly executed.
Statutory compliance is another crucial aspect of the core of CTM, and
relates to managing the rules of the land laid down by Companies Act,
FEMA, SEBI and other legislations, and administered by the Reserve Bank
of India (RBI). Likewise, an important facet of CTM is its participation in the
companys working capital management.
While the focus of CTM is the de-risking of liquidity from financial and
business contingencies, lately the profit-making potential of Treasury has
assumed significance with corporates sporting huge cash balances. Idle

cash is never a good thing for a business, and increasingly companies are
fixing targets for income to be earned from cash surpluses.
This has spawned debates on whether Treasury should be a profit centre or
a cost centre. The checks and balances required when Treasury takes on
this role have to be respected and should not undermine the primary onus of
protecting the business from risk.
Finally two debatable issues with the organisation of corporate Treasury
function are the choice between centralisation and decentralisation, and the
concept of integrated treasury. Decision on both these questions is largely
context-sensitive and varies with the scope of the function in a company.
Course Objectives
The objective of this course is to introduce to the students the subject of
Corporate Treasury Management.
After studying this subject, the students should be able to
explain the process of treasury policy formulation
describe the features, structures and types of money market instruments
discuss the regulatory requirements in equity and debt securities
analyse features and types of foreign exchange market
describe the features of commodity market, regulatory issues, role
played by commodity exchanges and players in commodity market
discuss the development of forex market and RBIs approaches to
Capital Account Convertibility
describe cash management system and compare internal and
multinational cash management system
explain the concept of risk measurement and the methods used
discuss different types of liquidity risks and explain the methods used to
measure them
describe interest rate risk management
study enterprise risk management as an essential weapon in financial
risk management
explain different types of currency exposure
review the part played by Treasury in managing working capital
discuss treasury risk management in practice and describe treasury and
asset liability management
analyse treasury as a profit centre
A brief description of the 15 units is given below:

Unit 1: Introduction to Corporate Treasury Management
The unit gives an overview of Corporate Treasury Management, its need
and benefits, functions and Treasury exposures. The organisation structure
of treasury is briefly discussed.
Unit 2: Financial Markets: The Money Market
This unit describes money market, one of the two types of financial markets
(the other is capital market). It elaborates on money market instruments and
the need for regulation of the market.
Unit 3: Financial Markets Capital Market
This unit describes the other type of financial markets viz. capital market. It
includes discussion of stock market (both equity and preference) and debt
market. Regulation of capital market is elucidated. We briefly touch upon
commodity markets.
Unit 4: Treasury Products
The unit focuses on treasury products for foreign exchange (forex) markets
and forex derivatives. Commodity market instruments are also discussed.
Unit 5: RBI and the Foreign Exchange Market
The unit outlines the crucial role of our countrys central bank i.e. Reserve
Bank of India (RBI) in forex management. The development of forex market
in India is delineated. The subject of capital account convertibility is
discussed, and Foreign Exchange Management Act (FEMA) is introduced.
Unit 6: Liquidity Planning and Managing Cash Assets
The unit introduces the core of treasury management liquidity and
discusses planning and control of liquidity. It then elaborates on CMS or
cash management systems (both domestic and international). The role of
working capital management in liquidity is described.
Unit 7: Business Risk Management
This unit tackles the important subject of business risks. Measurement of
business risks and their mitigation by effective treasury management are
covered.
Unit 8: Corporate Liquidity Risk Management
An equally crucial type of risk liquidity risk is the subject matter of this
unit. We trace the origin of liquidity risk, its types, ways to measure it and
tactics for mitigating the risk.
Unit 9: Interest Rate Risk Management

Yet another significant Treasury risk, titled interest rate risk, is discussed in
this unit. After detailing traditional and modern theories of interest rate, the
unit outlines management strategies to cope with the risk and the role of
financial intermediaries with respect to interest rate risk.
Unit 10: Financial Risk
The unit discusses the subject of managing financial risks of a business.
Starting with types of financial risks and its dimensions, the unit goes on to
describe strategies that could effectively help a corporate tackle financial
risks, and the realm of enterprise risk management (ERM).
Unit 11: Foreign Exchange Risk Management
The very real risk of forex fluctuations, which impacts many a business in
the global milieu we live in, forms the subject of this unit. Types of fore risks
are listed, and the strategies for managing the risk, comprising policies,
procedures and controls, are described.
Unit 12: Working Capital Management
Working capital is often called the lifeblood of a business, and is analysed
in some detail in this unit. The need for working capital, its dimensions and
the cash cycle are detailed first, followed by management strategies for
working capital and ending with its financing. The subject is dealt with from
the perspective of the Treasury function.
Unit 13: Treasury Risk Management
This is the concluding unit on risk management and deals with Treasury
risks. Apart from the risks associated with the classical format of the function
the market risks related to treasury are also elaborated as the function is
increasingly becoming an income generator. The role of asset-liability
management is briefly covered.
Unit 14: Integrated Treasury
We conclude the module with the concept of integrated treasury as a
means for more effective and efficient management of the responsibilities of
Treasury. Accounting risks associated with financial reporting and disclosure
of treasury exposures in the balance sheet are also discussed.
Unit 1
Unit 1 Introduction to Corporate Treasury Management

Structure:
1.1
Introduction
Objectives
1.2
Treasury Management
Need for specialised handling of treasury
Benefits
1.3
Treasury exposures
Coping with treasury exposures
1.4
Treasury Functions
Traditional functions
Evolving functions
1.5
Formulation of Treasury Policy
Policy aspects of treasury
Liquidity policies
Treasury risk and return policies
Financial ratios tracking policy
Derivatives policy
Foreign exchange (Forex) policies
Statutory compliance policies
1.6
Treasury Organisation
Structure of the treasury organisation
Treasury: Cost centre or profit centre
Centralised and decentralised treasury management
The concept of integrated treasury
1.7
Summary
1.8
Glossary
1.9
Terminal Questions
1.10 Answers
1.11 Case Study
1.1 Introduction
Corporate Treasury Management is the planning, organising, and control of
funds or cash required by a corporate entity, with the objective of optimising
liquidity and minimising risk.
Page No. 1
Unit 1
In this first unit, we introduce the subject to you and discuss its need and
benefits, the activities involved, the requirement for a treasury policy, and
the fresh contours of the subject in the globalised environment today.
In this unit and in the rest of the book we will use the terms funds, cash
and finance interchangeably, to mean the same thing.
Objectives:
After studying this unit you should be able to:
explain treasury management and treasury exposure
describe the functions of treasury and its organisation structure
explain the process of treasury policy formulation
discuss the structure of treasury organisation
explain the concept of integrated treasury management
1.2 Treasury Management

Treasury management is the planning, organising and control of funds
required by a corporate entity. Funds come in several forms: cash, bonds,
currencies, financial derivatives like futures and options etc. Treasury
management covers all these and the intricacies of choosing the right mix.
According to Teigen Lee E, Treasury is the place of deposit reserved for
storing treasures and disbursement of collected funds. Treasury
management is one of the key responsibilities of the Chief Financial Officer
(CFO) of a company.
Figure 1.1 depicts the varied aspects of treasury management.
Fig. 1.1: Treasury Management

(Source: http://www.eurojournals.com/irjfe_19_15.pdf)
Page No. 2
Unit 1
1.2.1 Need for specialised handling of treasury

Treasury management should be practised as a distinct domain within the
Finance function of an organisation for the following reasons:
One of the most consistent demands on the CFO of a company is that
money must be available when needed, and this becomes a 24/7 task.
The cost of money raised for the business is probably the most crucial
metric in a company for many of its investment and operational
decisions. Hence cost of funds has to be tracked diligently.
Internal financial management in a multi-national corporate entity
requires monitoring of several global currencies.
Globalisation of business has thrown up an unbelievable basket of
opportunities for the CFO to optimise the utilisation of funds and
minimise its costs. This requires expert handling.
Globalisation has also brought in unexpected risks that are not visible to
the untrained eye but can even destroy a business. Who would have
thought that the crash of Lehman Brothers could impact business
houses in interior India? But that was what happened in 2009.
With increasing financial risk shareholders have become jittery about
their holdings and need reassurance often. For a company the
Treasurer is probably the best spokes person to allay the concerns of
stockholders and other interested parties.
1.2.2 Benefits
Managing treasury as an expert subject has many benefits:
Valuable strategic inputs relating to investment and funding decisions
Close monitoring and quick effective action on likely cash surpluses and
deficits
Systematic checks and balances that give early warning signals of likely
liquidity issues
Significant favourable impact on the bottom line for global corporations
through effective management of exchange fluctuation
Better compliance with the increasingly complicated accounting and
reporting standards on cash and cash equivalents
Self Assessment Questions
1. Globalisation of business has thrown up opportunities for optimising the
_________________ and minimising the _________ of funds.
Page No. 3
Unit 1
2. Treasury management improves bottom lines for multinationals through

effective management of _____________________.
1.3 Treasury Risk Management

In this section, we get a glimpse of the risks that are inherent in the treasury
function of a corporate entity and the ways and means adopted by
companies to cope with the risks.
1.3.1 Treasury exposures
The treasury function exposes an organisation to a number of risks:
Liquidity risks, arising from borrowings in the financial market and its
different constituents like banks, NBFCs etc.
Financial loss risks, arising from using a complex variety of financial
instruments such as derivatives.
Currency risks, arising from the fluctuation in the buying and selling
rates of foreign currencies handled.
Accounting risks, arising from decisions relating to accounting, reporting
and disclosure of foreign exchange transaction and translations
Political risks, arising from changes in economic policies and decisions
of governments in all countries in which the entity has business interests
1.3.2 Coping with treasury exposures
Any organisation has to have in place a competent system that:
identifies the exposures to each of the aforesaid risks (identification)
quantifies the impact of each risk to the extent possible (quantifying)
sets policy restrictions and systemic controls on risk taking (policy
formulation)
has a team in place that effectively monitors the external and internal
risks arising from Treasury operations
takes care of periodic reporting to the concerned stakeholders on
Treasury exposures
The treasury risk management team deals with events that impact the
financial results in such a way that the impact is favourable.
3. Accounting risks arise from decisions relating to accounting, reporting
and disclosure of foreign exchange transactions. (True/False)
Page No. 4
Unit 1
4. A corporation must have a team in place to deal with events that impact
the financial results. (True/False)
1.4 Treasury Functions

What are the typical activities of the Treasury function? We first look at the
traditional functions that Treasury has always handled, and then review the
changes that have evolved in the Treasury function in the 21stcentury.
1.4.1 Traditional functions
Funding Planning and controlling the sourcing of both equity and debt
funds for the business
Cash management organising and scheduling day-to-day movement
of cash and other money market instruments
Treasury cost control efficient negotiation of interest rates, bank
service costs and the cost of other finances raised for the business
Treasury administration Dealing with banks and other financial
agencies
Treasury accounting Complying with the relevant accounting
standards on accounting and reporting of cash and cash equivalents
Exchange management In the case of a multinational company,
managing currency fluctuation risks and deciding on actions to cope with
the risk.
1.4.2 Evolving functions
Strategic funds management The vanilla function of funding has now
given way to a strategic job of short-term and long-term sourcing and
use of funds that improves the financial health.
Systematic cash management Advanced cash management
services have come up in the last 20 years that focus on effectively
minimizing the cash float i.e. the sterile money in the pipeline, which
does not earn interest.
Treasury cost management It is no longer enough to control the
bank interest and service charges, in view of treasury cost variants
available now, like fixed and floating rate swaps and derivatives. As
instruments multiply, with newer and more attractive features, cash
management has to consider these and decide which ones to use in the
attempt to reduce treasury costs.
Page No. 5
Unit 1
Treasury administration The single-vendor concept has become

outdated, and businesses are working with multiple vendors in the
Finance space banks, NBFCs, loan syndicates and financial
consultants for specific purposes. The complexity of treasury
requirements has made specialisation mandatory.
Treasury accounting Accounting and reporting standards have
tightened across the globe, and after scams like Satyam it has become
crucial for companies to regularly monitor treasury reporting.
Exchange management Foreign exchange issues such as
fluctuation, inter-currency movement etc. have become far more
important with globalization of Indian business.
Advanced automation of Treasury The impact of Internet on the
contours of treasury management function has been phenomenal. Webbased tools, online transactions, and live monitoring of interest and
foreign exchange rates etc. have given a new dimension to Treasury.
The key differences between the traditional and the modern Treasury
functions are (a) the increase in complexity and (b) the recognition of
Treasury as a function that can add distinctly to the bottom line and become
a profit centre instead of being just a cost centre.
Activity 1:
Consider you are the chief financial officer of a software company. How
would you oversee the companys Treasury function?
(Hint: Treasury function to be seamlessly linked with (a) operations and
(b) the other finance functions. Different aspects of finance have to be
clearly tackled with an eye on treasury risks.)
5. Treasury accounting handles compliance with relevant ________
_________ in the accounting and reporting of cash.
6. The impact of _____________ on treasury management functions has
been phenomenal.
1.5 Formulation of Treasury Policy

Treasury policy provides the framework for treasury operations internally as
well as externally vis--vis related functions viz. Accounting and Finance.
Page No. 6
Unit 1
The policy framework comprises management thinking, dos and donts, and
treatment of exceptions. It helps the management keep control over the
function, and gives clarity to Treasury employees as regards their duties and
powers.
The steps in treasury policy formulation are:
1. Spelling out management thinking on the objectives of treasury
2. Writing out the procedures to be followed in implementing the policies,
the control limits, the exceptions and the escalation protocol, and the
process of making policy changes when needed
3. Communicating the policies to all concerned and ensuring they
understand and implement it in spirit
1.5.1 Policy aspects of treasury
While a function or an activity is largely described through a set of steps and
procedures, certain aspects of the activity are also usually governed by a
set of policies. Thus, a company normally has credit policy, which stipulates
policy guidelines on credit to be given to customers; or inventory policy,
which lays down minimum and maximum inventory levels and order quantity
etc. The functionary is expected to work within the framework of the policy.
In a similar manner Treasury function should work under policy guidelines
that cover the key aspects of Treasury. The facets of the Treasury function
that require enunciation in the policies are:
Liquidity or cash balance levels
Risk v. return the desired mix
Financial ratios applicable to Treasury
Dealings in derivatives, choice of instruments that can be used
Defining foreign exchange fluctuation risk levels
Statutory compliance
Cash here means liquid funds held in whatever form bank balances,
currency notes and coins, very short-period deposits etc.
It must be noted that policies take care of the normal circumstances and not
exceptional ones. Even the exceptions specified under each policy are small
and relatively low-end deviations. Major change in conditions may require a
fresh set of policies.
Page No. 7
Unit 1
1.5.2 Liquidity policies

Here we are concerned with
Long-term and short-term liquidity
Minimum and maximum idle cash
Forms in which cash is held
Handling of cash deficits
Investment of cash surpluses
Policy guidelines typically answer the following questions:
What constitutes long term and short term with respect to treasury
decisions?
What are the minimum and maximum cash balance levels?
In what form or forms is liquidity to be maintained? Which forms are not
to be used at all?
In case of cash deficit, what actions are permissible at each managerial
level? Which actions cannot be taken without Top management
approval?
How are long-term and short-term surpluses of cash to be disposed of,
and with whose approval in the organization?
1.5.3 Treasury risk and return policies
Treasury risk is the danger of not having the funds hen required. Treasury
return is the profit earned by investing surplus funds.
In delineating treasury risk-and-return policies we are concerned with
definition of acceptable risk level
definition of the cost of capital or discount rate for evaluating investment
criteria for short-term investment decisions
matching the tenure of investment to the tenure of funding
Policy guidelines typically specify answers to the following questions:
How is risk defined with respect to the financial instruments and other
treasury exposure?
What is acceptable risk level regarding receipt and payment of cash?
What is the companys weighted average cost of capital?
What are the criteria for decision on short-term investment options?
What is considered an appropriate match between the relative maturity
periods of the funding components and the investment portfolio?
Page No. 8
Unit 1
1.5.4 Financial ratios tracking policy

Financial ratios are an integral part of a companys analysis of its financial
position and performance. Ratios measure a number of metrics related to
the companys finances, including profitability, liquidity, solvency and market
performance.
Here we are concerned with
o treasury metrics that have to be tracked and kept under control like
current ratio, debt equity ratio and debt service coverage ratio
o specific financial ratios that have to be measured regularly
o range within which each ratio should move
o action to be taken when ratio goes out of range
Which parameters of treasury performance will be monitored? The most
crucial parameter usually is liquidity. Other metrics are idle cash, float,
returns on short-term investment, etc.
Which ratios will be used to measure these parameters? Classic ratios
of liquidity are current ratio and acid test ratio. Many others may be used
depending upon the specific entity and business situations.
What constitutes the acceptable range for each ratio?
What action is required at different managerial levels if the ratio goes out of
range? For instance, if a credit purchase decision will push the acid test
ratio below the minimum, the purchase may have to be cleared by a senior
manager in Commercial.
1.5.5 Derivatives policy
The US Department of Treasury defines derivatives as a wide variety of
financial instruments or contract whose value is derived from the
performance of underlying market factors such as market securities or
indices, interest rates, currency exchange rates and commodity, credit and
equity prices. Derivative transactions include a wide assortment of financial
contracts including structured debt obligations and deposits, swaps, futures,
options, caps, floors, collars, forwards and various combinations thereof.
The derivatives policy is concerned with the following:
Different types of derivatives
Managing risk through the use of derivatives
Derivatives as investment options
Page No. 9
Unit 1

Should the entity handle derivative products at all?
From the types of derivatives available which ones should be selected?
What is the selection and implementation process?
1.5.6 Foreign exchange (Forex) policies
Foreign exchange is the conversion of one currency into another currency.
For instance, the US dollar would be foreign exchange for an Indian
company, and will need to be converted to INR for being used in India.
The foreign exchange policies concern the following:
Global nature of the entity
Foreign exchange transaction in the company
Foreign exchange conversion
Methods of managing foreign exchange fluctuation risk
What is the entitys exposure to foreign exchange fluctuation risks and
what is the managements risk appetite?
How does the management want to respond to foreign exchange risks in
transactions, that is, imports and exports?
What is the policy with respect to translation risks in financial reporting?
Which methods are to be adopted for containing these risks and which
are to be avoided?
1.5.7 Statutory compliance policies
Statutory compliance policies concern the following:
The statutory regulations that the entity has to observe and comply with
The approach to compliance
Action to be taken if there are compliance issues
What are the laws applicable to the business in general and treasury in
particular?
Would the compliance requirement related to an activity be an important
consideration in deciding to take it up?
What level of compliance reporting would be required of the officers on
compliance issues, to the Board and to shareholders?
Page No. 10
Unit 1
What would be the companys attitude to compliance issues, for

example notice received from a government authority regarding a
delayed filing?

7. The last step in treasury policy is to __________ the policies to all
concerned and ensure that they ______________ the policies in spirit.
8. _______________ policies deal with handling cash deficits and
disposal of cash surpluses.
1.6 Treasury Organisation

Organising the treasury function of a corporate entity effectively is crucial to
the success of the function and eventually of the entity itself. The tasks
involved here are the following:
1. Defining the organisation structure for the treasury function
2. Deciding whether treasury should be a cost centre or a profit centre
3. Deciding whether to centralise or decentralise the treasury function
The answer to 1 (structure) will depend upon the authority and responsibility
bestowed on the function, which in turn will depend upon the answers to 2
(cost centre or profit centre) and 3 (centralised or decentralised).
1.6.1 Structure of the treasury organisation
Figure 1.2 depicts the structure of a comprehensive treasury organisation.
Fig. 1.2: Structure of a Treasury Organisation
Page No. 11
Unit 1
The treasury of a large corporate with Forex exposure is handled by the

following three key departments:
1. Treasurer-Research The Treasurer-Research and the team handle
all the research and analysis needed for both domestic and foreign
market operations. Policy-making, budgeting, setting and reviewing the
cost of capital the most crucial metrics of the treasury function are
the key responsibilities of this department.
2. Front Office Manager The Front Office Managers responsibility can
be divided into two parts: (1) money market operations, which are dealt
with by the Money Market Desk and (2) foreign exchange operations,
managed by the Foreign Exchange Desk. The Front Office closely aligns
its strategies and decisions with the analytical inputs provided by the
Treasurer-Research. Fund-based and non-fund-based facilities, Forex
risk measures and money market instruments are planned here and the
plans are relayed to the Middle Office. This department plans the
sourcing of fund- and non-fund-based facilities required by the business.
Decisions include debt v. equity, specific financing alternatives, securing
limits for bank guarantees and letters of credit, and guidance to middle
office on policy requirements of the Treasury in respect of each of these
areas of action.
3. Middle Office Manager The Middle Office mainly functions as a link
between the Front Office and the Back Office, in the sense that specific
market initiatives and course corrections are directed by it with inputs
from the Front Office and implemented with the help of the Back Office.
The role of the Middle Office is crucial in the effective management of
float, short-term investment planning and execution, organising fundbased and non-fund-based facilities and/or limits, within the policy
guidelines of the Front Office. It also ensures effective guidance to the
Back Office for day-to-day management of the activities related to
treasury.
4. Back Office Typically, the Back Office is a section of the Controllers
Office and not part of the treasury. It has to receive the right inputs and
signals on market movements and on the actions to be taken on a dayto-day basis. Only then the policies and strategies evolved by the Front
Office and directed by the Middle Office will be effectively implemented.
Page No. 12
Unit 1
1.6.2 Treasury: Cost centre or profit centre

The treasury function of a company can be viewed in two ways:
As a cost centre This means the function is a cost to the company,
working within a cost budget and providing the services described in the
previous section.
As a profit centre Here the function is regarded as a revenuegenerating unit and its services to the company are ascribed a market
value. The costs incurred by the function to render the services are
deducted from this revenue and its profit is the basis for evaluating how
well the function has performed.
The revenue ascribed for the services is only an imputed figure and not the
actual revenue for the company. Operations are debited for treasury
services at market rates.
Advantages of viewing Treasury as a profit centre:
It helps in providing market rates to the individual business units for the
services provided and thereby making operating costs more realistic.
The treasurer is motivated to ensure that efficient services are provided
and he makes a good profit.
Disadvantages:
The profit motive could tempt the treasurer to engage in activity that may
be inadvisable in the companys larger interests. It should be noted that
this is not the core business of the entity.
Time would be wasted in arguments between business units and
treasury with respect to charges for the services provided by the
treasury.
The accounting and administrative costs of this treatment could be high.
1.6.3 Centralised and decentralised treasury management
Treasury can be handled either as a central function to the entire company
or managed by individual units within an enterprise separately.
Centralised treasury
The process of centralisation consists of:
Fully centralised management of policies and strategies of the Treasury
function
Page No. 13
Unit 1
Providing centralised liquidity management, foreign exchange and

interest risk management across all geographies in which the company
operates
Cash and bank services management for all units of the company
Advantages:
Centralisation allows the treasurers to exercise greater control over
cash.
It enhances economies of scale and reduces costs for bulk services.
Centralisation can achieve low cost debt, increase investment returns,
reduce financial risks and ensure liquidity across the organisation.
It promotes specialisation of treasury management skills.
Disadvantages:
Delay in operations waiting for approvals from HQ
Central treasury taking decisions without considering local conditions
Increased cost of centralized control especially if the company has
operations in many countries
A good example of centralised treasury is Infosys Ltd, Bengaluru. All
treasury decisions are centralised and executed from the head office at
Bengaluru and almost all foreign operations are executed in the branch
model. Branches do not have the authority or the responsibility to source or
otherwise manage funds except as provided from the central office.
Decentralised treasury
In a decentralised environment, the company allows its subsidiaries,
divisions and Strategic Business Units (SBUs) to manage their treasury
function themselves within the overall policy guidelines. Corporate treasury
remains only a strategic hub responsible for laying down and implementing
treasury policy and overall liquidity management.
A good example of decentralised treasury is Axiata, the Kuala Lumpurbased telco enterprise (IDEA is its Indian extension) with revenues of over
$5.7 billion in 2012. Axiata has a fairly independent system for treasury
management at the units, the central control being limited to policy-making
and key decisions. The company has of course recently undertaken a
review of the system and elected to centralise its Treasury functions in more
areas.
Page No. 14
Unit 1
Advantages:
There are major challenges for large multinationals in managing treasury
in many countries operating out of the headquarters. Decentralising is
inevitable to some extent for them.
It facilitates quick and prompt decisions, which make sure that
operations do not get held up unduly for want of approvals from the
Head Office.
It helps develop all-round managerial talent across the organisation
since the divisional managers become adept at managing funds.
Decentralised treasury can enable the units to use local features of the
function to the benefit of the company, which may not even be known to
the officers in head office. India, for instance, has pre-shipment credit
facility for exports, which a global company can use effectively; however,
the headquarters of that company in some other part of the world may
not be aware of this.
Disadvantages:
Dilution of control over finance and related treasury functions
Scope for companys policy being violated due to abuse of power by
local units
Lack of expertise in the management of treasury as the job may not be
done by professionals at the divisional level
An effective solution is a mix of both approaches. While areas involving
domain expertise like foreign exchange or derivatives should only be
handled centrally, regular bank and cash operations and such other simpler
tasks are better left to the local units.
1.6.4 Concept of integrated treasury
Traditionally, foreign exchange dealings and money market operations were
considered as separate in a corporate organisation. However, with the
interest rate deregulation, liberalisation of foreign exchange activities and
development of foreign exchange market, a need for integrating foreign
exchange dealings and money market dealings arose and grew rapidly.
Integrated treasury manages all market risks associated with the
organisations liabilities and assets in all geographical locations. It
strategises the companys funding to balance cost and liquidity. Integrated
Page No. 15
Unit 1
treasury provides benchmark rates for cost of capital in consonance with the
degree of risk involved.
Activity 2:
Consider you are a member of treasury policy committee in a software
company. What will your policy framework contain?
(Hint: http://www.financeasia.com/News/174076,how-infosys-excels-atcurrency-management.aspx (Interview with the CFO of Infosys on 10
May 2010))
9. As a profit centre, treasury is regarded as a _______________ unit and
its services to the company are ascribed a _______________.
10. In a decentralised environment, the company allows its subsidiaries to
manage their treasury functions within overall ______ ___________.
11. Risk management deals with balancing risks and _________.
12. Integrated treasury manages all __________________ associated with
the organisations __________________ in all geographical locations.
1.7 Summary
Corporate Treasury Management is the process of managing a business

entitys financial resources in the most efficient manner.
The function has been recognised as a domain with distinct expertise
that can benefit a company in many ways and also expose the company
to a number of risks.
Treasury management functions include funding or financing, cash
management and accounting & reporting, The focus should always be
on the overall cost of the function.
The formulation of treasury policy is a prime task before the companys
CFO, and covers diverse subjects like liquidity, risk v. return, ratio
analysis of key treasury performance parameters, compliance matters
and foreign exchange transactions and translations.
The structure of a typical Treasury organisation has departments for
policy-making, funds & non-funded facilities and foreign exchange.
The company should decide whether its Treasury would be a cost centre
or a profit centre; and whether the function is to be decentralised or
Page No. 16
Unit 1
centrally directed from HO. The decision would depend upon a variety of
factors.
Integrated treasury is a concept that has emerged in the last couple of
decades as an effective solution for global treasury issues.
1.8 Glossary
Disbursement: Payment to discharge a debt or expense.
Legislative: Possessing the power to make laws or law-making.
Retention: The act of keeping in self-possession.
Surplus: Amount in excess of what is required.
Tenor: Period for which money is borrowed or lent.
1.9 Terminal Questions

1. Explain corporate treasury management, its need & benefits and the
meaning of treasury exposure.
2. List and briefly describe treasury functions.
3. What are the different aspects of treasury policy?
4. Draw up a typical treasury organisation and explain its different sections.
5. What are the pros and cons of decentralising the treasury function?
1.10 Answers
Self
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
Assessment Questions
Utilisation, cost
Exchange fluctuation
True
True
Accounting standards
Internet
Communicate, implement
Liquidity
Revenue-generating, market rate
Policy guidelines
Returns
Market risks, assets and liabilities
Page No. 17
Unit 1
Terminal Questions
1. Treasury management is the process of planning, organising and
managing the organisations holdings. Treasury exposure opens up the
organisation to a number of risks. For further details, refer to 1.2 and
1.3.
2. Treasury functions comprise funding, non-funded facilities, foreign
exchange management and investment. Refer to 1.4.
3. Aspects of treasury policy include liquidity, risk v. return, foreign
exchange, derivatives and statutory compliance. Refer to 1.5.
4. Treasury-Research, Front office and Middle office are three sections
which report into the treasury Head. The back office, which is part of
the Controllers office, executes decisions taken by Treasury. Refer to
1.6.1.
5. Pros: quicker decisions, development of managerial talent in Treasury;
cons: lack of control, company policy dilution (refer to 1.6.3).
1.11 Case Study

Excerpts from the Annual Report of Saint-Gobain, 2011, page 92.
Treasury and Financing Department
The Treasury and Financing Department defines financing policies for the
entire Group (Compagnie de Saint-Gobain, the General Delegations and the
subsidiaries). Cash management transactions are subject to periodic
controls and at Group level the cash position is monitored at monthly
intervals based on detailed analyses of gross and net debt by currency,
maturity and type of interest rate (fixed or variable), before and after
hedging. Due to Compagnie de Saint-Gobains central role in the Groups
financing, its debt structure is monitored through a specific monthly reporting
system. The Internal Audit unit performs periodic reviews, on a rotating
basis, of transactions by the General Delegations cash management units,
to check their compliance with Treasury and Financing Department policies
and the quality of internal control. Internal controls over cash management
transactions are an integral part of internal audit plans for the subsidiaries
and are also examined by the subsidiaries external auditors. The Groups
risk factors are described on pages 100 to 106. The Treasury and Financing
Department has drawn up a set of procedures for managing these risks
Page No. 18
Unit 1
which is updated on a regular basis and applies to the subsidiaries and

General Delegations. The Department also performs compliance controls on
financial market transactions carried out by the Corporate Treasury unit.
In addition, the Companys external auditors carry out the following reviews
and audits of the Treasury and Financing Department:
a half-yearly review and an annual audit covering
o the type of treasury transactions carried out
o the accounting treatment used for these transactions and
o the underlying risks
an annual review of the security of information systems used by the
Department for conducting its operations
Discussion Questions
1. How is the Treasury function organised in Saint-Gobain?
2. What are the risks managed by the function?
Source: http://www.saint-gobain.com/files/Saint-Gobain-annual-report-2011.pdf
Hint: The Treasury & Financing Department of Saint-Gobain manages

Treasury in a part-controlled, part-decontrolled setup. Subsidiaries, General
Delegations and Corporate Treasury are permitted to function freely but
within the ambit of policies set by Treasury & Financing, and subject to
internal and external audits. You are encouraged to read the report fully.
References:
Bhole, L. M., & Mahakud, J. (2009). Financial Institution and Markets
(5thed.).India: Tata McGraw-Hill.
Khan, M. Y. (2009). Indian Financial Systems (6thed.). India: Tata
McGraw-Hill.
E-References:
http://books.google.co.in/books?id=s4keBrCF2wMC&pg=PA4&dq=
Functions+of+Treasury+Management&hl=en&ei=F9eFTJzvBoiksQOz_
vz6Dw&sa=X&oi=book_result&ct=result&resnum=2&ved=0CDsQ6AEw
AQ#v=onepage&q=Functions%20of%20Treasury%20Management&f=
false(Retrieved on 13th September2010)
Page No. 19
Unit 1
http://www.acrobatplanet.com/non-fictions-ebook/pdf-ebook-treasurymanagement-versus-cash-management.html (Retrieved on 13th

September 2010)
http://www.citigroup.com/transactionservices/home/corporations/docs/
top_priorities_for_treasury.pdf (Retrieved on 13th September 2010)
http://www.ehow.com/about_5406415_role-corporate-treasurymanagement.html (Retrieved on 13th September2010)
http://www.eurojournals.com/irjfe_19_15.pdf
"Treasury Management: An Overview" by Teigen, Lee E. Business

Credit, Vol. 103, Issue 7, July 2001
Page No. 20
Unit 2
Unit 2
Financial Markets The Money Market
Structure:
2.1 Introduction
Objectives
2.2 Money Market
Characteristics and Participants
Purposes of Money Market
Organised and Unorganised Money Markets
Call money market
2.3 Money Market Instruments
Treasury bills (T-Bills)
Commercial papers (CPs)
Certificate of deposits (CDs)
Bills of exchange
Repo & reverse repos
2.4 Collateralised Borrowing and Lending Obligations (CBLO)
2.5 Regulation of Money Market
2.6 Summary
2.7 Glossary
2.9 Answers
2.10 Case Study
2.1 Introduction
In the previous unit, you were introduced to Treasury Management as a
specialist subject. You read about the contours of the science of treasury
management as applied in corporate houses. In this unit, we explore money
market, which plays an important role in treasury management.
Financial markets are places for trading of financial instruments. There are
two types of financial markets: money market and capital market.
Capital market is where securities issued by corporate and governments
are traded.
Money market is where short term cash needs of companies and
government are met using money market instruments. Almost all
financial institutions trade in money market instruments.
Page No. 21
Unit 2
In this unit, you will get familiar with instruments in the money market and
learn how money markets are regulated.
Objectives:
describe the features, structures and types of money market instruments
understand money market instruments and list different types of
instruments
explain the structure of repo and reverse repo transaction
discuss collateralised borrowing and lending obligations
examine how money market is regulated
2.2 Money Market

2.2.1 Characteristics and Participants
According to Reserve Bank of India (RBI), money market is the centre for
dealings, mainly of short-term character, in money assets; it meets the
short-term requirements of borrowers and provides liquidity or cash to the
lenders. It is the place where short-term surplus investible funds, at the
disposal of financial and other institutions and individuals, are bid by the
borrowers, again comprising institutions and the government itself. Money
market is a market for short-term borrowing and lending of funds. Short-term
refers to a period of less than one year.
Money market facilitates quick transactions of large amounts between
business corporations, government agencies, banks etc. in the short term.
Example A company has cash balances far in excess of its transaction
requirements. It can invest this in the money market for short periods and
take it back when a necessity arises.
The participants in money market are the financial intermediaries such as
money brokers, large business corporates, commercial banks and the RBI.
RBI plays an important role in the Indian money market. It modifies liquidity
of the financial institutions, influencing availability and cost of money in the
market.
Some characteristics of the Indian money market are:
It is a market for instruments with less than 1 year maturity.
Interest rates are based on demand for and supply of funds.
Page No. 22
Unit 2
The parties mutually agree on the tenure, rate and terms.

Money market operations are regulated by RBI.
The players in the money market are commercial banks, private firms
and the government.
2.2.2 Purposes of money market

Money market serves these purposes:
Maintain equilibrium between demand and supply of short-term funds
Act as bellwether for RBI intervention to regulate liquidity in the
economy.
Provide access to users of short-term funds to borrow and invest at
efficient market prices.
2.2.3 Organised and Unorganised money markets
The organised money market in India consists of the RBI, nationalised,
scheduled and non-scheduled commercial banks and foreign banks. RBI
regulates the entire banking sector in India. Non-banking financial
institutions namely Life Insurance Corporation (LIC), General Insurance
Corporation (GIC) and its subsidiaries and Unit Trust of India (UTI) operate
indirectly through banks in the market. Surplus funds of quasi-governmental
and other large organisations are also routed through banks.
The unorganised money market comprises unregulated financial
intermediaries, indigenous bankers and private money lenders. People who
borrow in this market include non-corporate and corporate small
businesses.
2.2.4 Call money market
An exclusive segment of money markets is the call money market.
Call money market is a short-term market where financial institutions borrow
and lend money. It is also known as interbank call money market as banks
are the major participants. The day-to-day surplus funds are traded in the
call money market. The maturity of the loans in this market varies between
one day and a fortnight. The loans are repaid on demand of either the
borrower or the lender. The loans in this market often help banks to meet
RBI reserve requirements.
The characteristics of call money market are as follows:
It is a market for short-term funds, also known as money on call.
Page No. 23
Unit 2
It is highly liquid as the funds are repayable on demand.

It is a sensitive segment of financial system.
Changes in the demand and supply for short-term funds get quickly
reflected in the financial system.
In India, call loans are unsecured. Call rates, or the rates of the interest paid
on the call loans are subject to seasonal fluctuations in demand. Intra-day
fluctuations in call rates are also huge and rates can vary every hour.
Call money market is not relevant to corporate entities as they cannot
operate in it.
1. Money markets are used by organisation that needs to borrow, lend or
invest for the ___________.
2. ___________ is used by the central banks for conducting open market
operations.
3. Unorganised sector comprises indigenous bankers and moneylenders.
(True/False)
2.3 Money Market Instruments

In this section we will discuss the instruments with which operations are
conducted in the money market.
A plethora of money market instruments take care of borrowers' short-term
needs and provide required liquidity to lenders. We will review the following
well-known instruments:
treasury bills
commercial paper
certificate of deposits
bills of exchange
repo and reverse repo
2.3.1 Treasury Bills (T-Bills)
A T-Bill is a promissory note issued by RBI on behalf of Government of India
at a discounted value to meet its short-term requirements. T-Bills are highly
liquid because they are guaranteed by the Central Government and can be
used as claims against the government without any need for acceptance or
endorsement.
Page No. 24
Unit 2
T-Bills are issued in 4 tenures: 14 days, 91 days, 82 days and 364 days
through auctions. Auction amounts and dates are announced by RBI from
time to time. Organisations like Provident Funds, state-run pension funds
and state governments are allowed to participate in the auction, but not bid.
RBI invites bids every fortnight and decides the cut-off rate on the bids.
The fluctuation in the discount rate of T-bills is very low and so is the
transaction cost.
While T-bills are a good choice for reflecting risk-free rate of return,
corporate houses prefer 10-year Government bond rate as the yardstick for
risk-free return while computing their cost of capital threshold. This is
because 10-year Government bond rates, duly adjusted for currency of
issue and the concerned governments economic record, reflect the risk-free
rate of return better than T-bills.
2.3.2 Commercial Paper (CP)
Commercial Paper (CP) was first introduced in January 1990 in India. It is a
short-term unsecured promissory note issued by large corporations in bearer
form on a discount to face value. It meets the corporations short-term need
for funds. The maturity period ranges from 7 days to one year. CP is
negotiable by endorsement and delivery. They are highly liquid as they are
bought back.
CPs are issued in denominations of ` 5 lakh or multiples. Generally CPs
are issued through banks, dealers or brokers and sometimes directly and
bought mostly by commercial banks, non-banking finance companies
(NBFCs) and other corporates. CPs issued in international financial
markets are known as euro-commercial papers.
Salient features:
CP is an unsecured promissory note.
CP can be issued for maturity periods of 7days to a year.
CP is issued in the denomination of ` 5 lakh. The minimum size of an

issue is ` 25 lakh.
The issue size of CP should not exceed the working capital of the
issuing company.
Page No. 25
Unit 2
The investors in CP market are banks, NBFCs, corporates in India and

high-net-worth individuals (HNIs).
The interest rate of CP depends on the prevailing rates in the CP
market, foreign exchange market and call money market.
The eligibility criteria for the companies to issue CP are as follows:
o The tangible worth of the issuing company should not be less than
` 4 crore.
o
The company should have a minimum credit rating of P2 and A2

obtained from Credit Rating Information Services of India (CRISIL)
and Investment Information and Credit Rating Agency of India
Limited. (ICRA) respectively.
o The company must have a sanctioned working capital limit from a
bank or a financial institution and the account must be classified as a
standard asset.
The RBI circular RBI/2011-12/89 IDMD.PCD. 4/14.01.02/ 2011-12
contains the updated regulations re: issue of commercial paper.
Advantages of CP
Negotiable by endorsement and delivery
Higher returns than from risk-free investments
High safety and liquidity CP is believed to be one of the highest quality
investments available in private sector
Flexible instrument that can be issued with varying maturities
CP is a close competitor to T-Bills, but T-Bills have an edge because they
are risk-free and more liquid.
2.3.3 Certificate of Deposits (CDs)
Certificate of deposit (CD) is a short-term instrument issued by scheduled
commercial banks and financial institutions. It is a certificate issued for the
amount deposited in a bank for a specified period at a specified rate of
interest. The concerned bank issues a receipt which is both marketable and
transferable by the holder. The receipts are in bearer form and transferable
by endorsement and delivery.
Basically they are a part of banks deposits; hence they have less risk
associated with repayment. CDs are interest-bearing, maturity-dated
obligations of banks. CDs benefit both the banker and the investor. The
Page No. 26
Unit 2
bankers need not worry about premature cashing of the deposit as the
investor can sell the CDs in the secondary market if she needs cash.
CDs can be issued only by scheduled banks. It is issued at discount to face
value. The discount rate depends on the market conditions. CDs are issued
in the multiples of ` 1 lakh and the minimum size of the issue is ` 1 lakh. The
maturity period ranges from 7 days to one year. There is no restriction on
the discount rate and the bank is free to fix its own rate.
Features of CDs in Indian market
Schedule commercial banks are eligible to issue CDs
Maturity period is from 7 days to one year
Banks are not permitted to buy back their CDs before the maturity or
grant loans against the CDs
CDs are subjected to CRR and Statutory Liquidity Ratio (SLR)
requirements
They are freely transferable by endorsement and delivery. They have no
lock-in period.
CDs have to bear stamp duty at the prevailing rate in the markets
NRIs can subscribe to CDs on repatriation basis
2.3.4 Bills of exchange
A bill of exchange is a financial instrument which is traded in bill market.
According to the Indian Negotiable Instruments Act, 1881 it is a written
instrument containing an unconditional order, signed by the maker directing
a certain person to pay a certain amount of money only to, or to the order of
the bearer of the instrument.
Bills of exchange are drawn by the seller on the buyer for the value of goods
or services delivered by the seller. They are therefore trade bills. They are
negotiable instruments freely transferable by endorsement and delivery and
accepted by banks. The liquidity of bills of exchange is next only to call
loans and T-bills.
Classification of bills of exchange
Broadly there are two kinds of bills of exchange: documentary bills and
Accommodation bills.
Documentary bills of exchange: These bills are accompanied by
documents related to goods such as loading bills, railway receipts or bills of
Page No. 27
Unit 2
lading; or related to performance of services. There are several types of

documentary bills:
Demand bill and Usance bill Demand bill has to be paid immediately
when payment is asked for and there is no waiting period. Usance bill is
a bill of exchange drawn for a specified period of time and becomes
payable when the time specified expires.
In the Indian parlance, documentary bills are known as hundis. The two
types of hundis are darshani (demand bills) and muddati (usance bills).
Inland bill It is drawn in India upon a person residing in India and must
be payable in India.
Foreign bill It is drawn outside India in favour of a person residing
inside or outside India. They are payable both in and outside India.
Supply bill It is a bill made by the supplier to the government or semi
government to get advance payment for the goods supplied to them.
Accommodation bills: An accommodation bill is a bill of exchange which is
accepted and sometimes endorsed without the backing of any trade in
goods or delivery of services. The bill is created on the basis of a fictitious
transaction and is only an accommodation for a person in need of funds.
There was a flourishing trade in huge volumes in accommodation bills a few
decades ago but this has been effectively curbed by regulations prohibiting
it.
2.3.5 Repos and reverse repos
Repo and its structure
Repo is the short form for repurchase. Repo is a money market instrument.
It is a transaction in which a person (seller) sells securities to another
(buyer) with an agreement to repurchase it at a specified date and interest
rate. The transaction is a repo from the viewpoint of the seller. Repos
enable collateralised short-term borrowing or lending through sale or
purchase of debt instruments. The maturity of repos is from 1 day to one
year. For details, refer to draft guidelines issued by RBI in this regard
(http://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=2054).
Page No. 28
Unit 2
The structure of repo is shown in the figure 2.1.
Figure 2.1: Structure of Repo Transactions
The important features of Repos are:

Repos have low credit risk as there is collateral and a Subsidiary
General Ledger (SGL) mechanism.
Interest rate risk is low as the period of lending is short.
Low liquidity risk as the seller has surplus funds.
Settlement risk is small because all the transactions are settled through
SGL system and public debt office at RBI.
Repo rate is the annual interest rate for the funds transferred by lender to
borrower. Repo rates are lower than interbank loan rates. The factors
affecting repo rate are credit-worthiness of the borrower and the collateral
loan rates vis--vis rates of other money market instruments.
2.3.5.1 Types of repos
Interbank repos Interbank repos are permitted for eligible instruments

and participants. Central and State government securities and T-Bills
are eligible for repo. In order to participate in repo, banks need to route
their SGL accounts maintained by RBI. Non-bank participants can
participate only in reverse repo which means they can only lend funds to
eligible participants. Non-banking entities having their SGL accounts
with RBI can participate in reverse repo transactions with banks,
Governments and primary dealers (PDs). The phasing out of non-bank
entities from call money market and establishment of Clearing
Corporation has made interbank repo an important component in money
market.
Page No. 29
Unit 2
RBI repos RBI undertakes repo and reverse repo with banks and PDs
as an element of its Open Market operations (OMOs). It also absorbs or
injects liquidity. The introduction of Liquidity Adjustment Facility (LAF)
has led RBI to infuse liquidity into financial system on a daily basis.
Banks and PDs can participate in repo auctions which are conducted
daily except Saturdays. Auctions under LAF have a single repo rate for
all the bidders. Multiple price auctions were introduced subsequently.
The average cut-off yield is released to the public. Cut-off yield along
with cut-off price provides a range for call money market. RBI conducts
repo auctions to provide a channel to manage short-term liquidity for
banks and to stabilise short-term liquidity fluctuations in the money
market.
Reverse repo and its structure

A reverse repo is a transaction of cash in which the lender purchases an
asset from the borrower as a guarantee to get the loan repaid at the agreed
interest on a specific date. It is the same transaction of repo but from the
viewpoint of the lender. In other words, it is a repo transaction for the
borrower, but the same transaction is a reverse repo for the lender. The
structure of a reverse repo transaction is shown in the figure 2.2.
Figure 2.2: Structure of Reverse Repo Transaction
Reverse repo was started to earn additional income on idle cash. The
difference between the rate at which the securities are purchased and sold
is the lenders profit. This transaction has an element of security purchase &
sale as well as money market borrowing/lending. Repos and reverse repos
are used for the following reasons:
To meet shortfall in cash
To increase the returns on funds held
Page No. 30
Unit 2
RBI conducts reverse repo operations under Liquid Adjustment Facility to

prevent sudden spurts in call rates. Repos and reverse repos operations
play an important role in imparting stability to the market.
Activity 1:
The interest rate offered on CDs varies from bank to bank. Refer the
business magazines and analyse the best interest rates offered by the
banks on CDs.
(Hint: Analyse the factors affecting CD rates in section 2.3.3, Also refer
to http://www.yesbank.in/global_indian_banking/yesinvestor.php)
4. Commercial papers are known as __________ in international markets.
5. ___________ are drawn by the seller on the buyer for the value of
goods delivered by the seller.
6. In reverse repo a party buys a security from another with a commitment
to sell it back to the latter at specified time and price. (True/False)
2.4 Collateralised Borrowing and Lending Obligations (CBLO)

Collateralised Borrowing and Lending Obligations (CBLO) is a product in the
money market launched in 2003 by Clearing Corporation of India Limited
(CCIL). Collateral is a physical security given as a guarantee by a borrower
for participation in the transaction. CBLO provides liquidity to non-banking
entities that have been phased out of call money market or have restrictions
on borrowing/lending transactions in call money market. It is a tripartite repo
in which the borrower deposits his securities with a third party acceptable to
the lender.
CBLO is a repo used in international markets. The third party guarantees
the return of funds from the borrower on the specified date. The third party
sells the securities in the market to repay the funds to lender. In most of the
repo transactions, both the borrower and lender cant unwind the deal
before the due date. In certain cases even if the liquidity condition of the
borrowers improves before the specified date, they cannot unwind repo
deal. Similarly, even the lenders cannot get back their funds until the
maturity date of the repo deal. When lenders need funds, they have to enter
Page No. 31
Unit 2
into a new repo deal or borrow funds. To resolve this problem, CCIL
designed the CBLO to lend or borrow at various maturities.
RBI has prescribed the mode of operations in the CBLO segment. The
minimum order for auction market is ` 50 lakh and in multiples of ` 5 lakh. In
2002 RBI permitted CBLOs developed by Clearing Corporation of India
(CCIL) without any restriction on denomination or lock-in period.
There is a facility to unwind lending and borrowing at prices depending on
the market situation. Since the lenders and borrowers have the flexibility to
unwind the deal at their will, they may have to bear risk of buying CBLOs
with longer maturity period. In auction market, the borrowers will submit their
offers and the lenders will give their bids, specifying the discount rate and
maturity period. The bids and offers are screened from 9.45 am to 1.30
pm on working days.
In normal market, the minimum order lot is fixed at ` 5 lakh and in multiplies
of ` 5 lakh. The members will place their buy/sell orders on the screen
which is opened from 9:30 am to 3.30 pm on all working days. The orders
are selected based on best quotations and negotiations are also allowed.
The borrowers issue the debt instruments under the guarantee of CCIL.
CCIL identifies lenders and borrowers to promote CBLO. It, provides
guarantee, manages the instrument, and acts as a clearing house for
settlement between the purchaser and seller through clearing operations. In
a demanding situation, it also acts as a buyer or seller.
The CBLO members are required to maintain a cash margin with CCIL as a
cover for the exposure obligations during the course of borrowing. The
borrowing members retain the ownership of the securities as the securities
are not transferrable to the lenders. The participants in CBLO transactions
are the members of Negotiated Dealing System (NDS) such as banks,
financial institutions, cooperative banks mutual funds and primary dealers.
The Non-NDS members like cooperative banks, corporates, Non-banking
Financial Companies (NBFCs), pension/provident funds and trusts can
participate by registering themselves as associate members to CBLO
segment. The associate members can participate in normal market to
borrow and lend funds, but not in auction market. The CCIL designates a
Page No. 32
Unit 2
bank and the associate members are required to open a current account for
settlement of funds.
Activity 2:
Visit a financial institution or bank and find out the procedure involved in
obtaining membership of CCIL for CBLO.
(Hint: CBLO procedure is explained in section 3.4. Also refer to
http://www.ccilindia.com/faq.aspx?subsectionid=44#147)
Self
7.
8.
9.
_________ was launched by the Clearing Corporation of India Limited.
___________ identifies lenders and borrowers to promote CBLO.
Collateral means a physical security given as a guarantee by a
borrower for participation in the transactions. (True/False)
2.5 Regulation of Money Market

The regulatory bodies of financial markets in India are RBI for the money
market and Securities and Exchange Board of India (SEBI) for capital
markets. Money market comes under the direct purview of RBI.
Regulation of money market is essential to effectively prevent liquidity
mismatch in the system and to transmit policy changes to the other parts of
the financial system. During the global financial crisis in 2008-09, policy
initiatives were attempted for smooth functioning of money market. The
sustained availability of liquidity helped in handling stress levels in market
segments. Growth and stabilisation of markets in 2009-10 has led to certain
regulatory measures. They were aimed at improving transparency,
expanding the markets and promoting liquidity. Some of the regulatory
measures of RBI are as follows:
Reporting platform for CDs and CPs RBI introduced a reporting

platform to promote secondary market for CDs and CPs. The reporting
platform is operated by Fixed Income Money Market and Derivatives
Association of India (FIMMDA). It disseminates secondary market
transactions in CDs and CPs. The RBI has directed all its regulated
entities to report their Over the Counter (OTC) trades in CDs and CPs to
FIMMDA. Other regulators such as SEBI and Insurance Regulatory and
Page No. 33
Unit 2
Development Authority (IRDA) have also been advised to regulate their

CPs/CDs in their trade entities on this platform.
Repo in corporate bonds RBI has accepted repo in corporate bonds to

develop corporate bond market. All the repo trades of corporate bond
market are reported to FIMMDA reporting platform for dissemination of
price/yield information to the market participants. Repo trades in
corporate bonds shall be settled through mechanism available in the
case of OTC trades in corporate bond market. Only listed corporate debt
securities, which are rated AA and above is eligible for repo
transactions. The repo trade transactions in corporate debt securities will
be considered as borrowing/lending transactions. The participants
entering repo in corporate bonds are required to sign the Global Master
Repo Agreement (GMRA) as finalised by FIMMDA.
Revised guidelines for accounting of repo/reverse repo transactions The revised guidelines were issued on March 24, 2010, and came into
effect from April 1, 2010. They require repo/reverse repo transactions to
be reported as outright sale and purchase as per the current market
convention. The movements should be reported in books of the
counterparties by showing same contra entries for greater transparency.
Regulation of Non-Convertible Debentures (NCDs) of maturity up to one

year RBI issued directions under the sections 45W of the RBI
(Amendment) Act on June 23, 2006 to address the regulatory gap that
existed in issuance of NCDs of maturity up to one year through private
placement. According to the directions, which are applicable for secured
and unsecured NCDs, the NCDs cannot be issued for maturities less
than 90 days and options that are exercisable within 90 days from the
date of issue cannot be modified. Issuers of the NCDs have to appoint a
Debenture Trustee and every issue should be reported to RBI. NCDs
have been prescribed for the eligibility criteria, rating requirements, etc.
while issuing CPs.

10. The regulatory bodies of financial market in India are the RBI and
___________.
11. Money market is under direct purview of the RBI. (True/False)
12. The reporting platform for CDs and CPs is operated by ___________.
Page No. 34
Unit 2
2.6 Summary
Financial market is the place for trading in financial instruments. Money

market and capital market are two types of financial markets.
Money market helps fulfil short-term cash needs of government and
large companies.
Money market instruments take care of the borrowers' short-term needs
and provide the required liquidity to the lenders. The types of money
market instruments are treasury bills, commercial papers, certificates of
deposit, bills of exchange, repo and reverse repo.
Collateralised Borrowing and Lending Obligations (CBLO) provide
liquidity to entities that have been phased out of the call money market
or have restrictions on borrowing/lending in that market.
Regulation of money market is essential to manage liquidity effectively
and prevent liquidity mismatch in the system.
2.7 Glossary
Collateral: Property or assets made by available by the borrower to the

lender as a security against a loan
Liability: An obligation that legally binds an individual or a company to a

payment.
Liquidity: Money, investments or property that can be changed into

money readily.
Surplus funds: Money remaining after all immediate liabilities is paid.

1.
2.
3.
4.
Explain the features, structures and types of the money market.

List money market instruments and describe each.
Describe collateralised borrowing and lending obligations.
Discuss the regulations of money market.
2.9 Answers
1. Short-term
Page No. 35
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
Unit 2
Call money market

True
Euro Commercial Paper
Bills of exchange
True
Collateralised borrowing and lending obligations (CBLO)
Clearing Corporation of India Limited (CCIL)
True
Securities and Exchange Board of India
True
FIMMDA
Terminal Questions
1. Money market is the centre for dealings, mainly of short-term character,
in money assets; it meets the short-term requirements of borrowers and
provides liquidity or cash to the lenders. Refer to section 2.2.
2. Money market instruments take care of the borrowers' short-term needs.
Major instruments are certificates of deposits, bills of exchange, repos &
reverse repos, and commercial paper. Refer to section 2.3.
3. CBLO provides liquidity to non-banking entities that have phased out of
call money market. Refer to section 2.4.
4. Money market comes under direct purview of RBI. Key regulations
include introduction of reporting platform for CDs, revision in accounting
guidelines for repo transactions, and additional controls on specific
instruments like NCDs. Refer to section 2.5.
2.10 Case Study

Repo Auctions in India
The monetary policy of 1992 announced auction mechanism for sale of
government securities as a new approach to internal debt management.
Repo auctions for government securities were introduced in Dec 1992. RBI
conducts repo auction in government securities to balance the short-term
liquidity in the money market and provides a channel for the banking system
to optimise returns on short-term surplus funds.
Repos gained prominence in 1993-94 due to the sharp increase in liquidity
caused by large capital inflows. The average value for bids accepted that
Page No. 36
Unit 2
year was ` 2,729 crores. The sharp expansion of non-food credit and the
rigid liquidity conditions due to decline in capital inflow led to suspension of
repo auctions in Feb 1995. To address this issue, reverse repo auction on
government securities was extended to STCI and DFHI in order to inject
liquidity into the system. As a result, the rise in the call money rate was
stopped.
During 1992-93, the total value of bids accepted was ` 68, 636 crore with
cut-off ranging from 5% to 19.5%.In 1993-94 it was ` 98, 239 crore with cutoff between 5.75% and 11.5%. The success ratio in auctions was 66%. Due
to tight liquidity conditions in 1994-95; repos remained subdued with an
average turnover of ` 6,428 crore. During 1997-98 the average repo value
was ` 165, 000 crore with repo rate of 2.9%- 5%.
Repo transactions resumed in Nov 1996. Repos with maturity period of 3-4
days became active from Jan 1997. A calendar for monthly repo auctions
was introduced in Jan 1997 to facilitate treasury management. The repo rate
varied from 5.75% to 7% for a period of 14 days.
From Nov 97 fixed repo rates were introduced. The daily turnover for threeday repos was ` 3,465-10, 000 crore. Initially the repo was at 4.5%, raised to
7% in Dec 97 and to 9% in Jan 98. In order to maintain stability in domestic
and foreign exchange markets the repo rate was brought down to 8%.
During 1997-98 repos managed short-term liquidity in the financial systems.
Discussion Question
1. Explain the aim of reverse repo auctions.
(Hint: Inject liquidity into the system)
Source: http://mpra.ub.unimuenchen.de/12147/1/repo_auction_bidders_behaviour.pdf retrieved on 23.10.10
References:
Bhole L. M & Mahakud J (2009), Financial Institutions and Markets, Fifth
Edition, Tata McGraw-Hill New Delhi
Dr. K. Natarajan & Prof. E. Gordon (2009), Financial Market Operations
1st Edition, Himalaya Publishing House, Girgaon, Mumbai 400 004.
Page No. 37
Unit 2
G. Ramesh Babu (2007), Management of Financial Institutions in India,

First Edition, Concept Publishing Company, New Delhi
Khan M. Y. & Jain P. K. (2006), Management Accounting and Financial
Analysis, Second Edition, Tata McGraw-Hill New Delhi.
Pathak B. V. (2008),The Indian Financial Systems: Markets, Instruments
and Services, Second Edition, Dorling Kindersley Pvt. Ltd, NOIDA
E-References:
http://www.rbi.org.in/scripts/AnnualReportPublications.aspx?Id=984
Retrieved on 14.9.10
http://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=
&ID=34 Retrieved on 15.9.10
Page No. 38
Unit 3
Unit 3
Financial Markets Capital Market
Structure:
3.1
Introduction
Objectives
3.2
Capital Market
3.3
Stock Market
Primary market
Types of equity issues in primary market
Secondary market
Instruments in the secondary market
3.4
Preference shares
3.5
Debt Market
Types of Debt instruments
Debentures and bonds
Government securities market
Loans, Mortgages and Financial Leases
3.6
Regulatory Requirements
The functions of SEBI
3.7
ADRs and GDRs
Benefits of depository receipts
Participatory notes
3.8
Foreign Exchange Derivatives
3.9
Commodity Markets
Commodity future trading
3.10 Summary
3.12 Answers
3.13 Case Study
3.1 Introduction
We discussed money market, which is one of the two types of financial
markets, in the previous unit. In this unit we will discuss the other type of
financial markets the capital market.
In every economic system some participants have surplus funds (investors)
while others have deficits (issuers). Capital market brings the issuers and
Page No. 39
Unit 3
investors together. It establishes trading facilities for different types of

securities and ensures proper and equal access to all investors through
appropriate communication channels.
We describe in this unit the activities in the capital market in a variety of
financial securities including foreign instruments.
Objectives:
explain the features and types of capital market
describe equity and debt markets and their features
discuss the regulatory requirements in equity and debt securities
explain the features of ADRs and GDRs
explain the meaning and features of participatory notes, foreign
exchange derivatives and commodities
3.2 Capital Market

Capital markets work for the creation and trading of financial assets like
stocks, bonds, hybrid instruments, commodities and derivatives. A number
of participants like brokers, dealers, investment bankers and financial
mediators operate in capital markets.
Capital market is of two types: stock markets, which trade equity
instruments and the bond markets, which trade debt instruments. Examples
of Capital Market in India are the Bombay Stock Exchange (BSE) and the
National Stock Exchange (NSE).
While commodity market comprising commodity exchanges is not usually
regarded a part of capital market, it is in a sense a market that operates on
similar lines and we will briefly cover this topic in the end.
The regulation of capital market is essential for its perfect functioning. In
India Securities and Exchange Board of India (SEBI) is the regulator.
Features of capital market are:
Capital markets deal with financial instruments like equities, bonds etc.
Trading can occur without the intervention of an intermediary, though
dealings in stock markets are usually done through member brokers to
reduce settlement risk.
Page No. 40
Unit 3
There is information asymmetry in capital markets that needs to be

handled effectively.
The security prices are volatile by nature.

1. SEBI regulates stock exchanges. (True/False)
2. There is information _________ in capital markets.
3.3 Stock Market

Stock market is a place where shares are issued and traded through stock
exchanges. It gives company access to capital and in return a portion of the
ownership in the company is given to investors. Stock market is split into
primary and secondary markets.
Apart from equity shares, the single-most prolific type of shares issued by
companies, there are also preference shares.
Large companies are listed on BSE and NSE while small and medium ones
are listed with OTCEI (Over the Counter Exchange of India). The Indian
stock markets are regulated and supervised by SEBI.
3.3.1 Primary market
Primary market, also called new issues market or IPO market is involved in
issuing new securities to investors. Many small and medium companies
enter this market to raise money from public for their businesses.
Rights issue, Initial Public Offer (IPO) and preferential issue are three
approaches through which equity shares can be issued in the primary
market. Initial Public Offer involves sale of securities to general public for
the first time. Rights issue involves sale of securities to the existing
shareholders at a fixed price. Preferential issue, also called private
placement is an offer of equity by a listed company to a relatively small
group of Investors (mostly banks, insurers or pension funds).
Before making an issue in the primary market a company must fulfil the
stipulations of the concerned stock exchange called listing requirements.
There are two types of lists maintained by a stock exchange: cash list and
forward list. The equity shares listed on the cash list are non-cleared
securities and those listed on the forward list are cleared securities.
Page No. 41
Unit 3
The following are some of the important listing requirements (conditions to

be fulfilled for listing of the securities on a stock exchange):
Company needs to file a Prospectus with SEBI and get it approved
Minimum paid up capital of ` 3 crore
Minimum issue size of ` 10 crore
At least 25% of the equity shares must be owned by the public.
Features of primary market

It is the market where securities are sold for the first time.
The securities are issued directly by the company to the investors.
Primary issues are used to set up new businesses or expand existing
businesses.
3.3.2 Types of equity issues in primary market
Equity issue increases the amount of capital in the market by release of new
shares.
Figure 3.1 depicts the types of equity issues in primary market.
Figure 3.1: Types of Equity Issues

Source:
http://docs.google.com/viewerinvestor.sebi.gov.in/faq/pubissuefaq.pdf+equity+
issues+in+primary+market Retrieved on 23.10.10
The types of equity issues are:

Initial Public Offer (IPO) An IPO is a public issue made by a company
for the first time. The two methods of IPO are:
Page No. 42
o
o
Unit 3
Through issue of fresh shares by the company

Through offer for sale of existing shares by the existing shareholders
to the public
Under the IPO involving fresh issue of shares, the equity base of the
company increases with the value of the issue. Under the offer for sale
method, the equity base of the company does not increase as no fresh
shares are issued by the company. Only the existing shares are being
sold by one shareholder to another.
Rights issue In a rights issue, shares are issued to the existing

members of the company viz. members whose names are registered as
on the record date in proportion to the shares they currently hold.
Subsequent public offer It is an issue made by a company that has

already gone public and has issued shares through an IPO earlier. The
offer can be either a public issue or an offer for sale or composite issue.
A composite issue is the combination: the company makes a rights issue
to its existing shareholders while making a concurrent public issue to the
general public.
Preferential issue also known as private placement is an offer of equity

by a listed company to a select group of Investors. SEBI has laid down
the guidelines governing the pricing of such issues (Chapter XIII of SEBI
(DIP) Guidelines 2000).
3.3.3 Secondary market

Secondary market or after-market is the market where an investor buys a
security from another investor and not from the issuing company. Secondary
market helps in reducing the investment risks and providing liquidity to the
investors.
3.3.4 Instruments in the secondary market
Equity shares Present holders of equity shares who initially bought
them from the issuing company sell them in the secondary market.
People also buy shares in the secondary market.
Rights issue/Rights shares Rights shares offered by a company to its
existing shareholders are sometimes offloaded by them in the secondary
market.
Page No. 43
Unit 3
Bonus shares Bonus shares, meaning shares given free to existing

shareholders by a company converting its free reserve to share capital,
are offloaded in the secondary market.
Debentures and bonds Debit instruments i.e. debentures & bonds that
were subscribed to by the holders are sold in the secondary market.
Commercial paper Subscribers to commercial paper issues may at
times sell them in the secondary market.
Government securities: Treasury bills and other securities issued by the
government and subscribed to by the institutions and individuals can be
sold in the secondary market.
Security receipts Security receipt is a receipt issued by a securitisation
company or a reconstruction company to any qualified institutional buyer
and is traded in the secondary market.

3. ________ and _______ market are the two segments of equity market.
4. Primary market is also called new issue market. (True/False)
3.4 Preference Shares

Preference shareholders enjoy the preferential rights to dividend and return
of capital ahead of equity shareholders. They get a fixed dividend that
accrues in the years in which it is not paid for want of profit.
Some types of preference shares are:
Cumulative shares It gives a right to unpaid dividends of any previous

year to be paid when the company makes profits. Unless specifically
stated as non-cumulative, preference shares are cumulative in nature.
Redeemable shares Preference shares have to be necessarily

redeemed (bought back from the holders) within a maximum of 20 years
of issue. Irredeemable preference shares could be issued till 1996, when
an amendment put an end to their issuance.
Participating shares Preference shares which are given dividend over

and above the agreed dividend are known as participating shares. This
happens when the company earns extra profits, which gives the holder
the right to receive a fixed dividend plus share in excess of profits.
Convertible shares Convertible preference shares give the holders a

choice to either convert their preference shares into equity shares at a
Page No. 44
Unit 3
specified time and on specified terms, or have the share redeemed by

the company.
3.5 Debt Market

Debt market is an important source of funds especially in a developing
economy where investors may be averse to investing in volatile equity
shares. Debt market establishes a regulated environment where debt
instruments like mortgages and bonds are traded.
Debt market takes different names based on the types of debt instruments
traded. If the market deals mainly with municipal and corporate bonds, it is
known as bond market. If mortgages are the main focus of trading, the
market is known as credit market. When debt instruments have fixed rates,
the market is known as fixed income market.
Debt market contributes in reducing the degree of risk associated with
investment in financial securities by providing liquidity to the investor. It is a
market with more assured returns, though significantly lower than returns
from equities. There is risk in debt market too, due to interest rate changes
and possibility of default in repayment. Retail participation is rare in this
market.
The Indian debt market can be classified as Government Securities market
(G-sec market) and Bond Market.
3.5.1 Types of debt instruments
Debenture A debenture is a written instrument containing a promise to
repay principal amount after a definite period and the interest at a fixed
rate which is paid typically half-yearly or yearly on fixed dates.
Bond A bond is a fixed income debt instrument issued to the investor
by a corporate or government entity. The loan is to be repaid over a
period of time with a fixed interest rate.
Government Securities Debt securities issued by RBI on behalf of the
government of India are called government securities or G-Secs.
Loan A loan is a debt instrument between a specific investor and the
borrowing company. It marks a one-to-one relationship and cannot be
traded as it is not negotiable.
Page No. 45
Unit 3
Mortgage A mortgage is loan on residential property secured by its title

deed. If the borrower fails to pay the loan, the lender can take the
property to discharge the unpaid debt. Like a loan this is also nontransferable.
Financial Lease A financial lease is an agreement between an owner
of a property and tenant. It creates a secured debt.
3.5.2 Debentures and bonds

Debt takes the form of a transferable instrument in debentures and bonds,
and can be traded freely.
A debenture is a document that creates a debt or acknowledges it. A
debenture is thus like a certificate of loan or a loan bond evidencing the fact
that the company is liable to pay a specified amount with interest. Senior
debentures get paid before subordinate debentures, and there are varying
rates of risk and payoff for these categories.
Debentures are generally freely transferable. Debenture-holders have no
voting rights in the company's general meetings of shareholders but can
have separate meetings among themselves when their rights are affected.
The interest paid to them is a charge against profit in the company's
financial statements, unlike equity and preference dividends, which are
distributions of after-tax profits.
Types of debentures:
Secured or Mortgage debentures
Unsecured debentures
Redeemable debentures
Convertible Debentures
Bonds
A bond is a debt investment in which an investor loans money to an entity
(corporate or governmental) for a defined period of time at a fixed interest
rate.
Globally identified assets secure a corporate bond but debentures are not
secured by specific assets but by the general credit of the corporation. In
India however, the terms bond and debenture are used interchangeably.
Page No. 46
Unit 3
Issuers of bonds include public financial institutions and corporations.

Lenders may be bond funds or individual investors who originally buy the
bond from the Fund and then sell in the secondary market.
Risk factors involved while investing in bonds

Any investment involves risk. A bonds risk level is reflected in its yield.
Understanding bond yield is essential for an investor. The risks involved in
bonds are:
Interest rate risk A general rise in market interest rates reduces the
bond price. Bonds with longer maturities have greater interest risk.
Reinvestment risk Interest income has to be reinvested to obtain

assure returns, and this involves reinvestment risk.
Inflation risk Inflation reduces bond investors returns on future interest

payments and principal amount. Higher inflation also increases interest
rates, which depresses bond prices.
Market risk The systematic risk that affects the bond market as a
whole
Selection risk The risk of selecting a non-performing security,

i.e. default risk
Timing risk The risk of investing at the wrong time leading to

increasing the above-mentioned risks
Types of bonds
Zero coupon bonds These are issued at a discount to their face value,
and the face value is repaid to the holders on maturity. There is no
interest payment to the bondholders in the holding period.
Floating rate bonds The bonds in which the coupon rate is fixed with
reference to a benchmark rate and varies with changes in the bench
mark rate are called floating rate bonds.
Callable bonds The issuer of callable bond has the right to change the
tenor of the bond. Before the actual maturity date the issuer of such
bond might repay it fully or partially as per the terms of issue.
Page No. 47
Unit 3
Put-able bonds The buyer of the put-able bond has the right to redeem
the bond during the specified period mentioned in the bond indenture.
Junk bonds Junk bond or high yield bond is a bond which is issued by
a company that has a credit rating below investment grade and is
considered a high credit risk. These bonds have higher returns as a
result.
Foreign currency bonds Bonds denominated and repayable in foreign
currencies to make them more attractive to investors. The company
should evaluate international interest rate differences on a fully hedged
basis to optimise the cost.
Price determination factors of bonds

Bond price refers to the price an investor would pay for an existing bond.
The main factors that influence bond prices are:
Interest rate or Coupon rates When interest rates are on the rise, new
issues become more attractive and adversely impact existing bond
prices.
Inflation High inflation erodes the return on the bond.
Frequency of interest payments or Cash flows Bond produces cash
flows from three bases viz., coupon payments, price appreciation and
coupon re-investment returns.
Yield There are three vital yield measures which help decide bond
prices.
o Coupon yield Coupon yield signifies the interest rate determined by
the terms of issue of a bond. The interest rate is determined as a
percentage of the face value. Coupon yield will not change for fixed
rate bonds.
o Current yield Current yield evaluates the coupon payment on the
prevailing bond price.
o Yield to Maturity This is the internal rate of return on the bond
based on inflows till maturity at current discount rates.
Total bond returns It considers the interest income and investment
profit/losses while determining the accurate return of the bond. This
analysis is performed by financial companies and is known as mark-tomarket method.
3.5.3 Government securities market (G sec market)
Page No. 48
Unit 3
Government securities are created and issued by the government notified in

an official publication and in government securities acts.
G-Secs can be obtained either from the primary or secondary market. The
securities are issued by the RBI on behalf of the Government of India.
The features of government securities are as follows:

Government securities are identified by specific coupon rate and the
year of maturity.
Government securities are available both in the primary and secondary
markets.
Entities like financial institutions, corporate houses and individuals buy
them.
After the tenure is completed the bonds are redeemed.
3.5.4 Loans, Mortgages and Financial Leases
Debt arrangements that are personalised and cannot be transferred or
traded include loans, mortgages and financial leases. The most
preeminent forms of such arrangements are bank loans of different
types.
Bank loans are sought by businesses either for investment in fixed
assets like buildings, plant & machinery etc. or for working capital. Banks
have tailor-made products to suit the specific needs, and so you can
have term loans, overdrafts or non-fund based arrangements.
All types of bank credit are typically secured against prime and collateral
property. Thus if the borrower defaults the bank could cash the security
and set off the proceeds against the dues. An elaborate agreement is
prepared and executed by borrowers before any bank loan can be
disbursed.
A bank loan agreement usually specifies the actions that can be taken
by the bank for recovering the loan and interest dues from the borrower.
These include
o Regular follow-up through the banks own employees
o Appointing debt recovery agencies which will follow up with the
borrower in steadily escalating degrees of toughness
Page No. 49
o
o
o
Unit 3
Approaching the guarantor, in case there is one, and recovery from

him/her
Instituting legal action against the defaulting borrower after giving
due notice
Security repossession i.e. taking possession of properties charged to
the bank as prime or collateral security.
There are strict RBI regulations guarding borrowers against undue

harassment by the bank, and scheduled banks have to respect and
adhere to these rules.
Activity 1:
You are the Finance Manager of TS Ltd, and you are finding it difficult to
service a loan taken from LD bank. Prepare a report to the Board on
likely actions that could be taken by the bank against your company.
(Hint: Refer to 3.5.4. For more detail, go to any scheduled banks
website and you will find the list of specific actions the bank may take
when the borrower defaults}

5. Yield to maturity is the interest rate determined by the terms of issue of
a bond. (True/False)
6. A debt instrument is a _______________ assurance to repay debt.
3.6 Regulatory Requirements

In India capital market activities are regulated by SEBI. SEBI governs stock
exchanges and through it listed companies. SEBI has separate control
measures on listed and unlisted companies, issue of debt instruments and
so on.
3.6.1 Functions of SEBI:
Protecting the interest of investors
Promoting the development of the securities market
Regulating the workings of Stock Exchanges
Registering and regulating the working of stockbrokers, sub-brokers,
share transfer agents, depositories, participants and foreign institutional
investors
Page No. 50
Unit 3
Checking and preventing insider trading

Monitoring and inspection of mutual funds
Addressing complaints from investors against mutual funds, securities
market etc.: SEBI has promulgated investor associations which create
consciousness about securities markets to investors. Complaints can be
addressed in www.scores.gov.in.
Clause 49 of Listing Agreement

A new clause was introduced by SEBI for improving corporate governance
in 2004 and became effective from Dec 2005. The clause sets out elaborate
measures to be taken by listed companies with regard to all the following
aspects of governance and shareholder relations:
Board of directors: Focus is on the proportion of non-executive and
independent directors, which should be between 33% and 50%. Tenures
of non-executive directors have also been specified.
Directors remuneration: Prior approval and disclosure relating to
remuneration of independent directors has been made stricter.
Audit committees: Financial and accounting knowledge is mandatory for
all audit committee members, since the committee has to confirm the
authenticity of the companys financial reporting. For the same reason,
their interaction with statutory auditors is also substantially increased.
Board & management procedures: Code of conduct has to be published
and adherence to the code confirmed by Board and management in
every annual report. The new whistle blower policy gives power to an
employee to speak to the audit committee about any malpractices of the
management.
Shareholder interaction: The annual report will set out in much greater
detail the risk assessment of the business, and spell out more clearly the
impact of changes if any in accounting practices.
Reporting and compliance: Statutory compliance is to be reported every
quarter to the Board for review and corrective action if required. Report
on corporate governance has to be sent to the stock exchange within 15
days of the close of each quarter.
Activity 2:
Page No. 51
Unit 3
You are the Chief Financial Officer (CFO) of a listed company. What
checks and balances will you have in the company to comply with the
SEBI guidelines?
(Hint: Refer to 3.6 above. Go through the requirements of clause 49 of
listing agreements, and plan the controls you should install in your
company.)

7. SEBI governs the public issues, rights issues, preferential issues made
by companies. (True/False)
8. SEBI prohibits the ______________ as part of its regulatory measures.
3.7 ADRs and GDRs

A Depository Receipt (DR) is a versatile financial security issued by a
depository for holding the shares of a foreign publicly listed company that is
traded on a local stock exchange. Two of the most common types of DRs
are the American Depository Receipt (ADR) and Global Depository Receipt
(GDR).
ADR is a financial instrument representing shares of a non-U.S. company
and is traded on U.S. stock exchanges. ADRs are issued to facilitate
investments by US residents in foreign company shares that can be traded
on local exchanges. ADRs are listed on NYSE, AMEX or NASDAQ.
Advantages of ADRs:
Subscribing to ADRs is a simple method of buying shares in foreign
companies.
ADRs save money by reducing administration costs and avoiding foreign
taxes on the transaction.
GDRs were developed on the basis of ADRs and are listed on stock
exchanges outside US. GDRs are traded globally instead of the original
shares on exchanges. The objective of GDR is to enable investors to gain
economic exposure to a company in emerging markets.
Features of GDRs:
GDR holders do not have voting rights.
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Unit 3
It has less exchange risk than a foreign currency loan.

The investor can cancel his receipt and get the underlying shares by
instructing the depository.
ADRs and GDRs are excellent instruments of investment for NRIs and
foreign nationals who want to invest in India. By buying these, they can
invest directly in Indian companies.
3.7.1 Benefits of depository receipts

The increasing demand for DRs reflects the need of investors to diversify
their portfolios, reduce risk and invest internationally. DRs allow investors to
achieve the benefits of global divergence without the added expense and
complexities of investing directly in the local trading markets.
3.7.2 Participatory notes
International presence in Indian capital market is limited to Foreign
Institutional Investors (FIIs). The market has found a way to overcome the
limitation by creating an instrument called Participatory Notes (PNs). PNs
are basically contract notes.
India-based brokerage houses and FIIs buy securities and issue PNs to
other non-registered foreign investors. Any dividends or capital gains
collected from the primary securities are passed on to the investors.
Investing in PNs eliminates the need to register with SEBI, whereas all FIIs
have to.
Benefits of PNs:
Entities route their investment through PNs to extract advantage of the
tax system.
They enable large funds to carry their investments without revealing
their identity.
Investors use PNs to enter Indian market and shift to full-fledged FII
structure when they are established.
9. ADR is a security representing shares of a non-US company and is
traded on US stock exchanges. (True/False)
10. ________________ are foreign entities authorised to invest in India.
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Unit 3
3.8 Foreign Exchange Derivatives

Financial instruments like foreign currency forward contracts, currency
option, currency swap and currency futures are called foreign exchange
derivatives.
Globalisation and the breakdown of trade barriers have considerably
increased flow of foreign capital across nations. This has given rise to the
popularity of forex derivatives, which promote hedging of foreign currency
risks.
Advantages:
1. The USD and euro are the two most traded currencies in the market. As
far as banks and finance companies are concerned forex derivatives
contribute a large share to their profitability, as this is their central
business. But our focus is on corporates, where the role of derivatives is
limited to de-risking or hedging.
2. At a routine transaction level meaning export or import which is a
regular occurrence in any global business forex derivatives play the
role of hedging against risks of adverse price fluctuation. So if an
importer were to buy goods worth $1 million today and payment is due 2
months later, he could book a forward contract and get a firm price at
which he will get the dollars 2 months later and pay off the bill.
Please note that he may actually make a loss if the dollar price on the date
of payment is actually lower than his contracted price. But by booking
forward he is sure of the price, and so in a manner this is re-risking.
11. Any ____________________ that participates in future movements in
foreign currency rates is a foreign exchange derivative.
12. Forex derivatives perform the important function of hedging forex risk.
(True/False)
3.9 Commodity Markets

Commodities markets are places where commodities are traded. They can
be either regulated markets or exchanges. Commodities have immense
potential as financial assets for knowledgeable investors.
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It is the market where a wide range of commodities like precious metals and
crude oil are traded. An active and liquid commodity market helps investors
hedge their commodity risks.
Commodity market exists in two distinct forms namely Over the Counter
(OTC) market and exchange-based market. Their subdivisions are spot and
derivative markets. Spot markets are basically OTC markets and only the
people who are involved with the trading of same commodity participate.
Derivative trading is through exchange-based markets with standardised
contracts and settlements.
New York Mercantile Exchange (NYMEX) and London Metal Exchange
(LME) are two preeminent commodity markets. In India we have National
Commodity and Derivatives Exchange (NCDEX) and the Multi-commodity
Exchange of India (MCX).
3.9.1 Commodity future trading
Commodity trading is a complex investing method. In commodity trading an
investor trades on exchanges to get the products they need or to make profit
from the fluctuating prices. The size of the market has grown manifold with
introduction of futures trading. In India commodity future trading is regulated
by the Forward Markets Commission (FMC). FMC is a statutory body that
was set up in 1953 under the Forward Contracts (Regulation) Act, 1952.
The benefits of futures commodity trading are:
Greater flexibility, certainty and transparency in obtaining commodities
Efficient price detection which prevents the seasonal price variability
Access to a large financial market
13. Active commodity market assists investors to hedge their commodity
risk. (True/False)
14. Derivative trading is through ____________________.
3.10 Summary
Capital market is the place where financial securities in debt and equity
are traded.
Primary and secondary markets are the two types of equity market.
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Regulation of capital markets is essential as a massive volume of funds

flow through them regularly. In India regulation of capital markets is
done by SEBI.
ADR is a security representing the shares of a non-U.S. company and is

traded on U.S. stock exchanges. GDRs were developed on the basis of
ADRs and are listed on stock exchanges outside US.
Commodities are products that are traded on exchanges at prices based

on supply and demand. A liquid commodity market helps investors to
enhance investment opportunities.
3.10 Glossary
Concurrent: Happening or existing at the same time
Derivative: Instruments or ideas which have their origin in some other

basic form
Dividend: The portion of profits of a company that is paid to the

shareholders
Surplus: More than or in excess of what is required

1.
2.
3.
4.
5.
What are the features of a capital market?

Describe different types of bonds.
What are the features of ADRs and GDRs?
Explain the benefits of participatory notes.
What are the benefits of future commodity market?
3.12 Answers
1. True
2. asymmetry
3. Primary, secondary
4. True
5. False
6. Contractual
7. True
Page No. 56
Unit 3
8. Insider trading
9. True
10. FIIs
11. Financial instrument
12. True
13. True
14. Exchange based markets
Terminal Questions
1. Capital markets deal in primary securities. Refer 3.2.
2. The issuer of callable bond has the right to change the tenor of a bond.
Refer 3.5.2.
3. ADR reduces administration cost. GDR has less exchange risk as
compared to foreign currency loan. Refer 3.7.
4. Investors use PNs to enter Indian market. Refer 3.7.2.
5. Access to a huge potential market will increase due to future trading
market. Refer 3.8.1.
3.13 Case Study

Sterlite mops up $1.5 billion via ADRs for power push
ET Bureau Jul 17, 2009, 02.41 am IST
MUMBAI: Sterlite Industries, part of the London-listed Vedanta Resources,
on Wednesday raised $1.5 billion (about ` 7,200 crore at current exchange
rates) through an American Depository Receipt issue, reviving hopes of
similar equity offerings from other companies, especially in the power
sector.
The Anil Agarwal-controlled company said the funds raised the first ADR
for an Indian company in two years would be used to part-finance its
power generation plans and other planned capital expenditure programs. Of
the $1.5 billion raised, about $500 million (about ` 2,400 crore) would come
from parent Vedanta, while $1 billion (about ` 4,800 crore) is from
institutional investors. Housing finance major HDFC had raised $698 million
(now about ` 3,350 crore) through an ADR issue in 2007.
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Vedanta's investment is aimed at retaining its stake in Sterlite at 61.7%.

Selling the entire ADS to other investors would have brought down
Vedanta's holding to 53% to 54%.
JP Morgan and Morgan Stanley were the joint book runners for the issue
which, at $12.15 was priced at a 6.1% discount to Sterlite's Wednesday
ADS close.
Sterlite's ADS issue is the first in a series of measures that would soon
include acquisition of mining assets in Africa and Central America, said
chairman Anil Agarwal.
In its July 15 edition, ET had reported that Sterlite is planning to raise about
$1 billion through either a qualified institutional placement issue or an ADS
to part finance its growth.
Sterlite's power plans are being built through wholly-owned subsidiary
Sterlite Energy, which is building two commercial power plants a 2,400
mw plant at Jharsuguda in Orissa and another 1,980 mw plant in Punjab, at
a total investment of about ` 15,000 crore (about $3.12 billion). "The
response to the Sterlite issue shows that there is a lot of interest in India,"
said Vedika Bhandarkar, MD and head (investment banking) at JPMorgan
India. "In terms of sectors, it also shows a robust interest in power
generation," she added.
The books to the issue opened at around 2.30 am India time on Thursday
and closed at about 7.30 am India time. According to people close to the
development, the issue was 80% covered within the initial three to four
hours. About 80 to 100 investors participated and approximately a fourth of
the book came from hedge fund investors, while there were some anchor
investors, they sources added. About 85% of the demand came from the US
and Asia, underscoring the fact that the India growth story is intact.
The parent Vedanta Resources is a metals conglomerate and has been
planning to increase its presence in the Indian power sector, given the sharp
gap in generation and demand.
India currently has an installed generation capacity of 149,391 MW and a
peak hour deficit of 12% due to the huge surge in demand from industrial
and retail consumers. The Union government has publicly announced plans
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Unit 3
to add 78,700 MW during the five years to March 2012 to meet this demand.
If the country needs to maintain an annual growth rate of 8%, it needs to
build 20,000 MW every year.
Shares of Sterlite Industries ended down 6% at ` 590.15 in a flat market.
The stock traded down as much as 9% in intra-day trade, before recovering
and closing 6% down. An ADR issue was in line as it enabled the global
mining firm, Sterlite, to tap a broader investor base.
http://articles.economictimes.indiatimes.com/2009-0717/news/27651735_1_sterlite-energy-adr-issue-power-generation
1. What do you think led Sterlite to select ADRs as the route to raise
money? What alternatives did they have and why did ADRs appear to
them to be the best?
(Hint: Prominent criteria are cost of capital and success potential of the
issue. Analyse the circumstances at that time in regard to these two
criteria.)
2. What is the present situation of the ADRs issued in 2009? What does
the company plan to do regarding return of the funds raised, and why?
(Hint: Search for information about Vedantas subsequent actions in
regard to the 2009 ADR issue, through news reports and company
annual report.)
Reference:
Dr. Guruswamy, S, (2009), Capital Markets, Second Edition, India, Tata
McGraw-Hill Education Private Ltd.
E-References:
http://finance.mapsofworld.com/capital-market/instruments.html
Retrieved on 13/09/10
http://business.mapsofindia.com/india-market/debt.html Retrieved on
13/09/10
http://sawaal.ibibo.com/personal-finance-and-tax/what-adrs-gdrs427131.html Retrieved on 14/09/10
http://democracyfornwohio.org/participatory/what-are-participatorynotes-whats-its-importance-in-india-2 Retrieved on 15/09/10
Page No. 59
Unit 3
http://www.investopedia.com/articles/stocks/04/122204.asp Retrieved
on 15/09/10
http://useconomy.about.com/od/commoditiesmarketfaq/f/Futures.htm
Page No. 60
Unit 4
Unit 4
Treasury Products
Structure:
4.1 Introduction
Objectives
4.2 Foreign Exchange Market
Types of foreign exchange market
Participants
4.3 Exchange Rate Mechanism
Factors influencing exchange rate
4.4 Treasury Products and Delivery Periods
Spot market
Forwards market
4.5 Futures Contract
Comparison of futures and forwards contracts
4.6 Swaps
Foreign exchange swaps
Currency swaps
Foreign exchange swap vs. currency swap
Interest rate swaps
4.7 Options and the Underlying Assets
Counterparty risks
Options pricing
4.8 Commodities Market
Definition of commodities markets
Regulators of commodities markets
Commodity exchanges
Players in commodity market
4.9 Summary
4.10 Glossary
4.12 Answers
4.13 Case Study
4.1 Introduction
In the previous unit we discussed capital market. The unit described
different market instruments and explained regulatory requirements on
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Unit 4
capital market participants. We also analysed depository receipts,

participatory notes, foreign exchange derivatives and commodity
exchanges.
In this unit we will discuss treasury products.
Treasury products are arrangements based on financial instruments that are
used to protect oneself from adverse changes in the value of the
instruments or to make profits by using the products effectively in the
financial markets.
Interestingly, commodity markets also employ treasury products and we
take a look at how these markets work.
Treasury products range from simple forward contract booking of foreign
exchange to sophisticated derivatives.
Treasury products are largely related to derivatives and foreign exchange
derivatives are a significant part of it. Hence we need to understand foreign
exchange operations well in order to learn about treasury products. Interest
and its movement is another area in which treasury products are used, but
at much smaller levels compared to foreign exchange.
Objectives:
analyse features and types of foreign exchange market
explain the exchange rate mechanism
differentiate between futures and forward contracts
explain delivery periods and swaps
explain the concept of options and underlying assets, counter party risk
and option pricing
describe the features of commodity market, regulatory issues, role
played by commodity exchanges and players in commodity market
4.2 Foreign Exchange Market

Foreign Exchange market (forex market) deals with purchase and sale of
foreign currencies. The bulk of the market is over the counter (OTC)
i.e. not through an exchange which is well regulated.
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International trade and investment essentially requires foreign markets.

Banks act as intermediaries and perform currency exchange transactions by
quoting purchase and selling prices.
In India the Foreign Exchange Management Act (FEMA) 1999 is the law
relating to forex transactions and its aim is to develop, liberalise and
promote forex market and its effective utilisation.
4.2.1 Types of foreign exchange market
Figure 4.1 depicts the types of foreign exchange market.
Figure 4.1: Types of Foreign Exchange Markets
Spot market Spot market is a market in which a currency is bought or

sold for immediate delivery or delivery in the very near future. Trading in
the spot market is for execution on the second working day. Both the
delivery and payment take place on the second day. The rate quoted is
called as spot rate, the date of settlement known as value date and
the transactions called spot transactions.
The forward market involves contracts for delivery of foreign exchange

at a specified future date beyond the spot date and the transaction is
called a forward transaction. The rate that is quoted at the time of the
agreement is called the forward rate and it is normally quoted for value
dates of one, two, three, six or twelve months.
Unified and dual markets Unified markets are found where there is
only one market for foreign exchange transactions in a country. They
have greater liquidity, increased price discovery, lower short-run
exchange rate volatility and reliable access to foreign exchange. In
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Unit 4
contrast, dual markets are found in countries with multiple exchange

markets. For example, a country may consider forex market for current
account transactions and a different exchange for capital transactions or
market for trade transactions and another market for regulated
transactions like India had in the early 1990s, when dual exchange rates
prevailed.
Offshore and onshore markets During the earlier stages of financial

development, forex market operated onshore i.e. within India. But after
liberalisation of the economy, offshore markets have developed and
instruments based on foreign currencies issued by Indian firms are
traded in foreign markets.
4.2.2 Participants
The participants in forex market are the RBI at the apex, authorised dealers
(ADs) licensed by the central bank, corporates and individuals engaged in
exports and imports.
Corporates Corporates operate in the forex market when they have
import, export of goods and services and borrowing or lending in foreign
currency. They sell or buy foreign currency to or from ADs and form the
merchant segment of the market.
Commercial banks Banks trade in currencies for their clients, but much
larger volume of transactions come from banks dealing directly among
themselves.
RBI RBI intervenes in forex market to ensure reasonable stability of
exchange rates, as forex rates impact, and in turn are impacted, by
various macro-economic indicators like inflation and growth.
Exchange brokers They facilitate trade between banks by linking the
buyers and sellers. Banks provide opportunities to brokers in order to
increase or decrease their selling rate and buying rate for foreign
currencies. Exchange brokers also specialise in specific currencies that
have lower demand and supply to add value to banks. In India, many
banks deal through recognised exchange brokers.
1. Banks act as ___________ and perform currency transactions.
2. Exchange brokers impact the economy by controlling money supply.
(True/False)
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4.3 Exchange Rate Mechanism

Exchange Rate Mechanism (ERM) deals with the process by which value of
one currency is converted into the value of another currency. For example
one US$ is converted at ` 53 as of Jan 2013.The exchange rate is
determined by the regulations prevailing in the foreign currency market.
There are two types of ERM. They are:
Floating (market-based) exchange rate In this mechanism exchange
rates are determined by the free market. There is no central bank
interference and the market forces decide the prevailing exchange rates.
Values of currencies will therefore float freely. US $, UK , Japanese
and Euro are some examples of floating / market based currencies.
Fixed (regulated) exchange rate In this mechanism the value of a
nations currency is matched with another currency or to another
measure like gold or basket of currencies. Unless the reference value
changes the value of currency pegged does not change. This helps in
reducing exchange rate fluctuations and reduces volatility in the
economy.
There are three main types of floating exchange rates:
Managed float a floating exchange rate with the participation of the
central bank to reduce excessive volatility in the currency market. They
are also called dirty float. Indian rupee is an example of managed float
currency.
Pegged currency exchange rate pegged to another foreign currency
like US $ or . Saudi Riyal is an example of currency pegged to the
US $.
Fixed exchange rate or crawling peg exchange rates that are fixed to
some par value or another currency and so having only a small degree
of flexibility. Chinese Yuan is an example of such a currency.
4.3.1 Factors influencing exchange rate
1. Differential in inflation
2. Differential in Interest rates
3. Current account deficits
4. Public debt
5. Terms of trade
6. Political stability and economic performance
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3. The exchange rate in the forex market is determined by demand and
supply of foreign currency. (True/ False)
4. A countrys economic ups and downs will not impact its exchange
rates. (True/false).
4.4 Treasury Products and Delivery Periods

Exporters and importers buy and sell currencies and related products from
their banks depending on business requirements. Forex Dealers in banks
quote rates based on volumes and delivery periods. Delivery can be
immediate or in the future.
4.4.1 Spot market
Spot market trades in commodities and financial instruments for cash on
immediate delivery. The spot market is also known as cash market or
physical market. The rate quoted for spot delivery is called as spot rate and
date of settlement is known as value date.
Forex spot rate is valid for settlement up to two working days from the deal
date. Forex spot market can be broadly classified into:
Interbank trades This is the market for bankers who buy and sell
currency for delivery and settlement with other banks.
Merchant trade This market consists of private traders transacting with
banks for their business needs.
Factors that affect spot rate of a currency include inflation trends, balance of
payment situation, government and central bank policies, and other
economic indicators of the country.
The quoting methods are:
Direct In this method the foreign exchange rate is quoted as domestic

currency per unit of foreign currency. For example, the direct quotation
of exchange rate for GBP is stated as GBP 1 is equal to INR 85.99.
Indirect It refers to the number of units of foreign currency required to

buy one unit of the domestic currency. For example, the indirect
quotation of exchange rate for USD is stated as INR 100 is equal to
USD 1.8182.
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Cross rates The currency exchange rate between two currencies both
of which are not official currencies of the country in which the exchange
rates are quoted. For example, exchange rate between USD and GBP
will be stated in India as GBP 1 is equal to USD 1.5635.
Selling and buying rates: In Indian forex markets a quote by a bank is given
as: 1 USD = INR 53.23/53.34, which means the banks buying rate is equal
to INR 53.23 and the banks selling rate is equal to INR 53.34. Buying rate
of the bank is always lower than the selling rate. Thus when as a business
you buy US$ you have to pay more than when you get when sell US$ which
you may have earned and want to convert.
4.4.2 Forward market
Forward market deal with delivering products for a future date at the prices
agreed upon on the date of the contract. The rate at which the forward
transaction is to be completed is negotiated and agreed between the
parties.
Forward contracts are a means to hedge against sharp fluctuation in prices
especially in commodity and currency markets. Exporters and importers
receive and pay foreign currency amounts at a future date. Buying forward
contracts reduces their price risk and is called hedging.
In addition to forward contracts three other hedge instruments exist. They
are:
Swaps These are private agreements between the two parties for
exchange of cash flows in the future. The commonly used swaps include
interest rate swap and currency swap.
Options It refers to the right without the obligation to either buy or sell
a specific amount of the identified asset at a specified price. An option to
buy is called a call option and an option to sell is called a put option.
Futures It is like a forward contract, but for a fixed lot and for a fixed
delivery date, which is traded in organized exchange.
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The process of hedging with forwards involves fixing the price for the
transaction at a future date. The types of hedges with respect to forwards
are:
Selling hedge It occurs when a business holds an asset and sells a
forward contracts to protect against downward price movement in the
cash market.
Buying hedge It occurs when a business needs an asset at a future
date and buys forwards contracts to protect against upward price
movement in the cash market.
5. Factors affecting spot rates include ___________ and RBI policies.
6. Selling hedge happens when a business holds an asset and buys a
forward contract to protect against downward price movement.
(True/False)
7. In ___________ method, foreign exchange rate is quoted as domestic
currency per unit of foreign currency.
4.5 Futures Contract

A futures contract is an agreement that requires the seller to deliver to the
buyer a specified quantity of security, commodity or foreign exchange at a
fixed time in future at an agreed price. Futures contracts are traded in
organized exchanges unlike forward contracts which are executed over the
counter. The terms of future contracts are standardized and so transaction
costs are very small.
Characteristics of futures markets: organized exchanges, standardization,
clearing house, margins, and marking to market. Actual delivery is rare.
4.5.1 Comparison of futures and forwards contracts
Forward and futures contracts are both used for securities, currencies and
commodities trading. These have to be settled at a future date. In the
trading world these contracts often work in tandem and are considered as
derivative trading methods.
Some significant differences between futures and forwards contracts are
given in Table 4.1.
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Unit 4
Table 4.1: Differences between Futures and Forwards Contracts

Difference
Forwards
Futures
Size of the
contract
Decided between buyer and

seller
Standardized in each future

market
Contracted price
Remain the same till maturity
Changes every day
Mark to market
Not done
Done everyday
Margin
No margin required
Margins are to be paid by

both buyer and seller
Counterparty risk
Present
Not present
Liquidity
No liquidity
Highly liquid
Nature of market
Over the counter
Traded on the Exchange
Activity 1:
Consider you are the Chief Financial Officer of a company involved in
export business, and consequently sizeable foreign exchange exposure.
How do you evaluate the methods available in the foreign exchange
market to contain the risk? Explain with illustrations.
(Hint: Refer to 4.4 and 4.5.Options available include forward booking of
exchange exposure, hedge instruments like options, swaps and futures
etc.
http://www.mbaknol.com/managerial-economics/foreign-exchange-risk/)
Self
8.
9.
10.
In forward contracts the receiver of delivery is not known. (True/False)
Forward and futures contracts often work in ___________.
Futures contracts are traded _______________ unlike forward
contracts which are ________________________.
4.6 Swaps
Swaps are exchanges of one set of rights or obligations for another set of
rights / obligations. Financial swaps permit borrowers to exchange one
stream of payments to settle a liability with another stream of payments.
Similarly investors use swaps to exchange inflows denoting one type of risk
with inflows with a different risk element.
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4.6.1 Foreign exchange swaps

Foreign exchange swaps are transactions in which one currency is bought
spot or forward on a given day, and the same amount is sold on a different
value date. In reality therefore two transactions are involved:
a spot purchase in foreign exchange, and
a forward sale in foreign exchange
These two transactions nullify each other, and the risk is minimized.
Alternatively, we have forward to forward contracts, in which one currency is
bought forward for another and also sold forward at the same time in other
words two forward transactions are entered into on different dates. These
are used by corporates in order to lock in currency premiums.
4.6.2 Currency swaps
Currency swap is an agreement to exchange interest/principal payments
contracted in one currency for payment in a different currency for the same
value calculated as per the exchange rate on the date of the swap. Thus if a
currency is seen to be going up sharply, payments in future due in that
currency could be exchanged for payments in another currency which is
more stable. This helps in eliminating the risk of adverse changes.
Corporates deploy currency swaps at times on payments related to loans
taken in foreign currencies.
Benefits of forex swaps:
Swaps help decide exchange rates associated with imports and exports
and avoiding unpleasant surprises in future.
Swaps can also help companies with huge forex exposure to smartly
manage payments and receipts in forex at the most beneficial rates.
4.6.3 Foreign exchange swap vs. currency swap
Foreign exchange swaps are a kind of hedge against currency risks but
currency swaps only shift the risk from one currency to another.
Foreign exchange swaps are exclusive to banks and forex dealers and are
not open to corporates. Currency swaps can be entered into by corporate
treasurers to move their exposure between different currencies.
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4.6.4 Interest rate swaps

Interest Rate Swap is a customised agreement of exchanging one stream of
future interest payments based on a specified principal amount with another
stream. Usually the exchange is between fixed interest payments and
floating interest payments linked to reference interest rates. The
organisations typically use the swap to manage exposures in interest rate
fluctuations, or to gain low-margin interest rates. These are widely used by
banks, other financial institutions and governments, and can be effectively
deployed by corporates in their long-term loans.
There are three types of interest rate swaps:
Coupon Swaps: fixed to floating rates or vice versa
Basis Swaps: exchange of one benchmark interest rate for another
benchmark interest rates (MIBOR* or T-Bill^ rate)
Cross-currency interest rate swaps: fixed rate flows in one currency to
floating rate flows in another currency
Illustration:
XYZ Inc., a manufacturing firm wants to raise 5-year fixed rate dollar funding
for an expansion. It finds that will have to pay 2% over the 5-year T-Bill rate
of 9%. Alternatively it can issue 5-year floating rate notes (FRN) at a margin
of 0.75% over the prime rate.
On the other hand, ABC Inc. a large bank looking for floating rate funding
finds that it will have to pay prime rate while in the fixed rate market it can
raise a 5-year loan at 50bp(0.50%) above T-bills due to its AAA ratings.
Requirement
Cost (fixed)
Cost (floating)
XYZ Inc.
ABC Inc.
Fixed rate
Floating rate
11%
9.5%
Prime +0.75%
Prime
ABC has an absolute advantage over the XYZ in both the markets but XYZ
has a comparative advantage in the floating rate market. Both can achieve
cost savings by each borrowing in the market where it has a comparative
advantage and then doing a fixed-to-floating interest rate swap.
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Unit 4
Figure 4.2: Illustration of Interest Swap
ABC borrows at 9.5% fixed. XYZ borrows at prime +0.75% floating rate.
ABC pays the swap bank (prime 0.25T) and swap bank passes this on to
XYZ. XYZ pays the swap bank 9.75% and swap bank pays ABC 9.5%. The
key result is that both the parties have achieved their objectives with some
cost savings.
XYZ: 9.75% + [prime +0.75 (prime 0.25)] % = 10.75% fixed 25bps below
its own cost of fixed rate funds.
ABC: 9.5% 9.5% + prime 0.25% = prime 0.25% i.e. 25bps below its
own cot of floating rate. The swap bank earns a margin of 25bps.
The major benefits of interest swaps are:
It helps in obtaining lower cost funding.
It provides hedge against interest rate exposure and obtains higher yield
in investment assets.
It helps to asset or liability management.
11. Currency swap is an agreement to exchange interest/principal
payments in one currency with those of the same value in a different
currency. (True/False)
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Unit 4
12. Interest Rate Swap is an agreement of exchanging one stream of

future interest payments with another based on specified __________
amount between two parties.
4.7 Options and the Underlying Assets

An option is a contract in which the seller(writer of the option) grants the
buyer the right to purchase from or sell to the writer a designated asset for
a specified price within a specified period of time, without the obligation to
buy or sell it. For example, a stock is currently being sold at ` 100 and the
investor pays ` 20 for the right buy with an obligation to do so of one share
for ` 120 at the year-end. If the stock price is say ` 140 when the option
matures, the investor makes a profit of ` 20 by buying the stock at the
contracted price of ` 120. On the contrary if the price has remained at
` 100, he will choose not to exercise the option, by which he restricts his loss
to ` 20 that he paid to buy the option. If he had used a forward contract or
futures contract, he would have been obliged to buy it at ` 120 the
contracted price.
The expiry date in the options refers to the specified date after which the
contract no longer is considered valid. The price specified in the contract is
known as the exercise price or the strike price.
Types of Options:
Options can be classified on the basis of three criteria: the item involved, the
strike price, and the intended action.
1. Based on the item involved:
Currency option: an option to buy or sell a currency
Stock Option: an option to buy or sell a stock
Bond Option: an option to buy or sell a bond
Stock index option: an option to buy or sell a stock index
Multi-currency option: an option to draw funds in one or more of
the specified currencies and switch from one currency to another
2. Based on strike price of the option
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At the Money Option: When strike price is equal to the price of the
underlying security, the option is called an at the money option. In
this situation the option has no intrinsic value.
In the Money Option: An option is in the money when at its strike
price it will yield a gain. Thus a call option price will be lower than
the spot price, while a put option price will be higher than the spot
price.
Out of Money Option: This is the exact reverse of in the money
i.e. the option will make a loss at its strike price. For example if it is a
call option the strike price will be above the spot price.
3. Based on the action intended:
Call Option: the right but not the obligation to buy at a specific price
within a specified period of time
Put Option: the right but not the obligation to sell at a specified price
within a specified period of time
Based on timing of action: European Option: can be exercised
only on the expiry or maturity date
American Option: can be exercised anytime during the life of the
option period
4.7.1 Counterparty risks
Counterparty refers to the other party in a contract. Counterparty risk is with
respect to a party that does not honour its contractual agreement. In an
options contract the seller of an option has little counterparty risk once the
premium has been recovered; however there is a settlement risk at the time
of exercise of the option for the buyer of options. The buyer has a
counterparty exposure on the seller, of the seller becoming insolvent before
the expiry of the option which may make the contract worthless.
4.7.2 Options pricing
Options pricing, or the price payable for an option is called Option premium.
Option premium depends upon the spot price, strike price, time remaining
for the option to be exercised and the volatility of the underlying stock.
The options price has two components: intrinsic value and time value.
Intrinsic value:
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Unit 4
The intrinsic value of an option is the difference between the strike price and
the spot price of the stock. This is the amount by which the option is in the
money, i.e. the gain to the option holder if he exercises the option
immediately.
Intrinsic value of a call option = Spot price call strike price, the amount
saved by exercising the option to buy
Intrinsic value of a put option = Put strike price Spot price, the amount
gained by exercising the option to sell
Time value:
Time value of an option is the difference between the option premium and
the intrinsic value of the option as defined above. Time value is the premium
market is willing to pay for an at the money option at any point of time
before its maturity.
Time value of an option = Option price or Option premium Intrinsic value
The two option pricing models are:
Black Scholes model The model computes the current exact value of
an option based on historical data and probabilities of future stock
prices.
This model is used to calculate a call price using key determinants such as
stock price, strike price, volatility, expiration time, risk free interest rate.
Binomial model This model helps to split expiration time into a large
number of miniscule time intervals. The stock price is analysed in every
step and moved according to the amount calculated using volatility and
expiration time.
13. _________ allows the buyer the right but not the obligation to buy the
underlying asset.
14. Underlying assets refers to the amount per share that an option buyer
pays to the seller. (True/False)
4.8 Commodities Market

We discuss commodity markets, their participants and regulators in this
section.
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4.8.1 Definition of commodities markets

Commodities market is the market in which commodities like oil, gold, and
agricultural products are traded. It operates on agreements for buying and
selling commodities at agreed prices on a specific date. The main
commodities markets are in London, New York and Chicago.
In India, commodities market facilitates multi-commodity exchange within
and outside the country based on requirements. The Indian commodity
market has grown tremendously after the liberalisation of the economy. The
demand for commodities in the Indian domestic and global market is
estimated to grow four times in the next five years.
4.8.2 Regulators of commodities markets
Regulation of commodity market is done by governmental commissions that
process the trading.
In India Forward Market Commission (FMC) acts as the regulator. Head
quartered in Mumbai, FMC is overseen by the Ministry of Company Affairs.
FMC helps introduce new instruments like options, benefiting the
stakeholders including farmers who benefit from price discovery and price
risk management.
4.8.3 Commodity exchanges
Commodity exchange refers to commodity purchases and trading contracts
for future delivery. These exchanges facilitate trading in physical goods like
corn, timber or oil. Most commodity exchanges trade in a single commodity
product like oil or rice.
A few commodity exchanges work with spot market for providing immediate
delivery. This paves way for traders to purchase products in spot market
and use or store them for later use. Other products include futures, where
an agreement is made for trading at a given price in future. These markets
help people make investments that hedge the risk. Some of the commodity
exchanges work over the counter (OTC) and have no central place for
sharing price quotes or set terms. Instead the traders and brokers deal
among themselves. This advantage is a certain amount of certainty and
clarity of process and terms, but the disadvantage is limited liquidity and
relatively low prices for commodities.
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Unit 4
The three commodity exchanges set up in India in the year 2003 are
National Commodity and Derivatives Exchange, Multi-commodity Exchange,
and National Multi-commodity Exchange.
4.8.4 Players in commodity market
Hedgers and arbitrageurs The group includes production, processing

or merchandising of a commodity. Commercials do the bulk of trading in
commodity markets.
Large speculators group of investors pooling their money to reduce

risk and increase gain. Large speculators consist of money managers
making investment decisions for overall investors group
Small speculators group of individual commodity traders trading on

their own account or through brokers.
Activity 2:
Consider you are the director of a commodity and currency market. What
will be your role and responsibilities?
(Hint: Refer 4.8.1 and 4.8.3 above. Also look up the
websitehttp://www.slideshare.net/shamikbhose/shamik-bhose-profile-asdirector-of-commodity-currency)

15. _______________ consists of agreements for buying and selling
commodities at an agreed price on a specific date.
16. Large speculator groups include production, processing and
merchandising of a commodity. (True/False)
4.9 Summary
Foreign Exchange market produces a high level of liquidity and provides

an opportunity to traders to invest. It includes spot and forwards and can
either be a unified or a dual market. Forex markets are both onshore
and offshore. ERM refers to the method by which value of one currency
is exchanged into another currency value. .
Swaps deal with exchange of payments, assets, cash flows,
investments, liabilities for another. Forex, currency and interest rate
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Unit 4
swaps are different types of swaps. Options are another type of

derivatives.
Commodities market is a place for buying and selling commodities. The
players in commodities market include hedgers, speculators,
arbitrageurs, investors, producers and so on.
4.10 Glossary
Bullion transaction: Transactions made by considering the value of

commodity like gold or silver rather than quantity.
Mortgage: A legal document pledged as surety to obtain loan.
Regulator: An authority monitoring and controlling a market, exchange

and players.
Stakeholders: Parties who are engaged in the markets and who will be
impacted by the market happenings

1. Explain foreign exchange market, its types and participants.
2. Describe ERM and classify the differences between futures and
forwards contracts.
3. Explain spot and forwards market, concept of swaps and its various
types.
4. Discuss options and the underlying assets and explain the concept of
commodity market.
4.12 Answers
Self
1.
2.
3.
4.
5.
6.
7.
8.
Intermediaries
False. Exchange brokers link buyers and sellers.
True
False. Economic performance of a country directly affects foreign
currency rates.
Government
False. Selling hedge occurs when a business holds an asset and sells
forward contracts to protect against the downward price movement in
the cash market.
Direct
False. Forward contracts are personal contracts.
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Unit 4
9.
10.
11.
12.
13.
14.
Tandem
in organised exchanges, executed over the counter
True
Principal
Call option
False. Underlying asset refers to the security based on which the
options have been generated.
15. Commodity market
16. False. Large speculators are money managers making investment
decisions.
Terminal Questions
1. Foreign exchange market plays a very important role in corporate
finance. It is classified into spot, forwards. It involves participants like
corporates, banks. Refer 4.2.
2. ERM or Exchange Rate Mechanism refers to the rate at which value of
one currency is changed to another. Refer 4.2. Differences between
Futures and forwards are listed in Table 4.1. Forwards are one-on-one
contracts and not negotiable, but futures are market phenomena and
well-traded.
3. Spot markets deal with trading with immediate delivery whereas forward
market deals with trading on a future delivery. The concept of swaps
refers to the exchange of payments or cash flows according to
conditions. Types of swaps include forex swaps, currency swaps and
interest rate swaps. Refer 4.4.1, 4.4.2 and 4.6.
4. Options refer to the right without the obligation to trade a specific stock
or currency or commodity at a specified price and time. Commodities like
groceries, metals are traded in commodity market. Refer 4.7 and 4.8.
4.13 Case Study

Commodity Market at Unicon Investment Solutions
Unicon is a financial services company established in 2003providing onestop investment solutions. The company has a large number of regional
offices across India. It caters to both long-term and short-term financial
needs of customers. The companys services range from offline and online
trading in equity, commodities, currency derivatives to debt markets and
portfolio management.
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Unit 4
The commodity arm in Unicon offers commodity trading on National

Commodities and Derivatives Exchange (NCDEX) and Multi-commodity
Exchange of India (MCX). The current market share in commodity is
approximately one percent and average turnover ` 250 crore per day. There
has been a rapid growth in commodity clients from 101 in the year 2006 to
22,272 in the year 2009.
The NCDEX trading system provides a fully automated screen-based
trading for futures commodities on basis of nationwide online monitoring and
surveillance. The quantity fields are based on units and price in rupees.
Time stamping is made for each trade and helps in providing a complete
audit trail. The strategies for trading in the commodity market include
Going long Investors agreeing to buy and take delivery of assets at
prices set to gain profits from anticipated future appreciation
Going short Investors agreeing to sell and deliver assets at price set to
gain profit from anticipated price decline
Spreads Buying and selling contracts in order to take advantage of
rising or declining prices in future.
Risks associated with commodity markets are initial margins, exposure
margins, mark-to-market on daily positions and surveillance.
The company identifies the issues related to customer dissatisfaction in
minute detail. This provides an opportunity to know where the customers are
located in the development process so that the brand loyalty program can
be implemented to retain existing customers and strategies can be evolved
to move the new customers to the next level and make him a client or a
member of the company.
1. Explain in detail the process incorporated by Unicon in commodity
market transactions.
Hint: Fully automated screen-based trading, online monitoring and time
stamping (to provide audit trail) are some of the features.
2. Classify the risks associated with commodity market.
Source: http://www.scribd.com/doc/33976780/Commodities-2010
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Unit 4
Hint: Risks associated with commodity markets are initial margins,

exposure margins, mark-to-market on daily positions and surveillance.
References:
Dun and Bradstreet, (2007), Foreign Exchange Markets, India, Tata
McGraw-Hill Publications, Mumbai
E-References:
http://www.coolavenues.com/know/fin/tushar_1.php3 Retrieved on
20.9.10
http://www.docstoc.com/docs/14560536/EXCHANGE-RATEMECHANISM Retrieved on 20.9.10
http://www.ehow.com/about_6594253_commodities-exchangedefinition.html Retrieved on 20.9.10
http://indianblogger.com/factors-affecting-foreign-exchange-rate/
Page No. 80
Unit 5
Unit 5
RBI and the Foreign Exchange Market
Structure:
5.1 Introduction
Objectives
5.2 Role of RBI in Exchange Rate Management
5.3 Development of Foreign exchange Market
5.4 Approaches to Capital Account Convertibility (CAC)
Current account convertibility
Fuller Capital Account Convertibility (FCAC)
5.5 Foreign Exchange Management Act (FEMA) 1999
Highlights of FEMA
Buyer/suppliers credit
Effects of liberalisation
5.6 Information System on Forex
5.7 Foreign Exchange Dealers Association of India (FEDAI)
Functions
5.8 Summary
5.9 Glossary
5.11 Answers
5.12 Case Study
5.1 Introduction
In unit 4 you were introduced to treasury products in the foreign exchange
market. We discussed how foreign exchange operations are done through
specialised instruments like swaps options etc.
In this unit we study the role of the central bank of a country in India, the
Reserve Bank of India (RBI) in the foreign exchange (forex) market.
An Indian corporate treasurer would do well to understand the role of RBI in
forex management for the greater good of the economy, because actions by
his Treasury team should be aligned to RBI actions. Much of what you study
in this unit will be information that will serve as the backdrop for treasury
strategies and plans of corporate India.
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Indian domestic currency has current account convertibility but does not
have capital account convertibility. Hence, RBI can intervene in the forex
market primarily to influence exchange rate movement i.e. value of the
Indian rupee (INR) vis--vis other currencies in the desired direction. There
are situations when the INR gets overvalued; and RBI may devalue the
currency as a temporary measure. The interventions are relatively small
compared to the turnover in the market but significant due to the central role
played by RBI in policy making.
In this unit you will study the actions of RBI in exchange rate management.
We will review the development of forex market and approaches of RBI
towards Capital Account Convertibility (CAC).
This unit also introduces Foreign Exchange Management Act 1999 and the
reporting requirements in respect of forex transactions under FETERS
(Foreign Exchange transactions Electronic Reporting System). We
conclude with a study of Foreign Exchange Dealers Association of India
(FEDAI).
Note: The abbreviation CAC is used throughout the text to mean Capital
Account Convertibility and not Current Account Convertibility.
Objectives:
define the role of RBI in exchange rate management
discuss the development of forex market and RBIs approaches to
Capital Account Convertibility
review FEMA with particular reference to the economic liberalisation of
the last two decades
explain the role of FEDAI
5.2 Role of RBI in Exchange Rate Management

RBI is responsible for monitoring the financial systems in India. It has the
task of maintaining the credibility of banks and other financial institutions vis-vis Indian public and international investors. RBI has the dual concern for
exchange rate stability (INR v. other currencies) and domestic interest rates
which impact the real value of INR.
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Exchange rates respond regularly to demand and supply changes caused

by import and export volumes respectively and also react sharply to major
events. An example of event-based reaction is the rupee value is the fall
immediately after the 1998 Pokhran nuclear test and US governments
imposing of sanctions.
Intervention by RBI takes the form of buying or selling of US$. Thus when
INR depreciates against US$ and RBI wants to negate it, they sells US$ to
commercial banks and buys up INR. When INR appreciates against US$
and RBI wants to negate it, RBI buys US$ from commercial banks and
releases INR in the forex market.
Whenever RBI buys US$ from commercial banks, it releases INR into the
money market thereby an inflationary impact is caused. To check the
inflation RBI could issue bonds to commercial banks which are paid for in
INR. RBI thus removes the excessive money supply. This process is called
sterilisation intervention.
1. RBI ___________ exchange rate of INR in foreign exchange market.
2. ___________ refers to buying or selling rupees against foreign
currency by RBI.
3. The process of removing excess money supply is known as sterilised
intervention. (True/False)
5.3 Development of Forex Market

The sequence of happenings that would best describe the way in which
forex market has evolved and developed in India is given below:
1. Commencement of trading in 1978: In 1978 RBI allowed banks to
commence intra-day trading in foreign exchange. This marked the
beginning of forex market in India.
2. Dual exchange rate introduction in 1991: In 1991 with the introduction of
Liberalized Exchange Rate Management System (LERMS), marketdetermined exchange rate system was introduced, but RBI could
intervene and set official rate if circumstances warranted. This gave rise
to a dual rate system viz. market-based rate and official exchange rate.
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3. Unified exchange rate in 1993: LERMS was replaced by a unified

exchange rate in 1993, and the rate system was unified at the interbank
free rate.
4. Market determined rate from 1995: As part of continuing development in
forex market, Internal Technical Group on Foreign Exchange Market
was constituted based on the Sodhani Committee report. The groups
aim was to review the measures by RBI and identify areas for further
liberalisation in a medium-term framework. As a result of the review,
banks were allowed to determine rates of interest and use derivatives for
asset-liability management. They could borrow and invest funds in
foreign markets and fix their trading limits.
5. Current account convertibility: With liberalisation of the economy in
1991, the government relaxed buying and selling of foreign currency on
trade account. Exporters and importers were permitted to sell and buy
foreign currency without having to get RBI clearance case to case. Thus
began the economys first steps at making INR convertible on current
account.
6. Roadmap for capital account convertibility and the Tarapore Committee
report: The Tarapore Committee was first appointed in 1997 to
investigate into the pros and cons of fuller capital account convertibility
(FCAC). While it was granted that 100% CAC would be infeasible, the
idea was to look at increasing the percentage to a bigger figure.
The Committee was appointed again in 2006 to review the status of the
recommendations in the first report and to lay out an action plan for
FCAC. Both reports stressed the need to pursue FCAC as a strategy to
achieve (a) a liberalised financial structure and (b) effective alignment of
the Indian economy with international economy in the quest for the
economic super-power status India is seeking.
7. Asian currency crisis and deferment of capital account convertibility
After both the Tarapore Committee reviews in 1997 and 2006, currency
crises surfaced in India and compelled RBI to put the brakes on the
pursuit of CAC.
In both the reports the Committee has underlined some concomitants
(or preconditions) for successful move towards FCAC. These are a)
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Unit 5
strong fiscal discipline; b) financial stability viz. the ability of the financial
system to withstand violent fluctuations and c) the strength of the
banking system to support and ensure financial stability.
Forex market in India has grown in size and depth. However India was
not severely affected by the Asian crisis because of the constant
monitoring and timely action and recourse to strong measures to prevent
speculative activities.
4. Forex market is a market in which ___________ of various countries
are sold against each other.
5. The development of forex market in India was based on
recommendations of the Sodhani Group and later the Tarapore
Committee. (True/False)
6. The forex market has grown in size and depth in India. (True/False)
5.4 Approaches to Capital Account Convertibility (CAC)

Capital Account Convertibility (CAC) refers to removing controls on capital
account transactions. It means freedom of currency conversion in terms of
inflow and outflows with respect to capital account transactions.
Only a few countries in the world have capital account convertibility; these
countries have market determined exchange rates. Most countries have
some regulations for influencing inward and outward capital flow.
The perception of CAC has undergone some changes following events of
emerging market economies (EMEs) in Asia and Latin America, which went
through currency and banking crises in the 1990s. A few counties
backtracked and re-imposed capital controls as part of crisis resolution. The
cost-benefit from capital account liberalisation continues to be debated
among academics and policymakers. EMEs still use considerable caution in
opening up capital accounts.
The Committee on CAC (Chairman S.S. Tarapore) which submitted its
report in 1997 highlighted the benefits of a more open capital account but
cautioned that CAC could pose tremendous pressures on the financial
system. India has cautiously opened its capital account.
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The benefits of fuller CAC are:

The confidence of international investors in the country that has full
convertibility is significantly higher.
Removal or loosening of exchange restrictions tends to increase capital
inflows as well, aiding economic growth.
Possible approaches to CAC:
Open the capital account for residents and non-residents
Initially open the inflow account and later liberalise the outflow account
Liberalise control of both inflow and outflow accounts
5.4.1 Current account convertibility
Current account convertibility refers to converting domestic currencies freely
into foreign currency and vice versa for the purpose of trade of goods and
services. The benefits of current account convertibility are:
It enhances foreign trade in the country.
Relaxing exchange restrictions improves the Balance of Payment (BOP)
position.
RBI has introduced more relaxations in current account transactions. The
authorised dealers (ADs) have been permitted to provide exchange facilities
to their customers up to certain limits without prior approval of the RBI.
The liberalisation rules regarding current account transaction of RBI under
FEMA 1999 are as follows:
Category I banks can permit foreign exchange payments up to US$ 2
million under technical collaboration agreements without the approval of
Ministry of Commerce and Industry, provided the payment does not
exceed 5% of local sales and 8% of exports.
Liberalised remittance schemes of RBI announced from time to time
permit resident Indians to make foreign exchange remittances for a
variety of purposes. These include gifts to non-residents, donations,
investments in overseas companies etc. up to a total value of
US$200,000 per annum,
Liberalisation of Exchange Earners Foreign Currency (EEFC) account EEFC account is a foreign currency account maintained by a resident
person with an authorised dealer (meaning a bank) in India. Since the
account is in a foreign currency, the person can make foreign currency
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Unit 5
payments directly out of the account from receipts in foreign currency,

thus getting an automatic hedge against exchange rate fluctuations.
5.4.2 Fuller Capital Account Convertibility (FCAC)
Indias has always adopted a cautious approach towards capital account
convertibility but with the massive globalisation over the last two decades,
we have felt the need to revisit CAC and move towards FCAC. RBI, in
consultation with the Government of India (GOI) appointed a committee on
FCAC. S.S Tarapore was the chairman of committee. The Committee made
several recommendations for the timing and sequencing of capital account
liberalisation measures.
The advantages of FCAC are:
Economic growth It facilitates economic growth through higher capital
inflows into the country. This will lead to growth in employment
opportunities, and infrastructure development.
Development of the financial sector Large capital flow into the system
will enhance performance of the companies and the liquidity in the
system.
Diversification of investment - Ordinary people can invest in foreign
countries without restriction and diversify their portfolios.
Risks involved in FCAC
FCAC risk arises primarily from inadequate preparedness for the changes
that it will inevitably cause. The risks are as follows:
Market risks Markets risks like interest rate and foreign exchange risks
become more complicated when financial institutions have access to
new markets or securities. Participation of foreign investors in domestic
market changes the working of the domestic market. For example,
banks have to quote rates and take open positions in new and more
volatile currencies. Likewise change in foreign interest rates affects the
domestic interest rate.
Credit risk It includes a new dimension with cross-border transactions.
Country risks economic, social and political will be faced by domestic
market participants.
Risk in derivative transactions Derivatives are key tools used in
hedging risks and with FCAC derivative transactions will become
complicated.
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Liquidity risk It includes risk in foreign currency-denominated assets

and liabilities. Large flow of funds in different currencies will expose
banks to greater variations in their liquidity position and complicate their
asset-liability management.
Operational risk With fuller FCAC, it becomes vital to understand the
difference between domestic and foreign legal rights and obligations and
their enforcements.
Limitations of a fully convertible INR

Making INR fully convertible poses a number of challenging questions:
Are Indian industries strong enough to fight global competition?
Is the quality of our labour and are our management practices good
enough?
Is our technology adequate?
Can the Indian government become more prudent in fiscal
management?
Is our forex reserve sufficiently resilient?
Can we bring our tariff system and our tax structure to match world
standards?
How can we keep our inflation in check?
Consequences of full convertibility
India might face the following consequences if full convertibility is sought
without matching reforms.
The economy will become vulnerable to free movement of foreign
capital, and further worsen macro-economic imbalances.
Banks and financial institutions may not be able to handle the volatility of
fuller convertibility.
The prevailing high interest rates in the economy will attract capital
inflow. This will result in rupee appreciation which will affect Indian
exporters.
7. __________ refers to relaxing controls on capital account transactions.
8. Current account transaction refers to converting ___________
currencies freely into foreign currency and vice versa for trade of goods
and services.
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Unit 5
9. Liquidity risk includes risk in foreign currency-denominated assets and

liabilities. (True/False)
Activity 1:
Discuss the recommendations of Tarapore Committee for CAC with your
friends.
(Hint: In section 5.4 the pros and cons of CAC for Indian economy at its
present stage of development has been discussed, with particular
reference to the Tarapore Committee recommendations. Get more
details from http://www.slideshare.net/gauravtaranekar/a-presentationon-recommendations-by-tarapore-committiee)
5.5 Foreign Exchange Management Act (FEMA), 1999

The foreign exchange activities in India are governed by Foreign Exchange
Management Act (FEMA) 1999. FEMA came into effect in June 2000
replacing Foreign Exchange Regulation Act (FERA).
The objectives of FEMA are:
Promoting external trade through foreign exchange
Orderly development and maintenance of foreign exchange market in
India
5.5.1 Highlights of FEMA
FEMA applies to forex transactions of all persons resident of India and
to Indian operations of non-residents.
Non-authorised persons are prohibited from foreign exchange dealings.
If any person residing in India receives foreign currency without making
a corresponding inward remittance, the payment is deemed to be from a
non-authorised person.
Seven types of foreign accounts are totally prohibited. They include
transactions relating to lotteries, football pools, banned magazines etc.
Resident of India (ROI) is entitled to own or hold or transfer any foreign
security or immovable property situated outside India subject to rules.
Similar freedom is given to a resident who inherits foreign security or
immovable property from a ROI.
A ROI is permitted to hold shares, securities and properties acquired by
him when he was a resident or inherited such properties from a resident.
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Unit 5
Value limits have kept getting revised upwards through the years making
transaction bases substantially bigger.
5.5 2 Buyer/suppliers credit

Buyers credit refers to loans arranged by importers for payments of imports
made by Indian buyers from a bank outside India for maturity less than three
years. Suppliers credit refers to credit by the overseas supplier for imports
into India. Trade credit refers to credit for imports by overseas supplier for
less than 3 years from the date of shipment.
RBI has issued the following guidelines for trade credit:
Amount and tenor Authorised dealers (ADs) are permitted trade
credits up to USD 20 million per transaction with a maturity period up to
one year and with a maturity period of up to 3 years for import of capital
goods. No rollover should be extended beyond the permissible period.
Trade credit for more than 3 years comes under External Commercial
Borrowing (ECB) and they are governed by ECB guidelines.
All-in cost ceiling The ceiling on all-in cost i.e. the total cost of the
trade credit are as follows:
o Maturity period up to 1 year: 6-month London Interbank Offered Rate
(LIBOR) + 50 basis points.
o Maturity period of more than 1 year but less than 3 years: 6-month
LIBOR +125 basis points for respective credit currencies like Euro
Interbank Offered Rate (EURIBOR), Singapore Interbank Offered
Rate (SIBOR) and Tokyo Interbank Offered Rate (TIBOR).
o The issue of guarantee, Letter of Undertaking (LOU) or Letter of
Comfort (LOC) in favour of overseas lender. ADs have permission
for issuance of letter of guarantee/LOU/LOC in favour of overseas
supplier for import of all non-capital goods up to period of one year
for USD 20 million per transaction. In case of capital goods, the
period is up to 3 years.
Request for trade credit has to comply with RBI stipulations and the importer
needs to have approval from RBI.
5.5.3 Effects of liberalisation
The liberalisation of Indian investments in global financial market has
increased the access to commercial borrowings by Indian corporates and
participation of foreign investors in the Indian stock market. The aim of
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Unit 5
FEMA is to simplify, consolidate and amend the law related to foreign

exchange and facilitate external trade and payments. FEMA seeks to
establish a more liberal and orderly regulatory framework for economic
growth.
Some measures under FEMA are:
Current account transactions such as foreign trade, current business,
short-term banking services, remittances for living expenses of parents,
spouse and children residing abroad, expenses in education, foreign
travel and medical care of parents ,spouse and children have been
liberalised.
The following cases are exempted from realisation and repatriation:
o Possession of foreign currencies or coins up to a limit specified by
RBI.
o Foreign currency account held and operated by person or group of
persons up to a limit specified by RBI.
o Foreign exchange acquired or received, or any income arising which
is held outside India by any person in pursuance of a general or
special permission granted by the RBI
10. Foreign exchange activities in India are governed by ___________.
11. ___________ refers to the loans arranged by the importer for
payments of imports in India from a bank outside India for maturity less
than three years.
12. The aim of FEMA is to simplify, consolidate and amend the law related
to foreign exchange and facilitate external trade and payments.
(True/False)
5.6 Information System on Forex

The flow of information regarding foreign exchange is important to GOI and
RBI for policy decisions. Financial transactions take place through banks
(authorised dealers or ADs) and are the sources of information. ADs report
the information in R-Returns.
All exchange transactions have to be reported to banks by companies and
other units involved in forex. External borrowing should be reported by
corporates to RBI, which has the obligation to present quarterly Balance of
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Unit 5
Payments (BOP) to IMF within three months from the close of the quarter.
BOP statistics provides details about the countrys transactions relating to
trade, services, assets and liabilities with the other countries during the
quarter.
The two major types of R-returns are: Nostro accounts returns, and Vostro
accounts returns.
Nostro accounts refer to the accounts of constituents and other banks held
by a bank on their behalf. The balances in these belong to the other party
and hence these are on the credit (liability) side of the banks balance sheet.
Vostro accounts refer to the banks own account held by another person,
typically another bank. These balances belong to the bank and so these are
on the debit (asset) side of the banks balance sheet.
R-returns should be submitted twice a month, on the 15thand the last day of
each month. The returns should reach RBI 7days from the closing date.
While reporting requirements are to be fulfilled only by banks, corporates
have to make sure that their reporting to banks re: forex transactions are
accurate and timely, to avoid default notices that may be served on them by
RBI.
Activity 2:
Make a concise report on how a business house is affected by the
information system on forex transactions between banks and the RBI.
Illustrate your report.
(Hint: While the reporting of forex transactions to RBI is the duty of the
banks, all companies that have dealings in forex must ensure their data is
accurate and their bank does not inadvertently report erroneous figures
on export values, reason for remittances or receipts etc.
p://www.rbi.org.in/scripts/ECMUserView.aspx?Id=55)
13. Banks are the ___________ and they are the source of information in
foreign exchange market. Choose the correct answer.
a) Primary Dealers
b) Authorised dealers
c) Exchange controllers
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Unit 5
14. The two types of R-returns are___________ and ___________.

15. ___________should be submitted twice a month.
5.7 Foreign Exchange Dealers Association of India (FEDAI)

Foreign Exchange Dealer Association of India (FEDAI) is a self-regulatory
body incorporated under Section 25 of Companies Act 1956. It was set up
as an association of banks dealing in foreign exchange in India. The major
activities of FEDAI are framing rules, governing the conduct of inter-bank
foreign exchange business among banks and liaison with RBI for reforms
and development of forex market.
5.7.1 Functions
The functions of FEDAI are:
To formulate of FEDAI guidelines and rules for forex business
To recognise forex brokers
To announcement periodicals rates to member banks
To assist banks to identify the members of FEDAI in settling issues in
their dealings
To represent the member banks on government/RBI/ other bodies
To provide training to the bank employees in foreign exchange business
The role of FEDAI has changed due to ongoing integration of global
financial markets. It plays a catalytic role for smooth functioning of the
markets with close coordination with RBI and other organisations like Fixed
Income Money Market and Derivatives Association of India (FIMMDA), the
Forex Association of India and other market participants. FEDAI also
enhances benefits derived from the collaboration of member banks through
innovation in fields like new customised products, maintaining international
standards on accounting, market practices and risk management systems.
16. Formulation of FEDAI guidelines and rules for forex business is one of
the functions of FEDAI. (True/False)
17. ____________ plays a catalytic role for smooth functioning of the
markets with close co-ordination with RBI and other organisations.
Choose the correct answer.
a) FEDAI.
b) FIMMDA.
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Unit 5
c) FCAC
d) VOSTRO
18. FEDAI increases the benefits derived from the collaboration of member
banks through ___________ in fields like new customised products,
risk management systems.
5.8 Summary
RBI has the responsibility of enforcing discipline on the financial systems

in India. RBI manages the stability of rupee versus foreign currencies
(exchange rate stability) and also ensures that the price levels in the
country are stable (domestic rate stability).
Forex market is a market in which currencies of various countries are
sold against each other. It is the largest financial market in the world in
terms of cash value.
Capital account convertibility (CAC) refers to relaxing controls on capital
account transactions. It means freedom of currency conversion in terms
of inflow and outflow with respect to capital account transaction. Most
countries have liberalised their capital accounts but with regulations.
Foreign exchange activities in India are governed by Foreign Exchange
Management Act (FEMA) 1999. FEMA is oriented to development of
forex markets in India in a healthy manner.
The flow of information regarding foreign exchange is important to the
Government of India and RBI for important policy decisions. Banks are
the Authorised Dealers (ADs) and they are the source of information in
foreign exchange market. Corporates and other businesspersons should
however match their information systems with those of the bank and
ensure zero discrepancy, failing which they could be hauled up for
improper forex actions.
Foreign Exchange dealer Association of India (FEDAI) is a selfregulatory body. The major activities of FEDAI are framing rules,
governing the conduct of inter-bank foreign exchange business among
banks and liaison with RBI for reforms and development of forex market.
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Unit 5
5.9 Glossary
Currency: Money used in a particular country at a particular time

Currentaccount: The account which receives inflows and makes
payments in foreign currencies arising out of revenue transactions
Intervention: The intention to become involved in a difficult situation in
order to improve it or prevent it from getting worse
Remittance: A sum of money sent
Shipment: Goods sent to a place or the act of sending them

1.
2.
3.
4.
5.
Define the role of RBI in exchange rate management.

Discuss the development of forex market.
Describe the approaches to CAC.
Explain FEMA and highlight the effect of FEMA on liberalisation.
Explain the role of FEDAI.
5.11 Answers
Self
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
Stabilises
Intervention
True
Currencies
True
True
CAC
Domestic
True
FEMA
Buyers credit
True
b - Authorised Dealers
VOSTRO and NOSTRO
R-Returns
True
a - FEDAI
Innovation
Page No. 95
Unit 5
Terminal Questions
1. The central bank of the country, Reserve Bank of India (RBI) has the
responsibility of enforcing discipline on the financial systems in India.
Refer to section 5.2 for details.
2. Forex market is a market in which currencies of various countries are
traded against each other. Refer to section 5.3.
3. Capital account convertibility Refer to relaxing controls on capital
account transactions. Refer to section 5.4.
4. The foreign exchange activities in India are governed by Foreign
Exchange Management Act (FEMA). Liberalisation has necessitated a
number of significant changes in the regulations under FEMA to reflect
the increase in FDI and global business in much greater volumes. Refer
to section 5.5.
5. Foreign Exchange dealer Association of India (FEDAI) is a selfregulatory body. Refer to section 5.8.
5.12 Case Study

Reliance Infrastructures Violation of FEMA
Reliance Infrastructure (RIL) is Indias largest private corporation in power
sector. RIL is the sole distributor of power to the suburbs of Mumbai. It is
headed by Anil Ambani, son of Dhirubhai Ambani.
RIL was asked to pay ` 125 crore as compounding fees for parking its
foreign loan proceeds worth USD 300 million with its mutual fund in India for
315 days. The money was later repatriated to a joint venture company
abroad. According to RBI, this act was in violation of FEMA.
RBI stated that RIL raised USD 360-million through External Commercial
Borrowing (ECB) on July 25, 2006 for investing in infrastructure projects in
India. The ECB proceeds were temporarily parked as overseas liquid
assets. RIL repatriated the ECB proceeds worth USD 300 million to India
and the balance amount remained abroad in liquid assets.
RIL then invested these funds in Reliance mutual fund growth option and
Reliance floating rate fund growth option on April 26, 2007. On the next day,
April 27, 2007, the entire money was withdrawn and invested in Reliance
Fixed Horizon Fund III Annual Plan series V. On March 5, 2008, Reliance
Page No. 96
Unit 5
Energy repatriated USD 500 million which included the ECB proceeds
repatriated on April 26, 2007, and invested in capital market instruments for
investment in an overseas joint venture called Gourock Ventures in British
Virgin Islands.
According to FEMA guidelines issued in 2000, a borrower can park ECB
proceeds till actual requirement in India but cannot utilise the funds for any
other purpose. In a situation where ECB proceeds are parked overseas, the
exchange rate gains or losses are neutralised. In this case, the exchange
gain was realised and accumulated to the company which contravenes
FEMA. The company had made an additional unlawful income of ` 124
crore. It was asked to pay a compounding fee of ` 124.68 crore.
1. Why was Reliance Infrastructure asked to pay a compounding fee?
(Hint: Compounding fee was asked for parking foreign loan proceeds
worth USD 300 million with its mutual fund in India for 315 days)
2. How did Reliance Infrastructure use ECB proceeds?
(Hint: ECB proceeds were temporarily parked as overseas liquid assets)
Source: http://www.mbaknol.com/management-case-studies/case-study-on-femarbi-slapped-rs-125-crore-on-reliance-infrastructure/
References:
(2006), Economic Developments in India Continuing Series, Volume

98, [many writers] India, Academic Foundation
(2007), Economic Developments in India Continuing Series, Volume

115, [many writers] India, Academic Foundation
(2006), Money Banking and Finance, [many writers] India, Academic

Foundation
Sharan, V, (2009), International Financial Management, Fifth Edition,

India, PHI Learning Private Ltd.
Khan, M.Y, (2009), Indian Financial Systems, Sixth Edition, India, Tata
McGraw-Hill
Page No. 97
Unit 5
E-References:
http://www.infodriveindia.com/Exim/Reserve-Bank/FOREIGNEXCHANGE-CONTROL-MANUAL/ANNEXURE-I-GUIDE-TOAUTHORISED-DEALERS-FOR-COMPILATION-OF-R-RETURNS.aspx
retrieved on 17.2.13
http://www.rbi.org.in/scripts/ECMUserView.aspx?Id=55 retrieved on
17.2.13
http://taxguru.in/fema/rbi-circular-on-current-account-transactions%E2%80%93-liberalisation.html. Retrieved on 17.2.13
http://www.mbaknol.com/management-case-studies/case-study-onfema-rbi-slapped-rs-125-crore-on-reliance-infrastructure/ Retrieved on
17.2.13
Page No. 98
Unit 6
Unit 6
Liquidity Planning and Managing Cash Assets
Structure:
6.1
Introduction
Objectives
6.2
Liquidity
Standards for maintaining liquidity
Impact of liquidity on the economy
6.3
Liquidity Planning
6.4
Cash Reserve Ratio
6.5
Proportion of Riskless Investments
6.6
Non-Banking Finance Companies
6.7
Liquid Assets
6.8
RBIs Monetary Policy & its Impact on Corporates
6.9
Cash Management System
Effective management of cash
Cash management system products
6.10 Multinational Cash Management
6.11 Working Capital Management
Liquidity and working capital management
6.12 Summary
6.13 Glossary
6.15 Answers
6.16 Case Study
6.1 Introduction
We discussed the role of RBI in exchange rate management, forex market,
Foreign Exchange Management Act (FEMA), and Foreign Exchange
Dealers Association of India (FEDAI) in the previous unit. In this unit we will
discuss liquidity planning and cash management.
Maintaining the right level of liquidity is crucial for successful performance in
business. Too much liquidity will mean more cost and less profits; but too
little liquidity could spell the end of a company. A balanced approach is vital.
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Unit 6
We will examine the concept of liquidity from the standpoint of a corporate

entity, and cover working capital, effective systems to reduce pipeline cash,
relevance of the banking system for efficient liquidity management and the
importance of efficient working capital management in managing liquidity.
Objectives:
define liquidity and explain statutory prescriptions in liquidity planning
describe the meaning and features of cash reserve ratio and statutory
liquidity ratio
explain non-banking finance companies, liquid assets and instruments of
monetary policy
describe cash management system and compare internal and
multinational cash management system
analyse working capital management
6.2 Liquidity
Liquidity is defined as the extent to which an asset or security can be traded
in the market without affecting the asset's price. Liquidity is characterised by
a high degree of trading activity. Assets that can be easily bought or sold
are known as liquid assets.
Liquidity for a corporate entity is related to the business cycle. The liquid
assets of the firm move fast in an economic boom, while they are much
harder to convert to cash in a slump.
The liquidity of an organisation depends upon the following factors:
Organisations trade volumes, frequencies and short-term need for cash
Sales distribution through the year and Working capital cycle
Current asset portfolio of the business
Available credit lines
Organisation ownership structure
Organisations reputation in the marketplace
The risk orientation of the management
6.2.1 Standards for maintaining liquidity
Every organisation should lay down a standard set of guidelines on policies
and controls to ensure that liquidity is maintained in an optimal range. The
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Unit 6
standards will be based on the factors spelt out above, applicable to the
organisation. In particular these should cover the following aspects:
Sales distribution through the year and Working capital cycle
Trade credit
Debt financing
Investment of surplus funds
Minimum and maximum cash balances
The guidelines should also be clear about the authority levels for decisions
on the above aspects, and about handling of exceptions.
6.2.2 Impact of liquidity on the economy
In an economy, the enhanced desire to purchase goods and services results
in a corresponding increase in demand. It enhances liquidity in the market,
which in turn reduces the probability of financial crises and the output losses
associated with such crises. The benefits as a result significantly exceed the
potential output costs in the economy.
Healthy levels of liquidity yield the following benefits:
Frequent trading and symmetric relationship between the buyers and
sellers
Reduced inflation
Protection of shareholders' wealth from forced sale of assets
Activity 1:
You are the CEO of an MNC. How would you implement and maintain
effective liquidity practices in your company?
(Hint: Main things to look into are working capital cycle, effective policies
fully implemented, tight and on-time reporting system, and relentless focus
on preventive action. See 6.2 above for key ideas, and also refer
tohttp://www.financeasia.com/News/264704, the-secret-to-good-treasurymanagement.aspx)
1. _______________ is characterised by a high degree of trading activity.
2. The liquidity of an organisation depends on the organisations shortterm need for cash. (True/False)
Page No. 101
Unit 6
6.3 Liquidity Planning

Liquidity planning is the exercise conducted from time to time by a company
to maintain liquidity at optimal levels. This involves predicting fund
requirement in the face of seasonal phenomena and growth needs.
Liquidity planning involves two steps:
Strategic planning: Strategy is critical to management of funds; and it
has to be planned for the medium-term and long-term. Strategic
planning evolves the companys strategy with respect to liquidity, taking
into account
o
o
the growth and diversification plans of the company

the risks of all kinds business, economic and capital market risks
to which the company is exposed
Contingency planning: Every organisation should have a contingency

plan that spells out the fall-back action options that it should consider to
bolster its liquidity if its strategic plans suffer a setback. A what-if type of
analysis should be done with respect to each of the key factors that
impact liquidity; and alternative action plans listed out for each situation.

3. Liquidity planning comprises two steps: ________ planning and
______ planning.
4. Listing fall-back action options is a feature of a liquidity plan.
(True/False)
6.4 Cash Reserve Ratio

A prudent liquidity plan usually specifies cash reserve or the minimum cash
balance a company should have.
For the Indian economy, RBI prescribes a Cash Reserve Ratio (CRR) for
banks to hold to meet the withdrawal demands of customers, in the form of
authorised currency stored in the bank treasury or with RBI. In the same
manner a sensible corporate treasury head will hold a cash reserve for
transactional needs of his company that cannot be deferred.
Holding reserves in excess has to be guarded against, as it has a cost.
Page No. 102
Unit 6

5. Which is the ratio that sets the minimum cash balance that each bank
must hold?
6. Holding excess cash reserve is good for a company. (True/False)
6.5 Proportion of Riskless Investments

Another stipulation a Treasury Manager must make with regard to liquid
funds is the amount of surplus cash to be invested in riskless investments.
The return could be low but funds are safe and fully liquid. In banking
parlance, this is called Statutory Liquidity Ratio (SLR), or the percentage of
total deposits that banks must invest in government bonds, gold and other
approved securities. RBI determines the percentage of SLR.
Fixing and controlling a ratio like SLR has become crucial these days in the
corporate sector for two important reasons:
1. Many companies in the new economy have cash surpluses in billions
and reckless investment of these funds could be disastrous.
2. Huge cash balances in unknown investment destinations could even
mean fudging or fraud, as was the case with Satyam.
7. In India, ____________ determines the percentage of SLR for banks.
8. Ratios like SLR are not relevant for the corporate sector. (True/False)
6.6 Non-Banking Finance Companies and the Corporate Sector

Non-Banking Financial Companies (NBFCs) are financial organisations that
provide banking services, but do not possess a banking license. These
organisations are allowed to accept deposits from the public and provide
loans to various wholesale and retail traders, small-scale industries and selfemployed persons.
NBFCs are quickly emerging as an important section of the Indian financial
system. Their functions are complementary to the banking sectors functions
and they are popular because of their customer-focused facilities, simplified
methods, appealing rates of return on deposits and flexible options to meet
the cash needs.
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Unit 6
The operations of NBFC are regulated by RBI in India. NBFCs are allowed
to accept public deposits subject to conditions imposed by RBI with regard
to tenure, interest rates and terms of repayment.
The following are some types of NBFCs:
Equipment leasing companies whose principal business is leasing out
machinery, equipment and vehicles
Hire purchase companies whose principal business is in hire purchase
Loan companies which provide financial assistance
Investment companies whose principal business is buying and selling of
securities
9. The operations of NBFC are regulated by ________.
10. A loan company is a type of NBFC. (True/False)
6.7 Liquid Assets

Liquid assets are described as cash and cash equivalents, including
currency, bank accounts, money market fund shares, bonds, mutual funds,
insurance policies, mortgages and tax refunds.
Holding enough liquid funds is a safety device that gives power and relevant
options to the holder. The benefits of holding liquid assets are:
Avoiding compulsory debt: When need arises for urgent repayment of a

liability, keeping enough liquid funds lessens the chance of having to
contract a debt for meeting the payment.
Meeting emergencies: Maintaining an emergency fund is necessary to

cope with sudden downturns.
Preserving the integrity of investment portfolio: Possible illiquidity forces

a company to liquidate long-term assets at considerable losses.
Seizing business opportunities faster: Liquidity gives an investor a great

edge when attractive investment opportunities crop up.
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Unit 6
Activity 2:
It is annual budget time in your company. As Treasury Chief you are
asked to spell out the companys liquid assets plan. Make a draft for
circulation.
Hint: Refer to 6.4 for key points. Include in your draft the following
matters: (1) changes required in the liquidity policy, (2) reasons for the
changes, (3) your requirements for information from Operations and
Finance about their projections for the budget, to help you quantify the
liquid asset values, and (4) cost saving and revenue generating initiatives
you are considering in the budget year.
11. Liquid assets cannot be converted quickly and easily into cash.
(True/False)
12. Avoiding _________ _____ is one of the reasons for the requirement of
liquid assets.
6.8 RBIs Monetary Policy& its Impact on Corporates

Monetary policy is one of the most important tools that RBI uses to direct the
economy. Its objectives are to channelize economic activity into desired
sectors for proper, balanced growth.
Monetary policy is administered through multiple instruments that impact the
financial sector and is very relevant to the corporate sector. It is therefore
necessary for the Treasury Head of a company to understand these and be
aware of their specific relevance to the companys financial operations. RBI
announces monetary policy changes every year and sometimes in the
interim.
The following are a few important monetary policy instruments:
Reserve requirement i.e. CRR and SLR: An increase in reserve ratios

will reduce the money supply and bank loans will be tougher to get.
Open market operations are the purchase and sale by RBI in securities
like treasury bills and government securities: Purchase or sale in open
market operations affects money supply in the economy.
Lending by RBI: This affects reserve levels and lending power of banks.
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Unit 6
Direct bank credit control: RBI can limit or liberalise lending by banks to
different economic sectors, which can trigger or retard corporate activity.
For example export credit could become cheaper, spurring companies to
act
Guidelines on corporate deposits: These direct pronouncements affect

corporate debt policy directly, and may include changes in terms that
companies should implement carefully to avoid penalty.
Exchange rates: In a controlled economy like ours, foreign exchange is

still not fully market-driven and RBI does play a key role in shaping the
movement of INR vis--vis US$ and other hard currencies.

13. Monetary policy is one of the tools that RBI uses to ____ the economy.
14. Understanding instruments of monetary policy of RBI is not relevant for
Corporate Treasury managers. (True/False)
6.9 Cash Management System

Cash is king; and maximising cash available for use is a major challenge for
most companies. This is done with the help of Cash management Systems
(CMS).
The key hurdle faced by a CMS is collection or deposit float meaning the
amount of money that is collected but not usable as it is in the pipeline. For
instance customer in Bhatinda has given a cheque, but for it to be credited
to the companys overdraft account in Mumbai it may take 12 days. An
efficient CMS that reduces this float is vital to a companys control over
cash.
6.9.1 Effective Management of Cash
The CMS of a company should enhance collection of receivables, control
payments to trade creditors and efficiently manage liquid cash. This can be
done by enabling greater connectivity to their branch network and providing
better IT solutions and services in cash management.
An effective cash management system looks at three things:
Deciding and controlling the optimal cash balance to hold
Planning inflows and outflows of cash
Investment of surplus cash at the best returns and the least risk
Page No. 106
Unit 6
It seeks to achieve these objectives by

Building and operating a robust networking facility that connects different
agencies involved in the movement of cash and thereby cutting down
the time taken between any two agencies to the minimum
Running a powerful information system that tracks cash online and
ensures that concerned managers act on the information quickly to
resolve issues and prevent cash getting stuck in the pipeline
Making banks and other financial intermediaries partners in the process
of finding cost-effective solutions to the problem of inordinate time-lags
in getting the cash credited and available for use.
In the last two-and-a-half decades the banks in India have done remarkable
work in this field by introducing a number of innovative CMS products, and
are now able to give their customers credit the very next day even for local
cheques deposited in some distant branches. CMS features also include
cheque collection, tracking of actual payment, and Management Information
System (MIS) on collection behaviour of parties. So much so, it is not just an
operational tool now, but a strategic device as well.
The benefits of a well-planned and efficiently managed CMS are:
1. Online information on global cash balances all the time
2. Anywhere and anytime banking without loss of controls
3. Optimal utilisation of cash and minimal idle cash balances
4. Quick and accurate compliance with external reporting requirements like
bank statements, Credit Authorisation Scheme (CAS) data etc.
5. Ability to manage MBA (multi-banking arrangement) from one location
6. Ability to generate better revenues from cash balances
6.9.2 CMS products and tools
1. Decentralised collection: An outstation cheque travelling all the way to
Head Office and going back again for clearing is a huge waste of time.
This can be avoided by branches of banks receiving cheques and, using
the Net connectivity for updating the system at the Head Office and
enables credit to be given to the HO account the next day itself.
2. Concentration banking: This idea has evolved into a compact banking
practice known as concentration banking. A company will have the
overdraft at the HO, and a plethora of current accounts in all its sales
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Unit 6
and stock points. Thanks to concentration banking, information is always

available on balances across the country, and transfers are enabled.
Even at international level this is increasingly becoming a practice: a
global company does not work with a local bank but prefers to work with
a branch of its main bank at the HO.
3. Lockbox system: Here the cheques are received directly into a lockbox
provided for the purpose by the bank, and customers are advised send
their cheque to this lockbox. Through this process, the time involved for
the customer in collecting and depositing the cheques is eliminated.
Thus one more link in the chain is thus removed, speeding up the
process.
4. Electronic receipts and payments: In the new age of anywhere and
anytime banking it is now possible to directly credit the payees account
using online banking services. This is especially beneficial for making
regular payments like payment of salaries and payment to vendors. Only
a simple list of payees and amounts, duly authorised, is sent to the
bank; and credits happen instantly if employees have accounts in the
same branch.
Banks also give the facility to their customers of preparing and mailing
cheques on their behalf, reducing clerical workload of the customers.
All this facilitates control over bank balances a great deal because one
does not have to worry about the float.
5. Electronic data transfer between constituents: When two companies are
in advanced stages of automating all their processes, paperwork relating
to the transactions between them can disappear altogether. This is
facilitated by electronic transfer of orders, invoices, debit notes and
finally payments and receipts. The reconciliation is also done online.
Accounting packages provide excellent interface with spread-sheets
from which data can be downloaded or into which data can be uploaded
and sent.
6. Improved clearing systems of banks: Thanks to advanced information
technology banks have effected innovations in clearing house activities
and this has in turn reduced turnaround time (TAT) significantly.
7. Payment management: Large companies operate on payment cycles
viz. specific days of the week or the month when payments to vendors
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Unit 6
would be organised. If the vendor is lax or if the invoice is not made

properly he will miss the cycle and has to perforce wait till the next cycle,
even if the bill becomes due in between.
This is a good method also to get the companys vendors to become
more efficient and precise in their administration, documentation and
accounting, and can have lasting benefits in year-end closing and audit
time and effort.
15. CMS is a strategic tool to efficiently manage cash and liquidity.
(True/False)
16. The key hurdle in maximising cash available for use is ___________ or
__________ ________.
6.10 Multinational Cash Management

A multinational company, viz. a company that has offices in many countries
requires a CMS that can handle the additional issues arising from the global
exposure of the Treasury function. The principal aim of such a CMS is to
see how quickly and inexpensively money available in one end of the world
can be used by an office at the other end.
The answer to this lies in combining global strategy with local practices. The
treasury policies of an MNC will strive to blend the best practices of cash
management available in the countries in which they operate, but without
hurting their global strategic intent. Thus a company renowned for its best
paymaster name may find cash movement logistics in a third-world country
very slow. Instead of damaging its reputation for prompt payment, the
company will work with the vendors to set up automatic transfers to the
vendors bank accounts in an international bank.
Another challenge in multinational cash management is exchange rate
fluctuation. The objective here is to minimise adverse impact of exchange
rate changes on the companys bottom line.
A variety of strategies are adopted by MNCs to achieve this objective.
These include
Making contracts with customers and vendors that fix the exchange rate
band and stipulate price change if exchange rate goes outside the band
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Establishing Exchange Earners Foreign Currency (EEFC) accounts

i.e. bank accounts in foreign currencies, with freedom to convert the
balances to local currency at the favourable time, or make foreign
currency payments out of that account
Linking accounts with one bank across geographies, making payment
much easier and in the process reducing idle cash

17. The principal aim of a multinational cash management system is to
make money available for use __________ and ____________.
18. Another challenge in multinational cash management is ___________
________ ______________.
6.11 Working Capital Management

Working capital is that part of a firms capital which is required for financing
short-term or current assets including inventories and receivables. This is
the operating capital required for day-to-day activity.
Both short-term and long-term funds can be used for financing working
assets. Short-term sources of funds provide flexibility and lower cost, and
long-term sources provide reduced risk and enhanced liquidity. The
permanent or long-term segment of working capital should be financed with
long-term funds, and variable segment with short-term funds
Permanent or core working capital is the minimum amount of net working
assets required for the business, below which the business volumes are
unlikely to go This is a permanent investment to be continually financed.
This comprises the working capital required for maintaining the capital in
circulation, plus a reserve to provide for unpredictable contingencies like
strikes or unforeseeable shortages. This amount has to be budgeted every
year and its funding closed through long-term sources, at the least cost and
on the best terms.
Variable or temporary working capital is the fluctuating portion of the net
working assets. Variation happens because of seasonality, one-time
exercises like campaigns and period-end spurts in activity, or seasonality of
customer/vendor cash flow. This capital is financed with short-term funds.
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Smart management of working capital is a vital factor in the success (or

failure) of a business.
Factors that determine working capital management are:
Planned level of activity
Nature of business and specific characteristics of its working assets
Seasonality
Management initiatives with regard to
o Inventory control
o Trade credit to be given to customers
o Trade credit available from vendors
o Cash management
Requirement of other current assets like deposits & advances
How much working capital does a business need?
Is there a number or value or ratio that can be laid down as the standard
for working capital of any company? The answer is no, certainly not. What is
ideal for one company may be unacceptable to another, and it all depends
on proper evaluation of the factors listed above. A trading firm will require a
healthy volume of fast-moving inventories; a company selling to end users
on the other hand would probably need much less inventory, but they would
invest more in credit and receivables.
6.11.1 Liquidity and working capital management
Working capital management has a direct impact on liquidity. The cash
crunch felt by many businesses is often the result of bad management of
working capital, like over-producing and stocking up, or excessive credit to
customers for getting business etc.
Liquidity or ability of a firm to meet short-term fund requirements is not only
affected by the amount of money invested in working capital but in its
composition too. For instance a company that has a huge current liability
amount because of advances received from customers is on a much better
wicket than a company whose current liabilities are huge because of unpaid
vendors. The former business is healthy but the latter is sick.
Constructive working capital management is required to ensure that a firm
has sufficient resources to satisfy maturing short-term debt and upcoming
operational expenses.
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19. The working capital requirements should be met both from short term
as well as long term sources of funds. (True/False)
20. The cash crunch felt by many businesses is often the result of bad
management of _________ ___________.
6.12 Summary
Liquidity defines the extent to which an asset or security can be traded

in a market without affecting the asset's price. Liquid assists lend great
market stability and safety to an organisation.
The treasury function of a corporate is akin to the banking system of a

country, and has to use devices like cash reserves, liquidity ratios etc.
that are mandatory for banks, with suitable adaptations.
Effective management of liquid assets has to balance the cost of idle

funds kept as reserve and the cost of inadequacy of funds at crucial
times that can strike at the very roots. This is an on-going, regular job.
The Treasury manager should make efforts to understand the monetary

policy of his country and align his practices to changes therein.
He should also know in some detail the workings of banks and NBFCs
and ascertain the best sources for his liquid fund needs.
Working capital levels directly impact liquidity of a business; and

constructive management of working capital means planning and
controlling the amount and the content of different items of working
liabilities and assets.
6.13 Glossary
Contingency: Something that might possibly happen that can have an

adverse impact
Hedge: A way of protecting an open item and limiting possible losses

because of its movement
Seasonality: The propensity to change according to the season
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1.
2.
3.
4.
5.
Why is liquidity so important to a business?

Describe the corporate equivalent of CRR and SLR and their relevance.
Explain commonly used monetary policy instruments.
What is multinational cash management? What are its purposes?
How is working capital management important for liquidity?
6.15 Answers
Self
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
Liquidity
True
Liquidity
True
Cash reserve ratio
False. Excess cash may give safety but it is very expensive.
RBI
False. Ratios like SLR quantify an important aspect of business viz.
liquidity. They are therefore relevant.
RBI
True
False. The word liquid means easily convertible to cash.
Debt
Direct
False. Corporate Treasury Managers need to be well up on
instruments of monetary policy.
True
Collection, deposit, float
True
quickly, inexpensively
exchange rate fluctuation
Working capital
Terminal Questions
1. Liquidity affords security and comfort in terms of smooth flow of day-today activities. Refer to 6.2.2.
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2. CRR and SLR have to be fixed and managed by any Treasury, including
corporate treasuries. Liquidity is quantified by these ratios, and liquidity
is an important parameter for corporate performance too. Refer to 6.4.
3. Reserve requirements and open market operations are some monetary
policy instruments. Refer to 6.8.
4. Funds availability and exchange risk management are two purposes.
Refer to 6.10.
5. Levels of working capital and the items making up the total can indicate
whether the company has normal or abnormal liquidity. Refer to 6.11.
6.16 Case Study

PeopleSoft Enterprise Cash Management
Liquidity management is critical to the financial health of any company.
Treasury organizations must have real-time visibility into their global cash
position to accurately forecast cash requirements, ensure liquidity and
optimize the use of cash by investing it appropriately. Oracle's PeopleSoft
Enterprise Cash Management enables organization to monitor and forecast
cash requirements, perform automated bank reconciliations, distribute
payments efficiently and securely, and automatically generate accounting
entries. PeopleSoft Cash Management is at the heart of PeopleSoft's
treasury management solution which offers a complete solution for
addressing the critical planning, processing, and reporting requirements of
global treasury units. Cash Management's straight-through payment
processing feature, Financial Gateway provides a single platform for
seamless communication between banks, financial institutions, and
corporations to process all payments and receipts.
PeopleSoft Enterprise Cash Management is integral to PeopleSoft's
treasury management solution and is part Oracle's PeopleSoft Financial
Management family of applications.
Benefits
Streamline Cash Management Operations
Improve bottom line by accurately forecasting long-term cash
requirements with information directly from PeopleSoft Receivables and
PeopleSoft Payables
Improve cash positions by using intraday cash capabilities
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Increase efficiency by automating manual processes; cash positioning,

cash forecasting, and bank reconciliation
Improve Return On Investment

Gain visibility into real-time cash positioning with cash position analytics
through treasury dashboards and cash sweep
Improve performance by executing investment transaction for surplus
funds through tight integration with PeopleSoft Deal Management
Improve return on investment by effectively managing idle cash through
cash sweep and cash pooling
Seamless Integration
Reduce manual entry errors of payment instructions with out-of-the-box
integration with PeopleSoft Payables, PeopleSoft Receivables, and
PeopleSoft eSettlements
Strengthen reconciliation and proper accounting of your cash with builtin controls and automated accounting bank and book (General Ledger)
to bank reconciliation
Ensure straight through processing with Financial Gateway
1. Evaluate the features mentioned in this advertorial that claims a number
of benefits it can offer to the Cash Manager of a company. Make an
impartial assessment of what could be genuinely achieved, and what
may be exaggerated.
Hint: List out the features one by one, and explain whether in typical
Indian conditions the feature can work. For instance electronic payments
may be tough for a company doing business in small towns.
2. How can a company make sure that the advantages offered by this
system can in fact be achieved and realised?
Hint: Connect the features, one by one, to the companys specific
requirements (you can assume the requirements).
Source: http://www.oracle.com/us/products/applications/peoplesoftenterprise/srm/053366.html-p
Reference:
Moorad Choudhry, Bank Asset and Liability Management, John Wiley
and Sons, WILEY FINANCE 27.10.2011
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E-Reference:
http://www.rediff.com/money/2007/jul/20nbfc.htm
http://www.cnb.cz/en/monetary_policy/instruments/
http://accounting-financial-tax.com/2009/06/multinational-cashmanagement-a-detail-overview/
http://www.docstoc.com/docs/4582919/working-capital-management
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Unit 7
Unit 7
Business Risk Management
Structure:
7.1 Introduction
Objectives
7.2 Risks in Business
Risks based on source internal and external risks
Risks based on nature of risk Strategic, operational, compliance
and reporting risks
Domain specific risks
7.3 Measurement of Risk
Quantitative risk assessment
Measurement of specific risks
7.4 Mitigation of Risks
An overview of risk mitigation
Processes for risk containment
Tools available for managing risks
Specific risk mitigation tactics
7.5 Summary
7.6 Glossary
7.8 Answers
7.9 Case Study
7.1 Introduction
In the previous unit we discussed liquidity and how it is important for the
Corporate Treasury function. We went through different measures adopted
by the banking system of a country in managing liquidity, and saw how
these are equally relevant to companies.
In this unit you study risk measurement and mitigation. We discuss types of
business risks, measurement of these risks and processes and tools
available for managing the risks.
Risk measurement is the process of quantifying risk. Large companies
usually have a department that measures the risk of every endeavour and
enables management to decide whether it would be sensible to proceed.
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Objectives:
define the risks in business
analyse the major types of risks
explain the concept of risk measurement and the methods used
describe the processes and tools available for risk mitigation
7.2 Risks in Business

Business risk implies uncertainty in profits or danger of losses on account of
internal and external decisions and events. Risk is inherent in every area of
business activity and varies according to the nature and size of business.
Some examples of risk are irregular supply of raw materials, breakdown of
machinery, price fluctuations, errors in sales forecasting, trade cycles,
natural and manmade disturbances etc.
Risks are inevitable and cannot be eliminated but only controlled through
proper preventive and corrective measures of risk management. First it is
important to sort the risks faced in business to know them better.
Risks can be classified across three dimensions:
a) Source of risk: On the basis of the origin or source of the risk, they can
be classified as Internal and external risks.
b) Nature of risk: On the basis of the nature of risks, they can be classified
as Strategic, operational, compliance and reporting risks.
c) Risk domain: Risks can be categorized on the basis of the domain or
the subject-matter. The list of these risks will depend upon the company
and its business. A few key domains that can be seen to exist in all firms
are liquidity risk, credit risk or default risk, market or price fluctuation risk,
reputational risk, supply chain risk, business continuity risk,
environmental risk, physical security risk and cyber security risk
7.2.1 Risks based on source internal and external risks
Here we discuss risks originating internally and those arising from external
sources.
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Internal risks: These risks arise from events and decisions within the
organisation. Some notable internal risks are:
o
Human actions and lapses: Employees and other stakeholders of the

company cause significant internal risk through their deliberate or
accidental action or inaction. Strikes, lockouts, theft, pilferage and
sabotage, accidents, supplier failures, customer insolvencies, wrong
management decisions etc. are some examples.
Technology failures: These include investing in wrong technology,

blunders in production process, product design mistakes, inability to
cope with market requirement of technology, lagging behind competition
in product development etc. There is also an external perspective to
technology which we will see later.
Physical occurrences: Manmade happenings can result in loss or

damage to the property, like machinery breakdown, and fire, flood or
earthquake losses, transit damages, third-party loss of life or property
etc. which the company has failed to insure.
External risks: Risks arising from events outside the organisation are
external risks. These events are far more difficult to predict, measure and
control. Notable external risks are:
o
The economy: The performance indicators of the economy have a

bearing on individual company fortunes
Systemic risk or the collapse of the entire market or entire financial

system being hampered is a variety of external risk. We have seen
instances of this in the last 5 years in a few major economies.
Customers, vendors and competitors and their actions are crucial to the
operations of a business and have a definite external risk element.
Interest rate changes, foreign currency fluctuations and credit risks are
major external risks
Movements in cost of living, industrial growth, stock exchange index,

inflation and recession, unemployment etc. impact businesses in general
and particular, depending upon how closely related the business is to
the factor.
Natural factors: Natural calamities like earthquake, cyclone, famine and

drought may cause loss of life and property to an organisation.
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Political factors: Changes in governments and government policies,

communal violence, and inter-state squabbles can seriously hamper the
working of an organisation.
7.2.2 Risks based on nature of risk Strategic, operational,

compliance and reporting risks
In this section we discuss risks at the different stages of management action
viz. planning the strategy, execution, administrative matters, and
communication with stakeholders. At each stage the management faces a
set of risks.
1. Strategic risk: Strategic risk refers to the business losing out on options
available to it by taking a decision that pre-empts other paths.
Risks arising from the strategy deployed by the firm and strategic decisions
taken are of two kinds:
Structural strategy decisions: The approach of the firm with regard to
technology, market, product diversity, expansion etc. are fundamental
structural decisions and the risk of any of these going wrong is a
strategic risk.
Executive strategy decisions: The approaches of the firm with regard
to processes, systems, transactions, management style, employee
management etc. are the operational aspects of strategy. These also
are strategic risks.
2. Operational risk: A number of operational decisions are required to be
taken in a business day to day. Each of these has a risk element varying
with the monetary value of the decision and time period for which the
decision may impact the business. For instance a decision to give an
employee advance may be seen as a small, one-time commitment and so
not risky; but other employees may set it as a precedent and then it
becomes a significant risk.
This is by far the simplest of the risks to understand and act on. It includes
the risk of mistakes being made in implementing an operating decision.
There are two varieties here accidental and deliberate. An example is the
risk in entrusting a large sum of money to be drawn from the bank by the
cashier without proper security and with no insurance cover.
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3. Compliance risk: The risk of failure in complying with the rules can be a
serious matter especially for companies with global reach, which have to
understand and observe the rules set in as many countries as they are
working in.
These are risks of non-compliance with the rules and regulations that apply
to the business, and the risk multiplies if the firm operates in many
countries. Non-compliance often happens because of omission or ignorance
of law, and is not intended. At times foolhardy managements also take the
risk of consciously violating a rule and hope not to be found out. But this is
becoming increasingly difficult, with automated legal processes in many
statutes like income tax.
4. Reporting risk:
This is the risk that a public company makes accounting errors that reflect in
the annual financial report in the form of wrong profit/loss which causes an
adverse reaction in the stock market. This is also the risk that a wilful
deviation in accounting and reporting by a company gets detected and the
company and its directors are penalised. The application of statutory
standards and independent test of the reported figures by auditors to a large
extent mitigates the first risk. But the second risk, of deliberate creative
accounting has gone up in the last decade and its impact on a company
can sometimes be fatal, like Enron and Satyam.
Risks of reporting are threefold:
a) Failure to report (errors of omission) depending upon the nature of
the report or disclosure this risk can be costly or small.
b) Undesirable effects of reporting (errors of commission) at times
voluntary reporting by key corporates can boomerang on them. An
example is the financial guidance or forecast of net income for the
succeeding quarter.
c) Mistakes in reporting the risk of having to retract reports issued can
sometimes play havoc with the reputation of a company.
7.2.3 Domain specific risks
Classifying business risks into the domains in which they occur is a good
way to assign responsibility for managing them. The bigger the domain, the
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higher is the risk factor. For instance a company in consulting services will
have no inventory risks but sizeable market and competitor risk.
We discuss here domain risks common to all businesses.
1. Sales and Production risks: The two biggest threats to any business
are (a) non-availability of a market for their product (sales risk) and
(b) incapability of fulfilling the demand (production risk).
Inability to sell is the first and last reason for business failure. The risks of
misjudging market, competition and customer behaviour can prove fatal to
the business.
Production risks relate to quantity, quality and cost of manufacture.
Production quantity is usually well-planned and controlled but could go awry.
Excess production can give rise to huge inventories and eventual disposal
at a loss. But production falling short of demand is an even greater risk.
2. Employee risks: An organisations success depends upon employees,
a key resource. Hiring people introduces several types of risks:
a) Risks related to the job: A job that calls for late night work, like a BPO,
and with female workers, raises risks like health hazards, accidents and
harassment, and high levels of attrition.
b) Risks related to human behaviour: Trade union relations, interdepartmental rivalries, managerial issues like appraisals etc. are all
matters that pose a threat and carry a risk element.
c) Risks related to handing of employee relations: Employee engagement,
viz. getting the best out of your workforce, is not only about high salaries
but sensitive management of employee relations. This includes work
environment, supportive employee policies, systematic reskilling and
grievance redressal. The risks here are very real and crucial.
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Figure 7.1 depicts the personnel risk in different areas.
Figure 7.1: Personnel Risk in Different Areas

Source: http://www.pk-rh.fi/pdf/en/personnel-risk-management-booklet
3. Financial Risks: These are risks associated with the financial structure
of a company and financial transactions.
A few typical financial risks here are
Capital structure: This is the proportion of owned and borrowed capital,
also called the extent of leverage, and is a significant risk indicator. The
higher the debt portion of the capita, the greater is the risk.
Investment risk: This denotes the risk of poor returns on or complete
loss of investments made with the capital sourced. It is easy to perceive
when a single big investment fails; but the risk that is much harder to
see, and therefore control, is the persistent fall in return on investment
compared to cost of capital. If not watched, this can also kill a business.
Liquidity risk: Inability to pay for maturing liabilities is a grave financial
risk that can sometimes result in the closure of a firm. Prudent treasury
managers maintain a liquidity buffer that would enable them to always
meet urgent cash requirements. In the 1970s companies would have
unused overdraft limits that they could draw upon: this was probably the
least expensive form of liquidity. But a series of Government committees
came down heavily on this practice and it is no longer possible.
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Default risk: This is a variety of liquidity risk and deals with the risk of
defaulting on a loan servicing liability. Default risk occurs when the
companies cannot pay their debt obligations. Most lenders and investors
are exposed to default risk in all forms of credit extensions. Hence to
reduce risk, lenders often charge return rates corresponding the debtors
level of default risk.
Capital market risks: Capital market, comprising debt and equity
markets both primary and secondary is important for the Finance
function. Lack of alignment of the companys financial decisions with
market mood could be disastrous. For instance if a company fresh funds
at a time when the capital market has got harder and capital has
become scarce, the cost of raising the funds will go up and reduce
profitability. Public issues of even reputed companies flop if it is done at
an inopportune time.
The secondary market i.e. Sensex is important for listed companies, and
share price movement can hurt or benefit stockholders immensely.
Debt market poses a challenge as well, in particular choice of banks and
liability relationships with the banks. Significant risk here is interest rate risk.
Basis risk, risk of change in prime lending rates and variations in movement
of interest rates across maturity spectrum are different aspects of interest
rate risk.
4. Foreign exchange risk: Companies that deal in multiple currencies are
open to the risk of adverse movements in the currencies relevant to them. A
company may have to close out a long or short position in a foreign currency
at a loss due to an adverse movement in exchange rates.
The two types of foreign exchange risk or exposure are:
Transaction risk: This is the loss from drop in exchange rates while
getting paid for exports or jump in rates while paying for imports. In both
cases there is a financial loss.
Translation risk: Also known as accounting exposure, this is the impact
of changes in the values at which reported figures of assets and
liabilities are carried in the companys yearly financials. An Indian
company, for instance, has to present all its worldwide figures in INR in
its annual report; and if on the balance sheet date the rate of the
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relevant foreign currency has gone down sharply, and the company has
a huge foreign asset base, the fall in value of assets reported could
seriously dent the result for the period.
5. Credit risk: Trade credit is an important tool in selling and gives rise to
the possibility and the risk of default by the customer. The main goal of
credit risk management in organisations is to increase rate of return by
maintaining credit risk exposure within acceptable parameters.
Credit risk is also associated with the return on an investment. The yield on
a bond, for instance, is strongly aligned to the perceived credit risk.
6. Stakeholder relations: Management of relations with investors, banks
and other lenders, and interface with the capital (secondary) market also
pose important risks.
7. Environmental risk: The environment in which the business operates is
a preeminent factor in the success of the company. Happenings one-time
or regular that affect environment automatically affect the business. Apart
from natural factors like climate and terrain, other key aspects of
environment are monsoon failures, depletion of natural resources, new
industries, demographic factors etc. A company that uses large amounts of
paper for example would need to find continued supply in the face of the
declining growth of trees.
Activity 1:
You are the manager of a company operating in three countries: India,
the US and the UK. What are the risks you face relating to foreign
exchange?
Hint: Refer to 7.2.3 (4). Risks to be ascertained in terms of exports,
imports, technology payments, dividend payouts, capital infusion and
onsite deputations
1. _______________ refers to the risks arising from the events within the
business organisations.
2. Basis risk arises from the variations in the movement of interest rates
across maturity spectrum. (True/False)
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3. _____________ occurs when the companies or individuals are unable

to make required payments on their debt obligations.
a) Market risk
b) Default risk
c) Foreign exchange risk
d) Production risk
4. One of the major risks companies experience with personnel is work
related ________________.
5. Inventory risk occurs due to the problems arising in quantity and quality
of the manufactured products. (True/False)
7.3 Measurement of Risk

Having studied different varieties of risks present in business, we now take
up ways to measure the risk. It must be noted, however, that the usefulness
of risk analysis is directly proportional to the data quality, data interpretation
and follow-up action.
7.3.1 Quantitative Risk Assessment
Quantitative risk assessment (QRA) is the process of quantifying risks and
evolving methods to reduce risks to acceptable levels. It includes analysing
and classifying the identified risks and providing quantitative information for
effective decision-making. QRA is performed during the design of setting up
a new business, expansion or designing a new process or formulation of a
new plan to quantify the amount of risk present and decide whether to
accept it or not.
QRA measures effectively three parameters of the degree of risk.
Sensitivity or Importance
Sensitivity analysis tries to quantify the impact of each element of risk on
the result, to decide how sensitive the results are to changes in each
element. For example if an increase of 2% in process loss reduces profit
by 12%, process loss is a crucial risk factor.
Volatility or Probability of Occurrence

The quantitative risk measurement based on volatility includes
assessing the extent of uncertainty in the business operations. The
changes are assessed and monitored for future implementation of
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countermeasures. It includes analysis of various data-sets, operating

processes, occurring elements, and affecting stakeholders. The current
measurement of risk is analysed and any immediate occurring changes
are addressed by various simulation methods like Monte Carlo which
consists of simple statistics for analysing key strategic decisions.
Downside potential or Possibility of loss

Risk measurement is usually assessment of both threats and
opportunities. The risk process aims to manage both threats and
opportunities so that the vital elements causing risks can be quantified.
This involves determining the upside phase (best estimates) and
downside phase (worst estimates) of the risks. If the organisation
experiences only threats the measurement process is said to be
potential downside.
7.3.2 Measurement of Specific Risks

Let us see methods deployed by businesses for measuring a few specific
risks.
Credit risk / Default risk
Credit risk is measured based on the business or commercial borrowers
ability to repay the amount, by evaluating collateral assets, revenue
generating ability and balance sheet ratios. In a negative sense this is called
default risk viz. the risk that a borrower or a credit customer will not pay his
dues to the lender or the seller.
Altmans model and a few other credit score formulae have been developed
to measure credit risk. Altmans Z-score is considered an excellent method.
The steps to calculate credit risk using Altmans Z-score are:
Compute the ratio working capital / total assets.(X1)
Compute the ratio retained earnings / total assets (X2)
Compute the ratio operating income / total assets (X3)
Compute the ratio market capitalization / total liabilities (X4)
Compute the ratio sales / total assets (X5)
Enter the five ratios in the following weighted formula:
Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5
If the Z score is 1.8 or lower, the company is in distress and default risk
is very high. Between 1.8 and 2.7, Z score indicates a company in
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moderate financial health, but with default possibilities. Above 3.0,

Z score indicates excellent credit-worthiness and negligible default risk.
Standard tools to measure default risk of individual borrowers in retail
lending include Fair Isaac Corporations (FICO) credit scoring model. This is
a mathematical model used by lenders to determine the credit-worthiness of
the borrower.
Default risk premium is the premium required from a security over the riskfree rate, to take care of the default risk. This is calculated as follows.
Define risk-free rate: Firm up a risk-free rate by using the rate of
interest on treasury bills or some such gilt-edged security.
Determine credit risk: Evaluate the credit-worthiness of debt issuer
using Z score or equivalent.
Create ratio: Create a ratio that shows the premium over risk-free rate.
6. ________________ is performed during the design of the new process
in order to calculate the amount of risk present in the process.
7. Altmans model and a few other credit score formulae have been
developed to measure credit risk or default risk. (True/False)
8. Usefulness of risk analysis is directly proportional to the data quality,
data _______________ and follow-up action.
7.4 Mitigation of Risks

We now take up risk mitigation and the tools that can be used in doing so. It
is important that an organisation is not only aware of the risks before it
impacts their bottom line, but has well-laid action plans to meet the risks and
mitigate its adverse impact.
The overall responsibility for risk management lies with the top management
and the board of directors of the enterprise.
7.4.1 Risk Mitigation An Overview
Here is a birds-eye view of risk mitigation methods and processes that
will help you to appreciate the details of the subject that you will be studying
in this and the 4 units that follow this unit.
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Unit 7
Risk mitigation can be handed in four ways:

a) Risk avoidance: We can withdraw from an activity perceived to be
risky, and elect not to go through with it.
b) Risk transfer: We can insure ourselves against the risk and transfer it to
another party called the insurer.
c) Risk sharing: We can disperse the risk element in an activity and
reduce its impact, by the use of derivative instruments,
d) Risk acceptance: We can build our competence and capability to deal
with the risk by detailed study, research and methods developed
specifically for the concerned activity and its risk component.
As you can see, the four approaches listed above start with the simplest
(and the least profitable) to the toughest (but the most profitable). De-risking
by the first approach of simply avoiding the activity is the easiest answer but
you also stand to lose the money you could have made. At the other end the
fourth approach where you analyse the risk carefully and find specific
solutions can bring great gains, but needs spending time and effort.
7.4.2 Processes for risk containment
The basic steps in a typical risk containment process are:
Establishing the context i.e. analysing the strategic and organisational
context in which risks occur
Identifying risks i.e. defining the risks associated with business, to have
a fundamental understanding of the activities causing risk of loss
Quantifying risks i.e. measuring the probability, frequency and hence the
value of the risks, besides listing non-quantifiable effects of the risks
Formulating policy i.e. providing a framework to handle risks, which lays
down standard levels of exposure and policy guidelines for each level
Evaluating risk i.e. ranking the risks based on priority, and aligning
action and cost thereof with the rank
Treating risk i.e. development and implementation of a plan with specific
methods to handle the identified risks
Monitoring risk i.e. reviewing the methods regularly vis--vis their
efficacy in controlling risk, and updating methods from time to time in
keeping with changes in the organisation and the environment
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7.4.3 Tools available for managing risks

Risk management tools do analysis and implementation of methods for
mitigating risks. The major tools available for risk are:
Failure Mode Effects Analysis (FMEA): This tool is used for identifying
the cost of potential failures in business. This method can be applied
during analysis and design phases of new business to identify the risk of
failure. The FMEA method is divided into three steps:
o The first step is identifying the elements causing failure.
o The second step is studying the modes of failure.
o The last step is assessing the probability and effects of failure
Fault Tree Analysis (FTA): The tool is used as a deductive technique to

analyse reliability and safety of an organisation. It is usually
implemented for dynamic systems. It provides the foundation for
analysis and justification for changes and additions of various actions to
reduce risks.
Process Decision Program Chart (PDPC): The tool identifies the

different levels of risk and the countermeasure tasks. The process of
planning is essential before the tool is used for measuring risks. It
includes identifying the element causing risk. The next process consists
of identifying the context of problem and measures to reduce risks.
Figure 7.2 depicts the processes in PDPC.
Figure 7.2: Process Decision Program Chart (PDPC)

Source:http://www.syque.com/quality_tools/tools/TOOLS12.htm
Risk calculations: This method is the continuous scanning of risks at

various phases of the business, to identify the most common ones and
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Unit 7
assigning high priority to them. This calculation is obtained by the

following methods:
o
Risk exposure: The probability of the risk occurrence and total loss
to the organisation provides the overall exposure of specific risk.
Risk Exposure (RE): Probability of risk occurring x Total loss due to
the risk
Risk reduction leverage (RRL): The value of the return on

investment for countermeasures is obtained. The reduction in the
risk exposure and cost of countermeasure helps in prioritising the
possible countermeasures.
Risk reduction leverage (RRL) = Reduction in Risk Exposure Cost
of countermeasure
Managing risk: Once the risks are identified and calculated the best
plan which reduces risk exposures is chosen. If abandonment is
considered, the risk management chooses alternative actions to
counterpart the risk. If it is reduction method it changes the current
action by adding new action to reduce the risk. The contingency
planning depends upon the risk exposure and reduction leverage.
Figure 7.3 depicts the process of managing risk
Figure 7.3: Managing Risk

Source:http://www.syque.com/quality_tools/tools/TOOLS11.htm
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Unit 7
7.4.4 Specific Risk Mitigation Tactics

Insurance: One of the most important risk mitigation methods,
insurance is also the only tool some organisations use. Insurance covers
asset protection against natural and manmade losses, transit insurance,
cash covers and employee lives and medication.
At a managerial level, specific risk mitigation tactics are listed below for
each area of operation in a typical business.
A. For sales and production risks
1. Economic research and forecasting of the shape of future business
2. Consumer research and prediction to reduce risk of over-production or
making the wrong products
3. Product research and quality control measures
4. Careful screening of customers, to reduce bad debts and improve speed
of collection
5. Continual retraining and reskilling of employees and workmen
B. For accounting and reporting risks:
1. Ensuring robustness and authenticity of audits, both external and
internal, and observing statutory standards in spirit and letter
2. Giving importance to governance principles and investor interests
3. Viewing shareholder value as a long-term perspective without buckling
to short-term interests
C. For foreign exchange risks:
1. Hedging with futures and forwards contract: The best way to manage
foreign exchange risk is by balancing foreign currency holdings or
expected revenue with futures or forwards.
2. Trade options: The foreign currencies contain options which allow the
buyers to buy or sell financial assets at a specified price and time. The
process to hedge foreign currency with options is similar to hedging
futures and forwards.
3. Purchasing swaps: The exchange of future income streams in different
currencies
4. Opening a foreign bank account: The method of depositing foreign
currency in foreign banks or Exchange earners foreign currency (EEFC)
accounts to cope with exchange fluctuation
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D. For credit risks

Creating suitable credit risk environment
Operating under credit granting process
Maintaining suitable credit administration
Measuring and monitoring process and ensuring suitable controls over
credit risk
E. For employee risks:
Proper planning of work and manning
Effective grievance redressal process
Installation of surveillance and alarm equipment
Safe practices for sensitive tasks in the factory and office
Enhancing degree of engagement of employees with motivational
methods and practices.
Activity 2:
You are the CEO of the Indian manufacturing arm of an automobile MNC.
List the tools you will adopt to minimise risk that can occur in production
processes.
Hint: Tools listed in 7.4.3 A
9. _______________ deals with analysing the possibility that some future
event may cause harm to the growth of the organisation.
10. Identifying risk is the process of measuring the probability and
frequency of the risk. (True/False)
11. _______________ includes the process of continuous scanning of the
risk at various phases in the business operations.
12. Insurance tool is used as a deductive technique to analyse the
reliability and safety in the organization. (True/False)
7.5 Summary
Risk management is the process of determining the risk associated with

business operations, evaluating its magnitude and developing a
mitigation plan.
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The primary goal of assessing risk is to decide whether the

organisations investment with regard to time and money is in line with
their reward expectations. The risk in the business implies threat of loss
due to unexpected events. Factors causing risks include human,
technological, economic and political.
The process of risk management consists of establishing the context,

analysing and quantifying risk, formulating policy, treating, monitoring
and reviewing.
Quantitative risk assessment is based on assessing sensitivity, volatility

and downside potential of risks.
Some tools for managing risks are FMEA, PDPC, risk calculations, and
FTA.
7.6 Glossary
Illiquid Products: Products which cannot be easily converted to cash,

like trade receivables.
Hedge: An action initiated to reduce risk of adverse price movements.
Leverage: The ratio of borrowed money to own money used in an

operation or business.
Liquidity buffer: The amount of cash and cash equivalents held to meet
the needs of business and needs which arises over a short period of
time under stressed conditions.
Collateral assets: Properties or assets which are pledged to secure

loan or other credits.

1. Describe risk measurement.
2. Explain the major types of risk.
3. Explain the process of risk management and various tools involved in
managing risks.
4. Explain the concept of quantitative risk assessment.
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Unit 7
7.8 Answers
Self
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Internal factors
False. Basis risk is the risk due to possible change in spreads.
Default risk
Physical violence
True
Quantitative risk measurement
True
Interpretation
Management of risks
False. Identifying risk is the process of understanding and defining the
risk associated with an activity.
11. Risk calculations
12. False. What is described here is fault tree analysis (FTA). Insurance is
a method used to mitigate risk.
Terminal Questions
1. Risk measurement is the process of determining the risk associated with
business operations and evaluating its magnitude. Refer to section 7.1.
2. The major risks are associated with banking organisations. It includes
interest rate risk, credit risk. Refer to section 7.2.1.
3. The process of risk management consists of generic steps. The risk
management tools forecasts the analysis and implementation of various
methods to mitigate risks. Refer to sections 7.3.1 and 7.3.2.
4. Quantitative risk measurement (QRA) is the process of estimating the
occurring risks and providing methods to reduce risks. Refer to
section 7.4.
7.9 Case Study

Risk management at Toyota
Toyota was founded by Sakichi Toyoda in 1937. The company suffered
financially during the Second World War crisis. It experienced financial
downside but with the consortium of banks it restructured worldwide. Toyota
made huge profits in 1952 and restored its financial growth effectively.
Toyota focused on Total Quality Management (TQM) process for inventing
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Unit 7
new automobiles and hence made entry into the United States market. The
launch of Lexus and Celica cars brought major success to the company. By
the end of the millennium the company was considered as the strongest
global auto manufacturers.
The organisation faced credit risks due to the usage of a number of financial
instruments although executed only with creditworthy financial institutions.
The major foreign currencies were dominated by US and Euro dollars. Later,
the company experienced market risk due to the various emerging
competitions. Hence the company initiated to use derivative products to
overcome market risk. The currency risk affected the company due to
translation and transaction financial statements. The forex currency
exposures were affected in the Western Europe. The company used value
at risk analysis to analyse the risk by Monte Carlo estimation method. The
company was also hindered with interest rate risk due to some of the
shortcoming occurring in the present process scenario. The company
invested in fair value of its securities in March 2002 which was 564.4 billion
Yen but it declined in March 2003 to 487.6 billion Yen hence experiencing
equity price risk.
The company adopted derivative instruments which improved the assets
and liabilities. To overcome the fair value hedges it implemented interest
rate swaps, currency swaps and various swap agreements between the
organisations.
1. Why did Toyota suffer huge losses?
(Hint: The company suffered financial loss on account of the Second
World War.)
2. Explain the risks associated with the company and the measures adopted
to reduce the risk.
(Hint: The organisation faced credit risks because of the usage of various
financial instruments.)
References:
Marrison C. (2005).The Fundamentals of Risk Measurement. India: Tata
McGraw Hill.
Page No. 136
Unit 7
Leslie G. Eldenburg and Susan K Wolcott, Cost Management Second

Edition, John Wiley & Sons Inc. Chapter 1
E-References:
http://www.boj.org.jm/pdf/StandardInterest%20Rate%20Risk%20Manag
ement.pdf Retrieved on 15 October 2010
http://www.scribd.com/doc/8361414/Financial-Risk-Management-atToyota Retrieved on 15.10.10
http://www.syque.com/quality_tools/tools/TOOLS12.htm Retrieved on
15.10.10
Page No. 137
Unit 8
Unit 8
Corporate Liquidity Risk Management
Structure:
8.1 Introduction
Objectives
8.2 Liquidity Management
Need for liquidity management
Sufficiency of liquidity
Internal factors affecting liquidity risk
External factors affecting liquidity risk
8.3 Types of Liquidity Risks
8.4 Measuring Liquidity Risk
Net Funding Requirement (NFR)
Managing Market access
Contingency planning
8.5 Liquidity Gap
Structural and dynamic liquidity
Liquidity gap statement analysis
Alternative scenarios
Assumptions in preparation of gap report
8.6 Summary
8.7 Glossary
8.9 Answers
8.10 Case Study
8.1 Introduction
In the previous unit we discussed different types of risks in business and
how they can be managed. One of the major risks among financial risks
liquidity risk forms the subject-matter of this unit.
Here we will discuss different types of liquidity risks that a corporate entity
has to cope with. We review procedures to measure and manage liquidity
risk. We will explain the concept of liquidity gap and the external and internal
factors that we have to heed in effectively closing the gap.
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Unit 8
Objectives:
After reading this unit you should be able to:
describe liquidity management
discuss different types of liquidity risks and explain the methods used to
measure them
examine the meaning of liquidity gap report and the assumptions made
during the preparation of gap report
explain the meaning of contingency planning
8.2 Liquidity Management

Liquidity management refers to the management of assets and liabilities
(both on and off-balance sheet) and generation of cash to meet the ongoing
requirements. A company should ensure that lack of liquidity does not
endanger its operations or reputation.
Liquidity risk is represented by the difficulty of an organisation to generate
cash to do a transaction or meet a liability when desired. Effective liquidity
management enables the organisation to achieve optimal gains at minimum
cost.
The main objectives of effective liquidity management are:
Keeping track of cash outflow commitments (both on- and off-balance
sheet) regularly
Monitoring cash inflows into the business
Avoiding raising funds at high rates or through the forced sale of assets
8.2.1 Need for liquidity management
Liquidity management prevents and effectively tackles liquidity crises that
could impact an organisation. Some problematic situations are:
When there is a difficulty in synchronising activities in multiple accounts
held in different banks.
When cash flow fluctuates significantly from period to period.
When float cash locked in the operational processes is very high.
When reconciliation work keeps staff from working on useful activities.
When the organisation is unable to predict short-term and long-term
cash requirements.
When funding becomes difficult because of high leverage.
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When multiple cash management systems are on varied IT platforms

and have alignment issues.
Liquidity risk has two elements. In the context of a business liquidity risk is
the inability to meet liability or a commitment for want of cash. It also arises
when a party is interested in trading an asset but there is no buying party or
vice versa.
8.2.2 Sufficiency of liquidity
Companies must define in as much detail as possible what sufficient liquidity
level is and ensure liquid funds availability does not drop below this level. In
addition, one-time requirements that could arise have to be forecasted and
taken care of. Finally, a robust online reporting on liquid funds should be
kept up, and management attention sought well in advance.
8.2.3 Internal factors affecting liquidity risk
Here are a few internal factors that create liquidity risk:
High and non-moving receivables and inventory levels
Other current assets that have got stuck like tax refund claims and
insurance claims, ad hoc deposits that are no longer required etc.
Embedded option risk that is not recognised: a person may hold a bond,
for instance which has an option embedded within it for being called by
the issuer prior to its maturity. This means there is a risk that the issuer
may call and redeem the bond when the interest rates are down, and the
holder will have to settle for a lower return.
Excessive dependence on a few stakeholders in the cash flow cycle.
Off-balance sheet liabilities that are not recognised.
8.2.4 External factors affecting liquidity risk
Some of the external factors that impact liquidity risk are:
Unexpected changes in bank policies, interest rates etc.
Irregular behaviour of financial markets
Macroeconomic imbalances
World economic problems that impact global corporations
Political crises
Technical issues with the cash flow systems like Cash Management
Systems.
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Unit 8
Activity 1:
For each internal and external factor listed above, give an imaginary or a
real-life example.
Hint: Some examples are given in 8.2. Take examples from financial
newspapers, of events like bank failures, sudden market crash, Satyam
type of fraud etc. These can be good examples of factors affecting
liquidity.
1. A party is interested in trading an asset but there is no buying party.
This is an example of a _____________________.
2. Failure of payment system can lead to liquidity risk. (True/False)
3. Funding could become difficult because of high leverage. (True/False)
8.3 Types of Liquidity Risks

Liquidity risk can be classified into the following types:
Funding risk Funding risk occurs when a company fails to raise funds
as planned for whatever reason.
Funding can be from three sources: a) equity funding b) debt funding
and c) using retained earnings as a source of funds. Requirement for
funds is of two varieties: a) investing in long-term assets and b) need for
working capital.
This is probably one of the most sensitive risks of the Treasury function.
As stated elsewhere the Treasury is expected to fund operations when
required, and if this does not happen the function has not performed.
It could be argued that if operations are not profitable funding sources,
whether equity or debt or retained earnings, will dry up; and it would not
be fair to blame Treasury for an Operations failure. But this is not usually
accepted: Treasury is supposed to be alert to fund requirements and
provide answers to make sure operations are not hampered for want of
funds. In case of serious business difficulties also, Treasury is expected
to have in place long-term funding strategy to bail out the company.
Timing risk Timing risk occurs when there is a serious mismatch in

the timing of inflows and outflows.
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Mismatch in timing happens in two ways: funds are not available when
needed; and a large amount of money is available for which there is no
ready avenue for profitable utilisation.
This is a natural phenomenon in seasonal businesses like education,
school uniforms, Diwali crackers or even umbrellas. In such cases the
Treasury should plan its strategy for coping with the mismatch even at
the time of making the original business plan.
But even in industries that have no seasonal pattern mismatch of funds
can arise for any of the following reasons.
Large customer dues that get significantly delayed
Major mishaps or accidents
Unexpected statutory notices or demands
Competitor activity
Attractive business opportunity to be exploited
In these cases Treasury will not get sufficient time for rear-guard action
unless the management information system includes Treasury and is
able to give early warning signals. Of course in case of unexpected
happenings like accidents no notice can be expected; and for such
eventualities Treasury should have a buffer,
Call risk Call risk occurs either when reserve fund sources do not
materialise resulting in lost business opportunities; or when non-funded
limits have to be funded and repaid.
Call risk is a variant of the funding risk described above. It happens
when
a) the fundraising planned for the business takes longer to close and
get the funds released; or
b) Non-funded facilities have to be funded i.e., documents covered by a
letter of credit become due for payment, or a bank guarantee is
invoked by the beneficiary or
c) Borrowed funds are tied to a particular operating inflow which fails to
happen or is delayed, and the debt becomes due.
This risk is very much in the direct domain of Treasury and so it is
assumed that Treasury will have sufficient fall-back plans to cope with it.
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Unit 8

4. What are the different types of liquidity risks?
5. The risk that occurs when reserve fund sources do not materialise
resulting in lost business opportunities is known as:
a) Call risk
b) Timing risk
c) Funding risk
6. Call risk occurs while exchanging non-fund based limits into fundbased limits. (True/False)
8.4 Measuring Liquidity Risk

A three-dimensional framework is recommended for measuring liquidity risk.
Net funding requirement (NFR)
Market access
Contingencies
8.4.1 Net Funding Requirement (NFR)
Net Funding Requirement (NFR) of an organisation like a bank or Treasury
of a global corporation consists in building a maturity ladder of cash outflow
for a specified period of time, matching it to inflow that can be planned and
deriving the net deficit that has to be funded. This is like cash forecast,
except that it is built step-by-step.
Using NFR, two simple ways to measure and forecast liquidity are:
Stock approach and
Flow approach
Stock approach
The stock approach treats liquidity as stock and extrapolates what the value
of this stock would be at the end of a period, by arriving at other asset and
liability balances using prevailing norms, ratios etc.
This method is excellent from an analytical perspective, as it gives valuable
information on the liquidity ratios and strategic indicators of liquidity.
However it is not a very good operational tool
Illustration:
One item of NFR is the amount required for payments to be made to raw
material suppliers. In this approach, the metric that is used for vendor
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payments is the When all figures of the balance sheet are similarly projected
the balancing figure is the cash deficit or surplus, which is the NFR.
Flow approach
The flow approach computes liquidity for different short periods like days,
weeks or months using the projected outflows and inflows for these periods.
Though this method does not give any strategic or managerial insight into
liquidity, it is operationally more powerful and helps balance the maturity
ladder with postponements or adjustments in the cash flows.
Illustration:
For payments to be made to raw material suppliers in this approach, the
projected purchases of raw materials is taken from Profit & Loss account
and with some adjustment for credit periods or advance payments the cash
requirement is projected. When all figures of the Profit & loss account are
similarly converted to cash, the deficit or surplus is the NFR.
Comparison of the two approaches:
Stock Approach
Flow Approach
Used to measure & forecast liquidity
Used to measure & forecast liquidity
Source of information is the

projected balance sheet
Source of information is the projected

profit & loss account
Valuable analytical tool
Valuable operational tool
Requires a qualified accountant
Can be done by an unqualified cashier
Preferable to use for longer periods,

e g. 6 months or 1 year
Preferable to use for short-term

assessment of NFR e.g. days, weeks or
months
8.4.2 Managing Market access

NFR focuses on internal factors of liquidity, but market is a key external
factor that has to be considered. Market access dimension becomes crucial
when the NFR included accessing market for either funding or redemption.
Here we measure the chances of success of a market access proposed and
the likely cost vis--vis budgeted cost.
8.4.3 Contingencies
An effective contingency plan should address two issues:
Have a strategy to handle crisis
Have backup liquidity sources to access cash in emergency
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Strategy
The contingency plan must incorporate strategy i.e. managerial inputs that
will protect the companys long-term interests while meeting a short-term
emergency. This comprises the following features:
Laying down priorities among choices for action
Establishing the authority levels for decision-making at crisis time and
clarifying the authority for exceptions
Spelling out the dos and donts down to the last level of management
Taking into account statutory requirements e g. items that have to be
cleared by shareholders, items requiring special resolution etc.
Some companies form a strategy group of a select list of top-level managers
and the group takes over in crisis situations. The group is given extra rights
to supersede even the Managing Director.
Two aspects of strategic management of contingencies are: a. information
systems and b. communication with the market. The Management
Information System (MIS) should be up-to-date and credible to avoid major
decisions being based on wrong analysis of problems. Communicating to
stockholders, lenders and other external units that are important to the
company is very important; this includes releases to the Press, public
announcements etc., which should be unambiguous and timely.
Backup liquidity
Contingency plans should also include backup sources of liquidity. Unused
credit facilities given by bank, increase of vendor credit, collection from
customers by offering cash discount and review of major cash out go are
some methods.
7. Stock and slow approaches are the two different ways of measuring
liquidity. (True/False)
8. Future cash inflows are compared with the future cash outflows over a
series of definite time-periods through ___________ .
a) Maturity ladder
b) Contingency plans
c) Stock approach
d) Flow approach
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9. To resolve a liquidity crisis, use of backup liquidity is a good method.

(True/False)
8.5 Liquidity Gap

A liquidity gap is the difference between balances of assets and liabilities at
a point of time. If assets exceed liabilities it denotes shortage of cash.
Marginal gap refers to the difference between the changes of assets and
liabilities over time. Gap profile changes as and when assets and liabilities
are added, and is represented in the form of tables or charts. All the assets
and liabilities are considered in the liquidity gap report with the dates of
maturity.
8.5.1 Structural and dynamic liquidity:
Structural liquidity is the picture of liquidity at a point in time, and is a
presentation of the payments that need to be made and the sources that
provide the resources for generating funds that will fill the net gap.
Dynamic liquidity is the change in the liquidity between one point of time
and the next. It presents the change in assets say over a quarter, the
change in liabilities for the same quarter, and the net increase or decrease
in the liquidity gap. This is the same as marginal gap described above.
8.5.2 Liquidity gap statement analysis:
A liquidity gap statement or report is an important document for a financial
company, because its principal business is cash. This statement takes the
shape of a cash flow statement for a non-finance business. The analysis
report seeks to determine the primary causes of liquidity gap and enables
thinking and planning of resource mobilisation to bridge the gap.
Activity 2:
Visit a financial firm and do a brief study on their liquidity gap report. This
may be difficult if you do not work in a Finance firm or have access. In
such a case do a web-search for published samples of liquidity gap
reports and do a white paper on your findings.
Hint: Take ideas from section 8.5.
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8.5.3 Alternative scenarios

The alternative scenario method assesses the adequacy of liquidity in
several alternative scenarios, to measure how vulnerable the liquidity is in
each scenario.
Three broad scenarios can be used for this exercise:
As a going concern
Enterprise-specific crisis
General market crisis
As a going concern
Liquidity standards are laid down for normal business conditions in this
scenario. Since this scenario is predominant the company can take
corrective action when liquidity levels fall significantly outside the standards.
Enterprise-specific crisis
Liquidity crisis that affects only the company is another scenario. The key
here is to evaluate the likelihood of this scenario, and how to take preventive
action. For example if there is a delay in commissioning of a mega-project
that is going to hit cash flow big time, visualising and measuring the issue is
very important.
General market, industry or economy crisis

A general crisis affects every corporate entity. And in these days of global
reach of our countrys businesses, even an international happening, like the
2008-09 economic crisis, can affect and Indian corporate. For a controlled
economy like India the good news is that such a crisis will be taken up at the
government level and will not be left to the individual players. This also has
the downside that what is decided may not be good for a specific unit. This
has to be visualised and duly hedged.
Ultimately liquidity measurement and management boils down to sketching
cash flows in terms of time period, size and probabilities in a flexible,
modular maturity ladder that is constantly monitored.
8.5.4 Assumptions in preparation of gap report
Assumptions relating to assets, liabilities and off-balance sheet liabilities
play an important role in determining the liquidity gap.
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Asset assumptions
Assumptions need to be made regarding the future value of assets and their
cash flow generating capacity, again in terms of value, time and probability.
Assets can be segregated into three categories according to their degree of
liquidity:
The highly liquid group of assets consists of quick assets i.e. cash &
cash equivalents and bills receivable. These are assets that can be
cashed at existing market values in almost any situation.
A less liquid group of assets consists of accounts receivable and shortterm investments. The probable realisable value and the time required
for disposal have to be forecast. The challenge here is proper evaluation
of overdue bills and their collectability.
Assets that rank the lowest in terms of liquidity among current assets are
inventories, more particularly finished goods. Items lying unsold in
inventory for a long time and valuation of inventories in a market
situation where prices are falling are crucial issues in inventories.
The least liquid group of assets comprise non-current assets, including

fixed assets and long-term investments, and some current assets that
do not have cash value like prepaid expenses and deferrals.
It is worth recalling that when assumptions are made about values of assets
the change in value in alternative scenarios has to be captured.
Liability assumptions
Balance sheet liabilities of a corporate are current liabilities, non-current
liabilities and provisions.
Assumptions on the cash value of short-term liabilities are generally likely to
pose no major challenges except for provisions, mainly income tax liability
for uncompleted assessments. The timing assumptions will also be specific
most of the time and the flexibility of postponing cash outgo is usually within
a small range.
Assumptions regarding long-term liabilities have to be done more carefully.
Several factors come into the reckoning, like interest rate on the bond
vis--vis market rate, new debt securities available, exchange fluctuation in
case of external borrowing, market sentiment etc. Cash outflow on long-term
debt therefore calls for thought and planning.
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A liability that needs to be addressed specially is return of equity capital. In

the case of widely-held large equity portfolios, the question does not arise
except at the time of winding up. The only other situation when it demands
cash is when the company buys back shares from existing holders, but this
is a strategic action and not an event. But the question of return of equity is
a key question in companies funded by venture capitalists who would want
to know their exit options. Careful projection of various possibilities is
needed in this case, and assumptions need to be monitored constantly.
Off balance sheet liability assumptions

The following are some typical items that do not get included in the liabilities
on a balance sheet, but that could have significant financial impact: These
are disclosed with estimates of values in the companys annual report under
Notes to Accounts along with explanation as to why management thinks
these liabilities will not arise.
Contingent liabilities like statutory and other claims on company, cases
against the company or payments contingent upon contract clauses
Operating leases
Export commitment impact on duties and taxes
Guarantees
Captive and project financing arrangements
Take-or-pay contracts
Throughput and deficiency agreements
Receivables that are transferred/factored/securitized
Debts of joint ventures and unconsolidated subsidiaries
Each of these will have a significant liquidity impact if it materialises and
payment becomes necessary. Major corporate disasters like Enron can be
directly linked to failures in managing off-balance sheet liabilities. Whether
the undervaluation or non-recognition of contingent liabilities is deliberate or
accidental, the effect is very severe if the liability is a big one. In the case of
Enron it was the omission to provide for losses on its derivative transactions
of related SPV-type enterprises.
10. A liquidity gap is the difference between income and expenditure of an
enterprise for a period. (True/false)
11. Alternative scenarios are used to tabulate the gap profiles. (True/False)
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Unit 8
12. Off-balance sheet liabilities not evaluated right can lead to corporate
disasters. (True/False)
13. Contingent liabilities that materialise and become payable are sources
of _____________.
8.6 Summary
Liquidity management is the control of assets and liabilities to make

them available when there is a cash inflow/outflow requirement. There is
scope for liquidity risks of three types namely the time risk, call risk and
funding risk.
Liquidity risks must be measured and calculated and there are various
approaches for this purpose like net funding requirements (NFR), the
stock approach and the flow approach, managing market access and
contingency planning.
The difference between the between balances of assets and liabilities
over time is called the liquidity gap. Liquidity gaps are calculated in
different scenarios based on assumptions regarding timing, value and
variability of value of assets, liabilities and off-balance sheet liabilities.
8.7 Glossary
Assets: Items of economic value
Liquid assets: Assets that could be easily converted into cash
Liquidity: Availability of cash meet current liabilities as and when they

fall due
Stock: Equity capital raised through sale of shares
Volatility: Rate of change over a given period

1.
2.
3.
4.
Describe liquidity management.

Explain the different types of liquidity risks
Explain the framework for measuring and managing the liquidity risks.
Analyse liquidity gap reports.
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Unit 8
8.9 Answers
Self
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Liquidity risk
True
True
Funding, time and call risk
a) Call risk
True.
False. The two approaches are Stock approach and Flow approach.
a) Maturity ladder
True
False. A liquidity gap is the difference between the balances of assets
and liabilities at a point of time.
11. False. Alternative scenarios determine a companys liquidity under
different conditions.
12. True
13. Cash outflows
Terminal Questions
1. Liquidity management deals with sources of the risk, factors that cause
the risk, adequacy of liquidity and how to measure and manage liquidity
risk. More details are available in section 8.2.
2. Liquidity risks can be categorised into three types: funding risk, timing
risk and call risk. Refer to section 8.3.
3. The framework for measuring and managing liquidity risks is structured
around measuring NFR, managing market access and contingency
planning. Refer to section 8.4.
4. Liquidity gap reports refer to the difference between balances of assets
and liabilities at a point of time under various scenarios. Refer to
Section 8.5.
8.11 Case Study

Long-term Capital Management (LTCM), Greenwich, Connecticut (USA)
LTCM, a hedge fund management firm, was founded by a team of traders
and academicians including a Nobel Laureate -- in an attempt to create a
fund that would profit with combination of the academics' quantitative
models and the traders' market judgement and execution capabilities.
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The strategy undertaken by LTCM was to make convergence trades.

Convergence trades meant searching for the securities that are priced
incorrectly, relative to each other. But as the differences in values were
almost negligible, the value of fund required to take large and highlyleveraged positions was small and hence the risk factor was also small.
Many investors, including large banks, invested around $1.3 billion in the
beginning. Four years later at the end of September 1998 the fund had lost
considerable amounts of the investors' equity capital, which had almost
been wiped out.
Analysis of the downfall of LTCM
The Proximate Cause: Russian Sovereign Default
One of the most proximate causes for the downfall of LTCM was Russia's
default on its government obligations (Gosudarstvennoye Kratkosrochnoye
Obyazatyelstvo or GKOs). LTCM believed it had somewhat taken care of its
GKO position by selling roubles. The belief was that, if Russia avoided the
government bonds, then the value of its currency would fall and a profit
could be gained in the foreign exchange market that would compensate with
the loss on the bonds.
Unfortunately, the banks guaranteeing the rouble hedge shut down when
the Russian rouble collapsed, and the Russian government prevented
further trading in its currency.
The Ultimate Cause: Flight to Liquidity
It is said that the ultimate cause of the LTCM downfall was the flight to
liquidity across the fixed income markets around the globe. As the loss that
Russia was facing was increasing at a high rate, the fixed income portfolio
managers began shifting their assets to more liquid assets mainly to the US
treasury market.
LTCM had not noticed the changes in the liquidity prices in its balance sheet
due to the shift in assets. After the crisis liquidity became more valuable and
its short position increased compared to long positions. This actually
aggravated the risk factor, further worsened by the fact that in the following
years the size of new issues of US treasury bonds was declining. It was
clear that a flight to liquidity could disrupt the market again.
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Unit 8
Factors
Liquidity risk is itself a factor
It is possible that liquidity itself can be a big risk, LTCM fell victim to a flight
to liquidity. This can be determined by stress testing, i.e., classifying
securities either as liquid (positive exposure) or illiquid (negative exposure).
Financial institutions must aggregate exposures to common risk factors.
Risk exposures should be aggregated across business. Also many of the
large dealer banks that had exposed themselves to the Russian crisis
across many different businesses became aware of the commonality of
these risk factors after the LTCM crisis.
1. Give a brief description of LTCM and its activities.
(Hint: LTCM was founded by a team of traders and academics and
practised convergence trading as its strategy)
2. Discuss the analysis techniques that were practised by LTCM.
(Hint: The techniques used to analyse were proximate cause and
ultimate cause)
3. Elaborate the various factors that were the cause for the downfall of
LTCM.
(Hint: Factors were liquidity risks and other common factors)
References:
Choudhry, M, (2002), The bond and money markets: strategy, trading,
analysis, First Edition, US, Butterworth-Heinemann
E-References:
http://finance.mapsofworld.com/finance-theory/yield-curve/liquiditypreference-theory.html Retrieved on 21st Sep, 10
http://www.erisk.com/learning/CaseStudies/Long-TermCapital
retrieved on 13.2.13
Page No. 153
Unit 9
Unit 9
Interest Rate Risk Management
Structure:
9.1 Introduction
Objectives
9.2 Interest Rate Risk Management (IRRM)
Components of IRRM
Features of IRRM
Risk Monitoring and Reporting
IRRM Hedging Techniques
9.3 Factors Affecting Interest Rate
9.4 Classical Interest Rate Theories
The classical theory
Loanable funds theory
Abstinence theory
Liquidity preference theory
9.5 Modern Approaches to Interest Rate Risk
Types of IRRM
Sources of IRRM in modern times
Gap Analysis
Asset-liability Sensitivity of Portfolio
9.6 Strategies for Controlling IRRM
9.7 IRRM Using FR and Swaps
9.8 Role of Financial Intermediaries
9.9 Summary
9.10 Glossary
9.12 Answers
9.13 Case Study
9.1 Introduction
In the previous unit we discussed liquidity risk measurement and
management.
In this unit we will learn about interest rate risk and its management, and
study factors that affect the interest rate and impact of treasurys exposure
to these risks.
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Unit 9
We will also review interest rate theories adopted originally and its evolution
over the years.
Objectives:
describe interest rate risk management
explain the factors that affect interest rate
discuss the various theories of interest rate
9.2 Interest Rate Risk Management (IRRM)

Interest Rate Risk is the risk
to the earnings from an asset portfolio caused by interest rate changes
to the economic value of interest-bearing assets because of changes in
interest rates
to costs of fixed-rate debt securities from falling bank rates
to impact of interest rates on cost of capital used by the firm as hurdle
rate for capital investment
9.2.1 Components of IRRM
IRRM can be broken into three parts: term structure risk, basis risk and
options risk.
Term structure risk also called yield curve risk is the risk of loss on
account of mismatch between the tenures of interest-bearing monetary
assets and liabilities. For example if investments are held in 7-year assets
yielding a fixed 7% return, funded by a 5-year bond costing 6%, but
renewed at the end of 5 years at 8%, there is a loss of 1% during the sixth
year. This can also happen if either of the tenures is on floating and not
fixed rates and the rate changes adversely.
This situation is called re-pricing and can be either asset-sensitive or
liability-sensitive, depending upon which gets re-priced first.
Basis risk is the risk of the spread between interest earned and interest
paid getting narrower.
Options risk is the term risk on fixed income options i.e. options based on
fixed income instruments.
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9.2.2 Features of IRRM

Following are the features of corporate IRRM process:
Clarifying the policy with regard to interest rate risk
Constant watch on market rate fluctuations and studying its relevance to
the firms cost of capital
Fixing the band beyond which interest rate changes should trigger
corrective action
Special attention to long-term fixed exposures in investments as well as
funding decisions
Effective, unambiguous and timely reporting on IRRM to the CEO and
the Board
The risk monitoring process is conducted as follows:
9.2.3 Risk monitoring and reporting
Asset returns as well as funding costs should be studied vis--vis
interest rates and action taken if the tolerance limits are exceeded.
The prevailing cost of capital applied to investment decisions should be
reviewed regularly and if necessary re-fixed in the context of significant
changes in interest rates.
Monthly reporting to executive management and quarterly reporting to
the Board on IRRM is important.
IRRM should be an important item in the regular internal audit program.
While it is crucial for a financial institution like a bank to have elaborate
methods for measurement of IRRM, corporate treasuries may not benefit
much from complicated calculations. The quantifying has to be restricted to
specific issues that affect term risk or spreads, and action taken when the
value falls outside tolerance limits.
Interest rates
Interest rate is an effective tool of RBI to control money supply. If there are
significant inflationary pressures in the economy RBI increases interest
rates and vice versa. Companies find themselves at a disadvantage if RBI
policy measures in this direction are contrary to their financial plans.
Investment
Normally a firm borrows funds from banks for investing. If interest rates rise,
fewer investment projects are possible.
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It is important for investors to adjust their financial plans to be aligned to

interest rate changes.
9.2.4 IRRM Hedging Techniques
Bank uses a number of derivative instruments like interest rate futures,
interest rate options, interest rate caps, collars and interest rate swaps to
hedge against interest rate risk. It would not be relevant for us to get into
details of these instruments since corporates neither have recourse to, nor
the need for such complex techniques, as their exposure to interest risk is
relatively small.
Activity 1:
You are the Chief Financial Officer of RTS Ltd, and you have been asked
to prepare a note on the sensitivity of the companys new project for
` 100 million, being financed 80% by debt. What points would you include
in your report? Make a draft.
Hint: Refer Section 9.2.3. Interest will be a significant cost element and
so interest rate risk has to be considered.
1. Financial and investment plans of companies should pay attention to
interest rate movement. (True/False)
2. Which of the following is not included in the IRRM?
a) Re-pricing risk
b) Yield curve risk
c) Exchange risk
d) Basis risk
3. IRRM is significant to overall profitability. (True/False)
4. An IRRM programme need not be independently reviewed.
(True/False)
5. Change in interest rate directly influences investment activity.
(True/False)
9.3 Factors Affecting Interest Rate
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Unit 9
Interest is usually a significant component of the companys cost of capital

unless the company is funded entirely by equity. It is important to learn the
factors that impact interest rates.
Macro factors
Cost of living index: Increases in price levels of goods and services
over a period of time reduce real value of the rupee and push interest
rates up.
Monetary policy changes: RBI works with monetary policy to balance

the twin objectives of economic growth and price stability for a
developing economy like ours, and interest rate is automatically affected
with increase and decrease of money supply by RBI using repo rates.
Condition of economy: Whether the economy is rapidly growing or its

growth rate is declining can make a difference.
Global liquidity: Global economic environment and availability of funds

across the world does have an impact.
Foreign exchange market activity: Foreign investor demand for debt

securities influences the interest rate. Higher inflows of foreign capital
lead to increase in domestic money supply which in turn leads to higher
liquidity and lower interest rates.
Micro factors
Micro factors, meaning factors specific to the borrower, which play a role in
the interest rate, are:
Individual credit and payment track record, credit rating
Industry in which the business is operating
Extent of leveraging of the company viz. debt-equity ratio
Quality of prime security and collateral
Loan amount
Activity 2:
As Finance Manager of the Indian arm of a MNC you have been asked to
effect a 10% reduction in interest cost of your company. Lay out the plan
for achieving the reduction.
Hint: Look at two factors the amount of borrowing, and the rate of
interest. If either of these is reduced, interest cost will go down. Our focus
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Unit 9
here is on the latter. Refer to micro factors listed above and see which
factors are relevant.

6. Interest rate is an important constituent of ____________________.
7. Which among the following factors does not influence the market
interest rates?
a. Intensity of inflation
b. Global liquidity
c. Social factors
d. Loan amount
8. Higher the debt-equity ratio, higher will be the interest rate.
(True/False)
9.4 Classical Interest Rate Theories

Theories of interest rate try to reason out the movement of interest rate
using fundamental and empirical logic, to gain the ability to predict interest
movement and reduce interest rate risk. Some theories are listed below.
9.4.1 Classical theory
Developed by Adam Smith and David Ricardo, this theory proposes that
interest rate balances savings with investment. In their analysis, interest rate
is determined by the demand for investment and the supply of savings. The
rate of interest is the price paid by investors for money borrowed or
alternatively the price received by savers for the money saved. Marshall,
Taussig and later Keynes have propounded amended versions of this
theory.
9.4.2 Loanable funds theory
This theory states that interest rate is based on the demand and supply of
loanable funds available in the capital market. The concept was created by
Knut Wicksell, a well-known Swedish economist. The focus of this theory is
on short-term interest rates and so directed at loanable funds segment.
9.4.3 Abstinence theory
In this theory, the rate of interest depends upon the demand and supply of
capital. The greater the productivity of capital, the greater will be the
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Unit 9
demand for it and people are encouraged to abstain from consumption and
instead save and invest. Consequently interest rates will be higher.
9.4.4 Liquidity preference theory

Liquidity is preferred by an entity or an individual for three reasons:
transaction, precaution and speculation. This theory of J M Keynes relates
interest rates to the maturity periods of investment. Investors maintain their
funds in liquid form like cash rather than less liquid assets like stocks, bonds
and commodities and will have to be lured with higher interest to give up
liquidity.
Thus if an investor has debt instruments that have longer term periods they
will receive a liquidity premium i.e. higher interest rates to stabilise the
financial risks of investing in longer-term debt instruments. This theory is by
far the best-accepted among classical theories.
9. The core focus of the interest rate theories is on reasoning out interest
rate movements. (True/False)
10. ______________________ suggested interest rate as the component
which balances savings with investment.
11. Knut Wicksell developed the loanable fund theory. (True/False)
12. Abstinence theory of interest supports the theory that the money used
for lending objectives is used for consumption. (True/False)
9.5 Modern approaches to Interest rate risk

We now take a look at the approach to interest rate risk management in
modern times and theories that have been formulated more recently. The
primary reason for new theories to explain interest rate has been the
globalisation of most economies and the widespread effect of policy
changes happening in any one country.
The modern theory of interest rates considers commodity price risk, interest
rate risk and currency exchange risks which were traditionally not
considered. The complexity in the subject of interest rate movements
occurring through a variety of factors has necessitated banks and large
corporate Treasuries to rethink their strategies.
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In particular many hedging techniques that were not open to managers of

corporate treasuries and were the prerogative of financial institutions are
now increasingly used by large corporations sitting on huge cash balances.
These include options, futures and cross-border derivative instruments.
9.5.1 Types of interest rate risk
Volatility risk The volatility or likelihood of adverse change in option
value on account of changes in the price of underlying asset
Rate level risk The change in interest rates according to the period of
investment, during which restructuring of interest rate levels might take
place
Reinvestment risk The risk of having to reinvest cash flows from an

investment at lower rates of interest
Price risk Variations in market price of securities or commodities on

which trading has taken place
Call/put risk The risk of swings in interest rates in reverse direction to

the option offered (call or put)
Real interest rate risk The risk of inflation and consequent fall in the
purchasing power of the rupee causing a dent in the real interest earned
vis--vis the nominal interest rate
9.5.2 Sources of interest rate risk in modern times

1. Yield curve risk: Market perception of long-term v. short-term, as
evidenced by the yield curve creates this risk. The capital market exhibits
buoyancy by a yield curve slanting upwards, showing higher long-term
interest rates; the reverse happens when the economy is under
recessionary trends. Investment action would be accordingly oriented to
long or short periods. This term structure risk also builds in the re-pricing
risk.
2. Basis risk: Basis risk occurs due to changes in relationships between
different financial markets or financial instruments, which vary with time and
amount. For example, an organisation holding large untraded stocks may
find offloading in the current market unprofitable and so enter into futures
contract with the stock index. This reduces the liquidity risk but increases
the basis risk due to the differences between the spot and stock index
prices.
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3. Optionality risk: This is similar to the option risk referred to earlier in 9.2
viz. the term risk on fixed income options. For instance the risk in an option
based on a bond would be proportionate to the term of the bond.
4. Embedded option risk: An embedded option is an inseparable part of
another instrument. The callable embedded option bond consists of hold
(option-free bond) option and call option. The value of the bond changes
according to the changes occurring in interest rates of embedded options
values. The price of callable bond is equal to the price of hold option bond
minus price of call option bond. The decline in interest rates increases the
callable option price bond.
9.5.3 Gap analysis
Gap analysis is a technique which is used to measure interest rate risk. The
unexpected changes occurring in interest rates which hamper the
organisations profits and market value of equity can be measured using gap
analysis.
This is relevant to financial institutions like banks, and can be of interest to a
corporate entity only if it has large cash balances that are being parked in
interest-bearing investments for a short while before being invested in the
business. It may be useful to a lesser extent to a company with large debt
capital.
A few types of gap analysis used for measuring interest rate risk are:
Duration gap analysis This method evaluates the sensitivity of the
worth (market value) of financial instruments to the changes in interest
rates.
Cumulative gap analysis It is used to evaluate the impacts on net
interest income due to the changes occurring in interest rates.
Dollar value gap analysis It deals with measuring the money value of
the assets present in the banks balance sheet which are sensitive to the
changes in interest rates.
Simulation techniques are used to compare various course of actions based
on the assumptions of pricing strategies for assets and liabilities, changes in
the interest rate levels, shape of yield curves etc. Such complex exercises
are however required only by large banks and Financial Institutions.
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Conducting gap analysis requires skilled personnel and can be costly. It is

therefore a sensible idea to ascertain the interest rate sensitivity of the
business, and decide the extent of detailed work to be done with respect to
gap analysis. A company that has tied up its loan terms for a long period or
arrived at a cap on the rate, has less worry as its bottom line will not be
unduly affected by interest rate hikes.
9.5.4 Asset-Liability Sensitivity of Portfolio
The Treasury Head of a corporation needs to keep an eye on the sensitivity
of monetary assets and liabilities on the balance sheet to interest rate risk.
Some recommended methods of doing this are:
Increasing asset sensitivity by purchasing short-term securities, reducing
loan maturities, and making rates aligned to market movement
Increasing liability sensitivity by relating maturity periods of liabilities to
the purpose for which they have been contracted: a short-term spike in
working capital should be funded with a short-term loan which would
leave no room for exposure to longer-term interest rate fluctuation.
Treasury liabilities like capital, bills payable, provisions and inter-office
adjustments are not rate-sensitive. Rate-sensitive liabilities include:
Short-term liabilities which are sensitive to interest movement. Treasury
has to estimate the sensitivity of floating-rate liabilities in particular.
Long-term borrowings, fixed and floating Fixed borrowing re-prices on
maturity and is sensitive. The amounts must be distributed based on the
remaining maturities. The floating borrowings re-prices with respect to
reset of interest rates. The amount must be distributed appropriately
based on re-pricing date.
Treasury assets like cash, bank accounts, inter-office adjustments, fixed
assets and equity investments are not sensitive. Sensitive assets include:
Interest-bearing loans, advances or deposits: The carrying balance is
sensitive to interest rate variations and has to be restated.
Leased assets: Earnings from a leased asset on floating rates are
sensitive. The carrying amount has to be restated based on the datewise cash flows.
All derivatives on the balance sheet are sensitive to rate variations.
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The various methods to cope with rate sensitivity of assets and liabilities on
balance sheet include:
Increasing liability sensitivity by paying premiums in order to attract
short-term deposit instruments and borrowing more through non-core
purchased liabilities.
Reducing liability sensitivity by paying premiums to attract long-term
deposits and issue long-term subordinated debts.
Increasing asset sensitivity by investing in short-term securities and
loans with loan maturities, and making more loans based on floating
rates.
Reducing asset sensitivity by investing in long-term securities and loans
with longer maturities and changing floating rate loans to fixed rate term
loans.
13. __________________ refers to the risk occurring in the future price of
underlying asset.
14. Price risk refers to the risk occurring in future due to the decline in price
of a security like bonds or physical commodities. (True/False)
15. The __________ refers to the relationship between short-term and
long-term interest rates.
16. Price risk occurs due to the changes in relationship between the
various financial markets. (True/False)
17. Cumulative gap analysis evaluates the sensitivity between the net
worth market value of financial instruments to the changes in interest
rates. (True/False)
18. The ________________ needs to keep an eye on the sensitivity of
monetary assets on the balance sheet.
9.6 Strategies for controlling IRRM

The following strategies could be used for controlling IRRM in an
organisation:
Interest rate expectations strategy The organisation must forecast the

future level of interest rates and alter portfolio sensitivity to the expected
changes. Duration is the major factor in interest rate sensitivity.
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Unit 9
Individual bond selection strategies This is the process of identifying

mispriced securities and repositioning in better securities during the
realigning of markets to make profits.
Yield spread strategies This strategy involves positioning portfolio with

respect to expected changes in yield spreads among various sectors of
bond market.
Derivative strategy It involves the process of hedging against adverse

movements through interest rate derivatives. The various derivative
instruments include:
o
Forward rate agreements This is the process of trading over the

counter such that specific rate is applied to a specific principal during
specified future time period.
Interest rate swaps The interest rate payments are exchanged on
the same principal amount with mutual agreement between the two
parties.
Interest rate futures It refers to the standardised forwards contracts
traded with derivative exchange.

19. The _______________ strategy is based on expectations of interest
rate movements.
a) Yield spread
b) Pricing
c) Interest rate expectations
d) Derivative
20. Derivative strategy involves the process of hedging against adverse
movements through interest rate derivatives. (True/False)
9.7 Interest Rate Risk Management Using FRA and Swaps

The Forward Rate Agreement (FRA) aims to protect the holder against
interest charges or interest yield for future periods. It is an agreement to
settle the difference between an agreed interest rate and the actual interest
rate prevailing at a future point of time between two parties. The contract
specifies the rate of interest, currency and a future date for settlement.
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The Interest rate FRA exchanges the fixed rate specified in the contract for
a variable one between the two parties. The borrower pays the fixed rate
and the lender receives the fixed rate.
Swaps refer to hedging instruments in derivatives market. Interest rate
swap is a combination of FRAs which involves agreement between parties
to exchange sets of future cash flows.
FRA and its features

FRA is the agreement made between two parties setting the interest rate
with notional principal amount for an agreed future time period. The FRA
buyer receives money if the interest rate increases more than the other
party in the contract. Similarly the FRA seller receives money from the buyer
if the interest rate decreases with other party in the contract.
Figure 9.1 depicts the process of forward rate agreement.
Figure 9.1: Forward Rate Agreement

Source:
http://www.google.co.in/imgres?imgurl=http://www.pascalroussel.net/images/forwar
1.gif&imgrefurl=http://www.pascalroussel.net/forward_rate_agreement.htm&h=322&
w=472&sz=13&tbnid=Smbl8XRXNjzs_M:&tbnh=88&tbnw=129&prev=/images%3Fq
%3Dforward%2Brate%2Bagreement&zoom=1&q=forward+rate+agreement&hl=en&
usg=__icwHVysZspWkdY_8GvXtTt7BNKw=&sa=X&ei=MPS3TIXCYXqvQOEj_TkDQ&ved=0CCUQ9QEwAw
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Unit 9
Swaps and its features

The interest rate swap is a derivative instrument present in the currency
market exchanging interest rate floating payments for fixed payments
between the two counterparties. It is used by hedging funds of investors
expecting changes in interest rates.
Plain vanilla interest rate swap
The plain vanilla swap deals with swapping fixed rate interest payments with
floating rate interest payments based on London Interbank Offered Rate
(LIBOR). The LIBOR is an interest rate that the banks with high credit
ratings, obtained from various rating agencies, charge for short term
financing. The payer in the vanilla swap agrees to receive floating interest
rate in exchange with fixed interest rate. The receiver agrees to receive
fixed interest rate in exchange with floating interest rate. The swap dealer
acts as intermediary in the plain vanilla interest rate swap.
The plain vanilla interest rate swap pays LIBOR through pay floating party at
each period in return for fixed rate payment. If the forward rate is higher,
then the fixed rate on swap increases. It has a contract which extends over
a period of time. The process of swapping usually has an expiration date
during which the contract of plain vanilla extends the expiration date of
swapping process to the end of plain vanilla swap contract.
Figure 9.2 depicts the plain vanilla process.
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Unit 9
Figure 9.2: Plain Vanilla Swap Process

Source:
http://books.google.co.in/books?id=nNlQYXpKxgEC&pg=PA676&lpg=PA676&dq=
plain+vanilla+swaps+importance&source=bl&ots=s5jTVpwLzs&sig=JWTwXzXUVud
XiHzTIVjVWdP0JW0&hl=en&ei=kAK4TNrjNZGgvQPN2ZTyDQ&sa=X&oi=book_
result&ct=result&resnum=6&ved=0CCwQ6AEwBQ#v=snippet&q=plain%20vanilla&f
=false
The swap dealer receives floating LIBOR from party B and pays it to party
A. The dealer has no cash during this transaction. After the transactions
between parties A and B, the swap dealer experiences residual risk which
are evident in the net cash flows. Later over a period of time, the dealer
receives cash from party A depending on the future interest rate by paying
LIBOR. The mortgagor repays the loan as soon the rates decrease.
21. ________________ is an agreement to settle the difference between
an agreed and actual future level of interest between the two parties.
22. The interest rate swap is a derivative instrument present in the
currency market for exchanging shares of floating payments for fixed
payments between the two counterparties. (True/False)
9.8 Role of Financial Intermediaries

Financial intermediaries facilitate transfer of funds from holders of surplus
funds to the needy and earn revenue thereby creating a business model.
These comprise banking and non-banking enterprises. NBFIs, which are
main intermediaries, include mutual funds, credit unions, finance
companies, brokerages and pension/superannuation funds.
Financial intermediaries provide liquidity to the savers and holders of
surplus funds by maximising return at reduced risk levels.
Two major classes of financial intermediaries include mutual funds and
pension funds with credit unions and brokerages.
Figure 9.3 depicts the various types of financial intermediaries.
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Figure 9.3: Types of Financial Intermediaries
Liquidity provided to savers by FIs refers to the ability of converting assets

into quick money. Liquidity reduces risk by making large amount of loans
and can predict the repayment of the borrowed money. The role of financial
intermediaries includes:
Providing financial assistance to organisations and investment support
to individuals. Household savings are converted to loans or equities.
Smooth functioning of the capital market with timely filling of gaps in
capital requirement
Mobilising standalone savings to become a major source of capital
Effective assistance in purchase of assets that come into the market
after restructuring and liquidation of firms
Activity 2:
You are a financial intermediary called by your entrepreneur friend to
organise a loan for his company. What functions are you expected to
perform?
(Hint: Networking between people with surplus funds and people who
need funds for the business, getting up-to-date knowledge of the money
market trends, expertise at managing bank documentation and
paperwork are some key functions. Refer to 9.8.
http://www.indianmba.com/occasional_papers/op125/op125.html)
Page No. 169
Unit 9
23. ____________ facilitate transfer of funds from holders of surplus funds

to the needy.
24. Financial intermediaries comprise __________________ and banking
organisations.
9.9 Summary
Interest Rate Risk is the risk of adverse changes in the value of an

interest-bearing asset due to variability of interest rates.
A number of financial tools can be used for managing interest rate risk,
including asset-liability management procedure. IRRM methods include
gap analysis, interest rate derivatives and duration analysis.
Hedging techniques including interest rate futures, interest rate options,

interest rate caps, collars and interest rate swaps provide good defence
against Interest Rate Risk.
Factors that influence market interest rates are inflation, monetary policy
fluctuation, global liquidity, foreign exchange market activity etc. Many
theories have been proposed to get hold of interest rate risk logically
and develop the capability to predict interest rates.
The older (pre-20th century) interest rate theories are classical theory,
loanable funds theory, abstinence theory and liquidity preference theory.
The globalisation of business and finance has caused development of
modern theories of interest rate risk and new approaches to interest rate
risk management.
Types of interest rate risks are volatility risk, reinvestments risk, pricing
risk and real interest rate risk.
The sources of Interest Rate Risk are yield curve risk and optionality
risk.
Gap analysis is a technique which is used to measure interest rate risk.
Forms of gap analysis include duration gap, cumulative gap and dollar
value gap.
The various strategies for controlling Interest Rate Risk include yield
curve strategy and pricing strategy.
Forward Rate Agreements aim to protect the holder of this agreement
against interest charge or interest yield for future periods. Swaps deal
Page No. 170
Unit 9
with swapping fixed rate interest payments with floating rate interest
payments based on LIBOR.
9.10 Glossary
Abstaining: Withdrawing from participation in an activity
Forecasting: Predicting the future
Mortgage: An agreement which allows an individual to borrow money

from a bank or similar organisation to buy a immoveable asset by
deposit of title deeds
Portfolio: A collection of shares and other investments that are owned

by a particular person or organisation
Premium: Describes the state which is higher than the normal
Option: Right to buy or sell a given commodity, currency or stock at

specified amount and time, without the obligation to do so
Credit union:
Non-profit financial institution providing financial
services to its members
Superannuation funds: Funds reserved for paying employees

retirement benefits.

1.
2.
3.
4.
5.
6.
7.
8.
Explain IRRM methods.

Explain Interest Rate Risk hedging techniques.
What are the key factors that influence the market interest rates?
Explain liquidity preference theory.
Explain interest rate and its various types.
Explain the various sources of interest rate.
Analyse the techniques for measuring Interest Rate Risk.
Explain the concept of asset-liability rate sensitivity and strategies for
controlling Interest Rate Risk.
9. Discuss the interest rate management using FRAs and swaps and the
role of financial intermediaries.
9.12 Answers
Page No. 171
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
Unit 9
True
Exchange risk
True
False. IRRM should be an important item in the regular internal audit
program.
True
Capital cost
Social factors
True
True
Classical theory
True
False. Abstinence theory states that people abstain from consumption
in order to save and invest.
Volatility risk
True
Optionality risk
False. Price risk is the risk on account of a likely future decline in price
of a security like a bond or physical commodity.
True
Treasury Head
Interest rate expectations
True
Forward Rate Agreement
False. Interest rate swap is exchange of interest rate floating payments
for fixed payments between the two counterparties
Financial intermediaries
Non-banking
Terminal Questions
1. Interest rate risk management methods include gap analysis, duration
analysis and simulation analysis. Refer to Section 9.2.
2. Interest rate risk hedging techniques include interest rate futures,
interest rate options, interest rate caps, collars and interest rate swaps.
Refer to Section 9.2.4.
3. The factors which affect market interest rates are inflation intensity,
monetary policy fluctuation, debt to income ratio. Refer to Section 9.3.
Page No. 172
Unit 9
4. The liquidity preference theory states that investors maintain their funds
in liquid form like cash rather than less liquid assets like stocks, bonds
and commodities. Refer to Section 9.4.4.
5. The interest rate risk is the risk to the earnings from an asset portfolio
and the value of the interest-bearing securities caused by interest rate
changes. The various types of interest rate include volatility risk,
reinvestment risk. Refer to Section 9.5Interest rate risk.
6. The interest rate risk affects adversely the organisations financial
situation. The various sources include yield curve risk, basis risk. Refer
to Section 9.5.2.
7. The different techniques include full valuation, gap analysis. Refer to
Section 9.5.3.
8. Asset-liability rate sensitivity studies the extent to which the mix of
treasury assets and liabilities can be influenced by interest rate risk.
Refer to Section 9.5.4 Asset liability sensitivity portfolios.
The strategies for managing interest rate risk include interest rate
expectation strategy. Refer to Section9.6 Strategies for controlling
interest rate risk.
9. FRA (Forward Rate Agreement) aims to guard the interest charges.
Refer to Section 9.7 Interest rate risk management using FRA and
swaps. The financial intermediaries offer lenders interest, and
simultaneously charge higher interest rate to their borrowers. Refer to
Section 9.8.
9.13 Case Study

Interest Income at Infosys Technologies Ltd
The following figures are extracted from the Annual Report of Infosys for the
year 2009.
Year 2009
Year 2008
` crore
` crore
Interest bank deposits & others
836
650
Deposit / investment with

INR Bank deposit accounts
Foreign currency deposit accounts
8,551
232
5,913
153
Page No. 173
HDFC Ltd
GE Capital
LIC
Total interest-bearing investments
Yield (%)
Unit 9
1,298
0
253
10,234
8.17%
1,000
285
161
7,512
8.65%
Income from investments is 12-13% of the total net profit of the company,
and so is quite significant.
The policy restrictions on investing are spelt out below: Our Treasury Policy
allows us to invest in short-term instruments with maturity up to 365 days, of
certain size with a limit on individual fund/bank. The increase in interest
income during the year was on account of higher cash generation and
increase in average yield during the year.
As a company with disposable cash surplus in excess of ` 10,000 crore,
Infosys should have a major focus on management of its monetary assets
and interest risk.
Source: Adapted from the Annual Report of Infosys for 2009, taken from
http://www.infosys.com/investors/reports-filings/annualreport/annual/Documents/Infosys-AR-09.pdf
Questions:
1. Analyse the interest yield of Infosys vis--vis returns on a similar
portfolio that you could have got using market rates of interest for the
relevant years. Subject to the policy restriction, has Infosys done well?
Why or why not?
2. Pick out interest trends during the 2 years and specific risk-related
events that may have happened and estimate what, if any, would have
the impact of these trends and happenings.
3. Take the annual report of Infosys for 2011 and download the same
figures as above for 2011 and 2010. Make a brief analysis to decide
whether Infosys has done better or worse, and what could have been
the factors of the better or worse performance.
Hints:
1. Compare Infosys interest earnings with comparable size incomes of
other corporates and market returns that were available in these years.
Page No. 174
Unit 9
2. Search for bank interest related news (RBI, SBI and general economy)
and write about any of the happenings that could have affected Infosys
interest income (both ways).
3. Download the Infosys balance sheet 2011 from the Net. It will have
figures for the above items for 2011 and 2010.
References:
Fabozzi, F. J, Mann, S. V, Choudhry, M, (2003), Measuring and

Controlling Interest Rate and Credit Risk, Second Edition, US, John
Wiley and Sons, Inc.
Suresh, P, and Paul, J, (2007), Management of Banking and Financial
Services, India, Dorling Kindersley (Ind) Pvt. Ltd
E-References:
http://docs.google.com/viewer?a=v&q=cache:-ogB6tvN16kJ:www.occ.
treas.gov/handbook/irr.pdf+interest+rate+risk+models&hl=en&gl=in&pid
=bl&srcid=ADGEESjkwJjF0X0zqoykXP1xXm6gBfqt-9J-QX07CWs
MRPIOY2iiAHNJNLQmyMtkMBUiSQsdLh5amSOMfVVzsfsDwgSuFH6s
9NVZqQinX7Vd3IEzjEezjNRWKXxst4wvJtIMGoNcQNoO&sig=AHIEtbRl
MDwFixHUAbcJ2tHtP9Tg8_LzXg Retrieved on 03/10/10
http://docs.google.com/viewer?a=v&q=cache:Kl2wF3cZiU0J:www.banko
fjamaica.net/pdf/Standard-Interest%2520Rate%2520 Risk%2520
Management.pdf+Interest+Rate+Risk+Management&hl=en&gl=in&pid=
bl&srcid=ADGEEShtqE9DFP6IB7IT9P_ptvEm83YfKcA-hmrULWx1l
bxqds- GOXSrXJy78GchMI9ZZVSmvYJBrsaAoU02tD7VAbDdc
Cw2xppeT8Ktz3zzNiKh427LqRq2YcMWGs7ZYxvL2A_PqM1x&sig=AHI
EtbQVAz5z7iq24olqc-nLvxXkF8JtFw - Retrieved on 04/10/10
http://www.forextraders.com/forex-analysis/forex-fundamentalanalysis/liquidity-preference-theory.html - Retrieved on 5 Oct10
http://homepage.newschool.edu/het//texts/keynes/chap14.htm
http://www.boj.org.jm/pdf/StandardInterest%20Rate%20Risk%20
Management.pdf Retrieved on 23 Sep10
Page No. 175
Unit 9
http://www.investorwords.com/2546/interest_rate_risk.html Retrieved
on 23 Sep10
http://www.occ.treas.gov/handbook/irr.pdf Retrieved on 23 Sep10
Page No. 176
Unit 10
Unit 10
Financial Risk
Structure:
10.1 Introduction
Objectives
10.2 Definition and Dimensions of Financial Risk
10.3 Types of Financial Risk Identification
Financial reporting risks
Cash management risks
Cost management risks
10.4 Strategies for Managing Financial Risk
Reporting risk management
Strategies for managing cash risks
Strategies for managing cost risks
Strategies for managing compliance risks
10.5 Role of the Finance Function
Financial Policies
Financial Procedures and Controls
10.6 Best Practices Reporting
10.7 Enterprise Risk Management
Need for ERM
Terms of reference of ERM
Methodology of ERM
Agencies involved in Evolving ERM practices:
10.8 Summary
10.9 Glossary
10.11 Answers
10.12 Case Study
10.1 Introduction
In the previous unit we discussed interest rate risk management (IRRM). A
significant part of capital and likewise investment in the corporate sector is
debt, and the cost/value of debt capital is directly affected by interest risk.
We saw methods and strategies that can be adopted to reduce IRR.
Page No. 176
Unit 10
In this unit we will do a detailed study of financial risk. In unit 7 we briefly

covered this subject, identified its facets and methods to cope with it. Here
we will analyse financial risk, its types, strategies to manage it and the role
of the Finance function in financial risk management. We will do a study also
of enterprise risk management, a major strategy in dealing with financial
risk.
Objectives:
define and outline the dimensions of financial risks
discuss different types of financial risks
list out strategies to cope with financial risk
discuss fundamentals of best practices reporting
study enterprise risk management as an essential weapon in financial
risk management
10.2 Definition and Dimensions of Financial Risk

The risks associated with the structuring of a companys finance, and with
the financial transactions and activity conducted by the company through its
Finance function usually headed by a Chief Financial Officer (CFO),
together comprise the financial risk of the company.
It is important to note that risks in business always have a financial impact,
but for this reason all risks cannot be classified as financial risks. Please
refer to Unit 7 where we reviewed the sub-classes under the broad heading
of Business Risks.
Dimensions of financial risk:
The Finance function has four distinct dimensions viz. financial reporting,
cash management, cost management and compliance management.
Financial reporting covers accounting, periodic reporting to internal and

external stakeholders, and taking care of shareholder value and
interests
The dimension of cash management covers the raising of funds,

managing capital-related decisions and interactions and money-market
instruments.
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Unit 10
The dimension of cost management covers reporting on the profitability

and efficiency of operations and highlighting the cost impact of different
decisions.
The dimension of compliance management covers statutory filings,
payments, returns and other reporting, and all interfaces with regulatory
authorities.
In the first two dimensions Finance department has a direct responsibility for
managing risk, as all decisions primarily flow from Finance. In the other two
however Finance department has an indirect, although equally important
role to play in risk containment. This is because a substantial part of the
work and decisions vest with Operations and not Finance.
In the following sections we will analyse risks in each of these dimensions
and explore ways to manage them.
Under Financial reporting risks we include risks arising from the following
activities, decisions or happenings:
Statutory and tax accounting and audit
Annual and other periodic statutory reporting of financials
Related reporting to other governmental authorities
Internal (intra-company) accounting and reporting
Under Cash management risks we include risks arising from the following
decisions or happenings:
Capital structure and funding
Interest rate fluctuation
Liquidity level changes
Default
Foreign exchange fluctuation
Under cost management we study risks arising out of the following actions
and events:
Investment decisions
Product costing and pricing
Revenue decisions including product mix, special pricing & discounts
and profit/volume equation
Inventory management and valuation
Page No. 178
Unit 10
Trade credit control

Cost control and cost reduction
Under compliance we study risks arising out of the following acts and
omissions:
Lack of awareness of statutes
Misinterpretation of legal pronouncements
Delayed filing or non-filing of crucial returns
Delayed payment of taxes and duties
Notices, orders or other directives from statutory authorities that are not
in the companys interests
Raids, seizures, freezing of bank accounts, confiscation of documents
etc.
A fundamental principle of financial risk management is prevention is better
than cure. In the ensuing sections therefore we will focus on preventive
action that a CFO and his team should take to keep these risks at bay,
rather than post-facto action.
1. The dimensions of financial risks are ________, _______, _________
and ___________.
2. As statutory authorities are not under our control, we cannot take any
preventive action for compliance risks. (True / false)
3. A fundamental principle of risk management is ___________________.
10.3 Types of Financial Risk Identification

We have said earlier that financial risks can be viewed with respect to the
dimension they cover. In each of the four domains viz. reporting, money,
cost and compliance, let us look at different types of financial risks that are
present in business.
10.3.1 Financial reporting risks
1. Failure to adhere to statutory reporting requirements: The company may
miss a reporting or a filing deadline.
2. Errors in reporting that send wrong signals to the target audiences:
There may be unintended errors in the figures reported, and if these are
sizable they can cause havoc.
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3. Intentional wrong reporting and being caught in the act: There may be
deliberate misstatements in the financial reports, and when these are
found out the firm can be in serious trouble.
4. Inability to establish and run a tight internal financial reporting for
support to management decisions: If financial reporting is essentially
oriented only to external users like shareholders and lenders, and no
effective reporting to operating managers is available, it will result in
suboptimal decisions.
5. Disregard of internal reports by Operations and erroneous decisions as
a result: When operating decisions are not based on relevant financial
reports the risk of wrong decisions can hurt the company.
Broadly financial reporting risks occur both in the making of the reports and
their use. The CFO has the difficult job of compiling the financials to present
a true and fair view of the business conditions, in line with the applicable
standards; the financials should also be simple enough for being understood
and used by the management who may not be conversant with financial
jargon. The CFO also has to foresee the impact of the reported figures on
the capital market, the shareholders and the industry, and have a ready
analysis that will send the correct cues.
10.3.2 Cash management risks
1. Funding risk: Cash may not be available when needed, short-term or
long-term
2. Capital structure risk: This is the risk that the tenure of liabilities and
assets are out of alignment and not matched.For instance long-term
assets may be funded with short-term liabilities.
3. Leveraging risk: Leveraging in simple terms is the ratio of debt capital
to the available equity capital. If the debt to equity ratio exceeds a
certain level the business is considered to be highly levered and this is a
big risk. The acceptable level of leverage depends upon many factors
including the industry, the economy and capital market conditions etc.
Debt capital is less costly than equity capital, and has the further
advantage of tax deductibility. Funding a portion of capital required with
debt keeps the total cost of capital low. But debt comes with the risk that
it has to be serviced regard less of whether the company makes profit or
not. So debt gives the company high return, but also a high risk.
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Unit 10
4. Liquidity risks: In Unit 8 we discussed different types of liquidity risks that

the Treasury Head should be aware of. This is different from funding
risk, which is the risk of a cash crunch. Here we deal with the risk of not
planning liquidity levels properly, not aligning liquidity to the needs of the
business. In a way this risk indicates the likelihood of fund shortage that
may happen in the near future.
5. Interest rate risks: In Unit 9 we have studied the risk of interest rate
changes that can affect the companys profits and asset values.
6. Foreign exchange fluctuation risk: The CFO of a global corporation
faces two kinds of risks with foreign exchange exposure:
a) The adverse movement of exchange rate in conversion of import and
export transactions
b) The translation of year-end figures of foreign operations in local
currency at exchange rates which are not favourable.
Cash management risks basically deal with the monetary liabilities and
assets of the business, and the balancing of risk and return in decisions on
capital structure. This class of risks is probably the most important for a
CFO to handle, as money forms the substantial bulk of his responsibility.
10.3.3 Cost management risks
The risks present in this area are the risks of losses arising from in effective
cost management. Major cost management risks include:
1. Risk of under-performing investments: There are two kinds of
investments in a business: active, where a company invests in a project and
runs it; and passive, where surplus funds are invested in securities and the
company has no further role to play.
In case of active investments, the financial risk takes the following forms:
a) Erroneous determination of cost of capital, leading to wrong selection or
dropping of projects
b) Failure to track financial performance of projects
In case of passive investments the risk is in the timing of decision to invest
and disinvest.
2. Product costing and pricing risks: When a company launches a new
product there is the risk of overpricing or under-pricing, and this is a distinct
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financial risk. In respect of an existing product the key risk is wrong costing
leading to incorrect price changes.
3. Revenue decision risks: Revenue decisions refer to product mix
changes, discount selling in peak season or to clear inventories and
generally actions relating to marketing and selling. The major risk here is not
considering the cost figures sufficiently in detail before making decisions;
and ignoring the adverse effects of a hasty decision.
For example, many companies have year-end bumper sales to reach
targets, or produce and stock up for seasonal sales. In the former case it
can happen that excess sales are made to middlemen who will not pay on
time; and in the latter case the off-take may not be as expected, leading to
excess inventories. Both these are costly risks.
4. Inventory risks: Finance has a role in the management of inventory that
cannot be exaggerated. Prompt and sensitive reporting to Production and
Sales managers on inventory ageing and slow-moving inventory is crucial.
The risk is that such objective and periodic reporting may not be happening,
and that even when it is present, Operations do not act upon it.
A less obvious risk which is far more serious is inventory valuation risk. This
is the over-valuation of inventory that is resorted to in some companies to
boost the bottom line. What is forgotten by even Finance managers at times
is that the closing inventory of this period will automatically become the cost
of sales in the next period. So if profit is shown higher in this period by overvaluing inventory, it will hit the next period profit and you are only postponing
the problem.
5. Trade credit risks: Trade credit is the credit extended to customers as a
tool to improve sales. Risks in trade credit include (a) not having a clear
credit policy, or violating the policy in actual practice; (b) ineffective reporting
on receivables ageing; and (c) using credit as a vital device for sales the
product should sell on its own merits and credit should only pay a supportive
role. Trade credit risk not handled well leads to bad sales, bad debts and
serious working funds shortage.
6. Cost control and cost reduction risks: Cost control is the process of
keeping cost within the budgeted limits, while cost reduction is the process
of reducing the budget limits themselves to become more competitive. The
risks faced by companies here are a) poor budgeting and fixing of standards
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for costs; b) lack of action and attention on cost overruns and c) mindless
cost cutting in the face of adverse market conditions, without realizing the
long-term impact of such measures. For instance a company may be known
for excellent after-sales service. If they decide to cut down the facility for
reducing cost, they may lose further market share and incur more losses.
10.3.4 Compliance risks
Ignorance of law is no excuse goes the old adage. This applies strongly to
businesses. A large number of statutes and regulations govern business,
and if the company is a multinational influence of legal observances is even
wider. In India for example a limited company has to work within the purview
of the Companies Act, the Income Tax Act, indirect tax laws, labour laws,
industry-specific rules etc. If the company has foreign trade or operations it
has to cope with Foreign Exchange Management Act and related rules. If it
issues shares to the public and is listed, it is also answerable to Security
Exchange Board of India (SEBI).
Finance plays a crucial role in compliance risk management for the reason
that the subject is interwoven with knowledge of commercial and industrial
laws of the country; and the CFO is therefore the best person to keep track
of the rules and regulations to be observed and advise operations suitably.
Risks of failure in compliance include
Internal acts and omissions that amount to violation of law: These are by
far the single most prominent risks. From the time a business decides its
organization structure, it is necessary to involve legal experts and take
their opinion. The legal machinery in India has become very efficient and
knowledge on observances is available online thanks to the Net. There
is therefore no room for casual or accidental mistakes. But there is a risk
of wilful deviation from the rules, which some companies try to do for
making a quick buck. The long arm of the law catches up quickly these
days, once again thanks to the internet. It would be a foolhardy thing to
try evading or outsmarting the statutes, because the gain is temporary
but loss is not only permanent but sometimes terminal, and business
has to close.
External actions and directions against the business: Businesses also

run the risk of being served notices or orders unexpectedly for alleged
violations of the law. These can be simple actions like show-cause
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Unit 10
notices, which can be answered at leisure and clarified. But there can
also be staggering blows from the authorities in the form of raids, search
& seizure, freezing of bank accounts, confiscation of companys goods
in transit etc. This risk is all the more when the company deals in priority
sector industry or in a sector that is sensitive. While it can be argued that
this risk is beyond the control of a companys management, this is not
really the case. Often the truth behind any such aggressive initiative by
law enforcers is that the company has been consistently violating the
law or it has poor compliance processes. Preventive steps can certainly
ensure that such raids etc. can never happen.
It will be seen that while financial risks have been analysed into various
types, these are not stand-alone risks but have significant correlation. In the
next section when we study ways to manage financial risk, this point needs
to be remembered.
4. Broadly financial reporting risks occur both in the ______ of the reports
and their _____.
5. Foreign exchange risk includes risks of __________ and __________.
6. Capital structure risk occurs when long-term assets are financed by
___________ liabilities.
7. Funding risk is when cash is not available when needed. (True/false)
8. There are two kinds of investments in a business: _____ and _______.
9. Prompt and sensitive reporting on inventory ______________ and
__________ inventory is crucial for managing inventory risks.
10. Trade credit risk not handled well leads to bad _____, bad _____ and
serious shortage of _______________.
11. Compliance risks include acts or omissions that amount to violation of
law. (True/false)
12. Risk of actions like raid etc. on companies by authorities is not under
the control of the company management. (True/false)
10.4 Strategies for Managing Financial Risk

We have made an impressive list of the financial risks that be set a firm, in
the previous section. We will now see strategies and actions that can be
taken to reduce the impact of these risks.
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Unit 10
Any strategy to mitigate the effects of a risk has to do with one of the
following actions avoidance, prevention and sharing. In the ensuing lists of
strategies for managing financial risks, you will note that the emphasis is on
preventive action in most cases.
10.4.1 Reporting risk management
Reporting risk can be managed with the following actions.
1. An accounting system in sync with the size and complexity of the firm,
including a robust chart of accounts and book keeping process
2. Disciplined closing of books and extraction of financials every month
3. Having a single set of books to respond to every need, instead of standalone systems for different purposes
4. Highlighting to the Board of Directors in case of reporting misdeeds by
executive management
5. Clear and unambiguous discussion and analysis of reports to enable
proper understanding of the figures
6. Telling the truth: this is the one strategy that will work better than all
other strategies combined.
10.4.2 Strategies for managing cash risks
Strategies, policies and procedures that can help in coping with risks in the
management of money are:
1. Prudent decisions with regard to capital structure and cost of capital,
and regular review and revision of the decisions
2. Fixing key liquidity and turnover ratio standards and having a good early
warning system when the ratios go out of line
3. Strong controls on all aspects of debt capital, from the sourcing of debt
to its servicing and redemption
4. Effective decision-making with regard to exchange risk and regular
review and revision of the decision
5. Having a workable backup plan to manage short-term liquidity crises
6. Ad hoc strategies and plans for company-specific money-related risks:
for example a company with huge cash reserves will need to monitor
interest rates, which is not usually necessary for corporates.
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Unit 10
10.4.3 Strategies for managing cost risks

The following actions are strongly recommended for mitigating the risk
element of cost management.
1. A strong investment analysis and capital budgeting system based on the
right cost of capital and evaluation techniques should be installed and
implemented.
2. The cost accounting system should reflect the complexity and size of the
business.
3. Product costs and profits should be reported regularly and effectively to
management by the CFO, and follow-up actions should be tabled and
pursued diligently.
4. Operating managers should work with Finance on every major product
or market decision and understand its likely impact on profitability before
making the decision.
5. Healthy policies and practices should be followed on inventories, trade
credit and the management of all other current assets including cash
It has been said, very rightly, that ignoring cost risks is dangerous because
they do not get highlighted like liquidity risks; and when they are recognised
it may be too late to do anything.
10.4.4 Strategies for managing compliance risks
The following steps are taken by well-governed companies to keep off the
high risk of failure in compliance management.
1. Statutory checklist: Preparing, updating and regularly reviewing and
revising a statutory checklist that elaborately lists out all statutory
payments, filings, returns and other actions required in the business.
Presentation of the checklist for review by Directors in Board meetings is
mandatory in well-run companies.
2. Competency: The officer in charge of compliances should be wellversed in the law of the land. It is not necessary that he knows the rules
by heart an impossible feat anyway; it is essential that he knows
where to get information on the rules and how to interpret it.
3. Seeking outside expert advice when required: This may be in the
form of a legal counsel on retainer, or access to the Net, or even
speaking with the law enforcement government agencies directly to
learn the procedures.
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4. Follow-up on open issues: Conscious effort by the company to close

all open issues with different authorities, like unfinished tax
assessments, notices and orders not yet replied, pending appeals etc.
These are like festering wounds if allowed to remain untreated for too
long.
5. Tactful handling of government action against the company: In the
event of punitive action on the company like seizures, working with the
authorities to resolve the issue instead of fighting with them, especially
when it is seen that there have been deviations on the companys side.
6. Above all, staunch belief in honesty: Taking the stand that enforcers
can be bought or squared up or that anything is possible in this
country is not only an affront and an insult to the land that helps you run
a profitable business but it can be downright suicidal if the law catches
up with you, which it eventually will.
13. A strong capital budgeting system based on the right ___________ and
__________________ mitigates investment risks.
14. A _______________ elaborately lists out all statutory payments, filings,
returns and other actions required in the business.
15. Key liquidity and turnover ratio standards should be fixed for handling
cash management risks. (True/false)
10.5 Role of the Finance Function

The Finance and Compliance function of a company plays a vital role in
financial risk management. Its role can be likened to the judiciarys role in
governance of a country. Just as judiciary institutes checks and balances on
the executive, and ensures that the countrys interests are not compromised
by accident or design, Finance has to rein in the penchant of the companys
operating managers for taking undue risks.
In doing this job, Finance uses two weapons: financial policies and financial
procedures.
10.5.1 Financial Policies
The financial policies of a business have to be recorded clearly and updated
regularly, and should be readily available to decision-makers in the firm. It
should not be possible for any manager to say but I Was not aware that the
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company policy did not approve of this decision. Vast corporations have
decision-making delegated to several levels, and written policies are a must
in such enterprises.
A typical Financial Policy Manual lays out the policy, authority for making
and administering it, exceptions permitted and authority for making
exceptions, in respect of every sphere of activity of the company.
Given below is an example of a Financial Policy Manual on the topic of
cash transactions.
Illustration: Policy manual on cash transactions
1. To the extent feasible, monetary transactions will be done by cheques
and electronic transfers, and cash handling will be kept to the minimum.
2. No transaction involving payment of cash in excess of ` 5,000 is to be
allowed except with Managing Directors written approval.
3. Petty cash recoupment will be done through imprest system.
4. Only the cashier and branch managers will handle company cash. Any
other executive using cash for company activity will use personal cash
and claim reimbursement.
5. Cash will not be received in amounts exceeding ` 10,000. In case of
larger amounts, cash will be deposited in the bank and then drawn out.
10.5.2 Financial Procedures and Controls
Financial processes are documented clearly in large corporations in the
form of Procedure Manuals. These are essential when operations are done
in distant lands and company culture has to be preserved.
Procedure manuals lay out the following aspects of every activity of the firm:
Procedural steps
Internal documents
External documents
Approval and exceptions
Accounting and recording
Statutory aspects
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Activity 1:
You have seen above the Policy Manual for cash transactions. Write out
the Procedures & controls manual for the same activity.
Hint: You will cover receipt of cash, payment, withdrawals, balance
checking, maintaining cash book and recording in the accounts.
16. A typical Financial Policy Manual lays out the policy, authority for
making and administering it, and exceptions allowed. (True/false)
17. Finance functions role in a company is likened to the role of the
____________ in governing a country.
18. Why are procedures manuals required in large, global companies?
10.6 Best Practices Reporting

Best practices mean processes that a company adopts for its activities that
become smooth, tremendously efficient and cost-effective over a period of
time, and are worthy of being called ideal, benchmark practices.
There was a time when a company would zealously guard its best practices
as it felt that the practice should not be easily copied by competitors, which
would lose for the company a distinct edge over its rivals. But this approach
to best practices has been more or less given up in the last 15 years. It is
increasingly seen that companies report their best practices on the Net, in
their annual reports and in ad hoc articles to the Financial Press.
Why and how has this transformation taken place? The main reason for
open publication of best practices is the explosion of internet, worldwide
web and the huge volumes of information now accessible even on your cell
phone. A company would be foolish to imagine that its best practices are still
preserved as secrets, when information is going out in myriad ways.
Besides companies have recognised the value of sharing best practices, as
they also get the opportunity of studying other companies practices. In the
continual improvement of processes this is a positive step for everyone.
Is there a financial risk involved in best practices reporting? If yes, what
should be done to lessen the risk? These questions should be answered
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from two standpoints: a. the company which shares its best practices and
b. the company which accesses best practices and uses them.
From the standpoint of a company which publishes its best practices, there
is certainly the risk that after all the time and cost it has spent in perfecting
its practice the result is available to the world almost free of cost. The
company runs the risk of not being able to recoup its investment in the
practice.
To cope with this risk, the following steps are recommended:
1. Publicise the broad outline of your approach and the after-effects. Do
not get into procedural details but stay at the level of policy guidelines.
2. Recognise the fact that there is no end to improving a process. So keep
reinventing especially customer-facing and production-related practices.
By the time your competitor has borrowed your idea, you are already
using a better version of the practice.
3. Make sure that in some activities your process remains secret, as these
are fundamental to your competitive strength.
From the standpoint of a company which studies and adopts best practices
of comparable enterprises, the major risk is the danger of mindless copying
without making appropriate changes to suit individual differences. A method
ideal for a European company may be ill-suited in India, for instance.
To cope with this risk, the following actions may be taken.
1. Study and absorb only the essence of any benchmark practice, and try
to work into your process the spirit of the practice. For instance, a
marketing firm may find surveys of its clients a great practice to get
closer to them. But if you are operating in a relatively less transparent
market and administer surveys, they may either not work or may give
you undependable results. The idea is to get closer to the customer, so
you must find other ways and means to do this.
2. While it is important to keep an eye on industry practices, it is even more
important to be internally focused and come up with best practices from
your own crew. For one thing they know the specific conditions much
better, and they will also see it as a great motivator when they are given
freedom to innovate and not told to copy best in town practices.
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Reporting and publicising best practices is becoming a way of life even in

India. Industry associations sometime make it even mandatory. Companies
would do well to recognise this and manage the risk.
19. Best practices mean processes that a company adopts for its activities
that become smooth, efficient and cost-effective. (True/false)
20. What is the risk in adopting best practices of other companies?
21. It is seen that companies report their best practices on ________ and
in their ______________.
10.7 Enterprise Risk Management

Business is all about seeking and exploiting opportunities to successfully
convert these into profitable ventures. The other side of an opportunity is
risk, as we have seen in the foregoing sections and in earlier units.
Rather than manage different risks separately, a movement has been
initiated in the last two decades for systematically identifying and evaluating
the risk component of every opportunity and formulating business strategy
to (a) say yes or no to the opportunity and (b) if the answer is yes, to
delineate the risk coping strategy and implement it. This major initiative is
called enterprise risk management (ERM).
ERM can be called a proactive approach to risk management processes of
a company. At one end of ERM are the stakeholders of the enterprise: the
stockholders, employees, customers, debt financiers and the government.
At the other end are the members of the management team, coordinated by
the CFO, or a special manager say, Chief Risk officer (CRO).
10.7.1 Need for ERM:
Large multinational corporations (MNCs) are consistently in the public eye
and capital market is no longer content with just their published quarterly
and annual results. Their actions, executive movements, announcements
and reactions to market happenings are watched carefully. Each of these is
evaluated for the risk content as much as return possibility. Credit-rating
agencies like CRISIL (formerly Credit Rating Information Services of India
Limited) and ICRA (Investment Information and Credit Rating Agency of
India Limited) or Moodys and Standard & Poor in the US are forever
examining risk management practices of these corporations. It is therefore
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vital for large MNCs to have their answers ready, structured and cohesive
for all queries on their risk management.
Secondly ERM as an approach recognises the multiple risk effects of an
action and therefore the need to have a comprehensive system instead of a
domain-wise risk strategy. For instance a relaxation of customer credit has a
distant but distinct effect on the profitability of the business. It is better to
factor this effect into the decision to relax credit terms.
10.7.2 Terms of reference of ERM
The scope of work for ERM is described below.
a) Improving the efficacy of risk management activities of all the separate
functions in a company, by coordinating and sharing their individual
tactics among all functions
b) Integrating the risk management practices for the company as a whole,
both for cohesive presentation to stakeholders and for a unified
evaluation of the companys capability in risk containment
c) Matching three aspects of the risk/return equation of a typical business:
i) the level of risk inherent in the business
ii) the risk appetite of stakeholders to the business
iii) the stated objective of the business in terms of ROI (return on
investment) or any other metric
10.7.3 Methodology of ERM
ERM operates at two clear levels: (1) pre-acceptance of risk and (2) postacceptance.
1) Pre-acceptance: The methodology in this phase involves identifying,
analysing and quantifying the risk with a view to decide whether to
abandon the opportunity and avoid the risk, or take it up and assume the
risk.
2) Post-acceptance: In this phase the risk has been taken, and the
method focuses first on ways and means to diminish the impact of the
risk, by insurance or reinsurance or by other devices. After reducing risk
to a level below which it cannot be reduced, the second set of methods
is devised and implemented, in order to manage it effectively at
company level.
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The methods deployed by ERM in managing of risk include integrating

across functions, assigning priorities, reporting and early warning, reviewing
and corrective action.
10.7.4 Agencies involved in Evolving ERM practices
Casualty Actuarial Society (CAS), Arlington VA, USA: This is a professional
association of actuaries (insurance experts)
Society of Actuaries (SOA), Ill USA: The Society has developed credentials
for qualification of risk managers as CERA (Chartered Enterprise Risk
Analyst).
Committee of Sponsoring Organizations of the Treadway Commission
(COSO), USA: This is basically a collection of accounting experts backed by
five major professional accounting organizations in the US.
Securities and Exchange Commission (SEC) and the Sarbanes-Oxley Act
enacted by the US government: SEC has been given wide powers as well
as accountability for bringing to book companies that compromise interests
of their stockholders by excessive risk-taking without adequate checks.
ISO 31000, the international standard for risk management, has been
published in 2009 together with ISO 31010 on risk managing techniques.
A number of major stock exchanges including the New York Stock
Exchange (NYSE), and major credit rating agencies have clarified their
position on ERM and made it almost mandatory for big widely-held
companies.
Thanks to globalisation, India has also entered the arena of ERM and we
have some major players who compete internationally. Cholamandalam MS,
First source Solutions, Axis Risk Consulting (a Genpact company), and CRP
Technologies (India) are some of the big names in offering ERM solutions.
22. Expand CAS, COSO and NYSE
23. ERM as an approach recognises the ________ risk effects of an action
and therefore the need to have a ____________________.
24. ERM can be called a proactive approach to risk management
processes of a company. (True/false)
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10.8 Summary
Risk is an inevitable facet of business and return or profit from a

business unfortunately moves in direct proportion to the risk level. This is
the premise of financial risk management.
Financial risk has four dimensions: financial reporting,

management, cost management and compliance management.
A large variety of risks are present in each of these dimensions, and it is

important for a company and its risk officer to be aware of each of these
risks and its relative impact on the companys activities.
It is equally essential for the companys risk management team to devise

and implement appropriate strategies for coping with every single one of
the risks, and to keep all the companys stakeholders updated on the
risks, the effects and the actions being taken.
Best practices reporting is an initiative that is at once both a boon and

a risk, for it requires sharing information with competition. With the new
age IT explosion, companies do not have a choice in this regard and
have to reckon and manage this risk.
Enterprise risk management (ERM) is a great coordinator of diverse risk

management practices within a company and seeks to achieve synergy
in using risk management to improve returns.
cash
10.9 Glossary
Cost control: is the process of keeping cost within the budgeted limits
Cost reduction: is the process of reducing the budget limits themselves

to become more competitive

1.
2.
3.
4.
What is financial risk? What are its dimensions?

What are the types of financial risk? How are the risks classified?
What strategies do companies deploy for managing financial risk?
Is best practice reporting good or bad for a company? Should it be
avoided?
5. What is enterprise risk management? Write about its need, terms of
reference and methodologies.
6. Name some organisations associated with risk management and ERM.
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10.11 Answers
1. Financial reporting, cash management, cost management, compliance
management
2. False. Preventive action against compliance risk is basically a clean
compliance record.
3. Prevention is better than cure
4. Making, use
5. Transactions, translation
6. Short-term
7. True
8. Active, passive
9. Ageing, slow-moving
10. Sales, debts, working funds
11. True
12. False. Often the truth behind raids etc. is poor compliance record of
the company.
13. Cost of capital, evaluation techniques
14. Statutory checklist
15. True
16. True
17. Judiciary
18. To preserve company culture
19. True
20. Because they may not be suitable
21. The Net, annual reports
22. Casualty Actuarial Society, Committee of Sponsoring Organizations of
the Treadway Commission, New York Stock Exchange
23. Multiple, comprehensive
24. True
Terminal Questions
1. The risk associated with financial structuring and financial transactions
of an organisation together are called financial risk. Financial risk has
4 dimensions: reporting, cash, cost and compliance. Refer to
Section 10.2.
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2. Financial risks are classified into reporting risks, cash availability risks,
cost management risks and compliance risks. Refer to Section 10.3.
3. Companies usually go in for preventive action strategies to manage
financial risk of all types. Refer to Section 10.4.
4. Best practice reporting is certainly good for a company. It has its risks
but these can be managed, Refer to Section 10.5.
5. ERM is a movement to systematically identify the risk components of an
opportunity and integrate them, to facilitate the decision of whether to
take it or not. Refer to Section 10.6.
6. CAS and COSO are two organisations associated with ERM and risk
management. Refer to Section 10.7.
10.12 Case Study

Satyam Computers Debacle
The chairman of Satyam Computer Services Ramalinga Raju resigned on
Wednesday, 7th Jan09 saying profits had been inflated over the last several
years.
Following are extracts from his letter to the Board.
Dear Board Members,
It is with deep regret and tremendous burden that I am carrying on my
conscience, that I would like to bring the following facts to your notice:
1. The Balance Sheet carries as of September 30, 2008
a. Non-existent cash and bank balances of 50.40 billion rupees out of
53.61 billion reported
b. An accrued interest of 3.76 billion rupees which is non-existent
c. An understated liability of 12.30 billion rupees on account of funds
arranged by me.
d. An overstated debtors position of 4.90 billion rupees as against 26.51
billion reported
2. The gap in the Balance Sheet has arisen purely on account of inflated
profits over a period of last several years. The differential in the real
profits and the one reflected in the books was further accentuated by the
fact that the company had to carry additional resources and assets to
justify higher level of operations -- thereby significantly increasing the
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costs. Every attempt made to eliminate the gap failed. It was like riding a
tiger, not knowing how to get off without being eaten.
3. The aborted Maytas acquisition deal was the last attempt to fill the
fictitious assets with real ones. Maytas' investors were convinced that this
is a good divestment opportunity and a strategic fit. Once Satyam's
problem was solved, it was hoped that Maytas' payments can be delayed.
But that was not to be.
4. Neither myself, nor the Managing Director (including our spouses) sold
any shares in the last eight years -- excepting for a small proportion
declared and sold for philanthropic purposes.
5. Neither I nor the Managing Director took even one rupee from the
company or benefited in financial terms on account of the inflated results.
6. None of the board members, past or present, had any knowledge of the
situation in which the company is placed. None of my or Managing
Director's immediate or extended family members has any idea about
these issues.
Having put these facts before you, I leave it to the wisdom of the board to
take the matters forward. However, I am also taking the liberty to
recommend the following steps:
a) A Task Force has been formed in the last few days to address the
situation arising out of the failed Maytas acquisition attempt.
b) Merrill Lynch can be entrusted with the task of quickly exploring some
Merger opportunities.
c) You may have a restatement of accounts' prepared by the auditors in
light of the facts that I have placed before you.
I have promoted and have been associated with Satyam for well over twenty
years now. I have seen it grow from few people to 53,000 people, with 185
Fortune 500 companies as customers and operations in 66 countries.
Satyam has established an excellent leadership and competency base at all
levels. I sincerely apologize to all Satyamites and stakeholders.
Under the circumstances, I am tendering my resignation. l is now prepared
to subject myself to the laws of the land and face consequences thereof.
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Unit 10
1. Analyse the risks Ramalinga Raju took, the reasons for doing so, and
the after-effects.
2. How does the case reflect on the control systems in governance and
financial reporting in India?
(Hint: Go to the case history and read the financial reports.)
References:
Financial Management by I M Pandey

Management Accounting by Dearden & Bhattacharya
Asset Liability Management: Issues and Trends in Indian Context by
R Vaidyanathan. ASCI Journal of Management 29(1).39-48
E-References:
www.infosys.com retrieved on 19.2.13
http://www.indianexpress.com/news/satyam-fraud-full-text-of-rajus-letterto-board/407799 retrieved on 19.2.13
http://www.pwc.com/us/en/issues/enterprise-riskmanagement/publications/guide-to-risk-assessment-risk-managementfrom-pwc.jhtml retrieved on 19.2.13
http://www.coso.org/-erm.htm retrieved on 19.2.13
http://www.pwc.com/corporatereporting retrieved on 19.2.13
Page No. 198
Unit 11
Unit 11
Foreign Exchange Risk Management
Structure:
11.1 Introduction
Objectives
11.2 Foreign Exchange Risk Management
Objectives
11.3 Types of Foreign Exchange Risks
Transaction risk
Settlement or credit risk
Mismatch or liquidity risk
Operational risk
Sovereign risk
11.4 Types of Currency Exposure
Transaction exposure
Translation exposure
Economic exposure
11.5 FERM Policies, Procedures and Controls
11.6 Gap Analysis
11.7 Summary
11.8 Glossary
11.10 Answers
11.11 Case Study
11.1 Introduction
In the previous unit, we studied financial risk management, exploring its four
dimensions viz. reporting, cash, cost and compliance. In this unit, you will
study foreign exchange risk management.
Foreign exchange (forex) risk can be defined as the probability of loss due
to an adverse movement in the foreign exchange rates. Foreign exchange
risk is also termed as currency risk or exchange rate risk. Banks involved in
multi-currency operations are most likely to be exposed to foreign exchange
risks. Corporates who have significant exports or imports and other foreign
exposures, like borrowings, investments and technical tie-ups also run this
risk.
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Clearly, banks and financial institutions which are licensed FEDAI (Foreign
Exchange Dealers Association of India) dealers have the maximum forex
risk exposure. But in this unit we will focus on forex risk management by
companies, and highlight the role of banks in corporate forex risk
management.
We will cover different types of foreign exchange risks, currency exposures
and risk management techniques.
Objectives:
describe foreign exchange risk management
classify different types of foreign exchange risks
explain different types of currency exposure
explain the concept of gap analysis
11.2 Foreign Exchange Risk Management (FERM)

Foreign exchange risk management (FERM) is intended to preserve the
value of currency inflows, outflows, investments and loans. The objective is
to predict adverse outcome of exchange rate fluctuation and minimiseit
effectively.
Illustration:
AB Ltd places an order for raw materials costing $1 million, and on the day
of ordering the exchange rate is ` 54/US$. But payment is to be made
3 months later on receipt of the goods, and the rate may depreciate or
climb to ` 56/US$. AB Ltd has a forex risk of ` 2 million ($1 million X
(56 54)).
A good plan for FERM requires:
Establishing and executing comprehensive forex risk policies
Evolving and implementing effective forex risk control procedures
11.2.1 Objectives of foreign exchange risk management

To reduce the variability of cash flows
To improve, simplify and modernise procedures of foreign exchange
dealings
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To develop preventive solutions to reduce negative influence of adverse

currency movements
FERM policies
Policies for the following aspects of foreign exchange management should
be well-defined:
The objective should be clear: is it only protection against loss or does it

mandate the management team to make profit from forex transactions?
The policies, strategies and procedures will be significantly different for
these two objectives. A typically risk-averse business will want only to
cover its exposure and reduce risk, while a reward-seeking firm may
want to gain from forex rate fluctuations.
The limits beyond which exposure should not be allowed: this depends
upon the risk appetite of the company and, to some extent, upon the
objective of FERM.
Authorisation levels for decisions on FERM: The managerial levels at

which decisions on forex risk cover can be taken should be defined.
FERM Instruments
Effective management of forex risks is done through a variety of financial
instruments mainly in the format of derivatives.
Forward contracts
Currency futures
Currency options
Currency swaps
Forward contracts
Foreign exchange forward contracts are the most common instrument for
hedging forex transactions.
A forward contract is an agreement to buy or sell foreign exchange for an
amount determined in advance at a specified exchange rate on a
designated date in future. The specified rate is called the forward rate and
the designated date the settlement date or delivery date.
Forward contracts are privately negotiatedover the counter and hence are
not standardized. This gives rise to counterparty risk or default risk arising
out of failure of the counterparty to honour its commitment. This
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counterparty risk is eliminated in currency futures which are transacted in a

regulated exchange.
Currency futures
Currency futures are standardized forward contracts in which two parties
agree to exchange something in the future on a regulated exchange. As
futures contracts are traded on exchange with appropriate controls,
counterparty risk is eliminatedd.
Globally the major currency futures market is the EUR futures market,
based upon the Euro to US Dollar exchange rate. The most popular
currency futures are provided by the Chicago Mercantile Exchange group,
and include the following futures markets:
EUR Euro to US Dollar futures
GBP British Pound (Sterling) to US Dollar futures
CAD Canadian Dollar to US Dollar futures
CHF Swiss Franc to US Dollar futures
India is not lagging behind in the world of currency futures trading. From
almost nothing a few years ago, daily volumes in this space have climbed to
nearly US$7 billion if an estimate in Sep10 is to be believed. So much so, a
new exchange was launched in Sep10 to focus on exchange-traded interest
rate and currency derivatives. Named the United Stock Exchange of India,
the organisation has grown in strength and operates in the following futures
currency pairs:
United States Dollar-Indian Rupee (USD-INR)
Euro-Indian Rupee (EUR-INR)
Pound Sterling-Indian Rupee (GBP-INR)
Japanese Yen-Indian Rupee (JPY-INR)
Currency options
A currency option is an alternative tool for managing forex risk. A foreign
exchange option is an agreement for future supply of a currency
interchanged with another, where the owner of the option has the right to
buy (or sell) the currency at a settled price, but is not obligated to do so. The
right to buy is called a call option; the right to sell is called a put option.
For such a right without the obligation the option holder pays an upfront
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price called the option premium. The option seller receives the premium and
is obliged to make (or take) delivery at the agreed price if the buyer
exercises his option.
Currency swaps
Currency swaps deal with the exchange of payments in different currencies
between two trading partners. For better productivity currency swaps feature
netting, in which the party in money gets payment at the end of the swap
term. In other words the transaction does not have to be completed but only
the net difference settled.
Activity 1:
Illustrate how a bank enters into a currency swap. Assume amount,
tenure, currencies involved and the swap ratio.
(Hint: Refer to section 11.2 Foreign Exchange Risk management)
1. Foreign exchange risk management is intended to preserve the value
of ________, _________, and __________.
2. Forward contracts are privately ___________ over the counter and
hence are not ________________.
3. Currency swaps cannot be netted out; transactions have to be
completed. (True/False).
11.3 Types of Foreign Exchange Risks

The different risks associated with foreign exchange can be classified as
follows:
Transaction risk
Settlement or credit risks
Mismatch or liquidity risk
Sovereign risk
Position risk
Cross-country risk
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Of the above position risk and cross-country risk arise only for licensed forex
traders, and we need not discuss these. The other risks are faced by all
entities engaged in foreign exchange.
11.3.1 Transaction risk
Transaction risk is the in-built risk in foreign exchange transactions including
invoiced export receivables, import payables, other foreign currency receipts
and payments, and foreign currency loan transactions. This is the risk of
adverse exchange rate movement occurring between the date of recording
the transaction in the books of accounts and the actual realization or
payment being made subsequently during the course of the transaction.
11.3.2 Settlement or credit risk
Settlement risk is the risk of a counterparty failing to meet the obligations in
a financial deal. Settlement risk arises depending upon the way settlement
is structured. There are two factors which could cause this risk:
Different time zones Different time zones implies that there is a risk
that the bank paying rupees to the counterparty in India during Indian
business hours may not get payment from the counterparty in the United
States when the US banks open. Alternatively the company may make
payment to bank but the foreign counterparty may not get the proceeds
for the same reason.
Cable-in factors Cable-in factors occur mainly in countries such as the

United States where cables reaching up to 12 noon only are accepted
and acted upon. In some countries like West Germany messages have
to be delivered on the day previous to the settlement day.
A good amount of settlement risk has now been eliminated as a result of
Society for Worldwide Interbank Financial Telecommunication (SWIFT).
The SWIFT messaging system does not enable funds transfer but sends
payment orders to be settled by correspondent accounts that the
institutions have with each other. SWIFT messaging centres share realtime information with each other so that if one of them runs into a
problem the other centre can take over the operations of the entire
network. SWIFT conducts most of its messaging services in areas such
as payments and cash management, treasury, securities and trade
services.
11.3.3 Mismatch or liquidity risk

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In the foreign exchange dealings it is not possible that sales and purchases
are always matched in value terms. There can be substantial periodic
mismatches mainly in banks. Large-scale global businesses also experience
this risk.
Illustration:
MN Ltd has a net positive forex balance i.e. its foreign currency inflows
exceed payments.It prefers managing forex transactions in foreign currency
itself, doing away with conversion risk. But in a specific period its outgo is
much larger compared to inflow and it has to buy forex. The mismatch risk
occurs for MN Ltd.
11.3.4 Sovereign risk
Sovereign risk is based on the government of a country. Although an
importer agrees to pay for his imports the central bank of the country may
not allow the importer to do so. This has happened in a number of African
and South American countries on account of economic volatility and political
uncertainties.
Activity 2:
Compare and contrast the different types of foreign exchange risks of a
multinational corporation (MNC) based in India.
(Hint: Refer to section 11.3 on types of forex risks)
5. The in-built risk in foreign exchange transactions is ____________.
a) Credit risk
b) Transaction risk
c) Cross-country risk
d) Sovereign risk
6. Sovereign risk is the risk based on the ____________ of a country.
7. The risk of a counterparty failing to meet the obligations in a financial
deal after the bank has fulfilled the obligations on the date of settlement
of the contract is known as ___________.
a) Settlement risk
b) Position risk
c) Pre-settlement risk
d) Cross-country risk
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11.4 Types of Currency Exposure

In the previous section we discussed the types of foreign exchange risks. In
this section we will analyse currency exposures and their risk component.
Forex exposure can be defined as the sensitivity of the real value of an
entitys assets, liabilities and operating incomes expressed in its domestic
currency to unexpected changes in exchange rates. The types of currency
exposure are:
Transaction exposure
Translation exposure
Economic exposure
11.4.1 Transaction exposure
Transaction exposure also referred to as conversion exposure or cash flow
exposure deals with the actual cash flows involved in settling transactions in
foreign currency. These include:
Sales receipts
Payment for the goods and services
Dividend or royalty or technology fee payment/receipt
Servicing and repayment of loans
Receipt of investment and returns on investment
It is important to start monitoring currency exposure from the time a foreign
currency commitment is made. The financial gain or loss is the difference
between the actual cash flow in the national currency and the cash flow
calculated at the time of starting the transaction.
Life cycle of transaction risk exposure:
The foreign exchange risk in a forex transaction can be first studied with
respect to its life i.e. the total period of time for which the risk is present.
Illustration
The life span of transaction risk exposure occurs by selling a product on
credit. Figure 11.1 depicts the life span of transaction risk exposure. T1, T2,
T3 and T4 are various events related time periods in transaction risk
exposure. Transaction risk exposure consists of three types of exposures:
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Quotation exposure Quotation exposure is the time between quoting a

price and reaching a contractual sale. Quotation exposure occurs from
time period T1 to T2.
Backlog or customer order exposure Backlog exposure is the time

taken by transaction risk exposure to fill the order after the contract is
signed. Backlog exposure occurs during the time period of T2 to T3.
Billing or receivables exposure Time taken to get the customer invoice
paid in cash after it is issued is known as billing exposure. Time period
from T3 to T4 reflects billing exposure.
Figure 11.1: Life Cycle of Transaction Risk Exposure

th
Source: Chapter 9, Multinational Business Finance 11 Edition, by Michael Moffett,

Arthur Stonehill and David Eiteman, Publishers Pearson Prentice Hall
11.4.2 Translation exposure

Translation exposure, also termed as accounting exposure or balance sheet
exposure relates to the restatement of foreign currency financial statements
in reporting currency. Translation exposure is calculated at the time of
translating foreign financial statements for reporting purposes.
Illustration
AB Ltd closes books on 31/3/12. On this date it has a balance of $100,000
in its Exchange Earners Foreign Currency (EEFC) account with its bank,
stated at ` 54 lakh on 15th Feb12, when it was received into the account.
But on 31/3/12 the $ rate has dropped to ` 52. AB Ltd has to restate its
EEFC balance as ` 52 lakh and the translation loss is ` 2 lakh.
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11.4.3 Economic exposure

Economic exposure, also termed as operational exposure, is relatedtothe
strategic evaluation of foreign transactions and relationships. It is concerned
with the changes in future cash flows on specific transactions due to
changes in exchange rates, or on the operating position within chosen
markets. Determination of economic exposure requires an understanding of
the structure of the markets in which a company obtains capital, labour,
materials, services and customers.
Thus, economic exposure denotes the probability that the value of the
enterprise, known as the net present value of future after-tax cash flows, will
alter when exchange rates change. Economic exposure is the effect on
future cash flows of future movements in exchange rates. This affects a
firms competitive position across the various markets and products and
hence the firms real economic value.
Illustration:
LMN Ltd has, on the balance sheet date of 2011-12 placed purchase orders
on a few European suppliers adding up to $3 million euros, which is yet to
be received. These orders were placed in the last quarter of 11-12 to meet
customer orders and are costed at ` 65/euro, as euro was selling at ` 65 at
that time. The total cost of this material was therefore taken as ` 195 million.
On 31/3/12 however the euro climbed steeply and was quoted at ` 70. The
cost of these imported materials will now increase to ` 210 million. LMN Ltd
has incurred a loss of (210 195) or ` 15 million, which is not considered in
its book of accounts, but will be considered by any buyer of LMN Ltd and
reduced from the value of business.
9. Foreign currency exposure is the magnitude of the future cash flows of
a bank, arising from ___________ and ___________ currencydenominated transactions.
10. A significant exposure for the future value of the organisation is
___________.
a) Transaction exposure
b) Translation exposure
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c) Economic exposure
d) Total exposure
11. Translation exposure can also be termed as _________ or
__________.
12. The exposure dealing with the actual cash flows involved in settling
transactions denominated in a foreign currency is called ___________.
a) Economic exposure
b) Transaction exposure
c) Translation exposure
d) Risk exposure
11.5 FERM Policies, Procedures and Controls

Forex risk involves trading risk in the case of a licensed FEDAI dealer. In all
other cases it is simply the risk of currency exposure in transactions and risk
of translation differences in year-end reporting. Companies are not allowed
to trade in foreign currencies as a business by itself.
There are numerous foreign exchange risk management practices that can
be used to reduce the effect of risk and financial exposure. Most of these
however are relevant only for banking companies that trade in foreign
currencies. We shall confine our discussion to exchange risk management
that is applicable to a non-trading entity.
Policies
A company controls foreign exchange risk based on its policies. In devising
a firms FERM policy the factors to be taken into account are the firms
exposure, attitude towards risk (risk-averse, risk-indifferent or risk-seeking),
the firms ability to absorb exchange losses without much impact,
competitors stance and most importantly regulatory requirements. The
policy should spell out whether the company would want to cover its
exposures using hedge instruments like forward contracts or leave them
uncovered. Authority levels for changes in the policy or exceptions to the
policy should be specified
Procedures
Procedures are the documented steps for a process.
FERM procedures include the following:
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Systems to capture, measure and monitor foreign exchange risk:An

adequate information system must be available that records and
measures the following accurately:
o
The risk exposures related to foreign exchange transactions
The impact of potential exchange rate changes
Controls
Controls are the checks and balances in the process to prevent errors.
Organisational controls:
There should be a clear and effective channel of communication between

persons who initiate foreign exchange transactions and the Treasury
function. The procedural requirements of both these wings of the company
should be documented. In these days of high volatility in exchange rates,
quickness in action matters a great deal and even a days delay in covering
positions can mean material losses.
Independent audits
Independent audits are important for FERM. Companies with sizeable forex
operations should have a well-planned internal audit program to evaluate
the companys FERM. The audit should cover:
o
Relevance of policy and policy adherence
Effectiveness and speed of organisational controls
Accuracy of management information reports on currency movements

and trends
o
o
Import / export procedures and their alignment to FERM practices

An overall evaluation of the profit / loss on exchange exposure for the
period and recommendations for action

13. Companies are not allowed to ____ in foreign currencies as a business
by itself only ___________ are licensed to do so.
14. An alternative tool for managing foreign exchange risk is ___________.
a) Currency options
b) Forex trading
c) Financial audit
d) Independent audit
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15. Foreign exchange ____________ are the most common instrument for
hedging transactions in foreign currencies.
11.6 Gap Analysis

Gap analysis is done to measure the overall exposure of the entity to
exchange risks Gap analysis is a procedure that associates the rate
sensitivity of forex assets with that of forex liabilities and measures the
difference between their respective rate sensitivities at a particular point of
time.
If the gap is positive the firm is considered to be positively rate-sensitive. If
the gap is negative the company is considered to be negatively ratesensitive.
MNCs with outflows as well as inflows in foreign currencies should attempt
gap analysis from time to time as this gives them a feel for the degree of net
exposure. For forex traders gap analysis and fixing gap limits is a crucial
activity and fundamental to their bottom lines.
Illustration
AX Ltd is a company with operations in the USA, Germany and Singapore.
The forex items in the balance sheet of AX Ltd on 31/12/12 are shown in
Table 1 (in million).
Table 1
Forex assets & liabilities
US$
Euro
Sing $
2.7
1.1
3.4
23.4
19.2
31.0
4.6
1.5
1.0
Fixed assets
45.3
23.2
13.6
Total assets
76.0
45.0
49.0
Trade payables
11.6
20.0
26.6
Short-term loans
0.0
21.2
5.2
10.4
3.6
3.2
0.0
44.2
20.0
Cash and cash equivalents:

Trade receivables
Other current assets
Other current liabilities

Long-term loans
Equity
54.0
(34.0)
(6.0)
Total liabilities
76.0
45.0
49.0
Table 1: Forex Items in AX Ltd balance sheet as at 31/12/12

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The gap analysis in respect of forex exposures of AX reveals a lopsided

picture. While the US$ asset value is much higher than the liabilities, the
company has higher liabilities in both and Singapore $.
Now if an analysis of the movement and trends of the three currencies
shows that US$ is headed downwards but both and Singapore $ are in the
upswing, AX has a major negative gap to be addressed. The balance sheet
of AX (consolidated) will take a bigger loss when it is presented in INR since
AX is an Indian company.
16. Gap analysis is done to measure the overall __________ of the entity
to exchange risks.
17. ___________ rate sensitivity is inversely proportional to the exchange
rates and profits.
11.7 Summary
Foreign exchange risk management preserves the value of currency

inflows, investments and loans.
The risks associated with foreign exchange are based on the
fluctuations in foreign currency.
Foreign currency exposure is the magnitude of the future cash flows of
an entity, arising from foreign currency-denominated transactions.
Every company with forex transactions should have a FERM strategy to
reduce the effect of risk and financial exposure.
Gap analysis is a useful tool to gauge the sensitivity of forex assets and
liabilities to exchange fluctuation.
11.8 Glossary
A/R: Accounts Receivable (A/R) is the money owed by customers to an

entity in exchange for goods or services that have been supplied or
used, but not yet paid for.
Default: Failure to perform a task or accomplish an obligation, especially

failure to meet a financial obligation
Equities: Common stocks representing ownership of the company
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Hedging: A risk management technique to eliminate adverse price

movements by fixing the price, normally used to reduce interest rate,
exchange rate or commodity price fluctuations
Open account: Account having non-zero debit or credit balance
Portfolio: Combination of risks
Spot transaction: A foreign exchange transaction in which each party

assures to pay a definite amount of currency to the other on the two
working days from the date of the transaction

1. Describe the concept of foreign exchange risk management.
2. What are the different types of foreign exchange risks? Explain in detail.
3. Explain the types of currency exposures in foreign exchange risk
management process.
4. What is gap analysis? How is it useful to a company?
11.10 Answers
1. Currency inflows, investments, loans
2. Negotiated, standardised
3. False. Currency swaps can be netted out.
4. b) Transaction risk
5. Government
6. Settlement risk
7. Domestic, foreign
8. c) Economic exposure
9. Accounting exposure, balance sheet exposure
10. b) Transaction exposure
11. trade, FEDAI dealers
12. Currency options
13. Forward contracts
14. Structure
15. Negative
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Unit 11
Terminal Questions
1. Foreign exchange risk management is intended to preserve the value of
currency inflows, investments and loans. Refer to section 11.2.
2. The risks associated with foreign exchange are many and are largely
based on the fluctuations in foreign currency rates. Refer to section
11.3.
3. Foreign currency exposure is the magnitude of the future cash flows of a
bank. The various types of currency exposures are explained in section
11.4.
4. Gap analysis is done to measure the overall exposure of the entity to
exchange risks. Refer to section 11.6.
11.11 Case Study

Managing Foreign Exchange Risk with Results
ADC Telecommunications is a global leader in providing network
infrastructure products and services that empower the profitable distribution
of high-speed internet, video, data, and voice facilities to residential,
business and mobile subscribers worldwide.
Challenges
The treasury team of ADC has exposed some major challenges inherent to
the systems and processes in place that would bind the companys ability to
manage risk, particularly during unstable market conditions. The challenges
are as follows:
Increased time and effort ADCs manual data abstraction process and
exposure analysis require almost an entire day. With ADC inspecting the
risk exposures only once a month, intra-month fluctuations are not
integrated and captured in the hedging activity.
Low confidence There are material gains/losses on certain currency risk
exposures that the extraction tool of ADC is not capturing.
Manual calculations and analysis The existing risk management
processes and procedures require a lot of manual effort. The process does
not offer aggregated currency exposures but forms individual exposures by
specific company.
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Lack of visibility No one is looking into the thousands of general ledger

accounts for verifying accuracy and completeness.
Objectives
Because ADCs visibility is restricted, the company has set relatively high
objectives:
Identify risk from the omitted risk exposures
Improve hedge coverage or reduce income volatility while restructuring
the process for risk management
Justify the ongoing cost of the project among staff reductions and capital
constraints
Solution
After exploring its options, the company has chosen to implement FiREapps
Transaction FX, a web-based software suite as a service (SaaS) solution
that interacts with ERP and other source data systems to automate the
exposure, data aggregation, calculation, analysis and decision-making
processes. This process ensures comprehensive and accurate exposure
calculation, inculcating greater confidence in the decisions that treasurers
make to mitigate foreign exchange risk and allows them to focus on valueadded analysis and decision-making.
Benefits
In association with FiREapps, the ADC Treasury Team is empowered to
view net foreign exchange exposures on any given day within a few
minutes. The transparency provided by FiREapps allows the ADC team to
monitor their exposures more closely and contributes to a vast improvement
in the companys hedging program.
1. What are the challenges faced by ADC Telecommunications for
management of foreign exchange risk?
(Hint: The challenges faced by ADC are explained in subsection
challenges in the case)
2. Explain the solution taken up by ADC for managing the foreign
exchange risks.
(Hint: The solution is explained in subsection solution in the case.)
3. What are the benefits yielded by ADC in the foreign exchange risk
management process?
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Unit 11
(Hint: The benefits are explained in subsection benefits in the case.)

Source:
http://www.fireapps.com/sites/default/files/Fireapps%20ADC%20casestudy%20091
009.pdf retrieved on 13.10.11
References:
Multinational Business Finance, 11th Edition by Michael Moffett, Arthur
Stonehill & David Eiteman. Publishers Pearson Prentice Hall
Machiraju, H. R, (2002), International Financial Markets And India,
Second Edition, India, New Age International Publishers
E-References:
http://www.qfinance.com/financial-risk-management-checklists/theforeign-exchange-market-its-structure-and-function Retrieved on
21/9/10
http://www.ehow.com/about_5467854_foreign-exchange-riskmanagement.html Retrieved on 21st Sept, 10
http://www.all-about-forextrading.com/foreign-exchange-riskmanagement.html Retrieved on 20th Sept, 10
http://www.boj.org.jm/pdf/Standards-Foreign%20Exchange%20Risk%20
Management.pdf Retrieved on 20th Sept, 10
http://nt.walletwatch.com/sathyamnew/NewsView.asp?NewsID=74073&
NewsBullet=0 Retrieved on 21st Sept, 10
http://www.mia.org.my/handbook/guide/imap/imap_3.htm Retrieved on
20th Sept, 10
http://www.bnet.fordham.edu/public/finance/goswami/eiteman_178963_
im08.pdf Retrieved on 22nd Sept, 10
http://www.finweb.com/investing/forward-and-futures-contracts.html
Retrieved on 22nd Sept, 10
http://foreignexchangerisk.net/stop-loss-forex-great-minimize.html
Retrieved on 21st Sept, 10
Page No. 216
Unit 11
http://www.adb.org/Documents/Conference/Sustainable_Recovery_Asia
/adb14.pdf Retrieved on 22/9/10
http://blogs.wsj.com/indiarealtime/2010/09/21/india-launches-new-stockexchange/ retrieved on 22/9/10
http://www.fireapps.com/sites/default/files/Fireapps%20ADC%20
casestudy%20091009.pdf retrieved on 13.10.11
PROBLEMS & SOLUTIONS

Q. 1. Forward v. Hedge: Grassroots PLC is a London-based company.
They will require making a payment of $250,000 in six months. The market
information is presented in Table 1 below. Grassroots is evaluating whether
to execute a forward contract, or to go for money-market hedge.
Give your reasoned recommendations on the best alternative.
Table 1
Forex rates
Spot
Six months forward
In US
In UK
$1.5617 1.5773
$1.5455 1.5609
Money market rates (%)
Deposit
Borrow
4.5%
6.0%
5.5%
7.0%
Table 1: Market information on exchange movements
Answer:
Grassroots will buy dollars to meet the liability. The appropriate forward
rate is 1.5455;
The Pound Sterling cost of this liability is 161,760 (that is, $
250,000/1.5455);
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Unit 11
To meet a liability, a matching asset has to be created;

Investment should be in dollars;
Dollar liability after six months is $250,000;
Dollar interest rate is 4.5 per cent annually. The applicable rate therefore
is 2.25 per cent;
At 2.25 per cent, the present value of dollar payment is $244,499;
This amount is required to be borrowed in pounds at spot rate, which is
1.5617. Amount to be borrowed in pounds is 156,560;
The Dollar amount received (against pounds) will be placed in dollar
deposits at an interest of 2.25 per cent, yielding maturity proceeds of
$250,000. This sum will be used to pay the overseas liability;
Principal amount of Sterling loan (rounded off) will be 156,560.
Applying interest at 3.5 per cent, principal and interest at the end of six
months is 162,039.60 (rounded off to 162,040).
The recommendation is given in Table 2.
Table 2
Evaluation table
Cost in
Forward exchange rate
1,61,760
Money market hedge
1,62,040
Solution: Select the alternative that has the

least cost in terms of
That is, select Forward contract,

the cost of which is 161,760.
Table 2: Recommendations to Grassroots Ltd
Q. 2. Forward Covers: A company operating in Japan has today made

sales to an Indian company, the payment being due three months from the
date of invoice. The invoice amount is 10.8 million yen.
At today's spot rate, it is equivalent to ` 3 million. It is anticipated that the
exchange rate will decline by 10 per cent over the three-month period, and
in order to protect the yen payments, the importer proposes to take
appropriate action in the foreign exchange market.
The three-month forward rate is at present quoted at 3.3 yen per rupee.
Calculate the expected loss, and show how it can be hedged by a forward
contract.
Page No. 218
Unit 11
Answer: Transaction summary:

Transaction: import by an Indian company
Amount: Japanese yen 10,800,000
Payment tenor: three months
Current rate: 3.60 yen per rupee (108/30)
Expected decline: 10 per cent in three months
Likely future rate: 90 per cent of 3.60 = 3.24 yen per rupee
Normally, the exchange rate changes are shown at as a percentage change
for an annual period. The problem, however, indicates that exchange rates
will decline 10 per cent over the three-month period, followed by a
requirement for computation of `expected loss' and, hence, the decline is
taken to be specific for three months.
If the decline is 10 per cent per annum the expected rate at the end of three
months would be 3.51 yen per rupee, and a forward cover would not be
advantageous.
Analysis leading to a decision on forward contract:
a) Forward rate: Yen 3.30 per rupee
Total yen required: 10,800,000
Conversion at 3.30 yen per rupee: that is, each rupee will get 3.30 yen
Rupee commitment under forward: ` 3,272,727
b) Expected rate: 3.24 per rupee
Total yen required: 10,800,000
Conversion at 3.24 yen per rupee: that is, each rupee will get 3.24 yen
If expectations were to materialise, rupee commitment will be
` 3,333,333.
Summing up,
Rupee outflow if no forward cover is taken [as per (b)] = ` 3,333,333
Rupee outflow if forward cover is taken [as per (a)]
= ` 3,272,727
Difference
=`
60,606
Forward contract is recommended.

Q. 3. Hedge using futures: XYZ Ltd is an export-oriented business house
based in Mumbai. The company invoices in customer's currency. Its receipt
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Unit 11
of $100,000 is due on September 1, 2005. The contract size is ` 472,000,

and the market information as at June 1, 2005, is as follows:
Exchange rates ($/`): Spot, 0.02140; June, 0.02126
One-month forward, 0.02136; September, 0.02118
Three-month forward, 0.02127
Initial margin: June, ` 10,000; September, ` 15,000
Interest rates in India: June, 7.5 per cent; September, 8 per cent.
On September 1, 2005, the spot rate ($/Re.) is 0.02133 and currency future
rate is 0.02134.
Comment on which of the following methods would be most advantageous
for XYZ Ltd:
i) using forward contract
ii) using currency futures
iii) not hedging currency risks
It may be assumed that variation in margin would be settled on the maturity
of the futures contract.
Answer
Step I: Exposure is in dollars, whereas currency future is available in
rupees. Therefore the requirement is rupees for hedging. Selling dollar is
equivalent to buying rupee.
Therefore, start with buying rupee futures for September 2005 and cancel
the same on September 1, 2005, by selling same number of contracts.
Number of contracts to be bought = (100,000 / 0.02118) / 472,000 = 10
Step II: Cash flow in the spot market will be = 100,000 / 0.02133 =
` 4,688,233
Step III: The currency future will give a profit calculated as under:
= Number of contracts x contract size (0.02134 - 0.02118)
= 10 x 472000 x (0.02134 - 0.02118) = $755.20
Profit = ` 35,406
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Unit 11
Total cash flow under currency future hedge = ` 4,688,233 + 35,406

Interest cost in initial margin = 15,000 x 10 x 8 per cent x 3/12 = 3,000
Net cash flow = 4723639 - 3000 = 4,720,639
Hedge using forward contract: The relevant forward rate for the three-month
period is 0.02127. The customer will sell forward and total cash flow after
three months will be ` 4,701,457.
Not hedging currency risk: Based on forward quote and future quote, the
rupee is depreciating and dollar is appreciating and, therefore, the exporter
may go for `No hedge'. However, this strategy is fraught with risk of
exchange rate moving adversely on the date of settlement.
98863 66351 09246460030 08022989729
Between currency future and forward cover, the former appears to be
beneficial as it gives more rupees.
Note: There appears to be a technical error in the data given for currency
future. Typically, when the spot price moves down, the future price should
also move down as the price of the future is derived from the spot price.
In the given quote, spot price has gone down from 0.02140$/Re to 0.02133
$/Re from June 1, 2005 to September 1, 2005, whereas currency future
price has moved up from 0.02118 to 0.02134 for the same period.
Q. 4. In the international money market (IMM) an international forward bid
on 15th Dec for one euro is $1.2816. At the same time the price for IIM euro
future for delivery on 15th Dec is $1.2806. The contract size of future is
62,500 euros. How could the dealer use arbitrage to profit from this
situation? What profit will be earned?
(ACS* Jun09)
Answer: The dealer can buy 1 futures contract @ $1.2806 and enter into a
forward sale in the IMM @ 1.2816 for delivery on 15th Dec. The two
transactions will effectively generate a profit of 10 cents without any risk. In
this case it may be seen that the maturity dates are exactly the same and
the contract amounts are also the same. Hence there is a perfect hedge is
possible. Of course, the dealer has to post the initial margin and
maintenance margin as required by the futures exchange.
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Unit 11
Q. 5. STU Ltd has to make a US$5 million payment in 3 months time. The
required amount in US$ is available with the company. The management
decides to invest it and the following information is available in this context:
$ (USD) deposit rate is 9% p.a.
Sterling (GBP) deposit rate is 11% p.a.
Spot rate of GBP/USD is 1.82
3 months forward rate of GBP/USD is 1.80
Required:
1. Where should the company invest for better returns?
2. Assuming the interest rates and spot rates are as indicated above, what
is the forward rate that would yield an equilibrium situation?
3. Assuming that the US interest rate on the spot and forward rates remain
as above, where should the company invest if sterling deposit rate is
15% p.a.?
4. With the originally stated spot and forward rates and the same US$
deposit interest rate, what is the equilibrium sterling deposit rate?
(ACS* Jun09)
Answer:
1. If the company invests $ 5million in a dollar deposit the amount
accumulated at the end of three months will be (5*1.09*3)/4=$1,362,500.
But if the company invests the amount in a deposit it will have
$1,372,253 on hand at the end of 3 months. {Working:
(5/1.82)*(1.11/4)*1.8 million $} Hence it would be better for the company
to invest in pounds. (Reason: the company buys @ $1.82 today and
invest in deposit and sell pounds @1.8$ at the end of three months).
2. If the forward rate is 1.787207 it would result in an equilibrium situation.
{1,362,500/(5,000,000/1.82)*(1.11/4) pounds= forward rate}.
3. The gain would be much higher if the interest rate on sterling is 15%
p.a.
4. If the forward rate is 1.725043 it would result in equilibrium.
Q. 6. HSD Ltd, an Indian telecom company, has approached Punjab
National Bank (PNB) for a forward contract of 500,000 delivery on 31st
May08. The bank had quoted a rate of ` 61.60/ . But on 31st May08 HSD
Ltd informs PNB that it is unable to deliver the 500,000 as the anticipated
Page No. 222
Unit 11
receipt from London has not materialised. HSD requests PNB to extend the
contract for delivery by 31st Jul08.
The market quotes for `/ available on 31st May08 are:
Spot: 62.60/65
1 month forward premium 20/25
Flat charge for cancellation of forward contract is ` 500
Required: Find the extension charges to be paid by HSD Ltd to PNB.

(ACS* Dec08)
Answer: As per FEDAI rules the bank has to cancel and rebook the
contract at the prevailing rates on 31/05/08. Therefore the bank will do the
following:
a. The forward sale contract will be cancelled at ` 62.65 per pound which is
the spot selling rate on 31/05/08.
b. Sterling bought under original contract at ` 61.60 per . Difference
` 1.05 per is recovered from the customer as cancellation charges.
` 500 are added as flat service charges (plus service tax @ 12.36%) to
the cancellation charges.
c. The new contract is booked at Rs63.02 valid on 31/07/08
Q. 7. Indigo Ltd plans to import equipment from Japan at a cost of 7.2
million yen. The company can get a loan for this purpose @ 10% interest
p.a. with quarterly rests. There is also an offer from the Tokyo branch of an
India-based bank offering 180 days credit @2% p.a. against an irrevocable
letter of credit (LC).
The present exchange rate is ` 100 = 360 yen. 180 days forward rate is
` 100= 365 yen. LC commission cost is 2% for 12 months.
What should Indigo do take the loan or import under the LC? (ACS*
Jun06)
Answer:
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Unit 11
The comparison of costs and benefits of a forex loan vis--vis opening a

letter of credit is shown in Table 3.
Table 3
Cash outflow- Under loan
Cash flow under LC

`/L
Investment
25920
Interest (%)
total outflow
`/L
Investment
26280
0.15865
L/C cost 1%
262.8
30032.21
Interest 1%
262.8
total outflow
26805.6
Table 3: Cost/benefit of forex loan and L/C
Hence it would be cheaper to import under the LC.

Q. 8. ABC Ltd is thinking of importing a machine from USA at a cost of
$15,000 at todays spot rate of $0.0227272 per rupee. The exchange rate is
expected to rise by 10% after 2 months and so the Finance Manager
proposes that the import may be deferred. Operations Manager is of the
view that postponing the import will cause a loss of ` 50,000 to the company
(for the 2-month period).
Express your view on whether the company should buy the machine now or
defer it by 2 months, giving reasons. (ACS* Dec06)
Answer: if the import is deferred by two months as proposed the cost will be
$16,500 equivalent to ` 726,002 instead of ` 660,002 today. Thus the
deferred import will cost the company ` 66,000 extra. The loss is in addition
to ` 50,000 likely to be lost due to the deferral.
If the company were to import the machinery now this extra cost would be
saved.The company hence should import now instead of two months later.
Note: *ACS: examination for Associate member of the Institute of Company
Secretaries of India (Inter)
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Unit 12
Unit 12
Working Capital Management
Structure:
12.1 Introduction
Objectives
12.2 Meaning and Contents of Working Capital
Working Capital and Working Capital Finance
Meaning of Working Capital
Contents of working capital
12.3 Need for Working Capital
12.4 The Operating Cash Cycle
12.5 Managing Working Capital
A few top-level requirements
Management of inventories
Management of receivables
Management of other working assets
Management of cash
12.6 Financing of Working Capital
Spontaneous financing of working assets
Planned or lender financing of working capital
12.7 Role of Treasury in Working Capital
12.8 Summary
12.9 Glossary
12.11 Answers
12.12 Case Study
12.1 Introduction
In the eleven units that you have read so far on the subject of Treasury
Management, you have studied the subject of money in all its contours, and
the Treasury function of a business entity which basically manages money.
You have explored the concept of financial and treasury risk in many forms,
as the Treasury Manager essentially plays a protectors role rather than a
revenue generators role.
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In this unit we study management of a companys working capital. The

Finance function together with Operations is responsible for working capital,
no doubt; but Treasury has a key role in the subject. In the ensuing sections
we learn about working capital in some detail and finally discuss how
Treasury can support working capital management.
Objectives:
explain the meaning and contents of working capital
evaluate the need for working capital in a business
explain the need to define and control the operating cash cycle
explore ways and means to manage working capital
discover the options for financing working capital
review the part played by Treasury in managing working capital
12.2 Meaning and Contents of Working Capital

Clear understanding of working capital and the need for it in business, and
of the distinction between working capital and working capital finance, is the
first step in working capital management.
12.2.1 Working capital and working capital finance
Capital, one of the key resources deployed in a business, can be studied
from two angles:
Where it comes from i.e. sources of capital
Where it is applied or invested i.e. uses of capital
When we talk about working capital it must be clearly understood that we
are talking about use of capital and not its source. The money used for
keeping the business working is working capital. The money sourced to
get working capital is working capital finance. We should not get confused
between the two terms.
12.2.2 Meaning of working capital
Working capital is the money invested in the working assets of a firm.
A business usually requires two kinds of capital: fixed capital invested in
plant, equipment, buildings, computers and other long-lived assets; and
working capital invested in inventories, receivables, deposits & advances
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and cash & bank balances. Fixed capital produces returns over a long
period of time for the business, while working capital helps the business
achieve revenue and profits on an ongoing basis.
The working assets of a business are also known by the term current
assets. This expression conveys the necessity for working assets to remain
current i.e. they should not become old or outdated. This is the essence of
working capital management to keep it flowing, current and productive.
12.2.3 Contents of working capital
As stated above, working capital comprises the working assets of a firm.
What are these assets? Look at the items in these examples.
A trading business for instance may have to purchase and store
products to be sold, paying for them before they can be sold and
cashed. A factory that produces and sells products has to store raw
materials and finished goods, besides having some unfinished materials
under process.
A company may also need to allow the customers to pay later instead of
insisting on cash at the point of delivery.
Payments in advance may be required for certain expenses like annual
insurance, deposit for renting the office, foreign currency and tickets for
foreign travel or advance fees/deposits for statutory registrations.
And finally the business must have some idle cash and bank balances
for making spot payments.
Each of these requirements takes the form of a working asset:
The first is a working asset or a current asset called inventories.
The second item is called trade receivables or accounts receivable
The third set of items are prepayments, advances and deposits
The final item is cash & cash equivalents.
These assets together comprise the working capital of a business.
It is worth repeating here that there is a separate set of assets including
land, building, machines etc. that make up the fixed capital of the company.
We are not talking about those assets here.
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1. The working assets of a business are also known as ______________.
2. A company may need to allow the customers to pay later. This is
known as prepayments. (True / false)
3. A business must have some ____ cash and unused bank balance for
______ __________.
12.3 Need for working capital

Can a business run without the need to invest in working assets like trade
receivables and inventories? Let us study the following case.
Pachai is a vendor of pani-puris in a makeshift stall of his own at the end
of the street in which he lives.
Every morning he goes to the market and buys the ingredients to make
pani-puris for the day, estimating the quantity based on anticipated
sales. He buys more in the weekends, naturally.
He does not pay for the material as he buys on credit.
Through the day he does the processing of the pani-puris to the stage
needed, and at 4 pm sets up the stall and runs it till 8 30 p.m.
As he sells the pani-puris he collects cash, and at 8.30 or earlier,
depending upon the demand, he sells his days produce completely.
He goes across to the vendor from whom he bought the ingredients and
pays for the supply, and returns home with the balance money, which is
his profit.
The cycle is repeated day after day.
Here is a businessman who, you might say, does not require working capital
at all: no idle cash, no deposits, no receivables and no inventories. But this
is an extreme case under ideal conditions.
If the produce is not sold fully it becomes inventory for the next day. Or the
vendor might want a security deposit. Or Pachai may think about expanding
by selling a part of his produce in bulk to another stall-owner, who will pay
once a week. In all these cases he will need to worry about working capital.
All businesses small, medium or big need working capital for survival
and growth. The more widespread the activity, the greater is the need. It is
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of paramount importance for the financial health of a business to assess the

requirement reasonably correctly, finance it sensibly and control it effectively
and make sure the working assets keep working, are current and do not
get stuck. This is the essence of working capital management.
Activity 1:
Download the balance sheet of WIPRO for 2011-12 and list its current
assets in as much detail as is available, and put down the figures for
31/1/12 and 31/3/11.
Hint: Write a brief note about each item, on how you think it has moved
and how healthy the change is. Refer to 12.2.3.
4. If the produce is not sold fully it becomes receivables for the next day.
(True / false)
5. All businesses small, medium or big need working capital for
______ and _______.
12.4 The Operating Cash Cycle

There is a different perspective from which we can look at working capital,
instead of defining it by its contents. This is the perspective of operating
cash cycle, which can be explained as the total period during which cash
stays invested in the working assets of the business.
Let us say we start a business with purchase of items to be sold. Cash goes
out, and this is to be treated as an investment. After we sell it and collect
cash from the customer it gets back, meaning the investment has been
returned. The time period for which it remains in the pipeline or the channel
before converting back to cash is the operating cash cycle.
As can be expected, the cycle time is brief for a small trader who buys
against specific, known demand. It increases if he has to stock the product
and then get customers. It expands further if he sells on credit. Finally if he
decides to make the product instead of buying it, the cycle becomes really
long.
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Operating cash cycle is another way of expressing working capital, in terms

of number of days or weeks. Working capital is expressed in value terms.
Illustration
Omkara Ltd is a manufacturing company. Its average working assets are at
the levels shown in Table 12.1:
Table 12.1
` lakh
Raw material inventory
35.00
Work in process (WIP)
45.00
Finished goods
30.00
Trade receivables
45.00
Table 12.1: Working Assets in Omkara Ltd
Omkaras operations on an average are at the levels shown in Table 12.2:

Table 12.2
` lakh
Daily sales
Daily raw material consumption
Daily value of WIP committed
Daily cost of goods sold
2.50
1.50
1.60
2.00
Table 12.2: Omkaras Operation Levels
Compute the operating cash cycle.

Answer
Operating cash cycle for Omkara Ltd is worked out in Table 12.3.
Table 12.3
Working asset
Raw material inventory

Work in process
Finished goods
Receivables
Total
Ave value
Daily burn
` lakh
` lakh
35.00
45.00
30.00
45.00
155.00
1.50
1.60
2.00
2.50
Days
Number
23.33
28.13
15.00
18.00
84.46
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Table 12.3: Operating Cash Cycle of Omkara Ltd
The operating cash cycle for Omkara is 84.46 days.

It therefore takes close to 3 months for the cash cycle to be completed and
the investment in working assets converted back into cash.
It should be noted that during this period the company will incur general
selling and admin expenses and has to pay for its financial costs. All these
will add to the working capital required.
Another aspect of operating cash cycle to be kept in mind is that the value
goes on increasing as each stage is crossed. When processing has just
begun only the raw material is invested, but when the sale is complete and
payment is delayed, the amount of money blocked is substantially higher.
6. Operating cash cycle is the total period during which cash stays
invested in the working assets of the business. (True/false)
7. The amount invested in the operating cash cycle goes on __________
as each stage is crossed.
8. If a firm decides to make a product instead of buying it, the operating
cash cycle becomes ___________ (longer / shorter).
12.5 Managing working capital

It would have been evident to you from the foregoing discussion on working
capital that it needs to be managed efficiently and effectively for a business
to achieve its goals of turnover and profits. Constructive working capital
management is required to ensure that a firm has sufficient resources to
satisfy maturing short-term debt and upcoming operational expenses.
We will briefly explore methods and strategies adopted by companies to get
the best returns for the capital employed in working assets.
12.5.1 A few top-level requirements
1. Having a fairly good idea of the total amount of money that needs to be
invested in working assets: Every company should quantify its operating
cash cycle and broadly know the amount of capital that will be required.
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2. Benchmarking the total working capital with the best and making a
determined effort to reach and surpass the record: There is great benefit
in identifying the company with the lowest investment in working capital
and analysing their strategies. If you company is the best-in-town, it is a
good idea to set further improvement targets.
3. Setting specific standards and budgets for seasonal fluctuations and
being ready for the changes: Seasonal businesses cannot have a single
set of numbers for working capital budgets. Spikes have to be estimated
and funded in time, to ensure the business is not lost.
4. Paying heed to statutory or other controls on working capital levels that
may have to be complied with: For instance if the company borrows from
a bank for financing its receivables, the bank may stipulate that
receivables as a ratio of sales should not exceed a certain ratio.
Likewise, the Indian arm of a US multinational may have limits on its
inventories set by the global Head of Finance.
12.5.2 Management of inventories
For manufacturing companies inventories are often the single biggest
working asset. Some ideas that can be tried out in inventory control are:
1. The purchase function should necessarily include the inventory effect in
deciding the vendor, import versus indigenous buying, order quantities
and reorder levels, and payment terms.
2. It happens frequently that the latest purchases are used up and old
stocks remain unused. Reporting on ageing of inventories and strict
norms for writing down old inventories is critical for ensuring that the
inventory valued is realizable.
3. ABC analysis of inventories for raw materials and consumables is an
excellent device to devote focused attention to high-value inventories.
This method works on the Pareto (80/20) principle which states that 20%
of the number of items in the list of inventories accounts for 80% of the
inventory value, and so high-value inventory items should always be on
the radar.
4. Just-in-time (JIT) system, two-bin system, perpetual inventory and
continual verification are some time-honoured methods used by good
companies in controlling inventory.
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5. Control over finished inventory is a different matter altogether. The key

here is production planning that is sensitive to the market requirement. If
these two parameters are not in sync, the result is either huge unsold
inventories or excessive dumping in the market as sales that will not be
collected. Product life cycle, obsolescence cycle and extended value
chain are some good ploys in controlling finished inventories.
6. Work in process and inventories of stores and spares can be technically
derived from the production plan and this should be done.
12.5.3 Management of receivables
Receivables are a crucial resource deployed by businesses to drive up
volumes, and become particularly important in sales to the trade, that is
sales to intermediaries who sell to the end customer. A few important dos
and donts in managing receivables are listed below.
1. As competition intensifies, the Sales function increasingly looks at trade
credit as a method to boost sales. This is fine as long as the company
has a tight credit policy effectively administered.
2. The sales decision should necessarily build in the cost of credit and the
likelihood of bad debt. Receivables control and Sales cannot and should
not operate in silos but work together.
3. Customer profitability review must include payment history as a metric
and performance on this yardstick should be rewarded or punished.
4. Ratio analysis, ageing and other analytical tools must be used regularly
and standards for key ratios strictly enforced. Customer despatch
embargo, managerial appraisals, expense restrictions on sales branches
with levels of receivables that are not acceptable etc. are strong
methods worth trying.
12.5.4 Management of other working assets
Other working assets typically are:
Prepayments
Deposits and advances
Tax deductions at source (TDS)
Claims receivable
Companies tend to ignore this group of assets as small but it would surprise
many to know that these account for 16-20% of total working capital. What
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is even more significant is that most of these have little cash value. Claims
for example are often disputed and after much effort in vain written off.
Control over other current assets can be improved with the following ideas.
1. The key to controlling other working assets is nipping in the bud. Find
avenues to stagger payment, for instance, if a vendor insists on advance
being paid. Or in case of claims negotiate and get the claim accepted,
and close the issue. Bargain for the lowest deposit in agreements like
rentals, to reduce the amount blocked.
2. TDS: Tax withholding by customers on sales invoices payable to the firm
is a major working asset for the service industry. If the company is
making profits this is cashed regularly while paying advance income tax.
But if it is not, the amount can be cashed only when assessments are
completed and refunds obtained. The other snag in TDS is perfection in
the documentation. The quarterly filing should be done accurately and
before due date.
3. Accounting methods and systems have a significant part to play in
precise valuation of other current assets. This is considered a safe
haven by some who would like to postpone the recording of expenses.
They quietly create this asset item and post the expense here, to reckon
it later when they choose to. This practice can be curbed by proper
accounting controls and constant watch on the items grouped and
reported as other current assets.
12.5.5 Management of cash
In unit 6 we covered liquidity management elaborately; and managing cash
balances properly is the essence of liquidity. Cash here means cash and
cash equivalents viz. bank balances, short-term investments and deposits
with banks that can be cashed on demand.
Cash can be held in idle form for three reasons: transaction, precaution and
speculation.
While online payments are becoming popular, a large number of
transactions are closed only by writing out a cheque or paying cash.
This necessitates keeping cash (transaction motive).
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Likewise as a precaution we need to keep idle cash in case of a sudden

bank strike or a technical glitch that prevents online banking (precaution
motive)
It is possible to treat cash, especially in foreign currency, as investment
that could appreciate, and hold balances that will give higher returns
later (speculation motive). This is not done normally, as the purpose of
the business is something else altogether not trading in currency.
Assessment of the cash balances to be kept and making sure that actual
cash balance is within a small band around the estimate is a crucial task of
every Treasury Manager.
9. Every company should quantify its _______________ and broadly
know the amount of capital that will be required.
10. ABC analysis of finished goods inventories is an excellent device to
devote focused attention to high-value inventories. (True/false)
11. ___________, ______ and other analytical tools must be used
regularly
12. Accounting methods have no role to play in working capital
management. (True / false)
13. Idle cash can be held for three reasons. What are these?
12.6 Financing of Working Capital

In the previous sections we spoke about the need to plan, organise and
control the working assets for the business and ensure availability of these
assets in the right values and right mix. Once an enterprise has decided the
amount of working capital required, the next step is to fund it i.e. get the
money required for investing in the working assets. This is the subject of
working capital financing.
Working capital can be financed in two ways:
1. Spontaneous or business financing
2. Planned or lender financing
12.6.1 Spontaneous financing of working assets
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The first source for funding working assets is the business itself. Just as the
customers demand credit and so the firm invests in receivables, it can also
demand credit from its vendors. This source of finance is trade payables.
Similarly for expenses incurred by the company it can get postponement of
payment in the form of expense payables. For example the salaries for the
full month of work are paid to employees by 6th of the next month. Service
bills like power, phones, water etc. are received at the end of the month and
the due date is 15th of the next month. This is one more source of financing
working capital.
These deferments of payment, labelled current liabilities in the balance
sheet, make up the spontaneous financing of working assets. A company
should first look for such funding before seeking external finance for its
working capital.
Customer advances are again a major source of working capital finance in
certain businesses like construction and job order execution. It is normal for
a builder to take advance from the client after signing the order and make
running bills from time to time and getting money based on percentage of
completion.
Gross and net working capital: Another way to look at spontaneous
funding is that the gross working capital of the business, comprising its
current assets, is to be netted with current liabilities and the net working
capital arrived at. This net amount is to be funded from outside, in the form
of planned or lender financing.
One question about spontaneous financing: is this interest free funding, or is
there a cost to it? The answer is that while current liabilities are an easy way
of financing working capital, they are by no means free. Thus, a company
that pays on receipt of goods can expect a lower price than one that pays
after 30 days: the price difference is the cost of trade credit, really.
It is also to be remembered that each industry has established norms for
funding with payables, and except under unusual circumstances these
practices cannot be changed. These are the limits to spontaneous funding.
12.6.2 Planned or lender financing of working capital
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As stated above, the net working capital of the business i.e. current assets
minus current liabilities is to be financed by external sources of finance. The
most prolific source of working capital finance is bank credit in the form of
cash credit overdrafts.
How does a bank cash credit work?
A company prepares its estimate of net working capital and applies to a
bank for an overdraft limit against the prime security of its inventories and
trade receivables. The bank examines the application, checks the creditworthiness of the party and the collaterals offered, and sanctions the limit for
a maximum term of one year, to be renewed annually. The overdraft limit is
set into the bank account, and the company can make payments up to the
limit.
Some important features of this arrangement are:
The bank lends against the value of inventories and receivables, less
current liabilities and after deducting a margin that depends upon the
quality of these assets. See the illustration below to understand how this
works.
The margin has two facets: it recognises the fact that a part of the
funding has to be done by the owner; and it also reflects the fact that
while working capital is always moving and current, a sizeable part of it
in value terms is permanent and will always be there as long as the
business is being done at a certain minimum volume. This part can
therefore be financed by a long-term source, which is the owners equity.
The bank credit in theory is repayable on demand. That is, even though
the limit is sanctioned for a year, at any time the bank can demand it
back and the company is obliged to pay the amount overdrawn.
The interest is charged only on the overdrawn balance and not on the
full limit. The daily balances of the overdraft account are used to
compute the interest. There may sometimes be a small commitment
charge on the un-drawn limit if it is seen that the utilisation is distinctly
below the limit.
The limit will be reviewed every month and adjusted in line with the
value of inventories and receivables held by the business. If the values
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go up there will be no change in the sanctioned limits, because the limits

are fixed only once a year.
Illustration
Keerthi Ltd has inventories ` 150 lakh and receivables ` 220 lakh. Its trade
payables are ` 70 lakh. The bank decides a margin of 25% on trade
receivables and 30% on inventories. What is the maximum overdraft amount
the bank will sanction to Keerthi Ltd?
Answer
The maximum overdraft limit possible is worked out and shown in Table
12.4.
Table 12.4
Asset
Value
Margin
Net Value
` Lakh
` lakh
` lakh
Inventories
150
45
105
Receivables
220
55
165
Total
270
Less payables
70
Net overdraft
limit possible
200
Table 12.4: maximum overdraft limit possible
Bank financing of working capital has taken many variations over the last
two decades, and especially in niche areas like exports and small-scale
industries, innovations like bill discounting, packing credit, post-shipment
credit, factoring and securitisation have come up.
Activity 2:
Download a soft copy or get a hard copy of a typical working capital
finance application by a company to its bank, and the sanction letter and
attachments issued by the bank. Study the whole set and make a paper
on its main contents.
Hint: working capital finance application and agreement are a mix of
financial analysis, legal terms and reporting requirements. This is a must
for augmenting your learning of Finance. Refer to section 12.6.2.
Page No. 238
Self
14.
15.
16.
Unit 12
What are the two basic methods of financing working capital?
The interest is charged on the full overdraft limit. (True/false)
Customer advance is a major source of spontaneous financing of
working capital in certain industries. (True/false)
12.7 The role of Treasury in working capital

The Treasury function of a company plays a key role in working capital. The
interface between treasury and working capital management can be seen in
the following aspects.
1. Cash balance, a significant component of working capital, is entirely in
the hands of Treasury. As we have seen above, deciding the optimum
cash balance and maintaining the actual balance at that level is a key
requirement of good working capital management. Especially when cash
is held in foreign currencies this becomes a technical matter and needs
a treasury managers expertise.
2. Treasury highlights hidden problems in working assets like pipeline
funds. For instance, a customer payment may take a week to get into
the bank and become usable. This will not be apparent from a balance
sheet but will be brought up by Treasury and can be resolved. Banks,
acting as the Treasury arm of corporate India, has played a major role in
reducing pipeline cash through cash management systems that make
cash available almost in real time though it is collected in a different
place, even a different country.
3. Foreseeing spikes and troughs in working asset balances and planning
for the same is an integral part of Treasury function. This calls for special
skills and precise information management. Particularly in seasonal
businesses, the variations are prominent and can cause great liquidity
hardships. Treasury assists managements in such situations to monitor
the ups and downs of assets like inventories and receivables, and
identify which part of the variation is acceptable and which has to be
attacked and resolved.
4. Current assets and liabilities in foreign currency pose a challenge to the
Treasury Head in terms of protection against adverse changes.
Monetary assets in foreign currency viz. cash and bank balances,
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receivables and investments, as well as monetary liabilities viz. import

payables, foreign currency loans and other liabilities to be repaid in forex
pose a threat to the bottom line in view of the volatility of the currencies.
Treasury helps in defining the risk more precisely and suggesting action
that can be taken to cope with the risk.
17. ___________, a significant component of working capital, is entirely in
the hands of Treasury.
18. Foreseeing ______ and _____ in working asset balances and planning
for the same is an integral part of Treasury function.
19. Variations in working asset balances are significant in seasonal
businesses. (True / false)
12.8 Summary
Working capital is the money invested in the day-to-day operations of a

business in the form of working assets also known as current assets.
Working capital should not be confused with working capital finance,
which is funding or getting money for the investment in working assets.
Efficient management of working capital is crucial both to liquidity and
profitability of a business.
Working capital is comprised of receivables, inventories, cash balances
and other current assets like advances, deposits, prepayments and
claims. The age of a current asset is its most important quality: the older
a receivable, the lesser are chances of its recoverability.
Working capital management should therefore be always focused on
keeping the assets moving and current.
The operating cash cycle is an important concept, and consists of
estimating the period of time for which each current asset remains
invested till it moves to the next stage. The total cycle time indicates the
extent to which the company has to invest in working capital.
Financing of working capital is done first with credits generated from the
business itself, in the form of trade payable, customer advances and
other current liabilities. This is called spontaneous financing.
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The net amount to be financed after deducting current liabilities from

current assets is called net working capital. Bank finance in the form of
cash credit overdraft is the best-known method of financing of the net
working capital, called planned financing.
Bank credit for working capital is sanctioned based on application by the
company, for periods up to one year (renewable). The amount depends
upon the business profitability, the value and quality of the current
assets, the margin required from the company, the current liabilities and
the collaterals offered.
Treasury plays a key role in working capital, and is directly and indirectly
involved in making sure that liquidity is taken care of with efficient
handling of working capital investment and financing.
12.9 Glossary
Net working capital: Current or working assets minus current liabilities
Cash credit overdraft: An overdraft limit set up by bank based on

current assets pledged
Margin: Portion of working capital to be funded by own capital
Customer advances:
Advance amounts received from customers
pending shipment of their orders

1. What is working capital? Why does a business need working capital?
2. Describe the operating cash cycle for a pharmaceutical company
making and selling tablets and syrups.
3. What steps will you to take for efficiently managing inventories?
4. How is ageing and age analysis done for trade receivables? Explain with
an example. Why is it useful?
5. Accounting methods and systems have a significant part to play in
precise valuation of other current assets. Explain this with an example.
6. Explain the process of getting bank finance for working capital.
12.11 Answers
Page No. 241
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
Unit 12
Current assets
False. These are known as trade receivables
Idle, spot payments
False. It becomes inventory for the next day.
Survival, growth
True
Increasing
Longer
Operating cash cycle
True
Ratio analysis, ageing
False. Accounting methods are relevant in working capital
management as working assets are valued using these methods, and
valuation is the first step in management.
Transaction, precaution and speculation
Spontaneous financing, and planned financing
False. Interest is charged only on the daily balances of the amount
overdrawn.
True
Cash balance
Spikes, troughs
True
Terminal Questions
1. Working capital is the money invested in the working assets of a
business. Working capital is essential for growing business volumes and
to provide short-term liquidity. Refer to Section 12.2.
2. The operating cash cycle of a pharmaceutical company making and
selling syrups and tablets will comprise inventories of materials, work in
process and finished goods, receivables from distributors and
government hospitals, and other current assets like deposits, advances
and claims. Refer to Section 12.4.
3. Foe effective management of inventories systems to be followed include
ageing reviews of inventories, ABC analysis, JIT methods, production
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planning, and proper layout and process controls. Refer to Section

12.5.2.
4. Ageing of receivables is done using a frequency distribution model in
which receivables are grouped into a few frequencies like not due,
0-30 days due, 31-60 days due, 61-90 days due and more than 90
days due. Collections and movement of the receivables are tracked in
these frequency groups and overall receivables ratio and level are
thereby controlled. Refer to Section 12.5.
5. Against an advance paid to a service-provider, service has already been
received but not accounted. The amount will continue to show as a
current asset but in reality it is to be expensed. This is an example of
how accounting is relevant to managing other current assets. Refer to
section 12.5.4.
6. For securing bank finance for working capital a company has to first
ascertain its investment in working assets and the extent to which this is
met by working liabilities like trade payables. The company then applies
for the bank limits for the working capital needed, using the formats
provided by the banks. Refer to section 12.6.
12.12 Case Study

Sachin Ltd
Sachin Ltd is commencing a new project for manufacture of a plastic
component. The cost information given below has been ascertained for
annual production of 12,000 units, which is the full capacity.
Cost components
Cost per unit (`)
Materials
40
Direct labour and variable expenses
20
Fixed manufacturing expenses
Depreciation
10
Fixed administrative expenses
Total
80
The selling price per unit is expected to be ` 96 and the selling expenses
would be ` 5 per unit. Eighty per cent of the selling expenses are variable. In
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the first two years of operations, production and sales are expected to be as
shown below:
Year
Production (Units)
Sales (units)
6,000
5,000
9,000
8,500
To assess the working capital requirements, the following additional

information is available:
Stock of materials 2.25 months' average consumption; work-in-process
nil; debtors, one month's average sales; Cash balance ` 10,000; creditors
for supply of materials one month's average purchase during the year;
creditors for expenses one month's average of all expenses during the
year.
1. Prepare for the two years:
the projected statement of profit/loss (ignoring taxation); and
the projected statement of working capital requirements
2. Analyse and comment upon the statement in terms of the key issues
facing Sachin Ltd in working capital management.
Hints: Estimate working capital based on the volume of activity that is
relevant to the working asset. So raw material inventory will be based on
purchase, finished goods inventory on production, and receivables on
sales.
The answers are:
1. The projected results for year 1: loss of ` 0.02 lakh, and year 2: profit of `
0.55 lakh.
Projected net working capital requirements are Year 1: ` 138,583 and
year 2: ` 209,792.
References:
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Unit 12
Brealey, R. A., Myers, S. C., & Allen, F. (2007). Principles of Corporate

Finance. New York: McGraw Hill, Chapter 30.
Jakhotiya, G. P. (2011). Strategic Financial Management (2nd edition).

New Delhi: Vikas Publishing House.
Pandey, I. M. (2010). Financial Management (10th edition). New Delhi:

Vikas Publishing House, Chapter 27.
Page No. 245
Unit 13
Unit 13
Structure:
13.1 Introduction
Objectives
13.2 Treasury Risk Management
Practices
Policies
Tools derivative products
Exposure controls
13.3 Treasury Functions and Associated Risks
13.4 Treasury Management Organisation
Treasury organisation vis--vis risk management
The evolving Treasury organisation
13.5 Market Risk Management Policy
13.6 Treasury and Asset Liability Management
13.7 Summary
13.8 Glossary
13.10 Answers
13.11 Case Study
13.1 Introduction
In the previous unit, we learnt about the relevance of working capital
management to the Treasury function, and reviewed the ways and means to
keep working capital under control and finance it sensibly.
This unit covers treasury risk management. In separate units we have
discussed earlier business risks, financial risks interest rate risks, forex risks
and liquidity risks. This unit summarises the various components in treasury
risk management, treasury management organisation and market risk
management policy.
Objectives:
explain the perspective of treasury risk management
explain treasury functions and the associated risks
explain different types of treasury risks
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discuss treasury risk management in practice and describe treasury and

asset liability management
13.2 Treasury Risk Management the perspective

Business entities, especially banks utilise various financial instruments and
deal with a multitude of counterparties. All these transactions include the
risk that the counterparty may fail to meet its commitments. This is the
essence of what we term treasury risk. In other words the risk in carrying a
host of treasury products and coping with the volatility of each of them is
studied under the title of treasury risk.
Treasury risk management requires certain practices, policies and tools,
besides controls through systems and precise reporting, to control these
risks.
13.2.1 Practices
Treasury management practices are deployed by companies to achieve the
policies and objectives of its treasury management policies. Treasury
management practices consist of the following steps:
Deciding the approaches for managing risks
Analysing and decision-making
Approving instruments, methods and techniques
13.2.2 Policies
The policy guidelines approved by the board will govern the investment
activities of the Treasury. Formulating policies provides a framework to
protect cash flows in the organisation and depends on the organisations
risk tolerance levels. The objectives of formulations policies are as follows:
Managing financing and financial exposures while assigning specific
responsibilities to appropriate business units.
Diversifying funding sources across diverse operational and other
requirements, with special treatment to project finance
13.2.3 Tools Derivative products
A derivative product is a financial instrument that derives its value from one
or more underlying assets. The asset could be traded in financial markets
like forex, bonds, equities and commodity markets.
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An entitys risk management policy should indicate the acceptable derivative

products that can be used by the business. The policy should also specify
whether the derivative products should be purchased or can also be
sold.The scope with derivative products is limited in case of companies not
in banking or non-banking finance areas.
Risk management of treasury assets and liabilities is often done through
derivative contracts. Interest Rate Swaps are the most commonly used
derivative instrument for managing interest rate risks. Traders meaning
bankers and authorised forex dealers use many option strategies to
manage risks as also to maximize earnings.
13.2.4 Exposure controls
Risk arises due to exposure and volatility. Volatility cannot be managed and
hence the risk management in treasury functions concentrates on exposure
management. Monitoring exposures through well-timed reporting of different
risk factors and transactions provides information that can be utilised to
assess risks.
This reporting is useful but does not provide an assurance of preventing
loss. Some of the controls that are used for effective risk management in
Treasury are:
In general:
Counterparty limits Depending on the counterpartys financial position
and rating, limits are pre-set on approved counterparties. Dealers are
not expected to take exposure beyond the approved limits. This will
minimize the counterparty risk.
Broker limits Not more than 5% of the business is to be carried out
with one broker; this is to ensure that some brokers are not favoured
and to prevent closeness of dealers with certain brokers which may lead
to risks.
Internal controls on exposure to a party based on credit and other
exposures
With particular reference to banks:
Limits on deal size
Limits on open position
Stop loss limits
Gap limits in forward position
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Activity 1:
Consider you are the CEO of a company. What treasury policies would
you authorize to handle financial risks?
(Hint: Please refer to section 13.2)
1. Treasury management practices start with deciding the
for
managing risks.
2. Formulating
provides a framework to handle risks.
3. A derivative product is a financial product that does not derive its value
from one or more underlying assets. (True/False)
13.3 Treasury Functions and Associated Risks

The basic function of treasury management is sourcing of equity and debt
capital, managing the use of the capital and investing surplus funds.
Treasury is expected to make funds available when required to support the
business. It is a key function that allows business managers to concentrate
on the business without worrying about where the cash will come from.
The functions of treasury management are:
Deciding and designing the policy framework for treasury functions, risk
and exposures this is the planning aspect of the function, where the
boundaries within which treasury exposure should be restricted are
drawn, and the policies sketched out for ensuring these boundaries are
not crossed.
Risk evaluation and compliance Risk measurement and management
concentrates on providing a systematic approach to control risk in
portfolio management. It provides an independent evaluation of the
market risks considered across several treasury businesses. Periodic
risk measurement and evaluation is done to decide if the limits set for
exposure need review and revision. Finally good compliance reporting is
important to ensure that the treasury function is seen to be acting in the
best interests of the company.
Day-to-day operations Handling treasury operational functions has
become more complicated due to the changes in the financial markets,
regulatory requirement and technological upgrades. Treasury has to be
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in sync with the times and delays and holdups do not spoil their record
despite excellent policies and systems.
Risks of the treasury function
Risks are majorly associated with banking organisations whose primary
function is to leverage the funds available for profit-making. While this is not
so for a product or service company not in banking business, risk
automatically becomes significant when leveraging takes place. The risks
common to Treasury functions are listed below. As we have covered these
in detail in earlier units we will not elaborate.
Interest rate risk
Forex risk
Liquidity risk
Default risk
Credit risk
Personnel risk
Environmental risk
Besides these risks applicable to all entities managing the treasury, banks
and financial institutions also have market risk which is relatively less
relevant for a non-banking enterprise. Market risk refers to the vulnerability
of the financial assets of a bank to capital market movements, both debt and
equity.
4.
is responsible to make the funds available when they
are required to support the business.
5. Market risk refers to the rise or fall in the market for a companys
products. (True/False)
6. Treasury risks do not matter very much to the Treasury of a product
company but are material only for a company in banking and finance
business. (True/false)
13.4 Treasury Management Organisation

We have covered in detail the subject of treasury organisation and you are
advised to go back to that unit for a quick refresher (section 1.6).
We will deal with two aspects of treasury organisation, which are important
for the subject of this unit viz. treasury risk management. The aspects are
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Unit 13
1. Organisational parameters of risk management

2. Evolution of the function and resultant changes in the organisational
format
13.4.1 Treasury organisation vis--vis risk management
We will first discuss treasury organisation from the standpoint of risk and
risk management.
The risk element in treasury function is influenced by two decisions relating
to the organisation of that function. These decisions are:
a. Will the function be treated as a profit centre or a cost centre?
b. Will the function be centralised or decentralised?
Cost centre v. profit centre: Treasury is regarded as a cost centre in a
company where it performs the fundraising, money management and the
related functions only*. The profit that may be brought in by Treasury on
investment of surplus cash will be a small source of income and so will not
get highlighted.
*: In such companies also a profit element is sometimes introduced by
charging to the operating divisions,interest on funds used by them on
transfer pricing basis.
In a company where treasury is given the position of a profit centre, there
will presumably be large cash surpluses that need to be parked all through
the year; and a large part of the companys retained earnings may also be in
the form of cash needing to be invested for good returns. The profit from the
Treasury operations becomes a specific target.
Evidently, the risk element of the latter organisation will be distinctly higher
than that of the former. Apart from liquidity, default, forex and credit risks
which will be common to both organisation formatsthe profit centre format
will have additionally market risk and interest rate risk.
Consequently the Treasury Head of the profit centre organisation will need
to be more of an expert in the money market, financial instruments, hedging
and investment analysis.
Centralised and decentralised structure: The issue of risk with respect to
centralised and decentralised treasury has to be discussed primarily in case
of multinational businesses that operate in several geographies.
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The risk component of treasury operation goes up when the company

delegates more and more of its treasury work. This is because decisions will
be taken by a multitude of managers and there could be conflict of interests.
A fully centralised treasury however has a different kind of risk viz. the delay
or failure to appreciate local requirements in distant branches of the
company. This is why it is sometimes said that central control is riskier for a
global corporation.
This brings us to the other dimension of treasury organisation i.e. its
evolution over the last 15 years.
13.4.2 The evolving Treasury organisation
A more advanced treasury organisation format has evolved in the past
decade in which the management requires Treasury to focus on corporatewide cash flow. The modern treasury organisation studies the statement of
cash flowsin the light of global business and has redefined the concept of
optimal liquidity irrespective of the different places from which the business
operates.
It is now important to evaluate the relationship between organisation models
and operational factors and ensure compatibility of the models with the
organisational situations.
Organisations must select treasury organisation models based on their
operations, irrespective of their underlying business. The most important
factors in deciding the treasury organisation model would be the range of
activities covered by the treasury and the extent of centralisation of
management control. Four main service models can be opted based on
these models. They are full service global, full service local, limited service
global and limited service local.
Treasury in an organisation focuses on the financial strategy, cash
management, capital market funding, tax management and international
financial activities of the firm. Multinational firms which usually have foreign
subsidiaries ensure that these are managed at the regional level for day-today activities and control them at policy level.
Regional treasuries are an intermediary step between the barely staffed
foreign affiliate and the central Treasury.
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Unit 13

7. Modern treasury organisation concentrates on the statement of
.
8. Organisations must select treasury organisation models based on their
operations, irrespective of their underlying business. (True/False)
9.
are always required as an intermediary step between
the barely staffed foreign affiliate and the central Treasury.
13.5 Market Risk Management Policy

Market risk is the risk which arises from unfavourable fluctuations in
financial asset prices, both domestic and international. The major elements
of market risk are interest rate risk, equity risk, commodities risk and
currency risk.
The growth and establishment of market risk management is very significant
for the reliability of the companys treasury risk management policies and
practices. A few policies that are typically used are:
Marking to market It refers to the (re)pricing of the portfolio in order to

reflect changes in asset prices on a monthly basis. In the case of bank,
however, price positions of the trading portfolio should be analysed and
marked to market daily.
Marking to market policy should also address the pricing responsibility

and the method used to determine the new market price of an asset.
The policy of risk management should specify the determined prices and
the officers who are independent of the respective dealers and
managers should execute the marking to market.
Position limits A market risk management policy must provide limits

and monitor the positions in markets and products with constant
consideration of liquidity risk that could arise from implementation of
unrealised transactions.
Stop-loss provisions Market risk management policy should also

contain stop-loss sale or consultation requirements that relate to a
predetermined risk budget. The stop-loss exposure limit should be
established with regard to the capital structure, trends of earning and
overall risk profile.
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New market presence limits Financial innovations like new markets or

instrumentsinvolve profits which are higher than those from standard
instruments. In a highly competitive market innovation pressurises
competitors to make profits or sustain the presence in market by
engaging in new businesses. Of course it has to be noted that the risk
element of innovations is high and unique.

10. Market risk is the risk arising from
in
market prices.
11. A market risk policy should provide limits and monitoring of positions.
(True / false)
12. Liquidity risk could arise from unrealised transactions. (True/False)
13.6 Treasury and Asset Liability Management (ALM)

The relationship between treasury and ALM is as follows:
The balance sheet of a bank contains business assets, financed by

equity and debt capital. Corporate Treasury on the other hand operates
in financial markets; and connecting the financial assets and liabilities of
core business with market operations is the responsibility of treasury.
Treasury deals in forex and securities markets and can create

alternative financial and forex instruments that enhance the financial
value of the company while keeping risks and losses down.
Many business assets and liabilities can be replaced with treasury

products for lower costs or better gains. For example, working capital
borrowing is supplemented by commercial papers at lower interest cost.
Risk management is an essential job of treasury and asset/liability

management is a distinct part of this job.
Activity 2:
Take 3 instances of business situations that require deft handling of
asset/liability mismatch by Treasury, and in each case write what
treasury can do to solve the problem.
Hint: The cases could be a) large loan repayment coinciding with delay
in receipt of a large trade receivable; b) conversion of portion of overdraft
to a term loan and subsequent inflow of cash from current assets making
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Unit 13
overdraft utilisation negative; and c) locking up customer advances in

payment towards fixed assets. Treasury should try looking at money
market instruments as an option, or postponing the occurrence by talk
with the concerned stakeholder like the bank or customer.
13. What provides a detailed report of asset and liabilities in the
organisation?
14. Business liabilities cannot be replaced with treasury products
(True/False)
13.7 Summary
Treasury risk management requires certain practices, policies and tools,

besides controls through systems and precise reporting, to control
treasury risks.
Treasury management practices are deployed by companiesto achieve

the policies and objectives of its treasury management policies.
Formulating policies provides a framework to protect cash flows in the

organisation and depends on the organisations risk tolerance levels.
An entitys risk management policy should indicate the acceptable

derivative products.The scope with derivative products is limited in case
of companies not in banking or non-banking finance areas.
The basic function of treasury management is sourcing of equity and

debt capital, managing the use of the capital and investing surplus
funds. Treasury is expected to make funds available when required to
support the business.
The functions of treasury management are launching the overall policy

framework, market activities, risk evaluation &compliance and day-today operations.
Treasury in an organisation focuses on the financial strategy, cash

management, capital market funding, tax management and international
financial activities of the firm.
Market risk is the risk which arises from unfavourable fluctuations in

financial asset prices, both domestic and international.
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Unit 13
A market risk management policy must provide limits and monitoring of

positions in markets and products with constant consideration of liquidity
risk that could arise from implementation of unrealised transactions.
The balance sheet of a bank contains business assets, financed by
equity and debt capital. Treasury on the other hand operates in financial
markets; and connecting the financial assets and liabilities of core
business with market operations is the responsibility of treasury.
13.8 Glossary
Cumulative: The sum-total
Delegate: Authority given to an individual handed down to a lower level

in the hierarchy
Fluctuations: Change in both directions
Obligations: Mandatory actions or payments required of someone

1. What are the functions of treasury management?
2. Describe the risks associated with treasury functions.
3. How is treasury management organisation relevant for management of
treasury risks?
4. Illustrate the issues that need to be considered while developing market
risk management policies.
13.10 Answers
Self
1.
2.
3.
4.
5.
6.
7.
8.
9.
Approaches
Policies
False. A derivative products value is based on the value of the
underlying asset.
Treasury functions
True
True
Cash flows
True
Regional treasuries
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10.
11.
12.
13.
14.
Unit 13
Unfavourable conditions and fluctuations

True.
True
Balance sheet
False. Treasury often uses its expertise to replace assets or liabilities
to increase returns or lower costs.
Terminal Questions
1. The basic function of treasury management is sourcing of equity and
debt capital, managing the use of the capital and investing surplus
funds. Treasury is expected to make funds available when required to
support the business.Refer to section 13.2.
2. The risks associated with treasury are interest rate risk, forex risk and
liquidity risk. Refer to section 13.3.
3. Two aspects of treasury organisation which are important for treasury
risk management are organisational parameters of risk management
and the evolution of the function and resultant changes in the
organisational format. Refer to section 13.4.
4. Market risk is the risk arising from unfavourable fluctuations in market
prices. Refer to section 13.5.
5. The objective of ALM is to achieve perfect match in assets and liabilities.
The match is related to the changes in the present value of assets and
liabilities. Refer to section 13.6.
13.11 Case Study

Managing corporate treasury risks: G Inc. and Wells Fargo Bank
Wells Fargo is a major player in the field of treasury management; and apart
from being a regular banker their services extend to advisory for corporates
in mitigating treasury risks.
G Inc. is a global corporate with exposure to several types of treasury risks.
Corporates have to cope with three major treasury risks:
Supply chain finance risk
Forex risk
Interest rate risk
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Wells Fargo Bank has been approached by G Inc. a company that needs
help in all the three areas. The banks domain expert offers solutions that
are described below.
1. Supply chain financial risk: From time to time G Inc. faces the
situation that money gets blocked in the supply chain and each time this
happens there is a cascading effect on the liquidity and even default risk
results at times.
Wells Fargos recommendation: Supply chain finance affords the
opportunity to extend payment terms but gives the trading partners
attractive financing through early payment discounts. There are straight
receivables sales programs that can mitigate risk of large concentrations
of sales with the particular businesses, and there are channel finance
structures that can actually increase sales and market share by injecting
liquidity into the supply chain.
There should also be more interest shown by buyers and sellers in
working together to lower risk of illiquidity across the supply chain, and
adding visibility so that all partners have additional information with
which to make decisions.
Best practices:
Understanding the needs of your trading partners
Understanding what the competition does across the cash
conversion cycle and how you measure up
Looking at ways to get paid sooner without harming business
arrangements
Making subtle changes to your business model that can perhaps
increase sales
2. Forex risk: G Inc. has large exposure in US$ thanks to purchase of key
raw materials in that currency, while its sales are mostly in euros. G Inc.
in consequence has to absorb unrealized and realized losses through
change in forex rates.
Wells Fargos recommendation: Forex risk is a major component of
overall cash flow. When currencies are moving by 15 to 25% a year, it's
very difficult for treasurers and cash managers to understand what's
going to be at their disposal.
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Three things are important to your company:

Achieving stability and predictability of earnings: This is the number
one financial goal you have, and the volatility of forex can undermine
this objective.
Having good and clear data that allows you to analyze on a timely
basis and make the appropriate hedging decisions in order to
achieve that stability and predictability.
Establishing a good, cohesive, comprehensive forex risk
management policy
Some of the best practices that we would recommend would be:
Centralizing forex risk management into one location to achieve the
benefits of consolidation and economies of scale
Making sure you have a well-articulated philosophy around risk and
a tight plan
Summary Understand your objectives, figure out what you need to do,
and stick to your plan.
3. Interest rate risk: G Inc. is conscious of a likely upward movement of
interest rates that have remained flat for over 4 years and wants to make
sure the bottom line does not get unduly affected if it happens.
Wells Fargos recommendation: The key point is to be proactive
versus reactive.
Three approaches are recommended:
Use predictive models: Looking forward to the future, be prepared for
rising rates. By looking at where these rates are projected to go in
some of the models that you may have internally, it will definitely
assist you in terms of getting yourself better prepared for the future.
Review credit exposure: Credit ratings have impacted the economy
in terms of risk and exposure to other counterparties. As we look at
all of the business we do with others throughout the industry, it's
important we understand how well those other institutions are
performing.
Adopt a holistic approach: Take a holistic view of where your
organization stands today, looking at the balance sheet, looking at
your investments, your credit, any exposures you have, and
determine where you want to be down the road.
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1. What are G Inc.s issues with regard to the three Treasury risks?
Hint: Supply chain risk has a cascading effect on liquidity. Forex risk is a
mismatch of US dollar outflows and euro inflows. Interest rate risk is the
likelihood of increase in rates that have stayed relatively unchanged for
a long time.
2. Where does Wells Fargos advice fit into each of the situations?
Hint: Supply chain risk: extending the supply chain to work with trading
partners for earlier and more accurate prediction of inflows and outflows
Forex risk: A well-etched forex management policy with a centralized
approach
Interest risk: Proactive handling of the likely interest rate movement, with
a good amount of fundamental analysis of the balance sheet and
technical analysis of debt market
3. Write in your own words how G Inc. should utilize the ideas given by
Wells Fargo.
Hint: Imagine real-life problems in each risk and adapt the advice of
Wells Fargo into a concrete plan for each situation.
References:
Financial Risk and Corporate Treasury: edited by Risk Books
www.riskbooks.com
Corporate Treasury and Cash Management by Robert Cooper (Chapter
2), www.palgraveconnect.com
E-References:
http://accounting-financial-tax.com/2009/06/traditional-and-multinationaltreasury-management/ Retrieved on 15thOct10
http://www.ifc.org/ifcext/treasury.nsf/Content/RiskManagementProducts
Retrieved on 18th Oct10
http://www.citicpacific.com/eng/inv/report/pdf/interim/2009/EWF107.pdf
Retrieved on 19thOct10
http://www.treasurystrategies.com/content/risk-management0?mlid=750&plid=79 Retrieved on 20thOct10
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Unit 14
Unit 14
Integrated Treasury
Structure:
14.1 Introduction
Objectives
14.2 Concepts and benefits
14.3 Process of Globalisation
14.4 Integrated Treasury Operations
Drivers
Expanded scope
14.5 Treasury as a Profit Centre: the pros and cons
14.6 Treasury Products
Forex services
Money products
Securities
14.7 Balance Sheet and Accounting Risks
IAS 32
IAS 39
14.8 Summary
14.9 Glossary
14.11 Answers
14.12 Case Study
14.1 Introduction
We now come to the last unit of the subject of Treasury management. In the
previous unit we focused on treasury risks, and in this unit we discuss one
of the approaches to managing treasury that helps in risk control, viz.
integrated treasury.
Integrated treasury refers to integrating into a single treasury function
money market operations, capital market activity and forex dealings.
These aspects of treasury function have become more interdependent with
the deregulation of interest rates, liberalisation of exchange controls and
development of forex markets. Combining the three activities is also seen to
have a salutary effect on treasury risk control.
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Unit 14
In this unit we explain processes and techniques of integrated treasury

operations. We also analyse treasury as a profit centre and classify treasury
products used across the three domains.
Objectives:
explain the concepts and benefits of integrated treasury
explain the process of globalisation
describe integrated treasury operations
analyse treasury as a profit centre
classify the treasury products
14.2 Concept and Benefits of Integrated Treasury

The concept of integrated treasury works on the principle that Treasury can
be a single unifying force of a companys activities in the money market,
capital market and forex market; and can help the company derive synergy.
Synergy is a powerful advantage in business because it brings together two
or more activity domains and achieves a total effect that is greater than the
sum of all the individual domains.
Thus a decision related to money market instruments, for example, is taken
after reviewing possible forex actions that could enhance the benefit of the
decision.
The Indian rupee is freely convertible on current account and partially
convertible on capital account. This has made it possible to take a combined
approach to a treasury issue.
The major functions of integrated treasury are as follows:
Ensuring liquidity reserve
Deploying surplus funds in securities with low risk and moderate profits
Managing multi-currency operations
Exploring opportunities for profitable placements in money market,
securities market and forex market
Managing the sum total of treasury risks with some balancing actions as
between the three markets
The benefits of integrated treasury are:
Improved cash planning and better monitoring of the cash position
Constant watch on the impact of treasury activities on the balance sheet
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Unit 14
Greater financial control by integrating budgetary control and financial

information

1. Treasury deals with short-term cash. (True/False)
2. Functions of integrated treasury include ___________
___________.
a) Global cash management
b) Swap
c) Securities
d) Risk management
and
14.3 Process of Globalisation

Globalisation can be defined as the process of integrating domestic and
global markets, allowing free currency flow with minimum regulatory
intervention. The flow of money could be for exports and imports,
borrowings, investments, transfer of wealth and individual remittances for a
variety of purposes.
Over the last two decades, most of the emerging market countries have
realised free capital flow is vital for rapid economic growth and have relaxed
rules on foreign capital inflow considerably. Capital flow is multidimensional.
Overseas companies invest in domestic economy and the domestic
companies invert their surplus funds in overseas markets.
Indian government and RBI have reduced exchange controls significantly in
the decade of 1990s. RBI regulates movement of capital through Foreign
Exchange Management Act (FEMA) and related laws.
Since the domestic markets compete with global markets, a new institutional
structure has emerged in India on the lines of institutions in the developed
countries. Clearing Corporation of India Ltd (CCIL), National Securities
Depository Corporation Ltd (NSDL) and credit rating agencies like CRISL
and ICRA have come forward to support the financial markets. These new
institutions have expanded the debt market thereby grading and minimizing
the counterparty risks in the treasury dealings. Institutions like CCIL and
NSDL are comparable to similar global entities across the world.
Page No. 262
Unit 14
The new institutional structure has in turn given rise to the concept of
integrated treasury, by seamless linking of transactions in all the three
markets money, capital and forex.
The impact of globalisation is not only confined to the treasuries in banks
but to all companies with full-fledged treasury function.
3. The interaction between domestic and global market is ___________.
4. CCIL and NSDL have enabled the evolution of the concept of
integrated treasury. (True/False)
5. Globalisation has affected only banks. (True/False)
Activity 1:
Briefly explain at least three actions relating to treasury that have
changed substantially with globalisation.
Hint: Substantial reduction of exchange controls, emergence of
institutions for supporting financial markets in India of international
standard, and seamless linking of money market, capital market and
forex market: these are the 3 major actions resulting from globalisation.
In making the note on each of these three developments refer to the
websites of the institutions named in 14.3
14.4 Integrated Treasury Operations

Most banks and large corporates with sizable treasury exposure classify
their businesses into two segments: treasury operations (investment) and
financial operations (other than treasury). The role of treasury has gained
prominence in the recent years because income from investments has
increased significantly in IT companies with large surplus cash. Moreover,
the decisions on debt capital and raising equity have become multidimensional and Treasury is expected to play a role.
14.4.1 Drivers
During 1990s, various trends emerged in treasury functions. Treasury
activities have undergone radical changes due to adoption of new
technology, review of business operations, electronically linked business
partnering etc. The current integrated treasury drivers are:
Page No. 263
Unit 14
Integrated cash flow management - The analysis of the cash flow helps
an organization estimate the reserve at any point of time vis--vis the
short-term and medium-term cash forecasts. The integrated accounting
system like an enterprise resource planning (ERP) system is able to
show the effect of an ongoing transaction on the cash flow as soon as it
is updated in the system, and this gives Integrated Treasury an excellent
tool to take action far more precisely.
Interest arbitrage Interest arbitrage is defined as transactions in which

two or more financial centres or asset classes are used to make profits
by exploiting their price differences. Companies which have good credit
can borrow money in money market and lend or invest at a higher rate.
Treasury has a choice to borrow in one currency and invest in other
currencies too, to exploit interest arbitrage.
Investment opportunities Treasury can operate in all markets forex,

money and securities. This driver enables Treasury to get the optimal
combination of risk and return.
Risk management Treasury risk management assumes significance

since Treasury is now engaged in profit-oriented activities and so
exposed to market risk and balance sheet management. Market risk
includes interest rate, liquidity, exchange, equity and commodity risks.
14.4.2 Expanded scope

Over the last two decades deregulation of markets has expanded the scope
of integrated treasury. Treasury constantly gets access to the market for
lending, borrowing, trading and investing. It links core activities of the
business with the financial market actions. Treasury with its own trading and
investment activity has developed into a profit centre and its functions have
expanded in scope.
The widened ambit of treasury operations can be seen in the following
activities seen being performed by modern treasury managers.
Meeting reserve requirement Integrated treasury has access to

reserves in several locations that can be deployed. It also has the
responsibility to ensure easy accessibility
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Unit 14
Merchant services The integration of market activities has brought

treasury in direct contact with banks in matters relating to overseas
investments, foreign currency loans and hedging export receivables.
Global cash management The development of financial markets has

facilitated instant payment and settlement systems. Funds can be
transferred easily from security to money market, long-term to short-term
investments and from one currency to another. Integrated treasury can
operate across various sectors.
Managing balance sheet risks: An interesting new role of integrated

Treasury in multinational firms is the responsibility for managing balance
sheet risks. This is primarily the impact, on the capital market and
stockholders, of changes in the reported financial assets and liabilities
on the balance sheet. We discuss this in some detail in the last section
of this unit.

6. Treasury with its own trading and investment activity has developed
into a ___________. Choose the correct answer.
a) Profit centre
b) Cost centre
c) Service centre
d) Loss centre
7. Forex business and investment in securities were two different entities.
(True/False)
8. ___________ is used for transmission of data between customers,
suppliers, and companies
14.5 Treasury as a Profit Centre: Pros and Cons

Treasury makes profit (or loss) in the following operations:
1. Forex transactions
2. Interest on investments in securities
3. Buying and selling of money market instruments
We will see here the impact of these revenue-generating actions of
Treasury.
Interest arbitrage Treasury of a bank has choice of borrowing or lending or
investing in different currencies and market segments. Example - the
Page No. 265
Unit 14
treasury may borrow in USD and lend in Rupee in inter-bank market or vice
versa, depending on the foreign and domestic interest rates. This possibility
does not exist for a corporate, however.
Treasury products Banks sell risk management products and structure
loans to business organisations along with forex services In order to reduce
the interest rate or exchange risk. These can be bought by large
organisations. Example ABC Company buys a forward rate agreement
from the treasury and fixes the interest rate on a commercial paper and they
plan to issue this commercial paper after three months. In order to reduce
the interest cost of the company, the treasury offers currency swap for rupee
credit loan into USD loan.
The advantages of operating treasury as a profit centre than as a cost
centre are:
Individual business units can be charged a market rate for the service
provided, thereby making their operating costs more realistic.
The treasurer is motivated to provide services as economically as

possible to make profits at the market rate.
The disadvantages are:

The profit concept is a temptation to speculate. For example, the
treasurer might swap funds from the currencies that are expected to
depreciate and risk the company cash values.
Management time could be wasted in arguments between Treasury and
business units over the charges for services, distracting the latter from
their main operations.
The additional administrative costs may be excessive.
Self assessment Questions
9. Treasury makes profit (or loss) in the following operations: forex
transactions, interest on investments and money market instruments.
(True/False)
10. Treasuries are exposed to __________.
a) Credit risk
b) Liquidity risk
c) Price risk
d) Market risk
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Unit 14
11. Treasury uses __________ and risk management to control cost of the
funds.
14.6 Treasury Products

Treasury products are the products in the market available to the treasury
for raising and deploying funds for investment, and trading in securities and
forex markets. Treasury products yield returns and manage the mismatches
in the liquidity position.
14.6.1 Forex services
Forex is a market where currencies of various countries are traded. It is the
most liquid market as free currencies such as USD, EURO and other
currencies are instantly bought and sold. Free currencies refer to the
currencies of developed countries. Partially convertible currencies have
limited demand. Some forex products are:
Spot trades Spot refers to payment and receipt of funds in foreign

currencies two working days from the transaction date. Currencies of
various countries are traded in spot centre. Companies typically are
buyers of spot trades.
Forwards Forwards are sales and purchases of a currency at a

specified future date at a rate fixed on a given day. Treasury enters into
forward contracts with banks based on import/export exposure. The
customers enter into forward contract with their respective banks to
cover currency risk. The main purpose of treasury in forward contracts is
to cover the currency risk, but for banks it is a big opportunity to make
profits.
Swaps Swaps refers to an agreement between two parties to

exchange currencies at a certain exchange rate and at a certain time in
future. Swaps are a combination of spot and forward transaction. Swap
is used for funding requirements, limiting risks, overcoming restrictions in
certain markets and balancing portfolios. It also provides financial profit.
Example ABC Company has USD funds, but it is in need of rupees to
invest in commercial papers for three months. The company may enter
into USD/Rupee swap and it sells USD at spot rate .It converts USD
funds into rupee and buys back the USD after 3 months at forward rate.
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Unit 14
The rupee fund on commercial paper has earned interest higher than
the cost of USD funds. This swap results in profit.
Debt capital Though the treasury is not usually involved in sourcing of

debt funds and this is handled by a separate team in Finance, it gets
involved in short-term arrangements like discounting of foreign and
domestic bills, bridge loans or meeting with temporary cash
requirements.
Forex management with EEFC accounts A company with exports and

imports will want to eliminate its forex risk exposure by operating an
EEFC (exchange earners foreign currency) a/c. Remittances received in
foreign currency can be banked in this account and converted at the
option of the company subject to guidelines of RBI implemented by the
bank. The rules updated by RBI* stipulate that 100% forex earnings can
be credited to the EEFC account subject to the condition that the sum
total of the accruals in the account during a calendar month should be
converted into Rupees on or before the last day of the succeeding
calendar month after adjusting for utilization of the balances for
approved purposes or forward commitments. The account balance can
even be sold forward for future delivery and rolled over. This is a good
instrument in Treasurys hands that offers scope both for hedging and
for making a good profit if rupee weakens against the US$.
*: (A. P. (DIR. Series) Circular No. 12, dated July 31, 2012)
14.6.2 Money products

Money market is a short-term market with maturity period less than one
year. The funds are borrowed or lent for a short-term. The money market
products are Treasury Bills (T-bills), Commercial Paper (CPs), Certificate of
Deposit (CDs), repo and bill rediscounting. Almost all these are relevant for
banks and banking companies. Treasuries of companies can float CPs and
make very short-term investment in other instruments. Rediscounting and
repo are purely between banks.
14.6.3 Securities
Securities products form an integral part of integrated treasury. In securities
market investors can buy and sell the products available in the securities
market. Some of the securities products available are:
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Unit 14
Government securities (G-sec) are debt instruments auctioned by RBI

on behalf of the Government of India. Study the FAQ section of RBI
website (http://www.rbi.org.in/scripts/FAQView.aspx?Id=79#3) to know
more on RBIs view on government securities.
Corporate debt issued by other corporates: Since the corporate debt
security paper is issued in demat form and have a credit rating they are
active in the secondary market. Global rating is necessary if the debt
paper is issued in international markets. Treasuries invest on corporate
debt paper because the yields on these bonds are higher than from
government securities. It can invest in Foreign Currency Non-Resident
(FCNR) funds and foreign currency surplus in the global market as per
guidelines approved by the organisation.
Debentures and bonds issued by corporates of private sector: The
interest is received at regular intervals and the principal amount repaid
on maturity. Debentures and bonds are issued in different structures to
enhance the marketability and to reduce the cost of the issue.
Convertible bonds which give option to the bondholder to convert bonds
to common stocks or shares of the issuing company.
Activity 2:
Visit a bank and analyse the various treasury products offered by the
bank to its customers. Identify which of these are suitable for a large
company with cash to invest, and why.
Hint: Refer to 14.6.1 to 14.6.3.
(http://www.axisbank.com/corporate/treasury/moneymarket/moneymarket.asp)

12. Treasury products are used to manage mismatches in liquidity position
and to get returns. (True/False)
13. ___________ refers to an agreement between two parties to exchange
currencies at a certain exchange rate and at a certain time in future.
14. ___________ are debt instruments which are issued by way of auction
by RBI on behalf of the Government of India.
a) Swaps
b) Forwards
c) Convertible bonds
d) Government securities.
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Unit 14
14.7 Balance sheet and Accounting Risks

In this final section of the module on Treasury Management we look at the
balance sheet of a corporation and risks inherent in the reporting of certain
balance sheet figures that Treasury can and should manage.
These risks arise from compliance requirements, primarily with applicable
Accounting Standards. In India the standards are prescribed by the Institute
of Chartered Accountants and elsewhere by expert accounting bodies. With
the move by many countries towards harmonising accounting practices
followed by them, International Accounting Standards Board (IASB) has
been mobilising adoption of a common set of standards across the globe.
International Accounting Standards have been issued by IASB, and in this
section we will briefly deal with a few standards relevant for the treasuryrelated balance sheet figures.
We cover three main pronouncements:
1. Presentation of the financial instruments in the balance sheet (IAS 32)
2. Recognition, classification and valuation of financial assets in the
balance sheet (IAS 39)
3. Valuation of hedges (FAS 33)
While the equivalent Indian standards (AS 30, 31 & 32) have differences in
terminology used and procedural aspects, the purport is similar: to the
extent possible keep the shareholder informed of risks inherent in the
financial assets in the balance sheet, notably derivatives.
14.7.1 IAS 32
IAS 32 deals with the subject of presentation of (the balances in) financial
instruments at the end of the accounting period.
The standard seeks to reach better clarity to readers on the relationship of
the financial instruments issued by the company to its financial position,
performance and cash flows.
A brief commentary on IAS 32 follows.
1. The thrust of the standard is on distinguishing between debt and equity;
and making sure that the company does not report a debt liability as an
equity instrument, by accident or design.
Page No. 270
Unit 14
2. Similarly the income or expense reporting should be in sync with the

classification of the instrument in the balance sheet.
3. The problem occurs mainly with hybrid instruments like convertible
debentures or preference shares. IAS 32 requires specific disclosures in
regard to such instruments.
4. The debt/equity ratio of an entity has relevance for the degree of risk of
the company; and to this extent this standard is crucial.
14.7.2 IAS 39
IAS 39 is one step before IAS 32.While IAS 32 talks about presentation, IAS
39 spells out the standards for recognising and measuring financial liabilities
and some contracts to buy or sell non-financial items.
The rulings in respect of accounting for and valuing financial liabilities are:
1. All financial assets and financial liabilities, including all derivatives and
certain embedded derivatives, must be recognised on the balance
sheet.
2. Financial instruments should be measured, when being acquired or
issued, at fair value on the date of acquisition or issuance, which is
normally the cost.
3. An entity should be consistent in recognising purchases and sales of
securities either at trade date or settlement date. If settlement date is
used, some value changes between trade and settlement dates have to
be measured and recognised while accounting for the purchases and
sales.
4. After initial issuance or acquisition, the question is how the instrument
should be measured and reported at the end of every accounting period
till the disposal of the item.
IAS 39 describes 4 categories into which financial assets have to be
classified.
Assets not held for trading purposes
Held-to-maturity (HTM) investments, such as redeemable preference
shares or debentures
Derivatives (other than those held for hedging) and other such assets
held for trading viz. short-term profits,
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Unit 14
Assets that do not fall into the first three categories: these are known by
the term available-for-sale financial assets. Investments in equities and
in rare cases loans or other receivable assets usually get into this set.
5. The first two classes of assets are valued at amortised cost subject to
the test for impairment. These are largely debt-oriented instruments and
their value depends upon cash flows from them duly amortised. In
addition they are tested for any major drop in value for business or
market reasons, and to that extent reduced in value.
6. Assets in the third category are to be valued using the fair value option
and the difference in value in each period is taken to the P&L a/c.
7. Available-for-sale assets (category 4) are measured at fair value and the
value changes are recognised in equity. These are also tested for
impairment. If an asset in this class cannot be measured reliably using
this basis, it is carried at cost.
16. Compliance with accounting standards has a major risk element in
regard to reporting treasury assets and liabilities on the balance sheet.
(True / false)
17. IAS 32 makes rules on the relationship of the financial instruments
issued by the company to its __________, _________ and
___________.
18. IAS 39 classifies financial assets reported on the balance sheet into
four categories. What are these?
14.8 Summary
Integrated treasury refers to integrating into a single treasury function

money market operations, capital market activity and forex dealings.
The concept of integrated treasury works on the principle that Treasury

can be a single unifying force of a companys activities in the money
market, capital market and forex market; and extract synergistic benefits.
Globalisation can be defined as the process of integrating domestic and

global markets, allowing free currency flow with minimum regulatory
intervention.
The role of treasury has gained prominence in the recent years because
income from investments has increased significantly in IT companies
Page No. 272
Unit 14
with large surplus cash. Moreover, the decisions on debt capital and
raising equity have become multi-dimensional and Treasury is expected
to play a role.
Over the last two decades deregulation of markets has expanded the
scope of integrated treasury. Treasury constantly gets access to the
market for lending, borrowing, trading and investing. It links core
activities of the business with the financial market actions. Treasury with
its own trading and investment activity has developed into a profit centre
and its functions have expanded in scope.
Treasury products are the products in the market available to the

treasury for raising and deploying funds for investment, and trading in
securities and forex markets. Treasury products yield returns and
manage the mismatches in the liquidity position.
There are risks inherent in the balance sheet of a corporation and in the
reporting of certain assets and liabilities, and this risk has to be
managed by Treasury.
Understanding of IAS 32 on presentation, IAS 33 on accounting and

reporting, and FAS 33 on hedging of financial assets and liabilities
should be clearly understood and implemented, to avoid the risk of
wrong reporting and penal action.
14.9 Glossary
Convertible: Ability to alter and use for a different purpose.
Deregulation: Removing national or local government controls on a

business or other activity
Surplus: More than the needed quantity

1.
2.
3.
4.
5.
What are the functions and benefits of integrated treasury?

Describe integrated treasury operations.
Explain the sources of profit for treasury.
Discuss the products of forex service.
Discuss the compliance requirements regarding financial assets and
liabilities under International Accounting Standards.
Page No. 273
Unit 14
14.11 Answers
Self
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
True
a Global cash management and d Risk management
Treasury
True
False. Globalisation has impacted all businesses, not just banks.
a) Profit centre
True
Electronic data transfer
True
d) Market risk
Hedge
True
Swap
d) Government securities
True
Financial position, performance, cash flows
The four categories are not-for-trading, held-to-maturity, derivatives
and available-for-sale.
Terminal Questions
1. The functions of integrated treasury are not restricted to traditional
functions. The major functions of integrated treasury are reserve
management. Refer to section 14.2.
2. Most of the banks in India have classified their business into two
segments. They are treasury operations (investment) and banking
operations (other than treasury). Refer to section 14.4.
3. Treasury departments have different role within an organisation. Profits
for contemporary treasury are generated from a number of sources.
Refer to section 14.5.
4. Forex is a market where currencies of various countries are traded. The
products of forex services are spot trades, swaps. Refer to section 14.6.
5. IAS 32, IAS 39 and FAS 133 cover three important aspects of reporting
the financial assets and liabilities on a balance sheet. Refer to section
14.7.
Page No. 274
Unit 14
14.12 Case Study

Global Cash Management
Global cash management is one of the functions of integrated treasury. ABC
is a Singapore based company and it depends on XYZ bank for its banking
needs. The bank has corporate internet banking channel. The companys
transactions are reported through the XYZ bank. ABC Company wants to
expand its business in India. The company intends to set its head office in
Mumbai and branches in other cities. It chooses XYZ bank for its Indian
office. The company can simultaneously view and manage their accounts
through the internet banking channel.
The company in India has to make payments for the raw materials
purchased. It initiates its payment from India or Singapore through any of
the following methods:
Electronically - It will use Real-Time Gross Settlement (RTGS) for high
value payments and National Electronic Fund Transfer (NEFT) for
Vendor or salary payments.
Physically - Paper based instruments like drafts; cheques are used for
other payments.
The company can initiate the payment manually through on of its
representative companies-S and S associates. XYZ bank uses a 128-bit
secure socket layer encryption in order to ensure confidentiality of
information. The details of payment transaction are communicated within
S&S associates and ABC for payment reconciliation. Customers can access
data transmission and receipt function easily. This application eliminates
errors of manual payment.
Assuming the representative company, S and S associates sells its products
in India. The payment is received at its Indian head office. XYZ bank has
network of its correspondent banks. It facilitates local transaction like local
cheques pickup and clearing across many cities. The bank provides
management information service in India and Singapore through internet
banking channel. The information includes like when were cheques
deposited and cleared on a detailed note, cheques which are getting
returned, and period of outstanding on these cheques. This information
provides an insight to S and S associates about the payment status of its
dealers and customers. It enables the company to deal with them more
efficiently.
Page No. 275
Unit 14
1. Describe the methods followed by ABC Company for its payment.
(Hint: The Company initiates its payment from India or Singapore.)
2. Explain the role of S and S associates and its functions?
(Hint: It is a representative company.)
References:
Indian Institute of Banking and Finance, Risk Management in Banking,
India, Macmillan Publication
Horcher. K. A, (2006), Essentials of Managing Treasury, U.S, John
Wiley & Sons
Choi, F.D.S, International Finance Accounting Handbook, Third Edition,
U.S, John Wiley & Sons
E-Reference:
http://accounting-financial-tax.com/2009/06/traditional-and-multinationaltreasury-management/ Retrieved on 12.10.2010
___________________
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Treasury Management

Revised Edition: Spring 2010

Sikkim Manipal University

Mr. Pankaj Khanna

Mr. Shankar Jaganathan

Mr. Abraham Mathew

Dr. T. V. Narasimha Rao

Ms. Sadhna Dash

Dr. Sireesha Nanduri

assumed significance with corporates sporting huge cash balances. Idle

A brief description of the 15 units is given below:

Unit 9: Interest Rate Risk Management

Treasury Management (Finance)

Unit 1 Introduction to Corporate Treasury Management

Treasury Management (Finance)

1.2 Treasury Management

Fig. 1.1: Treasury Management

Treasury Management (Finance)

1.2.1 Need for specialised handling of treasury

Treasury Management (Finance)

2. Treasury management improves bottom lines for multinationals through

1.3 Treasury Risk Management

Treasury Management (Finance)

1.4 Treasury Functions

Treasury Management (Finance)

Treasury administration The single-vendor concept has become

1.5 Formulation of Treasury Policy

Treasury Management (Finance)

Sikkim Manipal University

Treasury Management (Finance)

1.5.2 Liquidity policies

Treasury Management (Finance)

1.5.4 Financial ratios tracking policy

Treasury Management (Finance)

Policy guidelines typically specify answers to the following questions:

Sikkim Manipal University

Treasury Management (Finance)

What would be the companys attitude to compliance issues, for

Self Assessment Questions

1.6 Treasury Organisation

Fig. 1.2: Structure of a Treasury Organisation

Sikkim Manipal University

Treasury Management (Finance)

The treasury of a large corporate with Forex exposure is handled by the

Treasury Management (Finance)

1.6.2 Treasury: Cost centre or profit centre

Sikkim Manipal University

Treasury Management (Finance)

Providing centralised liquidity management, foreign exchange and

Treasury Management (Finance)

Treasury Management (Finance)

Corporate Treasury Management is the process of managing a business

Sikkim Manipal University

Treasury Management (Finance)

Disbursement: Payment to discharge a debt or expense.

Legislative: Possessing the power to make laws or law-making.

Retention: The act of keeping in self-possession.

Surplus: Amount in excess of what is required.

Tenor: Period for which money is borrowed or lent.

1.9 Terminal Questions

Sikkim Manipal University

Treasury Management (Finance)