Sikkim Manipal University 4th Semester Spring 2011

Name

: Alaji Mamadou Cire BAH

Roll No.

540910685

Subject Treasury

: Management

Subject Code : MF0007

Program

: MBA Semester 4

University University

Sikkim Manipal

Learning Centre : KnowledgeWorkz Limited (02544)

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Alaji Mamadou Cire BAH 540910685

MF0007 SET 2

Sikkim Manipal University 4th Semester Spring 2011

MBA SEMESTER 4 Treasury Management MF0007 SET - 2 1. Explain loanable fund theory and liquidity preference theory Answer: Loanable Funds Theory. Many theories have been propounded about interest from the time of classical Economics to contemporary Economics. Investment being a function of interest rates; the stimulating impact of interest rates on the economy is very significant. Loanable Funds theory makes an improvement on the classical theory. Money can play a decisive role in saving and investment. In turn, the saving and investment determine the income level. According to this theory, rate of interest is the price that equates the demand and supply of loanable funds. Loanable funds are defined as the sums of money supplied and demanded at any time in the money market. Classical theory talked about money supplied as a result of savings of the people. This theory takes into account money resulting from savings of the people and money resulting from credit creation of the banks. Thus, Loanable Funds Theory redefines the supply side. Demand side is also redefined by this theory. Demand for money comprises demand for investment (as per classical theory) and the demand arising from need to hoard the money. Money borrowed may not be invested immediately. It may be hoarded and invested in the near future at an opportune moment for investment. Classical Theory held the rate of interest as a determinant of saving and investment. Loanable Funds Theory holds that savings, investment, credit creation in the economy and the demand for money arising out of a need to hoard the money determines interest.

Alaji Mamadou Cire BAH 540910685

MF0007 SET 2

Sikkim Manipal University 4th Semester Spring 2011

Liquidity Preference Theory J.M. Keynes propounded this theory. He held that interest is a purely monetary phenomenon in that the rate of interest is determined by demand and supply of money. Interest is considered to be the reward for making the people to part with liquid money i.e., cash. People prefer to hold their wealth in the form of cash rather than in the forms of assets like bonds and securities. Demand for money arises due to demand to hold cash. Demand to hold cash arises due to the role of money as a medium of exchange and as a store of value. It is used as a medium of exchange for transaction motive and as a precautionary motive. Store of value arises due to speculative motive. The demand for money is the total of money needed for all these there motives. The liquidity preference schedule expresses the functional relation between the quality of money demanded for all these motives and the rate of interest. As per the Liquidity Preference Theory, the equilibrium rate of interest is decided by the interaction between liquidity preference function and the supply of money. Any change in the liquidity preference alters the demand for money and thus causes a change in the interest rate. In the same way, any change in money supply also has its effect on the interest rate. Prof. Hansen criticizes Keynes Theory on the same ground on which Keynes criticized Classical Theory. The liquidity preference function depends upon level of income. To know the level of income, we should know the rate of interest 2. Explain the objectives of foreign exchange control and management Answer: Objectives of Foreign Exchange Control and Management Generally, the central banks have the following objectives in foreign exchange control and management. Facilitating Economic Development: Developing the economy and country through providing infrastructure, strengthening the defense of the
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Alaji Mamadou Cire BAH 540910685

MF0007 SET 2

Sikkim Manipal University 4th Semester Spring 2011

country and establishing basic industries require import of machinery, equipment and technology. The foreign exchange is controlled so as to make it available for strengthening the country basically in all its requirements. Even during abnormal conditions as war, the country needs to import a lot of equipment including a higher quality of import of crude oil for the movement of troops and defense equipment. By managing the foreign exchange, the central bank makes it available for such unavoidable purpose. Rationing Foreign Exchange: Developing countries generally import more than what they export. Therefore, there is always insufficiency of foreign exchange to meet the import demands. For that matter imports cannot be curbed blindly. Many of the exporters import raw material, base metals, equipments, technology and such other things in order to manufacture and export. Therefore, the central bank intervenes in order to control the imports without affecting the exports. This is done by way of rationing the foreign exchange among the various segments of the country that are in need of importing one or the other thing. Supplementing Trade Controls of Government: Trade Control aims at the control of foreign companies entering India. The trade control has the objective of ensuring that foreign companies entering India are not setting up an adverse position against the interest of the economy. While the trade controls regulate physical transfer of goods, equipment and technology, the central bank supervises the method of payment for imports and repatriation of proceeds of exports through foreign exchange control. Trade control is concerned only with imports and exports. Exchange control is more comprehensive encompassing all exports and imports, capital transactions and the invisibles. Managing Excess Inflows of Foreign Funds: Excess inflows of foreign funds pose as many problems as shortage of foreign exchange. In the year 2007, the problem for the RBI is to manage the huge inflow of foreign exchange into the country. India is regarded as a favored destination for investment by major investors in almost all the countries. This is causing a huge inflow of foreign investments into the country. In addition to that,
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Alaji Mamadou Cire BAH 540910685

MF0007 SET 2

Sikkim Manipal University 4th Semester Spring 2011

the remittances made by NRIs have increased so much that India is accounting for about 20% of the total remittances taking place in the entire world in 2006-07. When the funds are coming in, the RBI has to release an equal amount in rupees to the recipient in India. This will result in inflationary pressure on the economy. Moreover, the external value of rupee may go up affecting the exports of the country adversely. Therefore, the central bank must encourage liberal usage of foreign exchange to meet such a situation. Control of Hawala Transactions: Hawala market is a market for conversion of rupees into foreign currency illegally. The Hawala market creates a distortion in the legal market. It will act as a parallel market defeating the efforts of the central bank. Through exchange control, the central bank attempts to curb such activities. Curbing Activities of Terrorists Organizations: Both the World Bank and the IMF are very much concerned about the flow of the money of the terrorist organizations through the legal channel like banks through benami accounts. Most of the transactions involve foreign exchange for buying the arms and ammunitions from different foreign countries. Both the world bodies introduced the Know Your Customer concept to prevent such transactions. With foreign exchange controls, the RBI can do a good job in this respect. 3. Explain the role of liquidity risk management in Asset liability management. Answer:Role of Liquidity Management (ALM) Risk Management in Asset Liability

The Asset-Liability mismatch can do any of the two things: it may make the bank run out of cash leading to borrowing at a higher cost or selling the investment premature at a loss, or at a loss of profit. If liquidity planning is not proper, the banker may run out of cash very often. To meet the emergency, the bank may liquidate its investments at a time when the market for such securities are depressed. Alternatively, the bank may go for emergency borrowing. This
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Alaji Mamadou Cire BAH 540910685

MF0007 SET 2

Sikkim Manipal University 4th Semester Spring 2011

may be a worse option, as the cost of borrowing will be very high. Such a liquidity risk will depict itself in impairing the profitability of the bank. The second thing is that the bank may have lent at a lower interest rate of interest, whereas the renewal of the deposit may have to be made at a higher rate. In both the cases, a strain is created on the profit margins. The profit margins ultimately get reflected in the Balance Sheet in shaping up thenetworth of the bank (capital+reserves). ALM tries to preserve the networth of the bank at as a high level as possible. In other words, it strikes a balance between the liquidity and profitability. It preserves the profitability and the networth of the bank without endangering the liquidity position of the bank. Liquidity Risk Management plays a very crucial role in ALM. For the banker, liquidity is a devilish angel. It can enhance networth. At the same time, it can also destroy the networth depending upon how it is managed. Managing liquidity through its measurement as a first step is very important for the survival of the bank. It tries to achieve sufficient cash assets at all points of time. Through the achievement of this objective, it reduces the chances of the bank facing a liquidity crunch in the future. It can be ensured through liquidity risk management that enough cash is carried always without impairing profitability so that the bank has no problem in meeting the demand of the customers. The liquidity problem that may materialize for one bank is not confined to that bank alone. It may spread to the whole of the banking system. As each bank is lending to other banks or maintaining deposits with other banks, the liquidity problem of a bank will make it to withdraw from other banks, thus creating a problem for others also. It may also create a chain effect in the whole of the banking system. Moreover, the depositors may undergo the trauma of incredibility of the whole banking system for some time. It is the duty of the management to measure and manage the liquidity not only as a part of day- to- day management, but also for planning it for different types of scenario in the future. The Management must imagine the various scenario of adversity regarding liquidity and develop an action plan for each one of the scenarios. The asset that is regarded as a liquid asset in the conventional sense may turn out to be illiquid due to the market and participants having a uniform
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Alaji Mamadou Cire BAH 540910685

MF0007 SET 2

Sikkim Manipal University 4th Semester Spring 2011

attitude or behaviour. Organised markets run on the principle of contrarian thinking. If an investor thinks that a security is worth buying, another one thins it is worth selling at the same point of time. That is how buying and selling takes place. If all the investors think that it is worth selling, then no trade will take place. Avoiding mismatches in the cash flow, or in the maturity profile, or in the assets and liabilities help us in carrying out liquidity risk management. The RBI has provided guidelines to the banks to manage the liquidity risk by preparing the Statement of Structural Liquidity (refer to Annexure 13-A-I given in unit 7). An effective tool can be developed through the use of the concept called, maturity ladder. The maturity ladder can be used to measure surplus or shortage of funds at specific maturity dates. As the statutory reserve cycle is 14 days, a time span of 14 days is selected as relevant period for the first two legs of the maturity profile. Each time span selected for calculating the maturity profile is called a time bucket. According to the RBI Guidelines and the appendices provided, the time buckets for preparing the maturity profile can be identified as given below: 1 to 14 days 15 to 28 days 29 days to 3 months 3 months to 6 months 6 months to 1 year 1 year to 3 years 3 years to 5 years More than 5 years

While determining the maturity buckets of specific investments, the SLR investment, which is considerable in volume, is assumed to be not liquid. To be classified as liquid, the securities must be included in the category, Held for Trading. Such securities must be included in the trading book of the bank. The holding period of such securities should not exceed 90 days. The volume of
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Alaji Mamadou Cire BAH 540910685

MF0007 SET 2

Sikkim Manipal University 4th Semester Spring 2011

securities and their composition must be clearly specified. The stop-loss limit must be stated. They should also be marked-to-market (the value of the securities should be compared to daily or weekly market values and any increase or decrease in the market value should be recorded as profit or loss in the books). The defeasance period of securities should also be specified. Defeasance period is the period required to sell the securities in the secondary market or the time taken by the securities to mature.

Alaji Mamadou Cire BAH 540910685

MF0007 SET 2