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Treasury Management
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Treasury ManageMenT Module
NATIONAL STOCK EXCHANGE OF INDIA LIMITED
Test details:sr. no.
name of Module Fees (rs.) Test duration (in minutes)
no. of Questions
Maximum Marks
Pass Marks (%)
Certificate Validity (in yrs)
FoundaTIon1 Financial Markets: A Beginners Module ^ 1686 * 120 60 100 50 52 Mutual Funds : A Beginners' Module 1686 * 120 60 100 50 53 Currency Derivatives: A Beginners Module 1686 * 120 60 100 50 54 Equity Derivatives: A Beginners Module 1686 * 120 60 100 50 55 Interest Rate Derivatives: A Beginners Module 1686 * 120 60 100 50 56 Commercial Banking in India: A Beginners Module 1686 * 120 60 100 50 57 FIMMDA-NSE Debt Market (Basic) Module 1686 * 120 60 100 60 58 Securities Market (Basic) Module 1686 * 120 60 100 60 5 InTerMedIaTe1 Capital Market (Dealers) Module ^ 1686 * 105 60 100 50 52 Derivatives Market (Dealers) Module ^ [Please refer to footnote no. (i)] 1686 * 120 60 100 60 33 Investment Analysis and Portfolio Management Module 1686 * 120 60 100 60 54 Fundamental Analysis Module 1686 * 120 60 100 60 55 Options Trading Strategies Module 1686 * 120 60 100 60 56 Operations Risk Management Module 1686 * 120 75 100 60 57 Banking Sector Module 1686 * 120 60 100 60 58 Insurance Module 1686 * 120 60 100 60 59 Macroeconomics for Financial Markets Module 1686 * 120 60 100 60 510 NSDLDepository Operations Module 1686 * 75 60 100 60 # 511 Commodities Market Module 2022 * 120 60 100 50 312 Surveillance in Stock Exchanges Module 1686 * 120 50 100 60 513 Corporate Governance Module 1686 * 90 100 100 60 514 Compliance Officers (Brokers) Module 1686 * 120 60 100 60 515 Compliance Officers (Corporates) Module 1686 * 120 60 100 60 5
16Information Security Auditors Module (Part-1) 2528 * 120 90 100 60
2Information Security Auditors Module (Part-2) 2528 * 120 90 100 60
17 Technical Analysis Module 1686 * 120 60 100 60 518 Mergers and Acquisitions Module 1686 * 120 60 100 60 519 Back Office Operations Module 1686 * 120 60 100 60 520 Wealth Management Module 1686 * 120 60 100 60 521 Project Finance Module 1686 * 120 60 100 60 522 Venture Capital and Private Equity Module 1686 * 120 70 100 60 523 Financial Services Foundation Module ### 1123 * 120 45 100 50 NA24 NSE Certified Quality Analyst $ 1686 * 120 60 100 50 NA25 Certified Credit Research Analyst Level 1 ~ 1686 * 120 80 120 50 NA adVanCed1 Financial Markets (Advanced) Module 1686 * 120 60 100 60 52 Securities Markets (Advanced) Module 1686 * 120 60 100 60 53 Derivatives (Advanced) Module [Please refer to footnote no. (i) ] 1686 * 120 55 100 60 54 Mutual Funds (Advanced) Module 1686 * 120 60 100 60 55 Options Trading (Advanced) Module 1686 * 120 35 100 60 56 FPSB India Exam 1 to 4** 2247 per exam * 120 75 140 60 NA7 Examination 5/Advanced Financial Planning ** 5618 * 240 30 100 50 NA8 Equity Research Module ## 1686 * 120 49 60 60 29 Issue Management Module ## 1686 * 120 55 70 60 210 Market Risk Module ## 1686 * 120 40 65 60 211 Financial Modeling Module ### 1123 * 120 30 100 50 NA nIsM Modules 1 NISM-Series-I: Currency Derivatives Certification Examination ^ 1250 120 100 100 60 3
2 NISM-Series-II-A: Registrars to an Issue and Share Transfer Agents Corporate Certification Examination 1250 120 100 100 50 3
3 NISM-Series-II-B: Registrars to an Issue and Share Transfer Agents Mutual Fund Certification Examination 1250 120 100 100 50 3
4 NISM-Series-III-A: Securities Intermediaries Compliance (Non-Fund) Certification Examination 1250 120 100 100 60 3
5 NISM-Series-IV: Interest Rate Derivatives Certification Examination 1250 120 100 100 60 36 NISM-Series-V-A: Mutual Fund Distributors Certification Examination ^ 1250 120 100 100 50 37 NISM Series-V-B: Mutual Fund Foundation Certification Examination 1000 120 50 50 50 3
8 NISM-Series-V-C: Mutual Fund Distributors (Level 2) Certification Examination 1405 * 120 68 100 60 3
9 NISM-Series-VI: Depository Operations Certification Examination 1250 120 100 100 60 3
10 NISM Series VII: Securities Operations and Risk Management Certification Examination 1250 120 100 100 50 3
11 NISM-Series-VIII: Equity Derivatives Certification Examination 1250 120 100 100 60 312 NISM-Series-IX: Merchant Banking Certification Examination 1250 120 100 100 60 313 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination 1250 120 100 100 60 314 NISM-Series-X-B: Investment Adviser (Level 2) Certification Examination 1405 * 120 68 100 60 315 NISM-Series-XI: Equity Sales Certification Examination 1405 * 120 100 100 50 316 NISM-Series-XII: Securities Markets Foundation Certification Examination 1405 * 120 100 100 60 3
* in the Fees column - indicates module fees inclusive of service tax^ Candidates have the option to take the tests in English, Gujarati or Hindi languages. # Candidates securing 80% or more marks in NSDL-Depository Operations Module ONLY will be certified as Trainers.** Following are the modules owf Financial Planning Standards Board India (Certified Financial Planner Certification)- FPSB India Exam 1 to 4 i.e. (i) Risk Analysis & Insurance Planning (ii) Retirement Planning & Employee Benefits (iii) Investment Planning and (iv) Tax
Planning & Estate Planning - Examination 5/Advanced Financial Planning ## Modules of Finitiatives Learning India Pvt. Ltd. (FLIP)### Module of IMS Proschool$ Module of SSA Business Solutions (P) Ltd.~ Module of Association of International Wealth Management of IndiaThe curriculum for each of the modules (except Modules of Financial Planning Standards Board India, Finitiatives Learning India Pvt. Ltd. and IMS Proschool) is available on our website: www.nseindia.com > Education > Certifications. note: (i) SEBI / NISM has specified the NISM-Series-VIII-Equity Derivatives Certification Examination as the requisite standard for associated persons functioning as approved users and sales personnel of the trading member of an equity derivatives exchange or equity derivative segment of a recognized stock exchange.
Treasury Management Module
Background
Treasury management has always been an important function in banking and finance companies. It
is gaining in importance in manufacturing and services companies too. This Workbook discusses the
role and functioning of treasury management in both types of organisations. It also discusses the
role of various products in fulfilling the objectives of treasury management, and approaches to risk
management in treasury operations.
Learning Objectives
To know how to calculate and interpret return and risk associated with investments
To understand the working of cash and futures markets and various derivative products and
their role
To understand the structure of balance sheet of companies and how they help in gauging
inherent risk
To appreciate the significance of capital structure and know the sources of funds and calculation
of their cost
To know the various risks that manufacturing companies are exposed to and the treasury
management products that help in mitigating them
To understand the risks of banking and finance companies and role of treasury management
in mitigating them
To appreciate the accounting issues that have a role in treasury management decisions
To know the various treasury management processes and how risk is to be managed in the
treasury
Contents
Acronyms .............................................................................................................7
Chapter 1 Treasury Management Fundamentals ..............................................9
1.1 Background .......................................................................................9
1.2 Return Metrics ....................................................................................9
1.3 Risk Metrics .....................................................................................13
1. Standard Deviation .......................................................................13
2. Beta ...........................................................................................15
3. Weighted Average Maturity ............................................................17
4. Modified Duration .........................................................................17
Self-Assessment Questions ................................................................18
Chapter 2 Product / Exposure Structures ......................................................20
2.1 Background .....................................................................................20
2.2 Cash Market .....................................................................................21
2.3 Futures ...........................................................................................22
2.4 Forwards .........................................................................................25
2.5 Options ...........................................................................................27
2.6 SWAPs ............................................................................................32
1. Interest Rate Swap .......................................................................32
2. Currency Swap ............................................................................34
3. Credit Default Swap (CDS) ............................................................35
4. Swaption ....................................................................................42
2.7 SSELECTIVVELLY-Invest Classification Scheme for Investment Products ...42
2.8 Off-Balance Sheet Exposures ..............................................................43
Self-Assessment Questions ................................................................45
Chapter 3 Capital Structure & Weighted Average Cost of Capital ....................46
3.1 Background .....................................................................................46
3.2 Capital Structure ..............................................................................46
3.3 Earnings, Interest and Debt Servicing ..................................................48
3.4 Sources of equity funds .....................................................................49
3.5 Cost of equity ..................................................................................49
3.6 Sources of debt funds .......................................................................50
3.7 Cost of debt .....................................................................................51
3.8 Weighted Average Cost of Capital ........................................................52
3.9 Cost of Capital for Trading Portfolios ....................................................53
3.10 Leasing and hire purchase .................................................................54
Self-Assessment Questions ................................................................56
Chapter 4 Treasury Management in Manufacturing and Services Companies ..57
4.1 Background .....................................................................................57
4.2 Contribution Analysis ........................................................................57
4.3 Operating Leverage & Financial Leverage .............................................58
4.4 Balance Sheet ..................................................................................59
4.5 Liquidity Management .......................................................................60
4.6 Foreign Exchange Exposures (Operations) ............................................62
4.7 Foreign Exchange Exposures (Loans taken or investments made) ............63
4.8 Commodity Exposures .......................................................................65
4.9 Credit Exposures ..............................................................................65
Self-Assessment Questions ................................................................68
Chapter 5 Treasury Management in Banking & Finance Companies ................69
5.1 Background .....................................................................................69
5.2 Capital Adequacy ..............................................................................69
5.3 Balance Sheet ..................................................................................73
5.4 Yield Curve and Spreads ....................................................................74
5.5 Credit Risk .......................................................................................75
5.6 Interest Risk ....................................................................................78
5.7 Re-financing Risk ..............................................................................79
5.8 Asset-Liability Management ................................................................80
5.9 Securitisation ...................................................................................80
5.10 Foreign currency risk .........................................................................82
5.11 Equity Exposure ...............................................................................83
Self-Assessment Questions ................................................................86
Chapter 6 Accounting Issues in Treasury Management ..................................87
6.1 Background .....................................................................................87
6.2 Long-term supply arrangements .........................................................88
6.3 Foreign Currency borrowing for a fixed asset ........................................88
6.4 Hedge and Hedged Instrument ...........................................................89
6.5 Investment types..............................................................................90
Self-Assessment Questions ................................................................91
Chapter 7 Treasury Management Processes and Risk Management in Treasury . 92
7.1 Background .....................................................................................92
7.2 Domestic Remittances .......................................................................92
7.3 International Remittances ..................................................................94
7.4 Liquidity Management .......................................................................95
7.5 Risk Management in Treasury .............................................................96
Self-Assessment Questions .............................................................. 100
References ........................................................................................................ 101
1Acronyms
BIS Bank for International Settlements
BIFR Board for Industrial and Financial Re-construction
CDS Credit Default Swap
CORF Corporate Operational Risk management Function
CD Certificate of Deposit
CP Commercial Paper
CRAR Capital to Risk-weighted Assets Ratio
DPS Dividend per Share
DSCR Debt Servicing Coverage Ratio
EBIT Earnings before Interest and Tax
EPS Earnings per Share
FII Foreign Institutional Investor
GoI Government of India
ICAI Institute of Chartered Accountants of India
ICR Interest Coverage Ratio
IFRS International Financial Reporting Standards
IMF International Monetary Fund
IndAS Indian Accounting Standards
IPDI Innovative perpetual debt instruments
IRR Internal Rate of Return
MDB Multilateral Development Banks
NBFC Non-banking Finance Company
NCD Non-Convertible Debenture
NEFT National Electronic Funds Transfer
NPA Non-performing Assets
NSE National Stock Exchange
P/E Price Earnings Ratio
PCNPS Perpetual Non-Cumulative Preference Shares
PD Primary Dealer
RBI Reserve Bank of India
RTGS Real Time Gross Settlement
RWA Risk-Weighted Assets
SPV Special Purpose Vehicle
SWIFT Society for Worldwide Interbank Financial Telecommunication
WACC Weighted Average Cost of Capital
2distribution of weights of the Treasury Management Module Curriculum
Chapter
no.Title
Weights
(%)
1 Treasury Management Fundamentals 20
2 Product / Exposure Structures 14
3 Capital Structure & Weighted Average Cost of Capital 10
4 Treasury Management in Manufacturing and Services Companies 19
5 Treasury Management in Banking & Finance Companies 20
6 Accounting Issues in Treasury Management 4
7 Treasury Management Processes and Risk Management in Treasury 13
Note: Candidates are advised to refer to NSEs website: www.nseindia.com, click onEducation
link and then go to Updates & Announcements link, regarding revisions/updations in
NCFM modules or launch of new modules, if any.
This book has been developed for NSE by Mr. Sundar Sankaran, Director, Advantage India
Consulting Pvt. Ltd. and finberry academy pvt ltd.
Copyright 2013 by National Stock Exchange of India Ltd. (NSE)
Exchange Plaza, Bandra Kurla Complex,
Bandra (East), Mumbai 400 051 INDIA
All content included in this book, such as text, graphics, logos, images, data compilation etc.
are the property of NSE. This book or any part thereof should not be copied, reproduced,
duplicated, sold, resold or exploited for any commercial purposes. Furthermore, the book in
its entirety or any part cannot be stored in a retrieval system or transmitted in any form or by
any means, electronic, mechanical, photocopying, recording or otherwise.
3Chapter 1 Treasury Management Fundamentals
1.1 Background
At the outset, it is important to differentiate between treasury management and financial
management. Since treasury deals with finance, treasury management can be viewed as a
subset of financial management, in theory. In practice, treasury management has always
been a distinct function in banks and non-banking finance companies especially, those that
have an active involvement with the markets on their assets or liabilities side. Increasingly, it
is emerging as a distinct function in manufacturing and services companies too.
Some aspects of treasury management are common between companies in the financial
sector and other sectors. However, there are distinct differences in many other aspects.
These similarities and contrasts are discussed in relevant portions of this Workbook.
A common pursuit in most treasury management situations is the balancing of risk and return
metrics. The ideal is to maximise the return for a given level of risk, or minimise the risk for
a given level of return. Measurement of return and risk are therefore a fundamental aspect
of treasury management.
1.2 Return Metrics
Investments are made with a view to earn a return. How is return (yield) to be measured?
Suppose an investment is made in a debenture offering a coupon of 9% p.a., payable half-
yearly. How is the return different from another debenture offering the same coupon of 9%
p.a., but payable annually?
The debenture that offers half-yearly interest gives the investor the option of investing the
interest for the first 6 months in some other instrument for the second 6 months. Therefore,
receiving interest half-yearly is superior to receiving interest annually, if the coupon in both
cases is the same. The benefit of receiving coupons more frequently can be quantified by
compounding, as shown in Table 1.1.
In the case of annual interest, there is nothing to compound during the year. So the return is
the same as the coupon. In the half-yearly interest case, the coupon per period (half-year)
is 4.50%. There are 2 such periods (half-years) in any year. So the compounded return is
worked out as (1+4.50%)2-1 i.e. 9.202%. The more-frequent interest receipt has helped
boost the return from 9% to 9.202%. The implicit assumption here is that the interest for
the first 6 months can be re-invested for the next 6 months at the same coupon of 9% p.a.
If the re-investment rate is lower than 9%, the compounded return would be lower; a higher
re-investment rate will push the compounded return above 9.202%.
4Table 1.1
Compounded Returns
In MS Excel, the exponential function is denoted by ^. Therefore, the formula is written as
=(1+4.50%)^2-1.
The above simple approach works, so long as investment and redemption are at face value.
Suppose investment was at a 1% discount i.e. investor invests Rs. 99, but receives coupon
calculated at 9% on Rs. 100. In such cases, a crude return measure, current yield may be
used. It is calculated as Rs. 9 Rs. 99 X 100 i.e. 9.091%.
A more professional approach is to use the Internal Rate of Return (IRR) function, as shown
in Table 1.2. Cash flow 1 is a situation where there is no discount; Cash flow 2 is a situation
where the discount of Rs. 1 is applicable.
The calculation entails putting down the cash flows at various points of time inflows are
denoted as positive and outflows are denoted as negative.
5Table 1.2
IRR (1 year debenture)
As is obvious from the IRR calculation for Cashflow 1, the calculated IRR is for a period. It
will need to be compounded using (1+4.50%)2-1 i.e. 9.202%. The compounded IRR in the
case of Cash flow 2 works out to 10.33%. The discount of Rs. 1 has boosted the yield by more
than 1%.
The calculations are made in the Table, assuming the debenture will mature in 1 year. The
same calculations work for debentures of any maturity. This can be seen in Table 1.3, where
the tenor of the debentures is extended to 2 years. Further, an additional scenario, Cash flow
3 is introduced. In the new scenario, investment is at par, but redemption is at a premium
of 1%.
6Table 1.3
IRR (2 year debenture)
Between Cash flow 1 and Cash flow 2, the difference in IRR Compounded is much less than
1%. It is lower than in Table 1.2 because the 1% upfront benefit is now distributed over 2
years.
IRR Compounded is lower for Cash flow 3 as compared to Cash flow 2. Although investor gets
a 1% extra benefit in both cases, in Cash flow 3 the benefit is back-ended (on redemption).
In the case of Cash flow 2, it is front-ended (on investment). Therefore, it can be said that the
earlier the benefit is received, the better (higher return) it is for the investor.
The IRR calculations give the IRR per period. Therefore, the cash flows need to be for periods
that are equal. In practice, this may not always be the case. For instance, suppose the 2-year
debenture is issued on December 31, 2013. However, the issuer would like to standardise the
interest payment cycle as March 31 and September 30. Only the last interest payment would
need to be on another date viz. December 31, 2015.
In this case, the first and last debenture servicing will be for 3 month periods, while the
middle periods are all 6 months. In such cases, IRR cannot be used. XIRR needs to be used,
as shown in Table 1.4. This calls for entering the actual dates for each debenture servicing, in
7a form that MS Excel recognises as date format. Thereafter, the XIRR function can be used,
where two ranges of cells need to be selected viz. the cash flow values and the dates.
Table 1.4
XIRR
The table also shows IRR, which is wrong to apply. The benefit of XIRR is that no further
compounding is required. XIRR is a compounded return by itself.
Return for the investor is cost for the issuer. Therefore, the same calculations are used to
determine the cost for the issuer. Only difference will be in the signs used for the cash flows.
Initial receipt of money from the investor will be shown as positive and subsequent payments
towards interest and redemption will be negative. The calculated values of IRR and XIRR will
remain the same.
The explanations so far are given in the context of primary issue of securities by an issuer. The
methodology is equally applicable for secondary market trades. There is only one technical
difference viz. accrued interest, when it comes to secondary market trades.
Suppose Party A buys from Party B for Rs. 98, the debenture mentioned in Table 1.4 on
May 5, 2014 and holds it beyond September 30, 2014. On September 30, 2014, the issuer
will pay Party A interest for the entire period from March 31, 2014. However, Party A held
the debenture only from May 5, 2014. Interest for the period April 1, 2014 to May 5, 2014
rightfully belongs to Party B, which held the debenture during that period.
8Therefore, Party A will not only pay Party B the clean price of Rs. 98, but also accrued
interest for the period from the last interest payment date to the settlement date (May 5,
2014). This is paid on the settlement date, although the interest will be received by Party A
from the issuer only on the next interest payment date. The total of Clean Price and accrued
interest is called dirty price. The calculations are shown in Table 1.5.
Yield to maturity (YTM) for Party A is 10.907%.
1.3 Risk Metrics
Various qualitative aspects of risk are mentioned in the rest of this Workbook. Quantitatively,
four measures of risk are commonly used viz. standard deviation, beta, weighted average
maturity and modified duration.
1. Standard Deviation
This is applicable for investments that have a market element i.e. their values fluctuate
in the market. In such cases, investors return would be a combination of payments
by the issuer (interest or dividend) and returns from the market (capital gains or
losses).
Since the investment has a value in the market at any point of time, returns can be
worked out for various periods of holding, even if the investment has not been sold.
9Table 1.5
Secondary Market Yield
For example, if a share is quoted at Rs. 50 on Day 1, Rs. 55 on day 2 and Rs. 66 on day 3.
The return on Day 2 is Rs. 5 Rs. 50 X 100 i.e. 10%. The return on Day 3 is Rs. 11 Rs.
55 X 100 i.e. 20%.
Standard deviation measures the extent to which such returns vary over different time periods.
Specifically, it measures how much the returns vary as compared to its own past standards
of return. Unlike returns, which are calculated for each period, standard deviation is a single
number for a series of periods.
This can be easily calculated using the MS Excel function STDEV as shown in Table 1.6 in the
context of returns from a mutual fund scheme.
The standard deviation, based on monthly returns is 2.53%. This needs to be compounded to
its annual equivalent, by multiplying it by the square root of 12. (If the periodic returns were
weekly, the multiplication factor would be square root of 52. While working with daily returns,
the norm is to multiply by the square root of 252).
10
Thus, the annualised standard deviation is 8.78%.
A high standard deviation would mean that the investment deviates more from its past
standard i.e it is more risky.
At times, the term variance is used. This is nothing but the square of standard deviation.
In the above case, annualised standard deviation was calculated as 8.78%. Variance will be
8.78%2 i.e. 0.77%.
Table 1.6
Standard Deviation
2. Beta
An alternate approach to measure equity risk is based on Capital Assets Pricing Model
(CAPM), discussed in NCFMs Workbook titled Securities Market (Basic) Module. We
saw that there are two risks in investing in equity:
Systematic risk () is inherent to equity investments e.g. the risk arising out
of political turbulence, inflation etc. It would affect all equities, and therefore
cannot be avoided.
11
Non-systematic risk is unique to a company e.g. risk that a key pharma
compound will not be approved, or the risk that a high performing CEO leaves
the company. Non-systematic risk can be minimized by holding a diversified
portfolio of investments.
Since investors can diversify away their non-systematic risks, they have to be
compensated only for systematic risk.
Calculation of beta calls for information on the value of the market index on each of
the days for which the NAV information is used. A diversified index like S&P CNX Nifty
has to be used.
Based on the value of Nifty on each of those days, the periodic returns can be calculated,
as was done for the scheme returns. Thereafter, the slope function can be used in MS
Excel. The details are shown in Table 1.7.
Table 1.7
Beta
The Beta of 0.98 is close to 1. This means that the investment returns are closely
aligned with that of the Nifty.
12
If the beta is more than 1, it means that the investment is more risky than the market.
A value of beta that is less than 1 would mean that the investment is less risky than
the market.
3. Weighted Average Maturity
Fixed rate debt instruments have a price risk. When interest rates in the market go
up, the debt instruments already issued, based on the erstwhile lower interest rates,
lose value. Similarly, when interest rates in the market go down fixed rate debt
instruments gain value.
The extent of such depreciation or appreciation of fixed rate debt instruments in response
to changes in yields in the market, is influenced by the tenor of the instruments.
Instruments that have a longer maturity are more volatile than those with shorter
maturity.
Therefore, the weighted average maturity of a debt portfolio becomes an indicater of
its price risk. Higher the weighted average maturity, more the portfolio value is likely
to fluctuate in response to changes in market yields.
The calculation of weighted average maturity is illustrated in Table 1.8 for a debt
portfolio of Rs. 255 crore. The weighted column is calculated as Tenor X Proportion for
each row.
Table 1.8
Weighted Average Maturity
4. Modified duration
While maturity influences the price risk in a debt security, a more scientific approach
would be to consider its modified duration.
13
Suppose the modified duration is to be calculated as of January 15, 2012, for a security
that offers a coupon of 11% p.a., payable half-yearly, until it matures on January 25,
2014. The security is currently traded in the market at an yield of 11.5%.
The modified duration can be calculated using the MDURATION function in MS Excel.
This is shown in Table 1.9.
Table 1.9
Modified Duration of a Debt Security
The implication is that if the yields in the market were to change by 1%, this debt
security is likely to change in value by 1.68%.
If the coupon payments were quarterly, the frequency would be shown as 4; annual
coupon payment would mean frequency of 1.
In this manner, the modified duration can be calculated for every debt security. Other
things being equal, longer the maturity, higher the modified duration. The modified
duration of a zero coupon bond is the same as its maturity.
Weighted average maturity and modified duration are used for debt investments, beta
is for equity investments and standard deviation is used for both debt and equity
investments.
14
Self-Assessment Questions
Treasury management is useful for
- Banks
- Non-banking finance companies
- Manufacturing companies
- All the above
Which of the following spreadsheet functions is to be used for calculating returns if
periods are not the same?
- IRR
- XIrr
- Stdev
- Slope
Beta is a measure of
- Systematic risk
- Non-systematic risk
- Total risk
- Variance
Which of the following is used only for equity investments?
- Standard deviation
- Beta
- Weighted average maturity
- Modified duration
Market yields have gone up by 0.5% for comparable securities. What would be the
revised price of a debt security trading at Rs105 with modified duration of 1.2?
- Rs. 105.63
- Rs. 105.53
- rs. 104.37[105 (0.5% X 1.2 X 105)]
- Rs. 104.48
15
Chapter 2 Product / Exposure Structures
2.1 Background
Investors can take two kinds of exposures long and short.
If an investor is going to make a profit when the asset price goes up and / or make a
loss when the asset price goes down, he is said to be long on the asset.
If an investor is going to make a loss when the asset price goes up and / or make a
profit when the asset price goes down, he is said to be short on the asset.
Exposures are built in the asset side of the balance sheet through investment in various
products.
Some products give the desired exposure directly (e.g. gold or shares of Infosys). The
market where these direct exposures trade is referred to as cash market.
In the case of some other products, the exposure is built indirectly (e.g. gold futures
or Infosys stock futures). The products that give the desired exposure indirectly are
called derivatives.
Some derivatives trade in the market. These are called exchange-traded
derivatives. Those that do not trade in the market are called over-the-counter (OTC)
derivatives.
Suppose an investor owns a contract that entitles him to 5 grams of gold. The value of that
contract would vary with the price of gold. This contract is a derivative product. Gold, in the
example, is referred to as the underlying. The derivative contract derives its value from the
value of the underlying.
The underlying in a derivative contract could be a financial asset such as currency, stock and
market index, an interest bearing security or a physical commodity. Today, around the world,
derivative contracts are traded on electricity, weather, temperature and even volatility.
According to the Securities Contract Regulation Act, (1956) the term derivative includes:
a security derived from a debt instrument, share, loan, whether secured or unsecured,
risk instrument or contract for differences or any other form of security;
a contract which derives its value from the prices, or index of prices, of underlying
securities.
A benefit of derivative is the leveraging. For the same outgo, it is possible to have a much
higher exposure to the underlying asset in the derivative market, than in the underlying cash
market. This makes it attractive for speculaters and hedgers, besides normal investors.
16
Derivatives comprise four basic contracts namely Forwards, Futures, Options and Swaps.
Over the past couple of decades several exotic contracts have emerged. But these are largely
variants of these basic contracts. These four basic contract types are discussed later in this
chapter.
2.2 Cash Market
Suppose an investor buys shares of Infosys at Rs. 4,000. If the share price goes up to Rs.
5,000, a profit of Rs. 1,000 is earned (assuming no transaction costs or taxes). If the share
price goes down to Rs. 3,000, a loss of Rs. 1,000 is booked. Thus, the investor is long on
Infosys shares.
On the other hand, suppose an investor sells shares of Infosys at Rs. 4,000. He does not have
the shares. It is possible to sell shares that you do not own in the stock exchange.
A day trader will seek to cover the position i.e. buy back the sold shares by the end
of the day. Since the position is squared at the end of the day, the trader has no
obligation to receive or deliver the shares. The difference between the two prices is
profit (if bought back at a lower price) or loss (if bought back at a higher price).
It is not necessary to square the position at the end of the day. An investor can borrow
the shares and deliver them as per the normal stock exchange settlement schedule,
to fulfil the obligation arising out of the shares sold. However, the shares need to be
purchased and given back to the stock lender at some time. Therefore, the investor
continues to have a position in that stock. The investor also keeps paying a fee to the
stock lender until the borrowed shares are returned.
After selling the Infosys shares at Rs. 4,000, if the share price was to go up to Rs. 5,000, then
the investor will have a loss of Rs. 1,000. On the other hand, if the share price goes down to
Rs. 3,000, a profit of Rs. 1,000 is earned. Thus, the investor is short on Infosys shares.
The pay-off on Infosys shares at different subsequent price levels of Infosys shares in the
market for long and short positions are shown in Figure 2.1.
17
long and short positions in Infosys shares
Figure 2.1
2.3 Futures
Infosys stock futures are traded in the market. The underlying is the shares of Infosys.
Therefore, if Infosys shares were to go up in value, its stock futures will also appreciate.
Similarly, a decline in Infosys shares pulls down the value of its stock futures.
18
The rate of interest that equates the cash price to the futures price is the cost of carry. The
futures price is given by the formula
FP = S0 X (1+r)t
Where,
FP = Futures Price
S0 = Spot Price
t = number of days
r = cost of carry
Suppose, cost of carry is 6%, and Infosys shares are trading at Rs. 4,000. Value of Infosys
stock futures, maturing in 20 days, can be calculated as
Rs. 4,000 X (1+6%)(20365)
i.e. Rs. 4,012.80 (rounded to nearest 5 paise)
(In practice, the cost of carry is calculated from the independently traded price of the share
and the stock futures.)
If the share price were to increase, other things remaining the same, the stock futures will
also appreciate, as would be evident from the formula.
In the same example, let us now suppose that Infosys is expected to give a dividend of Rs. 1
per share in 12 days.
An investor holding the underlying share will receive the dividend. But the holder of
Infosysfutures will not be entitled to the dividend. The Present Value of Dividend (PVD)
therefore will need to be subtracted from the spot price.
PVD = Rs. 1 (1 + 6%)(12/365)
= Rs. 0.998
FP = (S0 PVD) X (1+r)t
= (4,000 0.998) X (1+6%)(20365)
= Rs. 4,011.80 (rounded to nearest 5paise)
This calculated price is the no arbitrage price, where the investor is neutral between buying
in the cash market and futures market. If Infosys futures are available in the market at a
price lower than the no arbitrage price, then the investor would prefer to take the position
with Infosys futures instead of the underlying Infosys shares.
As in the case of shares, the pay-off matrix can be prepared for investment strategies of going
long or short on Infosys futures. This is shown in Figure 2.2. (Cost of carry has been kept zero
for the illustration. Addition of cost of carry will not change the pattern of the pay-off).
19
Long and short positions in Infosys stock futures
Figure 2.2
Thus, both cash market and futures market give the investor a similar profile of returns. Why
should an investor opt for the futures market?
One reason was given earlier as part of the calculation of futures price. If the futures are
trading below their theoretical price (given the cost of carry for the investor), then buying the
futures is more sensible than buying the Infosys shares.
20
Another reason to favour futures is the leveraging it offers. On purchase of Infosys shares,
the investor has to pay the entire price by the settlement date. However, in the futures
market, the investor pays only a margin. Suppose the initial margin is 20%, then the investor
needs to pay only 20% of the value of the position taken. For the same outflow as in the case
of cash market, the investor can take a futures position that is 100 20 i.e. 5 times.
In the normal course, companies leverage by borrowing money. In the case of futures, the
leveraging is built into the product. So the investor does not need to go about mobilising debt
to take the higher exposure.
A point to note is that apart from initial margin, there are also daily mark-to-market margins.
Thus, if an investor is long or short on the futures, and the position is in profit on any day,
the investor will receive mark to market margin. However, if the position is in a loss, then the
investor will need to pay mark to market margins. Investors should consider their ability to
pay mark to market margins before taking positions in the futures market.
The explanations given above for stock futures are equally applicable for index futures, interest
rate futures and currency futures. However, in line with the difference in underlying, there are
differences in the contract structure between different types of futures.
2.4 Forwards
Forwards are like futures. The differences are as follows:
Unlike futures, forwards are not traded in the stock exchange. This raises issues about
liquidity, transparency of pricing, transactional convenience etc.
In order to enable trading in the stock exchange, futures trade on the basis of
standardised contracts. For example, all futures contracts are settled in the National
Stock Exchange (NSE) on the last Thursday of the concerned month. Since forwards
are OTC products, the parties can customise a contract structure that meets their
mutual needs best.
Since futures are traded in the stock exchange, transactions are guaranteed by the
clearing house. Therefore, exposure of the investor is not to the party at the other end
of the trade, but to the clearing house.
In the case of forwards, the investor is exposed to the counter-party risk. If the counter-
party defaults, then courts will need to be approached to enforce ones rights.
While investors can cover their foreign currency risks through currency futures, in many
instances, forward contracts are used. Suppose, an exporter expects to receive USD1mn
after 1 month.He wants to freeze his export receipts in rupees. He will enter into a forward
contract with his banker to sell USD at, say, Rs. 60. If USD subsequently depreciates to a
spot rate ofRs. 59, then his forward contract is profitable to the extent of Rs. 1. But if USD
21
appreciates to a spot rate ofRs. 61, then the forward contract is a loss to the extent of Rs. 1.
Thus, his position is one of being short on the USD.
An importer who needs to pay USD is in a reverse position. In order to freeze the rupee
outflow, he will book a forward contract to receive USD i.e. he will go long on the USD. Pay-
offs in the two cases are shown in Figure 2.3.
Exporter and Importer in USD forward contract
Figure 2.3
22
Point to note is that the profit or loss in the payoff matrix refers to the forward contract in
isolation. The exporter and importer have entered into the forward contract to hedge their
position of USD receivable or payable. When the exporter receives the export proceeds in
USD, these will be sold at a profit (if the USD appreciates and forward contract is in loss) or
a loss (if the USD depreciates and forward contract is in profit). Thus, the overall currency
impact will be neutral, for both exporter and importer. This is the purpose of the hedge.
2.5 options
Let us re-visit the earlier example of importer doing a 1-month forward contract for USD1mn
at Rs. 60 =1USD.
Variation 1
Suppose the importer, instead of being obliged to buy the dollars (which was the case in the
forward contract), had the right to buy the dollars but he was not obliged to buy them.
Thus, 1 month down the line, importer can choose, NOT to buy them. Such contracts are
option contracts.
In this case, the importer, the buyer of USD, has the option (but the bank is committed. If
the importer decided to buy the dollars, the bank is obliged to sell them at Rs. 60=1USD).
Such contracts, where the party has the option to buy the underlying are called call options.
In option terminology,
Importer has bought the call option (to buy USD)
The bank has sold (or written) the call option.
Variation 2
Suppose the exporter, instead of being obliged to sell the dollars (which was the case in the
forward contract), had the right to sell the dollars but he was not obliged to sell them.
Thus, 1 month down the line, the exporter can choose, NOT to sell them. Such contracts are
also option contracts.
In this case, the exporter, the seller of USD, has the option (but the bank is committed. If
the exporter decided to sell the dollars, bank is obliged to buy them at Rs. 60 =1USD). Such
contracts, where the party has the option to sell the underlying, are called put options. In
option terminology,
Exporter has bought the put option (to sell USD)
The bank has sold (or written) the put option.
The party that buys an option (a call or a put) is said to have a long position; the party that
sells (a call or a put) is said to have a short position.
23
It should be noted that:
In the first two types of derivative contracts (forwards and futures), both the parties
(buyer and seller) have an obligation i.e. the buyer needs to pay for the asset to
the seller; and the seller needs to deliver the asset to the buyer on the agreed date
(settlement date).
In case of options, only the seller of the option (the option writer) is under an obligation
and not the buyer of the option (the option purchaser).
In a call option, the buyer of the option has the right to BUY the underlying
In a put option, the buyer of the option has the right to SELL the underlying.
In either case, the price at which the option can be exercised is called exercise price
The option buyer may or may not exercise his right. In case the buyer of the option
does exercise his right, the seller of the option must fulfil whatever is his obligation (for
a call option, the option-seller has to deliver the asset to the buyer of the option; for
a put option the option-seller has to receive the asset from the buyer of the option).
In order to enter into such a contract, the option seller will expect to receive a
compensation from the option buyer upfront. This is the option premium. It is an
income for the seller and expense for the buyer, irrespective of whether or not the
option is subsequently extinguished.
In the above cases, the option was to be exercised 1 month down the line i.e. on a specific
date (settlement date, at the end of the contract period). Such options are known as European
option contracts.
If in the above cases, the option buyer {Importer (in the case of Variation 1) or Exporter
(in the case of Variation 2)} could exercise their option anytime up to the expiry of the
contract period. This would be an American option contract.
The examples above were explained in the context of OTC options sold by the bank. Options
are also traded in stock exchanges. Exchange-traded options have a standardised contract
structure and are guaranteed by the clearing house. They offer the benefits of liquidity,
pricing transparency, transaction convenience etc.
Since one party (seller of the call or put option) is committed, while the other party (buyer of
the call or put option) has the option, the pay off profile is different as compared to forwards
and futures.
The maximum income for the seller is the option premium earned. However, if the
market moves adversely (USD becomes stronger for call option or weaker for put
option), then the losses increase.
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The maximum expense for the buyer is the option premium earned. However, if the
market moves favourably (USD becomes stronger for call option or weaker for put
option), then the profits increase.
Since the USD can go up to any price, the maximum profit for the buyer of the call and
maximum loss for the seller of the call is unlimited.
Since the USD cannot go below zero, the maximum profit for the buyer of the put and
maximum loss for the seller of the put are capped.
The payoff graphs are shown in Figures 2.4 (for call) and 2.5 (for put). Option premium is
assumed to be Rs. 3. Breakeven point in the case of call option is at Exercise Price + Option
Premium i.e. Rs. 63. In the case of putoption, it is at Exercise Price Option Premium i.e.
Rs. 57.
Payoffs in the case of direct exposures, futures and forwards are depicted as a straight line.
Therefore, these products are said to have a symmetric payoff.
Payoffs in the case of options do not follow a straight line. So, options are said to have an
asymmetric payoff.
Option pricing is beyond the scope of this Workbook.
In the case of futures, both buyer and seller are liable to pay margins to the stock exchange.
However, in the case of options, only the option seller pays margins to the stock exchange.
Payments for the option buyer are capped at the option premium (plus exercise price if option
is exercised).
25
Payoff for long and short positions on call
Figure 2.4
26
Payoffs for long and short position on puts
Figure 2.5
27
2.6 SWAPs
Swaps are contracts where the two parties commit to exchange two different streams of
payments, based on a notional principal. The payments may cover only interest, or extend
to the principal (in different currencies) or even relate to other asset classes like equity or
commodities.
Unlike futures and options, which are created and traded in the stock exchanges, swaps are
largely OTC products. Often a bank finds two parties with divergent views about the market
(interest rates, exchange rates etc.) and facilitates swap trade/s between them. The bank
performs either of two roles:
Broker
Here, the swap is direct between the two parties. So, the two parties will know each
other when the bank brokers the swap. As broker, the bank will earn commission from
one or both parties.
Dealer
Here, the bank executes independent swap trades with both parties. Consequently,
neither party will know the identity of the other; for both parties, the bank is the
counter-party.
In such trades, the bank earns the difference between the two matching trades. Suppose
the bank agrees to pay 7% fixed to one party (in return for MIBOR), and receive 5%
fixed from the other party (in return for MIBOR). The bank neither has an exposure
to MIBOR nor an exposure to fixed interest rate, on account of the combination of the
two swaps. Yet, it will earn a spread of 2% p.a., calculated on the notional principal.
The bank is however exposed to credit risk from both parties.
Since swaps are OTC products, without the benefit of a transparent pricing benchmark,
the spreads can be quite large.
1. Interest rate swap
This is the most elementary form of a swap.
Suppose Party A is worried about its 2-year loan of Rs. 1 crore, on which it
has committed to pay interest at 1-month MIBOR + 2% (Mumbai Inter-Bank
Offered Rate). If interest rates were to go up, it will have to pay higher interest
to its lender.
On the other hand, Party B is worried that interest rates may fall, and it will
earn less on its deposits.
28
Party A and Party B can do an interest rate swap. Party A will agree to pay Party
B interest at a fixed rate, say 8%, in return for a receipt of 1-month MIBOR,
calculated on a notional principal of Rs. 1 crore.
While the swap may be direct between Party A and Party B, it is understood
better if we bring in a 3rd party viz. Party As Lender. (The bank that brings
Party A and Party B together may be a 4th party). The position of the 3 parties
is shown in Figure 2.6.
swap Parties
Figure 2.6
Party A will pay MIBOR + 2% to its lender, out of which, it will receive MIBOR
from Party B under the swap. Thus, it is no longer exposed to the fluctuations
in MIBOR. If MIBOR rises, it will receive more from Party B and pay the amount
to its lender.
Party As cost of funds is the 2% additional it needs to pay its lender, plus the
8% it has to pay Party B i.e. 10% fixed.
Party B, on the other hand, is assured of 8% fixed interest income, from Party
A. In return it has to pay MIBOR, which it expects will fall.
The actual cash flows of the parties are shown in Table 2.1 (the MIBOR rates
are assumed).
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Table 2.1
Cash Flows of Swap Counter Parties
date Mibor Party A's Cashflows Party B's Cashflows
30-Jun-13 9.00% -5,50,000 -4,00,000 4,50,000 -5,00,000 -4,50,000 4,00,000 -50,000
31-Dec-13 9.25% -5,62,500 -4,00,000 4,62,500 -5,00,000 -4,62,500 4,00,000 -62,500
30-Jun-14 8.75% -5,37,500 -4,00,000 4,37,500 -5,00,000 -4,37,500 4,00,000 -37,500
31-Dec-14 7.90% -4,95,000 -4,00,000 3,95,000 -5,00,000 -3,95,000 4,00,000 5,000
Party As net interest cost is Rs. 5 lakh every 6 months i.e. Rs. 10 lakh p.a. On
the Rs. 1 crore notional principal, it works out to 10%.
Party Bs benefits if MIBOR goes below 8%.
A few points to note:
Party A's lender will continue receiving MIBOR + 2% from Party A. The swap is a separate transaction between Party A and Party B. Party A's
lender may not even be aware of the swap.
The parties avoid multiple payments by netting. Thus, either Party A will pay Party B or Party B will Party A, depending on MIBOR.
2. Currency Swap
In a currency swap, the two streams of payments are in different currencies.
Suppose Party D and Party R, are counter-parties to a 2-year swap. Party
D agrees to pay Party R, 3% p.a., semi-annually, on a notional principal of
USD1mn. In return, Party R commits to pay Party D 7% p.a., semi-annually,
on a notional principal of Rs. 5 crore. When the swap is initiated, Party R pays
USD1mn to Party D; and receives Rs. 5 crore from Party D. On maturity, Party
D pays USD1mn to Party R, and receives Rs. 5 crore from Party R.
Party Rs cash flows are shown in Table 2.2.
Table 2.2
Party Rs Cash Flows
date usd mm rs. Cr.
30-Jun-13 -1.00 5.00
31-Dec-13 0.03 -0.35
30-Jun-14 0.03 -0.35
31-Dec-14 1.03 -5.35
Party Ds cash flows are shown in Table 2.3.
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Table 2.3
Party Ds Cash Flows
date usd mm rs. Cr.
30-Jun-13 1.00 -5.00
31-Dec-13 -0.03 -0.35
30-Jun-14 -0.03 0.35
31-Dec-14 -1.03 5.35
Party R has thus taken up a USD asset and a Rupee liability. Party D has done
the reverse viz. assumed a USD liability and a Rupee asset.
Parties R & D are exchanging interest rates on fixed basis. The swap is Fixed
for Fixed. Similarly, Fixed for Floating is also possible, where interest rate for
one leg is in LIBOR or MIBOR. Alternatively, it can be Floating for Floating,
where one leg may be in LIBOR and the other may be in MIBOR.
3. Credit default swap (Cds)
Non-Sovereign bonds involve a credit risk. Having invested in such bonds, it is
possible for the investor to seek protection from credit risk by buying a CDS.
A CDS has two parties - buyer and seller. The buyer pays premium to the seller
for the protection. In return, the seller promises to compensate the buyer, if
the issuer of the underlying bond defaults on the payments.
CDS issues without proper credit risk assessment led several CDS issuers to
bankruptcy in the developed markets in the last few years. RBI has therefore
imposed a strict regulatory regime for the product. The key regulations are as
follows:
Participants in the market are classified into two:
users Commercial Banks, Primary Dealers (PDs), Non-Banking Finance
Companies (NBFCs), Mutual Funds, Insurance Companies, Housing
Finance Companies, Provident Funds, Listed Corporates, Foreign
Institutional Investors (FIIs) and any other institution specifically
permitted by the Reserve Bank.
These entities are permitted to buy credit protection (buy CDS contracts)
only to hedge their underlying credit risk on corporate bonds.
Such entities are not permitted to hold credit protection without having
eligible underlying as a hedged item.
31
Users are also not permitted to sell protection and are not permitted to
hold short positions in the CDS contracts. However, they are permitted
to exit their bought CDS positions by unwinding them with the original
counterparty or by assigning them in favour of buyer of the underlying
bond.
Market Makers Commercial Banks, standalone PDs, NBFCs having sound financials and
good track record in providing credit facilities and any other institution
specifically permitted by the Reserve Bank.
Insurance companies and Mutual Funds would be permitted as market-
makers subject to their having strong financials and risk management
capabilities as prescribed by their respective regulators (IRDA and SEBI)
and as and when permitted by the respective regulatory authorities.
These entities are permitted to quote both buy and/or sell CDS spreads.
They are permitted to buy protection without having the underlying
bond.
All CDS trades need to have an RBI regulated entity at least on one side of the
transaction.
Detailed eligibility criteria have been specified for every category of market
maker. In case a market-maker fails to meet one or more of the eligibility
criteria subsequent to commencing the CDS transactions, it would not be
eligible to sell new protection. As regards existing contracts, such protection
sellers would meet all their obligations as per the contract.
The party against whose default, protection is bought and sold through a CDS
is called the reference entity. It should be a single legal resident entity [the
term resident is as defined in Section 2(v) of Foreign Exchange Management
Act, 1999] and the direct obligor for the reference asset/obligation and the
deliverable asset/obligation.
CDS is allowed only on the following reference obligations:
Listed corporate bonds Unlisted but rated bonds of infrastructure companies. Unlisted/unrated bonds issued by the SPVs set up by infrastructure
companies.
Such SPVs need to make disclosures on the structure, usage, purpose
and performance of SPVs in their financial statements.
32
The reference obligations are required to be in dematerialised form only.
The reference obligation of a specific obligor covered by the CDS contract
should be specified a priori in the contract and reviewed periodically for better
risk management.
Protection sellers should ensure not to sell protection on reference entities /
obligations on which there are regulatory restrictions on assuming exposures in
the cash market such as, the restriction against banks holding unrated bonds,
single/group exposure limits and any other restriction imposed by the regulators
from time to time.
Users cannot buy CDS for amounts higher than the face value of corporate bonds
held by them and for periods longer than the tenor of corporate bonds held by
them. They shall not, at any point of time, maintain naked CDS protection i.e.
CDS purchase position without having an eligible underlying.
Proper caveat has to be included in the agreement that the market-maker,
while entering into and unwinding the CDS contract, needs to ensure that the
user has exposure in the underlying.
Further, the users are required to submit an auditor's certificate or custodian's
certificate to the protection sellers or novating users (users transferring the
CDS), of having the underlying bond while entering into/unwinding the CDS
contract.
Users cannot exit their bought positions by entering into an offsetting sale
contract.
They can exit their bought position by either unwinding the contract with the
original counterparty or, in the event of sale of the underlying bond, by assigning
(novating) the CDS protection, to the purchaser of the underlying bond (the
"transferee") subject to consent of the original protection seller (the "remaining
party").
After assigning the contract, the original buyer of protection (the "transferor")
will end his involvement in the transaction and credit risk will continue to lie
with the original protection seller.
In case of sale of the underlying, every effort should be made to unwind the CDS
position immediately on sale of the underlying. The users are given a maximum
grace period of ten business days from the date of sale of the underlying bond
to unwind the CDS position.
33
In the case of unwinding of the CDS contract, the original counterparty (protection
seller) is required to ensure that the protection buyer has the underlying at the
time of unwinding.
The protection seller should also ensure that the transaction is done at a
transparent market price and this must be subject to rigorous audit discipline.
CDS transactions are not permitted to be entered into either between related
parties or where the reference entity is a related party to either of the contracting
parties.
Related parties are as defined in 'Accounting Standard 18 - Related Party
Disclosures'.
In the case of foreign banks operating in India, the term 'related parties'
includes an entity which is a related party of the foreign bank, its parent, or
group entity.
The user (except FIIs) and market-maker need to be resident entities.
CDS Contracts
The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined a priori in the
documentation.
The reference asset/obligation and the deliverable asset/obligation should be to a resident and denominated in Indian Rupees.
The CDS contract has to be denominated and settled in Indian Rupees. Obligations such as asset-backed securities/ mortgage-backed securities,
convertible bonds and bonds with call/put options are not permitted as
reference and deliverable obligations.
CDS cannot be written on interest receivables. CDS cannot be written on securities with original maturity up to one
year e.g. Commercial Papers (CPs), Certificate of Deposits (CDs) and
Non-Convertible Debentures (NCDs) with original maturity up to one
year.
The CDS contract must represent a direct claim on the protection seller.
The CDS contract must be irrevocable; there must be no clause in the contract that would allow the protection seller to unilaterally cancel
34
the contract. However, if protection buyer defaults under the terms of
contract, protection seller can cancel/revoke the contract.
The CDS contract should not have any clause that may prevent the protection seller from making the credit event payment in a timely
manner, after occurrence of the credit event and completion of necessary
formalities in terms of the contract.
The protection seller shall have no recourse to the protection buyer for credit-event losses.
Dealing in any structured financial product with CDS as one of the components is not permitted.
Dealing in any derivative product where the CDS itself is an underlying is not permissible.
The CDS contracts need to be standardized. The standardisation of CDS contracts in terms of coupon, coupon payment dates, etc. will be as put
in place by FIMMDA in consultation with the market participants.
The credit events specified in the CDS contract may cover: Bankruptcy, Failure to pay, Repudiation/moratorium, Obligation acceleration,
Obligation default, Restructuring approved under Board for Industrial
and Financial Reconstruction (BIFR) and Corporate Debt Restructuring
(CDR) mechanism and corporate bond restructuring.
The contracting parties to a CDS may include all or any of the approved credit events.
Further, the definition of various credit events should be clearly defined in the bilateral Master Agreement.
A Determination Committee (DC) formed by the market participants and
FIMMDA has a key role. The DC, based in India, has to deliberate and resolve
CDS related issues such as Credit Events, CDS Auctions, Succession Events,
Substitute Reference Obligations, etc.
At least 25 per cent of the members should be drawn from the users.
The decisions of the Committee are binding on CDS market participants.
The parties to the CDS transaction have to determine upfront, the procedure
and method of settlement (cash/ physical/ auction) to be followed in the
event of occurrence of a credit event and document the same in the CDS
documentation.
35
For transactions involving users, physical settlement is mandatory.
For other transactions, market-makers can opt for any of the three settlement
methods (physical, cash and auction), provided the CDS documentation
envisages such settlement.
While the physical settlement would require the protection buyer to transfer
any of the deliverable obligations against the receipt of its full notional / face
value, in cash settlement, the protection seller would pay to the protection
buyer an amount equivalent to the loss resulting from the credit event of the
reference entity.
Auction settlement may be conducted in those cases as deemed fit by the
DC. Auction specific terms (e.g. auction date, time, market quotation amount,
deliverable obligations, etc.) will be set by the DC on a case by case basis.
If parties do not select Auction Settlement, they will need to bilaterally settle
their trades in accordance with the Settlement Method (unless otherwise freshly
negotiated between the parties).
The accounting norms applicable to CDS contracts are on the lines indicated
in the 'Accounting Standard AS-30 - Financial Instruments: Recognition and
Measurement', 'AS- 31, Financial Instruments: Presentation' and 'AS-32 on
Disclosures' as approved by the Institute of Chartered Accountants of India
(ICAI).
Market participants have to use FIMMDA published daily CDS curve to value their
CDS positions. However, if a proprietary model results in a more conservative
valuation, the market participant can use that proprietary model.
For better transparency, market participants using their proprietary model for
pricing in accounting statements have to disclose both the proprietary model
price and the standard model price in notes to the accounts that should also
include an explanation of the rationale behind using a particular model over
another.
The participants need to put in place robust risk management systems.
Market-makers have to ensure adherence to suitability and appropriateness
criteria while dealing with users.
CDS transactions must be conducted in a transparent manner in relation to
prices, market practices etc.
From the protection buyer's side, it would be appropriate that the senior
36
management is involved in transactions to ensure checks and balances.
Protection sellers need to ensure:
CDS transactions are undertaken only on obtaining from the counterparty, a copy
of a resolution passed by their Board of Directors, authorising the counterparty
to transact in CDS.
The product terms are transparent and clearly explained to the counterparties
along with risks involved.
Market-makers have to report their CDS trades with both users and other
market-makers on the reporting platform of the CDS trade repository within 30
minutes from the deal time.
The users are required to affirm or reject their trade already reported by the
market- maker by the end of the day.
In the event of sale of underlying bond by the user and the user assigning
the CDS protection to the purchaser of the bond subject to the consent of
the original protection seller, the original protection seller has to report such
assignment to the trade reporting platform and the same should be confirmed
by both the original user and the new assignee.
4. swaption
A swaption is an option to enter into a swap.
Suppose that a borrower has entered into a 5-year loan agreement where he
has to pay MIBOR + 2%. He is prepared to take interest risk for 2 years. But,
he is worried about interest rates after 2 years.
At the end of 2 years, he can do a swap to pay fixed and receive floating. The
only problem is that the terms of the swap will depend on the interest rate
scenario at that time.
Instead, he can enter into a swaption today. This will give him the right, but
not an obligation to do the swap after 2 years. The terms of the underlying
swap are decided today, for which he will have to pay an option premium. The
borrower, in this case, can be said to have gone long on a call option (because
he will receive floating under the swap) on the swap.
Suppose that the original loan agreement was on fixed interest rate basis, and
the subsequent swap is for the borrower to pay floating and receive fixed. If
the borrower does a swaption, he is said to have gone long on a put option
(because he will pay floating under the swap) on the swap.
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2.7 SSELECTIVVELLY- Invest Classification Scheme for Investment Products1
The ever widening range of investment products does create confusion in the market place.
The positives of a product, effectively marketed, can cover up the risk elements inherent to
the product. This can lead the investor to take wrong investment decisions.
SSELECTIVVELLY-Invest Classification Scheme that helps the investor to get a comprehensive
understanding of any investment product. The following drivers of risk and return are the
attributes of SSELECTIVVELLY-Invest:
Source (Issuer)
Sector - for non-government exposures
Exposure (Asset Class)
Liquidity (offered by Issuer / Issuer's agent / Market)
End (Maturity)
Cost
Tax Exemption
Insurance level
Vehicle
(The structure through which investment is being made, e.g. Direct, Mutual Fund,
Insurance, PE Fund, VC Fund, Structured Product, etc.)
Valuation
Exchange Rate
Leverage (asset class)
Leverage (foreign currency)
Yield
2.8 Off-Balance Sheet Exposures
The discussions in this chapter so far focussed on items that appear in the balance sheet of
the company. It is possible to have exposures that are not part of the balance sheet numbers,
though they may be mentioned in the Notes to the accounts.
For example, the company may give a guarantee to a party A for the benefit of some third
1 Chapter 29 of Wealth Engine: Indian Financial Planning & Wealth Management Handbook by SundarSankaran
38
party, B. It will be mentioned in the Notes to the accounts. However, if Party B defaults, then
the company becomes liable to Party A for the guarantee amount. At that stage, it will be
mentioned in the liability side of the balance sheet.
Securitisation with recourse, discussed in Chapter [5], is another example of Off-Balance
Sheet exposure.
Off-Balance Sheet exposures are a form of financial engineering where the company takes up
risks without it affecting its balance sheet immediately. Such transactions need to be handled
with care. In particular, it should be ensured that the company has the balance sheet strength
to bear the consequences, if the exposure becomes a liability.
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Self-Assessment Questions
Which of the following are traded in an exchange?
- Futures and Options
- Futures
- Options
- Swaps
Which of the following has asymmetric payoff structure?
- Futures and Options
- Futures
- Options
- Swaps
ABC buys an option for which exercise price is Rs100 and option premium is Rs5. What
is the breakeven price?
- Rs. 105
- Rs. 95
- Rs. 105 if it is a call
- Rs. 95 if it is a call
Off-balance sheet exposures are illegal.
- True
- False
Swaption is
- Option to enter into a swap
- Swap between two options
- Option backed by a swap
- Swap backed by an option
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Chapter 3 Capital Structure &Weighted Average Cost of Capital
3.1 Background
The previous chapter focused on products / exposures related to the asset side of the balance
sheet of any company. Here, we consider various aspects of the liability side.
3.2 Capital Structure
Capital structure refers to the mix of equity and debt in the balance sheet of a company.
In many of the capital structure and return calculations, the term equity includes not only
equity share capital but also reserves. Further, miscellaneous expenses not written off (e.g.
preliminary expenses), if any, appearing on the asset side of the balance sheet, is subtracted.
Thus, equity is a loosely worded reference to net worth i.e. the entire equity shareholders
funds.
For example, suppose a company has equity capital of Rs. 30mn, reserves of Rs. 20mn and
preliminary expenses not written off amounting to Rs. 1mn. In a strict sense, equity is only
Rs. 30mn. However, reserves also belong to equity shareholders; preliminary expenses are
to be written off from the books over a period of time i.e. they will not be converted into cash
unlike assets like inventory or investments in other companies. Net worth of the company is
calculated as Rs. 30mn + Rs. 20mn Rs. 1mn i.e. Rs. 49mn.
Equity does not need to be repaid to investors. Similarly, there is no compulsion to service
the equity. If the companys performance suffers, it can choose not to pay a dividend to
shareholders. Therefore, equity is often seen as a safe source of funds for companies.
On the other hand, debt needs to be repaid to investors. Debt has to be serviced, even if the
company suffers losses. If it is not serviced, lenders can take-over assets of the company
against which the debt is secured, or even file for winding up of the company. So, debt is
seen as a risky source of funds.
One reason for companies to opt for debt, despite the risk, is the influence it has on the return
on equity, as shown in Table 3.1.
Four companies in the same business are concerned. Each has invested Rs. 100mn in the
business, but with different mixes of equity and debt. Company A is entirely equity funded;
Company B has an equal mix of equity and debt; and Company C and Company D have debt
that is 4 times its equity. Suppose all companies are able to borrow at 10%.
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Table 3.1
Effect of debt on shareholder return
Company a Company B Company C Company d
Shareholders funds (Net Worth) Rs. Mn. 100 50 20 20
Debt Rs. Mn. 0 50 80 80
Capital Invested Rs. Mn. 100 100 100 100
Interest Rate 10% 10% 10%
Business Return (pre-interest) % 12% 12% 12% 8%
Business Profits (pre-interest) Rs. Mn. 12 12 12 8
Interest Cost Rs. Mn. 0 5 8 8
Profits for Equity Investors Rs. Mn. 12 7 4 0
Return for Equity Investors % 12% 14% 20% 0%
Company A, Company B and Company C are equally efficient, generating a business return of
12%. Company D is less efficient, with a business return of 8%.
Since Company A has no debt, shareholder return (also called return on equity or return on
net worth) is the same as the business return viz. 12%.
Company B is able to generate 12% as against its cost of debt of 10%. The differential return
becomes available to shareholders. This boosts the shareholder return to 14%.
Company C, too, is able to generate 12% as against its cost of debt of 10%. The differential
return is available for a higher amount of debt than in the case of Company B. This differential
return becomes available to a smaller base of shareholders funds. This boosts the shareholder
return to 20%.
A point to note is that the actual business profits are the same for companies A, B and
C. Interest cost is higher for Company C as compared to Company B; Company A has no
interest cost. So the profit for equity investors (in Rs.) is higher for Company A as compared
to Company B, whose profits are higher than Company Cs profits. However, the shareholder
return(%) is higher for Company C as compared to Company B, whose return (%) is higher
than that of Company A.
Company D generated 8% return, which is lower than its cost of debt of 10%. Thus, it lost
money on the debt. Overall, the business return just about covers for the interest cost.
Nothing is left for the shareholders. If the interest rate were higher (which it ought to be,
given the weaker financials) or business return were lower, the return for equity investors
would have become negative.
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Thus, debt can improve shareholder return, provided the overall business return is higher
than the cost of debt.
In a poor year, Company Cs business return can dip to 8% or lower, in which case it will end
up with no profits or even losses for shareholders. However, at 8% business return, Company
B will still have a profit for shareholders (Calculate and see how?) and Company A will have
the same 8% return for shareholders.
Thus, it is not adequate to only ensure that business return is more than cost of debt. Higher
the debt as a percentage of shareholders funds (i.e. debt equity ratio also called leverage),
greater the risk to the shareholders. The debt equity ratio is 1:1 for Company B, and 4:1 for
Company C and Company D.
It follows that more risky the capital structure, lesser should be the risk taken on the asset
side. This is discussed in greater detail in Chapters [4] and [5].
3.3 Earnings, Interest and Debt Servicing
The money flows for debt servicing comes from the earnings of the company. So, another
perspective on risk related to debt comes from the comparision of earnings with debt servicing
requirements of the company. This is measured through the interest coverage ratio (ICR) and
overall debt servicing coverage ratio (DSCR), as shown in Table 3.2 and Table 3.3.
Table 3.2
Interest Coverage Ratio
Rs. Mn.
1 2 3 4 5
EBIT 12 25 43 68 103
Interest 9 8 6 4 2
ICR (EBIT Interest) 1.33 3.13 7.17 17 51.5
Interest coverage of 1.33 in year 1 means that even if the Earnings before Interest and Tax
(EBIT) of the company were to go down by (1.33 1) 1.33 i.e. 25%, it will have adequate
profits to pay interest. (The legal position is that the company has to service its debts even if
the company does not earn profits)
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Table 3.3
Debt Servicing Coverage Ratio
Rs. Mn.
1 2 3 4 5 Total
EBIT 12 25 43 68 103
Depreciation 10 9 8 7 7
Cash Flows for Debt Servicing 22 34 51 75 110 292
Interest & Principal Paid 18 17 16 14 13 78
DSCR (Cashflow EMI) 1.22 2.00 3.19 5.36 8.46 3.74
DSCR of 1.22 in year 1 means that even if the cash flows (EBIT + Depreciation) of the
company were to go down by (1.22 1) 1.22 i.e. 18%, it will have adequate cash flows to
service the debt. (The legal position is that the company has to service its debts even if the
company does not have cash flows)
Higher the ICR and DSCR, the more comfortable is the companys borrowing. This needs to
be viewed in the context of the companys business environment and overall cost structure.
These are covered in the discussions on leverage in Chapter [4].
3.4 Sources of equity funds
Initial equity comes from the promoters. Thereafter, profits boost the equity funds of the
company; losses eat into the equity funds. Profits that are not distributed as dividends are
the retained earnings, which become part of reserves (included in shareholders funds) of the
company.
Equity capital is also mobilised from venture capital and other private equity funds, foreign
institutional investors, banks, financial institutions, collaboraters, employees and the general
public.
3.5 Cost of equity
The actual payment that a company makes to investors regularly is the dividend. It is declared
as a percentage to face value e.g. 20%. If shares of the company have face value of Rs. 10,
then the Dividend per Share (DPS) is Rs. 2. However, the effective yield for investors depends
on the market price of the shares. An investor who buys share of the company at Rs. 80, has
a dividend yield of only Rs. 2 Rs. 80 X 100 i.e. 2.5%.
Neither 10% nor 2.5% reflects the true cost of equity, because investors buy equity shares for
44
the capital gain dividend is incidental to the investment. There are various approaches to
determining the cost of equity. Two methods are more commonly used are as follows:
D/P + g
D/P is the dividend yield that was worked out earlier. The capital gains is captured
in g, which stands for earnings growth. If earnings were to go up 12%, then Price-
Earnings ratio remaining the same, the share price will also go up by 12%. This flows
from the relationship EPS X P/E Ratio = Price.
In the above case, dividend yield was 2.5%. If earnings growth is 12%, cost of equity
can be computed as 2.5% + 12% i.e. 14.5%.
Beta-based approach
Beta as a measure of systematic risk was discussed in Chapter [1]. Investors have
the option of placing their moneys in government securities and earn a risk-free return
(Rf). Suppose this is 8%.
Investing in the market entails greater risk. Suppose investors are able to earn 14%
by investing in a diversified portfolio of equities. The difference between market return
(Rm) and Rf is called risk premium. It is the premium that investor is earning for taking
the additional market risk.
Investing in a diversified portfolio ensures that non-systematic risk is eliminated. So
risk premium is a return for systematic risk i.e. beta. The market is said to have a beta
of 1. If beta of the company is higher than 1, then it is more risky than the market.
So, its equity ought to offer a higher return to investors, than the market. A company
with beta lower than 1 can afford to offer a lower return than the market. Accordingly,
cost of equity can be computed as per the following formula:
Rf + (Rm Rf) X
In the above case, if beta of a company is 1.2, then cost of equity is
8% + (14% - 8%) X 1.2
i.e. 15.2%
3.6 Sources of debt funds
Debt is mobilised either in the form of loans or issue of securities. Loans can be from banks,
domestic financial institutions, international financial institutions and such other lenders. Fixed
deposits mobilised from the public are a form of loan by the depositers to the company.
Debt securities issued may be short term or long term. Bonds and debentures are a form of
long-term debt security. Commercial paper and certificate of deposits meet the short-term
debt needs of companies.
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Bill discounting is another form of short-term debt funds. Suppose an automobile company
has purchased silencers from an auto ancillary company. The normal credit terms are 1
month. The ancillary company will receive money in the normal course, only after a month.
If the auto ancillary company needs money urgently, it can raise a Bill of Exchange on the
automobile company. A Bill of Exchange is a document prepared by the auto ancillary company,
calling upon the automobile company to pay the said amount in 1 month.
Once the automobile company signs the Bill, as a token of acceptance of its liability, the auto
ancillary can discount it with a bank and receive money upfront. It will endorse the bill in
favour of the bank. At the end of 1 month, the bank will produce the bill to the automobile
company and get paid.
Suppose the Bill is for Rs. 1,000,000 and the bank pays the auto ancillary company a discounted
amount of Rs. 989,750, 28 days before the maturity of the bill. The difference of Rs. 10,250 is
effectively an interest cost for the auto ancillary company for 28 days. The effective borrowing
cost can be computed as Rs. 10,250 Rs. 989,750 X (365 28) i.e. 13.5%.
Besides receiving the money upfront, the automobile ancillary company has other benefits
from
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