Individual Currency Limits

Normally there are specialist dealers allocated to each currency in which case
the individual currency limits will be the dealer limits too. Or the pound could be
split between two dealers and each allocated 1.5 million and so on. Positions
could be oversold or overbought in the individual currencies; but they would not
be netted out between dealers or between currencies. However, at the whole,
the daylight position would be computed using the short-hand method discussed
in the last unit
It is expected that all commercial and market-making positions would be
squared (neutralized) during the day and the only positions carried forward would
be the banks proprietary trading positions. One thing to be made clear is the
bank as an entity does not trade but authorizes senior traders to take up
proprietary positions. Proprietary traders may prefer to carry their positions
overnight. Overnight positions are again controlled and the overnight limit for the
bank will depend upon Basel Capital adequacy allocation. Overnight limits are
computed using the short-hand method, but individual currency limits operate
like the individual daylight currency limits but smaller in size. Daylight limits are
operational limits while overnight limits are related to capital allocation.
Positions will arise out of spot transactions and outright forward
transactions. Foreign exchange swaps do not affect the exchange position.
Derivatives also affect the currency position, but they will not be discussed here.

Individual Gap Limit and Aggregate Gap Limit

The limits on gap risks are:
Individual gap limit: Determines the maximum mismatch for any calendar
month; currency-wise.
Aggregate gap limit: Is the limit fixed for all gaps, for a currency,
irrespective of their being long or short. This is computed by adding the
absolute values of all overbought and all oversold positions for the various
months, i.e. the total of the individual gaps, ignoring the signs. This limit is
also fixed currency-wise.
Total aggregate gap limit: Is the limit fixed for all aggregate gap limits in
all currencies.
Please note the gaps expose the bank to interest rate risks and gap limits
are linked to capital adequacy requirements indirectly

Value-at-Risk
The market risk of a portfolio refers to the possibility of financial loss due to the
adverse movement of variables such as interest and exchange rates. Quantifying
market risk is important to regulators in assessing solvency and to risk managers
in allocating scarce capital. Value-At-Risk (VAR) is a method of measuring the
financial risk of an asset, portfolio, or exposure over some specified period of
time. It is often used as an approximation of the maximum reasonable loss a
company can expect to realize from its financial exposures. Value-at-risk is a
summary statistic that quantifies the exposure of an asset or portfolio to market
risk or the risk that a position declines in value with adverse market price changes.
It is the maximum loss that an institution can be confident it would lose on a

portfolio of assets due to market movements over a particular horizon. For example,
the bank might specify a horizon of one day and set the frequency of maximum
loss to 98 per cent. In such a case, a VAR calculation might reflect that the maximum
loss amounts to $1 million. Therefore, on average, in 98 trading days of 100, the
loss on the portfolio will not exceed $1 million over a one-day horizon. However,
on two trading days in 100, losses could, on average, exceed $1 million.
How does one compute VAR? Lets take an equity share of value `100
and watch its daily return over the next 100 days. On some days the share
increases in value and on others it decreases. Suppose we observe that on 98
days its value did not fall below `70 (loss of 30 per cent). Only on two days it
exceeded the 30 per cent loss. We can say the one-day VAR on the equity
share is `30 with 98 per cent confidence. This method is called historical
simulation and uses actual historical data. We can use this approach for the
portfolio approach too. A similar approach uses Monte Carlo simulation but the
distribution is worked out using random numbers. Monte Carlo simulation uses
expected values or future values, while historical simulation uses past data.
However, risk professionals do it slightly differently. This is called the
parametric approach. They measure the VAR by computing two numbers: the
mean return and the volatility or variance of returns.
According to elementary statistics, if the returns reflect a certain pattern
called the normal, or bell-shaped, distribution, all the outcomes on the wheel
can be summarized by these two numbers. The second number, the volatility,
determines how much the return is likely to deviate from its mean value. The
average return being zero and the volatility of our stock's returns, we can find
the VAR over a one-day horizon at the 98 per cent confidence level using a
simple procedure. For the calculation of VAR for our stock, we need to only
multiply today's stock price of `100 times the square root of the volatility times a
number corresponding to the 98 per cent confidence level, called the confidence
factor. The confidence factor is derived from the properties of the normal
distribution. At the 98 per cent confidence level, it is equal to 2.054.
Computation of volatility of a portfolio requires not only computing volatilities
of individual stocks in the portfolio, but also their correlations.

Question 4) Write short notes on:

a) Methods of cash-flow forecasting
b) Liquidity forecasting
c) Market instruments

Answer 4) A cash flow forecast shows the anticipated income and expenditure of the
business and resulting surplus or shortfall which will occur each month. While a
thorough knowledge of business profitability is vital, it is more important to know
the state of the business cash flow i.e. where the money is, from where it is
coming and where it is going.
Forecasting incoming cash enables a treasury to plan and manage cash

outflows and maintain solvency. In addition, cash flow projections underlie a

banks capital structure, asset valuations and strategic planning processes. Cash
flow budgeting enables organizations, and also banks and financial institutions,
to assert control of its financial situation in various ways:
Ensure adequate cash is available to make salaries and wages, pay
suppliers and cover operating expenses
Time capital expenditures and investments based on projected revenues
Grow strategically through expansion and/or acquisitions
Anticipate and address potential deficits proactively
Invest surplus capital for maximum return
Methods of cash-flow forecasting
Direct forecasting would mean computing anticipated cash receipts and
disbursements. Receipts are accounts receivable from sales, asset disposals,
and miscellaneous proceeds. Whereas disbursements include rent and/or lease
payments, payroll, accounts payable to vendors and suppliers, dividends and
debt servicing. To develop a direct-method of cash flow projection, a bank should:
determine projected revenue.
estimate timing and amount of receipts (Accounts Receivable or AR)
identify any additional expected cash inflows, such as loans, refunds, and
deposits
compile all expenses and other payables
estimate payment dates for disbursements (Accounts Payable or AP)
calculate the amounts in cash disbursements forecast.
To forecast cash flow through an indirect method, a bank should consider
the projected income statements of the project.
Liquidity forecasting
Great significance attaches to assessment/ forecasting of short-term liquidity
of any central bank operating in a market. This is crucial for sound management
of monetary policy and ensuring smooth functioning of financial system. The
central bank needs to regularly announce the stages of this policy to help market
participants.
Dealing with any possible mismatches in the demand and supply of liquidity
at regular intervals forms the cornerstone of this function. Liquidity management
function also serves the task of steering the direction of the operating target
(viz., the short-term interest rate).
The central bank is the single supplier of bank reserves. Its assessment
of liquidity begins by capturing the movements of the balance sheet components with a view to
estimating aggregate inflows and outflows. This will give them a
picture of the prevailing or likely liquidity position.
9.2.2 Market Instruments
The financial market is characterized by two elementscapital and money
markets. Equity or debt securities, the two intermediate to long-term financing
source with maturities of more than one year, are part of the capital market. The
money market on the other hand provides short-term funds to the government
and government bodies. These are debt issues with maturities of one year or
less. There are several players in the money market which is characterized by
various instruments. These instruments consist mainly of government securities,
securities issued by private sector and banking institutions. We have already

discussed the market instruments in Unit 3.

Question 5) Capital adequacy is one of the major indicators of the financial health of a banking
entity. Explain about capital adequacy and its ratio measures.
Also explain the ratios that are necessary under the assets quality.
Answer 5)