Risk Management in Banking and Insurance · Interest Rate Risk Management

Funds Transfer Pricing and Yield Curve Explained

Updated 11 October 2026 · Fact-checked

Funds transfer pricing (FTP) is an internal method by which a bank's treasury charges lending units for funds and credits deposit units for funds raised, at a rate matched to maturity from the yield curve. It separates margin earned from interest rate risk. Solve questions by finding the matched rate, then computing each unit's spread.

Understand Funds Transfer Pricing and Yield Curve

A bank raises money through deposits and borrowings and lends it out. Branches that gather deposits and units that make loans are different. If you only look at the bank's total interest income, you cannot tell which unit created the profit.

Funds transfer pricing (FTP) solves this. The bank's treasury acts as an internal market. It charges the lending unit a transfer rate for the funds it uses. It credits the deposit unit a transfer rate for the funds it supplies. The difference between the customer rate and the transfer rate is the unit's own margin.

The transfer rate should match the maturity or repricing of the product. A 5-year fixed-rate loan is charged a 5-year rate. A 3-month deposit is credited a 3-month rate. The rate comes from the yield curve, which plots market yields against maturity. The mismatch between asset and liability tenors is left with the treasury. So the interest rate risk is managed centrally, not by the business units.

The yield curve is usually upward sloping, but it can be flat or inverted. Term structure theories explain its shape:

Expectations theory: long rates are the average of expected future short rates. A rising curve means markets expect short rates to rise.
Liquidity preference theory: investors want a premium for lending long, so long rates exceed expected short rates by a liquidity premium.
Market segmentation theory: each maturity has its own supply and demand, so rates at each tenor are set separately.
Preferred habitat theory: investors prefer certain maturities but will move if the yield difference is enough.

A bank uses the curve to set transfer rates and to judge how a shift or twist in the curve will change its earnings and value.

Key rules to remember

Unit spread (lending unit): Spread = Customer lending rate − Transfer rate charged; This is the margin earned by the business unit for credit and customer service.
Unit spread (deposit unit): Spread = Transfer rate credited − Deposit rate paid; This rewards the unit for raising funds cheaply.
Treasury (ALM) spread: Treasury spread = Transfer rates charged to lenders − Transfer rates credited to depositors; Weight by amount. This is the result of the maturity mismatch, kept with the treasury.
Total net interest margin check: Sum of all unit spreads + Treasury spread = Bank's net interest income; Use it to confirm your allocation is complete.
Forward rate from spot rates: (1 + s₂)² = (1 + s₁) × (1 + f); f is the one-year rate one year ahead. s₁ and s₂ are annual spot rates for 1 and 2 years.
Expectations theory: Long rate ≈ average of expected short rates over the period; Liquidity preference adds a positive premium to this.

How to solve Funds Transfer Pricing and Yield Curve questions

Use this order for any numerical or descriptive question on FTP and the yield curve.

1Identify each product: amount, customer rate, and tenor or repricing date.
2Read the matching transfer rate from the yield curve given. Use the repricing tenor for floating-rate items and the maturity for fixed-rate items.
3Compute the lending unit spread: customer rate minus transfer rate.
4Compute the deposit unit spread: transfer rate credited minus deposit rate.
5Multiply each spread by the amount to get rupee margin. Divide by the year fraction if the period is not one year.
6Find the treasury result as the difference between transfer charges and credits. Check that all margins add up to the bank's net interest income.
7For theory questions, state the shape of the curve, name the theory, and explain what it implies for rates and the bank's risk.
8Close with a recommendation: who bears the risk, and what should be hedged or repriced.

Quickest way: Match, subtract, reconcile

When to use it: Use this for numerical questions with a yield curve table and several products.

Write each product in one line: amount, customer rate, matched transfer rate.
Subtract in the right direction: lenders get rate minus FTP, depositors get FTP minus rate.
Multiply by amount and add up the unit margins.
Compute net interest income directly from actual rates. The difference from the unit margins is the treasury result.
Write one line on who holds the interest rate risk.

Common mistakes in Funds Transfer Pricing and Yield Curve

Using one pooled average cost of funds for every loan.
It is simple, and students remember the old single-pool approach.
Fix: Use a transfer rate matched to the loan's tenor or repricing date from the yield curve. A pooled rate hides maturity mismatch.
Reversing the spread direction for depositors.
Students apply the lender formula to both units.
Fix: Remember: lenders earn customer rate minus FTP. Depositors earn FTP minus deposit rate.
Using the loan's maturity for a floating-rate loan.
Tenor and repricing period get mixed up.
Fix: Match floating-rate items to the time until the next repricing, not the final maturity.
Saying an upward curve always proves the market expects rates to rise.
Expectations theory is learned alone.
Fix: Note that under liquidity preference theory part of the slope is a premium. State that the curve reflects expectations and premium.
Leaving the treasury result out of the answer.
Students stop after computing business unit margins.
Fix: Always show the treasury spread and reconcile the total with net interest income.

Worked examples

Example 1

A bank's yield curve gives FTP rates of 6.0% for 1 year and 7.0% for 5 years. Unit A lends ₹10,00,000 for 5 years at a fixed 9.5%. Unit B raises a ₹10,00,000 one-year deposit at 5.0%. Compute each unit's annual margin in rupees and the treasury result for the two items.

Show the solution

Unit A is charged the 5-year rate of 7.0%. Spread = 9.5% − 7.0% = 2.5%. Margin = 2.5% × ₹10,00,000 = ₹25,000.
Unit B is credited the 1-year rate of 6.0%. Spread = 6.0% − 5.0% = 1.0%. Margin = 1.0% × ₹10,00,000 = ₹10,000.
Treasury charges A 7.0% (₹70,000) and credits B 6.0% (₹60,000). Treasury result = ₹70,000 − ₹60,000 = ₹10,000.
Check: actual interest income ₹95,000 − interest paid ₹50,000 = ₹45,000. Unit margins plus treasury = ₹25,000 + ₹10,000 + ₹10,000 = ₹45,000.

Answer: Unit A earns ₹25,000, Unit B earns ₹10,000, and the treasury earns ₹10,000, totalling ₹45,000. The treasury result is positive here because the curve is upward sloping, but it carries the risk of funding a 5-year asset with a 1-year liability.

Example 2

One-year spot rate is 6% and two-year spot rate is 7% per annum, compounded annually. Find the implied one-year forward rate one year from now, and state what a rising curve means under expectations theory and liquidity preference theory.

Show the solution

Use (1 + s₂)² = (1 + s₁)(1 + f).
(1.07)² = 1.1449.
1 + f = 1.1449 ÷ 1.06 = 1.08009.
f = 8.01% approximately.
Expectations theory: the market expects the one-year rate to rise to about 8.01%, so the whole slope comes from expected rate rises.
Liquidity preference theory: part of the 8.01% may be a premium for lending long, so the expected future short rate may be lower than 8.01%.

Answer: The implied forward rate is about 8.01%. Under expectations theory this is the expected future rate. Under liquidity preference theory it equals the expected rate plus a liquidity premium.

Exam tips

In numerical questions, always show the matched transfer rate with its tenor before computing any spread.
Show the treasury result and reconcile it to net interest income. This earns marks and catches errors.
For theory, name each term structure theory in one line and link it to what the curve shape implies for the bank.
Close FTP answers with a recommendation: who should own the risk, and whether to hedge or reprice.
In MCQs, read carefully whether the unit is a lender or a depositor before choosing the spread direction.

Practice questions from Interest Rate Risk Management

Funds Transfer Pricing and Yield Curve in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Funds Transfer Pricing and Yield Curve: frequently asked questions

What is funds transfer pricing in banks?

It is an internal pricing system where the treasury charges lending units and credits deposit units at matched transfer rates. It lets the bank measure each unit's true margin. It also moves interest rate risk to the treasury.

How does the yield curve link to FTP?

The yield curve gives market rates for each maturity. The bank reads the transfer rate for a product from the point on the curve that matches its tenor or repricing date.

What is the difference between expectations and liquidity preference theory?

Expectations theory says long rates reflect only expected future short rates. Liquidity preference theory adds a premium that investors demand for holding longer-term securities.

Why does the treasury hold the interest rate risk under FTP?

Business units are charged a matched rate, so their margins are locked in. The mismatch between asset and liability tenors is left with the treasury, which manages it through ALM and hedging.