Treasury Division

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Treasury Division its functions
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TREASURY ACTIVITIES

• Treasury Division Heart of the bank
• Managing Asset Liabilities of the bank The
  Balance Sheet Management. Thereby enhancing the
  risk-adjusted return on equity.

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Objectives Maximizing Risk Weighted Returns

• Risk Weighted Returns take into account liquidity
  and interest rate gap risk associated with
  certain asset or liability instead of applying
  same interest rate to assess the cost/return of
  liability/asset
• e.g. Branch A

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MONEY MARKETMECHANISM, MARKET INSTRUMENTS
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Functions of Money Market Desk

• The need for financial institutions to indulge in
  money market transactions arises primarily from
  the statutory reserve and liquidity requirements
  imposed by the State Bank.

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MARKET TYPES

• Primary Market
• This constitutes all securities issued for the
  first time.
• Secondary Market
• The securities issued in the primary market
  are then traded in the secondary market among
  banks, investors etc.

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MARKET PARTICIPANTS

• Commercial Banks /NBFIs.
• State Bank of Pakistan.
• Corporate Treasuries.
• Public Sector/Government.
• Inter-Bank Brokerage Houses-Playing the role of
  facilitators.
• Exchange Companies

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PRIMARY DEALER SYSTEM

• The PDs are Price makers, quoting two-way prices
  reflective of market sentiment and actively
  participating in trading of all marketable
  securities.
• PD must be a Band/ DFI/ Investment Bank/ Listed
  Brokerage House.
• The PD status is assigned by the SBP.

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Money Market Activities

• Money Market Transactions
• Call/Term lending/borrowing
• Clean lending/borrowing among banks.
• Providing KIBOR as a benchmark for term lending
  to the corporate sector.
• Less developed as compared to other countries
  because of the presence of more developed
  REPO/Reverse REPO market.

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Money Market Activities

• Money Market Transactions Contd.
• REPO/Reverse REPO
• Repurchase of securities. Introduced in early
  80s. Akin to Collateralized lending borrowing and
  Governed by Master REPO Agreement.
• Securities usually repurchased are T Bills, FIBs,
  PIBs etc.

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Money Market Activities

• Money Market Transactions Contd.
• Outright Purchase/Sale of Securities
• Purchase of government securities i.e. Treasury
  Bills and Pakistan Investment Bonds (PIBs) for
  portfolio management.
• Purchase/Sale of securities is based on the
  portfolio strategy and market conditions.

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Money Market Activities

• Major Money Markets instruments.
• Market Treasury Bills.
• 3, 6 and 12 months maturity, zero coupon
  instruments priced at discount.
• Issued by Govt. to finance current expenditure.
• Sold by SBP through auctions.
• Risk free, highly liquid and reserve eligible.

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Money Market Activities

• Federal Investment Bonds.
• Half yearly coupon bonds. 3,5 10 years
  maturity.
• Discontinued in the Primary Market
• Issued by GoP, these bonds are only traded in the
  secondary market.
• Are SLR eligible security.

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Money Market Activities

• Pakistan Investment Bonds.
• Launched in the year 2000 to replace FIBs as a
  long term investment.
• Half yearly coupon bonds. 3, 5, 10, 15 20 years
  maturity. Are sold to Primary Dealers through
  auction.
• Active secondary market catering to banks and
  institutional investors etc.
• Are SLR eligible securities up to 5 of DTL.

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Money Market Activities

• Outstanding Stock

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MARKET YIELDS

• T-Bills

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MARKET YIELDS

• PIBs

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BENCHMARK RATES

• Discount Rate
• The SBP discount window facility offer funds to
  banks as the lender of last resort.
• Current rate is 7.5.
• Karachi Inter-bank Offer Rate (KIBOR)
• Lending rate for 1, 2 weeks and 1, 3, 6, 9 and 12
  months.
• Recently established as a benchmark rate for all
  corporate term lending.

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BONDS

• Investments for period of more than 1 year.
• Currently, PIBs are auctioned by SBP (traded in
  Primary Market).
• FIBs are no more auctioned and are traded in the
  secondary market.
• Riskier than T-Bills because of longer maturity
  and presence of coupons.

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Bonds Pricing

• A Bonds price is simply the present value of
  its
• Coupons to be received during life of the bond,
  and
• Principal repayment at the maturity.

Price C1 C2 . Cn FV
1 i (1 i)2 (1 i)n (1 i)n
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Bonds Pricing

• Issued / traded at Premium or Discount depending
  upon the coupon rate and the market yield for the
  tenors.
• Bond trades at Premium when
• Coupon Rate gt Market Yield
• and vice versa.

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Bonds Pricing

• Bonds price (whether at premium or at discount)
  converges to its par value as the bond reaches
  its maturity.

Premium Bond
Maturity
Par Value
Discount Bond
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Sensitivity Measures for Bonds

• Duration
• Price Value of a Basis Point (PVBP or PV01)
• Convexity

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Duration

• Measures the Interest Rate Risk or Price Risk.
• Measures the change in price of the bond w.r.t
  change in the yield.

Price
Change in Price as the yield drops by 1
Yield
3
4
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Duration

• Higher for papers with longer maturity.
• Lower for bonds with higher coupon rate.
• For a zero coupon bond, duration is approx. equal
  to life of the bond.
• However, duration of a zero coupon security is
  higher compared to that of coupon bonds.

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PVBP

• Calculates the change in price as a result of 1
  basis point (0.01) change in yield.
• As Duration measures the change in price for 100
  basis point change in yield, PVBP is
• PVBP Duration (for 1) / 100

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Convexity

• The change in duration for a change in yield.
• Convexity adjusts the flaw in the price estimated
  by duration, especially for larger changes in the
  yield.

Convexity Adjustment
Price
Price estimated through Duration
Yield
1
4
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Convexity

• Duration underestimates the increase in Bonds
  price and overestimates the decline.
• Therefore, Convexity adjustment is to be added to
  the duration estimate in both the cases of price
  increase or decrease.

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Interest Rate Derivatives

• Interest Rate Swap (IRS)
• Forward Rate Agreement (FRA)

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The Derivatives Market

• A Derivative transaction is a contract whose
  value depends on (or derives from) the value of
  an underlying asset, reference rate or index.
  (Group of Thirty, Global Derivatives Study 1993).
• Underlying asset may refer to
• Currency
• Interest Rate
• Stock Price
• Commodity
• Derivatives are sometimes referred to as
  contingent claims.
• Derivatives contracts are of two types
• Exchange traded contracts.
• OTC (Over the Counter) Contracts.

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Forward Rate Agreement (FRA)

• An agreement to fix interest rate for a future
  transaction based on a certain benchmark.
• Agreement to borrow/lend an amount of money
  (nominal principal)
• At a specified future date (settlement date)
• For a specified tenor
• For a specified interest rate (forward rate)
• FRA buyer hedges against rising interest rates.
• Buy a 6-over-9M FRA for PKR10 Million at 9
• Agreement to...
• Borrow PKR 10 Million for 3M
• At a date 6M from today
• At 9 cost

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FRAs A Practical Example

• A bank needs to fund a six month fixed rate
  Dollar Loan.
• Two choices are available
• Borrow for six months at KIBOR, 8 3/8.
• Fund the first three months using its own funds
  at a cost of 8 1/16.
• In choosing option 2 the runs the risk that
  interest rates will rise within
• three months and that overall funding cost will
  be above 8 3/8
• To guard against this risk, the bank could buy a
  three against six FRA
• which is being quoted at 8 ¼ - 8 ½ ..
• By buying a 3/6 FRA at 8 ½ the bank locks in a
  borrowing cost of 8
• ½ from the third to the sixth month. The
  overall cost of borrowing in
• this fashion is 8.36 almost exactly the same as
  borrowing for six
• months at 8 3/8 .

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Forward Rate Agreements - Settlement

• Suppose after three months, three month KIBOR has
  risen
• to 10 ½ . The bank receives the difference
  between the
• current KIBOR and the agreed FRA rate (10 ½ - 8 ½
  2).
• Suppose FRA bought had been for a notional
  principal of
• PKR 10 M. Settlement would be as under
• The buyer of the FRA would gain 2 on PKR 10 M
  for
• three months, discounted to take account of the
  fact that it
• is being paid at the start rather than the end of
  the three
• month period. This comes to
• PKR 10,000,000 2 0.25 PKR 48,721.07
• 1 (10.50.25)

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Interest Rate Swaps

• An Interest Rate Swap is an agreement between
  counter parties in which each party agrees to
  make a series of payments to the other on agreed
  future dates until maturity of the agreement.
  Each partys interest payments are calculated
  using different benchmarks by applying the
  agreement terms to the notional principal amount
  of the swap.
• An agreement to exchange
• Floating rate payments for fixed rate payments
  (or vice-versa)
• At regular intervals over a pre-specified period
• On a certain principal amount
• Typical features
• Payments denominated in the same currency
• Payments are netted
• Principal in not exchanged
• Tailor made
• Off Balance Sheet

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IRS Floating to Fixed Swap
Fixed 3.8
Bank
ABC Ltd
6m KIBOR Current 2.25
5 year Floating rate Loan
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IRS - Applications

• If the borrowers view is that PKR interest rates
  will go higher an IRS synthetically converts a
  floating rate loan into a fixed rate loan (or
  vice versa).
• Users may be able to better match assets and
  liabilities using an interest rate swap matching
  dates, floating or fixed interest rates.
• Exchange certainly for uncertainty
• Synthetically convert a fixed rate liability into
  a floating rate liability if the borrowers view
  is that PKR interest rates will move lower.