Treasury Risk Management: CAIIB Paper 2 (Module C), Unit 4

Treasury Risk Management: CAIIB Paper 2 (Module C), Unit 4

Dear Bankers,
We all know that CAIIB exams are conducted by the Indian Institute of Banking and Finance (IIBF).  CAIIB is said to be one of the difficult courses to be cleared for the bankers. But we assure you that with the help of our “CAIIB study material”, you will definitely clear the CAIIB exam.
CAIIB exams are conducted twice in a year. Candidates should have completed JAIIB before appearing for CAIIB Exam. Here, we will provide detailed notes of every unit of the CAIIB Exam on the latest pattern of IIBF.
So, here we are providing “Unit 4: Treasury Risk Management” of “Module C: Treasury Management” from “Paper 2: Bank Financial Management (BFM)”

Supervision and Control Of Treasury

Treasury Risk Management

Treasury risk management assumes importance for two reasons:

  • The nature of treasury activity is such that profits are generated out of market opportunities and market risk is present at every step;
  • Treasury is also responsible for balance sheet management, i.e. market risk generated by other operation departments. We will deal with the first aspect a little more elaborately.

Concern for Treasury Risks

Bank management is highly sensitive to treasury risk, as the risk arises out of high leverage the treasury business enjoys. The risk of losing capital is much higher than, say, in the credit business. Bank’s capacity to extend loans is limited by the resources at its command, that is, deposits and other borrowings. In case of a loan, the risk is limited to the principal and interest, which may be lost, fully or partly, over a period of time. Most of the loans are also secured by tangible assets. The risk is ‘capped’ by the amount invested in the loan asset. Potential loss in loan assets is known as credit risk.

Treasury on the other hand, has a very low funding requirement, which we call as high leverage. For instance, treasury can buy and sell foreign exchange of value Rs. 100 crore without any direct investment of funds, except for allocation of risk capital as per capital adequacy requirement of RBI. At the same time, an adverse movement of the exchange rate by Re. 1 may result in a loss of over Rs. 1 crore to the bank – which is a straight loss of capital.

Treasury risks are primarily managed by conventional control and supervisory measures, mostly in the nature of preventive steps, which may be divided into three parts:

  • Organisational Controls
  • Exposure Ceiling
  • Limits on trading positions and stop-loss limits

Organisational Controls

The organisational controls refer to the checks and balances within the system. Treasury is basically divided into three parts: the front office, back office and the Mid office.

Internal Controls

The most important of the internal controls are position limits and stop loss limits. The limits are imposed on the dealers who trade in foreign exchange and securities. Trading is a high risk area, vulnerable to sudden market fluctuations and the limits imposed by management are preventive measures to avoid or contain losses in adverse market conditions.

The trading limits in the context of foreign exchange are of three kinds:

  • limits on deal size
  • limits on open positions and
  • stop-loss limits. All limits are expressed in absolute amounts.

Exposure Ceiling Limits

Exposure limits are kept in place to protect the bank from credit risk/counter-party risk. Credit risk in Treasury may be split into default risk and settlement risk. Default risk is typically when the bank lends in the money market (mainly to other banks), the borrowing bank may fail to repay the amount on due date. Similar risk is there in repo transactions also.

Market Risk and Credit Risk

While describing the conventional controls above, we have frequently referred to default by a counterparty and market movements. In that we are indirectly referring to two types of risks faced by the bank in a spheres of its activity. One is credit risk, or the risk of losing funds invested together with interest, fully or partly, on account of failure of the counterparty to honour its obligations. Then there is market risk where the price of a security, interest rates or exchange rates move in such a way that the value of an asset diminishes or the liability under an existing obligation increases.

Thus market risk is a confluence of liquidity risk, interest rate risk, exchange rate risk, equity risk and commodity risk. Considering all these factors, the Bank for International Settlements (BIS) defines market risk as “the risk that the value of on- or off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices”. The market risk is also known as price risk.

The three main components of market risk are liquidity risk, interest rate risk and currency risk.

Liquidity Risk: Liquidity risk refers to cash flow gaps which could not be bridged. Let us assume that the Treasurer has borrowed in call market and purchased a 5-year government security, assuming the bond prices would go up next day and he can sell the security with profit. Let us further assume that the bond market collapses next day and the Treasurer could not dispose off the security. Though the bank is solvent, the treasury has faced liquidity risk, as he needs to borrow funds in the market at whatever cost, if he has to avoid default or delay in repayment of the call borrowings. Liquidity risk thus translates into interest rate risk.

Interest Rate Risk: Interest rate risk refers to rise in interest costs (of a liability) or fall in interest earnings (from assets) eroding the business profits.

Treasury deals in financial assets, value of which is highly sensitive to interest rate movements. A steep rise in interest rates may cause a crash of bond market, eroding the value of securities held by Treasury. If liquidity is not planned ahead, Treasury may need to borrow at a higher cost to meet its obligations.

Currency Risk: Currency risk or exchange rate risk is also a manifestation of interest rate risk, although for the sake of clarity, it is identified as a component of market risk. Interest rates are influenced by factors like domestic money supply, rate of inflation, activity in debt and equity markets etc. which also influence exchange rates. However, exchange rates are influenced more by external trade, global interest rates and capital flows. As globalization progresses, exchange rates and interest rates are increasingly influenced by similar factors, most prominent being GDP growth rate, global interest rates and capital flows.

Risk Measures: VaR and Duration

The movement in currency prices or security prices cannot be accurately predicted and the uncertainty associated with their price movements gives rise to price risk. At the same time the treasurer should have some idea of the inherent risks and the way they would affect his positions. This quest for risk solutions, led to two important measures of risk, known as value at risk and duration.

Value at Risk (VaR)

VaR is a statistical measure indicating the worst possible movement of a market rate, over a given period of time, under normal market conditions, at a defined confidence level. For instance, an overnight VaR of 45 bps for USD/INR rate at 95% confidence level implies that there is only 5% chance of the rate worsening beyond 45 bps next day. If today’s spot rate is Rs. 64.00, tomorrow the worst possible rate for exports can be assumed to be Rs. 63.55. With reasonable safety – there is only 5% chance of the rate being worse than Rs. 63.55.

Similarly, if overnight VaR of 1-year G-Sec yield is 0.35%, current yield of 7.75% is expected to fall/ rise by not more than 0.35% by tomorrow. In the worst-case scenario, a prospective buyer of security may therefore expect the yields to fall to 7.75%-0.35% = 7.40% by next day, while a seller of security may expect rise in the yield to 7.75% +0.35% = 8.10% by next day. At 95% confidence level, there is only 5% possibility of adverse change being higher than 0.35% (at 99% confidence level, there is only 1% possibility of loss being higher than VaR).

There are a number of ways, with technical variations, to calculate the VaR. Three popular approaches to VaR are:

  • Parametric approach, based on sensitivity of various risk components. This approach is also called as Correlation approach or Variance-Co-Variance approach. For instance, say the price of a stock depends on its sensitivity to index changes, to interest rate changes and to changes in the exchange rates – all these components are built into a complex formula to arrive at the VaR of the stock. This approach can best be explained as follows. VaR is derived under this approach from a statistical formula based on volatility of the market. Volatility is the standard deviation from the mean of, say, USD/INR exchange rates (or any other asset prices) observed over a period. Volatility assumes a normal distribution curve and the no. of standard deviations from the mean denote the probability of reaching a target level. The volatility multiplied by the no. of standard deviations required for a given confidence level results in the VaR.
  • The second approach is based on Monte Carlo simulation, where a number of scenarios are generated at random and their impact on the subject (stock price/exchange rate etc.) is studied.
  • The third approach is to use historical data to arrive at the probable loss. The historical data may simply be time series of data prevailing over a period (e.g. daily USD/INR exchange rate for last 90 days), or an index of changes (e.g. change in price over previous day). Progressive weights may also be assigned to the data, as more recent information has greater impact on future price movements.


  • Duration is a measure widely used in investment business, though the concept of duration is applicable to all assets and liabilities, where interest rate risk is present . To understand Duration, we need to be familiar with the concept of YTM or Yield to Maturity of a bond.
  • Treasury invests in government securities and non-government securities of various descriptions, viz. bills, bonds and debentures – hereafter referred to as bonds. The bonds carry a coupon rate of interest which is payable on 100% value of the bond (par value, as at the time of issue). However, the bonds may be traded at a discount (<Rs. 100) or at a premium (>Rs. 100), depending on the interest rate trends in the market. The traded price is based on the market rate of interest for residual period of the bond and is constantly changing in the market.

Use of Derivatives In Risk Management

Derivatives are financial contracts which derive their value based on an underlying market for a commodity or financial product. Derivatives are used to protect treasury transactions from market risk. Derivatives are also useful in managing balance sheet risk i.e. asset liability management. For instance, if an asset is highly sensitive to interest rate changes, and if we have a view that the rates are likely to rise, we can swap fixed rate of interest into floating rate by entering into an interest rate swap. Similarly exchange rate risk can be avoided by entering into a forward rate contract or option contract. We will study derivatives in the next chapter in greater detail.

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