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SECTION A QUESTION 1 – Chapter 12 Policies and Limits a) Explain your understanding of the term Trading Policy . (3 marks) b) Provide a brief description of the following concepts as they relate to the Trading Policy as per your explanation in (a) above. i) Delegation of Duties and Limits (4 marks) ii) Authorized currencies and Instruments (4 marks) iii) Position Management (4 marks) (Total 15 marks) SOLUTION 1 a) Trading Policy is a document detailing how the activities of treasury are governed in relation to the following aspects relating to trading other day to day operations of Treasury. (From page 208) Delegation of duties and dealing limits Authorized currencies and instruments Position management Clients and counterparties Overall treasury operations. bi) Delegation of duties Activities, duties & limits delegated to Treasury by senior management. Duties further delegated by Treasury management to the dealers according to ability and market expertise. Dealers only trade according to the sanctioned limits Dealers not to be involved in any settlement or processing beyond the initiation of the deals Overall limits approved vested in one individual although delegated this person will be liable for the actions of all Treasury staff, usually the Head of Treasury. bii) Authorized currencies and Instruments Dealers only trade in currencies that have the potential to be bought and resold at a profit. Currencies must be authorized in dealers mandates and as per exchange control regulations. biii) Position Management From buying and selling of currencies, positions build up and there are laid down rules for the management of those positions. Unauthorized positions expose the bank to currency risk. Dealers must keep accurate record of positions. Transaction limits and daylight as well as overnight positions and stop loss mechanisms must be carefully delegated and communicated. Dealers are not allowed to keep speculative positions, eg keeping an open position because they believe rates will go down or keeping an overbought position because they believe rates will go up. Manipulation of exchange rates to suit the dealer’s positions is strongly discouraged. QUESTION 2 – Chapter 6 Instruments and Settlement At Basic Banking Ltd (BBL), you are employed as the corporate dealer in the Treasury department responsible for the money market desk. A ‘Premium deposit’ is one of the products provided to clients on that desk and it has the following features: Interest Rate 15% p.a Tenor 30 Days Service Charge MWK3,800 Withholding tax 20% a) A client places MWK2, 000,000 under Premium Deposit with you with all the conditions stated above. Compute the final interest amount (after all deductions) that the client pockets at the end of the investment period. (4 marks) b) Another bank Chester Merchant Bank Ltd (CMB) offers the same product with the following characteristics: Interest Rate 10.5% p.a Tenor 30 Days Service charge MWK1,400 Withholding tax for the first K20, 000 of interest absorbed by the bank. Required Comment on the attractiveness of the conditions as offered at your bank BBL and conditions as offered by your competition CMB for the same amount of investment, MWK2,000,000 (4 marks) c) Contrast the risk rating of a bond issued by the Central Bank on behalf of the government and a commercial paper issued by a reputable large institution. (4 marks) d) Give a brief explanation of the process of marking to market (3 marks) SOLUTION 2 a) Interest Less Tax Charge @ 20% Less Service Charge Final Interest = = = Deposit X Rate% X Days/365 2,000,000 X 0.15 X 30 / 365 24,657.53 = = = = 0.8 x 24,657.53 19,726.02 19,726.02 - 3,800.00 15,926.02 b) Interest Less Tax Charge @ 20% Less Service Charge Final Interest = = = Deposit X Rate% X Days/365 2,000,000 X 0.105 X 30 / 365 17,260.27 = = = = Absorbed by the bank since interest is less than K20,000 0 17,260.27 - 1,400 15,860.27 Despite the high service charge MWK3, 800 at BBL compared to MWK1, 400 at CMB, the higher interest rate (15% at BBL compared to 10.5% CMB) is enough to cover both the charge and the Tax charge. Conditions are better at BBL. c) Securities issued by the central bank, Treasury bills, Local registered stocks, Treasury Notes and Bonds have the full backing of the government of Malawi and carry virtually no risk as the government never defaults on debt. However on the international market these securities are subject to rating on the basis of country risk and have some perceived level of default depending on country risk. Commercial paper on the other hand although issued by reputable large institutions will have more risk than Central bank issued securities as companies can go into liquidation no matter how sound they may be. d) Marking to market – is the process of restating the carrying value of an asset or liability to equal its current value. Under FAS 115, financial instruments held in trading accounts must be marked to market by increasing income to reflect unrealized losses. QUESTION 3 – Chapter 3 Treasury Operations – Front office a) Provide any three drivers that explain volatility of exchange rates in the foreign exchange markets. (3 marks) b) The following is an extract from the exchange rate sheet of a local bank. PAIR QUOTE GBP/USD ## EUR/USD ## USD/ZAR ** USD/CAD ** AUD/USD ## USD/CNY ** RATE 1.5089 1.2035 10.256 1.1826 0.8678 6.2352 Key: ## - So much of USD is equal to a unit of the other currency in the currency pair. ** - A unit of USD is equal to so much of the other currency in the currency pair. i) Comment on which currency is stronger between the Canadian Dollar (CAD) and the Australian Dollar (AUD) (2 marks) ii) How much South African Rand (ZAR) is needed to buy CNY100,000 (2 marks) iii) Compute the currency quotes for the following currency pairs. EUR/ZAR (2 marks) GBP/AUD (2 marks) c) From the same local bank an extract of the dealer’s currency position was taken as follows; Currency USD GBP EUR ZAR CAD AUD CNY Required Opening Position 680,000.00 (200,000.00) 50,000.00 (350,000.00) (15,000.00) 30,000.00 270,000.00 Revaluation Rate 490.00 650.00 580.00 38.00 460.00 480.00 65.00 Compute the dealer’s overall currency position in EUR terms before any trading for the day. (4 marks) (Total 15 marks) SOLUTION 3 a) Drivers of exchange rate volatility Supply and Demand Market Sentiment Market Triggers Movement of other closely linked currencies. International Trade Policy shifts, Monetary and Fiscal Policies. b) i) Convert one of the two given quotes to reflect the other form of quote i.e both quotes have to be in the same quote format against the USD. e.g Convert the AUD/USD quote to reflect the same as the USD/CAD AUD/USD = USD/AUD = = USD/AUD = 0.8678 1 / 0.8678 1.15233925 1.1515 Compared to the USD/CAD quote 1.1826 the AUD appears stronger than the CAD as less AUD is needed to purchase a unit of USD. The same conclusion should be reached converting the USD/CAD quote as follows USD/CAD = USD/CAD = = USD/CAD = 1.1826 1 / 1.1826 0.84559445 0.8452 Compared to the AUD/CAD quote 0.8678 AUD still appears stronger as more units of USD is needed to buy a single unit of AUD than is needed to buy a unit of CAD. ii) To buy CNY100,000 first convert CNY100,000 to USD and then convert USD to ZAR. CNY100,000 USD ZAR = = = USD (CNY100,000/6.2352) 16,037.98 16,037.98 X 10.2560 = 164,485.52 iii) Currency Quotes EUR/ZAR = = = EUR/USD X USD/ZAR 1.2035 X 10.2560 12.3431 GBP/AUD = = GBP/USD ÷ AUD/USD 1.5089 / 0.8678 1.7388 c) Overall Position in EUR terms Opening Revaluation Position Rate 680,000.00 490.00 (200,000.00) 650.00 50,000.00 580.00 (350,000.00) 38.00 (15,000.00) 460.00 30,000.00 480.00 270,000.00 65.00 Total Position MWK Divide by EUR Rate Equivalent EUR Overall Position Currency USD GBP EUR ZAR CAD AUD CNY MWK 333,200,000.00 (130,000,000.00) 29,000,000.00 (13,300,000.00) (6,900,000.00) 14,400,000.00 17,550,000.00 243,950,000.00 580.00 420,603.45 QUESTION 4 – Chapter 8 Asset & Liability Management a) Evaluate the need for an Asset & Liability Management (ALM) program within a financial institution b providing four well explained objectives of the program. (8 marks) b) Refer to the table of currency exchange rates to the local unit (MWK) below on two randomly selected trading days. Required Trading Day GBP/MWK EUR/MWK Dealer Position -278,000 -323,000 Wed. 12 Mar 2014 708.5241 687.9512 Thur. 13 Mar 2014 701.8564 692.5473 Comment on the currency risk of the currencies indicated in relation to the open positions and the direction of exchange rates as per the currency table for the two trading days. (7 marks) (Total 15 marks) SOLUTION 4 a) ALM is the management of the pricing and mix of assets and liabilities with a view to minimizing exposure. The objectives of ALM are as follows Controlling interest rate risk within predetermined limits Maintaining adequate levels of liquidity Setting and achieving profitable spreads Achieving adequate returns on capital and assets Holding and maintaining adequate levels of capitalization. b) Both currencies have overbought positions and the exposure to currency risk is that left overnight as in the case given the bank’s margins would be compromised if the rates were to go up as this would mean that the open positions are being covered by more expensive money than the sales that led to the open positions. Specifically the losses on each currency are as follows. Trading Day GBP/MWK EUR/MWK Dealer Positions Wed. 12 Mar 2014 Thur. 13 Mar 2014 Rate change (278,000.00) 708.5241 701.8564 -6.6677 (323,000.00) 687.9512 692.5473 4.5961 Loss/Profit 1,853,620.60 (1,484,540.30) The open position on GBP will be covered at a lower rate (specifically K6.67 cheaper) and resulting into an effective profit of MWK1.85million. The open position on EUR will be covered at an expensive rate (specifically K4.60 expensive) and resulting in a MWK1.48million loss. SECTION B QUESTION 5 – a) Chapter 1 – The General Financial System b) & c) – Chapter 7 Roles of the Central Bank a) Provide four arguments for the need of financial intermediaries within the financial system. (4 marks) b) Explain the following roles of the Central Bank as they relate to stabilizing the financial system: i) Provision of accommodation and lender of last resort (3 marks) ii) Open Market Operations (3 marks) iii) Monetary Policy (3 marks) iv) Exchange Rate Policy (3 marks) c) A REPO is both an Asset and a Liability. Explain the assertion (4 marks) (Total 20 marks) SOLUTION 5 a) Need for financial intermediaries Matching the needs of surplus and deficit units Maturity Transformation Funds management for surplus units eg fund managers, pension managers asset managers. Funding, for deficit units. Funding of operations e.g international trade International settlements, especially where it woul be costly for counterparties to trade directly with one another. Financial intermediaries bridge the gap. b) Roles of the Central Bank i) Provision of accommodation and lender of last resort The central bank accommodates banks that are running short liquidity positions if they are unable to secure funds on the interbank. The bank comes in as lender of last resort to help the banks comply with regulatory requirements and stabilizing the markets to avoid panic and bank runs. ii) Open Market Operation (OMOs) – The Central Bank conducts OMOs to control the money supply and achieve the desired level of interest rates. When there is a lot of liquidity the reserve bank sells securities and thereby reducing the excess. When there a liquidity squeeze the Central bank would buy securities and as a result injecting liquidity. In the process stabilizing both the flow of money and the level of interest rates. iii) Monetary policy is a tool used to direct the economy by means of either interest rates or the money supply. Monetary authorities use monetary policy to influence the level of aggregate demand by lowering interest rates to boost aggregate demand or raise interest rates to slow demand. Policy choice depends on what the authorities seek to achieve in terms of inflation, employment, GDP growth. iv) Exchange rate Policy is another addition to the monetary policy tools that is used to achieve the same goals. The authorities can choose from various exchange rate policies depending on their overall objectives, either fixed exchange rate, freely floating, managed float. Authorities sell/buy currency to the market to affect local currency liquidity positions and the level of interest rates and inflation. c) A REPO is a tool used by interbank counterparties to manage liquidity, under the REPO arrangement a counterparty running a short liquidity position enters into an agreement to sell off securities for cash to satisfy immediate liquidity gap with an undertaking to buy back the securities at the end of the agreed period. When the counterparty receives cash it is recorded as a loan in its books (a liability) and the securities surrendered will be received at the end of the REPO period and therefore recorded as an asset in the books. The same transaction will be interpreted in reverse for the other counterparty with both an asset and a liability. QUESTION 6 – Chapter 9 Bank Supervision and Returns a) Provide two justifications of the need for exchange control. (2 marks) b) Describe the exchange rate regime that is currently being used by the Central Bank of Malawi and clarify the role of the Central Bank in that identified regime. (8 marks) c) Identify five returns that commercial banks report to the Central Bank with an explanation of why it is necessary for banks to comply with the reporting requirements for your identified returns. (10 marks) SOLUTION 6 a) Exchange control is necessary for the following reasons To ensure harmony of the foreign exchange market. To avoid the flight of foreign reserves and preserve the country’s sustainable foreign exchange reserves (as measured by the import cover). To advance major economic objectives eg attraction of Foreign Direct Investment (FDI) for growth, inflation control, employment, protection of a strategic sector against foreign competition etc. To protect the interest of the masses/the general public so that authorized dealer banks do not take undue advantage of their position in the financial markets. Exchange control regulations currently in use in Malawi Restrictions on capital account - Prior approval for inward and outward portfolio investments is to be sought from Reserve Bank beforehand. Retention rules for foreign exchange earned or owned by residents – 20% of all export proceeds must be immediately sold to ADBs upon receipt and the exporters only retain 80% in their FCDA accounts. Exchange control restrictions on current account – the current exchange control regulations do NOT impose any controls/restrictions on current accounts. Externalization of foreign currency - any payment for goods and services brought to Malawi must have the prior approval of the Central Bank and follows a strict authorization process that includes the confirmation of whether the same goods or services cannot be obtained from the local market. b) The current exchange rate regime is a freely floating regime. The price of the local unit, the Malawi Kwacha is determined on the foreign exchange market purely by the forces of demand and supply. The Reserve Bank allows the markets to work freely to determine the MWK exchange rate against all trading currencies. The role of the Central Banl is thus limited to only Supervision of the ADBs to ensure other exchange control regulations are being adhered to to maintain the harmony of the foreign exchange markets. No influence is put on the determination of the exchange rate in terms regulation. c) Returns submitted to the Central Bank Balance Sheet – Important so that the Central Bank knows the structure of the Assets and Liabilities of the reporting commercial bank and on a consolidated basis for the whole banking industry. The same information is further reported to the International Monetary Fund (IMF) and World Bank for the compilation of global/world data. Income statement – to show bank’s profitability Liquidity Risk return – Shows the assets and liabilities of the bank as they relate to liquidity risk especially in maturity bands. The Central Bank can thus have a view of the overall liquidity risk for the bank and determine whether the bank is properly safeguarding depositors funds, again it allows the bank to know the liquidity position on a global basis for the whole market. Capital Adequacy – banks that fail to meet capital requirements are not fit to continue in operations as going concerns as they pose a risk to the proper function of the financial market. Risk is in failure to safeguard depositors’ funds and a potential for systemic risk that would bring the whole financial system down. Large exposures – that is exposure that may have a bearing on the liquidity position of the reporting institution and thus its balance sheet structure. Minimum reserve balance and Liquiditry assets Risk exposures – Market risk, Liquidity risk, credit risk, counterparty risk, operational risk. All covered currently under Basel II reporting to the Central Bank and enables the Bank to determine the commercial banks’ ability to absorb shocks and thus hold capital levels adequate for the kind of risks they face. QUESTION 7 – Chapter 10 RISKS a) Explain how a gap/mismatch in assets and liabilities for a bank may arise and how this would affect the balance sheet of the bank (5 marks) b) Refer to the table of the asset & liability profiles for a given foreign bank. Maturity Band Up to 1 Month 2-3 Months 3-6 Months 6-9 Months 9 - 12 Months Over12 Months Assets (US$) 18,620.00 6,524.00 7,481.00 7,582.00 8,547.00 10,524.00 Liabilities (US$) 14,250.00 5,241.00 8,423.00 4,512.00 9,527.00 11,542.00 The bank earns 7.5% on all its assets across all the maturity bands and pays 7.8% in the up to 1 month band and 6.5% for all the other bands for all Liabilities. Required i) ii) Calculate the bank’s Asset/Liability re-pricing gap for each maturity band and indicate whether the gap is an asset or liability. (5 marks) The bank has just been downgraded by the credit rating agencies and interest rates earned on the assets fall by a percentage point while interest rates paid on liabilities go up by the same margin across all the maturity bands. Compute the net interest paid/earned before and after the downgrade and comment on the effect of the downgrade on the bank’s asset liability gap. (10 marks) (Total 20 marks) SOLUTION 7 a) A gap exposure arises from the differences in maturities and or re-pricing of assets and liabilities that are interest rate sensitive. It all stems from the structure of the assets and liabilities on the balance sheet for a bank. Assets i.e the loans extended to clients are on a long term basis and the liabilities I.e the deposits that support those loans are ususally on a short term basis. This results in a mismatch in the maturity structure of these assets and liabilities and hence the gap. This is managed through a bank’s Asset & Liability Management (ALM) activities. b) i) Maturity Band Assets Liabilities Re-pricing Gap Sensitivity Income Decrease if Rates Up to 1 Month 18,620.00 14,250.00 4,370.00 Asset 2-3 Months 6,524.00 5,241.00 1,283.00 Asset 3-6 Months 7,481.00 8,423.00 (942.00) Liability 6-9 Months 7,582.00 4,512.00 3,070.00 Asset 9 - 12 Months 8,547.00 9,527.00 (980.00) Liability >12 Months 10,524.00 11,542.00 (1,018.00) Liability Fall Fall Rise Fall Rise Rise 3-6 Months 7,481.00 8,423.00 (942.00) 7.50% 6.50% 1.00% -9.42 6-9 Months 7,582.00 4,512.00 3,070.00 7.50% 6.50% 1.00% 30.7 9 - 12 Months 8,547.00 9,527.00 (980.00) 7.50% 6.50% 1.00% -9.8 >12 Months 10,524.00 11,542.00 (1,018.00) 7.50% 6.50% 1.00% -10.18 3-6 Months 7,481.00 8,423.00 (942.00) 6.50% 7.50% -1.00% 9.42 6-9 Months 7,582.00 4,512.00 3,070.00 6.50% 7.50% -1.00% -30.7 9 - 12 Months 8,547.00 9,527.00 (980.00) 6.50% 7.50% -1.00% 9.8 >12 Months 10,524.00 11,542.00 (1,018.00) 6.50% 7.50% -1.00% 10.18 b ii) Net Interest Earned Before the Downgrade Maturity Band Assets Liabilities Re-25pricing Gap Interest Earned Interest Paid Margin Net Interest Earned Up to 1 Month 18,620.00 14,250.00 4,370.00 7.50% 7.80% -0.30% -13.11 2-3 Months 6,524.00 5,241.00 1,283.00 7.50% 6.50% 1.00% 12.83 Net Interest Earned After the Downgrade Maturity Band Assets Liabilities Re-pricing Gap Interest Earned Interest Paid Margin Net Interest Earned Up to 1 Month 18,620.00 14,250.00 4,370.00 6.50% 8.80% -2.30% -100.51 2-3 Months 6,524.00 5,241.00 1,283.00 6.50% 7.50% -1.00% -12.83 Comment The downgrade affected the bank’s net interest especially in the up to 1 month band as the interest expense margin increased by 2 percentage points from just -0.3% to -2.3% and thereby increasing the expense to 100.51 from 13.11 before the downgrade. The other bands however resulted in the same absolute number in terms of interest but with a change in the sign i.e all interest earned turned to expense and all interest expense turned to income after the downgrade. The up to 1 month band was mostly affected because the bank was paying more to its liabilities than what they were getting on the assets, after the downgrade the gap widened. QUESTION 8 – Chapter 5 Various Markets in which Treasury Operates Write a report to be considered for publication in a newly introduced financial magazine on the various markets that make up the financial system. Your report must have the following structure: Introduction A discussion of at least six different markets under a separate heading with examples of products traded in that market. Conclusion. (Total 20 marks) SOLUTION 8 Report Format Introduction Body – With sub-topics discussed as follows: Primary Markets Secondary Markets Money Markets Capital Markets Spot & Forward Markets Derivatives Markets Financial Exchanges Conclusion Candidates should be marked according to the clear articulation of points that shows understanding of the markets that they choose. End of Examination Paper.