Risk Latte - Interview Test #4: Job Interview of trainee Treasury Sales Executive

Interview Test #4: Job Interview of trainee Treasury Sales Executive

Team Latte
April 24, 2007


The following questions were asked to a candidate who appeared for a job interview for the position of Treasury Sales Executive in the Treasury/Global Markets team of a multinational bank in Asia . The candidate was a fresh certified accountant with less than one year's work experience with a non-bank financial company, and as such had no experience of working in a commercial bank or with Treasury operations of a bank. For the Our Comments section Team Latte has been assisted by another corporate FX sales professional working in the same bank

It should be pointed out that the candidate failed the interview and did not get the job.


Interviewer's Question :

Your client is a corporate who has recently received an approval for a term loan of $50 million by a financial institution in Germany ? The loan will be used for working capital expenses of his factories in India . He has however not availed of the line and drawn any portion of the loan. His base currency is INR (Indian Rupee), i.e. the P&L and the balance sheet are both in INR. Do you think he will have an FX exposure due to this loan?

Candidate's Answer :

No, if there is no draw down of the loan then it has not entered his books and hence there is no FX risk there.

Our Comment :

There is certainly an FX exposure (risk) there for the company. The timing of the drawdown will certainly affect his financial statements. Say, today, when the loan is approved the USD/INR is 43.00, and when the company draws down the loan (assuming there is 100% drawdown) say, in ten days time the USD/INR moves to 42.50 this certainly translates into lesser Rupees for the same amount of Dollars. Therefore, even though indirect there is an FX risk in this case.


Interviewer's Question :

If I say to you that he has an FX exposure, would you then be able to suggest as to how the company can hedge that FX risk?

Candidate's Answer :

Not available.

Our Comment :

If a loan in foreign currency (FCY) is not drawn then the company can buy a forward contract whereby it goes long on the Rupee (INR) and short on the FCY. In this case the company can short a USD/INR forward contract (i.e. it buys Rupees and sells US Dollars) for a week or a month for the whole or a partial amount of the loan, until the time, it decides to draw down the loan. This is provided of course, that such an hedge is permissible within the laws by the Reserve Bank of India . Of course, the company can also buy call options on the Rupee and put option on the USD (equivalent to buying a put on USD/INR) if such options are available in the market.


Interviewer's Question :

A corporate is long Dollar-Yen (USD/JPY) at 115.00 and long Euro-Dollar (EUR/USD) at 1.30. In a month's time Dollar-Yen moves up to 120.00 and Euro-Dollar moves up to 1.38. In cross currency terms this means that in a month, since the corporate takes the positions, the Euro-Yen (EUR/JPY) moves up from 149.50 to 165.60.
So, the return on the Dollar-Yen in a month's time is 4.35% and the return on Euro-Dollar is 6.15%. And thus if we add them up we should get the return for the cross currency Euro-Yen, which should be then equal to 10.50%. But in terms of the currency value of the cross product above, the return on Euro-Yen turns out to be 10.77%.
Is this an anomaly or simply a rounding off problem?

Candidate's Answer :

Obviously, it is a rounding off problem as 10.50% return is very close to 10.77% return so they are the same.

Our Comment :

This is in fact a very bad answer and something that is not expected from anyone who is seriously considering making a career in the financial markets. The problem relates to the concepts of geometric and arithmetic returns and how they are calculated. The rationale behind geometric return is that financial assets - including FX rates - are supposed to follow a geometric Brownian motion.
If you calculate returns using the formula , i.e. the ending value minus the initial value divided by the initial value, then you are using an arithmetic measure and you'll get the answer of 10.50% above. This will certainly not match with the cross-currency, EUR/JPY, return as the cross-currency value is not additive but rather is multiplicative as in: . Therefore, the return measure and the value measures will not match. However, if you calculate returns using the natural logarithm formula then you are using a geometric return, or what we call a lognormal price relative, and then the above returns will match. This is because and therefore the log return of the Euro-Yen is exactly equal to the sum of the log return of Euro-Dollar and Dollar-Yen. And hence both returns will turn out to be 10.23%. In fact, 10.23% is the correct return in the above case.


Interviewer's Question :

A company in India (base currency is INR) balance sheet has loans in both US Dollars and Euros. The loans are shown in local currency units. If the company does not hedge any of these foreign currency loan exposures then what material impact will they have on the financial statement of the company? What can you suggest to the company?

Candidate's Answer :

The FCY loans need to be marked to market on local currency basis on the date that the annual or interim accounts are made and any profit or loss from that MTM exercise should be reflected in the income statement as other income or loss. But a lot of companies don't mark to market their foreign currency loans and show them at historical values. This is incorrect. They should then hedge their FCY loan exposures with forward contracts or currency swaps and the profit and loss from that hedge should also show up as other income in the income statement. Hedge accounting is actually complex and there are GAAP or International Standards guidelines to follow.


Interviewer's Question :

If the company does indeed mark-to-market the forward contracts or currency swaps but the contracts have not yet expired then how you can realize the profit or loss on the income statement?

Candidate's Answer :

Well, then the unrealized gains or losses from the forward contracts which have not yet expired cannot be shown as other income or loss in the P&L but the forward contracts or swaps should be shown as "contingent liabilities" in the notes to the accounts. Once again, I am not very familiar with accounting issues here but I know that the accounting of off-balance sheet exposures are very detailed sometimes complex under different account standards.

Our Comment :

No specific comments there, as the questions pertain to accounting issues of off-balance sheet exposures and they may sometimes become quite treacherous to handle, especially with foreign currency exposures in inter-company accounts. It is indeed true that a lot of companies in the emerging market economies do not MTM their loan or other balance sheet FX exposures. Moreover, sometimes companies tend to capitalize an FX loss but if there is a gain from FX exposures they take it to their P&L statement as other income. Some companies on the other hand choose to manipulate the size of their balance sheet with any FX movement. We know of a company which had fixed asset investments offshore in foreign currency, which showed up on the asset side of its balance sheet. Every six months when the interim accounts were prepared the offshore assets were revalued in FX terms and the "revaluation reserve" on the liability side was adjusted accordingly. This maybe misleading, at times to any third party observer.


Interviewer's Question :

What is the objective of asset-liability management within the context of a bank's treasury function?

Candidate's Answer :

Not available

Our Comment :

The objective of asset-liability management (ALM) is multi-faceted. At its simplest level the problem can be understood as follows: all customers money in the form of deposits and saving & current accounts are a bank's liability on which it pays interest to the customers. All loans that a bank makes out to companies and other institutions are its assets on which it earns interest. The core revenue of the bank is the difference between these two interest flows - he difference between the interest that it earns on the loans and the interest it pays to the customers. The objective of an ALM is to maximize this interest income. However, there are constraints to this exercise. The assets and liabilities, being financial in nature, are subject to interest rate (market) and counter-party (credit) risks. Maximizing revenues can increase the risks significantly. The interest rate risk manifests as the duration (first order) and the convexity (second order) of the cash flows from interest streams. These need to be minimized, or at least the streams of the cash flows need to be immunized from these risks. Assets minus liabilities is equal to shareholders' funds or net worth and therefore the net worth of the bank's balance sheet needs to be immunized from duration and convexity risks. Therefore, one can surmise that the basic objective of an ALM management is to maximize the revenue from interest income subject to market and credit risk constraints.


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