Module: 4 - Managing Financial Risks

Different tools discussed earlier help to detect and assess extent of asset-liability mismatches on account of different categories of risks. As the next step it necessary to identify the specific options available to manage or mitigate the adverse effects of these risks.

There are three different but related ways of managing financial risks.

1. The first is to purchase insurance. This is a viable option only for management of certain types of financial risks such as credit risk.

2. The second approach refers to ALM. (Asset/Liabilities Management) This involves careful balancing of assets and liabilities so as to eliminate net value changes. ALM is an exercise towards minimising exposure to risks by holding the appropriate combination of assets and liabilities so as to meet certain objectives of the firm (such as achieving targeted earnings, while simultaneously minimising risk).

3. The third approach, which can be used either in isolation or in conjunction with the first two options, is hedging. Hedging is similar to ALM, but while ALM involves on-balance sheet positions, hedging involves off-balance sheet positions. The most basic derivative products used for hedging are forwards, futures, swaps and options.

One of the most important factors that bankers take into consideration is liquidity. In thinly traded markets, investors pay a significant cost for entry and exit if they require liquidity for short periods. Currently, only banks and PDs (Primary Dealers) can create liquidity in Government securities through repos. Repos in PSU and corporate bonds is still a non-starter.

Ready forward or Repo is a transaction in which the parties agree to buy and sell the same security at an agreed price at a future date. It is a combination of securities trading (involving a purchase and sale transaction) and money market operation (lending and borrowing). The repo-rate represents the borrowing/lending rate for use of the money in the intervening period. Internationally repos are versatile instruments and used extensively in money market operations. In India repos were discouraged by clamping severe restrictions on their use on account of large-scale violations of laid down guidelines leading to the 'securities scam' in 1992. However subsequently repo trading was permitted to be resumed after plugging all loopholes in their operation. All dated government securities are eligible for trading in the repo market.

Repos can be for any period. While earlier there was a minimum period of 3 days, this has since been withdrawn. The RBI has been using repo instrument effectively for its liquidity management, both for absorbing liquidity and for injecting funds in to the system.

Pursuant to the recommendations of the Narasimham Committee Report on Banking Reforms (Narasimham Committee II), it was decided in principle, to introduce a Liquidity Adjustment Facility (LAF) operated through repo and reverse repo since 5th June 2000.

Under this scheme, (i) Repo auctions (for absorption of liquidity) and (ii) reverse repo auctions (for injection of liquidity) will be conducted on a daily basis (except Saturdays). But for the intervening holidays and Fridays, the repo tenor will be one day. On Friday, the auctions will be held for three days maturity to cover the following Saturday and Sunday. With the introduction of the Scheme, the existing Fixed Rate Repo has been discontinued. The liquidity support extended to all scheduled commercial banks (excluding RRBs) and Primary Dealers through Additional Collaterialised Lending Facility (ACLF) and refinance/reverse repos under Level II, have also been withdrawn. Export Refinance and Collateralised Lending Facility (CLF) at Bank Rate will continue as per the existing procedures. Like-wise, Primary Dealers will continue to avail of liquidity support at level I at Bank Rate. The funds from the Facility are expected to be used by the banks/PDs for their day-to-day mismatches in liquidity.

Interest rates in respect of both repos and reverse repos will be decided through cut off rates emerging from auctions on "uniform price" basis conducted by the Reserve Bank of India, at Mumbai.

Derivatives are financial instruments that derive its cash flows and, therefore, its value by reference to an underlying instrument, index or reference rate. Derivative instruments can be classified as asset-liability based instruments, forward based contracts, swaps, options or some combination of the above. Such combinations may create synthetic financial instruments whereby the combined characteristics mirror those of another financial instrument. Further, derivatives may be classified as exchange-traded or over the counter. Exchange traded derivatives tend to be more standardised and offer greater liquidity than OTC contracts, which are negotiated between counterparties and tailored to meet each other party's needs.

Certain derivatives can be structured from existing assets or liabilities. For example, cash flows from certain assets can be disaggregated and repackaged into derivative securities designed to meet specific investor needs. These securities are often referred to as 'strips' for bond transactions and trenches for mortgage or loan related products. In addition, a wide variety of structured debt products with embedded options have been offered in the OTC market. Two of the more common asset liability based derivatives that could be introduced or developed in the Indian markets are Asset Backed Securitisation and Strips.

First, Asset Backed Securitisation provides the issuer with a more flexible, cheaper and there are two broad definitions of securitisation. The first is the usage in connection with replacement of traditional bank lending by securities in the capital market. It is also used in the narrower sense to refer to the issuance of asset backed securities, which are tradable instruments supported by a pool of loans or other financial assets. The interest and principal payments on the loans provide the cash flows required to pay interest and principal to investors. Securitisation has many advantages.

1. Rapid means of managing the fluctuating stock of underlying assets.

2. Second, it removes the assets from the balance sheet of the originator, thus liberating capital or other liabilities for other uses such as expansion of assets, etc. Certain conditions, however, are required to be satisfied to qualify for off-balance sheet treatment in the absence of which the assets concerned will be consolidated with the seller's balance sheet for risk asset ratio purpose.

3. Third, securitisation replaces receivables with funds.

4. Fourth, the transformation of previously illiquid assets into tradable securities enables originating institutions to make more flexible use of their balance sheets. In particular, greater liquidity of traded assets permits better management of credit risk through reduction of excessive concentration in particular areas or diversification of exposure into sectors with more attractive risk/ return profiles.

5. Fifth, asset backed securitisation enables originators to remove the market risk resulting from interest rate mismatches by transferring it to investors.

Strips, an acronym for separate trading of registered interest and principal of securities are the different components of a conventional bond separated and traded as distinct securities. A 10-year gilt, for example is strippable into 20 half-yearly coupons and one final redemption. The end result is a series of 21 zero coupon securities, with maturities of 6, 12, 18 months and so on. Strips are very useful instruments for participants in the financial markets. Paradoxically, they can offer safety and stability to one type of investor and be highly speculative for others. Unlike bonds that pay annual or half-yearly dividends, the total return on a strip is known at the time of purchase. Thus, strips give certainty of return, by removing reinvestment risk, but are much more sensitive to changes in yield. While the attractiveness of Strips to speculators arises from their greater leverage, the certainty component of Strips is attractive to those with long-term investment horizons. Through investment in a portfolio of strips, an investor could thus, in principle, achieve more easily a desired pattern of cash flows.

A major advantage of strips is that it helps development of a zero coupon risk-free yield curve. This could be used as a benchmark for pricing floaters and other derivative instruments. For banks, strips offer the special advantage of a trading instrument and an instrument for duration management. The Government Securities market in India has the necessary size to make Strips a success. There are, however, several structural issues that need to be addressed before introducing strips.

In the absence of MIS and slow pace of computerisation, the RBI has suggested traditional gap analysis as a suitable method to measure interest rate risk. The analysis begins with constructing a maturity gap report. This report categorises assets and liabilities according to the time remaining to their repricing or maturity in specific time periods known as 'repricing' buckets. The time buckets range from one month and beyond one year. Categorising assets and liabilities lacking definite time frames into specific time periods (buckets) varies according to institution. RBI guidelines permit banks to make reasonable assumptions while categorising these items.

The maturity gap approach enables a bank to measure for each time period or bucket the positive gap or the negative gap. A positive gap (asset sensitive) indicates that more assets than liabilities will reprice in a given time period. In this case earnings tend to increase as interest rates increase because more assets than liabilities reprice at higher rates. A negative gap indicates (liability sensitive) that more liabilities than assets will reprice in a given time period. If rates increase, earnings will be adversely affected. However, the gap approach does not adequately address the rate sensitivity of longer-term fixed rate instruments, the value of which can change dramatically without affecting short-term interest income. Duration analysis can complement gap analysis and can be used to analyse the financial condition of a bank with a complicated series of repricing mismatches. Duration analysis can add significant insights into the interest rate risk exposure of an institution. However, a caveat will be in order. Duration analysis presupposes the existence of a parallel yield curve.

Interest rate risk is an aspect of normal banking operations that has become increasingly important since the deregulation of interest rates. Interest rate exposure associated with a mismatching of asset and liability maturity or duration gap can be controlled using a variety of techniques, which fall into the general classification of direct and synthetic methods. Direct restructuring of the balance sheet relies on changing the contractual characteristics of assets and liabilities to achieve a particular duration or maturity gap. On the other hand, the synthetic method relies on instruments such as futures, options, interest rate swap and customised agreements to alter balance sheet exposure. Since direct restructuring may not always be possible, the availability of synthetic methods adds a certain degree of flexibility to the asset/liability gap management process. This flexibility can be further enhanced if new financial instruments used to hedge or profit from interest rate changes are allowed to be introduced in the Indian market.

In the absence of exchanges, derivative products, which are widely used overseas in managing interest rate risk, are forward rate agreements and interest rate swaps.

The forward rate agreement is an off balance sheet contract between two parties under which one party agrees on the start date (or trade date) that on a specified future date (the settlement date) that party will lodge a notional deposit with the other for a specified sum of money for a specified period of time (the FRA period) at a specified rate of interest (the contract rate). The party that has agreed to make the notional deposit has thus sold the FRA to the other party who has bought it. On the settlement date, a cash settlement is made by one party with the other calculated by reference to the difference between the contract rate and the 'settlement rate'. The settlement rate is the market rate of interest prevailing on the settlement date for the FRA. The instrument has been developed out of the forward cash market. The advantage of FRAs over the forward cash market is that no principal sums are transferred on the settlement date and thus banks can easily adjust their interest rate profiles without the credit risk associated with a cash deposit or having to affect their liquidity positions.

Since the payment is made at the beginning of the FRA period rather than the end (which is the normal basis on which interest rates are quoted), the actual cash settlement is computed as the present value of the amount that would normally be received at the end of the period. This present value is calculated according to a formula agreed at the outset of the contract and is normally the end of period amount discounted for the FRA period at the settlement rate.

FRAs can be used for risk management or for trading. FRAs allow a borrower or lender to 'lock in' an interest rate for a period that begins in the future thus effectively extending the maturity of its liabilities or assets. Banks can use FRAs as an integral part of their management of interest rate risk with a typical FRA book consisting of a portfolio of FRAs of varying periods and currencies. FRAs are an important product that banks can market to their corporate customers as part of a cash management service. When a customer takes out a FRA, the bank will be left with an open interest rate position that it can close with an FRA in the inter-bank market or carry against its existing interest rate profile.

Interest rate swaps are over-the-counter (OTC) contracts between two counterparties for exchanging interest payments for a specified period based on a notional principal amount. The notional principal is used to calculate interest payments but is not exchanged; only interest rate payments are exchanged.

An interest rate swap can achieve any of the following:

1. Alter the cost of existing or generally available borrowing from fixed to floating rate or vice versa.

2. Convert the rate of return on an asset from fixed to floating or vice versa.

3. Generate a profit (or a loss) from interest rate fluctuations (if the swap is not matched with an asset or borrowing.)

The principal uses to which swaps are put flow from these three specific uses. The swap market has thus seen development of many types of swap and swap related products. Each product can be tailored to the needs of the institutions that seek to use swaps to alter the interest and currency profiles of portfolios and balance sheets. The two basic forms of IRS are the fixed-versus floating swap and the basis swap.

Banks and other financial intermediaries enter into swap transactions for trading purposes or for hedging purposes. When it acts as an intermediary for other parties, a bank arranges and administers the swap transaction. The bank acts as the principal to both sides of the swap and thus both sides rely on the bank rather than each other for performance of the deal. A bank may use swap transactions for trading purposes by taking a view on the future interest rates. A bank that expects interest rates to increase might enter into a swap deal to pay a fixed rate of interest and to receive variable amounts.

Indian banks use swaps as an integral part of their management of interest rate risk. A bank can use an interest rate swap to achieve a closer match between its interest income and interest expense, thereby reducing its interest rate risk. The decision to use swaps will depend on the needs of customers and the size of the open interest rate position that it is prepared to run. A bank may use swap transactions to hedge existing assets and liabilities. If a bank finds itself with a preponderance of fixed rate assets and variable rate liabilities, an increase in interest rates could have a significant negative impact on earnings. To hedge against this possibility, the bank might enter into a series of swap contracts so as to effectively convert its variable rate liabilities into fixed rate obligations. The swaps will be profitable if the interest rates go up and will be unprofitable if they go down; however its overall earnings will be stable regardless of the direction in which rates move. Although banks tend to manage their swap portfolios on a deal by deal basis, larger banks often engage in portfolio hedging or management.