TCC Extract

TREASURY CRASH COURSE
By Jawwad Ahmed Farid

CONTENTS
WHAT IS A TREASURY? ........................................................................................................................... 10
Treasury ....................................................................................................................................................... 10
The Money Market desk ............................................................................................................................... 10
The FX Desk ................................................................................................................................................... 11
The Equity Desk ............................................................................................................................................. 11
The Specialized Desks ................................................................................................................................... 11
What do treasuries really do? ....................................................................................................................... 12
How is a corporate treasury different from a bank treasury? ....................................................................... 12
THE TREASURY FUNCTION ....................................................................................................................... 13
1. Trade Flows (FX desk)............................................................................................................................. 13
2. The Treasury Function Operations ......................................................................................................... 13
i. Introduction ....................................................................................................................................... 13
ii. Front Office Function ......................................................................................................................... 13
a. User Roles ............................................................................................................................... 14
b. Money Market Desk Activities................................................................................................ 14
c. Foreign Exchange Desk Activities ........................................................................................... 15
d. Capital Market (CM) Desk Activities ....................................................................................... 15
iii. Middle Office Function ...................................................................................................................... 16
a. User Roles ............................................................................................................................... 16
b. Activities ................................................................................................................................. 16
iv. Back Office Function .......................................................................................................................... 17
a. User Roles ............................................................................................................................... 17
b. Activities ................................................................................................................................. 17
c. Basic Treasury Back Office Tasks ............................................................................................ 18
3. Related Terminologies ........................................................................................................................... 24
i. Four eyes ........................................................................................................................................... 24
a. Ticket Approval ....................................................................................................................... 24
b. Ticket Verification ................................................................................................................... 24
c. Ticket Authorization ............................................................................................................... 24
ii. Confirmation ...................................................................................................................................... 24
a. Society for Worldwide Interbank Financial Telecommunication (SWIFT) .............................. 25
iii. Settlement ......................................................................................................................................... 25
a. Delivery versus payment (DVP) .............................................................................................. 26
iv. Reconciliation .................................................................................................................................... 26
a. Broker Reconciliation ............................................................................................................. 26
b. Securities Reconciliation ......................................................................................................... 27
v. Accounting ......................................................................................................................................... 27
vi. Price discovery ................................................................................................................................... 28
vii. Proprietary Trading ............................................................................................................................ 28
viii. Treasury Risks .................................................................................................................................... 29
a. Credit Risk ............................................................................................................................... 29
b. Market Risk ............................................................................................................................. 29
c. Operational Risk ..................................................................................................................... 29
4. Treasury Markets ................................................................................................................................... 30
i. Foreign Exchange Market .................................................................................................................. 30
a. FX Ready/ Forward/ Split ........................................................................................................ 30
b. FX Swap .................................................................................................................................. 31
c. FX Placements/ Borrowings .................................................................................................... 31
d. FX Miscellaneous .................................................................................................................... 32
e. FX TMU – Import/ Export/ Remittance/ Encashment ............................................................ 32
f. FX TMU – Foreign Bill Purchase (Bill Discounting) .................................................................. 33
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g. FX TMU – Close Out/ Take Up ................................................................................................ 33

ii. Fixed Income /Money Market ........................................................................................................... 34
a. Call/ Clean/ Placements ......................................................................................................... 34
b. Repo/ Reverse Repo ............................................................................................................... 34
c. Sale against Reverse Repo (SARR) .......................................................................................... 35
d. Outright purchase/ sale .......................................................................................................... 36
e. Inter branch ............................................................................................................................ 37
iii. Capital Market ................................................................................................................................... 37
a. Outright Sale/ Purchase -Ready Equity .................................................................................. 37
CROSS SELLING TREASURY PRODUCTS ........................................................................................................ 38
Five core themes for treasury customer discussions ..................................................................................... 38
Price ........................................................................................................................................................... 39
Risk or Volatility ............................................................................................................................................ 41
Value ........................................................................................................................................................... 42
Models ............................................................................................................................................... 42
Relative Value .................................................................................................................................... 43
Products ........................................................................................................................................................ 45
Limits ........................................................................................................................................................... 46
Wrap- up and overview ................................................................................................................................ 46
Core Treasury products and TMU customer reactions .................................................................................. 46
Core Treasury Products ................................................................................................................................. 47
TMU Customer Reactions ............................................................................................................................. 48
Payoff profile ..................................................................................................................................... 49
Answers for customers reactions ...................................................................................................... 49
DERIVATIVES – TERMINOLOGY ................................................................................................................. 55
1. The Terminology Crash Course ............................................................................................................... 55
i. Forward Contracts ............................................................................................................................. 56
a. The Investment Bank Intern ................................................................................................... 56
ii. Futures Contracts .............................................................................................................................. 56
iii. Options .............................................................................................................................................. 57
a. Maturities and Exercise date .................................................................................................. 57
vi. Payoff Profiles .................................................................................................................................... 58
v. The Payoff profile for a forward contract .......................................................................................... 59
vi. Payoff profiles for Calls and Puts ....................................................................................................... 60
vii. Building Blocks and Synthetic Configurations.................................................................................... 62
a. Comparing a Call with a Forward contract ............................................................................. 63
b. Comparing a Call and a Put with a Forward contract ............................................................. 63
c. Combining a long call with a short put to create a long forward ........................................... 64
PRODUCTS & PRICING ............................................................................................................................ 65
1. A Second Look at Derivative Contracts ................................................................................................... 65
2. Standard Template for Evaluating Derivatives ....................................................................................... 66
3. Options .................................................................................................................................................. 67
i. Option Price ....................................................................................................................................... 69
a. European option price ............................................................................................................ 70
b. American Option Price ........................................................................................................... 71
4. Forward Contracts.................................................................................................................................. 73
i. Forward Price ..................................................................................................................................... 73
5. Futures Contracts ................................................................................................................................... 74
i. Futures Price ...................................................................................................................................... 74
6. Swaps..................................................................................................................................................... 75
i. Interest Rate Swap (IRS) .................................................................................................................... 75
ii. Currency Swap ................................................................................................................................... 75
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PRODUCT VARIATIONS ........................................................................................................................... 76

1. Options .................................................................................................................................................. 76
i. Stock Options ..................................................................................................................................... 76
ii. Foreign Currency Options .................................................................................................................. 76
iii. Index Options..................................................................................................................................... 76
iv. Futures Options ................................................................................................................................. 76
v. Warrants ............................................................................................................................................ 77
vi. Employee Stock Options .................................................................................................................... 77
vii. Convertibles ....................................................................................................................................... 77
viii. Interest Rate Options......................................................................................................................... 77
a. Bond Options .......................................................................................................................... 77
b. Interest Rate Caps/ Floors/ Collars ......................................................................................... 78
c. European Swap Options ......................................................................................................... 79
ix. Exotic Options .................................................................................................................................... 79
a. Bermuda Option ..................................................................................................................... 79
b. Quanto Option........................................................................................................................ 79
c. Composite Option .................................................................................................................. 79
d. Digital or Binary or “All or nothing” options........................................................................... 79
e. Barrier Options ....................................................................................................................... 80
f. Asian Options ......................................................................................................................... 80
g. Average Strike Options ........................................................................................................... 80
h. Look back Options .................................................................................................................. 80
i. Compound Options ................................................................................................................ 81
j. Chooser (As you like it) Options ............................................................................................. 81
k. Exchange Options ................................................................................................................... 81
l. Forward Start Options ............................................................................................................ 81
m. Basket Options........................................................................................................................ 82
n. Shout Options ......................................................................................................................... 82
2. Forwards ................................................................................................................................................ 82
i. Synthetic Forward Contract ............................................................................................................... 82
ii. Forward Rate Agreement (FRA) ......................................................................................................... 83
3. Futures ................................................................................................................................................... 83
i. Stock Index Futures ........................................................................................................................... 83
ii. Futures Contracts on Currencies ....................................................................................................... 83
iii. Futures Contracts on Commodities ................................................................................................... 83
iv. Interest Rate Futures ......................................................................................................................... 83
a. Treasury Bond Futures ........................................................................................................... 83
b. Treasury Note Futures ............................................................................................................ 83
c. 5-year Treasury Note Futures ................................................................................................. 84
d. Treasury Bill Futures ............................................................................................................... 84
e. Eurodollar Futures .................................................................................................................. 84
4. Swaps..................................................................................................................................................... 84
i. Fixed for fixed currency swap ............................................................................................................ 84
ii. Floating for floating currency swap ................................................................................................... 84
iii. Cross-currency interest rate swap ..................................................................................................... 84
iv. Step-up Swaps ................................................................................................................................... 84
v. Amortizing Swaps .............................................................................................................................. 85
vi. Basis Rate Swap ................................................................................................................................. 85
vii. Forward or Deferred Swaps ............................................................................................................... 85
viii. Compounding Swaps ......................................................................................................................... 85
ix. LIBOR-in- Arrears Swap ...................................................................................................................... 85
x. Constant Maturity Swap .................................................................................................................... 86
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xi. Constant Maturity Treasury Swap ..................................................................................................... 86

xii. Differential Swap or Quanto .............................................................................................................. 86
xiii. Variance or Volatility Swap ................................................................................................................ 86
xiv. Equity Swap ....................................................................................................................................... 87
xv. Commodity Swap ............................................................................................................................... 87
xvi. Asset Swap ......................................................................................................................................... 87
xvii. Accrual Swap ...................................................................................................................................... 87
xviii. Cancellable Swap ............................................................................................................................... 87
xix. Extendable Swap................................................................................................................................ 87
ADVANCED PRODUCTS ........................................................................................................................... 88
1. Structured Products ............................................................................................................................... 88
i. Cross Currency Swaps ........................................................................................................................ 88
ii. Participating Forwards ....................................................................................................................... 88
iii. Equity Linked Notes ........................................................................................................................... 89
iv. Capital Protected / Capital Guaranteed Notes .................................................................................. 90
v. Commodity Linked Notes .................................................................................................................. 91
vi. Range Accruals ................................................................................................................................... 92
vii. Switchable.......................................................................................................................................... 92
viii. IRD (Interest Rate Differential) Trades .............................................................................................. 93
a. Swap basis .............................................................................................................................. 93
b. Note basis ............................................................................................................................... 93
c. Quanto .................................................................................................................................... 93
d. Cumulative Cap....................................................................................................................... 94
e. Steepener/ Flattener Note ..................................................................................................... 95
f. Inverted Curve Instrument ..................................................................................................... 95
g. Ranges .................................................................................................................................... 96
2. Credit products ...................................................................................................................................... 97
i. Credit Default Swaps ......................................................................................................................... 97
ii. Total Return Swaps ............................................................................................................................ 99
iii. Collateralized Debt Obligation (CDO) ................................................................................................ 100
CALCULATING FORWARD PRICES AND FORWARD RATES IN EXCEL .................................................................... 101
1. Introduction ........................................................................................................................................... 101
2. How to calculate the forward price of security....................................................................................... 101
Forward Price of a security with no income ................................................................................................. 102
Forward Price of a security with known cash income .................................................................................. 102
Forward Price of a security with known dividend yield ................................................................................ 103
3. How to determine Spot Rates and Forward Rates & Yield to Maturity ................................................... 103
How to determine Forward Rates from Spot Rates ...................................................................................... 105
How to determine Spot Rates from Forward Rates ...................................................................................... 105
How to calculate the Yield to Maturity (YTM) of a bond .............................................................................. 107
Trial and error process ....................................................................................................................... 107
EXCEL’s Goal Seek .............................................................................................................................. 109
4. How to calculate the values of Forward Rate Agreements (FRA) ............................................................ 110
Value of an FRA (zero coupon rate calculated on a discrete basis) .............................................................. 110
Value of an FRA (zero coupon rate calculated on a continuously compounded basis) ................................ 111
5. How to calculate Forward Exchange Rates ............................................................................................. 112
Interest Rates compounded on a discrete basis ........................................................................................... 112
Interest Rates compounded on a continuous basis ...................................................................................... 113
6. How to calculate the value of a forward contract................................................................................... 114
Value of a long forward contract (continuous) ............................................................................................. 114
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Value of a long forward contract (discrete) .................................................................................................. 115

Value of a long forward contract (continuous) which provides a known income ........................................ 115
Value of a long forward contract (continuous) which provides a known yield ............................................ 116
Value of a forward foreign currency contract ............................................................................................... 117
OTHER TREASURY FORMULAS .................................................................................................................. 118
Cost of deposit ............................................................................................................................................. 118
ASSET LIABILITY MANAGEMENT ................................................................................................................ 119
1. Introduction ........................................................................................................................................... 119
i. Interest Rate Risk ............................................................................................................................... 119
ii. Liquidity Risk ...................................................................................................................................... 119
2. Duration and Convexity ......................................................................................................................... 119
i. Duration ............................................................................................................................................. 119
a. Macaulay Duration ................................................................................................................. 120
b. Modified Duration .................................................................................................................. 120
iii. Convexity ........................................................................................................................................... 121
a. Impact of convexity ................................................................................................................ 121
b. Modified, Effective, Positive, Negative................................................................................... 122
c. Convexity in Asset Liability Management ............................................................................... 123
3. ALM Risk Measurement Tools ................................................................................................................ 123
i. Fall in Market Value of Equity ............................................................................................................ 123
ii. Earnings at Risk .................................................................................................................................. 128
iii. Cost to Close ...................................................................................................................................... 135
iv. Rate Sensitive Gap ............................................................................................................................. 138
v. Price Sensitive Gap ............................................................................................................................ 140
vi. Liquidity Gap ...................................................................................................................................... 140
vii. Net Interest Income (NII) at Risk ....................................................................................................... 140
viii. Duration Gap Analysis........................................................................................................................ 140
4. Applications ........................................................................................................................................... 141
i. Bank ................................................................................................................................................... 141
a. Duration matching/ immunization ......................................................................................... 142
ii. Pension Funds and Insurance ............................................................................................................ 143
a. Portfolio dedication ................................................................................................................ 143
LIQUIDITY MANAGEMENT ....................................................................................................................... 144
1. Liquidity Ratios and Analysis .................................................................................................................. 144
a. Current Ratio ..................................................................................................................................... 144
b. Quick Ratio......................................................................................................................................... 144
c. Unused lines of credit ........................................................................................................................ 144
d. Borrowing/ Debt-to-Equity Ratio ....................................................................................................... 144
e. Net Working Capital Ratio ................................................................................................................. 144
f. Loan-to-Deposit Ratio ........................................................................................................................ 144
g. Loan- to- Asset Ratio .......................................................................................................................... 144
2. Liquidity Management ........................................................................................................................... 145
i. Contingency Funding Plan ................................................................................................................. 145
a. General requirements for a liquidity contingency plan .......................................................... 145
b. Specific requirements for a liquidity contingency plan .......................................................... 145
ii. Liquidity enhancement tactics ........................................................................................................... 148
a. For Systemic Crisis .................................................................................................................. 148
b. For company specific crisis ..................................................................................................... 148
SETTING LIMITS .................................................................................................................................... 149
1. Risk Limits and Control Process .............................................................................................................. 149
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i. Operational (Exception or Management Action) Limits .................................................................... 149

ii. Capital Loss & Stop Loss Limits .......................................................................................................... 149
iii. Inventory Age Limits .......................................................................................................................... 150
iv. Concentration Limits.......................................................................................................................... 150
v. Transaction Limits .............................................................................................................................. 150
vi. Exposure and Sensitivity Limits ......................................................................................................... 150
vii. Pre Settlement Risk (PSR) and Potential Future Exposure (PFE) Limits ............................................. 150
viii. Hierarchy of Limits ............................................................................................................................. 151
2. A More Detailed Look at Limits .............................................................................................................. 152
i. Capital Loss and Stop Loss Limits ....................................................................................................... 152
ii. Value-at-Risk Limits ........................................................................................................................... 155
iii. Regulatory Approach Limits ............................................................................................................... 156
iv. Other Limits ....................................................................................................................................... 157
a. Duration Limits ....................................................................................................................... 157
b. Convexity Limits...................................................................................................................... 157
c. PVBP Limits ............................................................................................................................. 157
v. Credit Risk Limits ............................................................................................................................... 158
a. PSR Limits ............................................................................................................................... 158
b. Settlement Risk Limits ............................................................................................................ 159
c. Financial Institution (FI)/ Counterparty Limits ....................................................................... 159
d. Regulatory Limits .................................................................................................................... 161
e. Internal / Concentration Limits .............................................................................................. 161
vi. Application to Products ..................................................................................................................... 162
vii. Setting Limits for Liquidity Risk .......................................................................................................... 162
a. Cash flow mismatch or gap limits ........................................................................................... 163
b. Maturity Limits ....................................................................................................................... 163
c. Target Liquid Reserves............................................................................................................ 163
d. Concentration Limits .............................................................................................................. 163
e. Contingent liability limit ......................................................................................................... 163
f. Review .................................................................................................................................... 163
ix. Setting Limits for Interest Rate Risk ................................................................................................... 164
Repricing limits .................................................................................................................................. 164
x. Limit Breach, Exception processing, Action Plan for Trigger Zones ................................................... 164
a. Exception Handling ................................................................................................................. 164
b. Example of an Action Plan for Trigger Zones .......................................................................... 164
TREASURY PROFITABILITY ........................................................................................................................ 166
1. Treasury Profitability - Foreign Exchange Desk ....................................................................................... 166
2. Treasury Profitability – Capital Market (Equity (EQ)) Desk ..................................................................... 170
ANNEXURE A- CALCULATING VALUE AT RISK ................................................................................................ 174
1. Introduction ........................................................................................................................................... 174
2. VaR Methods ......................................................................................................................................... 175
a. Variance Covariance Approach .......................................................................................................... 176
b. Historical Simulation Method ............................................................................................................ 177
c. Monte Carlo Simulation ..................................................................................................................... 177
d. Quick Review ..................................................................................................................................... 178
e. Implementing VaR ............................................................................................................................. 178
2. Methodology ......................................................................................................................................... 179
i. Setting the Scene ............................................................................................................................... 179
Sample Portfolio ................................................................................................................................ 179
ii. Preliminary steps ............................................................................................................................... 179
iii. VaR Approach Specific Steps ............................................................................................................. 182
a. Variance-Covariance (VCV) VaR.............................................................................................. 182
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b. Determining Historical Simulation daily VaR .......................................................................... 184

iv. Scaling of the daily VaR ...................................................................................................................... 185
2. Caveats, Qualifications, Limitations and Issues ...................................................................................... 185
ANNEXURE B: BUILDING MATURITY & LIQUIDITY PROFILES FOR DEPOSITS AND ADVANCES FOR ALCO, LIQUIDITY COVERAGE
& ICAAP REPORTING. ............................................................................................................................ 187
Lesson Zero: Introduction and Course Overview........................................................................................... 187
Bank Deposit & Asset Maturity profiles for ALM - Objectives ...................................................................... 187
Advances and Deposits Maturity & Liquidity Profile - Methodology & Sample output ............................... 188
Step 1: The Core Banking Dump ........................................................................................................ 189
Step 2: Pre-processing the data and adding intelligence for the purpose of building a pivot table . 189
Step 3: Creating the ivot Table and Generating Presentation Graphs using Pivot Charts ................. 189
Lesson One: Preparing the Core Banking Dataset ......................................................................................... 192
Extracting Relevant Data ............................................................................................................................... 192
The DTM (Days to Maturity) formula ............................................................................................................ 192
Lesson Two: Adding Intelligence for the Pivot Table ..................................................................................... 194
Deposit Size Bracket ...................................................................................................................................... 195
Maturity Bucket Bracket ............................................................................................................................... 196
Cost of Deposits Bracket ............................................................................................................................... 196
Lesson Three: Creating the Pivot Table ......................................................................................................... 197
Lesson Four: Reading the PivotTable and PivotChart .................................................................................... 206
Lesson Five: Quick Review & Extending the framework................................................................................ 211
Lesson Six: Pivot Shoot Out- Pivot Tables and Pivot Charts Galore ............................................................... 212
Lesson Seven: The Pivot Chart Shoot out for Advances ................................................................................ 216
Maturity Profile Bucket ................................................................................................................................. 218
Advances Size Bucket .................................................................................................................................... 219
Pivot Table and Chart Variations................................................................................................................... 219
Lesson 8: Wrap up and building the ALM profile for the banking book ......................................................... 222
BIBLIOGRAPHY...................................................................................................................................... 225
LIST OF FIGURES .................................................................................................................................... 226
DISCLAIMER ......................................................................................................................................... 230
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B IBLIOGRAPHY
 Options, Futures and Other Derivatives, John C. Hull, 7th Edition, Prentice Hall, 2009
 The Handbook of Fixed Income Securities, Frank J. Fabozzi, 7th Edition, McGraw-Hill, 2005
 Risk Management and Financial Institutions, John C. Hull, Low Price Edition, Pearson Education,
Inc., 2007
 Exotic Equity Derivatives Manual, Salomon Smith Barney, August 1998
 Understanding Market, Credit and Operational Risk- The Value at Risk Approach, Linda Allen, Jacob
Boudoukh and Anthony Saunders, Blackwell Publishing, 2004
 Beyond Value at Risk, The New Science of Risk Management, Kevin Dowd, John Wiley & Sons, 1998
 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
 VaR Applications: Setting VaR-based Limits, Carlos Blanco and Sally Blomstrom, Financial
Engineering Associates, Inc., May 1999
 Commonly Used Market Risk Limits, Guidelines on Risk Management of Derivatives and other
traded instruments, Annex D
 Quantitative Finance, Second Edition, Paul Wilmott, John Wiley&Sons, Ltd., 2006
 Liquidity Risk Management, Leonard M. Martz, 2007
 Back Office and Beyond- A guide to procedures, settlements and risk in financial markets, Mervin J.
King, Harriman House Ltd., 1999
 Mastering Treasury Office Operations- Denis Nolan & Gordon Amos, FT Prentice Hall, 2001
 Valuation of interest-sensitive financial instruments, Babbel David F., SOA Monograph M-FI196-1,
1996
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L IST OF F IGURES
Figure 1: Treasury Desks ................................................................................................................................................................................................ 10
Figure 2: Money Market Desk ........................................................................................................................................................................................ 10
Figure 3: FX Desk............................................................................................................................................................................................................ 11
Figure 4: Equity Desk ..................................................................................................................................................................................................... 11
Figure 5: Specialized Desks ............................................................................................................................................................................................ 11
Figure 6: Flow chart for Treasury Function .................................................................................................................................................................... 13
Figure 7: Foreign Currency Asset and Liability balances import functionality on a Treasury system ............................................................................. 18
Figure 8: Foreign Currency Asset and Liability balances input screen on a Treasury system ......................................................................................... 19
Figure 9: Day Start and End functionality on a Treasury system ................................................................................................................................... 19
Figure 10: Five core themes for approaching TMU customers ...................................................................................................................................... 38
Figure 11: WTI price graph ............................................................................................................................................................................................. 39
Figure 12: Price and trailing volatility for WTI ................................................................................................................................................................ 41
Figure 13: Gold Price Model – Actual and Simulated Prices ........................................................................................................................................... 42
Figure 14: Gold WTI Ratio .............................................................................................................................................................................................. 43
Figure 15: Gold-WTI with USD/CHF................................................................................................................................................................................ 44
Figure 16: Product wise payoffs ..................................................................................................................................................................................... 45
Figure 17: Potential Future Exposure over life of contract ............................................................................................................................................ 46
Figure 18: Core Treasury Products and Exposure Estimation ........................................................................................................................................ 47
Figure 19: Difference between FX Forward Sale and Purchase contract and Bill Discounting ....................................................................................... 47
Figure 20: TMU customer reactions ............................................................................................................................................................................... 48
Figure 21: Payoff Profile Tool ......................................................................................................................................................................................... 49
Figure 22: Pay off profile for a long forward contract .................................................................................................................................................... 50
Figure 23: Payoff profile for a long call option ............................................................................................................................................................... 51
Figure 24: Treasury strategies and structures ................................................................................................................................................................ 51
Figure 25: Pay off profile for a short call option ............................................................................................................................................................. 52
Figure 26: Payoff profile for a combination of a short call and long call ........................................................................................................................ 53
Figure 27: Payoff profiles for forwards & futures contracts ........................................................................................................................................... 58
Figure 28: Payoff profiles for option contracts .............................................................................................................................................................. 58
Figure 29: Quadrant IV - Payoff profiles for a long forward contract ............................................................................................................................. 59
Figure 30: Payoff profile for a long forward contract ..................................................................................................................................................... 59
Figure 31: Payoff profile for underlying security ............................................................................................................................................................ 60
Figure 32: Payoff profile for the holder of a call option ................................................................................................................................................. 60
Figure 33: Payoff profile for the writer of a call option .................................................................................................................................................. 61
Figure 34: Payoff profile for the holder of a put option ................................................................................................................................................. 61
Figure 35: Payoff profile for the writer of a put option .................................................................................................................................................. 62
Figure 36: Building blocks for synthetic configurations.................................................................................................................................................. 62
Figure 37: Synthetic forward contract creations ............................................................................................................................................................ 62
Figure 38: Comparative payoff profiles for calls & forwards .......................................................................................................................................... 63
Figure 39: Comparative payoff profiles for calls, puts & forwards ................................................................................................................................. 63
Figure 40: Payoff profile for a synthetic long forward ................................................................................................................................................... 64
Figure 41: Revised payoff profile for a synthetic long forward ...................................................................................................................................... 64
Figure 42: Template for evaluating derivatives .............................................................................................................................................................. 66
Figure 43: Comparative look at derivatives.................................................................................................................................................................... 66
Figure 44: Payoff to the buyer & seller of a call option .................................................................................................................................................. 68
Figure 45: Payoff to the buyer & seller of a put option .................................................................................................................................................. 68
Figure 46: Binomial tree - prices of the underlying asset ............................................................................................................................................... 71
Figure 47: Using a Binomial tree to calculate the price of an American Call Option ...................................................................................................... 72
Figure 48: Payoffs for the buyer & seller of a forward contract ..................................................................................................................................... 73
Figure 49: Plain Vanilla Interest Rate Swap .................................................................................................................................................................... 75
Figure 50: Interest Rate Cap .......................................................................................................................................................................................... 78
Figure 51: Interest Rate Floor ........................................................................................................................................................................................ 78
Figure 52: Sample trade ticket for a Cap/ Floor ............................................................................................................................................................. 79
Figure 53: Sample term sheet for a double barrier ........................................................................................................................................................ 80
Figure 54: Sample term sheet for a look back swap....................................................................................................................................................... 81
Figure 55: Sample term sheet for a basket option ......................................................................................................................................................... 82
Figure 56: Payoffs for the buyer of a call & seller of a put i.e. of a synthetic forward contract ..................................................................................... 82
Figure 57: Sample term sheet for an amortizing swap................................................................................................................................................... 85
Figure 58: Sample term sheet for a variance swap ........................................................................................................................................................ 86
Figure 59: Term sheet for an Equity Linked Note ........................................................................................................................................................... 90
Figure 60: Key elements of a Capital Protected Note term sheet .................................................................................................................................. 90
Figure 61: Term sheet for a Commodity Linked Note .................................................................................................................................................... 91
Figure 62: Term sheet for a Range Accrual Option ........................................................................................................................................................ 92
Figure 63: Sample Trade Tickets for Switchables ........................................................................................................................................................... 92
Figure 64: Sample Trade Ticket for an IRD swap ............................................................................................................................................................ 93
Figure 65: Sample Trade Ticket for an IRD note ............................................................................................................................................................. 93
Figure 66: Sample Trade Ticket for a Quanto ................................................................................................................................................................. 93
Figure 67: Sample Term Sheet for a Cumulative Cap ..................................................................................................................................................... 94
Figure 68: Sample Trade Tickets for Steepener Notes ................................................................................................................................................... 95
Figure 69: Sample Trade Ticket for an inverted curve instrument ................................................................................................................................. 95
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Figure 70: Sample Trade Ticket for a single range step up ............................................................................................................................................. 96
Figure 71: Sample Trade Ticket for a tiered range ......................................................................................................................................................... 96
Figure 72: Sample Trade Ticket for a range note ........................................................................................................................................................... 96
Figure 73: Structure of a Credit Default Swap ................................................................................................................................................................ 97
Figure 74: Sample Term Sheet for a Credit Default Swap .............................................................................................................................................. 98
Figure 75: Structure of a Total Return Swap .................................................................................................................................................................. 99
Figure 76: Sample Term sheet of a Total Return Swap .................................................................................................................................................. 99
Figure 77: Sample Term sheet of a Collateralized Debt Obligation .............................................................................................................................. 100
Figure 78: Forward price of a security with no income ................................................................................................................................................ 102
Figure 79: Forward price of a security with known cash income ................................................................................................................................. 103
Figure 80: Forward price of a security with known dividend yield ............................................................................................................................... 103
Figure 81: Spot Rates and Forward Rates –time line ................................................................................................................................................... 104
Figure 82: Deriving forward rates from spot rates ....................................................................................................................................................... 105
Figure 83: Deriving spot rates from forward rates –method 1..................................................................................................................................... 106
Figure 84: Calculating accumulation factors ................................................................................................................................................................ 106
Figure 85: Deriving spot rates from forward rates –method 2..................................................................................................................................... 107
Figure 86: Iterations for determining YTM using the trial and error process ............................................................................................................... 109
Figure 87: Determining YTM using EXCEL’s Goal Seek functionality – setting up the input and out cells .................................................................... 109
Figure 88: Determining YTM using EXCEL’s Goal Seek functionality – selecting the Goal Seek function ..................................................................... 109
Figure 89: Determining YTM using EXCEL’s Goal Seek functionality – defining the values in the Goal Seek pop-up window ...................................... 110
Figure 90: Determining YTM using EXCEL’s Goal Seek functionality – solving for the YTM.......................................................................................... 110
Figure 91: Value of an FRA (zero coupon rate calculated on a discrete basis) ............................................................................................................. 111
Figure 92: Value of an FRA (zero coupon rate calculated on a continuous basis) ........................................................................................................ 112
Figure 93: FX rates (interest rates compounded on a discrete basis) .......................................................................................................................... 113
Figure 94: FX rates (interest rates compounded on a continuous basis) ..................................................................................................................... 114
Figure 95: Value of a long forward contract (continuous) ........................................................................................................................................... 115
Figure 96: Value of a long forward contract (discrete)................................................................................................................................................. 115
Figure 97: Value of a long forward contract (continuous) which provides a known income ....................................................................................... 116
Figure 98: Value of a long forward contract (continuous) which provides a known yield ............................................................................................ 117
Figure 99: Value of a long forward foreign currency contract ..................................................................................................................................... 117
Figure 100: Price-yield relationship ............................................................................................................................................................................. 121
Figure 101: Impact of convexity ................................................................................................................................................................................... 121
Figure 102: PKRV rates ................................................................................................................................................................................................. 123
Figure 103: Calculated return series ............................................................................................................................................................................ 124
Figure 104: Days to maturity/ reset ............................................................................................................................................................................. 124
Figure 105: Weights of each asset/ liability ................................................................................................................................................................. 124
Figure 106: Weighted average return series ................................................................................................................................................................ 125
Figure 107: Daily volatility and holding VaR ................................................................................................................................................................. 125
Figure 108: Weighted average YTM for each asset in the fixed income bond category .............................................................................................. 126
Figure 109: Weighted average YTM for assets ............................................................................................................................................................. 126
Figure 110: Holding VaR, YTM and Rate Shocks for Asset and Liability ........................................................................................................................ 127
Figure 111: Weighted average Duration for each asset in the fixed income bond category ........................................................................................ 127
Figure 112: Weighted average Duration for interest sensitive assets .......................................................................................................................... 128
Figure 113: Fall in Market Value of Equity ................................................................................................................................................................... 128
Figure 114: PKRV rates ................................................................................................................................................................................................. 129
Figure 115: Calculated return series ............................................................................................................................................................................ 129
Figure 116: Sample on and off balance sheet item ...................................................................................................................................................... 130
Figure 117: Expected Cash flow and Days to Maturity ................................................................................................................................................. 130
Figure 118: Expected Cash flows slotted into rate buckets as per their DTM .............................................................................................................. 130
Figure 119: Calculation of weights for each sub-bucket .............................................................................................................................................. 131
Figure 120: Weighted average return series ................................................................................................................................................................ 132
Figure 121: Rate VaR.................................................................................................................................................................................................... 132
Figure 122: Weighted average base rate ..................................................................................................................................................................... 133
Figure 123: Weighted average DTM ............................................................................................................................................................................ 133
Figure 124: On-balance sheet and cumulative gaps .................................................................................................................................................... 134
Figure 125: Earning at Risk ........................................................................................................................................................................................... 134
Figure 126: Buckets definition ..................................................................................................................................................................................... 135
Figure 127: Determination of future instalments due and time to receipt/ payment ................................................................................................. 136
Figure 128: Slotting cash flows into appropriate buckets based on time to receipt/ payment .................................................................................... 136
Figure 129: Cost to close .............................................................................................................................................................................................. 137
Figure 130: Rate Sensitive Gap .................................................................................................................................................................................... 139
Figure 131: Term sheet for coupon bearing instrument .............................................................................................................................................. 141
Figure 132: Limit monitoring and review process ........................................................................................................................................................ 151
Figure 133: Risk reporting process ............................................................................................................................................................................... 152
Figure 134: Capital Loss calculation example ............................................................................................................................................................... 153
Figure 135: Allocation of actual stop loss limits by lines of investment ....................................................................................................................... 153
Figure 136: Example of slippage .................................................................................................................................................................................. 154
Figure 137: Odds, Confidence Levels & Limits ............................................................................................................................................................. 155
Figure 138: Example - Setting VaR limits for sub portfolios ......................................................................................................................................... 156
Figure 139: Determination of multiple for setting an upper bound on VaR limit......................................................................................................... 156
Figure 140: Setting Duration & Convexity limits .......................................................................................................................................................... 157
Figure 141: Setting PVBP limits .................................................................................................................................................................................... 157
Figure 142: Limits applicable to Money Market Products ............................................................................................................................................ 162
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Figure 143: Limits applicable to Capital Market Products ............................................................................................................................................ 162

Figure 144: Limits applicable to Foreign Exchange Products ....................................................................................................................................... 162
Figure 145: Types of FX Deals ...................................................................................................................................................................................... 166
Figure 146: Components of FX Transactions ................................................................................................................................................................ 166
Figure 147: Treatment of FX Swap ............................................................................................................................................................................... 167
Figure 148: Currency Convention ................................................................................................................................................................................ 167
Figure 149: Example 1 – Single Currency Buy .............................................................................................................................................................. 168
Figure 150: Example 2 – Cross Currency Buy ............................................................................................................................................................... 169
Figure 151: Types of EQ Trades.................................................................................................................................................................................... 170
Figure 152: EQ Inventory ............................................................................................................................................................................................. 170
Figure 153: Realized Gain/ Loss on AFS transaction ..................................................................................................................................................... 171
Figure 154: Realized Gain/ Loss on HFT transaction .................................................................................................................................................... 171
Figure 155: Unrealized Gain/ Loss on AFS transaction ................................................................................................................................................. 171
Figure 156: Unrealized Gain/ Loss on HFT transaction................................................................................................................................................. 172
Figure 157: Dividend Income ....................................................................................................................................................................................... 172
Figure 158: Dividend Income ....................................................................................................................................................................................... 172
Figure 159: Treasury EQ Profitability ........................................................................................................................................................................... 173
Figure 160: Value at Risk .............................................................................................................................................................................................. 174
Figure 161: Distribution of returns .............................................................................................................................................................................. 175
Figure 162: Variance Co-variance Approach ................................................................................................................................................................ 176
Figure 163: Historical Simulation Method.................................................................................................................................................................... 177
Figure 164: Monte Carlo Simulation Method .............................................................................................................................................................. 177
Figure 165: Comparison of VaR Methods .................................................................................................................................................................... 178
Figure 166: Daily time series data ................................................................................................................................................................................ 179
Figure 167: Interpolated Interest Rates ....................................................................................................................................................................... 180
Figure 168: Derived Bond Price Series ......................................................................................................................................................................... 181
Figure 169: Daily return series ..................................................................................................................................................................................... 181
Figure 170: Calculation of portfolio weights ................................................................................................................................................................ 181
Figure 171: Portfolio daily return series ....................................................................................................................................................................... 182
Figure 172: Squared differences of the returns series ................................................................................................................................................. 182
Figure 173: Calculation of weights under EWMA......................................................................................................................................................... 183
Figure 174: Scaling of weights...................................................................................................................................................................................... 183
Figure 175: Calculation of EWMA variance .................................................................................................................................................................. 184
Figure 176: SMA and EWMA daily VaRs ....................................................................................................................................................................... 184
Figure 177: Ordered portfolio return series ................................................................................................................................................................. 184
Figure 178: Holding Period VaR ................................................................................................................................................................................... 185
Figure 179: Core banking data ..................................................................................................................................................................................... 189
Figure 180: Pivot Table - Maturity profile of deposits by size ...................................................................................................................................... 189
Figure 181: Pivot Chart - Deposits by maturity bucket................................................................................................................................................. 190
Figure 182: Pivot Chart – Deposits size versus maturity profile ................................................................................................................................... 190
Figure 183: Pivot Chart – Deposits cost versus size ..................................................................................................................................................... 190
Figure 184: Pivot Chart – Loan size versus maturity .................................................................................................................................................... 191
Figure 185: Pivot Chart – Loan Segment versus maturity ............................................................................................................................................ 191
Figure 186: Pivot Chart –loan product versus maturity ............................................................................................................................................... 191
Figure 187: Core banking data extract - deposits ......................................................................................................................................................... 192
Figure 188: Days to Maturity Formula ......................................................................................................................................................................... 193
Figure 189: Months to Maturity Formula .................................................................................................................................................................... 193
Figure 190: Applying formulas to dataset .................................................................................................................................................................... 194
Figure 191: Adding additional columns to data set for deposit size, maturity and cost ............................................................................................... 194
Figure 192: Grades/ Categories for bucketing deposit data ......................................................................................................................................... 195
Figure 193: Assigning grades for deposit size .............................................................................................................................................................. 195
Figure 194: Assigning grades for maturity bucket ........................................................................................................................................................ 196
Figure 195: Assigning grades for deposit cost .............................................................................................................................................................. 196
Figure 196: Applying formulas to entire data set ......................................................................................................................................................... 197
Figure 197: Selecting pivot table functionality from Excel spreadsheet Insert Tab ...................................................................................................... 197
Figure 198: Selecting pivot chart option from pivot table functionality....................................................................................................................... 197
Figure 199: Pivot Table information capture pop-up ................................................................................................................................................... 198
Figure 200: Selecting the data range for the pivot table functionality ......................................................................................................................... 198
Figure 201: Pivot table information capture pop-up after data range selection .......................................................................................................... 199
Figure 202: Selecting the location for display of the Pivot Table and Pivot Chart ........................................................................................................ 200
Figure 203: Display of the Pivot Table and Pivot Chart output field before population ............................................................................................... 201
Figure 204: Data fields and Pivot Table and Chart output construction customization functionality .......................................................................... 202
Figure 205: Data fields and Pivot Table only output construction customization functionality ................................................................................... 203
Figure 206: Data fields selection and allocation for rows (axis) and columns (legends) .............................................................................................. 204
Figure 207: Rows (axis) and columns (legends) polluted in pivot table and chart output ............................................................................................ 204
Figure 208: Data field selection and allocation for Values ........................................................................................................................................... 205
Figure 209: Values populated in pivot table and chart ................................................................................................................................................ 205
Figure 210: Pivot table output before number formatting .......................................................................................................................................... 206
Figure 211: Number formatting functionality in EXCEL ................................................................................................................................................ 206
Figure 212: Pivot table and chart output after number formatting ............................................................................................................................. 206
Figure 213: Grades/ Categories for bucketing deposit data ......................................................................................................................................... 207
Figure 214: Functionality for changing Value field settings -1 ..................................................................................................................................... 208
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Figure 217: Updated values field after value field setting is changed .......................................................................................................................... 209
Figure 218: Maturity profile versus size concentration by amount and number ......................................................................................................... 210
Figure 219: Selecting data fields for displaying size and cost ....................................................................................................................................... 212
Figure 220: Pivot table for deposit size and cost.......................................................................................................................................................... 212
Figure 221: Pivot table and chart combo for deposit size and cost.............................................................................................................................. 213
Figure 222: Pivot table and chart combo maturity and cost ........................................................................................................................................ 214
Figure 223: Pivot table and chart combo for deposit size and product ........................................................................................................................ 214
Figure 224: Pivot table and chart combo for cost and size by number of accounts ..................................................................................................... 215
Figure 225: Pivot table and chart combo for total deposit amounts by maturity ........................................................................................................ 215
Figure 226: Pivot table and chart combo for total deposit amounts by cost ............................................................................................................... 216
Figure 227: Core banking data for loans extract .......................................................................................................................................................... 217
Figure 228: Grades/ Categories for bucketing loan data .............................................................................................................................................. 218
Figure 229: Assigning grades for maturity buckets ...................................................................................................................................................... 218
Figure 230: Assigning grades for loan size ................................................................................................................................................................... 219
Figure 231: Pivot chart for loan size against maturities ............................................................................................................................................... 219
Figure 232: Pivot table for loan size against maturities ............................................................................................................................................... 219
Figure 233: Pivot chart for business line against maturities......................................................................................................................................... 220
Figure 234: Pivot table for business line against maturities ......................................................................................................................................... 220
Figure 235: Pivot table for advances product against maturities ................................................................................................................................. 220
Figure 236: Pivot chart for advances product against maturities ................................................................................................................................. 221
Figure 237: Pivot table and chart for advances maturities .......................................................................................................................................... 221
Figure 238: Pivot table and chart for concentration of advances in size versus maturity brackets by number ........................................................... 222
Figure 239: Maturity profile- advances ........................................................................................................................................................................ 222
Figure 240: Maturity profile- deposits ......................................................................................................................................................................... 223
Figure 241: Maturity profile-results ............................................................................................................................................................................. 223
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TREASURY CRASH COURSE

By Jawwad Ahmed Farid

g. FX TMU – Close Out/ Take Up ................................................................................................ 33

PRODUCT VARIATIONS ........................................................................................................................... 76

xi. Constant Maturity Treasury Swap ..................................................................................................... 86

Value of a long forward contract (discrete) .................................................................................................. 115

i. Operational (Exception or Management Action) Limits .................................................................... 149

b. Determining Historical Simulation daily VaR .......................................................................... 184

Figure 143: Limits applicable to Capital Market Products ............................................................................................................................................ 162

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