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1.5.3 The Treasury Desk

Of the cash used by a financial institution, some might be the institution's own and some might be borrowed, the latter with the intent of having it yield more than it cost to borrow in the first place. In order to borrow, the

A schematic representation of the role of a treasury desk in relation to other trading desks. Desk 1 provides the coupon and the other desks receive the proceeds of the issuance. 100/M, 100/N, 100/Π(with Μ, N, P some integers) are fractions of the original principal, 100, of the issuance.

FIGURE 1.2 A schematic representation of the role of a treasury desk in relation to other trading desks. Desk 1 provides the coupon and the other desks receive the proceeds of the issuance. 100/M, 100/N, 100/P (with Μ, N, P some integers) are fractions of the original principal, 100, of the issuance.

institution issues bonds (which are often called notes) and this activity is carried out by the treasury.

The treasury desk, after deciding what type of notes investors are mainly going to be interested in, enters into a structure with a trading desk in which the following takes place: the investor pays the nominal value of the bond (100) to the treasury desk, the treasury desk receives the coupon of the bond from the trading desk and it pays it to the investor. In return the treasury desk pays the trading desk some floating rate (e.g., LIBOR) plus or minus a spread. At maturity the investor receives the initial principal (par value) of the bond.

In Figure 1.2 we have drawn a rough sketch of the situation. According to the type of note, the treasury desk would contact a specific trading desk. For example if the note is a simple fixed- or floating-rate note, Desk 1 in Figure 1.2 would be the vanilla interest rates desk. If the note is linked to a more complex payoff, Desk 1 would be the interest rates exotics desk. Should the note be linked to, say, an equity option, then Desk 1 would be an equity desk. Once the desk is chosen, the issuing of the note and swapping it with the desk takes place.

The institution, through the treasury desk, is now in possession of 100 units of cash. This can be used for the needs of the private side of the

A more detailed version of the relation between treasury and any trading desk in need of funds.

FIGURE 1.3 A more detailed version of the relation between treasury and any trading desk in need of funds.

bank (i.e, for lending purposes) or it can be allocated to the needs of the different trading desks. When a trader on, say, Desk 2 enters into a swap with a client, at the beginning of the trade there is no gain or loss for either party (we assume that the swap is entered at par). As the trade seasons, the mark to market (or MTM, i.e., the net value of the swap, which we shall discuss in Chapter 2) becomes either positive or negative for the trader. Should the MTM be negative, the trader needs to post collateral with the client, meaning that the trader needs cash. The treasury provides the cash (as shown in Figure 1.2) and the trader pays an overnight interest on this amount. If the MTM is positive, in which case the trader is owed by the client, the trader receives collateral from the client and he gives it to the treasury. The treasury, on this amount of cash (which it can use for general purposes), pays the trader an overnight rate, which in turn the trader passes to the client. In Figure 1.2 to avoid confusion we have not included the collateral going from the trader to the treasury: we have done so in Figure 1.3 where we show the two cases of MTM being either positive or negative.

Collateral management is a complicated process that is beyond our scope, however, we can easily see how changes in MTM for an institution are potentially dangerous in terms of liquidity. Although MTMs, as we shall see in Chapter 2, are netted for each counterparty at some high institutional level and therefore should be less volatile than individual ones, a change of sign from positive to negative can mean that an institution not only cannot

count on that collateral for its needs, but it needs to find some cash to provide collateral. This is one of the manifestations of the funding risk we shall observe in Chapter 7. Hedge funds, which are by definition poorly funded (the investors' money is invested in order to obtain the highest return with the smallest up front), are masters of structuring trades so that the collateral needed is kept to a minimum.

 
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