Treasury Crash Course
Treasury Crash CourseBy Jawwad Ahmed Farid
Contents
What is a Treasury?
Treasury
The Money Market desk
The FX Desk
The Equity Desk
The Specialized Desks
What do treasuries really do?
How is a corporate treasury different from a bank treasury?
The Treasury Function
1. Trade Flows (FX desk)
2. The Treasury Function Operations
i. Introduction
ii. Front Office Function
a. User Roles
b. Money Market Desk Activities
c. Foreign Exchange Desk Activities
d. Capital Market (CM) Desk Activities
iii. Middle Office Function
a. User Roles
b. Activities
iv. Back Office Function
a. User Roles
b. Activities
c. Basic Treasury Back Office Tasks
3. Related Terminologies
i. Four eyes
a. Ticket Approval
b. Ticket Verification
c. Ticket Authorization
ii. Confirmation
a. Society for Worldwide Interbank Financial Telecommunication (SWIFT)
iii. Settlement
a. Delivery versus payment (DVP)
iv. Reconciliation
a. Broker Reconciliation
b. Securities Reconciliation
v. Accounting
vi. Price discovery
vii. Proprietary Trading
viii. Treasury Risks
a. Credit Risk
b. Market Risk
c. Operational Risk
4. Treasury Markets
i. Foreign Exchange Market
a. FX Ready/ Forward/ Split
b. FX Swap
c. FX Placements/ Borrowings
d. FX Miscellaneous
e. FX TMU – Import/ Export/ Remittance/ Encashment
f. FX TMU – Foreign Bill Purchase (Bill Discounting)
g. FX TMU – Close Out/ Take Up
ii. Fixed Income /Money Market
a. Call/ Clean/ Placements
b. Repo/ Reverse Repo
c. Sale against Reverse Repo (SARR)
d. Outright purchase/ sale
e. Inter branch
iii. Capital Market
a. Outright Sale/ Purchase -Ready Equity
Cross Selling Treasury Products
Five core themes for treasury customer discussions
Price
Risk or Volatility
Value
Models
Relative Value
Products
Limits
Wrap- up and overview
Core Treasury products and TMU customer reactions
Core Treasury Products
TMU Customer Reactions
Payoff profile
Answers for customers reactions
Derivatives – Terminology
1. The Terminology Crash Course
i. Forward Contracts
a. The Investment Bank Intern
ii. Futures Contracts
iii. Options
a. Maturities and Exercise date
vi. Payoff Profiles
v. The Payoff profile for a forward contract
vi. Payoff profiles for Calls and Puts
vii. Building Blocks and Synthetic Configurations
a. Comparing a Call with a Forward contract
b. Comparing a Call and a Put with a Forward contract
c. Combining a long call with a short put to create a long forward
Products & Pricing
1. A Second Look at Derivative Contracts
2. Standard Template for Evaluating Derivatives
3. Options
i. Option Price
a. European option price
b. American Option Price
4. Forward Contracts
i. Forward Price
5. Futures Contracts
i. Futures Price
6. Swaps
i. Interest Rate Swap (IRS)
ii. Currency Swap
Product Variations
1. Options
i. Stock Options
ii. Foreign Currency Options
iii. Index Options
iv. Futures Options
v. Warrants
vi. Employee Stock Options
vii. Convertibles
viii. Interest Rate Options
a. Bond Options
b. Interest Rate Caps/ Floors/ Collars
c. European Swap Options
ix. Exotic Options
a. Bermuda Option
b. Quanto Option
c. Composite Option
d. Digital or Binary or “All or nothing” options
e. Barrier Options
f. Asian Options
g. Average Strike Options
h. Look back Options
i. Compound Options
j. Chooser (As you like it) Options
k. Exchange Options
l. Forward Start Options
m. Basket Options
n. Shout Options
2. Forwards
i. Synthetic Forward Contract
ii. Forward Rate Agreement (FRA)
3. Futures
i. Stock Index Futures
ii. Futures Contracts on Currencies
iii. Futures Contracts on Commodities
iv. Interest Rate Futures
a. Treasury Bond Futures
b. Treasury Note Futures
c. 5-year Treasury Note Futures
d. Treasury Bill Futures
e. Eurodollar Futures
4. Swaps
i. Fixed for fixed currency swap
ii. Floating for floating currency swap
iii. Cross-currency interest rate swap
iv. Step-up Swaps
v. Amortizing Swaps
vi. Basis Rate Swap
vii. Forward or Deferred Swaps
viii. Compounding Swaps
ix. LIBOR-in- Arrears Swap
x. Constant Maturity Swap
xi. Constant Maturity Treasury Swap
xii. Differential Swap or Quanto
xiii. Variance or Volatility Swap
xiv. Equity Swap
xv. Commodity Swap
xvi. Asset Swap
xvii. Accrual Swap
xviii. Cancellable Swap
xix. Extendable Swap
Advanced Products
1. Structured Products
i. Cross Currency Swaps
ii. Participating Forwards
iii. Equity Linked Notes
iv. Capital Protected / Capital Guaranteed Notes
v. Commodity Linked Notes
vi. Range Accruals
vii. Switchable
viii. IRD (Interest Rate Differential) Trades
a. Swap basis
b. Note basis
c. Quanto
d. Cumulative Cap
e. Steepener/ Flattener Note
f. Inverted Curve Instrument
g. Ranges
2. Credit products
i. Credit Default Swaps
ii. Total Return Swaps
iii. Collateralized Debt Obligation (CDO)
Calculating Forward Prices and Forward Rates in EXCEL
1. Introduction
2. How to calculate the forward price of security
Forward Price of a security with no income
Forward Price of a security with known cash income
Forward Price of a security with known dividend yield
3. How to determine Spot Rates and Forward Rates & Yield to Maturity
How to determine Forward Rates from Spot Rates
How to determine Spot Rates from Forward Rates
How to calculate the Yield to Maturity (YTM) of a bond
Trial and error process
EXCEL’s Goal Seek
4. How to calculate the values of Forward Rate Agreements (FRA)
Value of an FRA (zero coupon rate calculated on a discrete basis)
Value of an FRA (zero coupon rate calculated on a continuously compounded basis)
5. How to calculate Forward Exchange Rates
Interest Rates compounded on a discrete basis
Interest Rates compounded on a continuous basis
6. How to calculate the value of a forward contract
Value of a long forward contract (continuous)
Value of a long forward contract (discrete)
Value of a long forward contract (continuous) which provides a known income
Value of a long forward contract (continuous) which provides a known yield
Value of a forward foreign currency contract
Other Treasury Formulas
Cost of deposit
Asset Liability Management
1. Introduction
i. Interest Rate Risk
ii. Liquidity Risk
2. Duration and Convexity
i. Duration
a. Macaulay Duration
b. Modified Duration
iii. Convexity
a. Impact of convexity
b. Modified, Effective, Positive, Negative
c. Convexity in Asset Liability Management
3. ALM Risk Measurement Tools
i. Fall in Market Value of Equity
ii. Earnings at Risk
iii. Cost to Close
iv. Rate Sensitive Gap
v. Price Sensitive Gap
vi. Liquidity Gap
vii. Net Interest Income (NII) at Risk
viii. Duration Gap Analysis
4. Applications
i. Bank
a. Duration matching/ immunization
ii. Pension Funds and Insurance
a. Portfolio dedication
Liquidity Management
1. Liquidity Ratios and Analysis
a. Current Ratio
b. Quick Ratio
c. Unused lines of credit
d. Borrowing/ Debt-to-Equity Ratio
e. Net Working Capital Ratio
f. Loan-to-Deposit Ratio
g. Loan- to- Asset Ratio
2. Liquidity Management
i. Contingency Funding Plan
a. General requirements for a liquidity contingency plan
b. Specific requirements for a liquidity contingency plan
ii. Liquidity enhancement tactics
a. For Systemic Crisis
b. For company specific crisis
Setting Limits
1. Risk Limits and Control Process
i. Operational (Exception or Management Action) Limits
ii. Capital Loss & Stop Loss Limits
iii. Inventory Age Limits
iv. Concentration Limits
v. Transaction Limits
vi. Exposure and Sensitivity Limits
vii. Pre Settlement Risk (PSR) and Potential Future Exposure (PFE) Limits
viii. Hierarchy of Limits
2. A More Detailed Look at Limits
i. Capital Loss and Stop Loss Limits
ii. Value-at-Risk Limits
iii. Regulatory Approach Limits
iv. Other Limits
a. Duration Limits
b. Convexity Limits
c. PVBP Limits
v. Credit Risk Limits
a. PSR Limits
b. Settlement Risk Limits
c. Financial Institution (FI)/ Counterparty Limits
d. Regulatory Limits
e. Internal / Concentration Limits
vi. Application to Products
vii. Setting Limits for Liquidity Risk
a. Cash flow mismatch or gap limits
b. Maturity Limits
c. Target Liquid Reserves
d. Concentration Limits
e. Contingent liability limit
f. Review
ix. Setting Limits for Interest Rate Risk
Repricing limits
x. Limit Breach, Exception processing, Action Plan for Trigger Zones
a. Exception Handling
b. Example of an Action Plan for Trigger Zones
Treasury Profitability
1. Treasury Profitability - Foreign Exchange Desk
2. Treasury Profitability – Capital Market (Equity (EQ)) Desk
Annexure A- Calculating Value at Risk
1. Introduction
2. VaR Methods
a. Variance Covariance Approach
b. Historical Simulation Method
c. Monte Carlo Simulation
d. Quick Review
e. Implementing VaR
2. Methodology
i. Setting the Scene
Sample Portfolio
ii. Preliminary steps
iii. VaR Approach Specific Steps
a. Variance-Covariance (VCV) VaR
b. Determining Historical Simulation daily VaR
iv. Scaling of the daily VaR
2. Caveats, Qualifications, Limitations and Issues
Annexure B: Building Maturity & Liquidity profiles for Deposits and Advances for ALCO, Liquidity Coverage & ICAAP reporting.
Lesson Zero: Introduction and Course Overview
Bank Deposit & Asset Maturity profiles for ALM - Objectives
Advances and Deposits Maturity & Liquidity Profile - Methodology & Sample output
Step 1: The Core Banking Dump
Step 2: Pre-processing the data and adding intelligence for the purpose of building a pivot table
Step 3: Creating the ivot Table and Generating Presentation Graphs using Pivot Charts
Lesson One: Preparing the Core Banking Dataset
Extracting Relevant Data
The DTM (Days to Maturity) formula
Lesson Two: Adding Intelligence for the Pivot Table
Deposit Size Bracket
Maturity Bucket Bracket
Cost of Deposits Bracket
Lesson Three: Creating the Pivot Table
Lesson Four: Reading the PivotTable and PivotChart
Lesson Five: Quick Review & Extending the framework.
Lesson Six: Pivot Shoot Out- Pivot Tables and Pivot Charts Galore
Lesson Seven: The Pivot Chart Shoot out for Advances
Maturity Profile Bucket
Advances Size Bucket
Pivot Table and Chart Variations
Lesson 8: Wrap up and building the ALM profile for the banking book
Bibliography 9
List of Figures 10
Disclaimer
Bibliography
v Options, Futuresand Other Derivatives, John C. Hull, 7th Edition, Prentice Hall, 2009
v The Handbook of Fixed Income Securities, Frank J. Fabozzi, 7th Edition, McGraw-Hill, 2005
v RiskManagement and Financial Institutions, John C. Hull, Low Price Edition, Pearson Education, Inc., 2007
v Exotic Equity Derivatives Manual, Salomon Smith Barney, August 1998
v Understanding Market, Credit and Operational Risk- The Value at RiskApproach, Linda Allen, Jacob Boudoukh and Anthony Saunders,Blackwell Publishing, 2004
v Beyond Value at Risk, The New Science of Risk Management, Kevin Dowd, John Wiley & Sons, 1998
v Higher-Order Simulations: Strategic Investment Under Model-Induced Price Patterns, Gilbert Peffer and Bàrbara Llacay, Journal of Artificial Societies and Social Simulation vol. 10, no. 2, 6 <http://jasss.soc.surrey.ac.uk/10/2/6.html>, 2007
v VaRApplications: Setting VaR-based Limits, Carlos Blanco and Sally Blomstrom, Financial Engineering Associates, Inc., May 1999
v Commonly Used Market RiskLimits, Guidelines on Risk Management of Derivatives and other traded instruments, Annex D
v Quantitative Finance, Second Edition, Paul Wilmott, John Wiley&Sons, Ltd., 2006
v Liquidity Risk Management, Leonard M. Martz, 2007
v Back Office and Beyond- A guide to procedures, settlements and risk in financial markets, Mervin J. King, Harriman House Ltd., 1999
v Mastering Treasury Office Operations- Denis Nolan & Gordon Amos, FT Prentice Hall, 2001
v Valuation of interest-sensitive financial instruments, Babbel David F., SOA Monograph M-FI196-1, 1996
List of Figures
Figure 1: Treasury Desks
Figure 2: Money Market Desk
Figure 3: FX Desk
Figure 4: Equity Desk
Figure 5: Specialized Desks
Figure 6: Flow chart for Treasury Function
Figure 7: Foreign Currency Asset and Liability balances import functionality on a Treasury system
Figure 8: Foreign Currency Asset and Liability balances input screen on a Treasury system
Figure 9: Day Start and End functionality on a Treasury system
Figure 10: Five core themes for approaching TMU customers
Figure 11: WTI price graph
Figure 12: Price and trailing volatility for WTI
Figure 13: Gold Price Model – Actual and Simulated Prices
Figure 14: Gold WTI Ratio
Figure 15: Gold-WTI with USD/CHF
Figure 16: Product wise payoffs
Figure 17: Potential Future Exposure over life of contract
Figure 18: Core Treasury Products and Exposure Estimation
Figure 19: Difference between FX Forward Sale and Purchase contract and Bill Discounting
Figure 20: TMU customer reactions
Figure 21: Payoff Profile Tool
Figure 22: Pay off profile for a long forward contract
Figure 23: Payoff profile for a long call option
Figure 24: Treasury strategies and structures
Figure 25: Pay off profile for a short call option
Figure 26: Payoff profile for a combination of a short call and long call
Figure 27: Payoff profiles for forwards & futures contracts
Figure 28: Payoff profiles for option contracts
Figure 29: Quadrant IV - Payoff profiles for a long forward contract
Figure 30: Payoff profile for a long forward contract
Figure 31: Payoff profile for underlying security
Figure 32: Payoff profile for the holder of a call option
Figure 33: Payoff profile for the writer of a call option
Figure 34: Payoff profile for the holder of a put option
Figure 35: Payoff profile for the writer of a put option
Figure 36: Building blocks for synthetic configurations
Figure 37: Synthetic forward contract creations
Figure 38: Comparative payoff profiles for calls & forwards
Figure 39: Comparative payoff profiles for calls, puts & forwards
Figure 40: Payoff profile for a synthetic long forward
Figure 41: Revised payoff profile for a synthetic long forward
Figure 42: Template for evaluating derivatives
Figure 43: Comparative look at derivatives
Figure 44: Payoff to the buyer & seller of a call option
Figure 45: Payoff to the buyer & seller of a put option
Figure 46: Binomial tree - prices of the underlying asset
Figure 47: Using a Binomial tree to calculate the price of an American Call Option
Figure 48: Payoffs for the buyer & seller of a forward contract
Figure 49: Plain Vanilla Interest Rate Swap
Figure 50: Interest Rate Cap
Figure 51: Interest Rate Floor
Figure 52: Sample trade ticket for a Cap/ Floor
Figure 53: Sample term sheet for a double barrier