This topic is crucial for bankers handling investment portfolios, ALM desks, or treasury operations.
In Part 1, we covered the basics of risk management; here, we’ll explore the advanced, numerical, and regulatory aspects of the treasury environment — the very areas from which IIBF sets most questions.
This post is written especially for aspirants preparing for the upcoming CAIIB BFM Exam.
You’ll find detailed explanations of important concepts, practical examples, and a full list of expected questions with short answers.
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1. Concept of Duration & Modified Duration
Duration is the measure of the weighted average time it takes to receive a bond’s cash flows.
It reflects the sensitivity of the bond’s price to interest rate changes.
The two key types are:
- Macaulay Duration: Average time (in years) until the bond’s cash flows are received.
- Modified Duration: Measures how much the price of a bond will change for a 1% change in yield.
Formula: Modified Duration = Macaulay Duration ÷ (1 + Yield)
Example
Suppose a bond has a duration of 5 years and a yield of 6%.
Modified Duration = 5 / (1 + 0.06) = 4.72 years.
So, if the yield increases by 1%, the price falls by about 4.72%.
Duration helps in quantifying **interest-rate risk**.
A higher duration means higher sensitivity and risk, while a lower duration means lower volatility.
2. Significance of Duration in Treasury Portfolios
Banks use duration to manage the risk of their investment books.
Treasury managers aim to align the duration of assets and liabilities (Duration Matching) to immunize the balance sheet from interest-rate fluctuations.
- When interest rates rise, bond prices fall → Mark-to-Market loss.
- Short-term bonds react less to rate changes than long-term bonds.
- Duration is the first-order measure; convexity is the second-order correction.
Practical Tip: In volatile rate environments, keep the average portfolio duration short (below 4 years) to minimize MTM losses.
3. SLR Calculation – Eligible Assets & Exclusions
Statutory Liquidity Ratio (SLR) is the minimum percentage of NDTL (Net Demand and Time Liabilities) that every scheduled commercial bank must maintain in liquid assets.
Eligible Assets:
- Central and State Government Securities
- Treasury Bills (T-Bills)
- Other approved securities as notified by the regulator
Non-Eligible / Excluded Items:
- Equity Shares and Corporate Debentures
- Unapproved or unlisted securities
- Securities pledged or under lien
Only securities held in Subsidiary General Ledger (SGL) accounts are generally considered for SLR.
Banks report daily SLR positions through automated systems linked with the RBI.
4. Daylight vs Overnight Limits in Treasury
Daylight Limits
These refer to the maximum exposure that a dealer can take during trading hours (intra-day).
All such positions must be squared off before end of day.
The aim is to avoid unhedged positions after market hours.
Overnight Limits
Overnight limits apply to exposures carried into the next trading day.
They attract higher capital and are monitored by the ALCO (Asset Liability Committee) and the Risk Management Department.
Key Differences:
| Parameter | Daylight Limit | Overnight Limit |
|---|---|---|
| Time Horizon | During trading hours | After trading hours |
| Risk Exposure | Intraday market movements | Global overnight events |
| Monitoring | Dealer level / Real-time | ALCO / Risk Department |
| Capital Charge | Low | High |
5. Negotiated Dealing System (NDS) – Purpose & Scope
The Negotiated Dealing System (NDS) is an RBI-approved electronic trading platform for
Government Securities and Money Market instruments.
It enables transparency, faster settlement, and real-time monitoring.
- Participants include Banks, Primary Dealers, and Financial Institutions.
- Trades are reported and settled via CCIL using Delivery-versus-Payment (DvP).
- Enhances market efficiency, reduces manual intervention, and supports compliance audits.
NDS has replaced traditional voice-based dealing rooms, ensuring fair price discovery and risk control in the G-Sec market.
6. Bond Duration Factors & How to Reduce Duration Risk
Factors Affecting Duration:
- Coupon Rate: Higher coupons shorten duration.
- Yield: Higher yields shorten duration.
- Maturity: Longer maturity increases duration.
- Payment Frequency: More frequent payments reduce duration.
- Embedded Options: Callable/putable features alter effective duration.
How to Reduce Duration Risk:
- Shift investments to shorter-maturity bonds.
- Adopt Barbell or Ladder strategies to diversify maturity buckets.
- Use floating-rate securities whose coupons reset with market rates.
- Enter into Interest Rate Swaps or Futures for hedging.
- Match the duration of assets and liabilities to immunize the balance sheet.
7. Role of Compliance Officer & CRR/SLR Returns
The Compliance Officer is a key person in the Treasury Department responsible for ensuring that all regulatory and internal controls are followed.
- Ensures adherence to RBI guidelines on CRR, SLR, and reporting formats.
- Monitors treasury transactions to detect limit breaches and exceptions.
- Verifies correctness of returns before submission to regulators.
- Coordinates with Risk and Audit functions for periodic inspections.
- Maintains records for all NDS-based and OTC transactions.
CRR/SLR Reporting Includes:
- Daily position statements and liquidity ratios.
- Details of eligible SLR securities and holdings.
- Classification under HTM, AFS, and HFT categories.
8. Important Questions with Answers – CAIIB BFM Treasury Risk Management
Conceptual Questions
- What is the significance of Modified Duration for a bank’s investment book?
- Differentiate between Duration and Convexity.
- Why are Daylight limits important in Treasury operations?
- Explain how SLR acts as a monetary policy tool for the central bank.
- What are the main objectives of the Negotiated Dealing System (NDS)?
- State the role of CCIL in settlement of G-Sec trades.
- List the responsibilities of a Compliance Officer in the Treasury department.
Numerical / Practical Questions
- A 5-year bond with a 10% coupon and 8% yield has what approximate duration? (Answer: Around 4.2 years)
- If Modified Duration is 4.5 and yield increases by 0.5%, what is the price impact? (Answer: −2.25%)
- A bank holds G-Secs worth ₹800 crore against NDTL of ₹10,000 crore. What is its SLR %? (Answer: 8%)
- What is the difference between a Daylight and an Overnight open position in Forex dealing?
- How can a bank hedge its duration risk using interest-rate futures?
Application / Scenario Questions
- A bank expects interest rates to rise. Should it increase or decrease portfolio duration?
- What would be the impact on bond prices if the yield curve flattens?
- How does NDS enhance transparency in government security trading?
- What steps must be taken if a dealer breaches the approved Daylight Limit?
- Why is convexity adjustment necessary for accurate price sensitivity estimation?
Treasury Risk Management in Banking: CAIIB BFM Complete Guide
9. Exam-Focused Quick Facts
- Duration is expressed in years; Modified Duration indicates % price change per 1% change in yield.
- SLR must be maintained on NDTL; failure attracts penalties under the Banking Regulation Act.
- NDS facilitates DvP settlement through CCIL, minimizing counterparty risk.
- Compliance ensures no regulatory reporting errors under CRR/SLR requirements.
- ALCO defines limits; Risk Dept monitors breaches; Treasury executes trades.
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10. Conclusion & Exam Tips
Understanding Treasury Risk Management is not just for passing exams — it’s vital for every banker involved in balance-sheet management.
Focus on mastering duration calculations, regulatory ratios (CRR / SLR), and operational controls such as Daylight and Overnight limits.
- Revise formulas for Duration, MD, and Convexity before the exam.
- Read the latest RBI circulars for updated SLR % and eligible assets.
- Practice numerical questions daily.
- Revisit your Treasury Risk Management Part 2 video before the test for quick reinforcement.
Keep learning, stay compliant, and aim for conceptual mastery — that’s how you secure top marks in CAIIB BFM and apply the knowledge confidently in your banking career.
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