UNIT: 1 INTRODUCTION

Treasury:

Treasury refers to the management of an organization's financial resources and activities. It encompasses a wide range of
responsibilities, including cash management, risk management, funding and borrowing, and financial planning and
analysis.
Treasury is also responsible for managing the organization's financial risks, such as currency risk, interest rate risk, and
credit risk.

The treasury function is usually headed by a chief financial officer (CFO) or a treasurer, who is responsible for overseeing
all financial activities and making sure that the organization's financial goals are met. The treasury team may also include
other professionals with expertise in areas such as financial planning, accounting, and risk management.

Treasury Management:

Treasury management is the process of managing an organization's financial resources and risks, with the objective of
maximizing its liquidity, profitability, and efficiency. It involves the planning, implementing, and controlling of the
organization's cash and financial assets.
Treasury management functions typically include cash management, investment management, debt management, risk
management, and foreign exchange management.

Scope of Treasury Management:

Liquidity Management: Liquidity means the ability to meet short-term financial needs.

Liquidity management is about ensuring a business has enough cash to keep running in the future. For banks, it’s even
more important because they deal directly with money.
Objectives of Liquidity Management:
1. Keep enough cash available to meet needs.
2. Use extra funds to earn profits.

Importance of Liquidity Management:

1. Helps seize new opportunities (e.g., launching new products or acquisitions).

2. Funds future projects and research.
3. Provides collateral for loans.
4. Supports cash-heavy activities like development.

Money Market transaction:

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Banks invest in the money market to manage liquidity and earn returns.

Capital Market transaction :

Banks invest in government bonds, corporate bonds, and shares under central bank guidelines.

Correspondent Banking:
Treasury is a CB
Banks work with other banks in different countries to help customers make international payments

Foreign Exchange Management:

The foreign exchange (forex) market is where currencies are traded. Currencies are always bought and sold in pairs.
Forex trading is essential for international business, as it supports payments in foreign currencies.

Key participants: Large banks, financial institutions, companies, and governments.

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Rate determination:
Exchange rates depend on demand and supply. Dealers set daily exchange rates and update if market conditions
change.

Roles and Functions of Treasury Department:

1. Cash Forecasting
• Treasury collects cash flow data from all branches to predict future cash needs.
• These forecasts help plan investments, borrowing, or raising funds.
• They also guide strategies to manage currency risks.

2. Working Capital Management

This involves managing the day-to-day operations of an organization
• Treasury monitors the company’s short-term assets and liabilities.

3. Cash Management
• Ensures there is enough cash for daily operations.
• This involves forecasting cash flows, managing bank relationships, and making investment decisions to optimize the
use of cash resources.

4. Investment Management
Investment is employing money
• This involves making investment decisions, monitoring investment performance, and ensuring compliance with
investment policies and guidelines.

5. Risk Management
This involves identifying, evaluating, and mitigating financial risks, including interest rate risk, foreign exchange risk, and
credit risk.
• Protects the company from rising interest rates or currency fluctuations.
• Uses strategies like hedging to reduce risks.

6. Management Advice
• Advises on market trends, interest rates, and terms for loans or investments.

7. Credit Rating Agency Relations

• Provides information to credit rating agencies that evaluate the company’s financial health.

8. Bank Relationships
• Works with banks to manage loans, fees, and services like currency exchanges and wire transfers.
• Maintains strong relationships for better terms during financial challenges.

9. Fund Raising
• Builds relationships with investors and brokers to secure funds for the company.
• Collaborates with brokers to sell the company’s debt or equity to investors.

10. Other Activities

• Helps integrate treasury systems during mergers and acquisitions.

• Manages the company’s insurance and centralizes risk management.

Principles of Treasury Management

Treasury management follows key principles to ensure financial stability and efficiency. These include:
1. Security
• Banks should invest money in safe areas with minimal risk of loss.
• They must always be able to return customers’ money on demand or as per the agreed timeline.
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2. Liquidity
• Banks need enough liquid funds (cash or easily convertible assets) to meet customer demands for loans and
withdrawals.
• They must maintain a certain level of liquid assets as per regulations to ensure smooth operations.

3. Profitability
• Investments made by the bank should provide good returns.
• Since banks aim to make a profit, they allocate their funds to maximize earnings while following regulatory
guidelines.

4. Portfolio Management
• portfolio is the combination of investments in two or more than two financial asset•
The goal of the portfolio is to minimize the risk or diversification of risk.

In summary, treasury management ensures funds are safe, liquid, profitable, and well-diversified to minimize risks.

Treasury Control:

Treasury control refers to the processes and procedures that organizations use to manage and oversee their financial
resources, including cash, investments, debt, and other financial instruments. The purpose of treasury control is to ensure
that an organization's financial activities are conducted in a safe, efficient, and compliant manner.

The key components of treasury control include:

1. Policies and Procedures: Establishing policies and procedures that outline the roles and responsibilities of
treasury personnel, and set guidelines for financial decision-making, risk management, and compliance.

2. Financial Reporting and Analysis: Providing timely and accurate financial reports and analysis to support
decision-making and evaluate the performance of the treasury function.

3. Risk Management: Identifying, evaluating, and managing financial risks, including interest rate risk, foreign
exchange risk, and credit risk.

4. Internal Controls: Implementing internal controls to ensure that financial transactions are properly recorded and
reconciled, and that financial reports are accurate and complete.

5. Compliance: Ensuring that the organization's financial activities are in compliance with laws, regulations, and
internal policies and procedures.

6. Technology: Utilizing technology to automate and streamline treasury processes, reduce operational risk, and
enhance financial reporting and analysis.

In conclusion, treasury control is an important aspect of corporate finance that helps organizations to effectively manage
their financial resources and minimize financial risks. Effective treasury control requires a combination of sound policies
and procedures, financial reporting and analysis, risk management, internal controls, compliance, and technology.

Techniques of treasury control:

There are several techniques that organizations can use to enhance their treasury control processes and procedures.
Some of the most common techniques include:

1. SEGREGATION OF DUTIES: Segregating the duties among the treasury staff ensures that the person who
concludes the deal has no control over the resulting cash flows. For example: back-office staffs are not allowed to
deal and front-office staffs are not allowed to make or approve payments or confirmations.

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2. INTERNAL AUDIT: The second technique of treasury controls is the internal audit. It is concerned with matching
actual transactions with company policies and procedures. Internal audit provide comfort to the board that
treasury matters are effectively managed and controlled in the organization. The major limitation of internal audit,
however, is that it traces the problems only after they have incurred.

3. LIMIT CONTROLS: The third technique of treasury controls is to impose limit controls on a variety of transactions
to the treasury staff. This may include: (i) restricting to invest in certain types of financial instruments that exposes
to an excessive risk of capital Joss, (ii) limiting an amount of business a company can do with the counterparty,
(iil) limitation on certain currencies. This limit is applied when a country's leaders impose currency controls in the
near future. (iv) Putting caps on the total amount of transaction a staff of treasury department can commit the
company.

In conclusion, effective treasury control requires a combination of sound policies and procedures, financial reporting and
analysis, risk management, internal controls, compliance, and technology.

Treasury Centralization:

Treasury centralization is the process where financial, cash management, investment, foreign exchange and other
strategic matters are handled by a smaller number of highly skilled staff.

Treasury centralization refers to the consolidation of an organization's financial resources and decision-making processes
into a centralized treasury function. The main goal of treasury centralization is to improve efficiency, reduce costs, and
minimize financial risks by centralizing control over the organization's cash, investments, debt, and other financial
instruments.

The benefits of treasury centralization include:

1. Improved Cash Management: Centralizing cash management allows for better forecasting, optimization, and
management of an organization's cash resources.

2. Enhanced Risk Management: Centralizing risk management allows for a more comprehensive and integrated
approach to identifying, evaluating, and mitigating financial risks.

3. Increased Transparency: Centralizing financial reporting and analysis provides a clearer and more complete
picture of an organization's financial position and performance.

4. Enhanced Compliance: Centralizing compliance ensures that all financial activities are in compliance with laws,
regulations, and internal policies and procedures.

5. Improved Technology: Centralizing technology allows for the implementation of a more integrated and efficient
technology platform that can streamline treasury processes and reduce operational risk.

6. Reduced Costs: Centralizing treasury operations can result in reduced costs by reducing the number of bank
accounts, reducing the cost of banking services, and eliminating duplicative activities.

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UNIT: 2 TREASURY ORGANIZATIONS AND STRUCTURE

Treasury organization and structure:

Treasury organization and structure refer to the organization structure of corporate treasure department that describe how
a company’s treasury department is set up and who is responsible for managing the company’s funds. Each company
organizes its treasury team based on its specific needs.

Front Office:
The front office refers to the unit within an organization responsible for the management of financial instruments such as
bonds, currencies, and derivatives. The front office is the part of the treasury that interacts directly with clients, including
corporate customers, institutional investors, and other financial institutions.

The front office is the part of the treasury department responsible for making decisions about trading and investments. It
operates as the “dealing room,” where deals are made, market positions are taken, and risks are managed

The primary functions of the front office in treasury include:

1. Sales and Trading: The front office is responsible for executing transactions on behalf of clients, including
buying and selling financial instruments.

2. Market positioning: Takes current market positions and manages market risks.

Exchange Rate and Interest Rate Management

Liquidity Management
Currency Balance Management
•Maintains the balance of currency positions
Risk Management

Middle Office:

The middle office refers to the unit within an organization responsible for supporting the front office in its operations. The
middle office acts as a link between the front office and the back office, its main role is to manage and control risks,
ensure compliance, and monitor performance.
The mid office is a part of the treasury department created to implement risk management systems and provide key
information to management. The mid office focuses on analyzing and controlling risks related to treasury operations, such
as market and credit risks.

The primary functions of the middle office in treasury include:

1. Trade Processing and Settlements: The middle office is responsible for ensuring that trades executed by the
front office are processed and settled correctly.

2.Risk Management: Identifies, measures, and monitors financial risks, such as interest rate, currency, and credit risks,
helping to ensure that these risks align with the company’s policies.

2. Compliance: Ensures that all treasury activities meet regulatory requirements and internal policies, reducing
the risk of legal or financial penalties

3. Performance Monitoring: Tracks and reports on the treasury’s performance, providing insights into
investment returns, liquidity, and the effectiveness of risk management strategies.
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4.Valuation and Reporting: Calculates and reports the value of assets, liabilities, and risk exposures, keeping
management informed for decision-making.

Back Office:

The back office refers to the unit within an organization responsible for supporting the front office and the middle office in
their operations. The back office performs operational tasks related to the processing and settlement of trades, as well as
providing support for other activities within the organization.

The primary functions of the back office in treasury include:

1. Trade Processing and Settlements: The back office is responsible for the accurate and timely processing and
settlement of trades. This includes tasks such as trade matching, confirmation, reconciliation, and settlement.

2. Record Keeping and Reporting: The back office is responsible for maintaining accurate records of all trades
and transactions, as well as producing regular reports to support the middle and front offices.

3. Operations Support: The back office provides operational support to the front and middle offices by ensuring
that the systems, processes, and infrastructure needed for trading are in place and working effectively. This
includes the development and implementation of new systems and processes to support the front office's
activities.

4. Compliance:

Treasury Dealers:

Dealers are professionals in the treasury department who manage and execute financial transactions, particularly in
foreign exchange (forex) and other markets. They handle trading activities, manage risks, and maintain the bank’s
positions in various currencies or financial instruments. They ensure transactions comply with approved limits and
guidelines, and their work is crucial for balancing risks and returns for the bank.

Roles and Responsibilities of Dealers

1. Maintaining Transaction Limits:
• Ensure individual deals and dealers operate within approved limits.
2. Handling Interbank Transactions:
• Execute trades in interbank markets, currency trading, fund placements, and funds management.
3. Currency Position Management:
• Balance open currency positions to minimize risks.
4. Determining Rates:
• Set exchange rates and interest rates for money and capital market securities.
5. Managing Liquidity:
• Maintain the bank’s liquidity, including managing cash reserve ratios to meet obligations.
6. Daily Rate Setting:
• Establish daily foreign exchange rates for cash, tom (next-day delivery), spot (two-day delivery), and forward
transactions.
7. Maximizing Returns:
• Optimize returns on cash investments through strategic decision-making.

Overview of the Dealer’s Room (Dealing Room)

The dealer’s room, also known as the trading room, is where front office treasury operations occur. Dealers conduct
financial transactions here, often supported by advanced systems like Reuters or Bloomberg. These systems help in
identifying the best rates and managing transactions efficiently.
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Key Activities in a Dealer’s Room
1. Executing Transactions:
• Buy and sell currencies or other assets for customers or interbank markets.
2. Ensuring Documentation:
• Create deal tickets for every transaction, detailing all necessary authorizations and terms.
3. Compliance Checks:
• Ensure all deals comply with pre-set limits, mandates, and regulatory requirements.
4. Coordinating with Back Office:
• Pass deal tickets to the back office for confirmation and settlement.
5. Risk Management:
• Periodically mark-to-market positions and revalue assets based on prescribed benchmarks.
6. Audit and Reporting:
• Provide accurate reports on treasury holdings, forecasts, and cash positions to senior management.

Importance of Dealers

Dealers play a critical role in maintaining the bank’s financial health by managing liquidity, mitigating risks, and optimizing
returns. They ensure compliance with policies, provide insights on market movements, and contribute to achieving the
bank’s financial objectives.A Treasury dealer is a financial professional who specializes in buying and selling Treasury
securities on behalf of clients or their employer. Treasury securities are debt instruments issued by the government and
include Treasury bills, notes, and bonds.

Book Question:

1. Discuss the structure of a Treasury function of a bank and financial institutions.

The structure of a Treasury function in a bank or financial institution can vary depending on the size and complexity of the
organization, but typically includes the following components:

i. Front Office: The front office is responsible for generating revenue by trading and executing transactions in
various financial markets, including the Treasury market. This includes Treasury dealers who buy and sell
Treasury securities and interact with clients.

ii. Middle Office: The middle office is responsible for managing the risks associated with the Treasury function,
including interest rate risk, credit risk, and market risk. This includes risk management professionals who monitor
and manage these risks, as well as traders who support the front office.

iii. Back Office: The back office is responsible for supporting the front and middle offices by providing operational
and administrative support. This includes support personnel who perform tasks such as trade settlement,
reconciliation, and reporting.

iv. Treasury Management: Treasury management includes the management of the Treasury function, including
setting and enforcing policies, managing budgets, and monitoring performance. This component also includes
professionals who manage relationships with external counterparties, regulators, and other stakeholders.

v. Treasury Operations: Treasury operations include the day-to-day processes and systems that support the
Treasury function, such as trade settlement, cash management, and accounting. This component is critical for
ensuring that transactions are processed accurately and efficiently.

Overall, the Treasury function of a bank or financial institution is structured to provide effective and efficient support for its
trading activities and to manage the risks associated with these activities. The components of the Treasury function work
together to support the objectives of the organization and to deliver high-quality service and support to clients.

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2. How do you differentiate between front office and back offices of treasury department

The front office and back office of a Treasury department are distinct functions that perform different roles and have
different responsibilities.

The front office of a Treasury department is responsible for generating revenue by trading and executing transactions in
financial markets. This includes Treasury dealers who buy and sell Treasury securities and interact with clients. The front
office is often referred to as the "face" of the Treasury department as it is the point of contact with clients.

On the other hand, the back office of a Treasury department provides operational and administrative support for the front
office. This includes support personnel who perform tasks such as trade settlement, reconciliation, and reporting. The
back office is critical for ensuring that transactions are processed accurately and efficiently, but it is typically not directly
involved in client interactions.

The key difference between the front office and back office of a Treasury department is their focus and responsibilities.
The front office focuses on generating revenue through trading activities, while the back office focuses on providing
operational and administrative support. The front office is often seen as the "revenue-generating" part of the Treasury
department, while the back office is seen as the "support" part of the department.

Overall, the front office and back office of a Treasury department play complementary roles in ensuring that the Treasury
function is effective and efficient. The front office interacts with clients and generates revenue, while the back office
supports the front office by performing critical operational and administrative tasks.

3. Which part of BFIs is known as the revenue generators and why? Explain.

In a bank or financial institution (BFI), the front office is often considered to be the revenue generator. The front office is
responsible for generating revenue by trading and executing transactions in financial markets, including the Treasury,
bond, currency, and derivatives markets. This includes traders, salespeople, and relationship managers who interact with
clients and execute transactions.

The front office is known as the revenue generator because its primary focus is to generate profits through trading
activities. This is achieved by buying and selling financial instruments at the best possible prices, and by executing trades
on behalf of clients. The front office is typically the most visible part of a BFI, as it is the point of contact with clients and is
responsible for generating the majority of the BFI's revenue.

The back office, on the other hand, provides operational and administrative support for the front office, but does not
directly generate revenue. The back office is responsible for tasks such as trade settlement, reconciliation, and reporting,
and is critical for ensuring that transactions are processed accurately and efficiently.

Overall, the front office and back office play complementary roles in a BFI, with the front office generating revenue through
trading activities, and the back office providing support to ensure that these activities are executed effectively and
efficiently.

4. Explain the dealing room functions.

The dealing room, also known as the trading room or trading floor, is the hub of a bank or financial institution's trading
activities. It is where traders, salespeople, and other front-office professionals execute trades and interact with clients. The
dealing room is typically equipped with advanced technology, including high-speed computers, multiple monitors, and
communication systems, to enable traders to make quick and informed decisions.

The primary functions of a dealing room include:

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i. Trading: The most important function of the dealing room is to execute trades in various financial markets,
including the Treasury, bond, currency, and derivatives markets. Traders buy and sell financial instruments, such
as bonds, currencies, and derivatives, on behalf of clients or for the bank's own account.

ii. Market-making: Traders in the dealing room also make markets in various financial instruments, which means
they quote bid and ask prices and are willing to buy and sell the instrument at those prices.

iii. Risk Management: The dealing room is also responsible for managing the risks associated with trading
activities, including interest rate risk, credit risk, and market risk. Traders use risk management tools and
techniques to monitor and manage these risks.

iv. Client Relations: The dealing room is the main point of contact for clients, and traders and salespeople in the
dealing room are responsible for maintaining and developing client relationships. This includes providing market
insights and advice, executing trades, and resolving any issues that may arise.

v. Market Intelligence: Traders in the dealing room are also responsible for staying informed about market
developments and trends, and for providing market intelligence to clients and the rest of the bank. This includes
monitoring financial news and data, and analyzing market data to identify trends and opportunities.

Overall, the dealing room is a critical component of a bank or financial institution's trading activities, and its functions play
a key role in enabling the bank to execute trades effectively and efficiently, manage risks, and maintain strong
relationships with clients.

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UNIT: 3 SOURCES OF FUND

Sources of Bank Funds:

Banks raise funds from a variety of sources to support their lending activities and other operations. Some of the common
sources of funds for banks are:

Deposits: This is the most important source of funds for banks. Banks accept deposits from individuals, businesses, and
other entities and use those funds to lend to borrowers. Deposits can be in the form of savings accounts, checking
accounts, certificates of deposit (CDs), and other types of accounts.

Wholesale Funds: Banks also raise funds from wholesale sources, such as large corporations, institutional investors, and
other financial institutions. Wholesale funds can be raised through the issuance of bonds, commercial paper, or other
securities.

Capital Markets: Banks also raise funds through capital markets by issuing stocks, bonds, or other securities. This allows
banks to tap into a large pool of funds from a wide range of investors.

Central Bank Funding: In some cases, banks may also borrow from central banks, either in the form of overnight loans
or longer-term lending facilities. This type of funding is typically used to manage short-term liquidity needs.

Interbank Lending: Banks can also raise funds by borrowing from other banks. This type of lending is typically done
through the interbank market, where banks lend and borrow funds from one another on a short-term basis to meet their
funding needs.

Government Funding: In some cases, banks may also receive funding from the government through various programs
and initiatives.

Overall, banks use a combination of these sources of funds to support their lending and other operations. The specific
sources of funds that a bank uses will depend on a variety of factors, including its business model, funding needs, and
regulatory requirements.

Deposit:

A bank deposit refers to placing money in a bank account that typically pays interest. It allows customers to deposit and
withdraw money while keeping the funds safe.

Types of Bank Deposits:

1. Deposit Account:
• Pays interest to the account holder.
• May require advance notice or impose penalties for early withdrawal.
2. Deposit Receipt:
• An acknowledgment from the bank confirming the amount deposited.
3. Certificate of Deposit (CD):
• A transferable financial instrument that acknowledges the deposit.

Key Features of Bank Deposits:

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• Liability for the Bank: Deposited money is recorded as a liability for the bank because it owes the amount to
the customer.
• Account Types: Savings accounts, current accounts, or other types of accounts allow deposits and
withdrawals.
• Interest or Fees: Some accounts pay interest on deposits, while others may charge fees for services.

Deposit and Withdrawal:

• Deposit: Adding money to a bank account.
• Withdrawal: Removing money from a bank account.

Fixed Deposit:

A fixed deposit (FD), also known as a time deposit, is a type of bank account where a fixed amount is deposited for a
specific period at a higher interest rate.

Key Features of Fixed Deposit

1. Fixed Time Period: The deposit is locked for a predetermined duration, and withdrawals are typically allowed only
upon maturity.
2. Higher Interest Rates: Fixed deposits offer higher interest compared to savings accounts due to their longer lock-in
period.
3. Deposit Receipt: A receipt is issued, including details like depositor’s name, amount, maturity date, and interest rate.
4. Non-Transferable: Fixed deposits cannot be transferred like cheques.
5. Loan Facility: Banks may allow customers to borrow up to 90% of the FD amount by charging extra interest.
6. Renewal or Withdrawal: On maturity, the deposit can be renewed or withdrawn, with the depositor receiving principal
and interest.
7. Premature Withdrawal: Some banks allow early withdrawal, but at a reduced interest rate (1% lower than applicable
rates).
8. Cost-Effective: FDs incur lower administrative costs compared to savings accounts due to minimal transactions.

Revolving Deposit

A revolving deposit is a modified type of fixed deposit where additional amounts can be deposited periodically. It is also
referred to as a recurring deposit in Nepal.

Key Features of Revolving Deposit

1. Fixed Period and Interest: Deposits are made for a fixed duration with a fixed interest rate.
2. Flexible Contributions: Customers can add amounts at intervals.
3. Goal-Oriented Savings: Customers can set savings goals and receive a fixed amount upon maturity.
4. Loan Facility: Borrowing up to 90% of the deposit amount is allowed at a slightly higher interest rate.
5. Interest Calculation: Interest is often calculated daily and compounded quarterly.

Examples of Revolving Deposits in Nepal

1. NMB Mero Wish Deposit:
• Flexible deposits with fixed deposit-like returns.
• Tenor: 6 months to 6 years.
• Interest: Calculated daily and based on applicable FD rates.
2. SBI Ujjwal Bhavisya Bachat Yojana:
• Monthly fixed deposits with a lump sum payout at maturity.
• Deposit Amount: Rs. 200 and above in multiples of Rs. 100.
• Tenor: 12 months to 84 months.
3. EBL Flexi Recurring Deposit:
• Targeted at individuals with fluctuating incomes.
• Deposit Amount: Rs. 100 or multiples (up to 10 times the base amount).
• Tenor: 6 months to 10 years.

Conclusion

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Both fixed and revolving deposits are essential saving tools. Fixed deposits offer higher interest with a lock-in period, while
revolving deposits allow flexibility and periodic savings, making them ideal for different financial needs.

Interest bearing deposits:

Interest-bearing deposits allow account holders to earn interest on their deposited money. These deposits are typically
used by individuals and organizations to grow their savings while maintaining safety and liquidity. They can be divided into
three types:

1. Savings Deposit
• Definition: Savings accounts are deposit accounts that earn interest.
• Target Audience: Individuals, especially small depositors or low-income investors.
• Key Features:
• Limited withdrawals and transactions based on bank rules.
• Interest rate is lower than fixed deposits but higher than current deposits.
• Stability to bank deposits due to a large depositor base.
• Services offered: ATM cards, insurance, e-banking, etc.
• Examples: Ketaketi Bachat Khata, Budabudi Bachat Khata.

2. Fixed Deposit
• Definition: A fixed deposit (FD), or time deposit, requires depositing a fixed sum for a specific period.
• Target Audience: Individuals or organizations not needing funds for a set period.
• Key Features:
• Higher interest rates compared to other deposits.
• Funds are locked until maturity, ensuring no withdrawals or transactions.
• Deposit receipt issued (non-transferable).
• Loans can be taken against the FD by paying extra interest.
• On maturity, the deposit can be renewed or withdrawn.
• Banks may allow early withdrawals but with penalties on interest.

3. Call Deposit
• Definition: A hybrid account combining features of savings and current accounts.
• Target Audience: Firms, corporations, and financial institutions.
• Key Features:
• Flexible withdrawals without a specific maturity period.
• Interest rates are negotiable between the client and the bank.
• Mainly used for interbank borrowing and lending.

Non-Interest-Bearing Deposits

Non-interest-bearing deposits do not earn any interest. These accounts are designed for easy access to funds and are
commonly used for operational or transactional purposes.

1. Current Deposit
• Definition: Current accounts are demand deposits with no interest paid.
• Target Audience: Traders and businesses requiring frequent transactions.
• Key Features:
• Unlimited withdrawals and deposits.
• Highly volatile deposit volume.
• Banks may charge fees for maintaining these accounts.

2. Margin Deposit

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• Definition: Non-interest-bearing accounts used as collateral for availing bank facilities.
• Key Features:
• Deposits are used for guarantees, letters of credit, and remittances.
• No withdrawals allowed until the facility expires.

Capital or Equity:
Equity is the leftover value when you subtract all the liabilities (what the bank owes) from the total assets (what the bank
owns).
• It is a critical part of the bank’s balance sheet and includes:
• Common Stock: Shares held by shareholders.
• Preferred Stock: Special shares with fixed returns.
• Surplus: Extra money earned from selling stock above its basic value.
• Undivided Profits (Retained Earnings): Profits the bank has saved instead of paying to shareholders as dividends.

2. How is Equity Measured?

• Book Value of Equity:
• Based on historical data (e.g., the par value of shares, retained profits).
• It represents the accounting value of equity.
• Market Value of Equity:
• Includes future expectations of earnings and risk.
• Reflects what investors believe the equity is worth in the market.

3. Bank Reserves and Loan Losses

• Loan Loss Reserves:
• Banks save money in reserve accounts to cover losses when loans default.
• This ensures the bank doesn’t immediately lose current profits.
• Provision for Loan Losses (PLL):
• Banks set aside money as an expense (called PLL) on the income statement to prepare for loan defaults.
• This helps reduce taxes and ensures stability.
• Reserve for Loan Losses:
• Recorded as a liability on the balance sheet.
• Calculated as the total PLL minus actual loan losses.
• This reserve acts as a “safety net” and is subtracted from total loans to calculate net loans.

4. Importance of Capital Reserves

• What Are Capital Reserves Used For?
• To meet unexpected losses.
• To pay dividends to shareholders.
• To retire (buy back) stocks or bonds.
• Role in Regulation:
• Regulators use capital reserves to measure a bank’s financial health and ability to handle losses.
• Adequate reserves ensure the bank can continue operating safely.

Key Points to Remember

• Equity = Assets - Liabilities.
• It includes common stock, preferred stock, surplus, and retained earnings.
• Banks create reserves to handle loan losses and maintain financial stability.
• The value of equity can be different based on accounting records (book value) or market perceptions (market value)

Reserve and surplus:

Reserves and surplus are terms used in accounting and finance to describe the financial position of a company.

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Borrowings:

Borrowing helps banks get extra funds when they need money to manage their operations.

• It can be classified as short-term borrowing (for immediate needs) or long-term borrowing (for extended periods).

Short-Term Borrowing

This type of borrowing is used when a bank needs funds quickly, usually for a short period. Two common methods are:

A. Interbank Borrowing

• Banks lend money to each other for short durations (from overnight to one week).

• It helps banks meet their liquidity needs, as required by regulators.

• Example: A bank short on cash borrows from a bank with extra cash.

B. Repurchase Agreements (Repos)

• A repo is like a short-term loan backed by securities (e.g., government bonds).

• The borrower (bank) sells securities to another party and agrees to buy them back later at a higher price.

• The higher price acts like interest.

• Reverse Repo: The opposite side of the repo transaction. The buyer of the securities agrees to sell them back later.

• A repo from the seller’s point of view is a reverse repo for the buyer.

• Usually, repos last 1-14 days but can extend to 1-3 months.

Long-Term Borrowing

This type of borrowing is for financing needs over longer periods. It includes:

A. Long-Term Debt

• Examples: Subordinated notes and debentures.

• Subordinated debt: This is paid after depositors if the bank fails, so it carries higher risk.

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• Banks rely less on long-term debt compared to other companies because they mainly use short-term deposits for
funding.

Advantages of Long-Term Debt:

• Interest payments on debt are tax-deductible, making it cheaper than equity.

• It’s a more affordable way to raise funds compared to issuing shares (equity).

B. Borrowing from Institutions

• Banks can also borrow long-term loans from institutions like:

• Mutual funds

• Insurance companies

• Provident funds

These funds help banks finance projects or manage longer-term financial needs.

Key Points to Remember

• Short-term borrowing helps banks handle immediate liquidity needs (e.g., interbank loans, repos).

• Long-term borrowing provides funds for extended financial requirements (e.g., subordinated debt, borrowing from
institutions).

• Repos and reverse repos are common tools for short-term borrowing and are backed by securities.

• Long-term debt is less expensive after taxes and is a reliable funding source for banks.

Banks can also borrow funds in order to meet their funding needs, manage their liquidity, or finance their lending activities.
Banks may borrow from other banks, financial institutions, or directly from the capital markets. Borrowing for banks is
subject to regulation, including capital adequacy requirements, to ensure the stability and safety of the financial system. In
general, banks must carefully manage their borrowing activities and ensure that they have sufficient collateral and other
resources to cover any potential losses.

A. Short-term Borrowing: Short-term borrowing refers to borrowing that is intended to be repaid within a year or less.
It refers to the funds borrowed from the other banks, the central bank and other sources to solve the temporary
deficiencies. Banks go for short term borrowings when reserve, income from assets, and funds from capital are not
sufficient. They are used to pay liabilities or to manage their cash flows.

1. Federal Funds: Federal funds are short-term loans that banks make to each other overnight in order to meet
reserve requirements or manage their liquidity. Federal funds transactions are typically conducted between banks
with surplus funds and banks with a shortfall of funds.

2. Repurchase Agreement (Repo): A repurchase agreement is a form of short-term borrowing in which a bank
sells securities to a lender with an agreement to repurchase the securities at a later date. Repos are typically
used by banks to raise short-term funds and to manage their liquidity.
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3. Loans from Central Bank: Banks may also borrow from their central bank, such as the Federal Reserve in the
United States. This type of borrowing is typically used to manage short-term funding needs and to meet reserve
requirements. Central bank loans typically carry low interest rates and provide banks with a source of reliable
funding.

In general, these short-term borrowing options are subject to regulation, including capital adequacy requirements, to
ensure the stability and safety of the financial system. Banks must carefully manage their borrowing activities and ensure
that they have sufficient collateral and other resources to cover potential losses.

Book Questions:

1. Explain, the Internal and external sources of bank funds.

Internal sources of bank funds refer to the funds generated within the bank itself, while external sources refer to funds
obtained from outside the bank.

Internal sources of bank funds include:

i. Deposits: Banks generate funds from deposits, including checking accounts, savings accounts, money market
accounts, and certificates of deposit (CDs).

ii. Loan Repayments: Banks also generate funds from loan repayments, including payments on mortgages,
personal loans, and other types of loans.

iii. Profit Retention: Banks may retain a portion of their profits, which can then be used to fund growth and
expansion or to meet capital requirements.

External sources of bank funds include:

i. Borrowing: Banks can borrow funds from other financial institutions, such as other banks or the central bank,
through short-term or long-term loans.

ii. Capital Markets: Banks can raise funds from the capital markets by issuing bonds, which are debt securities that
are sold to investors.

iii. Equity Capital: Banks may also raise funds through equity capital, such as common or preferred stock offerings.

iv. Government Programs: Banks may also participate in government-sponsored programs, such as the Federal
Home Loan Bank System, which provides funds to financial institutions for lending to homebuyers.

In general, banks will use a combination of internal and external sources of funds to meet their funding needs and to
support growth and expansion. The choice of funding source will depend on a variety of factors, including the size and
type of the funding need, the creditworthiness of the bank, and market conditions.

2. What is a Checkable deposit? Explain.

Checkable deposits, also known as demand deposits, are bank deposits that allow the account holder to withdraw funds
at any time without notice or penalty. These deposits are typically held in checking accounts and are considered to be
highly liquid, as they can be easily converted into cash.

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Checkable deposits are an important source of funds for banks, as they can use the funds deposited in these accounts to
make loans to other customers. However, because checkable deposits are highly liquid, banks must also be prepared to
meet customer demand for withdrawals at any time. To manage this risk, banks may use a variety of techniques, such as
maintaining a high level of liquidity and investing in low-risk, short-term assets that can be easily sold.

Checkable deposits are insured by the Federal Deposit Insurance Corporation (FDIC), which provides insurance coverage
up to a specified amount per depositor per bank. This helps to ensure that depositors' funds are protected in the event of
a bank failure.

3. What are Components of equity capital. Explain with example.

Equity capital refers to the funds generated by a company through the sale of stock. It represents ownership in a company
and represents the residual interest in the assets of the company after all debts have been paid. Equity capital is an
important source of financing for companies and has the following components:

Common Stock: Common stock is the most common form of equity capital and represents ownership in a company. It
gives the stockholder a right to vote on company matters and to receive dividends.
Example: An individual buys 100 shares of Apple stock at $100 per share, their equity capital in the company would be
$10,000.

Preferred Stock: Preferred stock is a type of stock that pays dividends at a fixed rate and has a higher claim on assets and
earnings than common stock. Preferred stock does not typically have voting rights.
Example: An individual buys 100 shares of preferred stock in Microsoft at a dividend rate of 5%. They would receive $500
in dividends annually ($100 per share x 5% = $5 per share).

Retained Earnings: Retained earnings represent the portion of a company's earnings that are not paid out as dividends,
but are instead reinvested in the company.
Example: A company earns $1 million in profits and decides to retain $500,000 for future investments, the retained
earnings component of the company's equity capital would be $500,000.

Additional Paid-In Capital: Additional paid-in capital represents the amount of money received by a company from the sale
of stock above and beyond the par value of the stock.
Example: A company issues 1,000 shares of stock at a par value of $1 per share, but receives $10 per share from
investors. The additional paid-in capital component of the company's equity capital would be $9,000 ($10 per share - $1
per share = $9 per share x 1,000 shares = $9,000).

4. Differentiate the accounting value of equity from the market value with example
The accounting value of equity refers to the value of a company's equity as it is recorded in the company's financial
statements. This value is determined based on the historical cost of the assets and liabilities of the company and the
events that have affected the company's financial position over time.

On the other hand, the market value of equity refers to the value of a company's equity as determined by the current price
at which the company's stock is trading in the stock market. This value reflects the current supply and demand for the
stock, as well as market expectations about the future performance of the company.

Here's an example to illustrate the difference between the accounting value and market value of equity:

Suppose a company has 100,000 shares of stock outstanding and has recorded $1 million of equity on its balance sheet.
If the company's stock is trading at $10 per share, the market value of the equity would be $1 million ($10 per share x
100,000 shares). However, if the company has recorded a loss of $500,000 in the current year, the accounting value of
equity would be $500,000 ($1 million - $500,000 = $500,000).

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As you can see, the market value of equity can be significantly different from the accounting value of equity, as it is
influenced by many factors beyond the financial statements of the company.

5. Define surplus with example.

Surplus refers to an excess amount or a quantity that remains after the completion of a process or activity. In the context
of finance and accounting, surplus refers to the amount by which a company's assets exceed its liabilities. A surplus
indicates that a company has more assets than it needs to pay off its debts, and can be seen as a sign of financial
strength.

Here's an example to illustrate surplus:

Suppose a company has assets of $1 million and liabilities of $500,000. The surplus for the company would be $500,000
($1 million - $500,000 = $500,000). This means that the company has $500,000 in assets that are not needed to pay off
its debts, and can be used for other purposes such as reinvesting in the business, paying dividends to shareholders, or
paying down debt.

6. Difference between short-term borrowing and long-term borrowing

Short-term borrowing and long-term borrowing are two types of debt financing that differ in terms of the length of time for
which the funds are borrowed and the terms of repayment.

Short-term borrowing Long-term borrowing

Short-term borrowing refers to borrowing that is typically Long-term borrowing to borrowing that is typically repaid
repaid within one year. over a period of several years, typically ranging from 5 to
30 years.

It is often used by companies to meet their short-term cash It is often used by companies to finance long-term
needs, such as paying bills or covering operational investments, such as plant and equipment, real estate, and
expenses. research and development.

The interest rate on short-term borrowing is typically higher The interest rate on long-term borrowing is typically lower
than that on long-term borrowing because the lender is than that on short-term borrowing because the lender is
taking on more risk due to the shorter repayment period. taking on less risk due to the longer repayment period.

Short-term borrowing is ideal for companies with short-term Long-term borrowing is more appropriate for companies
cash needs with long-term investment needs.

Examples: lines of credit, commercial paper, and short-term Examples: bonds, long-term loans, and mortgages.
loans.

7. Difference between fixed deposit and revolving deposits

Fixed deposit and revolving deposit are two types of deposit accounts offered by financial institutions, such as banks and
credit unions.

Fixed deposit Revolving deposit

A fixed deposit is a type of deposit account where the A revolving deposit is a type of deposit account where the
customer deposits a lump sum of money for a fixed period customer can deposit and withdraw money as many times
of time, usually ranging from 3 month to several years. as they want during a specified period of time.
The customer agrees not to withdraw the money during this The customer earns interest on the minimum balance
period. maintained in the account
The financial institution pays a higher interest rate The interest rate is typically lower than that on a fixed
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compared to a regular savings account. deposit.
Fixed deposits are a low-risk, low-return investment option Revolving deposits are a flexible and convenient option for
that can provide a guaranteed return on investment. customers who need access to their money frequently, but
still want to earn some interest on their savings.

Fixed deposits are a good option for customers who are Revolving deposits, on the other hand, are a good option for
looking for a guaranteed return on their investment and customers who need access to their money frequently and
are willing to lock their money away for a specific period of want more flexibility.
time.
8. Difference between current deposits and saving deposits.

Current deposits and savings deposits are two types of deposit accounts offered by financial institutions, such as banks
and credit unions.

Current deposits Savings deposits

A current deposit is a type of deposit account that is meant A savings deposit is a type of deposit account that is
for customers who need to make frequent transactions, meant for customers who want to save money and earn
such as paying bills or making purchases. interest on their balance.
Current deposit accounts usually offer limited or no interest Savings deposit accounts usually offer a higher interest
on the balance, as the primary focus is on convenience and rate compared to current deposit accounts, as the financial
liquidity. institution is able to use the customer's money to generate
income.
Customers are allowed to make unlimited transactions, Customers are usually limited to a certain number of
including checks and electronic transfers, with a transactions per month, such as transfers or withdrawals, in
current deposit account. order to encourage them to save their money.

Current deposit accounts are a good option for customers Savings deposit accounts are a good option for customers
who need to make frequent transaction. who want to save money and earn interest on their balance.

The required minimum balance is higher compared to The required minimum balances in savings account it low.
savings account.

Current Account Savings Account

Interest No Interest earned Earn Interest on your savings

No. of Transactions Unlimited transactions Limited number of transactions

Purpose Used for business Build emergency funds

Required Balance High minimum required Balance Low minimum required balance

Normally used for Used for paying bills and business Used for salary accounts
transactions
Suitable for Business People Individuals

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UNIT: 4 Uses OF FUND

Loans and advances:

What Are Loans and Advances?
• Loans and advances are money provided by banks to customers as a form of financing.
• They are part of the bank’s assets because the bank earns interest income from them.

Types of Loans and Advances:

1. Business Loans: For businesses to meet short-term or long-term financial needs.
2. Project and Infrastructure Loans: For large projects like building infrastructure (e.g., roads, bridges).
3. Consumer Loans: For personal use (e.g., home loans, car loans).
4. Credit Card Loans: Borrowed money through credit cards.
5. Bills Purchased and Discounted: The bank pays the bill amount upfront to the seller, and the buyer repays
later.
6. Loans to Deprived Sectors: Special loans provided to support underprivileged groups.

How Loans Are Managed by Banks:

• Recognizing Loans:
• Loans are recorded in the bank’s books when they are given to the customer.
• Bills purchased or discounted are also treated as loans when they are bought by the bank.
• Derecognizing Loans:
• Loans are removed from the bank’s records when customers fully repay the

Credit products:

Banks offer different types of credit products (loans) to meet the needs of customers. These credit products vary based on
purpose, term, security, and borrower type. Let’s break it down:

1. Types Based on Use of Funds

a. Funded Loans:
• The bank gives the borrower physical cash or credit directly.
• The borrower pays interest based on the loan amount.
• Examples: Home Loan, Auto Loan, Term Loan, Education Loan, Overdraft Loan, etc.

b. Non-Funded Loans:
• No cash is given. Instead, the bank promises to pay the borrower’s creditor if the borrower fails to pay.
• The bank charges a commission, not interest.
• Examples: Bank Guarantees, Letters of Credit (LC).

2. Types Based on Loan Nature

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a. Term Loans:
• Fixed-term loans with a repayment schedule (usually more than one year).
• Payments are made in EMI (Equated Monthly Installments).
• Early repayment may include charges.
• Examples: Home Loan, Auto Loan.

b. Overdraft Loans:
• Flexible loans where borrowers can withdraw up to a limit as needed.
• Renewed yearly without prepayment charges.
• Examples: Working Capital Loans, Overdraft Facilities.

3. Types Based on Loan Term

a. Short-Term Loans:
• Loan tenure is up to one year.
• These loans are repaid or renewed within a year.
• Examples: Demand Loans, Overdraft Loans.

b. Long-Term Loans:
• Loan tenure is more than one year.
• Paid through fixed installments or EMI.
• Examples: Home Loan, Equipment Loan, Education Loan.

4. Types Based on Security

a. Secured Loans:
• The borrower pledges property (land, buildings, vehicles) as collateral.
• Common in Nepal (land and buildings are typical collateral).

b. Unsecured Loans:
• No property is pledged as collateral.
• Examples: Credit Card Loans, Professional Loans.

5. Types Based on Borrower

a. Consumer Loans:
• Loans for individuals, based on personal repayment capacity.
• Examples: Personal Loans, Retail Loans.

b. Commercial Loans:
• Loans for businesses, based on company financials.
• Examples: Business Loans, Corporate Loans.

6. Other Credit Products

a. Demand Loans:
• Short-term loans (less than one year).
• The bank can recall these loans when needed.

b. Revolving Demand Loans:

• Can be renewed based on borrower performance.

c. Trust Receipt (TR) Loans:

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• Provided for paying off import-related LCs (Letter of Credit).
• Borrowers can use or sell imported goods, but the bank retains ownership until full repayment.

d. Bridge Gap Financing:

• Short-term loans to fill the gap until a longer-term loan is finalized.

e. Margin Lending:
• Loans provided against shares of “A-rated” companies.
• Loan value depends on the stock market trend and borrower repayment ability.

f. Bill Purchase/Discounting:
• Loans against bills like cheques, drafts, or bills of exchange.

Why Banks Offer Diverse Credit Products

• To serve different customer needs (personal or business).
• To manage risks effectively (secured vs. unsecured loans).
• To increase their income through interest or commissions.

This variety ensures that banks remain competitive while supporting economic growth.
Credit products are financial instruments that allow borrowers to access funds from lenders for a set period of time. These
products include loans, credit cards, lines of credit, and other similar financial products.

Interbank lending:
Interbank lending is when banks lend money to each other, typically for short periods (overnight to a few months).
• These loans are used to help banks manage temporary cash shortages or surpluses.
2. Why it’s important:
• Even banks that mostly rely on customer deposits may need extra funds from interbank loans.
• It helps banks avoid holding excess cash, which would be inefficient.
• The market is highly liquid, meaning there is a lot of money available for banks to borrow and lend.
3. Interest Rates:
• Interest rates on interbank loans are lower compared to loans for other customers because banks are considered
low-risk.
• The interbank interest rate influences other loan rates and bond pricing.
4. Efficiency for Banks:
• Interbank lending allows banks to quickly cover unexpected payment flows or loan demands.
• It ensures that banks don’t need to hold too much cash, making the banking system more efficient.
5. No Need for Collateral:
• Banks often lend to each other without needing collateral, as long as they trust each other.
6. Temporary Funding Needs:
• The market helps banks with temporary cash shortages or surpluses and allows banks with extra money to invest it.
7. Supports Financial Markets:
• It plays a key role in maintaining the smooth functioning of financial markets by providing necessary liquidity.

Maintaining reserves:

Cash Reserve Ratio (CRR)

1. Definition: CRR is the minimum cash amount banks must keep with the central bank (NRB).
2. Rates:

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• Class ‘A’ banks: 6% of total deposits.
• Class ‘B’ banks: 5% of total deposits.
• Class ‘C’ banks: 4% of total deposits.
• Class ‘B’ and ‘C’ banks (except call and current deposits): 2% of total deposits.
3. Purpose: NRB uses CRR to control money supply in the economy.
4. Penalties: Banks that don’t maintain CRR face fines.
5. Average CRR: In the review year, commercial banks maintained an average CRR of 9.12%.

Statutory Liquidity Ratio (SLR)

1. Definition: SLR is the minimum amount of liquid assets (like cash, government securities, etc.) that banks must hold.
2. Rate: Banks must maintain 12% of their total domestic deposit liabilities as liquid assets.
3. Penalties: Banks failing to meet the SLR face monetary penalties based on the bank rate.
4. Average SLR: In the review year, the average SLR of commercial banks was 25.27%.
5. Types of Liquid Assets: Includes cash balances, NRB balances, money at call, and government securities.
6. Growth in Liquid Assets: Commercial banks’ total liquid assets increased by 13.30% in 2015/16.
7. Proportion of Liquid Assets: In mid-July 2016, liquid assets made up 28.01% of total deposits.

General Points
1. Reserve Management: Both CRR and SLR are tools for NRB to manage money supply and ensure banks remain
liquid.
2. Compliance: All banks complied with SLR norms in the review year.

In summary, CRR and SLR are rules that require banks to keep a certain amount of cash and liquid assets to ensure
financial stability. Banks that fail to comply face penalties.

Types of investments:

Foreign Exchange Market (Forex)

1. Definition: The forex market is the largest financial market where currencies are traded.
2. Currency Trading: Common currencies traded include the U.S. dollar, yen, euro, and others.
3. Trading Methods: Currencies can be traded in spot transactions, forwards, swaps, and options.
4. 24-Hour Market: Forex trading happens around the clock, five days a week.
5. Interbank Market: Most currency trading happens between banks, which also facilitate trades for clients.

Treasury Bills (T-Bills)

1. Definition: T-bills are short-term government securities sold at a discount, maturing in 13, 26, or 52 weeks.
2. Purpose: Governments sell T-bills to raise money, and investors make a profit when they buy them at a
discount and redeem them for full value.
3. Nepal: The minimum value of T-bills in Nepal is Rs. 25,000, and they are not listed on the stock exchange.

Government Securities
1. Issued by NRB: Nepal Rastra Bank (NRB) issues long-term bonds and other securities on behalf of the
government.
2. Types:
• Development Bonds: Long-term bonds to raise funds for national development.
• National Saving Bonds: Bonds for individual investors, with a 5-year maturity.
• Citizen Saving Certificates: Bonds for Nepalese citizens with a 5-year maturity.
• Special Bonds: Issued for special purposes or events.

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Shares and Debentures
1. Corporate Stock (Shares): Represents ownership in a company. There are two types:
• Common Stock: Gives ownership and the right to profits, but also comes with higher risk.
• Preferred Stock: Offers fixed dividends and priority in liquidation, but no voting rights.
2. Debentures: Long-term bonds issued by companies that offer fixed returns and higher risk than government
bonds.

Maintaining Liquidity
1. Liquidity: The ability of banks to meet financial obligations and customer withdrawals.
2. Liquidity Risk: The risk that a bank cannot get funds when needed at a reasonable price.
3. Management: Banks must carefully manage liquidity to avoid negative consequences and ensure they have
enough resources to meet demands.

Off-Balance Sheet Items

1. Loan Commitments: Unfunded loans or credit lines that banks may need to provide in the future.
2. Derivatives: Financial contracts that help manage risks but also carry liquidity and price risks.
3. Contingent Liabilities: Potential liabilities (like legal risks) that could affect a bank’s liquidity.

In summary, this section covers different types of investments like foreign exchange, treasury bills, government securities,
stocks, and bonds. It also explains how banks manage liquidity to ensure they can meet financial obligations.

Book Questions:

1. Why do banks invest in securities, even though loans typically generate a higher return?

Banks invest in securities for various reasons, even though loans typically generate a higher return. Some of the reasons
why banks invest in securities include:

i. Diversification: Investing in securities allows banks to diversify their portfolio and reduce their risk exposure. Loans
are typically more risky than securities because they are subject to borrower defaults, whereas securities are often
backed by collateral or guaranteed by government agencies. By investing in a variety of securities, banks can spread
their risk across different asset classes and reduce their overall exposure to any one type of investment.

ii. Liquidity: Securities are generally more liquid than loans, which means they can be sold or traded more easily in the
secondary market. This makes it easier for banks to manage their cash flow and respond to changing market
conditions. Loans, on the other hand, are often long-term investments that cannot be easily sold or traded.

iii. Regulatory Requirements: Banks are subject to various regulatory requirements that may limit their ability to lend
or invest in certain types of loans. Investing in securities can help banks meet these regulatory requirements while
still earning a return on their investment.

iv. Yield Curve Management: Banks may invest in securities to manage their interest rate risk exposure. The yield
curve, which represents the relationship between interest rates and the maturity of debt securities, can be used by
banks to manage their net interest margin. By investing in securities with different maturities, banks can manage their
interest rate risk exposure and earn a return on their investment.

v. Capital Requirements: Banks may invest in securities to meet their capital requirements. Certain types of securities,
such as government bonds, are considered low-risk investments that can be used to meet regulatory capital
requirements.

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In summary, banks invest in securities for various reasons, including diversification, liquidity, regulatory requirements,
yield curve management, and capital requirements. While loans may generate a higher return, investing in securities can
provide additional benefits that may be necessary for banks to manage their risk and meet regulatory requirements.

2. Explain the uses of funds in bfis?

BFIs, or financial institutions, use funds for a variety of purposes depending on their business objectives and regulatory
requirements. The following are some common uses of funds by BFIs:

i. Lending: One of the primary uses of funds by BFIs is to provide loans to individuals, businesses, and other
organizations. BFIs collect deposits from customers and use these funds to provide loans, which generate interest
income for the institution. Loans can be secured or unsecured, short-term or long-term, and can be used for a variety
of purposes such as buying a home, financing a business, or purchasing a car.

ii. Investment: BFIs also use funds to invest in various financial instruments, such as stocks, bonds, and other
securities. These investments can generate income through dividends, interest, or capital gains. Investments can
also be used to manage risk by diversifying the institution's portfolio and offsetting potential losses in other areas of
the business.

iii. Payment and Settlement: BFIs use funds to facilitate payment and settlement services for their customers. This can
include issuing debit and credit cards, providing online and mobile banking services, and facilitating electronic fund
transfers. These services generate fee income for the institution and provide convenience for customers.

iv. Asset Acquisition: BFIs use funds to acquire assets such as buildings, equipment, and technology. These assets
can be used to improve the institution's operations, provide additional services, and enhance the customer
experience.

v. Regulatory Compliance: BFIs use funds to comply with regulatory requirements, such as maintaining minimum
capital levels, meeting reserve requirements, and adhering to anti-money laundering and anti-terrorism financing
regulations. These requirements are designed to ensure the stability and safety of the financial system.

vi. Research and Development: BFIs use funds to invest in research and development to stay competitive and
innovative in the marketplace. This can include developing new products and services, improving existing technology,
and investing in training and development for staff.

In summary, BFIs use funds for a variety of purposes, including lending, investment, payment and settlement services,
asset acquisition, regulatory compliance, and research and development. These uses of funds are essential for BFIs to
achieve their business objectives and meet regulatory requirements while providing value to their customers.

3. Why is it important for banks to maintain liquidity?

It is important for banks to maintain liquidity for several reasons:

i. Meet Customer Demand: Banks need to have sufficient liquidity to meet the demand for withdrawals and other
customer transactions. Customers expect to be able to access their funds whenever they need them, and if a bank
cannot meet these demands, it can lead to a loss of customer confidence and potential bank runs.

ii. Regulatory Compliance: Banks are required by regulators to maintain a certain level of liquidity to ensure they can
withstand unexpected events or market disruptions. Regulators typically set minimum liquidity ratios that banks must
maintain, and failure to do so can result in penalties or even closure.

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iii. Manage Risk: Maintaining liquidity is an important risk management tool for banks. It allows them to manage
unexpected cash flow needs or market disruptions without having to resort to fire sales of assets, which can result in
significant losses.

iv. Access to Funding: Banks that maintain high levels of liquidity are viewed more favorably by investors and lenders,
which can provide them with access to funding at more favorable rates. This can help banks to better manage their
balance sheets and support their business operations.

v. Preserve Reputation: Maintaining liquidity is important for preserving a bank's reputation and standing in the
market. If a bank is unable to meet its obligations, it can damage its reputation and lead to loss of business and
profitability.

In summary, maintaining liquidity is crucial for banks to meet customer demand, comply with regulations, manage risk,
access funding, and preserve their reputation. It is an essential component of a bank's financial management strategy
and is critical to the long-term success of the institution.

UNIT: 5 Major Risks in Treasury Management

Meaning of Financial Risk:

Financial risk refers to the possibility of losing money or facing financial instability due to uncertainties in financial markets,
business operations, or external factors. It affects individuals, businesses, and governments, impacting their ability to earn
profits or repay debts.

Nature of Financial Risk:

1. Uncertainty: Financial risk arises due to unpredictable events like market fluctuations, interest rate changes, or
economic crises.
2. Variability in Returns: Investors and businesses may experience fluctuating profits or losses due to financial risks.
3. Impact on Decision-Making: Companies must carefully plan investments, loans, and financial strategies to manage
risks.
4. Influence of External Factors: Economic conditions, government policies, inflation, and exchange rates play a major
role in financial risk.
5. Different Types: Financial risk can be market risk, credit risk, liquidity risk, operational risk, or foreign exchange risk

Counterparty default risk .

Counterparty default risk is the risk that the other party in a financial transaction fails to meet its obligations. This can
happen in various financial transactions, such as loans, derivatives, bonds, or trade credits. If a counterparty defaults, the
party expecting payment or performance may suffer financial losses.
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Financial institutions manage counterparty default risk through measures like credit checks, collateral requirements,
netting agreements, and credit default swaps (CDS).

Explanation:
• In treasury management, companies and banks deal with multiple financial transactions, such as loans, bonds,
derivatives, and investments.
• If a counterparty goes bankrupt or defaults, the company may suffer losses.

Example:

A bank lends $10 million to a company. If the company goes bankrupt, the bank may lose the money or recover only a
part of it.

How to Manage This Risk?

• Credit Checks: Ensure the counterparty has a good financial history.
• Collateral: Take security (assets) against loans.
• Diversification: Avoid dealing with only one counterparty.
• Insurance & Hedging: Use financial instruments to protect against losses.

Managing counterparty default risk is crucial to protect financial stability in treasury management.

Sovereign risk is the risk that a government fails to meet its financial obligations, such as repaying debts or making
interest payments. This can happen due to economic instability, political issues, or changes in government policies.

Nature of Sovereign Risk in Treasury Management:

1. Default Risk: The government may fail to repay loans or bonds issued to investors.
2. Currency Risk: If a country’s currency devalues, foreign investors may suffer losses.
3. Political Risk: Changes in government policies, taxation, or regulations can affect financial transactions.
4. Legal Risk: Governments may change laws, affecting the ability to recover money from investments.
5. Transfer Risk: A country may restrict currency movement, making it difficult to transfer funds abroad.

Example:

An investor buys government bonds from Country A. If the country faces a financial crisis and cannot repay the bonds, the
investor loses money.

How to Manage Sovereign Risk?

• Diversification: Invest in multiple countries to reduce dependency on one government.
• Credit Ratings: Check a country’s credit rating (like S&P or Moody’s) before investing.
• Hedging Strategies: Use financial instruments to protect against currency and default risks.

Sovereign risk is crucial in treasury management because it affects international investments, foreign exchange
transactions, and government bond markets.

foreign currency risk (also called exchange rate risk) is the risk of losing money due to changes in currency exchange
rates. It affects businesses, investors, and financial institutions dealing with multiple currencies.

Why Does It Happen?

• Exchange rates fluctuate due to economic conditions, inflation, interest rates, and political events.
• If a company earns or spends money in a foreign currency, changes in the exchange rate can affect profits.

Example:

A company in India exports goods to the USA and expects a payment of $10,000.
• If the exchange rate is 1 USD = ₹80, the company gets ₹8,00,000.

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• If the exchange rate drops to 1 USD = ₹75, the company gets only ₹7,50,000 → Loss of ₹50,000.

How to Manage Foreign Currency Risk?

1. Hedging: Using forward contracts or options to lock exchange rates.
2. Diversification: Dealing with multiple currencies to reduce risk.
3. Monitoring Market Trends: Keeping track of global economic changes.

Foreign currency risk is important in treasury management because it affects international trade, investments, and overall
financial stability.
To reduce the impact of currency fluctuations, businesses and investors use various strategies. Some key arrangements
include:

1. Hedging Strategies
• Forward Contracts: Agreement to buy/sell foreign currency at a fixed rate in the future.
• Futures Contracts: Similar to forward contracts but traded on exchanges.
• Options Contracts: Gives the right (but not obligation) to buy/sell currency at a fixed rate.
• Swaps: Exchange of currencies between two parties for a fixed period to avoid exchange rate losses.

2. Natural Hedging
• Matching Inflows & Outflows: Earning and spending in the same foreign currency to reduce risk.
• Foreign Currency Accounts: Holding funds in the required currency to avoid conversion losses.

3. Currency Diversification
• Holding assets in multiple currencies to spread risk.
• Investing in countries with stable currencies.

4. Monitoring & Forecasting

• Keeping track of exchange rate trends, inflation, and global economic changes.
• Using financial experts or software for risk assessment.

By using these strategies, companies and investors can protect profits and reduce losses caused by foreign exchange
fluctuation

Risk Management:

Risk management is the process of identifying, assessing, and prioritizing risks, and then developing and implementing
strategies to mitigate or minimize those risks. The goal of risk management is to minimize the negative impact of risks on
an organization or individual and to enhance the potential opportunities that risks may offer.

The risk management process typically involves the following steps:

1. Identify the risks: This involves identifying all the potential risks that could impact an organization or individual. This
may include risks associated with financial, operational, legal, reputational, or strategic areas.

2. Assess the risks: Once the risks are identified, they need to be assessed to determine their likelihood and potential
impact. This will help prioritize which risks need to be addressed first.

3. Develop risk management strategies: Based on the assessment, strategies need to be developed to manage the
identified risks. This may include risk avoidance, risk mitigation, risk transfer, or risk acceptance.

4. Implement risk management strategies: The chosen strategies need to be implemented and integrated into the
overall operations of the organization or individual.

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5. Monitor and review: Risk management is an ongoing process, and the effectiveness of the strategies needs to be
monitored and reviewed regularly to ensure they remain relevant and effective.

Effective risk management can help organizations and individuals achieve their objectives while minimizing the negative
impact of risks. It can also help build trust and confidence with stakeholders and improve overall performance.

Risk Management frameworks:

Risk management frameworks provide a structured approach to managing risks. There are several frameworks available
that organizations can use to manage risks. Here are some of the most commonly used risk management frameworks:

1. Board and senior management oversight: The board of directors and senior management are responsible for
overseeing the risk management process and ensuring that the organization has an effective risk management
framework in place. This includes setting risk management policies and strategies, allocating resources, and
providing oversight and guidance to the risk management department.

2. Risk management department: The risk management department is responsible for implementing the risk
management framework and processes. This includes identifying and assessing risks, developing risk management
strategies, monitoring and reporting on risks, and providing guidance to the rest of the organization on risk
management issues.

3. Policies and procedures: Risk management policies and procedures provide the guidelines and processes for
managing risks. They help ensure that risk management activities are conducted in a consistent and effective
manner across the organization. Policies and procedures should cover risk identification, assessment, mitigation,
monitoring, and reporting.

4. Management information system: A management information system provides the data and information necessary
to support effective risk management decision-making. This includes information on risks, controls, and mitigation
strategies. The system should be designed to capture and report on risk-related data in a timely and accurate
manner.

5. Internal controls and limits: Internal controls and limits are designed to prevent, detect, and respond to risks that
may impact the organization. They include processes and procedures for monitoring and controlling risks, as well as
limits on exposure to certain types of risks. Internal controls and limits should be regularly reviewed and updated to
ensure they remain effective.

Together, these components provide a comprehensive framework for managing risks across the organization. By
implementing an effective risk management framework, organizations can minimize the negative impact of risks and
maximize the opportunities they present.

Counterparty default risk:

Counterparty default risk is the risk that a party to a financial contract will not be able to fulfill its contractual obligations,
typically due to financial distress or insolvency. This risk is a concern in a wide range of financial transactions, including
derivatives, loans, securities lending, and other types of financial contracts.

Counterparty default risk can be a significant concern for financial institutions, as it can result in significant losses if a
counterparty fails to perform its obligations. For example, if a bank has entered into a derivatives contract with
counterparty and the counterparty defaults, the bank may be exposed to significant losses if it is unable to offset the
position in the market.

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To manage counterparty default risk, financial institutions typically implement risk management practices that include
credit risk assessments, ongoing monitoring of counterparty creditworthiness and the establishment of credit limits and
collateral requirements. Additionally, institutions may use credit default swaps or other types of credit risk transfer
mechanisms to transfer the risk of counterparty default to another party.

Overall, managing counterparty default risk is an important part of effective risk management for financial institutions and
other organizations that engage in financial transactions. It requires ongoing monitoring and evaluation of counterparty
creditworthiness, as well as the implementation of appropriate risk mitigation strategies.

Liquidity risk:

Liquidity risk is the risk that an organization will not be able to meet its financial obligations as they come due, without
incurring unacceptable costs or losses. This can occur when an organization has insufficient liquid assets or when the
market for its assets or liabilities becomes illiquid.

Liquidity risk is a concern for any organization that needs to meet financial obligations, such as making payments on
loans, meeting payroll, or funding operations. If an organization is unable to meet its obligations due to liquidity
constraints, it may be forced to sell assets at unfavorable prices or take on additional debt at higher costs, which can
result in financial losses.

Some of the sources of liquidity risk for BFIs include:

i. Deposit outflows: If a significant number of depositors withdraw their funds from a bank at the same time, it can
create liquidity problems for the bank.

ii. Funding market disruption: A disruption in the funding markets can make it difficult for BFIs to raise funds at
reasonable rates or at all.

iii. Credit downgrades: If a bank's credit rating is downgraded, it may have to pay more to borrow funds, making it
more difficult to meet its obligations.

iv. Asset illiquidity: If a significant portion of a bank's assets cannot be sold quickly or at reasonable prices, it can
create liquidity problems.

v. Contagion risk: Liquidity problems in one BFI can lead to liquidity problems in other BFIs if investors and creditors
lose confidence in the banking system as a whole.

Managing liquidity risk requires a proactive approach to assessing and managing funding needs, as well as monitoring
the availability and cost of funding sources. This involves developing contingency plans and maintaining sufficient levels
of liquid assets, such as cash or highly liquid securities, to meet funding needs in times of stress.

To manage liquidity risk effectively, organizations also need to establish appropriate governance and risk management
frameworks. This includes establishing clear lines of responsibility and authority for managing liquidity risk, establishing
policies and procedures for monitoring and managing liquidity risk, and regularly reviewing and stress testing the
organization's liquidity position.

Overall, effective management of liquidity risk is critical to ensuring the ongoing stability and financial health of an
organization. It requires a comprehensive approach to assessing and managing funding needs, as well as a robust risk
management framework to manage liquidity risk effectively.

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Sovereign risk:

Sovereign risk is the risk that a government will default on its debt obligations or otherwise fail to meet its financial
obligations. This can occur due to a variety of factors, including economic, political, or social instability, as well as changes
in government policies, financial mismanagement, or external shocks such as natural disasters or pandemics.

Sovereign risk can have significant consequences for financial markets and economies, as government debt is a major
component of many investment portfolios and is often used as a benchmark for pricing other assets. A sovereign default
or downgrade can cause a loss of investor confidence, leading to higher borrowing costs and a decline in the value of
affected assets.

Managing sovereign risk involves assessing the creditworthiness of governments, monitoring economic and political
developments that may impact sovereign creditworthiness, and implementing appropriate risk mitigation strategies. This
may include diversifying investments across different countries and asset classes, establishing credit risk limits, and using
credit default swaps or other credit risk transfer mechanisms to hedge against sovereign default risk.

To manage sovereign risk effectively, investors and financial institutions also need to consider the legal and regulatory
environment in which they operate, as well as the potential impact of political and social instability on sovereign
creditworthiness. This requires a thorough understanding of local conditions and political dynamics, as well as a robust
risk management framework to manage sovereign risk effectively.

Overall, managing sovereign risk is an important part of effective risk management for investors and financial institutions,
as it can have significant consequences for financial markets and economies. It requires ongoing monitoring and
evaluation of sovereign creditworthiness, as well as the implementation of appropriate risk mitigation strategies.

Market risk:

Market risk refers to the risk of financial loss arising from adverse changes in market prices or other market variables,
such as interest rates, exchange rates, or commodity prices. Market risk is a concern for any organization that has
investments or other exposures to financial markets, including financial institutions, corporations, and investors.

Market risk can arise from a variety of sources, including changes in economic conditions, geopolitical events, or shifts in
investor sentiment. It can also result from specific exposures to certain markets or assets, such as equities, bonds,
currencies, or commodities.

To manage market risk, organizations typically use a range of risk management techniques and tools, including
diversification of investments, hedging with derivatives, and setting risk limits and controls. These techniques aim to
reduce the impact of adverse market movements on an organization's financial position and limit potential losses.

Effective management of market risk also requires ongoing monitoring and analysis of market conditions and trends, as
well as regular stress testing and scenario analysis to evaluate the potential impact of adverse market movements on an
organization's financial position. Risk managers must be able to identify and assess risks, as well as develop and
implement strategies to mitigate them.

Overall, effective management of market risk is critical to the financial health and stability of organizations with exposures
to financial markets. It requires a comprehensive approach to risk management that involves ongoing monitoring and
analysis of market conditions, as well as the use of appropriate risk management techniques and controls to manage
market risk effectively.

Foreign currency risk:

Foreign currency risk, also known as currency risk or exchange rate risk, is the risk that fluctuations in exchange rates will
negatively affect an organization's financial position. This risk arises when an organization has assets or liabilities
denominated in a foreign currency, or when it engages in international trade or investment.
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Foreign currency risk can impact an organization's revenue, profits, cash flows, and balance sheet. Fluctuations in
exchange rates can affect the value of foreign currency-denominated assets and liabilities, as well as the cost of goods
sold and the price of exports and imports. Currency risk can also impact the cost of financing, as changes in exchange
rates can affect the value of debt and interest payments.

To manage foreign currency risk, organizations use a range of techniques and tools, including hedging with derivatives,
currency swaps, and other risk management instruments. These tools aim to reduce the impact of adverse exchange rate
movements on an organization's financial position and limit potential losses.

Effective management of foreign currency risk also requires ongoing monitoring and analysis of exchange rate trends,
as well as regular stress testing and scenario analysis to evaluate the potential impact of adverse exchange rate
movements on an organization's financial position. Risk managers must be able to identify and assess currency risk, as
well as develop and implement strategies to mitigate it.

Overall, effective management of foreign currency risk is critical to the financial health and stability of organizations with
international exposures. It requires a comprehensive approach to risk management that involves ongoing monitoring and
analysis of exchange rate trends, as well as the use of appropriate risk management techniques and controls to manage
currency risk effectively.

Equity price risk:

Equity price risk, also known as stock price risk, refers to the risk that changes in equity prices will negatively impact an
investor's portfolio or an organization's financial position. This risk arises from fluctuations in the market value of equity
securities, such as stocks or shares in a mutual fund.

Equity price risk can impact an investor's return on investment, as well as an organization's earnings, cash flows, and
balance sheet. Fluctuations in equity prices can affect the value of equity securities held in a portfolio, as well as the value
of equity securities issued by an organization.

To manage equity price risk, investors and organizations use a range of techniques and tools, including diversification
of investments, use of hedging strategies, and implementation of risk limits and controls. These tools aim to reduce the
impact of adverse equity price movements on an investor's portfolio or an organization's financial position and limit
potential losses.

Effective management of equity price risk also requires ongoing monitoring and analysis of market conditions and
trends, as well as regular stress testing and scenario analysis to evaluate the potential impact of adverse equity price
movements on an investor's portfolio or an organization's financial position. Risk managers must be able to identify and
assess equity price risk, as well as develop and implement strategies to mitigate it.

Overall, effective management of equity price risk is critical to the financial health and stability of investors and
organizations with equity exposures. It requires a comprehensive approach to risk management that involves ongoing
monitoring and analysis of market conditions, as well as the use of appropriate risk management techniques and controls
to manage equity price risk effectively.

Commodity risk:

Commodity risk, also known as commodity price risk, refers to the risk that changes in commodity prices will negatively
impact an investor's portfolio or an organization's financial position. This risk arises from fluctuations in the market value
of commodities, such as agricultural products, energy products, or metals.

Commodity risk can impact an investor's return on investment, as well as an organization's earnings, cash flows, and
balance sheet. Fluctuations in commodity prices can affect the value of commodity investments held in a portfolio, as well
as the cost of goods sold and the price of commodities used in production.

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To manage commodity risk, investors and organizations use a range of techniques and tools, including diversification of
investments, use of hedging strategies, and implementation of risk limits and controls. These tools aim to reduce the
impact of adverse commodity price movements on an investor's portfolio or an organization's financial position and limit
potential losses.

Effective management of commodity risk also requires ongoing monitoring and analysis of market conditions and
trends, as well as regular stress testing and scenario analysis to evaluate the potential impact of adverse commodity price
movements on an investor's portfolio or an organization's financial position. Risk managers must be able to identify and
assess commodity risk, as well as develop and implement strategies to mitigate it.

Overall, effective management of commodity risk is critical to the financial health and stability of investors and
organizations with commodity exposures. It requires a comprehensive approach to risk management that involves
ongoing monitoring and analysis of market conditions, as well as the use of appropriate risk management techniques and
controls to manage commodity risk effectively.

Q. Why do you think that banks and financial institutions have foreign currency risk exposure?

Banks and financial institutions have foreign currency risk exposure due to the nature of their business activities. Some of
the reasons why they are exposed to foreign currency risks are:

1. Cross-border transactions: Banks and financial institutions facilitate cross-border transactions involving different
currencies. They may have to convert one currency to another in order to settle these transactions, which exposes
them to foreign currency risk.

2. Foreign currency denominated assets and liabilities: Banks and financial institutions may have assets and
liabilities denominated in foreign currencies. Fluctuations in exchange rates can impact the value of these assets
and liabilities, which can affect the bank's financial position and profitability.

3. Foreign operations: Banks and financial institutions may have subsidiaries, branches, or other operations in
foreign countries, which expose them to foreign currency risk. The earnings of these foreign operations may be
impacted by changes in exchange rates.

4. Foreign investments: Banks and financial institutions may invest in foreign securities, such as bonds or stocks,
which expose them to foreign currency risk. The value of these investments can be impacted by changes in
exchange rates.

5. Foreign funding: Banks and financial institutions may borrow funds in foreign currencies to finance their
operations. Changes in exchange rates can impact the cost of this funding, which can affect the bank's profitability.

To manage foreign currency risk exposure, banks and financial institutions use a variety of techniques, including hedging,
diversification, and monitoring foreign currency risk exposure. Hedging involves using financial instruments such as
currency futures, options, or swaps to offset the impact of foreign currency risk. Diversification involves spreading risk
across different currencies, assets, and markets. Monitoring foreign currency risk exposure involves regularly assessing
exposure to foreign currency risks and adjusting risk management strategies accordingly.

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UNIT: 6 PRICING OF THE PRODUCTS

Deposit Pricing:

Deposit pricing refers to the interest rates offered by banks and other financial institutions on deposits made by
customers. Deposits are a key source of funding for banks, and deposit pricing is an important aspect of their business
strategy.

Banks may offer different interest rates on different types of deposits, such as savings accounts, checking accounts,
money market accounts, certificates of deposit (CDs), and other types of time deposits. Generally, the longer the term of
the deposit, the higher the interest rate offered by the bank.

Deposit pricing is influenced by a variety of factors, including the overall level of interest rates in the economy, the bank's
funding needs, the competitive landscape, and regulatory requirements. In addition, banks may use deposit pricing as a
tool to attract or retain customers, or to manage their liquidity and balance sheet.

For consumers, deposit pricing is an important consideration when choosing a bank or financial institution. Higher interest
rates can mean greater returns on savings, while lower rates may be more beneficial for borrowers seeking loans. It's
important to shop around and compare deposit rates from different banks before making a decision.

Deposit pricing approaches:

There are several approaches that banks and financial institutions use to determine their deposit pricing. Here are some
of the common approaches:

Here’s a simple explanation of deposit pricing methods in banking:

1. Cost-Plus Deposit Pricing:
• The bank calculates all costs related to providing a deposit service (operating costs, overhead, etc.).
• It then adds a profit margin to determine the final price.
• Each deposit service is priced separately to cover its costs.
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If a banks cost of funds is 2 % and it wants a 0.5% profit margin the deposit rate offered would be 2%

2. Pooled Funds Approach:

• The bank considers or combines the cost of all funding sources (such as deposits, loans, and other capital).
• It calculates a weighted average cost to determine the minimum return needed from future loans and
investments.
• This method helps banks decide on competitive interest rates.

3. Marginal Cost Pricing:

• This focuses on the cost of raising new funds rather than overall average costs.
• If interest rates drop, the bank can raise new money at a lower cost, making loans more profitable.
• If rates rise, new funds become expensive, and the bank must ensure it earns enough from new loans.
• The bank compares the extra cost of new funds with the revenue expected from new investments.

Each method helps banks decide how to price deposits while balancing profitability and competitiveness.
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Here’s a simple explanation of different deposit pricing strategies used by banks:
1. Market Penetration Deposit Pricing:
• The bank offers high interest rates and low fees to attract as many new customers as possible.
• In the beginning, they may not focus on making profits but instead aim to build a large customer base.
• Later, the bank may increase fees and lower interest rates once it has a solid customer base.
2. Price Schedules to Segment Deposits (Conditional Pricing):
• Fees and interest rates depend on how much money a customer keeps in their account.
• Higher balances = lower fees or even no fees.
• Lower balances = higher fees.
• This encourages customers to maintain a higher balance in their accounts.

3. Upscale Target Pricing:

• The bank focuses on attracting wealthy customers (like doctors, lawyers, and business owners).
• They offer premium services for these high-balance customers and charge them higher fees.
• Accounts with low balances and high activity may have higher fees or be discouraged altogether.

4. Relationship Pricing:
• Customers who use multiple bank services (like loans, credit cards, and savings accounts) get discounts or
lower fees.
• This makes it harder for customers to leave the bank, as they get better deals by using more services.
• It builds customer loyalty and reduces the chances of customers switching to other banks.

5. Bank Goal Deposit Pricing:

• The bank sets prices to increase its overall profitability, not just to attract more customers.
• It may focus on keeping high-value customers and even discourage unprofitable ones.
• The goal is to make sure deposit pricing helps in maximizing long-term profits.

Each of these strategies helps banks decide how to attract and retain customers while managing their profits
effectively.
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Simple Explanation of Loan Pricing

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Loan pricing is how banks decide the interest rates and fees for loans. It depends on various factors like credit
risk, market conditions, and operational costs. The right pricing strategy affects both the bank’s profitability and
its reputation.

Types of Loan Pricing Methods

1. Risk-Based Pricing
• Interest rates depend on the borrower’s risk level.
• Low-risk customers (good credit history, strong repayment capacity) get lower interest rates.
• High-risk customers (poor credit score, uncertain repayment ability) are charged higher rates.
• This helps banks protect themselves from loan defaults.

2. Cost-Plus Pricing
• The bank sets loan prices based on its operating costs plus a profit margin.
• It ensures all costs are covered but may not be competitive in the market.
• If the loan price is too high, customers may choose other banks with lower rates.

3. Market-Based Pricing
• Loan prices are set based on market trends and what other banks (especially market leaders) are charging.
• It helps the bank stay competitive, but it may not always cover the actual cost of providing the loan.

4. Value-Based Pricing
• This is a mix of cost-plus and market-based pricing.
• The loan price is set based on both the borrower’s value (creditworthiness) and market conditions.
• It is commonly used in banking.

Base Interest Rate (Minimum Loan Rate)

• The base rate is the lowest interest rate a bank can charge on loans.
• Banks cannot lend below this rate to ensure fair pricing and avoid unhealthy competition.
• For example, if Nabil Bank’s base rate is 5%, it cannot offer loans below 5%, or it may face penalties.
• Base rates are calculated using factors like funding costs, operating expenses, and required reserves.
• Banks must publish their base rates monthly on their websites.

This system helps maintain transparency and fair competition in the loan market.
i. Market-based pricing: This approach involves setting deposit rates based on prevailing market conditions.
Banks may monitor interest rates in the broader economy, as well as rates offered by competitors, to determine
their own rates. This approach is generally more responsive to changes in market conditions.

ii. Relationship-based pricing: This approach involves offering different rates to customers based on the extent of
their relationship with the bank. For example, a customer with multiple accounts or a high balance may receive a
higher interest rate than a customer with a single account and a lower balance. This approach is designed to
reward loyal customers and encourage them to consolidate their banking relationship with the institution.

iii. Cost-of-funds pricing: This approach involves setting deposit rates based on the cost of acquiring and holding
funds. Banks may consider factors such as the cost of borrowing from other banks, the cost of issuing securities,
and the cost of maintaining reserve requirements. This approach may be more relevant for smaller institutions
that rely heavily on deposit funding.

iv. Profit-based pricing: This approach involves setting deposit rates based on the desired profit margin of the
bank. Banks may use mathematical models to determine the optimal pricing levels that balance the need to

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attract deposits with the need to generate profits. This approach is more common among larger institutions with
sophisticated analytics capabilities.

Ultimately, the approach that a bank uses will depend on its strategic objectives, market position, and competitive
landscape. Different approaches may be appropriate at different times, depending on changes in the economic
environment and the bank's funding needs.

1. Cost plus profit margin deposit pricing

Cost plus profit margin deposit pricing is a deposit pricing strategy that involves calculating the total cost of acquiring and
holding deposits, and then adding a markup or profit margin to arrive at the interest rate offered to customers. This
approach is used by banks and financial institutions to ensure that their deposit rates cover their costs and provide a
desired level of profitability.

The cost component of the deposit pricing calculation includes all the direct and indirect costs associated with acquiring
and holding deposits, such as marketing expenses, administrative costs, regulatory compliance costs, and the cost of
maintaining reserves. The profit margin component represents the amount of profit the bank wants to earn on top of its
costs.

For example, if a bank calculates that the total cost of acquiring and holding deposits is 1.5% and wants to earn a 0.5%
profit margin, it would set the interest rate on its deposits at 2% (1.5% cost plus 0.5% profit margin).

Cost plus profit margin deposit pricing has some advantages. It ensures that banks cover their costs and earn a desired
level of profit on their deposit business. It is also transparent and easy to understand for customers, who can compare
deposit rates from different banks.

However, there are also some limitations to this approach. It does not take into account market demand or the competitive
landscape, which may affect the optimal deposit rates for attracting and retaining customers. It also assumes that all
deposits are equally costly to acquire and hold, which may not be the case in reality. Finally, it may not be suitable for
banks operating in highly competitive markets, where deposit rates may need to be adjusted frequently to remain
competitive.

2. Marginal cost deposit pricing

Marginal cost deposit pricing is a deposit pricing strategy that involves setting deposit rates based on the additional cost of
acquiring and holding an additional dollar of deposits. This approach takes into account the fact that not all deposits are
equally costly to acquire and hold, and that the cost of funding additional deposits may be different from the cost of
funding existing deposits.

To implement marginal cost deposit pricing, a bank first calculates its marginal cost of funds, which is the cost of acquiring
and holding an additional dollar of deposits. This cost may include the cost of borrowing from other banks, issuing
securities, or attracting deposits through marketing or promotional activities.

The bank then sets its deposit rates based on its marginal cost of funds, rather than its average or total cost of funds. This
means that the bank may offer different rates for different types of deposits or for different deposit amounts, depending on
the marginal cost of acquiring and holding those deposits.

For example, if a bank's marginal cost of funds for a particular type of deposit is 1.5%, it may set the interest rate on that
deposit at 2% to earn a 0.5% profit margin. If the marginal cost of funds for a different type of deposit is 2%, the bank may
set the interest rate on that deposit at 2.5% to earn the same 0.5% profit margin.

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Marginal cost deposit pricing has some advantages. It ensures that banks are pricing their deposits based on the true cost
of acquiring and holding those deposits. It can also help banks optimize their funding mix by offering different rates for
different types of deposits based on their marginal cost.

However, there are also some limitations to this approach. It may be more complex and difficult to understand for
customers, who may prefer simpler pricing models. It may also be more difficult for banks to predict their deposit costs
and profitability, as marginal costs can be more volatile than average costs.

Marginal cost

Marginal cost is the additional cost incurred by a firm in producing one more unit of a good or service. It is calculated as
the change in total cost divided by the change in the quantity produced.

For example, if a company produces 100 units of a product at a total cost of $10,000, and then produces 101 units at a
total cost of $10,200, the marginal cost of producing the additional unit is $200 ($10,200 - $10,000 divided by 1).

Marginal cost is an important concept in economics and business because it helps firms make production and pricing
decisions. If the marginal cost of producing one more unit is less than the revenue generated from selling that unit, then
the firm can increase its profit by producing more. Conversely, if the marginal cost is greater than the revenue, the firm
may decrease production or raise prices to maintain profitability.

In addition, marginal cost can also be used to determine the optimal level of production for a firm. The firm should
continue to produce as long as the marginal cost is less than the marginal revenue, which is the additional revenue
generated by selling one more unit. The point at which marginal cost equals marginal revenue is known as the
profitmaximizing level of production.

Marginal cost can also be used to determine the optimal price for a good or service. If the firm wants to maximize profit, it
should set the price at the level where the marginal cost equals the marginal revenue. This is known as the
profitmaximizing price.

3. Conditional deposit pricing:

Conditional deposit pricing is a deposit pricing strategy that involves offering different interest rates or terms to customers
based on certain conditions or requirements. These conditions may include minimum deposit amounts, minimum
balances, length of the deposit term, or other criteria.

For example, a bank may offer a higher interest rate on a savings account for customers who maintain a minimum
balance of $10,000. Alternatively, the bank may offer a bonus interest rate on a certificate of deposit (CD) for customers
who agree to keep the funds invested for a specific term.

Conditional deposit pricing can be used to attract and retain customers who are willing to meet the bank's criteria or
requirements. It can also be used to manage the bank's funding costs by encouraging customers to maintain higher
balances or invest in longer-term deposits.

Conditional deposit pricing has some advantages. It can help banks tailor their pricing to different customer segments
based on their needs and preferences. It can also help banks manage their funding costs and liquidity by encouraging
customers to maintain certain balances or invest in longer-term deposits.

However, there are also some limitations to this approach. It may be more complex and difficult to understand for
customers, who may prefer simpler pricing models. It may also create additional administrative and operational costs for
banks, as they need to monitor and enforce the conditions of the pricing offers. Finally, it may not be suitable for banks
operating in highly competitive markets, where deposit rates may need to be adjusted frequently to remain competitive.

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4. Relationship deposit pricing
Relationship deposit pricing is a deposit pricing strategy that involves offering different interest rates or terms to customers
based on the total relationship the customer has with the bank. This relationship can include a variety of factors, such as
the customer's deposit and loan balances, credit history, length of relationship with the bank, and other factors.

For example, a bank may offer a higher interest rate on a savings account to a customer who also has a checking
account, credit card, and mortgage with the bank. Alternatively, the bank may offer a lower interest rate on a loan to a
customer who also has a significant deposit balance with the bank.

Relationship deposit pricing can be used to encourage customers to consolidate their financial activities with the bank and
to deepen the relationship with the bank over time. It can also help the bank manage its funding costs and liquidity by
encouraging customers to maintain multiple accounts and balances with the bank.

Relationship deposit pricing has some advantages. It can help banks strengthen their customer relationships and reduce
customer attrition by offering incentives for customers to consolidate their financial activities with the bank. It can also help
banks manage their funding costs and liquidity by encouraging customers to maintain multiple accounts and balances with
the bank.

However, there are also some limitations to this approach. It may be more difficult for customers to compare pricing
across banks if the pricing is based on a complex relationship model. It may also be more difficult for banks to manage
and track the different pricing offers for each customer, particularly if the customer has a complex relationship with the
bank. Finally, it may not be suitable for banks operating in highly competitive markets, where simpler pricing models may
be more effective in attracting and retaining customers.

5. Market penetration deposit pricing

Market penetration deposit pricing is a deposit pricing strategy that involves offering low-interest rates or other incentives
to attract new customers to the bank. This approach is often used when a bank is entering a new market or looking to
expand its customer base.

For example, a bank may offer a special introductory interest rate on a savings account or CD for new customers who
open an account within a certain timeframe. The bank may also offer other incentives, such as cashback rewards or fee
waivers, to attract new customers.

Market penetration deposit pricing can be effective in attracting new customers to the bank and building market share. It
can also help the bank establish a foothold in a new market and build its brand awareness.

However, there are also some limitations to this approach. The low pricing offers may attract customers who are primarily
interested in the incentives and may not be loyal to the bank in the long term. This may lead to high customer turnover
and increased customer acquisition costs. In addition, the bank may need to adjust its pricing strategy over time to remain
competitive in the market, which can be costly and may erode profitability. Finally, the bank may need to carefully manage
its funding costs and liquidity to ensure that it can support the increased deposit growth resulting from the pricing offers.

6. Upscale target deposit pricing

Upscale target deposit pricing is a deposit pricing strategy that involves offering premium interest rates or other benefits to
attract high-value customers who have larger deposit balances or investment portfolios. This approach is often used by
banks that are looking to target affluent or high-net-worth individuals.

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For example, a bank may offer a premium interest rate on a savings account or CD for customers who have a minimum
deposit balance of $100,000 or more. The bank may also offer other benefits, such as access to a dedicated relationship
manager, priority customer service, or exclusive investment opportunities.

Upscale target deposit pricing can be effective in attracting high-value customers and deepening the bank's relationship
with these customers over time. It can also help the bank generate higher deposit balances and increase profitability.

However, there are also some limitations to this approach. The high pricing offers may be costly for the bank and may
erode profitability, particularly if the bank is unable to generate sufficient additional revenue from the high-value
customers. In addition, the bank may need to carefully manage its funding costs and liquidity to ensure that it can support
the increased deposit growth resulting from the pricing offers. Finally, the bank may face competition from other banks
and financial institutions that offer similar pricing and benefits to high-value customers, which may limit the effectiveness
of this strategy.

Loan pricing

Loan pricing refers to the interest rate and other fees charged by a lender for providing a loan to a borrower. The price of a
loan is determined by several factors such as the amount of money borrowed, the creditworthiness of the borrower, the
duration of the loan, and the prevailing market interest rates.

Lenders use a variety of methods to determine loan pricing. They may consider the borrower's credit score, income,
employment history, and other financial factors. They may also look at the purpose of the loan and the collateral offered
by the borrower to secure the loan.

Loan pricing can also vary depending on the type of loan being offered. For example, mortgages often have lower interest
rates than unsecured personal loans because the mortgage is secured by the property being purchased.

In general, borrowers with higher credit scores and stronger financial profiles are likely to be offered lower loan pricing
than those with weaker credit profiles. It's important for borrowers to shop around and compare loan pricing from multiple
lenders to find the best deal.

Loan pricing approaches:

There are several approaches to loan pricing that lenders use to determine the interest rate and other fees they charge for
providing a loan. Here are some common approaches:

i. Risk-based pricing: This approach is based on the borrower's creditworthiness and the perceived risk of
default. Lenders assess the borrower's credit score, credit history, income, and other financial factors to
determine the interest rate and fees for the loan. Borrowers with higher credit scores and stronger financial
profiles are typically offered lower interest rates and fees, while those with weaker credit profiles are offered
higher rates and fees.

ii. Relationship pricing: This approach is based on the borrower's existing relationship with the lender. Lenders
may offer lower interest rates and fees to borrowers who have a history of borrowing and repaying loans from the
same lender or who have other financial products such as checking or savings accounts with the lender.

iii. Market-based pricing: This approach is based on prevailing market interest rates and the lender's cost of funds.
Lenders may adjust their interest rates and fees based on changes in the market, such as changes in the federal
funds rate or the prime rate.

iv. Profit-based pricing: This approach is based on the lender's desired profit margin for the loan. Lenders may set
interest rates and fees based on the amount of profit they want to earn from the loan.
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v. Tiered pricing: This approach offers different interest rates and fees for different loan amounts or loan terms.
For example, a lender may offer a lower interest rate for a larger loan amount or a shorter loan term.

Lenders may use a combination of these approaches to determine loan pricing, depending on their business strategy and
the specific characteristics of the borrower and loan.

1. Cost plus loan pricing:

Cost plus loan pricing is an approach to loan pricing where the lender sets the interest rate for a loan by adding a markup
to their cost of funds. This markup represents the lender's profit margin for the loan.

In cost plus loan pricing, the lender calculates the cost of funds by adding up their expenses related to borrowing money.
This can include the interest paid to depositors, administrative costs, and any other expenses associated with funding the
loan. The lender then adds a markup to this cost of funds to determine the interest rate they will charge the borrower.

The markup in cost plus loan pricing can vary depending on the lender's desired profit margin, the perceived risk of the
loan, and other factors. For example, if the lender's cost of funds is 3%, they may add a 2% markup to arrive at an interest
rate of 5% for the loan.

Cost plus loan pricing is one of several approaches to loan pricing, and lenders may use a combination of approaches to
determine the interest rate and other fees for a loan. It is important for borrowers to compare loan offers from multiple
lenders to ensure they are getting the best possible pricing for their loan.

2. The price leadership loan pricing

Price leadership loan pricing is an approach to loan pricing where one lender sets the interest rate for a particular type of
loan, and other lenders follow suit by matching or undercutting that rate. The lender that sets the interest rate is known as
the price leader.

In price leadership loan pricing, the price leader sets an interest rate that they believe is competitive and profitable for the
loan product. Other lenders in the market then evaluate this rate and decide whether to match it or set their own rate
slightly above or below it.

Price leadership loan pricing can benefit borrowers because it can create a competitive market where lenders are vying
for business by offering lower interest rates and fees. However, it can also lead to a situation where lenders engage in
price wars that may not be sustainable in the long run.

Price leadership loan pricing is often seen in markets where there are a few dominant lenders who set the standard for
interest rates and fees. It can also occur in markets where there is a lot of competition and lenders are constantly
adjusting their rates to remain competitive.

Borrowers should be aware that price leadership loan pricing is just one approach to loan pricing, and it's important to
compare loan offers from multiple lenders to ensure they are getting the best possible rate and terms for their loan.

Base interest rate

The base interest rate, also known as the benchmark interest rate or the prime rate, is the interest rate set by a central
bank or other monetary authority that serves as a reference rate for other interest rates in the economy. The base interest

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rate is typically used as a starting point for lenders to determine the interest rate they will charge on loans and other
financial products.

In the United States, the base interest rate is the federal funds rate, which is the interest rate at which banks and other
depository institutions lend reserve balances to each other overnight. The Federal Reserve sets the target range for the
federal funds rate, which influences other short-term interest rates such as the prime rate and the LIBOR (London
Interbank Offered Rate).

Changes in the base interest rate can have a significant impact on the economy, as they can affect borrowing costs for
consumers and businesses, and can influence inflation and economic growth. When the base interest rate is lowered, it
can stimulate borrowing and economic activity, but it can also lead to inflation. When the base interest rate is raised, it can
help control inflation but can also slow down economic growth.

The base interest rate can vary depending on the country and the monetary authority that sets it. In some countries, the
central bank may use a different interest rate as the base interest rate, such as the overnight lending rate or the discount
rate.

3. Risk based loan pricing :

Risk-based loan pricing is an approach to loan pricing where lenders assess the creditworthiness and risk of default of the
borrower and then set the interest rate and other fees for the loan based on this assessment.

In risk-based loan pricing, lenders consider a variety of factors when evaluating the borrower's creditworthiness, such as
their credit score, credit history, income, debt-to-income ratio, and employment history. Based on this evaluation, the
lender assigns the borrower a risk rating that reflects their perceived level of risk.

Lenders then use the risk rating to set the interest rate and other fees for the loan. Borrowers with higher risk ratings are
typically offered higher interest rates and fees, as the lender perceives them to be more likely to default on the loan.
Conversely, borrowers with lower risk ratings are offered lower interest rates and fees, as the lender perceives them to be
less likely to default.

Risk-based loan pricing allows lenders to tailor their pricing to the specific risk profile of each borrower. This can benefit
borrowers who have a strong credit history and financial profile by allowing them to obtain lower interest rates and fees.
However, it can also result in higher costs for borrowers who are perceived to be higher risk, which may make it more
difficult for them to obtain credit.

It's important for borrowers to shop around and compare loan offers from multiple lenders to ensure they are getting the
best possible rate and terms for their loan. Additionally, borrowers can work to improve their credit profile and reduce their
perceived risk to lenders by paying bills on time, reducing debt, and maintaining stable employment.

Q. Why do you think that deposit pricing is an important decision making issue for a depository
institution?
Deposit pricing is a critical decision-making issue for depository institutions for several
reasons:

i. Attracting and retaining deposits: Depository institutions rely on deposits to fund their lending activities, and
deposit pricing is a key factor in attracting and retaining customers' deposits. By offering competitive interest
rates, depository institutions can attract deposits from customers and retain existing customers.

ii. Managing profitability: Deposit pricing affects a depository institution's profitability. By managing deposit pricing,
depository institutions can balance the cost of funding with the revenue generated from lending activities.

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iii. Competition: Depository institutions face intense competition in the financial marketplace. By offering attractive
deposit rates, depository institutions can compete effectively with other financial institutions for customers'
deposits.

iv. Regulatory requirements: Depository institutions must comply with various regulatory requirements related to
deposit pricing, such as restrictions on paying interest on certain types of deposits. By managing deposit pricing
effectively, depository institutions can ensure compliance with these requirements while still attracting and
retaining deposits.

In summary, deposit pricing is an important decision-making issue for depository institutions as it affects their ability to
attract and retain deposits, manage profitability, compete effectively, and comply with regulatory requirements.

Q. “Deregulation of the banking industry has encouraged bankers to think creatively about their
deposit pricing policies and strategies”. In the light of this statement, describes the various deposit
pricing models of banking sectors.

There are several deposit pricing models that depository institutions may use to attract and retain deposits. These models
include:

i. Fixed interest rate: In this model, the depository institution offers a fixed interest rate on a deposit for a specific
period of time, such as six months or one year. This model is attractive to customers who want a predictable
return on their investment.

ii. Tiered interest rate: In this model, the depository institution offers different interest rates based on the amount
of the deposit. Typically, the interest rate increases as the deposit amount increases. This model is attractive to
customers with larger deposits who are seeking higher returns on their investment.

iii. Promotional interest rate: In this model, the depository institution offers a higher-than-normal interest rate for a
limited time period to attract new deposits. This model is often used to generate short-term increases in deposits.

iv. Variable interest rate: In this model, the interest rate on the deposit is tied to an external benchmark, such as
the prime rate or the LIBOR rate. This model is attractive to customers who want their deposit returns to be
aligned with changes in the broader financial market.

v. Negotiated interest rate: In this model, the depository institution negotiates the interest rate with the customer
based on factors such as the customer's relationship with the institution, the amount of the deposit, and the
deposit term. This model is often used for high-value deposits and institutional clients.

In summary, deregulation of the banking industry has led to the development of various deposit pricing models that allow
depository institutions to offer attractive interest rates and meet the needs of a diverse range of customers. These models
include fixed interest rate, tiered interest rate, promotional interest rate, variable interest rate, and negotiated interest rate
models.

Q. "The loan deposit pricing strategy has the direct impact on the profitability and goodwill of the
bank" explain this statement

The loan deposit pricing strategy of a bank refers to the way the bank prices its loans relative to the interest it pays on
deposits. This pricing strategy has a direct impact on the profitability and goodwill of the bank for the following reasons:

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i. Profitability: The interest rate charged on loans is a key factor in determining the bank's profitability. If the bank
charges higher interest rates on loans than it pays on deposits, it generates a positive interest rate spread, which
contributes to its profitability. However, if the bank charges lower interest rates on loans than it pays on deposits,
it may struggle to generate sufficient profits to cover its operating expenses.

ii. Customer loyalty: The loan deposit pricing strategy can affect customer loyalty and satisfaction. If the bank
offers attractive interest rates on deposits and charges reasonable interest rates on loans, customers are more
likely to stay with the bank and recommend it to others. Conversely, if the bank charges high interest rates on
loans and offers low interest rates on deposits, customers may be more likely to switch to a competitor.

iii. Reputation: The loan deposit pricing strategy can impact the reputation of the bank in the marketplace. If the
bank is seen as charging fair and reasonable interest rates on loans and paying attractive interest rates on
deposits, it is likely to be viewed positively by customers and industry analysts. However, if the bank is seen as
charging excessive interest rates on loans or offering uncompetitive deposit rates, it may be viewed negatively
and may struggle to attract new customers.

In summary, the loan deposit pricing strategy has a direct impact on the profitability and goodwill of the bank. By pricing
loans and deposits appropriately, banks can generate profits, retain customers, and maintain a positive reputation in the
marketplace.

UNIT: 7 ASSETS LIABILITY MANAGEMENT

Asset liability management

Asset Liability Management (ALM) is a financial management strategy used by organizations to manage the risks
associated with their assets and liabilities. The main goal of ALM is to optimize the balance between the assets
and liabilities of an organization in order to minimize risks and maximize returns.

ALM involves several key steps, including:

 Identifying and analyzing the various assets and liabilities of the organization, including their maturity profiles,
cash flows, and risks.

 Establishing appropriate risk management strategies to mitigate the risks associated with the assets and
liabilities, such as interest rate risk, credit risk, liquidity risk, and operational risk.

 Developing a comprehensive plan for managing the assets and liabilities of the organization, including setting
target asset and liability levels, establishing appropriate investment and borrowing strategies, and monitoring and
adjusting the plan as necessary.
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 Implementing the plan by investing in appropriate assets and liabilities that match the organization's risk profile,
as well as regularly monitoring and assessing the performance of the assets and liabilities to ensure they are
meeting the organization's goals.

Overall, effective ALM helps organizations to balance their assets and liabilities in a way that maximizes returns while
minimizing risk, ensuring the long-term financial health and stability of the organization.

Maturity mismatch

Maturity mismatch is a financial term used to describe a situation where an organization's assets and liabilities have
different maturities, which can result in financial risk.

Maturity Mismatch
1. Banks manage risks from differences between their assets (loans) and liabilities (deposits).
2. These risks include interest rate risk, currency exchange risk, and liquidity risk.
3. Asset Liability Management (ALM) helps banks handle these risks.
4. Banks try to match assets and liabilities based on their maturity and interest rate sensitivity.
5. ALM aims to reduce interest rate risk and liquidity risk.
6. ALM is a key financial management tool for banks.
7. It helps banks balance risks related to interest rates, foreign exchange, and liquidity.
8. ALM also considers credit risk and contingency risk.
9. The goal of ALM is to ensure banks have more assets than liabilities while earning a good return.
10. Financial markets are changing rapidly, increasing competition and risks for banks.

Interest Sensitive Assets & Liabilities

1. The main goal of ALM is to control a bank’s net interest income.
2. Banks can use defensive or aggressive ALM strategies.
• Defensive ALM aims to keep net interest income stable.
• Aggressive ALM tries to increase net interest income by changing the bank’s portfolio.
3. Aggressive ALM depends on predicting future interest rate changes.
4. Banks can be asset-sensitive or liability-sensitive:
• Asset-sensitive banks benefit when interest rates rise but lose when they fall.
• Liability-sensitive banks lose when interest rates rise but benefit when they fall.
5. The bank’s gap ratio helps determine if it is asset-sensitive (positive gap) or liability-sensitive (negative gap).
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sensitive assets and liabilities

Interest sensitive assets and liabilities are financial instruments that are sensitive to changes in interest rates. When
interest rates change, the value of these assets and liabilities also changes, which can impact the profitability and financial
stability of an organization.

Interest sensitive assets include investments such as bonds, mortgages, and loans with variable interest rates. When
interest rates increase, the value of these assets decreases, as their future cash flows are discounted at a higher rate.
Conversely, when interest rates decrease, the value of these assets increases, as their future cash flows are discounted
at a lower rate.

Interest sensitive liabilities include borrowings, such as loans, bonds, and deposits with variable interest rates. When
interest rates increase, the cost of these liabilities increases, as the organization must pay a higher rate of interest to its
lenders. Conversely, when interest rates decrease, the cost of these liabilities decreases, as the organization pays a
lower rate of interest.

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Managing interest rate risk associated with interest-sensitive assets and liabilities is an important part of asset liability
management (ALM). Organizations can use various strategies to manage interest rate risk, such as hedging with
derivatives, adjusting the mix of fixed and variable rate assets and liabilities, and setting appropriate interest rate floors
and caps. By effectively managing interest rate risk, organizations can minimize the impact of interest rate fluctuations on
their financial performance and improve their overall financial stability.

Interest Rate Risk:

Interest rate risk is the risk that an organization's financial performance will be negatively impacted by changes in interest
rates. Interest rate risk can affect both assets and liabilities, and can arise from a variety of factors such as changes in
economic conditions, inflation expectations, and monetary policy.

For example, if a company has a large portfolio of fixed-rate assets, such as bonds or loans, and interest rates rise, the
value of those assets may decrease, which could result in a decline in the company's overall financial performance.
Similarly, if an organization has a high level of variable-rate liabilities, such as floating-rate debt or deposits, and interest
rates rise, the cost of servicing that debt may increase, which could also impact the organization's financial performance.

Interest rate risk can be managed through various strategies, such as:

i. Asset liability management (ALM): This involves matching the maturities and cash flows of an organization's
assets and liabilities to minimize interest rate risk.

ii. Hedging with derivatives: Organizations can use financial instruments such as interest rate swaps and options
to hedge against interest rate risk.

iii. Diversification: By diversifying their portfolio of assets and liabilities, organizations can reduce their exposure to
interest rate risk.

iv. Setting interest rate floors and caps: Organizations can set limits on the minimum and maximum interest rates
they are willing to pay or receive to limit their exposure to interest rate risk.

It's important for organizations to carefully monitor and manage their interest rate risk to ensure they are well-positioned to
handle changes in interest rates and maintain their financial stability.

Determinants of interest rate risk of BFIs:

1. Repricing Risk: This type of interest rate risk arises from the mismatch between the repricing dates of a BFI's
assets and liabilities. For example, if a BFI has long-term fixed-rate loans but short-term variable-rate deposits, it
is exposed to repricing risk. Changes in interest rates can cause the BFI's assets and liabilities to reprice at
different rates, affecting its net interest income.

2. Yield Curve Risk: This type of interest rate risk arises from changes in the shape of the yield curve. If a BFI has
a significant amount of long-term assets and short-term liabilities, a flattening yield curve could lead to a decrease
in its net interest income as the yield on its assets decreases faster than the yield on its liabilities.

3. Interest Rate Level Risk: This type of interest rate risk arises from changes in the level of interest rates. If a BFI
has a significant amount of fixed-rate assets and liabilities, a rise in interest rates could cause the value of its
assets to decrease while the cost of its liabilities increases, leading to a decline in its net interest income.

4. Basis Risk: This type of interest rate risk arises from the mismatch between the indices used to determine the
interest rates on a BFI's assets and liabilities. For example, if a BFI has loans linked to LIBOR but its funding is
linked to a different index, changes in LIBOR could lead to a basis risk.

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5. Embedded Option Risk: This type of interest rate risk arises from the presence of embedded options in a BFI's
assets and liabilities. For example, if a BFI has mortgage loans with prepayment options, changes in interest rates
could lead to changes in prepayment behavior, affecting the cash flows of the BFI.

BFIs need to consider all of these determinants of interest rate risk when managing their interest rate risk exposure. They
can use various strategies such as asset-liability management, hedging with derivatives, and setting appropriate interest
rate floors and caps to mitigate their interest rate risk exposure.

Managing interest rate risk

Managing interest rate risk is crucial for Banks and Financial Institutions (BFIs) as it can significantly impact their financial
performance. Here are some common strategies that BFIs use to manage their interest rate risk:

1. Asset-Liability Management: Asset-Liability Management (ALM) is a comprehensive approach to managing

interest rate risk by matching the maturities, repricing dates, and interest rate sensitivities of a BFI's assets and
liabilities. BFIs use ALM to ensure that their net interest income is protected from fluctuations in interest rates.

2. Hedging with Derivatives: BFIs can use derivatives such as interest rate swaps, options, and futures to hedge
their interest rate risk exposure. For example, a BFI can enter into an interest rate swap to convert its fixed-rate
assets into floating-rate assets to match its floating-rate liabilities.

3. Setting Appropriate Interest Rate Floors and Caps: BFIs can use interest rate floors and caps to limit their
exposure to interest rate risk. Interest rate floors establish a minimum interest rate that the BFI will earn on its
assets, while interest rate caps establish a maximum interest rate that the BFI will pay on its liabilities.

4. Diversification of Funding Sources: BFIs can diversify their funding sources to manage their interest rate risk.
By accessing various funding sources, BFIs can reduce their reliance on a particular source of funding that may
be more exposed to interest rate risk.

5. Monitoring and Analysis: BFIs must continuously monitor and analyze their interest rate risk exposure. This
includes tracking changes in interest rates, analyzing the impact of interest rate changes on the BFI's net interest
income, and making necessary adjustments to the BFI's asset and liability mix to manage its interest rate risk.

Overall, effective interest rate risk management requires a comprehensive understanding of the BFI's balance sheet, the
factors that affect interest rate risk, and the tools and strategies available to manage that risk. It is important for BFIs to
have a robust risk management framework in place to ensure they can manage their interest rate risk effectively.

Gap Analysis :

Gap analysis is a commonly used technique for measuring and managing interest rate risk by Banks and Financial
Institutions (BFIs). The gap is the difference between a BFI's interest rate-sensitive assets and its interest rate-sensitive
liabilities at a specific point in time.

To conduct gap analysis, BFIs typically categorize their assets and liabilities into three categories based on their interest
rate sensitivity: non-sensitive, rate-sensitive, and highly sensitive.

Non-sensitive assets and liabilities have maturities or cash flows that do not vary with changes in interest rates.

Rate-sensitive assets and liabilities have maturities or cash flows that vary with changes in interest rates but to a lesser
extent than highly sensitive assets and liabilities.
Highly sensitive assets and liabilities have maturities or cash flows that vary significantly with changes in interest rates.

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BFIs then calculate the gap between their interest rate-sensitive assets and liabilities for each time bucket, typically using
a one-month, three-month, six-month, and one-year time horizon. The gap is calculated by subtracting the interest
ratesensitive liabilities from the interest rate-sensitive assets. A positive gap indicates that the BFI has more interest
ratesensitive assets than liabilities, while a negative gap indicates that the BFI has more interest rate-sensitive liabilities
than assets.

BFIs then use this gap analysis to assess their exposure to changes in interest rates. A positive gap indicates that the BFI
is more exposed to declining interest rates, while a negative gap indicates that the BFI is more exposed to rising interest
rates. BFIs can then use various strategies to manage their interest rate risk exposure, such as adjusting their asset and
liability mix or hedging with derivatives.

Overall, gap analysis provides BFIs with a simple and effective way to measure and manage their interest rate risk
exposure. By regularly conducting gap analysis, BFIs can identify potential interest rate risks and take appropriate
measures to manage them.

Maturity gap:

Maturity gap is a measure of interest rate risk used by Banks and Financial Institutions (BFIs). It represents the difference
between the weighted average maturity of a BFI's interest rate-sensitive assets and its interest rate-sensitive liabilities.
Maturity gap analysis helps BFIs to identify and manage their exposure to changes in interest rates.

To calculate the maturity gap, BFIs first categorize their interest rate-sensitive assets and liabilities based on their
maturities or cash flows. Assets and liabilities are classified into three categories: non-sensitive, rate-sensitive, and highly
sensitive. Non-sensitive assets and liabilities have maturities or cash flows that do not vary with changes in interest rates.
Rate-sensitive assets and liabilities have maturities or cash flows that vary with changes in interest rates, but to a lesser
extent than highly sensitive assets and liabilities. Highly sensitive assets and liabilities have maturities or cash flows that
vary significantly with changes in interest rates.

BFIs then assign weights to each category of assets and liabilities based on their respective maturities. The weights are
typically calculated as a percentage of the total dollar amount of assets or liabilities in each category. The weighted
average maturity of the interest rate-sensitive assets and liabilities is then calculated by multiplying the weights by the
maturity of each asset or liability and summing the products.

The maturity gap is then calculated by subtracting the weighted average maturity of the interest rate-sensitive liabilities
from the weighted average maturity of the interest rate-sensitive assets. A positive maturity gap indicates that the BFI's
interest rate-sensitive assets have a longer maturity than its interest rate-sensitive liabilities, meaning the BFI is more
exposed to declining interest rates. A negative maturity gap indicates that the BFI's interest rate-sensitive liabilities have a
longer maturity than its interest rate-sensitive assets, meaning the BFI is more exposed to rising interest rates.

BFIs can use maturity gap analysis to manage their interest rate risk exposure. They can adjust their asset and liability
mix or use hedging strategies to reduce their exposure to changes in interest rates based on the maturity gap. Overall,
maturity gap analysis is a useful tool for BFIs to measure and manage their interest rate risk exposure.

Duration gap:

Duration gap is a measure of interest rate risk used by Banks and Financial Institutions (BFIs). It represents the difference
between the weighted average duration of a BFI's interest rate-sensitive assets and its interest rate-sensitive liabilities.
Duration gap analysis helps BFIs to identify and manage their exposure to changes in interest rates.

To calculate the duration gap, BFIs first categorize their interest rate-sensitive assets and liabilities based on their cash
flows. Assets and liabilities are classified into three categories: non-sensitive, rate-sensitive, and highly sensitive.
Nonsensitive assets and liabilities have cash flows that do not vary with changes in interest rates. Rate-sensitive assets

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and liabilities have cash flows that vary with changes in interest rates, but to a lesser extent than highly sensitive assets
and liabilities. Highly sensitive assets and liabilities have cash flows that vary significantly with changes in interest rates.

BFIs then assign weights to each category of assets and liabilities based on their respective market values. The weights
are typically calculated as a percentage of the total market value of assets or liabilities in each category. The weighted
average duration of the interest rate-sensitive assets and liabilities is then calculated by multiplying the weights by the
duration of each asset or liability and summing the products.

The duration gap is then calculated by subtracting the weighted average duration of the interest rate-sensitive liabilities
from the weighted average duration of the interest rate-sensitive assets. A positive duration gap indicates that the BFI's
interest rate-sensitive assets have a longer duration than its interest rate-sensitive liabilities, meaning the BFI is more
exposed to declining interest rates. A negative duration gap indicates that the BFI's interest rate-sensitive liabilities have a
longer duration than its interest rate-sensitive assets, meaning the BFI is more exposed to rising interest rates.

BFIs can use duration gap analysis to manage their interest rate risk exposure. They can adjust their asset and liability
mix or use hedging strategies to reduce their exposure to changes in interest rates based on the duration gap. Overall,
duration gap analysis is a useful tool for BFIs to measure and manage their interest rate risk exposure.

Asset liability management Committee :

The Asset Liability Management Committee (ALCO) is a committee within Banks and Financial Institutions (BFIs)
responsible for managing and overseeing the institution's assets and liabilities, and the associated risks. The ALCO is
responsible for developing and implementing strategies to optimize the BFI's balance sheet, including managing interest
rate risk, liquidity risk, and credit risk.

The ALCO is typically composed of senior executives from various departments within the BFI, such as treasury, risk
management, lending, and investments. The committee meets regularly to review the BFI's balance sheet, assess risks,
and make recommendations on asset and liability management strategies.

Overall, the ALCO plays a critical role in managing the risks associated with a BFI's balance sheet and ensuring the
institution's long-term financial stability.

Roles and responsibilities of ALCO:

The Asset Liability Management Committee (ALCO) is responsible for managing and overseeing the assets and liabilities
of a Bank or Financial Institution (BFI) and the associated risks. The committee is responsible for developing and
implementing strategies to optimize the balance sheet and manage the risks associated with it. Here are some of the key
roles and responsibilities of the ALCO:

1. Setting policies and guidelines: The ALCO is responsible for setting policies and guidelines for asset liability
management (ALM) that define the BFI's risk tolerance, objectives, and limits. These policies are reviewed and
updated regularly to ensure they remain relevant and effective.

2. Risk management: The ALCO is responsible for identifying, measuring, and managing the various risks that the
BFI is exposed to, such as interest rate risk, liquidity risk, and credit risk. It develops strategies to manage these
risks and ensures that the BFI's overall risk profile remains within the defined limits.

3. Balance sheet management: The ALCO is responsible for managing the BFI's balance sheet, including the mix
of assets and liabilities and their maturity profiles. It ensures that the balance sheet remains consistent with the
BFI's risk appetite and business objectives.

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4. Monitoring and reporting: The ALCO regularly monitors the performance of the BFI's assets and liabilities and
reports on the status of the balance sheet to senior management and the board of directors. It provides
recommendations for any necessary changes to the balance sheet, policies, or risk management strategies.

5. Strategic planning: The ALCO participates in the strategic planning process of the BFI, providing input on the
impact of various strategies on the balance sheet and risk profile. It also provides recommendations on new
products and services that may impact the balance sheet.

Overall, the ALCO plays a critical role in ensuring that the BFI's balance sheet is optimized and that the institution remains
financially stable over the long term. Its responsibilities encompass a wide range of activities, including risk management,
balance sheet management, strategic planning, and reporting.

Q. What is the purpose of ALM? What are the factors affecting net interest income of a bank?

ALM stands for Asset Liability Management. The purpose of ALM is to manage a bank's assets and liabilities in a way that
optimizes its profitability and minimizes its risks. Specifically, ALM involves managing the maturity, interest rate, and
liquidity risks associated with a bank's assets and liabilities. The goal is to ensure that a bank has adequate liquidity to
meet its obligations when they come due, while also earning a sufficient return on its assets to cover its operating costs
and generate a profit.

There are several factors that can affect a bank's net interest income, which is the difference between the interest earned
on its assets and the interest paid on its liabilities. These factors include:

i. Interest rates: Changes in interest rates can have a significant impact on a bank's net interest income. When
interest rates rise, a bank's interest income on its loans and investments generally increases, but its interest
expense on its deposits and other liabilities may also increase.

ii. Loan and deposit mix: The mix of loans and deposits in a bank's portfolio can also affect its net interest
income. For example, if a bank has a higher proportion of loans with variable interest rates and a lower
proportion of fixedrate loans, its net interest income may be more sensitive to changes in interest rates.

iii. Competition: Competition from other banks and financial institutions can also impact a bank's net interest
income. When competition for deposits is high, banks may need to offer higher interest rates to attract deposits,
which can increase their interest expense and reduce their net interest income.

iv. Credit risk: The credit risk associated with a bank's loans and investments can also impact its net interest
income. If a bank experiences a higher rate of loan defaults or investment losses, its interest income may be
lower, and it may need to increase its interest expense to attract deposits or other sources of funding.

v. Regulatory requirements: Regulatory requirements, such as reserve requirements and capital adequacy ratios,
can also affect a bank's net interest income. For example, if a bank is required to hold a higher level of reserves,
it may need to increase its interest expense to attract deposits or other sources of funding.

Q. Why do you think that controlling the size of the GAP is an important consideration in gap analysis?

Controlling the size of the GAP is an important consideration in gap analysis because it helps a financial institution
manage its interest rate risk. GAP analysis is a method used to measure the difference between a bank's interest
ratesensitive assets and its interest rate-sensitive liabilities. The size of the GAP represents the degree to which a bank's
assets and liabilities are exposed to interest rate risk.

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If a bank has a large positive or negative GAP, it means that its interest rate-sensitive assets or liabilities, respectively,
exceed those of the opposite category. In other words, the bank's exposure to interest rate risk is high, and changes in
interest rates could significantly impact its net interest income.

By controlling the size of the GAP, a bank can better manage its interest rate risk and minimize the potential impact of
changes in interest rates on its profitability. For example, a bank may choose to reduce its interest rate-sensitive assets or
increase its interest rate-sensitive liabilities to reduce its positive GAP or increase its negative GAP, respectively.

Overall, managing the size of the GAP is an important consideration in gap analysis because it helps a financial institution
better understand its interest rate risk exposure and take appropriate steps to mitigate that risk.

Q. What are the basic problems with rupee gap management?

Rupee Gap Management (RGM) is a technique used by financial institutions to measure and manage their interest rate
risk. However, there are several basic problems associated with RGM, which include:

i. Assumption of static balance sheet: RGM assumes that a financial institution's balance sheet is static, which
means that it does not change over time. In reality, a bank's balance sheet is constantly evolving, with new loans
being issued, deposits being withdrawn, and other changes occurring. Therefore, the static nature of RGM makes
it difficult to accurately predict the bank's interest rate risk exposure.

ii. Narrow focus on maturity buckets: RGM focuses on the bank's exposure to interest rate risk in different
maturity buckets. However, this approach does not take into account the variability of cash flows within each
maturity bucket, which can be significant. As a result, RGM may not provide a comprehensive view of a bank's
interest rate risk exposure.

iii. Limited scope of analysis: RGM only considers the impact of changes in interest rates on a bank's net interest
income, which is the difference between interest income and interest expense. It does not take into account other
factors that could impact the bank's profitability, such as changes in credit risk, market risk, or liquidity risk.

iv. Overreliance on assumptions: RGM relies on several assumptions, such as the assumption of a static balance
sheet and the assumption of a parallel shift in interest rates. If these assumptions are not accurate, the results of
RGM may not be reliable or useful.

Overall, while RGM can provide a basic measure of a bank's interest rate risk exposure, it has several limitations and
should be used in conjunction with other risk management techniques to effectively manage interest rate risk.

Q. Explain the difference between aggressive and defensive interest rate risk management?

Aggressive and defensive interest rate risk management are two different approaches that financial institutions can use to
manage their exposure to interest rate risk. The main difference between the two approaches is their overall strategy and
objectives.

Aggressive interest rate risk management involves taking a more proactive approach to managing interest rate risk.
Financial institutions using this approach may take on more risk in order to generate higher returns. They may hold a
higher proportion of long-term, fixed-rate assets, which can provide higher returns when interest rates rise. However, this
strategy also carries greater risk, as a decline in interest rates can lead to a decline in the value of these assets.

Defensive interest rate risk management, on the other hand, involves taking a more conservative approach to managing
interest rate risk. Financial institutions using this approach may prioritize capital preservation over generating higher
returns. They may hold a higher proportion of short-term, variable-rate assets, which can provide greater flexibility to
adjust to changes in interest rates. However, this strategy may also result in lower returns over the long-term.
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In summary, the difference between aggressive and defensive interest rate risk management lies in their overall strategy
and objectives. Aggressive management seeks to generate higher returns by taking on more risk, while defensive
management seeks to preserve capital by taking a more conservative approach. Financial institutions must carefully
consider their risk appetite and objectives when choosing between these two approaches.

Q. How does the portfolio adjustment take place with aggressive and defensive duration gap
management? Explain

Portfolio adjustment is an important aspect of both aggressive and defensive duration gap management. Here's how
portfolio adjustment takes place with these two approaches:

Aggressive Duration Gap Management: In this approach, a financial institution seeks to maximize returns by taking on
more interest rate risk. This involves holding more long-term, fixed-rate assets, which are more sensitive to changes in
interest rates. As a result, if interest rates rise, the value of these assets will increase, generating higher returns for the
institution. However, if interest rates fall, the value of these assets will decline, leading to losses.
To manage the interest rate risk associated with these assets, an institution using aggressive duration gap management
may adjust its portfolio by either selling or buying assets to maintain a positive duration gap. For example, if interest rates
are expected to rise, the institution may sell short-term assets and buy long-term assets to increase the duration gap.
Conversely, if interest rates are expected to fall, the institution may sell long-term assets and buy short-term assets to
decrease the duration gap.

Defensive Duration Gap Management: In this approach, a financial institution seeks to minimize interest rate risk by taking
a more conservative approach. This involves holding more short-term, variable-rate assets, which are less sensitive to
changes in interest rates. As a result, if interest rates rise, the value of these assets will not be affected as much, but
returns will also be lower.
To manage the interest rate risk associated with these assets, an institution using defensive duration gap management
may adjust its portfolio by either selling or buying assets to maintain a zero or slightly negative duration gap. For example,
if interest rates are expected to rise, the institution may sell long-term assets and buy short-term assets to decrease the
duration gap. Conversely, if interest rates are expected to fall, the institution may sell short-term assets and buy long-term
assets to increase the duration gap.

Overall, the key difference between aggressive and defensive duration gap management is the degree of interest rate risk
that a financial institution is willing to take on. Aggressive management involves taking on more interest rate risk to
generate higher returns, while defensive management involves taking a more conservative approach to minimize interest
rate risk. The portfolio adjustment process in each approach is designed to maintain the desired level of duration gap and
manage interest rate risk accordingly.

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UNIT: 8 DERIVATIVE INSTRUMENTS

Derivative markets:

Derivative markets are financial markets where traders can buy and sell derivative securities, such as futures, options,
swaps, and forwards. These markets are used for a variety of purposes, including hedging against risk, speculating on
price movements, and arbitraging price discrepancies between different markets.

The derivative markets play a crucial role in modern finance because they allow investors to manage risks and allocate
capital more efficiently. For example, a farmer might use a futures contract to lock in a price for their crop before the
harvest season, thereby reducing the risk of price fluctuations. Similarly, a multinational corporation might use a currency
swap to protect against fluctuations in exchange rates when conducting business in multiple countries.

Derivative markets can be either exchange-traded or over-the-counter (OTC). Exchange-traded derivatives are
standardized contracts that are traded on organized exchanges, such as the Chicago Mercantile Exchange or the New
York Stock Exchange. In contrast, OTC derivatives are customized contracts that are negotiated directly between two
parties.

One of the advantages of exchange-traded derivatives is that they are highly regulated and provide transparency and
liquidity, while OTC derivatives are subject to less regulation and may be less liquid. However, OTC derivatives offer
greater flexibility and customization, which can be useful for complex transactions.

Derivative markets can be volatile and risky, and investors should have a thorough understanding of the instruments and
the associated risks before investing in them.

Derivative securities:

Derivative securities are financial instruments that derive their value from an underlying asset or security. The underlying
asset could be a stock, commodity, currency, or any other financial instrument. Derivatives allow investors to speculate or
hedge against the price movements of the underlying asset without owning it directly.

There are several types of derivative securities, including:

 Futures contracts: These are agreements to buy or sell an underlying asset at a predetermined price and date in
the future.

 Options: These give the buyer the right, but not the obligation, to buy or sell an underlying asset at a
predetermined price and date in the future.

 Swaps: These are agreements between two parties to exchange cash flows based on a predetermined set of
conditions.

Forward contracts: These are similar to futures contracts, but they are customized agreements between two parties rather
than standardized contracts traded on an exchange.

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Derivatives are used for a variety of purposes, including hedging against risk, speculating on price movements, and
arbitraging price discrepancies between different markets. However, they are also complex financial instruments that carry
significant risk and can lead to substantial losses if not used appropriately.

Commodity and financial derivatives

Commodity derivatives and financial derivatives are two broad categories of derivative securities that are traded in
financial markets.

Commodity derivatives are financial instruments whose value is derived from underlying physical commodities such as
metals, agricultural products, energy, and other natural resources. Commodity derivatives include futures contracts,
options, swaps, and forwards, and are used by market participants to manage the risks associated with price fluctuations
in the underlying commodities. For example, a farmer might use a futures contract to lock in the price of their crops before
the harvest season, thereby reducing the risk of price fluctuations. Similarly, a mining company might use a commodity
swap to protect against price volatility in the metals they produce.

Financial derivatives, on the other hand, derive their value from underlying financial instruments such as stocks, bonds,
currencies, and interest rates. Financial derivatives are used to manage financial risks such as interest rate risk, currency
risk, and credit risk. Some examples of financial derivatives include futures contracts, options, swaps, and forwards. For
instance, a multinational corporation might use a currency swap to protect against fluctuations in exchange rates when
conducting business in multiple countries, while a bond trader might use an interest rate futures contract to hedge against
interest rate risk.

Overall, both commodity derivatives and financial derivatives play important roles in financial markets, enabling investors
and businesses to manage risks associated with price volatility and other financial uncertainties. However, they also carry
risks, and investors should understand the risks involved before investing in them.

Options

Options are derivative securities that give the holder the right, but not the obligation, to buy or sell an underlying asset at a
specified price (called the strike price) and before a specific date (called the expiration date). The underlying asset can be
a stock, commodity, currency, or any other financial instrument.

There are two types of options:

1. Call options: These give the holder the right to buy the underlying asset at the strike price before the expiration
date.

A call option is a type of option contract that gives the holder the right, but not the obligation, to buy an
underlying asset at a predetermined price (called the strike price) on or before a specified expiration date. The
underlying asset can be a stock, commodity, currency, or any other financial instrument. If the price of the
underlying asset rises above the strike price before the expiration date, the holder of the call option can exercise
the option and buy the underlying asset at the lower strike price, making a profit. If the price of the underlying
asset does not rise above the strike price before the expiration date, the holder can simply let the option expire
and lose only the premium paid for the option.

2. Put options: These give the holder the right to sell the underlying asset at the strike price before the expiration
date.

A put option, on the other hand, is a type of option contract that gives the holder the right, but not the
obligation, to sell an underlying asset at a predetermined price (called the strike price) on or before a specified
expiration date. If the price of the underlying asset falls below the strike price before the expiration date, the
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holder of the put option can exercise the option and sell the underlying asset at the higher strike price, making a
profit. If the price of the underlying asset does not fall below the strike price before the expiration date, the holder
can simply let the option expire and lose only the premium paid for the option.

Overall, call and put options can be used for a variety of purposes, including speculation, hedging, and generating
income. However, they are also complex financial instruments that carry significant risks, and investors should have a
thorough understanding of the associated risks before investing in them.

Options are used for a variety of purposes, including speculation and hedging. Speculators use options to make bets on
the direction of the underlying asset's price movements, while hedgers use options to protect against potential losses.

When an investor buys an option, they pay a premium to the option seller. If the underlying asset's price does not move in
the direction that benefits the option holder, the holder can simply let the option expire and lose only the premium paid. If
the underlying asset's price moves in the desired direction, the option holder can exercise the option and buy or sell the
underlying asset at the strike price, making a profit.

Options trading can be complex and risky, and investors should understand the risks before investing in options. However,
they can be a useful tool for managing risk and generating profits in financial markets.

Swaps

A swap is a type of derivative contract in which two parties agree to exchange one stream of cash flows for another
stream of cash flows. Swaps can be used to manage risks or to speculate on future market movements. The two most
common types of swaps are interest rate swaps and currency swaps.

Swaps are typically traded over-the-counter (OTC), rather than on an exchange. This means that the terms of the swap
can be customized to meet the needs of the parties involved. However, because swaps are not standardized, they carry
counterparty risk, which is the risk that one party may default on their obligations under the contract.

Overall, swaps are complex financial instruments that can be used to manage risks or to speculate on future market
movements. However, they carry significant risks, and investors should understand the associated risks before investing
in them.

1. Interest swaps
An interest rate swap is a type of swap contract in which two parties agree to exchange interest rate payments on a
notional principal amount for a specified period of time. Typically, one party agrees to pay a fixed interest rate on the
notional principal amount, while the other party agrees to pay a floating interest rate based on a benchmark interest rate
(such as LIBOR).

The purpose of an interest rate swap is to manage interest rate risk. For example, a company that has borrowed money at
a variable interest rate may be exposed to interest rate risk if interest rates rise, causing their borrowing costs to increase.
By entering into an interest rate swap, the company can exchange its variable-rate payments for fixed-rate payments,
effectively locking in a fixed interest rate and reducing its exposure to interest rate risk.

Interest rate swaps can also be used for speculative purposes. For example, a hedge fund may enter into an interest rate
swap in order to profit from a predicted movement in interest rates.

Interest rate swaps are typically traded over-the-counter (OTC), rather than on an exchange. This means that the terms of
the swap can be customized to meet the needs of the parties involved. However, because swaps are not standardized,
they carry counterparty risk, which is the risk that one party may default on their obligations under the contract.

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Overall, interest rate swaps are complex financial instruments that can be used to manage interest rate risk or to
speculate on future interest rate movements. However, they carry significant risks, and investors should understand the
associated risks before investing in them.

2. Currency swaps
A currency swap is a type of swap contract in which two parties agree to exchange cash flows denominated in different
currencies for a specified period of time. Typically, one party agrees to pay cash flows denominated in one currency (such
as the US dollar), while the other party agrees to pay cash flows denominated in another currency (such as the Euro).

The purpose of a currency swap is to manage currency risk. For example, a company that operates in both the US and
Europe may be exposed to currency risk if it has cash flows denominated in both US dollars and Euros. By entering into a
currency swap, the company can exchange its US dollar cash flows for Euro cash flows, effectively converting its
currency exposure from US dollars to Euros.

Currency swaps can also be used for speculative purposes. For example, a hedge fund may enter into a currency swap in
order to profit from a predicted movement in currency exchange rates.

Currency swaps are typically traded over-the-counter (OTC), rather than on an exchange. This means that the terms of
the swap can be customized to meet the needs of the parties involved. However, because swaps are not standardized,
they carry counterparty risk, which is the risk that one party may default on their obligations under the contract.

Overall, currency swaps are complex financial instruments that can be used to manage currency risk or to speculate on
future currency exchange rate movements. However, they carry significant risks, and investors should understand the
associated risks before investing in them.

3. Forward rate agreement

A Forward Rate Agreement (FRA) is a type of derivative contract between two parties in which one party agrees to pay a
fixed interest rate on a notional principal amount to the other party at a future date, while the other party agrees to pay a
floating interest rate based on a specified reference rate (such as LIBOR) on the same notional principal amount at the
same future date.

The purpose of a FRA is to hedge against interest rate risk by allowing parties to lock in a future interest rate. For
example, a company that anticipates a future need for borrowing may enter into a FRA to lock in a favorable interest rate,
effectively protecting itself against potential interest rate increases.

FRAs are typically traded over-the-counter (OTC), rather than on an exchange. This means that the terms of the FRA can
be customized to meet the needs of the parties involved. However, because FRAs are not standardized, they carry
counterparty risk, which is the risk that one party may default on their obligations under the contract.

FRAs are settled in cash on the future date specified in the contract. If the floating rate at the future date is higher than the
fixed rate specified in the FRA, the party paying the floating rate will receive a payment from the other party. If the floating
rate is lower than the fixed rate, the party paying the fixed rate will make a payment to the other party.

Overall, FRAs are complex financial instruments that can be used to manage interest rate risk. However, they carry
significant risks, and investors should understand the associated risks before investing in them.

Credit derivatives

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Credit derivatives are financial instruments that allow investors to manage credit risk. They are essentially contracts that
transfer the risk of default from one party to another, often for a fee or premium.

There are several types of credit derivatives, including credit default swaps (CDS), credit-linked notes (CLN), and
collateralized debt obligations (CDO).

A credit default swap (CDS) is a contract in which one party agrees to pay the other party in the event of a default on a
specified debt instrument, such as a corporate bond or a loan. The buyer of the CDS pays a premium to the seller, and in
exchange, the seller agrees to pay the buyer a fixed sum of money if a credit event occurs.

A credit-linked note (CLN) is a type of bond that is linked to the creditworthiness of a specific entity or group of entities.
In a CLN, the bond issuer agrees to pay the bondholder a higher interest rate if the specified entity or entities default on
their debt obligations. CLNs are typically sold to investors who want to earn a higher yield than is available on traditional
bonds.

A collateralized debt obligation (CDO) is a type of investment vehicle that pools together a group of debt instruments,
such as mortgages or corporate bonds, and then issues tranches of securities that are backed by the cash flows from
those underlying assets. The tranches are rated according to their creditworthiness, with the most senior tranches being
the least risky and the most junior tranches being the most risky. CDOs were widely used prior to the 2008 financial crisis,
but their complexity and the lack of transparency surrounding their underlying assets contributed to their role in the crisis.

Overall, credit derivatives are complex financial instruments that can be used to manage credit risk. However, they carry
significant risks, and investors should understand the associated risks before investing in them. Additionally, the use of
credit derivatives has been controversial, with some critics arguing that they can exacerbate financial instability and
contribute to market volatility.

Types of credit derivatives:

1. Securitization:

Securitization is a process where a pool of assets, such as loans or mortgages, are packaged together and sold as
securities to investors. These securities are typically divided into tranches with different levels of risk and return, and they
are often backed by collateral. The cash flows generated by the underlying assets are used to pay the investors who hold
the securities.
Securitization can be used to transfer credit risk from the originator of the underlying assets, such as a bank, to investors
who are willing to take on that risk. This can allow the originator to free up capital and reduce their exposure to risk, while
also providing investors with access to new investment opportunities.

However, securitization can also increase systemic risk, as the collapse of a large pool of securitized assets can have
significant impacts on the broader financial system. Additionally, the use of securitization can make it more difficult to
evaluate and monitor the underlying credit risk, which can lead to mispricings and other problems.

2. Credit default swaps:

Credit default swaps (CDS) are a type of credit derivative that allow investors to hedge against the risk of default on a
particular debt instrument, such as a bond or a loan. In a CDS, the buyer of the swap pays a premium to the seller, and in
exchange, the seller agrees to compensate the buyer if the underlying debt instrument defaults.
CDS can be used to transfer credit risk from one party to another, allowing investors to hedge against potential losses and
providing liquidity to the market for credit risk. However, the use of CDS can also contribute to systemic risk, as a large
number of CDS contracts can create interconnectedness and counterparty risk in the financial system.

Overall, securitization and credit default swaps are both complex financial instruments that can be used to manage credit
risk. They each have their benefits and drawbacks, and investors should carefully consider the associated risks before
investing in them.
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Risk associated with derivative products:

1. Counterparty risk: This is the risk that the other party to a derivative contract will not be able to fulfill their
obligations under the contract. For example, if you enter into a derivative contract with a counterparty and they
default on their payments, you may be left with significant losses. Counterparty risk can be mitigated by carefully
selecting counterparties, using collateral or margin requirements, and diversifying counterparty exposure.

2. Market risk: This is the risk that the value of a derivative product will change due to changes in market
conditions, such as interest rates, exchange rates, or commodity prices. For example, if you hold a call option on
a stock and the stock price falls, the value of your option will also decrease. Market risk can be mitigated by
hedging with other instruments or diversifying across different markets and asset classes.

3. Liquidity risk: This is the risk that a derivative product will not be able to be bought or sold quickly or at a fair
price, which can make it difficult to exit a position. For example, if you hold an over-the-counter derivative product
that is not widely traded, you may have difficulty finding a buyer or seller when you want to exit the position.
Liquidity risk can be mitigated by diversifying across different markets and asset classes, using limit orders, and
avoiding illiquid or thinly traded products.

4. Basis risk: This is the risk that the value of a derivative product will not track the value of the underlying asset or
index as closely as expected. For example, if you hold a futures contract on an index and the futures price does
not move in line with the index price, you may experience basis risk. Basis risk can be mitigated by carefully
selecting derivative products and hedging with other instruments.

5. Legal risk: This is the risk that a derivative contract may not be legally enforceable or may be subject to legal
challenges. For example, if a court finds that a derivative contract is invalid, you may not be able to collect on your
profits or losses. Legal risk can be mitigated by carefully drafting and reviewing contracts, using standard
documentation, and ensuring compliance with legal and regulatory requirements.

6. Operational risk: This is the risk of losses due to inadequate or failed internal processes, systems, or human
error. For example, if an error in a trade settlement system causes a payment to be delayed or misdirected, it may
result in financial losses. Operational risk can be mitigated by implementing strong internal controls and risk
management processes, and regularly testing and monitoring systems and procedures.

Overall, derivative products carry significant risks, and investors should carefully consider the associated risks before
investing in them. They should also have a thorough understanding of the products they are investing in, as well as the
market and regulatory environment in which they are operating.

Q. How does the price behavior of underlying assets affects the intrinsic value of call and put options?
Explain with illustrations

The price behavior of the underlying asset is a crucial factor that affects the intrinsic value of call and put options. Let's
first define what we mean by intrinsic value:

The intrinsic value of an option is the difference between the current price of the underlying asset and the exercise price of
the option (also known as the strike price). For a call option, the intrinsic value is the difference between the current price
of the underlying asset and the strike price. For a put option, the intrinsic value is the difference between the strike price
and the current price of the underlying asset.

Now, let's consider the effect of the underlying asset's price on the intrinsic value of call and put options:

Call Options:

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When the price of the underlying asset increases, the intrinsic value of a call option also increases. This is because the
option holder now has the right to buy the underlying asset at a lower price (the strike price), which is more valuable when
the asset's price is higher.
Conversely, when the price of the underlying asset decreases, the intrinsic value of a call option decreases. This is
because the option holder now has the right to buy the underlying asset at a higher price (the strike price), which is less
valuable when the asset's price is lower.
For example, let's say you own a call option with a strike price of $50 on a stock that is currently trading at $60 per share.
If the stock price increases to $70 per share, the intrinsic value of your call option will increase to $20 per share ($70 -
$50). If the stock price decreases to $40 per share, the intrinsic value of your call option will decrease to $0 ($40 - $50).

Put Options:
When the price of the underlying asset increases, the intrinsic value of a put option decreases. This is because the option
holder now has the right to sell the underlying asset at a lower price (the strike price), which is less valuable when the
asset's price is higher.
Conversely, when the price of the underlying asset decreases, the intrinsic value of a put option increases. This is
because the option holder now has the right to sell the underlying asset at a higher price (the strike price), which is more
valuable when the asset's price is lower.
For example, let's say you own a put option with a strike price of $50 on a stock that is currently trading at $60 per share.
If the stock price increases to $70 per share, the intrinsic value of your put option will decrease to $0 ($50 - $70). If the
stock price decreases to $40 per share, the intrinsic value of your put option will increase to $10 per share ($50 - $40).

In summary, the price behavior of the underlying asset is a critical factor in determining the intrinsic value of call and put
options. As the underlying asset's price increases, the intrinsic value of call options increases and the intrinsic value of put
options decreases. Conversely, as the underlying asset's price decreases, the intrinsic value of call options decreases
and the intrinsic value of put options increases.

Q. What are the differences between futures and forwards contracts?

Futures and forwards contracts are both agreements between two parties to buy or sell an underlying asset at a
predetermined price and date in the future. However, there are several key differences between these two types of
contracts:

Standardization: Futures contracts are standardized contracts that are traded on organized exchanges, while forwards
contracts are customized contracts that are traded over-the-counter (OTC) between two parties.

Counterparty Risk: In a futures contract, there is no counterparty risk as the exchange acts as the counterparty to both the
buyer and seller. In a forwards contract, there is counterparty risk as the buyer and seller are exposed to the credit risk of
each other.

i. Trading Flexibility: Futures contracts are highly standardized and have standardized expiration dates, sizes,
and delivery locations. Forwards contracts are more flexible and can be customized to meet the specific needs of
the buyer and seller.

ii. Margin Requirements: Futures contracts require margin payments from both the buyer and seller to guarantee
their performance under the contract. Forwards contracts typically do not require margin payments.

iii. Liquidity: Futures contracts are more liquid than forwards contracts as they are traded on organized exchanges
and are standardized, making them easier to buy and sell. Forwards contracts are less liquid as they are traded
OTC and are customized, making them harder to buy and sell.

iv. Mark-to-Market: Futures contracts are marked-to-market daily, which means that the gains or losses are settled
daily between the buyer and seller. Forwards contracts are not marked-to-market, which means that the gains or
losses are settled only on the expiration date of the contract.
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In summary, futures contracts are standardized, traded on exchanges, have no counterparty risk, require margin
payments, and are marked-to-market daily. Forwards contracts are customized, traded OTC, have counterparty risk, do
not require margin payments, and are settled only on the expiration date.

Q. Why treasury bills and commercial papers are called discount securities? Explain

Treasury bills and commercial papers are called discount securities because they are issued at a discount to their face
value, which means that the investor buys them at a price lower than their actual worth.

In the case of Treasury bills, the government issues them at a discount to their face value, and when they mature, the
investor receives the face value of the bill. For example, if an investor buys a 90-day Treasury bill with a face value of
$10,000 for $9,500, they will receive $10,000 at maturity, which is a discount of $500. The difference between the
discounted purchase price and the face value of the bill represents the interest earned by the investor.

Similarly, commercial papers are also issued at a discount to their face value. These are short-term debt instruments
issued by corporations to meet their short-term funding requirements. They are typically issued for a period of less than a
year and are backed by the creditworthiness of the issuing corporation. When commercial papers mature, the investor
receives the face value of the paper. For example, if a company issues a 90-day commercial paper with a face value of
$10,000 at a discount of 3%, the investor will pay $9,700 to purchase the paper and receive $10,000 at maturity, which is
a discount of $300. The difference between the discounted purchase price and the face value of the bill represents the
interest earned by the investor.

Treasury bills (T-bills) and commercial papers (CPs) are called discount securities because they are sold at a
discount to their face value.

When a T-bill or CP is issued, it has a face value (also called par value or maturity value) that is greater than the price
paid by the investor to purchase it. This means that if a T-bill has a face value of $10,000 and is sold at a discount of
$9,800, the investor pays $9,800 to purchase the T-bill and will receive $10,000 at maturity, resulting in a gain of $200.

The difference between the face value and the price paid is known as the discount, and it represents the interest earned
by the investor. This interest is the equivalent of the coupon rate on a bond, which is the percentage of the face value that
is paid out annually in interest.

T-bills and CPs are typically issued for short-term periods, ranging from a few days to a year, and are considered to be
low-risk investments because they are backed by the creditworthiness of the issuing entity (e.g., the government for T-bills
or a corporation for CPs). The discount rate is determined by market forces and is based on factors such as prevailing
interest rates, the creditworthiness of the issuer, and the maturity date of the security.

In summary, T-bills and CPs are called discount securities because they are sold at a discount to their face value, and the
difference between the face value and the price paid represents the interest earned by the investor.

Q. What types of investments securities do commercial banks of Nepal seem to prefer the most? Why?

Commercial banks in Nepal seem to prefer investing in government securities and loans as their primary investment
securities.

 Government Securities: The Government of Nepal issues Treasury Bills (T-Bills) and Government Bonds that
are considered safe investment options. Commercial banks in Nepal prefer to invest in these securities due to
their low credit risk and guaranteed returns. Additionally, the Government of Nepal provides a tax exemption on
the interest earned from government securities, which makes them an attractive investment option.

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 Loans: Loans are another popular investment option for commercial banks in Nepal. They provide a higher rate
of return compared to government securities, and banks can earn interest income by lending money to borrowers.
However, loans are also riskier than government securities as they carry credit risk. Commercial banks in Nepal
mitigate this risk by diversifying their loan portfolio across different sectors and by analyzing the creditworthiness
of the borrowers before granting loans.

 Other investment securities such as shares, debentures, and mutual funds are also available in Nepal.
However, commercial banks seem to prefer government securities and loans due to their lower risk and higher
liquidity.

Additionally, commercial banks in Nepal are required to maintain a certain percentage of their assets in
government securities as per the regulations of the Nepal Rastra Bank, the central bank of Nepal. This regulatory
requirement also contributes to the preference of commercial banks in Nepal for government securities.

UNIT: 9 INVESTMENT PORTFOLIOS AND LIQUIDITY MANAGEMENT

Concept of investment portfolio

An investment portfolio is a collection of assets owned by an individual or entity that is designed to achieve a particular
financial objective. The assets can include stocks, bonds, real estate, mutual funds, and other financial instruments.

The concept of an investment portfolio is based on the idea of diversification, which means spreading your investments
across different asset classes and sectors to reduce risk. A well-diversified investment portfolio can help to minimize the
impact of market fluctuations and provide better long-term returns.

There are several factors to consider when creating an investment portfolio, including your risk tolerance, investment
goals, time horizon, and financial situation. These factors will help you determine the appropriate asset allocation and
investment strategy to achieve your goals.

Some common investment portfolio strategies include:

 Passive investing - This involves investing in a diversified portfolio of low-cost index funds or exchange-traded
funds (ETFs) that track a specific market index.

 Active investing - This involves selecting individual stocks or actively managed mutual funds in an attempt to
outperform the market.

 Asset allocation - This involves diversifying your portfolio across different asset classes, such as stocks, bonds,
and real estate, based on your risk tolerance and investment goals.

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Overall, the key to a successful investment portfolio is to have a clear investment strategy, diversify your investments, and
regularly review and adjust your portfolio as needed.

Importance of investment portfolio

Investment portfolio is important for several reasons, including:

An investment portfolio is important because:
1. Diversification): Investing in different assets reduces the chances of big losses if one investment fails.
2. Grows Money Over Time: A well-planned portfolio can increase wealth through interest, dividends, and rising stock
prices.
3. Helps Reach Financial Goals: It helps in saving for important things like retirement, buying a house, or children’s
education.
4. Manages Risk: A mix of investments reduces the impact of market ups and downs.
5. Protects Against Inflation: Investments can grow over time and keep up with rising prices.
6. Saves on Taxes: Smart investment choices can reduce the amount of tax paid on earnings.

A good investment portfolio helps secure financial stability and future growth.
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1. Diversification: Investing in a portfolio of assets helps to spread out your risk across different asset classes,
sectors, and geographies. This can help reduce the impact of market fluctuations on your overall portfolio.

2. Long-term growth: A well-diversified investment portfolio can provide long-term growth potential by capturing the
benefits of compounding interest, dividend income, and capital appreciation.

3. Achieving financial goals: A properly constructed investment portfolio can help you achieve your financial goals,
such as saving for retirement, buying a home, or funding your children's education.

4. Risk management: Investing in a portfolio of assets can help manage risk by reducing the impact of market
volatility and minimizing the risk of losing your entire investment.

5. Inflation protection: Investing in a portfolio of assets can help protect against inflation by generating returns that
keep pace with the rising cost of living.

6. Tax efficiency: An investment portfolio can be structured in a tax-efficient manner to minimize the impact of taxes
on your investment returns.

Overall, a well-constructed investment portfolio is an important tool for achieving long-term financial success and security.
It can help manage risk, generate returns, and achieve your financial goals over time.

Investment instruments

There are various investment instruments available to investors, including:

Stocks: Stocks represent ownership in a company and offer potential for capital appreciation and dividend income.
1. Bonds:
You lend money to a government or company. In return, they pay you interest and give back your money after a fixed
time.
2. Mutual Funds:
Many people put their money together, and experts invest it in stocks, bonds, or other assets to reduce risk.
3. Exchange-Traded Funds (ETFs):
Similar to mutual funds but bought and sold like stocks on the stock market.
4. Real Estate:
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Investing in houses, buildings, or land to earn rent or sell for a profit. You can also invest in companies that own real
estate (REITs).
5. Commodities:
Buying things like gold, oil, or crops that have value and can be sold for a profit.
6. Options and Futures:
Special contracts where you predict future prices of things like stocks or gold and try to make a profit.
7. Cryptocurrencies:
Digital money like Bitcoin that works without banks and is traded online.

1. Bonds: Bonds are debt securities issued by governments, municipalities, and corporations, and offer a fixed rate
of interest and return of principal at maturity.

2. Mutual Funds: Mutual funds are professionally managed investment portfolios that pool money from multiple
investors to invest in a diversified portfolio of stocks, bonds, or other securities.

3. Exchange-Traded Funds (ETFs): ETFs are similar to mutual funds, but trade like stocks on an exchange and
can be bought and sold throughout the trading day.

4. Real Estate: Real estate can be a tangible investment, such as buying a rental property or investing in a real
estate investment trust (REIT), which invests in income-producing real estate properties.

5. Commodities: Commodities, such as gold, oil, and agricultural products, can be invested in directly or through
commodity futures contracts.

6. Options and Futures: Options and futures are financial derivatives that allow investors to speculate on the price
movements of underlying assets, such as stocks or commodities.

7. Cryptocurrencies: Cryptocurrencies, such as Bitcoin and Ethereum, are digital assets that use cryptography to
secure and verify transactions and operate independently of a central bank.

Investors can choose to invest in one or more of these instruments based on their investment objectives, risk tolerance,
and financial situation. It is important to understand the risks and potential rewards associated with each investment
instrument before making any investment decisions.

Money Market

The money market refers to the market for short-term, low-risk debt securities, which are typically issued by governments,
corporations, and financial institutions. Money market instruments are characterized by their short-term maturity, high
liquidity, and low risk.

Some common money market instruments include:

i. Treasury bills: Short-term debt securities issued by the US government with a maturity of one year or less.

ii. Certificates of deposit (CDs): Time deposits offered by banks and financial institutions that typically offer a
fixed interest rate and are insured by the FDIC up to a certain limit.

iii. Commercial paper: Short-term debt securities issued by corporations to finance their short-term working capital
needs.

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iv. Repurchase agreements (repos): Short-term loans secured by government securities, which are typically used
by financial institutions to finance their trading activities.

v. Money market mutual funds: Mutual funds that invest in a portfolio of money market instruments, providing
investors with a low-risk, liquid investment option.

Money market instruments are considered low-risk investments because they are typically issued by financially stable
institutions and have short-term maturities, which reduces the risk of default. However, they also offer relatively low
returns compared to other investment options, such as stocks or long-term bonds.

Overall, the money market provides investors with a low-risk, liquid investment option that can be used to park cash or
earn a modest return on short-term investments. It can also serve as a source of short-term funding for corporations and
financial institutions.

Money Market instruments:

1. Treasury bills: These are short-term debt securities issued by the US government, with maturities of one year or
less. Treasury bills are sold at a discount to their face value and pay no interest until maturity, at which time the
investor receives the full face value of the security. Treasury bills are considered to be the safest money market
instrument, as they are backed by the full faith and credit of the US government.

2. Open market operations: This refers to the buying and selling of government securities by the Federal Reserve
in order to influence the supply of money and credit in the economy. When the Fed wants to increase the money
supply, it buys government securities from banks and other financial institutions, thereby injecting cash into the
economy. When the Fed wants to decrease the money supply, it sells government securities to banks and other
financial institutions, thereby removing cash from the economy.

3. Interbank transactions: These are short-term loans made between banks and other financial institutions to
manage their daily cash needs. Banks with excess reserves lend to other banks that need additional reserves to
meet their daily obligations. These transactions are typically facilitated through the Federal Funds market, which
is the market for overnight loans between banks.

4. Commercial papers: These are short-term debt securities issued by corporations to finance their short-term
working capital needs. Commercial papers typically have maturities of 270 days or less and are unsecured,
meaning they are not backed by any collateral. The creditworthiness of the issuing corporation determines the
interest rate on the commercial paper, with higher-quality issuers paying lower rates. Commercial papers are
typically issued in denominations of $100,000 or more and are sold to institutional investors such as money
market mutual funds.

Capital market and its instruments

The capital market is a market for long-term debt and equity securities, which are issued by governments, corporations,
and other organizations to raise capital for long-term investment. Capital market instruments are characterized by their
longer-term maturity, higher risk, and potentially higher returns.

Here are some of the commonly traded instruments in the capital market:

1. Stocks: Stocks represent ownership in a company and offer potential for capital appreciation and dividend
income. Stocks can be traded on stock exchanges or over-the-counter markets.

2. Bonds: Bonds are debt securities issued by governments, municipalities, and corporations, and offer a fixed rate
of interest and return of principal at maturity. Bonds can be traded on bond markets.

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3. Preferred stock: Preferred stock is a type of stock that has a higher claim on a company's assets and earnings
than common stock. Preferred stock pays a fixed dividend and may have other features, such as the ability to be
converted into common stock.

4. Convertible bonds: Convertible bonds are debt securities that can be converted into common stock at a
specified price or rate. Convertible bonds offer investors the potential for both fixed-income and equity-like
returns.

5. Options and futures: Options and futures are financial derivatives that allow investors to speculate on the price
movements of underlying assets, such as stocks or commodities. Options give the holder the right, but not the
obligation, to buy or sell the underlying asset at a specified price or before a specified date, while futures require
the buyer and seller to complete the transaction at a specified date and price.

6. Exchange-traded funds (ETFs): ETFs are similar to mutual funds, but trade like stocks on an exchange and can
be bought and sold throughout the trading day. ETFs can invest in a diversified portfolio of stocks, bonds, or other
securities.

7. Real estate investment trusts (REITs): REITs are investment vehicles that invest in income-producing real
estate properties, such as apartments, shopping centers, and office buildings. REITs offer investors the potential
for income and capital appreciation.

8. Foreign currency: Investors can trade foreign currencies in the capital market, either directly or through financial
derivatives such as currency futures and options.

Overall, the capital market provides investors with a range of investment options that offer higher potential returns but also
higher risk compared to the money market. Investors can choose to invest in one or more of these instruments based on
their investment objectives, risk tolerance, and financial situation. It is important to understand the risks and potential
rewards associated with each investment instrument before making any investment decisions.

Liquidity Management

Liquidity management refers to the process of managing cash and other liquid assets to ensure that an individual or
organization can meet its financial obligations in a timely manner. It involves balancing the need for liquidity, or ready
access to cash, with the need for returns on investments.

Effective liquidity management involves:

1. Forecasting cash needs: This involves forecasting future cash flows, such as incoming and outgoing payments,
to determine the amount of cash that will be needed to meet obligations in the short-term and long-term.

2. Maintaining adequate cash reserves: To ensure that cash is available when needed, individuals and
organizations should maintain an adequate level of cash reserves. The amount of cash that should be held in
reserve depends on factors such as the size of the organization, the volatility of cash flows, and the availability of
credit.

3. Investing excess cash: Excess cash can be invested in short-term, highly liquid investments, such as money
market funds, Treasury bills, or commercial paper, to earn a return on cash holdings while maintaining liquidity.

4. Accessing credit facilities: In the event of a cash shortfall, individuals and organizations can access credit
facilities, such as lines of credit or overdraft facilities, to bridge the gap until more cash becomes available.

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5. Monitoring liquidity: Regular monitoring of cash flows and other factors that could impact liquidity is essential to
ensure that individuals and organizations can respond quickly to changes in their financial position.

Effective liquidity management is important for individuals and organizations to ensure that they can meet their financial
obligations, avoid default, and maintain financial stability. It requires careful planning and regular monitoring of cash flows
and investments to ensure that adequate cash reserves are maintained and excess cash is invested in appropriate and
highly liquid instruments.

Estimation of liquidity

Estimating liquidity involves determining an individual's or organization's ability to meet its short-term financial obligations
using available cash and liquid assets. The following are some common methods used to estimate liquidity:

 Current Ratio: The current ratio is calculated by dividing current assets by current liabilities. It measures the
availability of current assets to cover current liabilities. A current ratio of 2:1 or higher is generally considered to
be a sign of good liquidity.

 Quick Ratio: The quick ratio, also known as the acid-test ratio, is calculated by dividing quick assets (current
assets minus inventory) by current liabilities. It measures the availability of quick assets to cover current liabilities.
A quick ratio of 1:1 or higher is generally considered to be a sign of good liquidity.

 Cash Ratio: The cash ratio is calculated by dividing cash and cash equivalents by current liabilities. It measures
the availability of cash and cash equivalents to cover current liabilities. A cash ratio of 0.5:1 or higher is generally
considered to be a sign of good liquidity.

 Operating Cash Flow Ratio: The operating cash flow ratio is calculated by dividing cash flows from operating
activities by current liabilities. It measures the ability of a company to generate cash from its operating activities to
cover its current liabilities. A ratio of 1:1 or higher is generally considered to be a sign of good liquidity.

 Days Sales Outstanding (DSO) Ratio: The DSO ratio is calculated by dividing accounts receivable by average
daily sales. It measures the average number of days it takes for a company to collect payment from its customers.
A lower DSO ratio is generally considered to be a sign of better liquidity.

 Inventory Turnover Ratio: The inventory turnover ratio is calculated by dividing cost of goods sold by average
inventory. It measures the number of times inventory is sold and replaced in a given period. A higher inventory
turnover ratio is generally considered to be a sign of better liquidity.

These ratios can provide a snapshot of an individual's or organization's liquidity position, but it is important to consider
other factors such as market conditions, credit availability, and the timing of cash flows when estimating liquidity. Regular
monitoring of liquidity ratios and cash flows is essential to ensure that individuals and organizations are able to meet their
short-term financial obligations and maintain financial stability.

Managing mandatory liquidity requirements

Mandatory liquidity requirements are regulations imposed by central banks to ensure that financial institutions maintain a
minimum level of liquidity to meet their short-term obligations. Two common mandatory liquidity requirements are Cash
Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).

1. Cash Reserve Ratio (CRR): CRR is a mandatory liquidity requirement in which banks are required to maintain
a certain percentage of their net demand and time liabilities in the form of cash reserves with the central bank.
The cash reserves held with the central bank do not earn any interest. By increasing the CRR, the central bank
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can reduce the amount of money available for lending in the economy, thereby controlling inflation. Banks can
manage their CRR requirement by adjusting their deposit base, or by reducing their lending activities.

2. Statutory Liquidity Ratio (SLR): SLR is a mandatory liquidity requirement in which banks are required to
maintain a certain percentage of their net demand and time liabilities in the form of liquid assets such as
government securities, gold, and cash. Unlike CRR, banks can earn interest on the liquid assets held under the
SLR requirement. By increasing the SLR, the central bank can reduce the amount of money available for lending
in the economy, thereby controlling inflation. Banks can manage their SLR requirement by adjusting their deposit
base, or by reducing their lending activities.

To manage their mandatory liquidity requirements, banks need to carefully manage their asset and liability profiles. They
can do this by:

 Monitoring their cash flows: Banks need to monitor their cash inflows and outflows to ensure that they have
sufficient cash to meet their mandatory liquidity requirements.

 Managing their asset portfolio: Banks need to invest in liquid assets such as government securities, which can
be easily sold to meet their mandatory liquidity requirements.

 Managing their liability portfolio: Banks can manage their liability portfolio by controlling the growth of their
deposit base, or by raising funds through other sources such as issuing bonds.

 Regular monitoring: Banks need to regularly monitor their mandatory liquidity requirements to ensure that they
are in compliance with regulations, and to make necessary adjustments in their asset and liability portfolios.

Effective management of mandatory liquidity requirements is important for banks to maintain financial stability, meet their
short-term obligations, and avoid penalties imposed by the central bank for non-compliance.

Q. "Liquidity Management encompasses the management of cash balances, including short term
funding and investment for excess cash". In the light of this statement, explain the liquidity estimation
techniques

Liquidity estimation techniques are used to assess the amount of cash a company needs to meet its financial obligations
in the short term. Below are some of the most common techniques:

i. Cash flow forecasting: This technique involves estimating future cash inflows and outflows for a given period.
By analyzing historical data and considering current and future business activities, a company can predict how
much cash it will need to meet its obligations.

ii. Scenario analysis: This technique involves creating different scenarios to assess the impact on a company's
cash flow. For example, if sales decrease or if there is a delay in receiving payments, the company can estimate
how much cash it will need to cover the shortfall.

iii. Working capital analysis: This technique involves analyzing a company's current assets and liabilities to
determine how much cash is available for short-term obligations. By understanding how quickly the company can
convert its assets into cash, management can estimate how much cash it will have available in the short term.

iv. Stress testing: This technique involves testing a company's liquidity under extreme scenarios, such as a sudden
drop in sales or a sharp increase in interest rates. By simulating these scenarios, management can assess the
company's ability to withstand adverse conditions and estimate the amount of cash it will need to survive.

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v. Ratio analysis: This technique involves analyzing a company's financial ratios to assess its liquidity position. For
example, the current ratio (current assets divided by current liabilities) can be used to determine whether a
company has enough current assets to cover its current liabilities. The quick ratio (current assets minus inventory
divided by current liabilities) can be used to assess a company's ability to meet short-term obligations without
relying on inventory sales.

In summary, liquidity estimation techniques are essential for a company's liquidity management. By estimating its cash
needs in the short term, a company can make informed decisions about short-term funding and investment for excess
cash.

Q. "Funds management approach to managing liquidity seeks to account for changes over time in both
liquidity needs and sources in measuring liquidity ". In the light of this statement, explain the
significance of funds management approach to liquidity management

The funds management approach to liquidity management focuses on maintaining a balance between a company's
liquidity needs and its sources of liquidity over time. This approach recognizes that a company's liquidity needs and
sources can change over time due to various factors, such as changes in business conditions, market conditions, or
economic conditions.

The significance of the funds management approach to liquidity management lies in its ability to provide a comprehensive
view of a company's liquidity position, taking into account both short-term and long-term liquidity needs and sources. By
adopting this approach, a company can ensure that it has sufficient liquidity to meet its short-term obligations while also
having the flexibility to invest excess cash in longer-term, higher-yielding assets.

One of the key benefits of the funds management approach to liquidity management is that it enables a company to
monitor its liquidity position on an ongoing basis and make adjustments as needed to ensure that it remains within
acceptable levels. By using a combination of liquidity measurement techniques, such as cash flow forecasting, scenario
analysis, working capital analysis, and ratio analysis, a company can gain a clear understanding of its liquidity needs and
sources and develop strategies to manage liquidity effectively.

Another significant advantage of the funds management approach to liquidity management is that it enables a company to
optimize its liquidity position by balancing the costs and benefits of different liquidity management strategies. For example,
a company may choose to maintain higher levels of cash reserves to ensure it can meet its short-term obligations, or it
may choose to invest excess cash in short-term, highly liquid securities to earn a return on its cash holdings.

Overall, the funds management approach to liquidity management is a comprehensive and flexible approach that enables
companies to manage their liquidity needs and sources effectively over time. By adopting this approach, companies can
ensure that they have the liquidity they need to operate and grow their businesses while also maintaining an optimal
balance between short-term liquidity needs and longer-term liquidity investments.

Q. "If too much funds are tied in near cash assets, the bank lose the high earnings opportunity from
investment in other assets ". In the light of this statement, explain optimum bank liquidity

Optimum bank liquidity refers to the ideal balance between a bank's need to maintain sufficient cash reserves to meet its
short-term obligations and its desire to invest excess funds in higher-yielding assets. Maintaining optimum liquidity is
crucial for banks to ensure that they can meet depositors' demands for withdrawals, make timely payments, and respond
to unexpected events, such as financial crises or economic downturns.

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If a bank holds too much of its funds in near-cash assets, such as cash or highly liquid securities, it may miss out on
higher earnings opportunities available from investing in other assets, such as longer-term loans or higher-yielding
securities. This can result in lower profitability and returns for the bank and its shareholders.

On the other hand, if a bank does not hold sufficient near-cash assets, it may face liquidity shortages, which can lead to a
loss of confidence among depositors, regulatory scrutiny, and ultimately, financial distress. In extreme cases, a bank may
be forced to sell assets at fire-sale prices, which can further erode its financial position and reputation.

Therefore, the optimum bank liquidity level is one that strikes a balance between the need for adequate liquidity and the
desire to maximize returns. This can be achieved by adopting a robust liquidity management framework that takes into
account factors such as the bank's business model, risk appetite, regulatory requirements, and market conditions.

An effective liquidity management framework should include measures such as stress testing, scenario analysis, and cash
flow forecasting to assess the bank's liquidity needs under different market conditions. It should also incorporate
strategies such as diversification of funding sources, asset-liability matching, and contingency planning to manage liquidity
risks effectively.

In summary, optimum bank liquidity is a critical component of effective banking management. By balancing the need for
liquidity with the desire for higher returns, banks can maintain a sound financial position, enhance profitability, and provide
stability and confidence to depositors and other stakeholders.

UNIT: 10 TREASURY MANAGEMENTFUNCTION IN NEPALESE BANKING SECTOR

Scope of Treasury management in Nepalese banking sectors

Treasury management plays an essential role in the banking sector, including in Nepal. The scope of treasury
management in Nepalese banking sectors includes:

1. Liquidity Management: Treasury management helps banks manage their cash flows efficiently by maintaining
sufficient liquidity to meet their daily operational requirements.

2. Asset Liability Management (ALM): ALM involves managing the bank's assets and liabilities to ensure a healthy
balance sheet. This involves monitoring interest rate risk, credit risk, and market risk to ensure that the bank is not
exposed to undue risk.

3. Foreign Exchange Management: Nepalese banks engage in foreign exchange transactions to support
international trade and investment. Treasury management helps banks manage their foreign exchange risks and
ensure they have sufficient foreign currency to meet their obligations.

4. Investment Management: Banks invest in various financial instruments such as government securities,
corporate bonds, and equities to earn returns. Treasury management helps banks make informed investment
decisions by analyzing market trends and assessing risk.

5. Capital Management: Treasury management plays a vital role in managing the bank's capital. It ensures that the
bank has sufficient capital to meet regulatory requirements and support business growth.

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In conclusion, the scope of treasury management in Nepalese banking sectors is broad and critical to the success of
banks. Efficient treasury management helps banks optimize their operations, reduce risks, and increase profitability.

Opportunities:

1. Growing Economy: Nepal's economy has been growing steadily in recent years, which has created
opportunities for the banking sector. The increased economic activity means that there is a growing demand for
banking services, including treasury management.

2. Increased Foreign Investment: With the government's push for foreign investment and the country's growing
reputation as a destination for foreign investment, Nepalese banks can expect to see increased foreign currency
transactions, which can benefit their treasury management functions.

3. Technology Adoption: The adoption of technology in the banking sector has been increasing rapidly in Nepal.
This has enabled banks to improve their treasury management functions by using sophisticated software and
tools to manage their risks and investments.

Challenges:

1. Lack of Skilled Manpower: The Nepalese banking sector faces a shortage of skilled manpower, including in the
area of treasury management. The lack of skilled professionals can hinder banks' ability to manage their risks and
investments effectively.

2. Regulatory Challenges: Nepalese banks operate in a highly regulated environment, which can create
challenges for treasury management. Compliance with regulations and reporting requirements can be complex
and time-consuming.

3. Political Instability: Political instability in Nepal can create uncertainties for the banking sector, which can impact
treasury management functions. The country's recent political developments and the ongoing COVID-19
pandemic have already created significant challenges for the banking sector.

4. Lack of Market Development: The Nepalese financial market is relatively underdeveloped compared to other
countries in the region. This can limit the investment opportunities available to banks, making it harder for them to
optimize their treasury management functions.

In conclusion, while there are several opportunities for Nepalese banks in the area of treasury management, there are
also several challenges they need to overcome. To succeed, banks need to invest in skilled manpower, adopt new
technologies, navigate complex regulatory environments, and deal with political uncertainties.

Foreign exchange dealers association of Nepal

FEDAN stands for Foreign Exchange Dealers Association of Nepal. It is an organization of treasury dealers from
commercial banks and some development banks in Nepal. Established in 1996, it helps regulate and facilitate foreign
exchange and money market transactions in Nepal.

Main Functions of FEDAN:

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1. Providing a Platform for Dealers: It allows treasury dealers from different banks to interact and make foreign
exchange transactions using platforms like Reuters Messenger and Ekon Messenger.
2. Reporting to Nepal Rastra Bank (NRB): FEDAN reports the USD exchange rate to NRB twice daily (at 10:00
AM and 2:00 PM).
3. Dealing with NRB on Behalf of Banks: It represents banks in discussions with NRB (Nepal Rastra Bank) and
MOF (Ministry of Finance) regarding foreign exchange and money market policies.
4. Enlisting Treasury Dealers: Only dealers registered with FEDAN can perform foreign exchange transactions.
Banks must request FEDAN to add or remove dealers from the system.
5. Organizing Meetings and Training: FEDAN conducts meetings, training, and workshops for treasury dealers
to improve their skills and stay updated on market trends.
6. Dispute Resolution: If conflicts arise between dealers or banks, FEDAN acts as a mediator to resolve issues.

Duties and Responsibilities of FEDAN:

• Authenticating Treasury Dealers: Ensuring only approved dealers handle foreign exchange transactions.
• Monitoring Compliance: Making sure all dealers follow rules set by NRB and other regulators.
• Representing Nepal’s Banking Sector: Attending national and international events on foreign exchange
matters.
• Ensuring Market Stability: Keeping close contact with regulators and addressing issues related to foreign
currency (FCY) and money markets.

Conclusion:
Duties of FEDAN:
1. Enlisting treasury dealers as authorized for foreign exchange transactions.
2. Fulfilling reporting requirements of Nepal Rastra Bank (NRB) on time.
3. Dealing with regulators like NRB and the Ministry of Finance (MOF) on foreign exchange issues.
4. Representing Nepal’s banking sector in national and international foreign exchange discussions.
5. Conducting meetings among bank treasury dealers.
6. Providing training and development for treasury dealers in Nepal.

Responsibilities of FEDAN:
1. Daily reporting of USD mid-rate at 10:00 AM and 2:00 PM to NRB.
2. Updating and enlisting treasury dealers as authorized members.
3. Holding meetings to resolve issues and discuss new market developments.
4. Settling disputes among treasury dealers and member banks.
5. Working with regulators (NRB, MOF) on foreign exchange and money market matters.
6. Ensuring compliance with foreign exchange and money market regulations.
Sent
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The Foreign Exchange Dealers Association of Nepal (FEDAN) is a self-regulatory organization that represents the
interests of foreign exchange dealers in Nepal. The association was established in 1993 and has since played a crucial
role in the development of the foreign exchange market in Nepal.

FEDAN works closely with the Central Bank of Nepal and other regulatory bodies to promote transparency and
professionalism in the foreign exchange market. The association provides a platform for foreign exchange dealers to
exchange information and ideas, address common challenges, and develop best practices.

Some of the key activities of FEDAN include:

hDuties of FEDAN:
1. Enlisting treasury dealers as authorized for foreign exchange transactions.
2. Fulfilling reporting requirements of Nepal Rastra Bank (NRB) on time.
3. Dealing with regulators like NRB and the Ministry of Finance (MOF) on foreign exchange issues.
4. Representing Nepal’s banking sector in national and international foreign exchange discussions.
5. Conducting meetings among bank treasury dealers.
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6. Providing training and development for treasury dealers in Nepal.

Responsibilities of FEDAN:
1. Daily reporting of USD mid-rate at 10:00 AM and 2:00 PM to NRB.
2. Updating and enlisting treasury dealers as authorized members.
3. Holding meetings to resolve issues and discuss new market developments.
4. Settling disputes among treasury dealers and member banks.
5. Working with regulators (NRB, MOF) on foreign exchange and money market matters.
6. Ensuring compliance with foreign exchange and money market regulations.
Sen
tThe Foreign Exchange Dealers’ Association of Nepal (FEDAN) is a non-profit organization established on
January 4, 1996, comprising banks in Nepal authorized to deal in foreign exchange. FEDAN serves as a self-
regulatory body with the following key roles and responsibilities:

1. Formulating Guidelines and Rules: FEDAN develops and enforces rules governing inter-bank
foreign exchange transactions among member banks and their dealings with the public.

2. Training and Accreditation: The association provides training programs for bank personnel in
foreign exchange operations and accredits foreign exchange brokers to ensure professionalism and adherence to
industry standards.

3. Advisory Support: FEDAN advises and assists member banks in resolving issues related to foreign
exchange dealings, promoting best practices, and ensuring compliance with regulatory requirements.

4. Representation: The association represents member banks in discussions with the Nepal Rastra
Bank (NRB) and other governmental or regulatory bodies, advocating for reforms and developments in the
foreign exchange market.

5. Exchange Rate Announcements: FEDAN collects daily exchange rate data from its members and
disseminates this information to the NRB and member banks, facilitating the determination of official exchange
rates and promoting transparency in the market.
Write to Sapana Chettri
 Policy Advocacy
 : FEDAN advocates for policies and regulations that promote a stable, transparent, and efficient foreign exchange
market in Nepal. The association regularly engages with government agencies and regulatory bodies to represent
the interests of its members.

 Training and Capacity Building: FEDAN organizes training programs and workshops to enhance the skills and
knowledge of its members. These programs cover various topics, including foreign exchange operations, risk
management, and compliance.

 Dispute Resolution: FEDAN provides a platform for members to resolve disputes through mediation and
arbitration. The association has established a code of conduct for its members, which includes ethical and
professional standards that members must adhere to.

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 Information Sharing: FEDAN regularly shares information and market insights with its members, enabling them
to make informed decisions about their foreign exchange operations. The association also provides market
updates and analysis to its members to help them stay abreast of market trends and developments.

In conclusion, FEDAN plays an important role in promoting professionalism, transparency, and best practices in the
foreign exchange market in Nepal. The association provides a platform for foreign exchange dealers to collaborate, share
information, and address common challenges, contributing to the overall development of the financial sector in Nepal.

Roles and responsibilities of FEDAN

The Foreign Exchange Dealers Association of Nepal (FEDAN) has several roles and responsibilities, including:

1. Promoting Professionalism: FEDAN is responsible for promoting professionalism and ethical behavior among
its members. The association has established a code of conduct that sets out the standards that members must
adhere to, including best practices for foreign exchange operations, risk management, and compliance.

2. Advocacy and Representation: FEDAN represents the interests of its members by engaging with regulatory
bodies and other stakeholders to advocate for policies and regulations that promote a stable and efficient foreign
exchange market in Nepal. The association also works to resolve disputes among its members through mediation
and arbitration.

3. Capacity Building: FEDAN provides training programs and workshops to enhance the skills and knowledge of its
members. These programs cover various topics, including foreign exchange operations, risk management, and
compliance. By improving the capacity of its members, FEDAN aims to improve the overall standard of foreign
exchange operations in Nepal.

4. Information Sharing: FEDAN regularly shares information and market insights with its members. This enables
them to make informed decisions about their foreign exchange operations and stay up-to-date with market
developments. The association also provides market updates and analysis to its members to help them stay
abreast of market trends.

5. Self-Regulation: FEDAN is a self-regulatory organization that regulates the conduct of its members. The
association has established a disciplinary committee that investigates complaints against members and imposes
sanctions for violations of its code of conduct.

In conclusion, FEDAN plays a vital role in promoting professionalism, transparency, and best practices in the foreign
exchange market in Nepal. The association's roles and responsibilities include advocacy and representation, capacity
building, information sharing, and self-regulation, contributing to the overall development of the financial sector in Nepal.

Central bank's regulations regarding ALM and treasury:

The Central Bank of Nepal, also known as Nepal Rastra Bank (NRB), has issued several regulations regarding Asset
Liability Management (ALM) and treasury management. Some of the key regulations are:

 Prudential Guidelines on ALM: In 2015, NRB issued the Prudential Guidelines on Asset Liability Management
to ensure that banks and financial institutions manage their assets and liabilities in a prudent manner. The
guidelines require banks to establish an ALM policy, develop appropriate risk management systems, and conduct
regular stress testing.

 Prudential Guidelines on Investment of Funds: NRB has issued guidelines on the investment of funds to
ensure that banks and financial institutions invest their funds in a prudent manner. The guidelines require banks

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to diversify their investments, maintain a certain level of liquidity, and ensure that their investments are consistent
with their ALM policy.

 Guidelines on Treasury Operations: In 2013, NRB issued guidelines on treasury operations to ensure that
banks manage their treasury functions in a prudent and transparent manner. The guidelines require banks to
establish a treasury policy, maintain appropriate risk management systems, and conduct regular stress testing.

 Guidelines on Foreign Exchange Risk Management: NRB has also issued guidelines on foreign exchange risk
management to ensure that banks manage their foreign exchange risks effectively. The guidelines require banks
to develop a foreign exchange risk management policy, maintain appropriate risk management systems, and
conduct regular stress testing.

 Guidelines on Capital Adequacy: NRB has issued guidelines on capital adequacy to ensure that banks
maintain sufficient capital to cover their risks. The guidelines require banks to maintain a minimum capital
adequacy ratio (CAR) of 11 percent, with a minimum Tier 1 CAR of 5 percent.

In conclusion, the Central Bank of Nepal has issued several regulations regarding ALM and treasury management to
ensure that banks and financial institutions manage their risks in a prudent manner. The regulations require banks to
establish appropriate policies and risk management systems, conduct regular stress testing, and maintain sufficient
capital to cover their risks. These regulations contribute to the overall stability and soundness of the financial sector in
Nepal.

In addition to the regulations on ALM and treasury management mentioned earlier, the Central Bank of Nepal, Nepal
Rastra Bank (NRB), has also issued specific regulations on liquidity risk, price and interest rate risk, and foreign exchange
risk. Some of the key regulations are:

1. Regulations on Liquidity Risk: NRB has issued guidelines on liquidity risk management to ensure that banks
and financial institutions maintain sufficient liquidity to meet their obligations. The guidelines require banks to
establish a liquidity risk management policy, maintain adequate liquidity buffers, and conduct regular stress
testing.

2. Regulations on Price and Interest Rate Risk: NRB has issued guidelines on price and interest rate risk
management to ensure that banks and financial institutions manage their exposure to fluctuations in interest rates
and market prices. The guidelines require banks to establish a price and interest rate risk management policy,
conduct regular stress testing, and maintain appropriate risk management systems.

3. Regulations on Foreign Exchange Risk: NRB has issued guidelines on foreign exchange risk management to
ensure that banks and financial institutions manage their exposure to foreign exchange risks effectively. The
guidelines require banks to establish a foreign exchange risk management policy, maintain appropriate risk
management systems, and conduct regular stress testing.

4. Regulations on Open Market Operations: NRB conducts open market operations to manage liquidity in the
banking system. NRB issues guidelines on open market operations to ensure that these operations are conducted
in a transparent and efficient manner.

5. Regulations on Reserve Requirements: NRB sets reserve requirements for banks and financial institutions to
ensure that they maintain sufficient reserves to cover their obligations. The reserve requirements are reviewed
regularly and adjusted as necessary to reflect changes in market conditions.

In conclusion, the Central Bank of Nepal has issued several regulations on liquidity risk, price and interest rate risk,
foreign exchange risk, open market operations, and reserve requirements to ensure that banks and financial institutions
manage their risks effectively. These regulations contribute to the overall stability and soundness of the financial sector in
Nepal.

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Q. "Banking and financial services sector has experienced changing wave of banking regulations to
address the consequences of economic instability. " in the light of this statement, explain the
opportunities and challenges associated with bank's treasury functions

The changing wave of banking regulations in response to economic instability has created both opportunities and
challenges for banks' treasury functions. On one hand, these regulations have helped to enhance the safety and
soundness of the banking system, which can benefit banks' treasury functions by providing a stable environment for their
operations. On the other hand, complying with these regulations can create new challenges for banks, particularly in
terms of their liquidity management and risk management practices.

Opportunities:

i. Greater transparency: The increased focus on regulation has led to greater transparency in the financial
system. This transparency can provide banks with better information about their liquidity positions and overall
financial health, which can help them to make more informed decisions.

ii. Access to new markets: The changing regulatory environment has also created opportunities for banks to
access new markets. For example, the introduction of Basel III regulations has encouraged banks to hold more
high-quality capital and reduce their exposure to riskier assets, which can open up new investment opportunities
in less risky assets.

iii. Improved risk management: The increased focus on risk management has led to the development of new tools
and techniques for managing risk. Banks can leverage these tools to improve their own risk management
practices and better manage their liquidity positions.

Challenges:

i. Increased compliance costs: The increased regulatory burden can result in higher compliance costs for banks,
which can impact their profitability. This can be particularly challenging for smaller banks that may not have the
resources to invest in sophisticated compliance systems.

ii. Tighter liquidity requirements: The introduction of new liquidity requirements under Basel III can create
challenges for banks' treasury functions. Banks may need to hold more liquid assets, which can reduce their
returns, or may need to develop new strategies for managing their liquidity positions.

iii. Heightened scrutiny: The increased regulatory focus on risk management can result in heightened scrutiny of
banks' treasury functions. Banks will need to demonstrate that they have adequate risk management practices in
place, which can require significant resources and expertise.

Overall, while the changing regulatory environment can create both opportunities and challenges for banks' treasury
functions, it is clear that compliance with these regulations is critical for maintaining a safe and stable financial system.
Banks that are able to effectively manage these challenges while taking advantage of the opportunities presented by the
changing regulatory environment are likely to be more successful in the long run.

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Q. "Foreign exchange dealers association of Nepal established under certain terms and conditions for
transactions in foreign exchange business.’ In the light of this statement, what are the major roles and
responsibilities of FEDAN?

The Foreign Exchange Dealers Association of Nepal (FEDAN) is an association of foreign exchange dealers in Nepal,
established under certain terms and conditions for transactions in foreign exchange business. The main objective of
FEDAN is to promote and regulate the foreign exchange business in Nepal. Its major roles and responsibilities include:

i. Setting guidelines and standards: FEDAN is responsible for setting guidelines and standards for foreign
exchange transactions in Nepal. These guidelines and standards help to promote transparency, efficiency, and
fairness in the foreign exchange market.

ii. Facilitating communication: FEDAN acts as a liaison between its members, the Nepal Rastra Bank (NRB), and
other stakeholders in the foreign exchange market. It facilitates communication between its members and the
NRB, and helps to ensure that its members are informed about any changes in regulations or policies related to
foreign exchange transactions.

iii. Providing training and education: FEDAN provides training and education to its members on topics related to
foreign exchange transactions. This helps to ensure that its members are knowledgeable about best practices
and are able to provide high-quality services to their customers.

iv. Resolving disputes: FEDAN is responsible for resolving disputes between its members and their customers.
This helps to ensure that customers are treated fairly and that disputes are resolved in a timely and efficient
manner.

v. Monitoring compliance: FEDAN monitors its members' compliance with regulations and guidelines related to
foreign exchange transactions. This helps to ensure that its members are operating in accordance with best
practices and are providing high-quality services to their customers.

Overall, FEDAN plays a critical role in promoting and regulating the foreign exchange business in Nepal. Its efforts help to
ensure that the foreign exchange market operates in a transparent, efficient, and fair manner, and that customers receive
high-quality services from its members.

OLD QUESTIONS:

1. Define major risk faced by Nepalese commercial banks. Explain briefly

One major risk faced by Nepalese commercial banks is credit risk. Credit risk refers to the potential for borrowers to
default on their loans, leading to losses for the banks. In Nepal, the credit risk faced by banks is exacerbated by several
factors including inadequate credit appraisal, lack of collateral, high levels of non-performing loans, and weak legal and
regulatory frameworks.

Inadequate credit appraisal practices lead to banks lending to borrowers who may not be able to repay their loans. Lack
of collateral means that banks may not have sufficient security to recover their funds if a borrower defaults. High levels of
non-performing loans, where borrowers have failed to make repayments, also increase credit risk for banks.

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Furthermore, weak legal and regulatory frameworks can make it difficult for banks to enforce loan agreements and
recover funds from defaulters. This can lead to delays in recovering funds, which can have significant financial
implications for banks.

To mitigate credit risk, Nepalese commercial banks need to improve their credit appraisal processes, enforce stricter
lending standards, and diversify their loan portfolios to reduce concentration risk. Banks should also focus on improving
their legal and regulatory frameworks to ensure that they can effectively recover their funds in the event of defaults.

2. Explain the roles and functions of Treasury Department of commercial bank

The Treasury Department of a commercial bank plays a critical role in managing the bank's financial resources, including
its assets and liabilities. Here are some of the key roles and functions of the Treasury Department:

i. Asset-liability management (ALM): The Treasury Department manages the bank's balance sheet and ensures
that the bank has sufficient liquidity to meet its obligations. This involves monitoring the bank's asset and liability
positions and managing interest rate risk to ensure that the bank is not exposed to undue risk.

ii. Risk management: The Treasury Department is responsible for identifying, measuring, and managing the
various risks that the bank faces, including credit risk, market risk, and liquidity risk.

iii. Trading and investment: The Treasury Department also engages in trading and investment activities on behalf
of the bank. This involves buying and selling financial instruments such as bonds, currencies, and derivatives to
generate profits for the bank.

iv. Funding and capital management: The Treasury Department is responsible for managing the bank's funding
and capital needs. This involves raising funds through debt and equity issuances and ensuring that the bank has
sufficient capital to meet regulatory requirements.

v. Relationship management: The Treasury Department also manages relationships with other financial
institutions and clients, including managing the bank's correspondent banking relationships.

Overall, the Treasury Department plays a crucial role in managing the bank's financial resources and ensuring that the
bank is able to meet its financial obligations while generating profits for its shareholders.

3. What is investment portfolio? Describe the open market operations and interbank transactions

An investment portfolio refers to a collection of financial assets, such as stocks, bonds, and other securities, held by an
individual or an organization. The purpose of an investment portfolio is to diversify risk and maximize returns by investing
in a range of assets with different risk levels and returns.

Open market operations (OMO) refer to the purchase or sale of government securities in the open market by the central
bank to influence the money supply and interest rates in the economy. When the central bank wants to increase the
money supply, it will purchase government securities from banks and other financial institutions. This injects new money
into the banking system and lowers interest rates. Conversely, when the central bank wants to decrease the money
supply, it will sell government securities to banks and other financial institutions, thereby removing money from the
banking system and raising interest rates.

Interbank transactions refer to the transactions between different banks to settle payments or transfer funds. These
transactions can take place through various channels, such as wire transfers, Automated Clearing House (ACH) transfers,
and Fedwire transfers. Interbank transactions are crucial for ensuring the smooth functioning of the financial system and
facilitating economic activity.

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In the context of investment portfolios, open market operations and interbank transactions can have significant
implications for the value of financial assets. For example, if the central bank engages in OMO to increase the money
supply and lower interest rates, this can lead to an increase in the value of stocks and other securities as investors seek
higher returns. Similarly, interbank transactions can impact the availability and cost of funds for investment, which can
affect the returns on various assets in an investment portfolio. Therefore, investors need to be aware of these factors
when constructing and managing their investment portfolios.

4. Define liquidity risk. How do you mitigate the liquidity risk in commercial banks

Liquidity risk refers to the risk that a company, such as a commercial bank, may not be able to meet its short-term
financial obligations due to a shortage of cash or cash equivalents. This can arise if a bank is unable to convert its assets
into cash quickly enough to meet its liabilities as they become due, or if it faces unexpected outflows of cash.

To mitigate liquidity risk, commercial banks can take several measures, including:

i. Maintaining adequate liquidity buffers: Banks can maintain a certain level of liquidity by holding cash,
government securities, and other liquid assets on their balance sheets. These assets can be easily converted into
cash to meet short-term obligations.

ii. Diversifying funding sources: Banks can reduce their reliance on a single source of funding by diversifying
their funding sources. This can include issuing different types of debt securities, borrowing from multiple
counterparties, and accessing various funding markets.

iii. Implementing sound liquidity risk management practices: Banks can develop and implement robust liquidity
risk management practices, including stress testing, scenario analysis, and contingency planning. This can help
identify potential liquidity risks and enable banks to take proactive measures to mitigate them.

iv. Establishing a sound governance framework: Banks can establish a strong governance framework to ensure
that liquidity risk management is integrated into their overall risk management practices. This can include
establishing clear roles and responsibilities for managing liquidity risk, ensuring adequate reporting and
monitoring of liquidity risk metrics, and having a well-defined crisis management plan.

By implementing these measures, commercial banks can better manage their liquidity risk and ensure that they have
sufficient funds to meet their short-term financial obligations, even in times of stress.

5. What is an option? Explain the types and characteristics of options

An option is a financial contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at
a predetermined price (called the strike price) within a specific time period. The holder of an option has the right, but not
the obligation, to exercise the option, while the writer (seller) of the option is obligated to fulfill the terms of the contract if
the option is exercised.

There are two types of options:

Call Option: A call option gives the holder the right to buy an underlying asset at the strike price within a specific time
period. Call options are typically used by investors who believe that the price of the underlying asset will increase in the
future.

Put Option: A put option gives the holder the right to sell an underlying asset at the strike price within a specific time
period. Put options are typically used by investors who believe that the price of the underlying asset will decrease in the
future.

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Some key characteristics of options include:

i. Exercise Price: The exercise price, also known as the strike price, is the price at which the underlying asset can
be bought or sold if the option is exercised.

ii. Expiration Date: The expiration date is the date on which the option contract expires. After this date, the option
can no longer be exercised.

iii. Premium: The premium is the price paid by the holder of the option to the writer (seller) of the option for the right
to buy or sell the underlying asset. The premium is determined by a number of factors, including the current price
of the underlying asset, the strike price, the time to expiration, and the volatility of the underlying asset.

iv. Intrinsic Value: The intrinsic value of an option is the difference between the current price of the underlying
asset
and the strike price of the option. For a call option, the intrinsic value is positive when the current price of the
underlying asset is greater than the strike price. For a put option, the intrinsic value is positive when the current
price of the underlying asset is less than the strike price.

v. Time Value: The time value of an option is the difference between the premium paid for the option and its
intrinsic value. Time value reflects the probability that the option will become profitable before expiration, and is
affected by a number of factors, including the time to expiration and the volatility of the underlying asset.

Overall, options can provide investors with a flexible and potentially lucrative way to manage risk and generate returns,
but they also carry significant risks and complexities, and should be used only by experienced investors with a thorough
understanding of their characteristics and risks.

6. Explain money market instruments that the treasury may include in its investment portfolio

The treasury department of a government typically invests in a range of money market instruments to manage its
shortterm cash flow needs and generate income. Some common money market instruments that may be included in
the treasury's investment portfolio include:

i. Treasury Bills (T-Bills): T-Bills are short-term debt securities issued by the government to finance its operations.
They have a maturity of one year or less and are sold at a discount to their face value, with the difference
between the purchase price and the face value representing the interest earned by the investor.

ii. Commercial Paper: Commercial paper is an unsecured, short-term debt instrument issued by corporations to
finance their short-term liquidity needs. It typically has a maturity of 270 days or less and is sold at a discount to
its face value.

iii. Certificates of Deposit (CDs): CDs are time deposits issued by banks and other financial institutions. They
typically have a maturity of less than one year and offer a fixed rate of return. CDs are FDIC-insured up to a
certain amount.

iv. Repurchase Agreements (Repos): Repos are short-term loans in which the government (or another investor)
sells securities to a counterparty with an agreement to repurchase them at a later date, typically within one to
seven days. Repos are a way for the government to temporarily invest cash while providing collateral to the
counterparty.

v. Treasury Notes: Treasury notes are medium-term debt securities issued by the government with a maturity of
two to ten years. They pay interest semi-annually and are sold at a discount to their face value.

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vi. Municipal Notes: Municipal notes are short-term debt securities issued by state and local governments to
finance capital projects or cover short-term cash flow needs. They typically have a maturity of one year or less
and are sold at a discount to their face value.

Overall, these money market instruments provide the treasury department with a range of options to manage its
shortterm cash flow needs and generate income while minimizing risk. The specific mix of instruments included in the
treasury's investment portfolio will depend on a range of factors, including its cash flow needs, risk tolerance, and
investment objectives.

7. What are the rights, duties and functions of Nepal Rastra Bank?

Nepal Rastra Bank (NRB) is the central bank of Nepal and performs a range of important functions in the country's
financial system. Some of the key rights, duties, and functions of NRB are:

i. Formulating and implementing monetary policy: NRB is responsible for formulating and implementing
monetary policy in Nepal, which includes setting interest rates, regulating the money supply, and managing
foreign exchange reserves to promote price stability and sustainable economic growth.

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ii.
Regulating and supervising banks and financial institutions: NRB is responsible for regulating and
supervising banks and financial institutions in Nepal to ensure their safety, soundness, and stability. This includes
issuing licenses, setting prudential regulations, conducting inspections, and taking corrective actions as
necessary.

iii. Issuing and managing currency: NRB is the sole authority for issuing and managing currency in Nepal. It is
responsible for designing, printing, and distributing banknotes and coins, as well as maintaining the integrity and
security of the currency.

iv. Managing foreign exchange reserves: NRB is responsible for managing Nepal's foreign exchange reserves,
which includes buying and selling foreign currencies to maintain the value of the Nepalese rupee and ensure
adequate foreign currency reserves for international transactions.

v. Promoting financial sector development: NRB plays an active role in promoting financial sector development
in Nepal, which includes supporting the growth of the banking and financial system, promoting financial inclusion
and literacy, and encouraging innovation and competition in the financial sector.

vi. Conducting economic research and analysis: NRB conducts economic research and analysis to inform its
policymaking and decision-making, as well as to provide insights into the broader economic trends and conditions
in Nepal.

Overall, NRB plays a critical role in promoting monetary stability, financial sector development, and economic growth in
Nepal. Its rights, duties, and functions are designed to ensure the safety, soundness, and efficiency of the financial
system, as well as to support the broader economic development goals of the country.

8. “Risk is an event that may cause damage to an institution's income and reputations.” Explain different
types of financial risk and non financial risk of a company.

Financial risks are risks that relate to the financial performance of a company, while non-financial risks refer to risks that
are not directly related to the financial performance of the company. Here are some of the different types of financial
and non-financial risks that a company may face:

Financial Risks:

i. Credit Risk: Credit risk is the risk of loss arising from the failure of a borrower to meet its contractual obligations
to repay a loan or debt.

ii. Market Risk: Market risk is the risk of loss arising from changes in market prices or conditions, including interest
rates, exchange rates, and commodity prices.

iii. Liquidity Risk: Liquidity risk is the risk of loss arising from the inability of a company to meet its short-term
obligations due to a lack of available cash or marketable assets.

iv. Operational Risk: Operational risk is the risk of loss arising from the failure of internal processes, systems, or
personnel, including fraud, errors, and system failures.

v. Reputational Risk: Reputational risk is the risk of loss arising from damage to a company's reputation or brand
due to negative public perception, such as through a scandal or controversy.

Non-Financial Risks:

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ii.
i. Strategic Risk: Strategic risk is the risk of loss arising from poor strategic decisions or the failure to adapt to
changes in the competitive or regulatory environment.

Compliance Risk: Compliance risk is the risk of loss arising from non-compliance with laws, regulations, or
ethical standards.

iii. Environmental Risk: Environmental risk is the risk of loss arising from damage to the environment or failure to
comply with environmental regulations.

iv. Cybersecurity Risk: Cybersecurity risk is the risk of loss arising from cyber attacks, data breaches, or other
cyber threats.

v. Political Risk: Political risk is the risk of loss arising from changes in government policies, political instability, or
geopolitical events.

Overall, companies need to be aware of both financial and non-financial risks in order to effectively manage their risks
and protect their business from potential damage to their income and reputation. By identifying and managing these risks,
companies can ensure their long-term viability and success.

9. What is interbank lending? Describe the reserve requirement provision of central bank. Explain

Interbank lending refers to the borrowing and lending of funds between banks. Banks typically engage in interbank
lending to manage their short-term cash needs or to earn interest income on excess reserves they hold. Interbank lending
is important because it helps to ensure that banks have access to the funds they need to operate, even if they experience
temporary shortages.

The reserve requirement provision of a central bank is a tool used by the central bank to regulate the amount of money
that banks can lend out. A reserve requirement is the percentage of deposits that banks are required to hold as reserves,
which they cannot lend out. When a bank receives a deposit, it must keep a certain portion of that deposit as reserves
and can lend out the remaining portion to borrowers. The reserve requirement provision sets a minimum level of reserves
that banks must hold, which restricts the amount of money that they can lend out.

For example, if the reserve requirement is set at 10%, a bank that receives a deposit of $100 will be required to hold $10
as reserves and can lend out $90 to borrowers. If the bank lends out the full $90, the borrower may deposit the funds into
another bank, which would then be required to hold $9 as reserves and could lend out $81 to borrowers. This process can
continue, with each bank holding a portion of the deposit as reserves and lending out the remainder, until the total amount
of lending in the system reaches a limit set by the reserve requirement provision.

The reserve requirement provision is an important tool used by central banks to control the money supply and to stabilize
the economy. By adjusting the reserve requirement, central banks can either increase or decrease the amount of money
that banks are able to lend out, which in turn affects the overall level of economic activity. For example, if the central bank
wants to stimulate the economy, it may lower the reserve requirement, allowing banks to lend out more money and
increasing the amount of economic activity. Conversely, if the central bank wants to slow down the economy, it may raise
the reserve requirement, which would restrict the amount of money that banks can lend out and reduce economic activity.

10. “Commercial bank is leading financial institutions in Nepal though it has so many challenges”. In this
context explain the opportunities and challenges of treasury management in Nepalese banking sector

Treasury management is the process of managing a bank's assets and liabilities to optimize its liquidity, profitability, and
risk. In the Nepalese banking sector, treasury management faces both opportunities and challenges.

Opportunities:

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ii.

i. Interest Rate Risk Management: Treasury management in Nepalese banks has an opportunity to manage
interest rate risk effectively by utilizing various financial instruments such as interest rate swaps, options, and
futures.

Foreign Exchange Risk Management: Nepalese banks have the opportunity to manage foreign exchange risk
by investing in currency futures and options, forward contracts, and foreign currency loans.

iii. Liquidity Management: Treasury management has an opportunity to manage liquidity efficiently by investing in
short-term money market instruments such as treasury bills and commercial papers.

iv. Capital Management: Nepalese banks have the opportunity to manage their capital by issuing debt instruments
such as bonds and debentures, which can help them raise funds at a lower cost.

v. Product Innovation: Treasury management has an opportunity to develop new financial products to meet the
changing needs of customers and the market.

Challenges:

i. Regulatory Compliance: Nepalese banks face regulatory challenges in complying with the regulations of the
central bank, such as reserve requirements, capital adequacy ratios, and foreign exchange regulations.

ii. Credit Risk Management: Treasury management faces the challenge of managing credit risk, which includes
the risk of default by borrowers, non-payment, and delay in payments.

iii. Technology: The Nepalese banking sector faces the challenge of technological advancement in treasury
management, such as investing in financial software, trading platforms, and data analytics.

iv. Human Resources: Nepalese banks face challenges in hiring and retaining qualified treasury management
professionals who can manage financial risks effectively.

v. Volatility: Treasury management faces the challenge of managing market volatility, which includes fluctuations
in interest rates, foreign exchange rates, and commodity prices.

Overall, treasury management in Nepalese banks has many opportunities to optimize their assets and liabilities for
profitability and risk management. However, they also face regulatory, credit, technological, human resource, and
market challenges that need to be addressed to improve their overall treasury management capabilities.

11. Define loan pricing. Describes the methods of loan pricing strategy of Nepalese commercial banking

Loan pricing is the process of determining the interest rate and other terms of a loan. Loan pricing is an important part of
commercial banking as it helps banks to earn interest income, cover their costs, and manage their risks. Loan pricing is
influenced by factors such as the borrower's creditworthiness, the purpose of the loan, the term of the loan, and the
prevailing market interest rates.

In the Nepalese commercial banking sector, the following methods are used for loan pricing:

i. Prime Rate Method: The prime rate method is the most common method used by Nepalese commercial banks
for loan pricing. Banks set their prime rate, which is the interest rate charged to their most creditworthy
customers, and then add a premium or discount depending on the creditworthiness of the borrower and the risk
associated with the loan.

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ii.

ii. Cost of Funds Method: The cost of funds method involves determining the bank's cost of funds, which is the
interest rate it pays on its deposits and other sources of funding, and then adding a premium to cover the bank's
operating costs and profit margin.

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iii. Risk-Based Pricing Method: The risk-based pricing method involves assessing the creditworthiness of the
borrower and charging an interest rate based on the risk associated with the loan. Higher-risk borrowers are
charged a higher interest rate to compensate for the higher risk of default.

iv. Yield Curve Method: The yield curve method involves setting the interest rate based on the term of the loan and
the prevailing market interest rates for that term. Banks will charge a higher interest rate for longer-term loans to
compensate for the increased risk of interest rate fluctuations.

v. Relationship Pricing Method: The relationship pricing method involves offering lower interest rates and other
favorable terms to customers who have a long-standing relationship with the bank, such as high-value
customers, large corporations, or government entities.

In conclusion, loan pricing is an important aspect of commercial banking in Nepal. The pricing strategies used by
Nepalese commercial banks are similar to those used by banks in other countries and are influenced by factors such as
creditworthiness, risk, term of the loan, and market interest rates. The choice of pricing method depends on the bank's
risk appetite, customer segmentation, and competitive landscape.

12. What do you mean by bank's investment portfolio? Explain the types of investment instruments
accessible to Nepalese commercial bank.

A bank's investment portfolio refers to the collection of assets that a bank invests in to earn a return on its excess liquidity.
The investment portfolio typically includes various types of securities such as government bonds, corporate bonds, equity
securities, and money market instruments.

In Nepal, commercial banks have access to a variety of investment instruments, including:

i. Government Securities: Government securities are debt instruments issued by the government to finance its
budget deficit. These securities include treasury bills, treasury bonds, and development bonds. Nepalese
commercial banks invest in government securities as they are considered to be low-risk investments.

ii. Corporate Bonds: Corporate bonds are debt instruments issued by corporations to finance their operations or
investments. Nepalese commercial banks invest in corporate bonds to earn a higher return than government
securities, although they carry a higher risk.

iii. Equity Securities: Equity securities are stocks or shares issued by companies to raise capital. Nepalese
commercial banks invest in equity securities as part of their investment portfolio, but they are generally a smaller
part of the portfolio due to the higher risk.

iv. Money Market Instruments: Money market instruments are short-term debt securities with a maturity of less
than one year. Nepalese commercial banks invest in money market instruments such as commercial papers,
certificates of deposit, and repurchase agreements to earn a return on their excess liquidity.

v. Mutual Funds: Nepalese commercial banks also invest in mutual funds, which are investment vehicles that pool
money from multiple investors to invest in various securities. Banks invest in mutual funds to diversify their
investment portfolio and earn a higher return.

In conclusion, Nepalese commercial banks have access to various investment instruments to build their investment
portfolio, including government securities, corporate bonds, equity securities, money market instruments, and mutual
funds. The choice of investment instruments depends on the bank's investment objectives, risk appetite, and market
conditions.

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13. “The baking and financial services sector has experienced changing wave of banking regulations to
address to consequences of economic instability.” In the light of this statement, explain the scope,
opportunities and challenges associated with the bank's treasury functions

The banking and financial services sector has indeed experienced changing waves of banking regulations over the years,
with the objective of addressing the consequences of economic instability. These regulations have had a significant
impact on the scope, opportunities, and challenges associated with the bank's treasury functions.

Scope:
The scope of a bank's treasury functions includes the management of the bank's assets and liabilities to optimize its
balance sheet and maximize profitability. This includes managing liquidity, interest rate risk, credit risk, and foreign
exchange risk. The treasury also manages the bank's investment portfolio and trading activities.

Opportunities:
The changing regulatory environment has created opportunities for banks to strengthen their treasury functions. For
instance, regulations such as Basel III have increased the focus on liquidity and capital adequacy, creating opportunities
for banks to improve their liquidity management practices and strengthen their capital base. The development of new
financial products and markets has also created opportunities for banks to diversify their investment portfolios and
generate new revenue streams.

Challenges:
The changing regulatory environment has also presented several challenges for the bank's treasury functions. One of the
key challenges is the increased compliance burden and the cost of implementing new regulatory requirements. The
complexity of the regulations also makes it challenging for banks to fully understand and comply with them.

Another challenge is the heightened volatility and uncertainty in financial markets, which increases the risk of losses from
market movements. This requires the treasury to have robust risk management practices to mitigate these risks.

Moreover, the changing nature of customer demands and expectations, as well as the emergence of new technologies,
have also created challenges for the bank's treasury functions. Banks need to invest in new technologies to improve
their efficiency and customer experience while managing the associated risks.

In conclusion, the changing regulatory environment has had a significant impact on the scope, opportunities, and
challenges associated with the bank's treasury functions. Banks need to adapt to these changes by improving their risk
management practices, investing in new technologies, and developing innovative solutions to meet the evolving needs of
their customers.

TRUE/FALSE

2022

1. The Treasury department of the bank invests the majority of its funds in high-risk asscts in order to maximize
earnings.

2. The front office is responsible for analyzing and controlling the risk of treasury dealings. .
3. Call deposit mainly serves the need for appropriate assets liability management of the banks and financial
institutions.
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4. Counterparty risk arises from the non-performing of a trading partner.
5. Deposit pricing’ is the process of determining the price of deposit-related services offered by depository
institutions.

6. Statutory liquidity ratio (SLR) is the maximum amount of liquid funds the bank has to maintain.
7. A bank with a positive duration gap would experience an increase in the market value of equity with rising interest
rates.

8. The market price of underlying securities determines the value of derivative securities.
9. Non-price competition for deposits has tended to distort the allocation of scarce resources in the banking sector.
10. FEDAN is an association of all banks and financial institutions in Nepal.

i. False. The Treasury department of the bank typically invests its funds in a variety of assets, including low-risk
assets such as government securities, in order to balance risk and maximize earnings.

ii. True. The front office of the bank is responsible for analyzing and controlling the risk associated with treasury
dealings, which can be complex and involve significant amounts of capital.

iii. True. Call deposits are short-term deposits that serve the need for appropriate asset liability management of
banks and financial institutions, providing them with greater flexibility in managing their cash reserves.

iv. True. Counterparty risk is the risk that arises from the potential non-performance of a trading partner, and is a
significant risk for banks and financial institutions that engage in trading activities.

v. True. Deposit pricing is the process of determining the price of deposit-related services offered by depository
institutions, such as interest rates on savings accounts and fees for checking accounts.

vi. False. The Statutory Liquidity Ratio (SLR) is the minimum percentage of liquid funds that a bank is required to
maintain in relation to its deposits and is set by the central bank of the country.

vii. False. A bank with a positive duration gap would experience a decrease in the market value of equity with rising
interest rates.

viii. True. The market price of underlying securities determines the value of derivative securities, such as options
and futures contracts.

ix. True. Non-price competition for deposits, such as offering promotional gifts or free services, can distort the
allocation of scarce resources in the banking sector and create inefficiencies.

x. False. FEDAN is not an association of all banks and financial institutions in Nepal. There is no organization with
this name in the public domain.

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2021

1. Correspondent banking provides only credit services to banks and financial instructions.
2. Arevolving deposit is a non-interest bearing demand deposit.
3. Front office determines the exchange rate and interest rate for money and capital market securities. .
4. Incall deposit interest rates are generally dependent on the negotiation between the client and the bank.
5. Consumer loan are made to fulfill the personal financial obligations of an individual.
6. Maintaining a diversified Joan portfolio helps a bank reduce systematic liquidity risk.
7. Relationship pricing promotes greater customer loyalty.
8. A bank with a positive duration gap would experience an increase in the market value of equity with rising interest
rates.

9. In open market operation, available loan able funds increase with respect to increase interest rate.
10. Funding gap is the ratio between variable rate assets and variable rate liabilities.

i. False: Correspondent banking provides a range of services including credit, clearing, settlement, and foreign
exchange services to banks and financial institutions.

ii. False: A revolving deposit is a type of demand deposit that allows the account holder to withdraw and deposit
funds freely, but it typically earns interest.

iii. False: Front office activities involve activities related to sales and trading of financial products and services, but
they do not determine the exchange rate or interest rate. Exchange rates are determined by the market forces of
supply and demand, while interest rates are determined by the central bank's monetary policy.

iv. True: Interest rates on call deposits are generally negotiable between the bank and the client.

v. True: Consumer loans are typically used to fulfill personal financial needs, such as purchasing a car or financing
a home renovation.

vi. True: Maintaining a diversified loan portfolio helps to reduce a bank's systematic liquidity risk by spreading the
risk across different types of loans and borrowers.

vii. True: Relationship pricing, which involves offering special benefits and discounts to long-term and loyal
customers, can promote greater customer loyalty.

viii. False: A bank with a positive duration gap, where the average maturity of its assets is longer than its liabilities,
would experience a decrease in the market value of equity with rising interest rates.

ix. False: In open market operations, available loan able funds decrease as interest rates increase because the
central bank buys securities from banks, reducing the amount of available funds in the market.

x. False: Funding gap is the difference between a bank's assets and liabilities in terms of their maturity or interest
rate sensitivity, and it does not necessarily relate specifically to variable rate assets and liabilities.
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2019

1. The main focus of the treasury is on the financial assets and liabilities for an organization.
2. The dealers and traders constitute the back office.
3. The interest on term deposits is very low.
4. Investment, development, administrative expenses, profit distribution etc. are the uses of fund management.
5. Counterparty risk comes from non-performance of a trading partner. :
6. Core deposit is an unstable base of fund that is highly sensitive to movements in market interest rates.
7. In the case of negative mismatch, the maturity of assets comes earlier than the maturity of liabilities.
8. The larger the value of the duration, the less sensitive is the price of that asset or liability to changes e in interest
rates.

9. Derivatives are a category of financial instruments.

10. The Treasury bill discount rate is quoted in terms of a 365-day year.

i. True: The treasury is responsible for managing an organization's financial assets and liabilities, including cash,
investments, debt, and foreign currency.

ii. False: The dealers and traders typically constitute the front office of a financial institution, responsible for
executing trades and generating revenue.

iii. True: Interest on term deposits is generally low because they are considered to be low-risk investments with a
fixed rate of return.

iv. True: Fund management involves using the capital raised from investors to invest in various areas, including
investments, development, administrative expenses, and profit distribution.

v. True: Counterparty risk refers to the risk of financial loss resulting from the failure of a trading partner to fulfill
their obligations.

vi. False: A core deposit is considered to be a stable source of funding that is less sensitive to changes in market
interest rates because they are typically long-term deposits.

vii. True: In a negative mismatch, an organization's assets have a shorter maturity than its liabilities, which can
create liquidity risk.
viii. False: The larger the value of the duration, the more sensitive the price of an asset or liability is to changes in
interest rates.

ix. True: Derivatives are a category of financial instruments that derive their value from an underlying asset, such
as stocks, bonds, or commodities.

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x. True: The Treasury bill discount rate is quoted on an annualized basis assuming a 365-day year.

2018
1. Treasury department of bank invest most of money in risky assets to earn high profit.
2. Front office of treasury department monitors open currency position.
3. Revolving deposit is a traditional type of saving deposit.
4. Interbank borrowing is the long-term funds borrowed from the central bank. -
5. Statutory liquidity ratio is the maximum amount of liquid fund the bank has to maintain.
6. Overdraft loans are of revolving nature and are to be renewed each year.
7. Maintaining a diversified loan portfolio helps a bank reduce systematic risk.
8. Non-price competition for deposits has tended to distort the allocation of scare resources in the banking sector.
9. If a bank expected interest rates to fall and if it wanted to profit from the decline, it should increase the duration of
assets and shorten the duration of its liabilities.

10. Assets liability committee is known as surplus management of the bank.

i. False. The Treasury department of a bank typically invests in a variety of assets to balance risk and return, and
usually avoids investing in highly risky assets.

ii. True. The front office of the treasury department monitors the bank's exposure to different currencies to manage
the associated risk.

iii. True. A revolving deposit is a traditional type of savings deposit where the account holder can withdraw money
and deposit funds again multiple times.

iv. False. Interbank borrowing is short-term borrowing between banks, typically for a period of less than a year.
Longterm funds are usually obtained through bond issuances or other methods.

v. True. The statutory liquidity ratio is the minimum percentage of a bank's net demand and time liabilities that it
must maintain in the form of liquid assets.

vi. True. Overdraft loans are typically of a revolving nature and need to be renewed annually.

vii. True. Maintaining a diversified loan portfolio can help a bank reduce its overall risk by spreading out its
exposure to different types of borrowers and industries.
viii. True. Non-price competition for deposits can lead to banks engaging in risky behavior to attract more deposits,
which can distort resource allocation in the banking sector.

ix. False. If a bank expects interest rates to fall, it should decrease the duration of its assets and increase the
duration of its liabilities to profit from the decline.

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x. True. The Asset Liability Committee (ALCO) is responsible for managing the bank's surplus funds and ensuring
that its assets and liabilities are properly aligned.

2017

1. The treasury department is responsible for a company's fund management

2. Front office keeps track of payments made/received to account.

3. In call deposit, interest rates are generally dependent on the negotiation between the |

4. Foeign risk arises from the fact that some domestic borrowers may not repay their loans.

5. Interbank transactions are short-term funds transferred between banks usually for no more than one week.

6. Relationship pricing promotes lower customer loyalty.

7. Banks manage the risks of assets liability management (ALM) mismatch by matching various assets and
liabilities. ‘

8. Put option gives the right to sell the underlying assets at a specified price.

9. Most liquidity problems in banking arise from inside the bank.

10. Foreign exchange dealer's association of Nepal represents the Nepalese banking sectors issue relating with
assets and liability management of banks.

i. True. The treasury department is responsible for managing a company's funds, including cash management,
cash forecasting, and investing excess cash.

ii. False. Nostro accounts are maintained by banks to track their own foreign currency transactions with other
banks. The front office of a bank typically deals with customer-facing activities such as sales and trading.

iii. True. In a call deposit, interest rates are negotiable between the depositor and the bank. The rate may be
influenced by various factors such as market conditions and the size of the deposit.

iv. False. Foreign risk arises from the possibility of losses due to changes in exchange rates, political instability, or
other factors when dealing with foreign entities, including borrowers.

v. True. Interbank transactions are typically short-term and involve the transfer of funds between banks to meet
short-term liquidity needs.

vi. False. Relationship pricing is a strategy used by banks to encourage customer loyalty by offering preferential
pricing based on the customer's overall relationship with the bank.

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vii. True. Asset liability management (ALM) is the process of managing the risks associated with the use of assets
and liabilities. Banks use various strategies, such as matching assets and liabilities based on their duration and
interest rate sensitivity, to manage these risks.

viii. True. A put option gives the holder the right to sell an underlying asset at a specified price on or before a certain
date.

ix. False. Liquidity problems in banking can arise from both internal and external factors, such as deposit
withdrawals, loan defaults, and market shocks.

x. False. The Foreign Exchange Dealers' Association of Nepal is a non-profit organization that represents the
interests of foreign exchange dealers in Nepal. It does not specifically focus on issues related to asset and
liability management of banks.

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