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Treasury Management in Financial Institution (Short Notes)

Asset Liability Management


Asset and liability management (ALM) is a practice used by financial institutions to mitigate financial risks resulting from a
mismatch of assets and liabilities. ALM strategies employ a combination of risk management and financial planning and are often
used by organizations to manage long-term risks that can arise due to changing circumstances.

The practice of asset and liability management can include many factors, including strategic allocation of assets, risk mitigation,
and adjustment of regulatory and capital frameworks. By successfully matching assets against liabilities, financial institutions are left
with a surplus that can be actively managed to maximize their investment returns and increase profitability.

 Asset and liability management (ALM) is a practice used by financial institutions to mitigate financial risks resulting from a
mismatch of assets and liabilities.
 By strategically matching of assets and liabilities, financial institutions can achieve greater efficiency and profitability while
also reducing risk.
 Some of the most common risks addressed by ALM are interest rate risk and liquidity risk.

Risk Management
Risk management is the process of identifying, assessing and controlling threats to an organization's capital, earnings and
operations. These risks stem from a variety of sources, including financial uncertainties, legal liabilities, technology issues, strategic
management errors, accidents and natural disasters.

A successful risk management program helps an organization consider the full range of risks it faces. Risk management also
examines the relationship between different types of business risks and the cascading impact they could have on an organization's
strategic goals. Indeed, the aim of any risk management program is not to eliminate all risk but to preserve and add to overall
enterprise value by making smart risk decisions.

Transfer Pricing
Transfer pricing is an accounting practice that represents the price that one division in a company charges another division
for goods and services provided. It refers to the prices of goods and services that are exchanged between companies under
common control. For example, if a subsidiary company sells goods or renders services to its holding company or a sister company,
the price charged is referred to as the transfer price.
Transfer pricing allows for the establishment of prices for the goods and services exchanged
between subsidiaries, affiliates, or commonly controlled companies that are part of the same larger enterprise. Transfer pricing can
lead to tax savings for corporations, though tax authorities may contest their claims. Entities under common control refer to those
that are ultimately controlled by a single parent corporation. Multinational corporations use transfer pricing as a method of
allocating profits (earnings before interest and taxes) among their various subsidiaries within the organization.

Capital Adequacy Ratio (CAR)


 The capital adequacy ratio (CAR) is a measure of how much capital a bank has available, reported as a percentage of a
bank's risk-weighted credit exposures.
 The purpose is to establish that banks have enough capital on reserve to handle a certain amount of losses, before being
at risk for becoming insolvent.
 Capital is broken down as Tier-1, core capital, such as equity and disclosed reserves, and Tier-2, supplemental capital held
as part of a bank's required reserves.
 A bank with a high capital adequacy ratio is considered to be above the minimum requirements needed to suggest
solvency.
 Therefore, the higher a bank's CAR, the more likely it is to be able to withstand a financial downturn or other unforeseen
losses.

As shown below, the CAR formula is:


CAR = (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets

Money Market vs Capital Market


The money market is where short-term financial instruments, i.e. securities with a holding period of one year or less, are
traded. Examples of money market instruments include:
• Bankers acceptances. Bankers acceptances are a form of payment that’s guaranteed by the bank and is commonly used to
finance international transactions involving goods and services.
• Certificates of deposit (CDs). Certificate of deposit accounts are time deposits that pay interest over a set maturity term.
• Commercial paper. Commercial paper includes short-term, unsecured promissory notes issued by financial and non-
financial corporations.
• Treasury bills (T-bills). Treasury bills are a type of short-term debt that’s issued by the federal government. Investors who
purchase T-bills can earn interest on their money over a set maturity term.

The capital market is the segment of the financial market that’s reserved for trading of long-term debt instruments.
Participants in the capital market can use it to raise capital by issuing shares of stock, bonds, and other long-term securities. Those
who invest in these debt instruments are also part of the capital market.

The capital market can be further segmented into the primary and secondary market. Here’s how they compare:
• Primary market. The primary market is where new issuances of stocks and bonds are first offered to investors. An initial
public offering or IPO is an example of a primary market transaction.
• Secondary market. The secondary market is where securities that have already been issued are traded between investors.
The entity that issued the stocks or bonds is not necessarily involved in this transaction.

As an investor, you can benefit from participating in the capital market by buying and selling stocks. If your stocks go up in
value, you could sell them for a capital gain. You can also derive current income from stocks that pay out dividends.

Money Market Capital Market

A random course of financial institutions, bill brokers, money dealers, A kind of financial market where the company or
banks, etc., wherein dealing on short-term financial tools are being government securities are generated and patronised with
settled is referred to as Money Market. the intention of establishing long-term finance to coincide
with the capital necessary is called Capital Market.

Money markets are informal in nature. Capital markets are formal in nature.

Commercial Papers, Treasury Certificate of Deposit, Bills, Trade Credit, Bonds, Debentures, Shares, Asset Secularisation, Retained
etc. Earnings, Euro Issues, etc.

Commercial banks, non-financial institutions, central bank, chit funds, Stockbrokers, insurance companies, Commercial banks,
etc. underwriters, etc.

Money markets are highly liquid. Capital markets are comparatively less liquid.

Money markets have low risk. Capital markets are riskier in comparison to money markets.

Instruments mature within a year. Instruments take longer time to attain maturity

To achieve short term credit requirements of the trade. To achieve long term credit requirements of the trade.

Increasing liquidity of funds in the economy Stabilising economy by increase in savings

ROI is usually low in money market ROI is comparatively high in capital market
Certificate of Deposits
A certificate of deposit (CD) is a savings account that holds a fixed amount of money for a fixed period of time, such as six
months, one year, or five years, and in exchange, the issuing bank pays interest. When you cash in or redeem your CD, you receive
the money you originally invested plus any interest. Certificates of deposit are considered to be one of the safest savings options.

As with all investments, there are benefits and risks associated with CDs. The disclosure statement should outline the
interest rate on the CD and say if the rate is fixed or variable. It also should state when the bank pays interest on the CD, for
example, monthly or semi-annually, and whether the interest payment will be made by check or by an electronic transfer of funds.
The maturity date should be clearly stated, as should any penalties for the “early withdrawal” of the money in the CD. The risk with
CDs is the risk that inflation will grow faster than your money, and lower your real returns over time.

Commercial Paper
Commercial paper is a type of debt issued by a company that can serve as a source of funding for its operations. Money
raised from commercial paper can be used to meet short-term needs, such as payroll, inventory finance, or payment for raw
materials. Companies often prefer commercial paper to bank loans, which tend to carry higher interest rates. Commercial paper
involves a specific amount of money that is to be repaid by a specific date. Terms to maturity extend from one to 270 days. They
average 30 days

Commercial paper is a type of unsecured debt, which means it isn’t backed by assets or other types of collateral. Instead,
issuers have lines of credit from banks to back the debt. Just as a person’s eligibility for a credit card is based on their credit score, a
company’s ability to issue commercial paper is based on its creditworthiness.

Treasury Bill vs Treasury Bond


A Treasury bill—also called a T-bill—is a short-term debt obligation (essentially a short-term loan) issued by the federal
government. These bills mature in one year or less from the date of purchase. This means you will see repayment of the amount
borrowed plus interest within 12 months. Due to their short terms and lower risk (because they're backed by the US government), T-
bills tend to offer lower returns compared to stocks or even many corporate or municipal bonds.

Treasury bonds—also called T-bonds—are long-term debt obligations that mature in terms of 20 or 30 years. They're
essentially the opposite of T-bills as they're the longest-term and typically the highest-yielding among T-bills, T-bonds, and Treasury
notes. "Typically" because this isn't always the case. When there's an inverted yield curve, yields on Treasuries with shorter
maturities can be higher than on those with longer maturities.

Difference between Treasury Bills and Treasury Bonds:

TREASURY BILLS TREASURY BONDS

T-bills are transient money market instruments that are issued by T-bonds are long-term capital market instruments that are
the public authority. issued by the public authority.

Cost change exceptionally less since it matures quicker than Cost varies more in bonds because of the longer maturity time
expected. frame.

91 Day Bill, 182 Day Bill, and 384 Day Bill. Corporate bonds, zero-coupon bonds, municipal bonds, and so
forth.

T-bills is issued at a discounted price. T-bonds are not issued at a discounted cost, but pay interest
twice a year and pay face value at maturity.

They are issued with a maturity of one year or less. T-bonds are issued with a maturity period equivalent to or over
10 years.

Balamce of Payment
The balance of payments (BOP) is the method countries use to monitor all international monetary transactions in a
specific period. The BOP is usually calculated every quarter and every calendar year.

All trades conducted by both the private and public sectors are accounted for in the BOP to determine how much money
is going in and out of a country. If a country has received money, this is known as a credit, and if a country has paid or given
money, the transaction is counted as a debit.

Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance, but in practice, this
is rarely the case. Thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the
discrepancies are stemming.

 The balance of payments (BOP) is the record of all international financial transactions made by the residents of a country.
 There are three main categories of the BOP: the current account, the capital account, and the financial account.
 The current account is used to mark the inflow and outflow of goods and services into a country.
 The capital account is where all international capital transfers are recorded.
 In the financial account, international monetary flows related to investment in business, real estate, bonds, and stocks are
documented.
 The current account should be balanced versus the combined capital and financial accounts, leaving the BOP at zero, but
this rarely occurs.

Quasi Money
The term quasi money refers to assets which can be easily converted to cash because they are in high demand and are
issued by entities with excellent creditworthiness.Examples of quasi money include gold certificates, bonds issued by creditworthy
governments and certificates of deposit issued by creditworthy banks.

Book money, such as account balances at commercial banks, may also be considered quasi money because it is assumed
that the bank will repay the debt in base money upon request. Other forms of quasi money include liquid cash equivalents like
travelers checks, gift cards and vouchers which have fixed redemption values.

Macroeconomic Equilibrium
Macroeconomic equilibrium is the point where the Aggregate Demand Curve crosses the
aggregate Supply curve. Aggregate Supply is a measure of the total volume of goods and services produced in the economy over a
given period. Aggregate Demand is a measure of the total quantity of goods and services demanded in the economy over a given
period. Macroeconomic equilibrium occurs at a point where the aggregate demand meets the aggregate supply. In
macroeconomics, equilibrium occurs when aggregate demand meets aggregate supply.

CRR vs SLR
CRR: CRR stands for Cash Reserve Ratio. It is a compulsory reserve that the central bank of the country. Every commercial
bank is obligated to maintain CRR, which is a specified percentage of their net demand and time liabilities. Commercial banks must
maintain the CRR in the form of cash balances. These banks are not allowed to use the money for economic or commercial purposes.
SLR: SLR stands for Statutory Liquidity Ratio. It is an obligatory reserve that commercial banks must maintain. Commercial
banks may maintain this reserve requirement in the form of approved securities per a specific percentage of the net demand and
time liabilities.

SLR can also be defined as a tool used to maintain the stability of the banks by restricting the credit facility they offer to
their customers. Banks usually hold more than the required SLR, stating that they must maintain a certain amount of money as liquid
assets. This helps banks fulfil their depositors' demands as and when they arise .

The difference between Cash Reserve Ratio(CRR) and Statutory Liquidity Ratio(SLR) are as follow:

 Cash Reserves Ratio (CRR) refers to the proportion of total deposits of the commercial banks which they must have keep as
cash reserves with the central bank whereas Statutory Liquidity Ratio (SLR) refers to liquid assets that the commercial banks
must hold on daily basis as a percentage of their total deposits.
 In cash reserve ratio only cash is maintained with the central bank whereas in statutory liquidity ratio both cash and other
types of assets like gold and securities can be maintained.
 Cash reserve ratio regulates the flow of money in the economy whereas statutory liquidity ratio ensures solvency of banks
in the economy.
 Cash reserve ratio is usually lower than statutory liquidity ratio so that solvency of commercial banks can be maintained.

BASIS FOR CRR SLR


COMPARISON
Meaning CRR is the amount of money that the banks are SLR is the amount of funds which the banks are
obligated to park with the central bank, in the form of required to maintain as liquid assets, i.e. cash,
cash. gold, approved securities. etc.
Regulates Monetary stability in the country Bank's leverage for credit expansion
Use To drain out excess money out of the economic system. To ensure the solvency of the commercial bank.
Maintenance with Central Bank Bank itself
Form Cash and cash equivalents Liquid Assets
Return Banks don't earn any interest as return on the money Banks usually earn interest as return on the
kept as CRR. funds kept as SLR.

Repo vs Reverse Repo:


The two Liquidity Adjustment Facility with the Central Bank are the Repo Rate and Reverse Repo Rate. Repo Rate is the rate
at which interest is charged by the central bank, i.e. Reserve Bank for granting loans to a commercial bank. As against, the Reverse
Repo Rate is the rate at which interest is given to the banks which park their excess money with the central bank.
Repo: Repurchase Agreements (Repo) are conducted whenever the Central Bank is mopping up excess liquidity from the
domestic market. A Repo is a collateralized loan involving a contractual arrangement between two parties, whereby one party sells a
security at a specified price with a commitment to buy back the same at a later date. The repo rate is the interest paid by the Central
Bank to Commercial Banks for lending money in the repo market.

Reverse Repo: Reverse Repos, on the other hand, are conducted whenever the Central Bank is injecting liquidity into the
domestic market. Reverse Repo transactions therefore, involve purchase of Government securities by the Central Bank from
Commercial Banks. The reverse repo rate is the interest paid by commercial banks for borrowing money from the Central bank.

SWAP:
A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different
financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the
instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap.
One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange
rate, or index price.
The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and retail investors do not
generally engage in swaps. Rather, swaps are over-the-counter (OTC) contracts primarily between businesses or financial
institutions that are customized to the needs of both parties.

Demand for Money


The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as
uncertainty about the future. The way in which these factors affect money demand is usually explained in terms of the three motives
for demanding money: the transactions, the precautionary, and the speculative motives.

Transactions motive. The transactions motive for demanding money arises from the fact that most transactions involve an
exchange of money. Because it is necessary to have money available for transactions, money will be demanded. The total number of
transactions made in an economy tends to increase over time as income rises. Hence, as income or GDP rises, the transactions
demand for money also rises.

Precautionary motive. People often demand money as a precaution against an uncertain future. Unexpected expenses,
such as medical or car repair bills, often require immediate payment. The need to have money available in such situations is referred
to as the precautionary motive for demanding money.
Speculative motive. Money, like other stores of value, is an asset. The demand for an asset depends on both its rate of
return and its opportunity cost. Typically, money holdings provide no rate of return and often depreciate in value due to inflation.
The opportunity cost of holding money is the interest rate that can be earned by lending or investing one's money holdings.
The speculative motive for demanding money arises in situations where holding money is perceived to be less risky than the
alternative of lending the money or investing it in some other asset.

Foreign Exchange:
Foreign exchange (Forex or FX) is the conversion of one currency into another at a specific rate known as the foreign
exchange rate. The conversion rates for almost all currencies are constantly floating as they are driven by the market forces
of supply and demand. The most traded currencies in the world are the United States dollar, Euro, Japanese yen, British pound, and
Australian dollar. The US dollar remains the key currency, accounting for more than 87% of total daily value traded.

Many factors can potentially influence the market forces behind foreign exchange rates. The factors include various
economic, political, and even psychological conditions. The economic factors include a government’s economic policies, trade
balances, inflation, and economic growth outlook. Political conditions also exert a significant impact on the forex rate, as events such
as political instability and political conflicts may negatively affect the strength of a currency. The psychology of forex market
participants can also influence exchange rates.

Spot vs Forward Market


A spot market is a market where financial instruments, such as stocks, currencies, commodities, and bonds, are traded for
immediate delivery or settlement. In a spot market, the buyer and the seller agree on the price, and the transaction is executed on
the spot. The settlement of the transaction happens within a short period, usually two working days. The spot market is widely used
for trading commodities, such as gold, silver, crude oil, etc. It is also used for trading currencies, where the value of a currency is
determined based on the market demand and supply. The spot market is highly liquid and transparent, and the prices of financial
instruments are determined based on the market conditions.

A forward market is a market where financial instruments are traded for future delivery or settlement. In a forward market,
the buyer and the seller agree on the price, quantity, and delivery date of the financial instrument. The transaction is executed on a
future date, as agreed upon by both parties. The settlement of the transaction happens on the delivery date of the financial
instrument. The forward market is widely used for trading currencies, where traders and investors hedge against currency
fluctuations. It is also used for trading commodities, such as agricultural products, where the delivery of the product is scheduled at
a future date. The forward market is less liquid than the spot market, and the prices of financial instruments are determined based
on the expectations of the market conditions.

Differences between Spot and Forward Markets

The key differences between the spot and forward markets are as follows:

1. Settlement: In a spot market, the settlement of the transaction happens within two working days, while in a forward
market, the settlement of the transaction happens on a future date, as agreed upon by both parties.
2. Time Horizon: In a spot market, the transaction happens immediately, while in a forward market, the transaction
happens at a future date.
3. Price Determination: In a spot market, the price of the financial instrument is determined based on the market demand
and supply, while in a forward market, the price is determined based on the expectations of the market conditions.
4. Risk: In a spot market, the risk is lower, as the transaction is executed immediately, while in a forward market, the risk is
higher, as the transaction happens at a future date, and the market conditions may change.

Forward vs Future Market


Futures are the same as forward contracts, except for two main differences:

 Futures are settled daily (not just at maturity), meaning that futures can be bought or sold at any time.
 Futures are typically traded on a standardized exchange.
The table below summarizes some key differences between futures and forwards:

Futures Forwards
Settled Daily Settled at Maturity
Standardized Not Standardized
Low risk of not fulfilling obligations, due to regulation and oversight Low level of regulation and oversight on settlement
Traded on Public Exchanges Private contract between two parties

Commodity Derivatives
Commodity derivatives are financial tools that allow an investor to invest in a commodity and make a profit without actually owning it.
A commodity derivative gets its value from ‘the underlying asset’, meaning its value is based on the physical commodity (e.g. wheat or gold) it
represents. They can be traded on the market or used as exchange-traded derivatives (i.e. bought and sold on organised exchanges). There are a
number of different types of commodity derivative contracts, such as:
 Forwards
 Options
 Futures
 Swaps

Although the market has been around for centuries, commodity derivatives remain a vital and increasingly sophisticated
product today. Airlines continue to hedge themselves against volatility in fuel prices, mining corporations against declines in metal
values and power companies against rises in the price of natural gas.

LIBOR vs DIBOR
LIBOR: The London Interbank Offered Rate (LIBOR) was a benchmark interest rate at which major global banks lent to one
another in the international interbank market for short-term loans.
LIBOR served as a globally accepted key benchmark interest rate that indicated borrowing costs between banks. The rate was
calculated and published each day by the Intercontinental Exchange (ICE), but scandals and questions around its validity as a
benchmark rate resulted in it being phased out.

According to the Federal Reserve and regulators in the U.K., LIBOR was phased out on June 30, 2023, and replaced by the Secured
Overnight Financing Rate (SOFR). LIBOR one-week and two-month USD LIBOR rates stopped publishing as of Dec. 31, 2021 as a part
of the phase out.

 LIBOR was the benchmark interest rate at which major global banks lend to one another.
 LIBOR was administered by the Intercontinental Exchange, which asks major global banks how much they would charge
other banks for short-term loans.

DIBOR: Dhaka inter-bank offer rate (DIBOR), which will help banks get a benchmark interest rate or reference rate. In line with
the international regulators, the central bank issued a circular in December making the inter-bank offer rate effective from January,
2010. "DIBOR will provide a leading indicator of our economic and financial condition to foreign investors, who for long have been
enquiring about such an indicator."For the domestic market it will provide a reference rate to price various new products. In the long
run, DIBOR should allow the financial institutions to develop new and innovative products, which will bring benefits to business
community and the economy as a whole."Lending to local customers as well as foreign investors may be benchmarked with this new
reference rate and will impact cost of fund of multiple entities."A benchmark rate will create a positive impression on our market
and attract more foreign investors, as they will now have a reference rate, which they can use to estimate their financial
projections."

Direct vs Indirect Quotation:


A direct quote is a foreign exchange rate quoted in fixed units of foreign currency in variable amounts of the domestic
currency. In other words, a direct currency quote asks what amount of domestic currency is needed to buy one unit of the fore ign
currency—most commonly the U.S. dollar (USD) in forex markets. In a direct quote, the foreign currency is the base currency, while
the domestic currency is the counter currency or quote currency.

 A direct quote is a currency pair quote where the foreign currency is expressed in per-unit terms of the domestic currency.
 A direct quote gives you the quantity of local currency needed to purchase one unit of foreign currency.
 Because the U.S. dollar is the most traded currency in the world, the USD generally serves as the base currency in most
direct quotes. Some major exceptions to this rule include the British pound and the euro.

The term indirect quote is a currency quotation in the foreign exchange market that expresses the variable amount of foreign
currency required to buy or sell one unit of the domestic currency. An indirect quote is also known as a “quantity quotation, ” since
it expresses the quantity of foreign currency required to buy units of the domestic currency. In other words, the domestic currency
is the base currency in an indirect quote, while the foreign currency is the counter currency.

 An indirect quote in the foreign exchange markets expresses the amount of foreign currency required to buy or sell one
unit of the domestic currency.
 An indirect quote is also known as a “quantity quotation,” since it expresses the quantity of foreign currency required to
buy a unit of the domestic currency.
 The opposite of an indirect quote is a direct quote which expresses the price of one unit of a foreign curren cy in terms of
variable number of units of the domestic currency.

Counterparty Risk
Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual
obligation. Counterparty risk can exist in credit, investment, and trading transactions.

 Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its
contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions.
 The numerical value of a borrower’s credit score reflects the level of counterparty risk to the lender or creditor.
 Investors must consider the company that’s issuing the bond, stock, or insurance policy to assess whether there’s default
or counterparty risk.

Varying degrees of counterparty risk exist in all financial transactions. Counterparty risk is also known as default risk. Default
risk is the chance that companies or individuals will be unable to make the required payments on
their debt obligations. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. Counterparty risk
is a risk that both parties should consider when evaluating a contract.

Translation Risk
Translation risk is the exchange rate risk associated with companies that deal in foreign currencies and list foreign assets on
their balance sheets. Companies that own assets in foreign countries, such as plant and equipment, must convert the value of
those assets from the foreign currency to the home country's currency for accounting purposes.

 Translation risk is the exchange rate risk associated with companies that deal in foreign currencies and list foreign assets
on their balance sheets.
 Companies with assets in foreign countries must convert the value of those assets from the foreign currency to the home
country's currency.
 A financial gain or loss is reported, depending on the extent of the exchange rate movements during the quarter.
 The risk that exchange rates could move adversely and depreciate the value of a company's foreign assets is called
translation risk.

Bear vs Bull Market


A bear market is when a stock market index falls by at least 20% from recent highs. A bull market, meanwhile, marks a
period of rising market index values.
Bull market Bear market
Market A bull market is a rising market. A bear market represents a declining market.
direction
Duration A bull market can last anywhere from a few months to A bear market can last from a few months to several years.
several years. The longest bull market lasted from 2009 The longest bear market spanned 61 months from 1937 to
to 2020. 1942 during the Great Depression.
Comparative Bull markets tend to last longer than bear markets with The average duration of a bear market is 1.3 years.
duration an average duration of 6.6 years.
Average The average cumulative gain over the course of a bull The average cumulative loss over the course of a bear market
gain/loss market is 339%. is 38%.

SOFR
The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that
replaced the London Interbank Offered Rate (LIBOR). The SOFR is an influential interest rate banks use to price U.S. dollar-
denominated derivatives and loans. The daily SOFR is based on transactions in the Treasury repurchase market, where investors
offer banks overnight loans backed by their bond assets. SOFR took the place of LIBOR in June 2023, offering fewer opportunities
for market manipulation and current rates rather than forward-looking rates and terms.

 The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans
that replaced the London Interbank Offered Rate (LIBOR).
 SOFR is based on transactions in the Treasury repurchase market and is preferable to LIBOR since it is based on data from
observable transactions rather than estimated future borrowing rates.
 While SOFR became the benchmark rate for dollar-denominated derivatives and loans, other countries have sought their
own alternative rates, such as SONIA and EONIA.

Liquidity Coverage Ratio:


The liquidity coverage ratio is a term that refers to the proportion of highly liquid assets held by financial institutions to
ensure that they maintain an ongoing ability to meet their short-term obligations (i.e., cash outflows for 30 days). 30 days was
selected because, in a financial crisis, a response from governments and central banks would typically take around 30 days. In other
words, the liquidity coverage ratio is a stress test that is intended to make sure that banks and financial institutions have a sufficient
level of capital to ride out any short-term disruptions to liquidity.

There is a simple LCR ratio formula that you can use to calculate LCR:
LCR = High-Quality Liquid Asset Amount (HQLA) / Total Net Cash Flow Amount

Net Stable Funding Ratio:


The net stable funding ratio is a liquidity standard requiring banks to hold enough stable funding to cover the duration of
their long-term assets. For both funding and assets, long-term is mainly defined as more than one year, with lower requirements
applying to anything between six months and a year to avoid a cliff-edge effect. Banks must maintain a ratio of 100% to satisfy the
requirement.
Introduced as part of the post-crisis banking reforms known as Basel III, the ratio ensures banks do not undertake excessive
maturity transformation, which is the practice of using short-term funding to meet long-term liabilities. It was finalised by the Basel
Committee in October 2014.

The NSFR is expressed as a ratio that must equal or exceed 100%. The ratio relates the bank's available stable funding to its
required stable funding, as summarised in the following formula:
Leverage Ratio:
Leverage ratio is one of the most important of the financial ratios as it determines how much of the capital that is present
in the company is in the form of debts. It also analyses how the company is able to meet its obligations.Leverage ratio becomes
more critical as it analyzes the capital structure of the company and the way it can manage its capital structure so that it can pay off
the debts. A leverage ratio is a financial measurement of debt. It puts an entity's debt into better context by showing it as a ratio
relative to another financial metric like equity or earnings. A leverage ratio can help determine the financial health of an entity.
There are two broad types of leverage ratios which are:

1. Capital Structure Ratio: Capital structure ratio is used to determine the financing strategy that is used so that the company
can focus on the long term solvency.
2. Coverage Ratio: Coverage ratios determine the ability of a company to meet its debt obligations which include interest
payments or dividends. A higher coverage ratio makes it easier for a business to pay off the dividends and interest
payments.

Advance Deposit Ratio:

Advance Deposit Ratio (ADR) is considered as a barometer of progress of all financial institutions. ADR is the ratio of total
advances to total deposits, where advances comprise all banking advances, except foreign currency (FC), held against export
development fund (EDF), refinance and offshore banking unit (OBU) exposure. Deposit comprises all demand and time deposit
excluding bank deposit and additional net borrowing.

A high ADR shows that banks are generating more credit from its deposits and vice-versa. The outcome of this ratio reflects
the ability of the bank to make optimal use of the available fund. ADR of commercial banks has great significance. Primarily, it is a
measure of the utilisation of fund by the banking system. This ratio is an important tool of monetary management. Magnitude of the
said ratio indicates management's aggressiveness to improve income through higher lending.

In a way, performance of banking industry may be measured through the ADR, since it reflects how the funds are utilised by
the banks to generate their revenue and increase the market share. But it has to be kept in mind that, comparing ADR of a bank
would be more effective only when this is compared with banks of the same size and similar makeup. Also, it is important for
stakeholders to compare multiple financial metrics while comparing banks' different ratios of performance and positions specially
the ADR.

Formula and Calculation of the ADR


ADR=Total Loans/Total Deposits*100

Recurring Deposit:
A Recurring Deposit, commonly known as RD, is a unique term-deposit that is offered by Banks. It is an investment tool
which allows people to make regular deposits and earn decent returns on the investment. Due to the regular deposit factor and an
interest component, it often provides flexibility and ease of investments to users/individuals.
However, it is essential to know that RDs are different from Fixed Deposits/FDs . RDs are flexible in most aspects. An RD
account holder can choose to invest a fixed amount each month while earning decent interest on the amount. RDs are an ideal
saving-cum-investment instrument.

Most major banks in offer Recurring Deposit Accounts, with a term that often ranges between 6 months to 10 years, also
providing individuals with the opportunity to choose a term according to their needs. However, the interest rate, once determined,
does not change during the tenure; and on maturity, the individual will be paid a lumpsum amount which includes the regular
investments as well as the interest earned.
Junk Bond:
Junk bonds, also known as high-yield bonds, are bonds that are rated below investment grade by the big three rating
agencies (see image below). Junk bonds carry a higher risk of default than other bonds, but they pay higher returns to make them
attractive to investors. The main issuers of such bonds are capital-intensive companies with high debt ratios, or young companies
that have yet to establish a strong credit rating.
Market analysts sometimes use the junk bond market to get an indication of the state of the economy. If more investors are
buying them, their willingness to take on risk indicates optimism about the economy. Conversely, if investors are shying away from
high-yield bonds, then that is a sign that they are risk-averse. This indicates a pessimistic view of the current state of the economy.
This circumstance may be used to predict either a contraction of the business cycle or a bear market.

Coupon vs Zero Coupon Bond:


The difference between a regular bond and a zero-coupon bond is the payment of interest, otherwise known as coupons. A
regular bond pays interest to bondholders, while a zero-coupon bond does not issue such interest payments. Instead, zero-coupon
bondholders merely receive the face value of the bond when it reaches maturity. Regular bonds, which are also called coupon
bonds, pay interest over the life of the bond and also repay the principal at maturity.

 A regular bond pays interest to bondholders, while a zero-coupon bond does not issue such interest payments.
 A zero-coupon bond will usually have higher returns than a regular bond with the same maturity because of the shape of
the yield curve.
 Zero-coupon bonds are more volatile than coupon bonds, so speculators can use them to profit more from anticipated
short-term price movements.
 Zero-coupon bonds can help investors to avoid gift taxes, but they also create phantom income tax issues.

Or,
Key Differences and Considerations

1. Suitable for Investors Seeking Periodic Cash Flow: Coupon bonds offer a regular income stream in the form of
interest payments; they are attractive to investors who are looking for periodic cash flow. Bonds with no coupon
payments, on the other hand, will pay out a single sum upon maturation. This featur e makes zero coupon bonds an
appealing option for supporting long-term financial goals, such as retirement or school.
2. Sensitivity to Interest Rates: Bonds with coupons are more sensitive to changes in interest rates, whereas bonds
with zero coupons are largely insulated from the effects of interest rate swings. When deciding between the two
options, investors need to take into account both their level of comfort with risk and their expectations for the
market.
3. Tax Considerations: The interest income from coupon bonds is normally subject to taxation in the same year it is
received; however, the imputed interest on zero coupon bonds is also subject to taxation, even though it is not
received until the bond reaches maturity. When trying to comprehend the tax ra mifications of various types of
bonds, investors should seek the advice of a tax professional.
4. Price Volatility: The fluctuation of interest rates might result in more price volatility for coupon bonds. It is
important for investors who hold coupon bonds to be ready for potential shifts in the market value of their bonds if
those shifts occur. Because they are less vulnerable to changes in interest rates, zero -coupon bonds may provide
greater price stability.
5. Financial Objectives: The choice between bonds with coupons and bonds with no coupons should be made in
accordance with the objectives of the investor. Income-focused investors prefer bonds with coupons; however, zero -
coupon bonds might be a smart choice for investors with longer investment horizons and particular foreseeable
financial requirements in the future.

Current Yeild:
The current yield of an investment is the annual income (interest or dividends) divided by the security’s current price. This
metric focuses on the current price of a bond rather than its face value. It represents the expected return for an investor who
purchases the bond and holds it for a year. However, it does not reflect the actual return an investor would receive if they hold the
bond until maturity.
To calculate the current yield, divide the annual income by the bond’s current market price. It is important to note that the
current yield formula expresses the yield as a percentage. The current yield provides insight into the return an investor can expect
from their bond investment based on the bond’s current market price.

The current yield formula can be expressed as follows:


Current yield = Annual coupon payment / Current bond price
Primary and Secondary market:

Primary market Secondary market

A primary market is a marketplace where corporations imbibe a fresh issue A secondary market is a prototype of the capital market where debentures, current
of shares for being contributed by the public for soliciting capital to meet shares, options, bonds, treasury bills, commercial papers, etc., of the enterprises are
their necessary long-term funds like extending the current trade or buying a patronised amongst the investors.
unique entity.

New issue market (NIM) Aftermarket

Direct purchase Indirect purchase

Buying and selling takes place between the company and the investors. Buying and selling takes place between the investors.

It provides financing to the existing companies for facilitating growth and It does not provide any kind of financing.
expansion.

Underwriters Brokers

Remain fixed Price level varies with variations in demand and supply

OTC Market:
An over-the-counter (OTC) market is a decentralized market in which market participants trade stocks, commodities,
currencies, or other instruments directly between two parties and without a central exchange or broker. Over-the-counter markets
do not have physical locations; instead, trading is conducted electronically. This is very different from an auction market system.
In an OTC market, dealers act as market-makers by quoting prices at which they will buy and sell a security, currency, or other
financial products. A trade can be executed between two participants in an OTC market without others being aware of the price at
which the transaction was completed. In general, OTC markets are typically less transparent than exchanges and are also subject to
fewer regulations. Because of this, liquidity in the OTC market may come at a premium.

 Over-the-counter markets are those in which participants trade directly between two parties, without the use of a central
exchange or other third party.
 OTC markets do not have physical locations or market-makers.
 Some of the products most commonly traded over-the-counter include bonds, derivatives, structured products, and
currencies.

Interest Rate Swap:


An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another
based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate,
or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than
would have been possible without the swap.
A swap can also involve the exchange of one type of floating rate for another, which is called a basis swap.

 Interest rate swaps are forward contracts in which one stream of future interest payments is exchanged for another based
on a specified principal amount.
 Interest rate swaps can exchange fixed or floating rates to reduce or increase exposure to fluctuations in interest rates.
 Interest rate swaps are sometimes called plain vanilla swaps, since they were the original and often the simplest such
swap instruments.
Plastic Money
Many people increasingly prefer using plastic money, sometimes referred to as credit and debit cards, as a form of
payment. The new payment method is plastic money. Payments can be made with a credit card, debit card, or even your phone. It’s
quite safe and a fantastic method to avoid carrying cash around. Almost anyplace you go, you may use this payment option, which
makes it really easy.

Credit cards and debit cards are the two most common types of plastic money. Banks issue credit cards that let users
borrow money up to a certain amount. Customers can use debit cards, which are connected to bank accounts, to make purchases
with funds they already have.

Plastic money refers to a payment mechanism that replaces physical currency transactions with plastic cards. These pocket-
sized cards are typically made from materials like plastic or a combination of plastic and metal, earning the moniker of plastic
money. The cards facilitate electronic transactions by storing your financial information securely on the plastic/metal card and you
can use them to access your financial accounts on the go. This way, you do not need to keep visiting your bank each time you want
to access your account.

Bank for International Settlement:


The Bank for International Settlements (BIS) is an international financial institution offering banking services for national
central banks and a forum for discussing monetary and regulatory policies. The BIS, which is owned by 63 national central ban ks,
also provides independent economic analysis.1

 BIS serves as a forum for monetary policy discussions and facilitates financial transactions for central banks.
 It is governed by a board elected by the 63 central banks with ownership stakes, with permanent seats reserved for the
U.S., U.K., Germany, France, Italy, and Belgium.
 BIS shares offices with, and provides a secretariat for, independently governed international committees and associations
focused on economic co-operation.
 BIS is the rare international financial organization with for-profit operations.

Stress Testing:
Stress testing is a computer simulation technique used to test the resilience of institutions and investment portfolios against
possible future financial situations. Such testing is customarily used by the financial industry to help gauge investment risk and the
adequacy of assets and help evaluate internal processes and controls. In recent years, regulators have also required financial
institutions to carry out stress tests to ensure their capital holdings and other assets are adequate.

 Stress testing is a computer-simulated technique to analyze how banks and investment portfolios fare in drastic economic
scenarios.
 Stress testing helps gauge investment risk and the adequacy of assets, as well as to help evaluate internal processes and
controls.
 Stress tests can use historical, hypothetical, or simulated scenarios.
 Regulations require banks to carry out various stress-test scenarios and report on their internal procedures for managing
capital and risk.
 The Federal Reserve requires banks with $100 billion in assets or more to perform a stress test.

Crypto Currency:
A cryptocurrency is a digital or virtual currency secured by cryptography, which makes it nearly impossible to counterfeit
or double-spend. Most cryptocurrencies exist on decentralized networks using blockchain technology—a distributed ledger
enforced by a disparate network of computers.
A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them
theoretically immune to government interference or manipulation.

 A cryptocurrency is a form of digital asset based on a network that is distributed across a large number of computers. This
decentralized structure allows them to exist outside the control of governments and central authorities.
 Some experts believe blockchain and related technologies will disrupt many industries, including finance and law.
 The advantages of cryptocurrencies include cheaper and faster money transfers and decentralized systems that do not
collapse at a single point of failure.
 The disadvantages of cryptocurrencies include their price volatility, high energy consumption for mining activities, and use
in criminal activities.

Sukuk:
Generally known by their Arabic name, sukuk, and often incorrectly referred to as ‘Islamic bonds’, sharia-compliant, fixed-
income capital markets instruments have steadily increased their share of global markets over the past decade. Initially developed
exclusively in jurisdictions with majority Muslim populations, the global market for sukuk has seen considerable development over
the past 10 years, with a number of high-profile corporate issuances and a number of sovereigns tapping the market.

Sukuk are financial products whose terms and structures comply with sharia, with the intention of creating returns similar
to those of conventional fixed-income instruments like bonds. Unlike a conventional bond (secured or unsecured), which represents
the debt obligation of the issuer, a sukuk technically represents an interest in an underlying funding arrangement structured
according to sharia, entitling the holder to a proportionate share of the returns generated by such arrangement and, at a defined
future date, the return of the capital.

Interest rate Risk:


Interest rate risk is the potential for investment losses that can be triggered by a move upward in the prevailing rates for
new debt instruments. If interest rates rise, for instance, the value of a bond or other fixed-income investment in the secondary
market will decline. The change in a bond's price given a change in interest rates is known as its duration.
Interest rate risk can be reduced by buying bonds with different durations, or by hedging fixed-income investments with
interest rate swaps, options, or other interest rate derivatives.

 Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond or other fixed -rate
investment:
 As interest rates rise bond prices fall, and vice versa. This means that the market price of existing bonds drops to offset
the more attractive rates of new bond issues.
 Interest rate risk is measured by a fixed income security's duration, with longer-term bonds having a greater price
sensitivity to rate changes.
 Interest rate risk can be reduced through diversification of bond maturities or hedged using interest rate derivatives.

Percentage in Point (PIP):


"Pip" is an acronym for percentage in point or price interest point. A pip is the smallest whole unit price move that an
exchange rate can make, based on forex market convention.

Most currency pairs are priced out to four decimal places and a single pip is in the fourth decimal place (i.e., 1/10,000th).
For example, the smallest whole unit move the USD/CAD currency pair can make is $0.0001, or one pip. The final decimal place
represents the smallest price shift in forex trading. Given that the majority of significant currency pairs, including those involving
the USD, EUR, and GBP, are quoted to four decimal places, a pip in this case represents a change in price of 0.0001. For instance,
the GBP/USD exchange rate changed by one pip if it went from 1.40 to 1.401. Comparatively, just two decimal places are quoted
for currency pairs employing the Japanese yen (JPY). A pip in this context refers to a price change of 0.01. For instance, the
GBP/JPY pair moved five pip if it changed from 150.00 to 150.05.

 Forex currency pairs are quoted in terms of pips, short for percentage in points.
 In practical terms, a pip is one-hundredth of one percent (1/100 x .01) and appears in the fourth decimal place (0.0001).
 It is the smallest price change increment for most forex pairs.
 The bid-ask spread of a forex quote is typically measured in pips.

Credit Risk:
Credit risk is the possibility of a loss happening due to a borrower's failure to repay a loan or to satisfy contractual
obligations. Traditionally, it can show the chances that a lender may not accept the owed principal and interest. This ends up in an
interruption of cash flows and improved costs for collection.
When lenders offer mortgages, credit cards, or any other type of loan, there could be a risk that the borrower might not
have the ability to repay the loan. Similarly, if a company extends credit to a customer, there could be a risk that the customer might
not pay their invoices. Credit risk also represents the risk that a bond issuer may fail to make a payment when requested, or
an insurance company will not be able to pay a claim.
Credit risks are identified based on the borrower's overall likelihood to repay a loan according to the initial terms. Lenders
look at the five Cs to assess credit risk - credit history, capacity to repay, the loan's conditions, capital and associated collateral.

BASEL III
Basel III is an international regulatory accord that introduced a set of reforms designed to mitigate risk within the
international banking sector by requiring banks to maintain certain leverage ratios and keep certain levels of reserve capital on
hand. Begun in 2009, it is still being implemented as of 2022.

 Basel III is an international regulatory accord that introduced a set of reforms designed to improve the regulation,
supervision, and risk management of the banking sector.
 Basel III is an iterative step in the ongoing effort to enhance the banking regulatory framework.
 A consortium of central banks from 28 countries devised Basel III in 2009, largely in response to the financial crisis of
2007–2008 and ensuing economic recession.1 As of 2022, it is still in the process of implementation

Liquidity Risk
Liquidity is a term used to refer to how easily an asset or security can be bought or sold in the market. It basically describes
how quickly something can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash
flow risk, while the second is market liquidity risk, also referred to as asset/product risk.

 Liquidity is how easily an asset or security can be bought or sold in the market, and converted to cash.
 There are two different types of liquidity risk: Funding liquidity and market liquidity risk.
 Funding or cash flow liquidity risk is the chief concern of a corporate treasurer who asks whether the firm can fund its
liabilities.
 Market or asset liquidity risk is asset illiquidity or the inability to easily exit a position.
 The most popular and crudest measure of liquidity is the bid-ask spread—a low or narrow bid-ask spread is said to be tight
and tends to reflect a more liquid market.

Call Money Market:

 The call money market is a market for very short-term funds repayable on demands with a period varying between one day to a
fortnight.
 It is the most viable market as the day-to-day surplus funds, mostly of banks are traded in this market.
 Call money market accounts for a major part of the total turnover of the money market.

Features of Call Money Market

 Call money market is also known as the “Notice Money” Market.


 The call money market is a highly liquid market.
 Call money market is highly risky and volatile.
 No security or collateral is required to cover the transactions in the call money market.
 It is basically an “Over-the-counter” market without the intermediation of brokers.
 The participants in the call money market are-scheduled commercial banks, non-scheduled commercial banks, foreign banks,
state, district and urban cooperative banks, brokers and dealers in the securities market, and primary dealers.

CAMELS Rating:
The CAMELS Rating System is one of the frequently asked topics as far as the Banking exams are considered. Banking aspirants
are expected to have an understanding of the CAMELS rating system and its uses, not only from the exam point-of-view but also for
practical knowledge. Hence, in the following finance study notes, let us know all the aspects related to the CAMELS Rating System,
its meaning, uses, functions, and so on.
o The CAMELS Rating System is considered as an internationally-recognized rating system developed in the United States.
o The bank supervisory authority uses the CAMELS rating system to measure a bank’s level of risk with the help of its financial
statements.
o Parameters like Capital Adequacy, Asset Quality, Management, Earnings, Liquidity, and Sensitivity, acronymed
as “CAMELS” are used by the supervisory bank authorities to review the banks’ level of risks.
o Unlike other regulatory ratings or ratios, the CAMELS Rating System is not released to the public. It is only used by the top
management to know and evaluate the possible risks.

Chinesse Wall:

The term Chinese wall, as it is used in the business world, describes a virtual barrier intended to block the exchange of
information between departments if it might result in business activities that are ethically or legally questionable. In the United
States, corporations, brokerage firms, investment banks, and retail banks have used Chinese walls to describe situations where there
is a need to maintain confidentiality in order to prevent conflicts of interest. In finance, a Chinese Wall (or a Wall of China) is a virtual
information barrier erected between those who have material, non-public information, and those who don’t, to prevent conflicts of
interest.

Over the years, large financial institutions have used Chinese wall policies as a means to self-regulate their business
dealings by creating ethical boundaries between departments. However, these efforts have not always been effective. Thus, the
Securities and Exchange Commission (SEC) has enacted regulations governing how financial institutions share information. The SEC
has implemented fines, penalties, and legal consequences for companies that break these regulations.

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