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As we said, this book is structured in an attempt to build the foundations of a clear understanding of the role of a treasury within a financial institution, the special functions of a development institution, and the specific risks that are associated with funding and managing debt.

In Chapter 1 we offer an introductory view to banking, development banking, and the role of the treasury within a financial institution. We present the fundamental activities of banking as lending (Section 1.2), borrowing (Section 1.3), and investing (Section 1.4). In Section 1.5 we offer a brief picture of how a financial institution is structured and in particular where the treasury is placed. In Section 1.6 we introduce development banking.

In Chapter 2 we discuss what can be considered the single most important problem in fixed income, curve construction. No attempt to value a financial instrument can be considered serious without a careful construction of its discount and index curves. In Section 2.1 we lay the foundation for the problem and in Section 2.2 we describe the instruments available in the market to construct a curve. In Section 2.3 we discuss the fairly recent development of the simultaneous use of multiple instruments to build a curve. The even more recent use of overnight index swaps to discount cash flows is approached in Section 2.4, where it is inserted in the historical evolution of the perception of credit risk when valuing derivatives. We conclude the chapter with Section 2.5, the first numerical example section, in which we lead the reader through the bootstrapping of an interest rate curve. Like the other numerical sections that will follow, the examples will be limited only to those calculations that the reader could then independently replicate on, say, a spreadsheet or in a simple VBA piece of code, such as the one presented on the web site.

Chapter 3 is dedicated to credit. Given the fact that a treasury's main activity is raising debt, credit is central to it, and this chapter attempts to understand its fundamental concepts. In Section 3.1 we describe what characterizes credit as an asset class and what its main underlyings are. We end by introducing credit default swaps (CDS) upon whose risk neutral definition of survival we shall base further credit considerations. In Section 3.2 we show the three main approaches to credit modeling and we settle on the preferred choice, for our purpose, of intensity based model. We conclude the section with a useful and rigorous toolkit for obtaining survival probabilities from CDS spreads. In Section 3.3 we discuss the fair value of loans and we dedicate a considerable space to issues specific to development banking. In Section 3.4 we conclude the chapter with the numerical example of pricing the same loan issued by a development institution to four different borrowers.

As introduced earlier, the reasons for the focus on emerging markets in Chapter 4 are twofold. As a text dedicating considerable attention to development banking, it is important to discuss the regions and the markets where this takes place. At the same time, under a financial point of view, emerging markets offer an invaluable example of phenomena such as liquidity and capital control. After attempting a definition of the essentially nebulous concept of emerging markets in Section 4.1, we touch upon the financial characteristics typical of these markets such as liquidity, capital control, and credit risk in Section 4.2. We continue with Section 4.3 where we see the role played by emerging markets in development banking (or vice versa). In Section 4.4 we present two case studies of realistic projects involving the action of a development institution in an emerging market.

Chapter 5 is dedicated to the most important instrument we deal with and the essence of debt: bonds. In Sections 5.1 and 5.2 we introduce the idea of bonds and the essential concepts associated with it, such as par, duration, and–the most fundamental of all–yield. In Section 5.3 we discuss the credit element of bond and we understand how to express it through proxies such as asset swap spread and how to view it in terms of CDS spreads. We continue in Section 5.4 with a look at how to price illiquid and/or distressed debt (using as an example in Section 5.4.2 the default of Greece); on this particular topic in Section 5.5 we try to estimate the numerical value of a coupon of a real emerging market entity.

In Chapter 6, after having built the necessary knowledge, we finally approach the topic of treasury. In Section 6.1 we return to the all-important concept of asset swap and we discuss how funding is essentially seen through it. In Section 6.2 we discuss what it means to search for ever-smaller funding cost, the main role of a treasury desk, and what it entails in terms of risk and valuation. In Section 6.3 we look at how a development institution differs from a normal investment bank. In Section 6.4 we revisit the concept of benchmark in the context of a development bank's borrowing and investment strategies.

In Chapter 7 we analyze some of the risk and challenges facing treasury operations, irrespective of whether it is within a development institution or a desk within an investment bank. In Section 7.1 we return to the concept of leverage and see it in terms of capital requirements. In Section 7.2 we discuss what replication and hedging means in terms of pricing and what it means to price a financial instrument when no hedging or static hedging is carried out. We continue the chapter with a view on risk management. First, in Section 7.3 we discuss the management of risk associated with financial variables. In Section 7.3.1 we look at interest rate and FX risk and its management through static hedging. In Section 7.3.2 mentions briefly the explicit treatment of credit risk. We continue in Section 7.4 with a look at the different types of funding risk that are typical of the situation where a pool of debt and loans needs to be managed. In Sections 7.4.3 and 7.4.5 we offer two numerical examples of estimating refinancing and reset risk in a loan/debt portfolio.

We finish the book with Chapter 8 where we draw some conclusions from our discussion. We stress how credit is present in any corner of the financial landscape, and finally, as a way of putting everything together, we imagine we are setting up a treasury operation and we recap what the fundamental steps would be.

A few interesting topics, which would have nonetheless disrupted the flow of the main text, have been presented in a series of appendices. Finally, in the chapter, About the Web Site, we direct the reader to a web site where we offer some implementations of numerical techniques presented in the preceding chapters.

Treasury Finance and Development


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