Lesson 11
Lesson 11
Treasury Management
LESSON OUTLINE
Treasury Management 351
LEARNING OBJECTIVES
– Meaning and objectives of Treasury
Management
Treasury Management is an activity associated
with managements of cash and funds in an
organisation. It is one of the core and most
important activity of financial management and
a finance manager should be aware about core
aspects of treasury management.
– Significance, Functions and Scope of
Treasury Management
– Relationship
between
Treasury
Management and Financial Management;
The object of the study is enable the students
understand
– Role and Responsibilities of Chief Finance
Officer
– Objectives of Treasury Management
– Function and scope of Treasury
Management
– Tools of Treasury Management;
– Unit level
– Internal Treasury Controls
– Domestic level
– Environment for Treasury Management
– International level
– Liquidity Management
– Treasury Management vis-a-vis Financial
Management
– Regulation, Supervision and Control of
Treasury Operations
– Role and responsibilities of Treasury
Managers
– Implications of Treasury on International
Banking
– Tools of Treasury Management
– Zero based Budgeting
– LESSOUN ROUND UP
– Financial Statement Analysis
– SELF TEST QUESTIONS
– Internal Treasury Control
– Environment for Treasury Management
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INTRODUCTION- TREASURY MANAGEMENT
Treasure management means "To plan, organise and control cash and borrowings so as to optimise interest
and currency flows, and minimise the cost of funds " or in other words "the handling of all financial matters, the
generation of external and internal funds for business, the management of currencies and cash flows, and the
complex strategies, policies, and procedures of corporate finance" It involves ensuring that proper funds are
available with the company at the time of outflow required & also that funds are not kept untilised for a good long
time...this requires investing/disinvesting funds in open ended mutual fund schemes. The scope of Treasury
management includes the management of cash flows, banking, money-market and capital-market transactions;
the effective control of the risks associated with those activities; and the pursuit of optimum performance consistent
with those risks.
OBJECTIVES OF TREASURY MANAGEMENT
We have noted above that the main function of a treasury manager is the management of funds. While managing
these funds, the treasury manager seeks to fulfill the under-noted objectives:
1. Availability of funds in right quantity
The treasury manager arranges funds for the unit. It is the duty of the treasury manager to ensure that after the
funds have been arranged in required quantity. The term quantity refers to the amount of funds required for day
to day functioning of the unit. This quantity is available to the firm either as external loans or as internal generation.
The loans quantity is arranged in the form of working capital treasury against the security of inventory and trade
receivables.
Availability of funds in the right quantity is the core objectives of treasury management. Alongside, the treasury
manager has also to ensure that the funds are just adequate for the requirements, neither more nor less. In case
funds are kept in excess of the requirement, the excess portion imposes an opportunity cost over the system,
i.e. the cost represented by the earnings which these funds would have obtained instead of being left idle. Again,
the adequacy of funds has to be determined carefully. For this purpose, the cash flows for the relevant period
have to be accurately charted out. Cash flows are the actual cash flows in this case as there can be a lag in
terms of less realization of the projected flows. Thus actual cash flows only have to be considered while determining
adequacy. Further, while actual inflows should be ascertained, as regards outflows a margin of contingency
should be maintained to take care of the uncertainties. Cash is understood here to include both cash and bank
balances plus that portion of highly liquid securities that can be converted into cash within a stipulated time
period.
2. Availability of funds at right time
The requisite funds for day-to-day working of the firm should be available in time. Timely availability of funds
smoothens the operations of the firm and brings about certainty to the quantum of inflows that would be available
at a particular point in time. What is timely is a relative matter dependent upon the situation of each case. Again
the inflows have to be actual inflows at the determined time and not projected or anticipated flows. This is
because the element of uncertainty has to be accorded due consideration. In case of a firm having a large
number of transactions, timely availability of funds is extremely important because the execution of many
transactions would be dependent upon funds position. This is relevant also for transactions involving foreign
exchange. For the purpose of treasury operations, we consider foreign currencies at par with the domestic
currency. It is assumed that the regulatory mechanism for holding foreign currency and domestic currency is the
same and there is no constraint on holding or converting currencies. For foreign exchange transactions, funds
have to be made available for meeting many critical situations. The treasury manager ensures that all the
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Treasury Management 353
receipts of funds are credited to the account of the firm well in time. Another way of ensuring timely availability of
funds is to park short-time surplus funds in liquid securities which can be sold conveniently and quickly to realize
cash. In this way, availability can be ensured without straining other resources.
3. Deployment of Funds in right quantity
Just as procurement of funds in right quantity is important for a treasury manager, equally important is to ensure
that the right quantity of funds is deployed. By deployment of funds, we mean earmarking of funds for various
expense heads, parking of short-term funds and investing surplus funds.
The expense heads can be capital expenditure and revenue expenditure. Capital expenditure involves allocation
of funds for acquisition of fixed assets. The amount involved per transaction in capital expenditure is large and
such expenditure is usually known well in advance. Revenue expenditure on the other hand is routine expenditure
for purchase of raw materials and making payment for utilities, wages and other miscellaneous items. The
number of transactions for revenue expenditure is large and the amount involved per transaction is smaller as
compared to the capital expenditure. Some items of revenue expenditure are in the form of cash payment but
the capital expenditure is mainly through bank account.
For deploying the right amount of funds, the treasury manager has to keep track of all receipts of funds.
Simultaneously, the time table of deployment of funds is to be drawn up. In this time table, the payees are
prioritized according to the urgency of their payments. There are certain expenses like important raw material
payments, utility payments etc. which have to be accorded top priority over others. Other payments like payment
to capital goods suppliers and financiers have also to be arranged in the right quantity. Apart from these payments,
some extra funds have to be kept available for meeting contingencies. The sum of all these deployments makes
the right quantum of funds to be deployed. For making the right development of funds at right time, it is necessary
to have a close tie-up with different department i.e. Purchase department, HR Department. Without this type of
tie-up, right quantity of funds cannot be deployed.
If the deployment is not in right quantity, the result can either be under deployment resulting in higher cost of
funds or over deployment resulting in funds remaining idle. In case all the requirements of deployment of funds
have been met and procurement of funds has been done in the right quantity, there is a possibility that some
amount of funds would remain in surplus with the treasury department. This surplus would be in excess of the
contingency requirements and as such can be deployed further on short term or long term basis depending
upon the quantum of funds. If the quantum of surplus is large enough, some amount from this can be earmarked
for long term deployment in investments etc. otherwise the entire surplus can be parked in short term securities.
Deployment of the right quantity of funds cannot be achieved in case the procurement of funds has not been
done in right quantity in the first place. This is because ultimately the inflows of funds shall be utilized for feeding
the outflows on whatsoever account. If the deployment has been done rightly, there shall be no bottlenecks in
the funds flow of the firm. The allocation and use of funds follow each other in a cyclical manner and both have
to be done in the right quantity for optimal use of the funds.
4. Deployment of funds at right time
A logical corollary of sourcing funds at the right time is that the funds should be deployed at the right time. The
description of the right time is a relative term and what amount of time is appropriate varies from firm to firm. The
span of time varies from a week to a month in case of purchase of fixed assets. However, in working capital
deployment, the range of time allowed may be quite narrow – say 2–3 days only. The treasury manager has to
honour the outstanding commitments on working capital account within this short span of time. Payment for wages
and utilities etc. has to be made in time to avoid any defaults. Similarly, payment to trade creditors, domestic and
overseas, has to be made within a stipulated short period of time for avoiding interest payments etc.
Timely disbursement ensures that the funds are not left idle for the shortest span of time. In case the sourcing
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and deployment of funds is well organized, surplus of funds shall soon start emerging which can be deployed in
short term liquid investments. However, if the inflow and outflow of funds is not evenly matched in the time
dimension, bottlenecks and mismatch of funds are sure to emerge. Apart from causing administrative problems
and rationing of funds, such a situation also leads to increase in cost of funds. Thus the treasury manager seeks
to avoid such situations. Timely deployment of funds is a well planned activity requiring intra-organisation coordination and liaison with banks and financial institutions apart from forex dealers.
5. Profiting from availability and deployment
One of the prime objectives of a treasury manager is to ensure timely procurement of right amount of funds and
timely deployment of right amount of funds. This objective results in administrative smoothening and paves way
for easier achievement of performance targets of the firm. Modern day treasury manager has another objective,
which is to profit from such sourcing and deployment. Profit from this function is derived as under:
Sourcing of funds at the right time and in right quantity is a result of realization of debtors and financing of
borrowings. Realisation of debtors in time has a direct impact upon profitability of the firm through decrease in
cost of holding debtors. Financing of borrowings is a capital structure decision but the actual availment of these
borrowings is the domain of the treasury manager. Adequate and timely utilization of the borrowed funds results
in the avoidance of strain on other sources of funds.
Once the funds have been sourced in correct measure, the deployment adds further to the profitability of the firm
it has been done in tandem with the pace of sourcing. Correct deployment ensures that there is no unnecessary
accumulation of funds in the firm at any point in time. Needs of every department are met as per schedule. This
action results in avoidance of special and extraordinary costs, interests and the like. With costs being in control,
surplus funds emerge from the system which is deployed profitably either as long term investments or as shortterm parking tools. Both ways, the net result for the firm is an addition to profits.
ROLE OF TREASURY MANAGEMENT AND BENEFITS
In its broadest sense Treasury covers cash management, corporate finance and financial risk management. Closer
inspection reveals that the Treasury function undertakes a range of complex and skilled tasks; liaises with internal
and external stakeholders and plays a key role in the smooth functioning and value creation of an organization.
Although the role of the Treasury function is constantly evolving, it can be broken down into 6 broad but interlinked
categories:
1. Planning and Operations
Key Activities
Key benefits
Cash flow forecasting
Subsidiary and Group financial management
Risk forecasting
Risks are identified early and mitigated
Investment appraisal
Resources are directed to the best opportunities
Tax planning
Clear and quantifiable approach to the future
Pensions planning
Tested contingencies in the event of exceptions
Co-operate with Board on strategic development
Operational risk management
Choose and operate Treasury systems
Transaction costs minimized
Negotiate, analyze and manage the fee’s and
margins of service providers
Smooth operations
Ensure quality standards of service providers
Efficiency gains
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Treasury Management 355
2. Cash and Liquidity Management
Key Activities
Key benefits
Manage internal capital market by investing and
lending to subsidiaries
Minimize external borrowing requirement
Work with the business to optimize commercial
cash flows
Optimize interest expense
Work with the business to optimize working capital
Optimize tax expense
Minimize idle cash through netting and cash
concentration
Avoid future liquidity problems
Confirmation and reconciliation of receipts
Create ‘cash is king’ culture
Timely disbursement of payments
Smooth operations and supplier relationships
3. Funding and Capital Markets
Key Activities
Key benefits
Optimization of capital structure
Optimization of Weighted Average Cost of Capital
(WACC)
Manage short, medium and long-term investments Maximize yield on assets
Ensure adequate liquidity to support the business
Minimize interest expense
Ensure adequate liquidity to meet obligations as
they fall due
Access to capital at the right time, price and conditions
Arrange liquidity for strategic events such as
M&A, Divestiture and JV’s
Removal of concentration risks
Diversify capital sources, partners and maturities
Ensure good credit ratings
Portfolio management of debt, derivatives and
investments
Ensure limits accurately reflected the borrowing
requirement (thus minimizing commitment fees)
Ensure contractual terms and covenants do not
constrain the business
Ensure hedging matches the funding profile (no over
hedging)
4. Financial Risk Management
Key Activities
Key benefits
Seek natural hedges and offsets within the business
Visibility of financial risks on an enterprise basis
Interest Rate risk management
Minimize external hedging requirement
FX risk management
Minimize impact of external risk on P&L and Balance
Sheet
Commodity risk management
Reduce volatility
Counterparty risk management
Access to capital at the right time, price and conditions
Credit risk management
Improve asset quality
Liquidity risk management
Create ‘risk aware’ culture
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Pension risk management
Certainty facilitates better decisions
Work with the business to de-risk contracts and
avoid bad debts
Scenario planning and stress testing avoid surprises
5. Corporate Governance
Key Activities
Key benefits
Ensure accurate valuation of financial instruments Ensure the financial profile represents and true and
fair view
Ensure accurate accounting of Treasury
transactions
Adequate internal controls
Implement and manage treasury policies and
procedures
Demonstrate preparedness
Provision of covenant tests and information to
investors
Reputational risk management
Provision of compliance information to regulators
Ensure accurate transaction history and audit trail
Work with internal and external auditors
6. Stakeholder Relations
Key Activities
Key benefits
Provide performance and risk analytics to Board
Access to capital at the right time, price and conditions
Manage relationship with banks and other investors Relationship benefit from proactive communication
Manage relationship with credit rating agencies
Reputational risk management
Co-operate with Board and Investor Relations on
shareholder matters
Valuable knowledge and contacts from deep
involvement with financial markets
Ensure the Treasury function is understood and
valued within the business
Tangible financial results in the form of cost savings,
efficiency gains, yield enhancement and protecting
profitability
SIGNIFICANCE OF TREASURY MANAGEMENT FUNCTION
The Treasury function in any corporate has always been important in making sure that the business has sufficient
liquidity to meet its obligations, whilst managing payments, receipts and financial risks effectively. With the ever
increasing pace of change to regulation, compliance and technology in the financial sector, Treasury has
increasingly become a strategic business partner across all areas of the business, adding value to the operating
divisions of the company: for example, working with the sales department to establish good financial contract
terms so that any trade discounts offered and the payment method agreed are beneficial to the business.
Current market conditions also reinforce the need for corporates to ensure that their financial position is managed
as efficiently as possible, with no excess working capital tied up in the business - the old adage ‘cash is king’ is
certainly as relevant today as it has always been.
Treasury departments need to cover the complete financial environment; from capital structure and long term
investments to liquidity and working capital management. If Treasury can drive improvements in the Purchase-
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Treasury Management 357
To-Pay and Order-To Cash cycles, there can be a direct effect on the overall debt and investment requirements
and thus on the capital structure required in the business.
The question then is: if the Treasury function is becoming more of a business partner, how can the department
manage its time to ensure that day to day administration, processing and transaction execution is completed
using the minimum of resource? The answer is that larger companies automate the majority of their daily financial
processing and administration tasks, supported by policy standards, control and monitoring processes, embedding
financial best practices across the whole business. Integrating corporate systems with those of their banks can
achieve significant levels of automation, reducing the amount of time that needs to be spent on tasks such as
calculating the daily cash position.
At the same time, the efficient use of secure systems can minimise operational risk, increase operational security
and maximise straight through processing. Add to this automatic reconciliation of bank account data and Treasury
can then manage exceptions rather than every item, giving them the time to devote to delivering value-added
services across the company.
FUNCTIONS AND SCOPE OF TREASURY MANAGEMENT
Government sector, business sector and the foreign sector are the major sectors of country’s economy. For
macro operations of these sectors, there is requirement of cash, currency and credit. In broader terms, all
financial resources including foreign exchange are to be made available to the industrial or business units.
Similarly, at the macro level return flow of funds in the form of taxes and repayment of loans is needed. Such to
and from movement of funds is part of the financial functioning.
Any business enterprise requires finance to start business operations. The first requirement is in the form of
capital for setting up of the project. Project finance needs long term funds. These funds can be obtained from
equity and debt both. Equity and internal accruals are considered the owners’ contribution whereas debt is
treated as the outsiders’ stake in the project. Once the company starts operations of production and manufacture,
it needs working capital funds also. These funds are required to meet the payments for raw materials and other
inputs, spares, utilities etc. The quantum of funds needed for working capital depends upon nature of the company’s
business and nature of its products or services.
The function of treasury management is concerned with both macro and micro facets of the economy. At the
macro level, the pumping in and out of cash, credit and other financial instruments are the functions of the
government and business sectors, which borrow from the public. These two sectors spend more than their
means and have to borrow in order to finance their ever-growing operations. They accordingly issue securities
in the form of equity or debt instruments. The latter are securities including promissory notes and treasury bills
which are redeemable after a stipulated time period. Such borrowings for financing the needs of the government
and the business sector are met by surplus funds and savings of the household sector and the external sector.
These two sectors have a surplus of incomes over expenditure. The micro units utilize these surpluses and build
up their capacities for production of output and this leads to the productive system and distribution and consumption
systems.
No company can operate in a vacuum. Its assets are both financial and human. As such, there are both quantifiable
and non-quantifiable factors involved in financial performance, forecasting and achievement of targets. The
company’s treasury manager is the pivot around which day to day operations of the company revolve. His operations
and performance have an impact on the company itself and the financial system and the economy in the broad
sense. An analysis of the sources of funds of business units reveals that broadly there are three categories of
resources – internal accruals of the unit, external sources from the capital and the money market and the external
sources. The same analysis holds good at the sectoral and national level. In fact, the emergence of international
financial markets can be traced to this sectoral inter-dependence, including the foreign sector and intra-national
dependence. Basically, as no country is self-sufficient, international economic and economic relations emerge.
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In a similar fashion, it would be appropriate to set out the pattern of use of funds of any company into various
sectors of the economy, including the foreign sector. Dispensation of funds for current or capital expenditures in
domestic and international markets can be separately set out. Such an analysis is particularly more relevant to
multinational corporations and branches or subsidiaries of foreign companies in whose case foreign markets
and foreign sources of supply play an important part. The head office or the holding company may spend apart
of its funds in investment in the host country, make inward remittances for working capital or investment purposes
and outward remittances for royalty and dividend payments or technical fees.
International financial markets emerged out of the need to facilitate operations of nations arising out of commercial
and financial transactions with the rest of the world. This emergence can be attributed logically to the interrelations of the economic unit with the corporate sector and of the latter with the other sectors of the economy,
including the foreign sector. It would be apt to set out here the inter-relations between micro level operations of
a treasury manager with the macro level working of the corporate sector and foreign sector. A treasury manager
is a micro unit in the financial sector. The environment he faces is competition from other similar units in the
corporate sector. Besides this, the corporate sector, in turn, is inter-linked with all other sectors of the economy.
The treasury manager is thus faced with a total environment of the economy which includes foreign sector and
it is thus necessary for him to be familiar with the international financial system, as much as to the domestic
financial system.
(1) Scope of Treasury Management of Unit Level
At the unit level, the treasury manager’s activities encompass all other management functions. The
performance of production, marketing and HRD functions is dependent upon the performance of the treasury
department. The lubricant for day-to-day functioning of a unit is money or funds and these funds are arranged
by the treasury manager. The treasury is involved in all the budgeting activities of the unit, whether these
are financial budget, costing budget, the marketing budget or the HRD budget. The feedback available
from interactions with the various departments of the company is utilized by the treasury department to fine
tune the overall performance targets of the company within the constraints of availability of currency, cash
and cash equivalents.
Treasury manager also monitors the cash flows of the unit on a continual basis. It is ensured by him that
adequate funds are made available for day-to-day working of the unit. In case there is genuine shortfall in cash
flows, the outflows are made in an order of priority with the more urgent payments being made first. The treasury
manager has two duties of taking decisions both in the areas of cash inflows and outflows. He has to integrate
the treasury function with with the production and marketing functions. The scope of the treasury management
function at the unit level can be better described in the following routine duties of the treasury manager:
1. Keeping a track, on monthly, fortnightly or weekly basis, of all cash inflows and outflows and their
variance with budget projections.
2. Maintaining a record of all receivables and payables, credit instruments, credit sales, deposits, loans
and advances etc.
3. Study regularly the quantity and quality of current assets and liabilities and position of current liquidity.
4. Assess from time to time the long-term and short-term solvency of the company and its overall solvency
position.
5. Keep liaison with stock exchanges, where the shares of the company are listed for a study of the share
price movements.
6. Keep liaison with banks and financial institutions for ant change in borrowing limits or to inform them of
any imminent changes in company’s financial position or policies. Payments of interest and instalment
of principal are to be arranged at the right times.
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Treasury Management 359
7. Keep liaison with Registrar of Companies and government departments concerned with the investment
and financing decisions for any information regarding policy changes.
8. Keep abreast with all legal and procedural requirements for raising funds and investment decisions.
9. Keep the top management or the board informed of any likely changes in the financial position of the
company due to internal factors.
(2) Scope of Treasury Management of Domestic Level
At the domestic or national level, the scope of treasury management function is to channelise the savings of
the community into profitable investment avenues. This job is performed by the commercial banks. Treasury
management is a crucial activity in banks and financial institutions as they deal with the funds, borrowing and
lending and investments. By nature of their activity, they earn their profits through operations in money or near
money claims. They borrow from the public in the form of deposits which along with other borrowings constitute
their liabilities. Their assets are mostly in the form of loans, advances and investments. As their liabilities are
mostly of short and medium term nature, funds management becomes critical for ensuring a proper matching
of assets and liabilities according to the maturity of each and their costing. Commercial banks being the
creators of credit have an additional responsibility of maintaining their image of creditworthiness, safety and
integrity.
Commercial banks are also required to observe capital adequacy norms and provide for non-performing
assets on a strict basis. Thus there are limits to which the banks can expand their credit portfolio. Banks are
also enjoined by regulations to maintain Cash Reserve Ratio (CRR) of a minimum of 3% and Statutory
Liquid Ratio (SLR) of 25% of their net demand and time liabilities. While the CRR is required to be maintained
with the RBI in the form of cash balances, the SLR is to be maintained in the form of investment in central
and state government securities. It has been observed that during times of slack credit demand, banks
invest in govt. securities to a higher extent than the statutory requirement of 25% of net DTL. This activity is
more pronounced when the interest rates are falling because the yields on govt. securities fall in such a
period, driving up their prices. Banks, which do their treasury management astutely, stand to gain
tremendously during such periods.
The gilt edged market has two forms–primary and secondary. The primary market is a wholesale market where
RBI is the underwriter and allots the securities to applicants on behalf of the government. On the same basis, the
RBI sells the repos (or repurchase agreements) of government securities to the institutions, banks, etc. to meet
the market demands. The interest rates are decided by the discounts quoted in these bids and these are market
related rates. In the primary market, RBI sells securities to banks, FIs, PF trusts, etc. RBI as the underwriter of
of government securities, makes up for any shortfall in subscription for them. But in the case of state government
securities, it only arranges for subscription.
The main features of the primary market are listed below:
– New borrowings to be made on behalf of govt. is decided by RBI and terms such as tenor and coupon
rates are announced.
– The RBI acts as underwriter and contributes to the loans unsubscribed by the public. Work of the RBI is
shared with a class of primary dealers.
– The timing and conditions, and the amounts involved are discussed by RBI with banks and FIs and
sometimes prior commitments are enlisted.
– The floatation of bonds is effected throughout the year depending on the conditions of the market and
requirements of the government.
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– The timing and quantum is also adjusted having regard to overall liquidity in the market.
– The subscription to the loans can be in cash as also in the form of rolling over of existing securities
which have fallen due for repayment.
In the secondary market, which is a retail market, trading is over the counter. Main operators in the secondary
market are the Discount and Finance House of India (DFHI), banks, FIs, PFs etc. This market is an over-the
counter (OTC) market where trading is done through phones, fax etc.
The concept of yields is important for understanding of the government securities market. Yield, as we know, is
the rate of return on an investment. In case of lending made by the banks, they stipulate a rate of interest per
annum which becomes the benchmark for their return. The actual yield may vary from the benchmark depending
upon whether the periodicity of interest is monthly, quarterly or half yearly basis. In case of government securities,
however, the yields are determined on the basis of the price at which the security is auctioned in the primary
market or the prices determined in the secondary market through sale and purchase.
Nominal Yield
Coupon rate is the rate of interest payable per annum per Rs. 100/- or the face value. If the purchase price is
different from the face value then the return is equal to (coupon rate/purchase price) x 100. This return is called
the normal yield.
Real Yield
Nominal yields deflated by the index of inflation rate, such as WPI or CPI will give real yields, which reflect the
true purchasing power of the return on these securities.
Net Yield
Nominal yields adjusted for the tax rate or payment of relevant taxes at which deduction of tax at source takes
place are called the net yield.
Current Yield
Coupon rate is the rate at which the bond carries interest. This is the nominal yield payable on on the face value
of the bond regularly and remains unaltered, say, for example 7.75% loan 2005. Current yield is equal to (coupon
rate x face value)/ cost or market price.
Redemption yield or yield to maturity
This takes into account the price paid for the bond, length of time to maturity and the coupon rate of the bond.
This is the yield which the holder gets per annum if he holds it until maturity and is the same as current yield if the
bond is purchased at par. Redemption yield is equal to current yield +/– average annual capital gain or loss (for
the bond purchased at a discount or premium as the case may be).
RBI is responsible for public debt management of the government. It does this by underwriting and subscription
to new issues not subscribed by public, by use of Open Market Operations (OMO) as a technique of sale and
purchase of government securities to control the liquidity and the interest rate structure and by use of SLR and
CRR as the method of controlling the liquidity of banking system and their contributions to government debt.
(3) Scope of Treasury Management of International Level
At the international level, the function of treasury management is concerned with management of funds in the
foreign currencies. Foreign exchange as a subject refers to the means and methods by which the rights to
income and wealth in one currency are converted into similar rights in terms of another country’s currency. Such
exchanges may be in the form of one currency to another or of conversion of credit instruments denominated in
different currencies such as cheques, drafts, telegraphic transfers, bills of exchange, trade bills or promissory
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notes. Exchange is done through dealers in foreign exchange regulated by the central bank of a country. Banks
are usually the dealers apart from other specialized agencies.
One of the important components of the international financial system is the foreign exchange market. The
various trade and commercial transactions between countries result in receipts and payments between them.
These transactions are carried out in the currencies of the concerned countries? any one of them or in a
mutually agreed common currency. Either way, the transactions involve the conversion of one currency to the
other. The foreign exchange market facilitates such operations. The demand for goods and services from one
country to another is the basis for demand for currencies in the market. Thus basically, demand for and supply
of foreign currencies arises from exporters or importers or the public having some transactions with foreign
countries.
Companies having an import or export component in their business profile have to frequently deal in forex
operations. Forex operations in a country being supervised by the central bank, reference to the central bank in
one form or the other is necessary to use foreign exchange. If the country on the whole is a net exporter of goods
and services, it would have a surplus of foreign exchange. If, on the other hand, it is a net importer then it would
have a shortage of foreign exchange. The extent of regulation of the forex market depends upon the availability
of foreign exchange in a country. If the forex is scarce, then holding and using it would be subject to a lot of
regulatory control. It also matters whether international trade forms a significant percentage of the GDP of a
nation. If it is so, then the awareness about forex regulations would be much more widespread as compared to
a situation when foreign trade forms an insignificant portion of GDP. Presently, however, with increasing
globalisation, forex dealing has become a normal part of treasury operations.
Every foreign exchange transaction involves a two-way conversion – a purchase and sale. Conversion of domestic
currency into foreign currency involves purchase of the latter and sale of the former and vice versa. These
transactions are routed through the banks. The transactions take the shape of either outright release of foreign
currency for meeting travel and related requirements or payments to outside parties in the denominated currency
via the medium of correspondent banks. For effecting payment, following instruments are generally used:
Telegraphic transfers (TT)
A TT is a transfer of money by telegram or cable or telex or fax from one center to another in a foreign
currency. It is a method used by banks with their own codes and correspondent relations with banks and
abroad for transmission of funds. It involves payment of funds on the same day, it is the quickest means of
transmission of funds. As there is no loss of interest or capital risk in this mode, it enjoys the best rate for the
value of receipts.
Mail Transfers (MT)
It is an order to pay cash to a third party sent by mail by a bank to its correspondent or branch abroad. It is issued
in duplicate, one to the party buying it and the other to the correspondent bank. The amount is paid by the
correspondent bank to the third party mentioned therein in the transferee country by its own cheque or by
crediting the party’s account. As the payment is made after the mail advice is received at the other end, which
will take a few days, the rate charged to the purchaser is cheaper to the extent of the interest gain to the seller
bank.
Drafts and cheques
Draft is a pay order issued by a bank on its own branch or correspondent bank abroad. It is payable on sight but
there is always a time lapse in the transit or in post between the payment by the purchaser of the draft to his
bank and the receipt of the money by the seller in the foreign center. As in the case of MT, there is risk of loss of
draft in transit or delay in release of payment to the beneficiary and loss of interest in the intervening period.
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Bills of exchange
It is an unconditional order in writing addressed by one person to another, requiring the person to whom the
order is addressed, to pay certain sum on demand or within a specified time period. If it is payable on demand,
it is called a sight bill. If it is payable after a gap of some time, it is called a usance bill. Such bills can be bankers’
bills or trade bills. Bankers’ bills are drawn on banks abroad while trade bills are made between individual
parties.
There are four major components of the forex markets, depending upon the level at which the transactions are
put through. These can be either
– Banks with public
– Inter-bank deals
– Deals with correspondents and branches abroad
– Deals with RBI.
In the market, there is no physical exchange of currencies except in small denominations when travelers and
tourists carry them across national borders. The medium of exchange is credit instruments or book entries in the
books of concerned banks.
Exchange rates can be spot rates or forward rates. If an importer is paying on receipt of documents, then he can
buy a foreign currency say dollars on spot basis. It means that the exchange of Indian Rupee and Dollars is
proceeding on current basis. But if the importer agrees to pay three or six months hence, his demand for dollars
might arise only after three or six months. In such a situation, the transaction is carried out through forward
transaction. The exchange of Rupee and Dollar is to take place after the stipulated time period, though the
exchange price has been pre-decided.
Just as the banks are buying and selling spot, they also do business in forward currencies. Corresponding to the
spot rate of exchange, there is a forward rate for various periods. Currencies sold or bought in forward are
subject to the influences of interest rates? both domestic and international. Forward rates also depend upon the
elative position of currencies vis-à-vis other currencies. Hence there is an implicit risk that the forward rates
contracted today may be different from actual spot rates that would prevail three or six months hence. If any
bank succeeds in forward purchases with forward sales of the same currency, it avoids exposure to the exchange
rate risk. If the forward sales and purchases do not match, the bank may have an uncovered position which it
may cover with another bank which has a contrary position. If it fails to cover with a bank, it may still do so with
the central bank of the country or with a correspondent bank abroad. If a bank takes a position uncovered, it may
take a calculated risk in the hope that the rate may move in its favour or else it may have to bear the exchange
rate differential.
When foreign exchange markets operate in a free manner, the assumption is that the exchange rates between
various currencies would be quoted at the same level at all the trading centers throughout the world. But it
seldom happens and at the best of times, there are discernible differences in exchange values across centers.
Banks and other dealers take advantage of these differences and profit from the rate difference. This operation
is called arbitrage. For example, if the Dollar-Euro parity is 1.00 in New York and 1.05 in Frankfurt, then a dealer
can sell Euros in Frankfurt, purchase Dollars and with the Dollars, buy Euros again in New York thereby profiting
from the deal.
Operations in the forex market are exposed to a number of risks. These risks are as follows:
– Credit risk arising out of lending to a foreign borrower whose credit rating is not known for certainty.
– Currency risk of trading in a currency whose stability and strength is known to fluctuate.
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– Country risks involved in dealing in the currency of a country whose political and economic stability is
uncertain.
– Solvency risks due to mismatch between current assets and liabilities of dealers and resultant default in
meeting forward commitments.
In India, commercial and most of the co-operative banks have been authorized to deal in foreign exchange.
Banks finance huge amount of foreign trade. This trade is conducted on daily basis through purchase and sale
of foreign currencies. The demand and supply of active currencies is matched by the banks from their own
stock. There are cases when the bank needs some currencies or has a surplus of such currencies. These needs
are met by buying or selling such currencies to the RBI.
The foreign exchange department of every bank draws up a position sheet for each currency daily in which
purchases and sales of the currency are recorded. The banks generally avoid taking any exchange risk by
covering uncovered balances at the end of the day. When the purchases exceed sales, the credit balance is
plus and the position is overbought. This is to be covered by equal sales of that currency. When the sales
exceed purchases, it is a situation of overselling and the same is covered by purchases of that currency.
A typical dealer in Forex may be a bank having the controlling and supervisory authority and the head office.
Actual dealings in forex would take place through authorized branches. At these branches, there are dealing
rooms and back office operations. Dealing room would perform the following functions normally:
– Quoting, negotiating and fixing rates of exchange for larger sized customer transactions involving
purchase or sale of foreign currencies.
– Arranging cover against purchase and sale of foreign currencies.
– Trading on own account, i.e. purchase/sale of foreign currencies for profit.
– Mobilisation of required foreign currency funds by swapping arrangements or purchases from other
dealers.
– Accepting customer forward contracts for purchase/sale of foreign currency and arranging cover against
the same.
The back office operations would comprise of the following:
– Consolidation of all exchange deals and provide cover operations
– Analysis of the structure of the deals for determining the future rates.
– Processing of inter-bank deals, sending or receiving contract notes or confirmation of deals.
– Follow-up work on contracts
– Transfer of funds to correspondents and their branches.
RELATIONSHIP BETWEEN TREASURY MANAGEMENT AND FINANCIAL MANAGEMENT
Finance function is a key element in the corporate activity. Its main objective is to keep the firm in good financial
health. To secure financial health, the finance manager has to perform the following functions:
– Investment functions and decisions
– Financing function and decisions
Investment function elates to the efficient use of funds in alternate activities. The aim is to allocate funds to each
activity so as to obtain optimal returns from such allocation. The short-term and long-term investment strategy
has to be planned in line with the objective of maximization of wealth of shareholders. The utilization of funds, as
and when they accrue, should take care of two prime considerations. The first consideration is that there should
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not be any idle funds and second consideration is that there should be no threat of liquidity crisis. Idle funds
have their own cost and it results in lowering of profitability. Extreme tightness of funds, on the other hand, raises
the specter of default and loss of commercial reputation. So a delicate balance between these two conflicting
objectives has to be maintained by the finance manager. It is in this context that the function of finance becomes
crucial to the survival and growth of a firm.
The financing function refers to the securing of right resources of funds at an appropriate cost and at the right
time. Here the decision is to be taken about the least cost combination of funds for capital requirements and for
working capital needs. Whether owners’ equity should be used for financing or should the firm resort to external
financing? If owners’ equity is to be arranged, what returns are to be assured? If borrowing has to be done, then
what rate of interest is to be paid?
In line with the twin objectives of investment and financing, the finance manager has to take responsibility for all
decisions pertaining to these areas. In the finance function, a macro view of the requirements and uses of funds
is to be taken. The finance manager has to arrange the funds within the approved capital structure of the firm.
The funds may be debt or equity. Once the funds have been arranged, it is left to the treasury function to utilize
these funds according to the approved parameters. Financial management is also concerned with the overall
solvency and profitability of the firm. By overall solvency, we mean that the funds should be able at all times to
meet its liabilities. The liabilities can be short-term or long-term. The long-term liabilities pertain to payment of
long-term borrowings. Internal liabilities like payment to shareholders are a matter of consideration once external
solvency has been attained by the firm. Profitability means that the firm should run its affairs profitably. It may be
possible that some segments of the firm may at times face strain upon their profitability due to macro-economic
or internal causes. But the firm should be in a position to earn reasonable return on its investment on the capital
employed. Capital employed, as we know, is the sum of own funds and borrowed funds. Profitability of operations
of the firm means that both the own funds and borrowed funds generate adequate surpluses for the firm. This
can be ensured by investing the funds in such projects which provide optimal returns.
The treasury function is concerned with management of funds at the micro level. It means that once the funds
have been arranged and investments identified, handling of the funds generated from the activities of the firm
should be monitored with a view to carry out the operations smoothly. Since funds or cash is the lubricant of all
business activity, availability of funds on day to day basis is to be ensured by the treasury manager. The role of
treasury management is to manage funds in an efficient manner, so that the operations in the area of finance are
facilitated in relation to the business profile of the firm. The treasury function is thus supplemental and complemental
to the finance function. As a supplemental function, it reinforces the activities of the finance function by taking
care of the finer points while the latter delineates the broad contours. As a complementary function, the treasury
manager takes care of even those areas which the finance function does not touch. Looked at from this point of
view, the treasury function integrates better with manufacturing and marketing functions than the finance function.
This is because the treasury department of a firm is involved in more frequent interaction with other departments.
For the purpose of performing this role, the treasury manager operates in various financial markets including the
inter-corporate market, money market, G-sec market, forex market etc.
DIFFERENCE BETWEEN FINANCIAL MANAGEMENT AND TREASURY MANAGEMENT
Following differences can be observed between financial management and treasury management:
1. Control Aspects
The objective of financial management is to establish, coordinate and administer as an integral part of the
management, an adequate plan for control of operations. Such a plan should provide for capital investment
programs, profit budgets, sales forecasts, expenses budgets and cost standards.
The objective of treasury management is to execute the plan of finance function. Execution of the plan takes
care of the issues arising in routine operations of the firm which have a bearing upon the funds position.
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Treasury Management 365
Thus the finance function of a firm would fix the limit for investment in short term instruments for a firm for
example. It is the treasury function that would decide which particular instruments are to be invested in within the
overall limit having regard to safety, liquidity and profitability. Again, the finance function would arrange the
borrowed funds for the firm but the treasury function would take care of day-to-day monitoring of the funds.
2. Reporting Aspects
Financial management is concerned with the preparation of overall financial reports of the firm such as Profit
and Loss account and the Balance Sheet. It also takes care of the taxation aspects and external audit. Based
upon the performance of the firm, budgets for the ensuing years are fixed. The reports are submitted to the top
management of the firm.
Treasury management is concerned with monitoring the income and expense budgets on a periodic basis visà-vis the budgets. The budgets are fixed department/ segment wise so as to dovetail with the overall corporate
budgets. Variances from the budgets are analysed by the treasury department on a continual basis for taking
corrective measures. The corrective measures that can be taken are pointing out of discrepancies to departmental
heads and refuse payments that are not according to approved procedures and guidelines. The treasury
department is also involved in the internal audit of the firm.
3. Strategic Aspects
The finance function is involved in formulating overall financial strategy for the firm. The top management chooses
the line of activity for the firm. The finance function firms up the investment and financing plans for the activity.
The strategic choices before the financial manager are the options of investment and financing. While making
these choices, the finance manager is taking a long-term view of the state of affairs. It is just possible that the
business of a firm may not be profitable in the initial years but it does not mean that the choice regarding
investing has been strategically incorrect. In fact, there are many mega projects where the gestation period is
even upto seven years. But given the correctness of the original assumptions, performance of the finance
function would be measured by the number of years that gets reduced in breaking even.
Strategy for treasury management is more short-term in nature. The treasury manager has to decide about the
tools of accounting and development of systems for generation of controlling reports. The maintenance of
proper systems of accounting is one of the objectives of treasury management. Another strategic objective for
treasury management would be maintenance of short-term liquidity. This is done through regulation of payments
and speedy realization of receivables.
4. Nature of assets
The finance manager is concerned with creation of fixed assets for the firm. Fixed assets are those assets which
yield benefit to the firm over a longer period of time. It can be said that the time span of a project coincides with
the span of the fixed assets. In case the fixed assets have depreciated physically by a significant measure, then
a decision has to be taken for upgradation and replacement of the assets.
The treasury manager is concerned with the net current assets of the firm. Net current assets are the difference
between the current assets and current liabilities of the firm, both normally realizable within a period of one year.
Current assets should always be more than the current liabilities for ensuring liquidity of the firm. Current assets
are the inventory, receivables and cash balances. Current liabilities are the trade creditors, statutory payables
and loan repayables within one year. To ensure a healthy level of net current assets, the treasury manager is to
ensure that the quality of the assets does not deteriorate.
As regards investments, the finance manager is concerned with long-term and strategic investments. These
investments could be funded from borrowed funds or from internal accruals. The investments are expected to
be held over a longer period of time as such day-to-day monitoring of the investments is not required. The
treasury manager is concerned with short-term investments. The tenor and quality of these investments has to
be constantly monitored by the treasury manager for ensuring safety and profitability.
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TREASURY ORGANIZATION: PICKING THE RIGHT MODEL
Organisations have extended debates on the kind of treasury they should have. The common themes include
services that the treasury should offer, the right size or structure, and the right spread of management control
There are many dimensions to the structure of a treasury organisation. Two key dimensions – range of services
and extent of centralisation of management control – define resultant organisation models. The relationship
between organisation models and factors that influence decisions on the right model to adopt.
There are various definitions of the word treasury. In its strictest sense, it refers to one function: asset liability
management, especially when used in the context of banks. In a wider sense, treasury includes a whole range
of activities encompassing various markets. A few significant activities are:
Asset liability management:
– Maturity mismatch;
– Interest rate and type mismatch; and
– Currency mismatch.
Sales and trading:
– Currency, interest rate, and credit products;
– Money market and long-tenure instruments; and
– Derivative products.
Risk management
– Back office processing, settlement, and accounting; and
– Customer and regulatory reporting.
Organisation Models: Dimensions
Any organisation can exercise its choice on the scope of the treasury functions it undertakes. In doing this, it
may be governed by a variety of considerations:
– It may choose to handle only those needs driven by utilitarian motives such as liquidity support or, on
the other hand, it may consider treasury as a “core” organisational process and hence handle the full
range of services.
– It may choose to outsource portions of the activities required or it may choose to foster these capabilities
in-house.
Independently, an organisation can also decide on the extent of centralisation of treasury management:
– It may be efficient to centralise back office processing, while the front office may need to be decentralized
to aid speedy local decision-making.
– It may be important to have a common risk management strategy, while execution may be decentralised.
A study of common practices relating to the two key influencers – the range of activities supported and the
degree of centralization or decentralisation – at treasury organisations globally suggests four models.
1. Full Service Global
Full service refers to a treasury that undertakes most, if not all, of the activities of treasury management. Global
treasury refers to one that either operates as the only treasury for all markets across the globe, or ultimately
combines all regional or local treasuries (that may exist due to legal or regulatory reasons) into a central treasury
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for pooling risks, for policies or strategies, or for both these. In this sense, management of the treasury function
in this model is very much centralised. Although this model readily lends itself to global organisations, it could
also be used by local businesses that need to access global markets.
2. Full Service Local
In this model, each treasury is a self-contained local unit dictated purely by the needs of the local business.
Thus, the treasury management function is, by and large, decentralised. While this sort of treasury is usually the
norm for a business with a local or regional spread, it may be adopted for a global organisation that operates as
a collection of highly independent business units. Again, the range of services offered is the full gamut, as
described in the full service global model above.
3. Limited Service Global
This model is different from the full service global model in that the range of services offered is limited. This could
largely be due to the fact that certain activities are kept outside the purview of treasury and are handled directly
by business units because the scale of these activities is not large enough to warrant the attention of the central
treasury. Examples are treasuries with limited or no foreign exchange trading activities, with the exposure being
either managed directly by the concerned export or import department or not managed at all. For those activities
that are included in the treasury in such a model, pooling is at a central level.
4. Limited Service Local
This model is akin to having virtually little or no treasury activities, beyond local cash and liquidity management.
These are very small decentralised treasuries where the concerned managers may also have other responsibilities
in the finance department.
ROLE AND RESPONSIBILITIES OF TREASURY MANAGER
The overall finance function starts with capital structuring, scouting for the least cost combination of internal and
external capital for financing of the project and forecasting the sources and uses of funds. In this function, one
has to coordinate with production and marketing functions and all others that constitute the management team.
The inflows and the outflows and their coordination and synchronization and meeting any gaps are the functions
of the finance manager. The treasury manager has a larger role of coordinating the apparently routine, yet
significant activities of the firm. The activities are apparently routine because a sense of repetition is involved in
these activities. Nevertheless, the activities are significant because smooth functioning of these activities paves
the way for eventual solvency and profitability of the firm. The role and responsibilities of the treasury manager
may be described as follows:
Role of a treasury manager
A treasury manager has a significant part to play in the overall functioning of the firm. At any point of time he is
engaged in a number of roles played. While the production manager or the marketing manager may be involved
in limited roles pertaining to their own fields, the roles of treasury manager intermingle with and overlap other
role sets. In any business entity which is engaged in marketing, a treasury manager could be performing a
variety of roles. The expected roles to be carried out by him would be slightly less in number in case the firm is
engaged in service activity but that does not deride the importance of treasury manager for a services organization.
The treasury manager has the following roles:
(a) Originating roles
The treasury manager inducts and originates system of accounting for the firm. Routine accounting of the firm is
then carried out along these established systems. These systems are the pivot around which the functioning of
the unit revolves. For operations of these systems, the treasury manager compiles exhaustive operations manual
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for the guidance of the users. It is expected that all the users shall comply with all important disclosure requirements
for endorsing the integrity and validity of the systems.
(b) Supportive Roles
The second role expected from a treasury manager is a supportive role. In this role, the treasury manager
supports the activities of other departments like manufacturing, marketing and HRD. The support is evidenced
through a meaningful and constructive coordination with the other departments. While doing this, the treasury
manager is acting as an extended arm of the finance manager. Allocation for expenses for every department is
made by the finance manager in the annual budget. It is the duty of treasury manager to ensure that each
department is able to spend the earmarked amount subject to completion of disclosure and documentation
formalities.
(c) Leadership Roles
The treasury manager also has a leadership role to play. This role comes into play during times of exigency. An
exigency could occur during times of systems break-down. During such periods, the treasury manager has to
make alternative arrangements for transaction processing. While doing this, he has to act like a leader and carry
the team along with him. Another example of exigency could be a situation when the firm is face to face with a
sudden and unexpected liquidity crunch. During such an eventuality, the treasury manager has to use his
ingenuity and leadership skills for tiding over the crunch. These skills could take the shape of postponing and
prioritizing payments and expediting recoveries.
(d) Watchdog Roles
The treasury department is the eyes and ears of the management. Every financial transaction passes through
his accounting system. As a processor of all the financial transactions, he keeps a watch on suspected bunglings
and frauds in the firm. He sets an example for other departments of the firm by adhering to sound accounting
practices and transparent dealings.
(e) Learning Roles
The accounting practices all over the world are in a state of constant flux due to evolution of new accounting
concepts and technological changes. The treasury manager accepts these changes with an open mind and
adopts the changes best suited to the organization. Simultaneously, he educates the other departments of the
firm also about the changes.
(f) Informative Roles
The treasury manager is the source of information for the top management regarding performance of the firm
vis-à-vis the budgets. For conveying this information, he develops a management information system suited for
the organization. This system provides concise and timely information on all the relevant parameters which
enable the top management to take decisions.
Apart from the above roles, the treasury manager has the under-mentioned responsibilities which he is expected
to shoulder along with his roles:
1. Compliance with statutory guidelines
While establishing operational systems for the firm, the treasury manager has a duty to ensure that the systems
comply with all statutory and regulatory guidelines. Particularly, he has to take care of provision regarding
taxation and other government dues. He must ensure that the system should be simple and not cumbersome.
The system should be transparent and it should protect the integrity of the transactions. Moreover, it should be
impersonal and capable of being operated on the basis of pre-established guidelines. It should be flexible also
to incorporate any subsequent changes in accounting and taxation norms.
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2. Equal treatment to all departments
While playing the supportive role, the treasury manager has a responsibility of professionalism and impartiality.
In accepting the demands for expenditure from various departments, the treasury manager has to ensure that
the role is carried out without any undue favour or bias. He has to keep the interest of the organization in mind
and not to promote intra-organisation conflicts. The support that he provides must be detached and objective.
3. Ability to network
While playing the leadership role in case of systems break-down or during periods of cash crunch, the treasury
manager should be able to exhibit traits of public relationship and networking. A crisis situation requires level
headedness and ability to think straight. What it also requires is the ability to provide comfort to all users of the
system. This can be done by exercising PR skills of a high order. Apart from this, the treasury manager should have
networking abilities for outsourcing some of the accounting work to outside agencies during the period of interruption.
4. Integrity and impartial dealings
Since the treasury manager is the watchdog of the management regarding honest and straight dealings, he has
to be impartial in his dealings. He must highlight the true state of affairs of the finances to the management. In
case of any inadvertent shortcoming on the part of his department, the same should be admitted and the whole
matter should be looked at in an impartial manner.
5. Willingness to learn and to teach
The treasury manager is required to keep himself of all the developments in the field. He should be able to pick
out the latest developments that are likely to help his organization. He must accept new ideas in an open minded
state rather than treating new ideas as a threat to his fiefdom. Simultaneously, he should be willing to teach and
inculcate the latest developments among his colleagues.
TOOLS OF TREASURY MANAGEMENT
Treasury manager is required to work in a fast changing and competitive environment. For carrying out his
activities, he has resort to certain tools and techniques. Most of the tools originate from the finance department
and as such can not be considered to be an exclusive prerogative of the treasury department. Yet it is the
treasury manager which is using these tools most extensively. The tools are being described below:
1. Analytic and planning tools
In treasury function, planning and budgeting are essential to achieve targets and to keep effective control on
costs. Analysis of the data and information is necessary for planning and budgeting. Performance budgeting is
referred to as setting of physical targets for each line of activity. The financial outlay or expenditure needed for
each is earmarked to choose the least cost mode of activity to achieve the targets. Productivity and efficiency
improves by decentralization of responsibility and that is achieved by performance budgeting, where each
department or section is made a profit center and is accountable for its targets, financial involvement and profits
in financial terms, relative to the targets in physical terms.
This type of planning involving performance budgeting is best suited for service industry say a financial services
company or bank where every department can function in a decentralized manner and achieve the targets.
2. Zero Based Budgeting (ZBB)
Another tool of analysis and performance is ZBB wherein each manager establishes objectives for his function
and gain agreement on them with top management. Then alternate ways for achieving these targets are defined
and most practical way for achieving the targets is selected. This alternative is then broken into incremental
levels of effort required to achieve the objective. For each incremental level of activity, costs and benefits are
assessed. The alternative with the least cost is then selected.
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3. Financial Statement Analysis
Financial analysis of a company is necessary to help the treasury manager to decide whether to invest in the
company. Such analysis also helps the company in internal controls. The soundness and intrinsic worth of a
company is known only by such analysis. The market price of a share depends, among other things on the
sound fundamentals of the company, the financial and operational efficiency and the profitability of that company.
These factors can be known by a study of financial statements of the company.
4. Internal Treasury Control
All economic units have the goal of profit maximization or wealth maximization. This objective is achieved by
short-term and long-term planning for funds. The plans are incorporated in the budget in the form of activities
and corresponding targets are fixed accordingly. The next step in the process is the control function to see that
the budgets are being implemented as per plans. Control is thus part of planning and budgeting in any organization.
Control is a process of constant monitoring to ensure that the activities are being carried out as per plans. It is
also noticed whether there is any divergence from the plans, what are the reasons for the divergence and what
remedial action can be suggested.
Internal treasury control is a process of self improvement. It is concerned with all flows of funds, cash and credit
and all financial aspects of operations. From time to time and on regular basis, the internal treasury control is
exercised on financial targets. The financial aspects of operations include procuring of inputs, paying creditors,
making arrangement for finance against inventory and receivables. The gaps between inflows and outflows are
met by planned recourse to low cost mix of financing.
The control aims at operational efficiency and removal of wastages and inefficiencies and promotion of cost
effectiveness in the firm. The control is exercised under phases of planning and budgeting. These phases
include setting up of targets, laying down financial standards, evaluation of performance as per these norms and
reporting in a standard format.
The quarterly and annual budgets would set the targets for each department and financial standards are set out
for each activity. Monthly budgets are evaluated by the performance sheets maintained daily and regular reports
go to the financial controller. Reporting and evaluation go together and on the basis of information system built
in the past, plans are prepared for the next period.
Following principles of internal control need to be mentioned here:
1. Control should be at all levels of management and participation should be from all cadres of personnel.
More important are specific levels of operations. The top management should concern itself with strategic
controls. The middle management is more concerned with segmental controls whereas the lower
management concerns itself with operational controls.
2. The management control can be decentralized or decentralized. In a decentralized form of control,
responsibility is given to lower managers to achieve the targets. A margin of deviation from the targets is
allowed but the basic objective of control is to see that activities are in the direction of the plan and the
budgetary targets are a guide.
3. For effective control, there has to be a system of building up of effective communication from top to
bottom and bottom to the top.
4. The control should be built upon the management information system. This function involves the collection
of data from all departments on their operations, analysis of operations and suggesting the methods of
improving the efficiency and productivity.
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ENVIRONMENT FOR TREASURY MANAGEMENT
Treasury management is carried out in the real corporate world and the corporate functioning is carried out in
the overall corporate environment. Environment for treasury operations can broadly be classified as under:
(a) Legal environment
By legal environment we refer to the legislations which govern corporate functioning. These legislations are the
one pertaining to company law, taxation, industrial regulation etc.
(b) Regulatory environment
The regulatory environment encompasses regulations regarding employment, wages, land laws, promotion of
units and closure of units etc.
(c) Financial environment
Financial environment pertains to policies regarding monetary and fiscal control, financial supervision, exchange
control etc.
ROLE OF INFORMATION TECHNOLOGY IN TREASURY MANAGEMENT
With the ever increasing pace of change to regulation, compliance and technology in the financial sector, treasury
has increasingly become a strategic business partner across all areas of the business, adding value to the
operating divisions of the company: for example, working with the sales department to establish good financial
contract terms so that any trade discounts offered and the payment method agreed are beneficial to the business.
The major role the information technology is playing in effective treasury management is as follows:
1. Automate repetitive tasks
Technology today is being leveraged to automate repetitive tasks such as data gathering, accounting, bank
polling, portfolio tracking and reporting. By automating these processes, the delays and the possibility of human
error may be minimized. Automation also facilitate information sharing across departments, offices and
geographies, and provide an accurate audit trail. Furthermore, automating these processes enable to focus on
more value added tasks, critical to providing effective decision support to management team.
2. Implement internal controls
To ensure compliance with rule and regulations, sound and effective internal controls must be implemented. The
focus should not only on system-related controls, but also on clear cut segregation of duties. In treasury
workstation, sophisticated rules must be implemented to ensure policy compliance. The solution that has obtained
a Internal audit and other compliance activities must be implemented.
3. Time saver and fraud & error detection Methodology
This best practice is a great time saver, especially when it’s time to close the books. On the first day of the accounting
close, there is a need to balance that day’s transactions, not the entire months. In treasury management system, the
source of cash transactions is the previous day’s bank data. Through the treasury management system, all repetitive
transactions are automatically tagged with the correct instructions. Most companies using a treasury management
system get 90-95% of their transactions automatically tagged accurately without any manual intervention.
4. Forecast cash flows
Effective forecasting helps manage financial risk by enabling to predict a cash shortfall or liquidity crisis, taking
into account interest rate changes and foreign exchange fluctuations. Forecasting also helps to enhance financial
returns, enabling to make more effective decisions regarding investments and borrowing needs. Finally, forecasting
helps maintain financial control by identifying unexpected occurrences for further review and action.
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5. Communicate with operating units
Operating units must be involved while building your forecasts to ensure incorporation of all the necessary and
up-to-date information. The past may not be indicative of the present so it’s important to have the latest and
updated information. There must be benchmarking resulted at the operating unit level, and the cash forecasting
results must be published. It’s important to keep a two-way flow of information by providing feedback to the
operating units based on how the actuals compare to the forecasts. The treasury forecast performance matters
must be compared to forecasts generated by other groups and/ or divisions. Significant variances may be
indicators that treasury is not yet aware of all the information that should be included in the forecast.
6. Choose a Web-based treasury management system
The full benefits of technology without unnecessary costs or delays may be achieved by selecting a web-based
treasury management system. Web-based solutions significantly reduce implementation costs and timeframes,
and enable to access the system from anywhere at any time. Furthermore, any enhancements to the system are
automatically deployed to all users, thus eliminating the need to spend internal resources on hardware or software
acquisition, testing or downloads. To ensure the security of your information, select a system with two factor
authentication and encryption technology must be selected.
7. Rethink treasury processes
There should be reassessing of the treasury workstation at transparent intervals to evaluate processes and
identify how they can/should be revised to maximize efficiencies. While reevaluating treasury management
system, the focus should not only be on data, but on experience and knowledge.
8. Pay for performance
To reinforce the importance of forecasting, portfolio management, cash consolidation, and other value added
activities across treasury department, benchmarks should be defined. The proper and effective use of information
technology in treasury operation increases the efficiency and effectiveness of corporate officers across the
treasury, investor relations, corporate finance and corporate communication function.
LIQUIDITY MANAGEMENT VIS-A-VIS TREASURY MANAGEMENT
Liquidity management ensures that the right amount of cash is available, at the right time and in the right
place, is firmly positioned as a pivotal task for every treasurer. Over the past few years, many treasurers have
made substantial progress towards increasing the visibility of their cash flow and centralising cash within
countries or regions. However, industry surveys indicate year on year that liquidity management and particularly
cash flow forecasting remain the greatest challenges facing treasurers. With credit more expensive and elusive
for many companies, it is now imperative to tackle these challenges effectively. Working capital management
of a financial institution or bank or company is some how different to that of other trading units, the process
starts with tapping of funds at lower rate in shape of deposits/borrowing and ends with investing the same in
higher rate to earn profit out of business with a margin of small portion of cash-in-hand kept to meet day to day
operation.
Efficient account and cash pooling structures are key to efficient and cost-effective liquidity management. Every
investment has a cost to the company even the shares tapped from the share holders. Deposits are tapped in
exchange of payment of interest. Borrowing has cost of payment of interest to creditors. So every fund has
dividend/interest payment risks for the banks/company. So if funds tapped are not properly utilized, the banks/
company should suffer loss. Idle cash balance in hand has no yield. On the other hand if we do not keep
balanced liquid cash-in-hand, we may not be able to pay the demand withdrawal of depositors, as well as,
installment of creditors and untimely payment for other contingent liabilities. These will lead overtrading position
to the company. So there must be a scientific liquidity management policy for the company/bank/financial institution.
Lesson 11
Treasury Management 373
Proper liquidity management can increase the turnover of business and also creates additional profit to the
company/banks. Liquidity management has great significance in modern days to the company/bankers/financial
institution, because they engage not only in retail business, but also deal in wholesale banking and investment
banking business.
Overliquidity on the other hand implies excess idle cash balance in hand. So every company should avoid both
the position and should manage the company without less/excess funds in hand i.e. just liquid position.
REGULATION & SUPERVISION OF TREASURY OPERATION
The Treasury Operations Department is responsible for treasury's middle and back office functions, all systems
services, and particularly cash management and banking relations services. Treasury operation’s cross-functional
staffs provide pricing and valuation, performance measurement, transaction and securities processing and
compliance support functions. The middle office provides quantitative analytics support and operational risk
reporting and coordinates treasury's control risk assessments related to internal corporate governance and risk
management functions.
Treasury Operations implements and manages information systems in support of treasury's asset management,
funding, pension investment, and cash operations functions.
The role of Treasury Manager, is to manage, mitigate and monitor financial risks arising due to differences in
currency basis and timing of pledges from donors, disbursements and debt service. The risk management tools
that are used include, among others, currency swaps and currency forwards, interest rate swaps and forward
rate agreements .Treasury Manager enters into a master derivatives agreement and hedges risk positions
using its counterparties in the market.
Risk management generally incorporates:
– a prudent approach to balance sheet management, with the aim of mitigating and controlling financial
risks;
– suitable risk limits and policies and procedures formulated to ensure that the limits are not breached;
and
– appropriate systems, controls and reporting mechanisms for measuring and monitoring residual risks.
In this context, the role of treasury manager typically includes:
(a) Policy Analysis: develop the risk management framework, taking into account Board’s risk preferences,
balance sheet dynamics and market limitations, as well as credit, interest rate, operational and foreign
currency risks, and the different instruments available for risk transfer.
(b) Strategy Design: advise on optimal risk transfer through a broad-based suit of risks to be hedged out
and the instruments available, based on modeling and evaluation of risk management options.
(c) Structuring, Negotiating and Executing transactions: The treasury manager is responsible to
efficiently remove interest rate and foreign currency exposure based on board-approved risk management
strategy; tactical decision-making on overall execution strategy and timing for transacting on the different
currencies to accommodate to market and liquidity limitations; benchmark counterpart market quotes
based on in-house models to negotiate prices and ensure best execution.
TREASURY CONTROL MECHANISM
Treasury management relates to most of the highly volatile instrument’s market dealing. The volume of transactions
involved in the dealings are usually heavy and risk in operation are also heavy. So any unorganisation operation
will create heavy loss for the institution. Generally control system may be related to :
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(a) Internal control of different, dealing rooms, settlement offices and control offices.
(b) Checking of unhealthy insider trading system.
(c) Mutual and ammicable solution of different conflicts of interest in dealing operation.
Internal Control System: It relates to forming policies to check leakage of profit for the institution. In treasury
operation, the role of Central Offices are vital. They should form suitable guidelines for the institution in respect
of various treasury dealing operations. There are advice dealing offices to bifract all treasury items into different
classes according to risk involvement. As treasury business is a risky business responsible positioned persons
should be delegated powers to deal in treasury operation with imposition of different limits on their discretionary
power.
Some important area should be taken (i) fixation of rates for each treasury items and (ii) fixing limits for dealers
to deal with different counterparties, with proper observation of confidentiality and adherance to best market
practice. Treasury executive should be ensured that the transactions were carried in correct manner by cross
checking during each dealing day.
For above facts the central offices should develop proper policies and guidelines for treasury operation and
should advice the dealers to deal according to policies of the following :
(i) restriction on deal in one’s own account.
(ii) timely advice to dealing offices in respect of any adverse transactions received or excess reporting.
(iii) timely submission of returns to different statutory authorities.
(iv) review of security and contingency arrangement of different offices.
(v) proper verification of compliance given by lower offices for irregularities.
Insider Dealings
Insiders are those who are in management including near and dear; and their dealings means-taking advantages
of unpublished internal informations of the corporate body. These may create price sensex situation. So these
unadvantages dealings should properly efficient internal control system should be taken by the management to
eliminate insider dealing by fixing penalties for insider dealers.
TREASURY OPERATIONS IN BANKING
All banks/financial institution (core principals and brokers) should ensure that they should try to serve for giving
best service in the market operation within code of conduct issued for time to time. Core principals should be
conducted non-investment business with private individuals should segregate them into retail or wholesale for
smooth function of business within sound guidelines. It is essential that all staff should be familiar to code of
conducts, in professional manner while entering into dealing transactions. Banks/financial institution will be
responsible for dealing actions of the staff members. So it should be segregated work for the staff members
such as no staff member control the full operation. Banks/financial institution should identify any potential or
actual conflict of interest that might arise when undertaking wholesale market transactions; and take measures
either to eliminate these practices and provide fair treatment to counter parties. Banks/financial institution should
know their counter party and their credit worthiness before entering into contract. It is good practice for principals,
subject to their own legal advice, to alert counter party to any legal or tax uncertainty which they know are
relevant to a proposed relationship or transaction. All principals have the responsibility to assessing the credit
worthiness of their counter parties, or potential counter parties whether dealing directly or through a brokers/
firms. Bank/financial institution should take measure of risk control and meet proper legal obligation for each
contract to minimize the loss. It is better to prepare a dealing mandate for each transaction. The mandate will be
helpful to clarify the extent of a relationship between core principals and their customers with responsibility.
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Treasury Management 375
Banks/financial institutions should observe confidentiality. It is essential for the preservation of reputable and
efficient market place for bank/financial institution. The transactions should not be dealt in non-market rates. So
this practice should be avoided. Adequate safeguards should be established to prevent abuse of informations
by staff members with respect to non-public price-sensitive informations.
PRESENT STATUS OF TREASURY MANAGEMENT IN INDIA
Treasury management is still in its infancy in India. It is still considered as a sub-function of the financial
management. In most of the companies, it is the finance manager which is also taking care of the treasury
function. Treasury operations are carried out professionally and systematically by some banks and financial
institutions. The first stage of evolution in treasury management is the establishment of a treasury function. The
second stage is running it as a profit center. In India, treasury operations at the micro level are expected to grow
at a fast pace with increasing integration of the Indian economy with the world economy.
Treasury management is the science of managing treasury operations of a firm. Treasury in its literal sense
refers to treasure or valuables of the Government. The valuables are nothing but the coins and the currency
which are the medium of financial transactions in the country. In the earlier days when the level of governmental
operations was comparatively smaller, there used to be a centralized treasury into which the revenue receipts of
the government were credited and from which the payments of the government were withdrawn. In a federal setup, both the central govt. and the state govts. had their treasuries for managing the inflows and outflows of
government finances.
As the size and spread of government revenues grew, it became difficult to manage the flows of cash into a
centralized treasury. The function of collecting revenues on behalf of the government was gradually shifted to
State Bank of India and other nationalised banks. These banks also started making payments on behalf of the
state governments through cash counters and through bank accounts of various government departments.
Simultaneously with the increase in size of government revenues, the corporate sector in India also grew manifold
in operations. There were companies with multi-locational set-up involving receipt and disbursement of cash
and cash equivalents at more than one places. In all such companies, the function of treasury management
developed analogous to the transfer of government treasury functions to Banks. Along with this growth evolved
the concept of profitable treasury management. Hitherto, the treasury management as practiced by the government
was a passive concept. The over-riding motive was to provide a platform for transactions and little effort was
made to evaluate the costs and expenses associated with managing large amount of currency, cheques and
other liquid instruments. Similarly, the opportunity available for making profits from holding large liquid funds
was not recognized. But with the arrival of corporate treasuries, the function of treasury management was
established as a profitable venture.
Today when we speak of treasury management, we refer to all activities involving the management of revenues,
inflows and outflows of government, banks and corporates etc. It is a general concept applicable to overall fund
management.
Government as the sovereign power is the fountainhead of all treasury operations. It creates money by printing
currency and minting coins. This money flows into various channels which take money to various users of
currency and coinage as a medium of exchange. Thus at the macro level, the treasury operations revolve
around Reserve Bank of India. RBI as a banker to the govt. creates the currency on behalf of the govt. and
manages public debt. It is also a banker to the banks and in this role, it controls the credit creation of banks.
At the micro level the concept of treasury and its management is mirrored in small corporate units which manage
the cash flows on a daily basis. As we move from the macro level to the micro level, the nomenclature of treasury
management becomes diffused. The terms treasury management and fund management are used almost
synonymously. Conceptually, the latter is a general term, applicable to the business sector, while treasury
management refers to the management of cash, currency and credit of sovereign power of the country. The
term currency here includes both national currency and the foreign currencies dealt with by the government.
376 PP-FT&FM
Historically, the treasury of a sovereign included gold, silver and other precious metals which were used as a
medium of exchange. As a ruler, the sovereign exercised un-challanged rights over all the precious metals
extracted from the earth. The booties earned from wars, foreign exploits and domestic plundering kept on
adding to the treasure chest of the sovereign. These metals were circulated in the form of coins which became
a medium of all commercial transactions in due course, replacing the earlier system of barter. The practice
continued till the nineteenth century when paper currency began to be issued.
Reserve Bank of India manages the macro treasury management of the country. This is done through
– Issue of Currency notes
– Distribution of small coins, one, two and five rupee coins and rupee notes on behalf of the government
– Maintenance of currency chests.
The currency is issued by the Reserve Bank of India in terms of the Indian Currency Act whereas the small coins
and rupee coins are issued under the provisions of the Indian Coinage Act. The provision of adequate supply of
currency and coins is the responsibility of the government which was at first discharged by providing currency
chests at the branches of Issue Department of RBI and at branches of Imperial Bank of India (which later
became State Bank of India). SBI carried out the business of Government treasury and maintained the currency
chests at all district headquarters. Later on all the nationalized banks were also entrusted with the task of
maintenance of currency chests.
The basic objective of keeping the currency chests at various places in India is to facilitate quick disbursement
of currency and coins to far flung places and also to facilitate remittance to banks. This way, the banks can remit
surplus cash to the currency chests located in their region and avoid transportation of cash over long distances.
Also, the banks can draw from the currency chests during time of need. Currency chests are the agents of the
Reserve Bank of India for keeping custody of currency and coins. Any deposit of currency and coins into these
chests implies that the money circulation has been curtailed to that extent. Similarly, any disbursal from these
chests would expand their supply. Thus expansion and contraction of currency takes place on continual basis
due to operation of the currency chest.
Government as a sovereign power has control on cash and currency circulated in the country. The issue of
currency and coins is based on the treasures of the government in the form of gold and silver stocks which
are supposed to back such issue. More recently, government securities and their promissory notes became
the basis of such issue. In fact, the coins of gold and silver were first replaced by the paper currency on the
one hand and coins of base metals like copper, nickel, bronze, zinc etc., on the other. To supplement the
available currency and to facilitate trade and business, credit instruments came into vogue in the form of
promissory notes to pay at a future date by the trade and industry. Thus on the one hand, the government
promissory notes became the basis for coins and currency rather than precious metals like gold and silver;
and on the other hand, the promissory notes of trade and industry became the source of credit instruments.
These credit instruments, particularly the safest among them such as government securities, in fact became
the medium of parking of liquid funds over a period of time. Thus apart from handling cash and currency and
bank funds, the liquid investment in government securities and mutual funds became another function of
treasury management.
Treasury function is a part of the total managerial functions. Managerial function set-up can be classified into
three broad units, viz. production function, marketing function and finance function. Production function pertains
to the building up of capacities and generation of output. Marketing function is concerned with the marketing
of the output through establishment of the sales and marketing network. In the finance function, the manager
is concerned with financing of inputs and outputs and management of funds during the entire production
cycle.
Availability of cash, currency and credit by the government, business and foreign sectors is a must for macro
Lesson 11
Treasury Management 377
operations of the economy. In broader terms, all financial resources including forex are to be made available to
the micro-economic units, i.e. the companies. Similarly, the operations at the national level involve return flow of
funds, repayment of loans, taxes, fees etc. to the government, business and foreign sector.
The finance function comes into play when the company is incorporated. With capital restructuring, efforts are
made for arriving at least cost combinations of capital for financing of a project and forecasting for working
capital. In this function, one has to coordinate with the production and operations manager, sales or marketing
manager and they together constitute the marketing team. Apart from arranging the requisite funds for
commencing an activity, the finance function is also concerned with managing the day-to-day finances of the
company. Whereas arranging project funds and working capital finance is a one-time assignment, management
of funds on daily basis is a much more astute activity requiring forecasting skills and prioritization ability of a
high order.
The inflows and outflows of funds, their coordination and synchronization and making arrangements for meeting
any gap between them is only one end of the spectrum of finance function. The other end of the spectrum is the
management of the surpluses and maximization of returns from short term funds. These two ends of the spectrum
form the core of activities of the finance function. But the handling of each of the activities requires further
specialization. Arranging of long-term funds is the domain of the proper finance function but the management of
funds required in and arising from the day-to-day activities of the firm is the domain of the treasury function.
These two have to be viewed together and analysed for overall assessment of financial efficiency. So a finance
manager need not have a treasury function or a treasury manager need not be bothered with long term
arrangement of funds. The finance manager can be termed as an arranger of funds whereas the treasury
manager can be viewed as a manager of funds.
Treasury management has both macro and micro aspects. At the macro level, the inflows and outflows of cash,
credit and other financial instruments are the functions of the government and the business sectors. These
inflows are arranged by them as borrowing from the public. In these sectors, the ratio of savings to investments
is less than one, i.e. the savings are inadequate to fund the investments. Hence the need for borrowing. They
accordingly issue securities or promissory notes which are part of the financial system. These borrowings for
financial needs are met by surplus savings and funds of the household and the foreign sector, where the ratio of
savings to investments is positive. The micro units utilize these inflows and build up their capacities for production
of output. This leads to establishment of a production system which logically leads us to the natural consequence,
i.e. the establishment of distribution and consumption systems. Once the production, distribution and consumption
systems are in place at the micro level, the generation of surpluses at the units begins. These surpluses are
channeled back into the macro system as outflows from the micro system. The inflows are the taxes paid to the
government and repayment of loans made to the banks and financial institutions. These inflows into the macro
level have to be managed by the treasury managers at the macro level.
While arranging funds for the micro unit, the finance manger aims at optimizing the value of his assets or wealth
and minimizing the burden of his liabilities. He may seek to maximise his operational profits and seek to maximise
the wealth of stakeholders of the micro unit. The basic objectives are economy, efficiency and productivity of
assets. These objectives can not be achieved at the one end of the finance spectrum unless the management
of funds at the other end of the spectrum, i.e. the treasury segment is equally triggered by the dictums of
economy, efficiency and productivity.
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LESSON ROUND-UP
– Treasury management is the science of managing treasury operations of a firm. Treasury in its literal
sense refers to treasure or valuables of the Government.
– Macro level: It is the inflows and outflows of cash, credit and other financial instruments are the functions
of the government and the business sectors. These inflows are arranged by them as borrowing from
the public. In these sectors, the ratio of savings to investments is less than one, i.e. the savings are
inadequate to fund the investments.
– At micro level, the finance manger aims at optimizing the value of his assets or wealth and minimizing
the burden of his liabilities. He may seek to maximise his operational profits and seek to maximise the
wealth of stakeholders of the micro unit.
– The availability of funds in right quantity, Availability in right time, Deployment in right quantity,
Deployment in right time and Profiting from availability and deployment are the main objective of the
Treasury Management.
– At unit level, treasury manager’s activities encompass all other management functions.
– Treasury manager monitors the cash flows of the unit on a continual basis. It is ensured by him that
adequate funds are made available for day-to-day working of the unit. In case there is genuine shortfall
in cash flows, the outflows are made in an order of priority with the more urgent payments being made.
– At domestic level or national level treasury management function is to channelise the savings of the
community into profitable investment avenues.
– At the international level, the function of treasury management is concerned with management of
funds in the foreign currencies
– Analytic and planning tools, Zero Based Budgeting and Financial Statement Analysis are the various
Tools of treasury management.
– Internal treasury control is a process of self improvement which is concerned with all flows of funds,
cash and credit and all financial aspects of operations.
– Environment for treasury management can be broadly classified as Legal environment, Regulatory
environment and Financial environment
SELF-TEST QUESTIONS
(These are meant for re-capitulation only. Answers to these questions are not to be submitted for evaluation)
1. What do you understand by treasury management? What are its main objectives?
2. What is the significant of treasury management for the top management of a company?
3. Distinguish between treasury management and financial management.
4. Describe the various tools of treasury management.
5. Bring out the importance of control in the treasury function.
CHAPTER 2
Treasury Policies for Debt,
Foreign Exchange and
Interest Rate Exposure
Management
INTRODUCTION
The previous chapter discussed how treasury policies flow from the identification and measurement of a company’s principal treasury-related financial
risks. This chapter starts with a further discussion of these risks as they relate
to debt management, interest and foreign exchange risk. It covers such questions as: ‘What factors determine a company’s treasury policies?’ ‘How does
a company establish treasury policies?’ ‘What should periodic treasury
reports look like?’ and ‘What information should they contain?’
D E BT M A N AG E M E N T
The objective of debt management is to ensure that a company has
adequate finance to fund its strategic plans and achieve its overall business
objectives. The role of treasury policies for debt management is to establish a number of prudential rules, whose purpose is to ensure that the
company always has access to the widest possible range of debt markets at
the best possible price.
These debt management policies, as with all other treasury policies, will
reflect a number of qualitative factors surrounding the company’s business.
25
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CORPORATE TREASURY AND CASH MANAGEMENT
They will include: the company’s strategic aims and objectives, the likely
cashflows being generated by the business and the present and forecast
volumes of debt, and the risk profile of the business, that is, the extent to
which its future is accurately forecastable. Whilst debt policies may vary
from company to company, they will have a number of common themes.
Loan maturity profile
A treasurer will always be concerned to ensure that re-financing risk is
minimized. This can find expression in a number of ways.
Some projects are financed on a stand-alone basis with each individual
project being separately financed. In such a situation the treasurer will
attempt to ensure that the repayment profile of the loan package that
finances a specific project will match the cashflow profile of that project
and that the loan only starts to become repayable once the project starts to
generate cash. Companies managing such projects may be those involved
in major infrastructure projects where a selection of projects may be
financed ‘on balance sheet’.
Very few companies however are in such a situation. Most have a whole
portfolio of projects, each one having its own specific cashflow profile. To
finance each project separately is impractical, since the projects are too small
and too numerous. Such companies therefore have to establish a number of
prudential rules to ensure that re-financing risk is minimized, and that loans
are capable of being re-financed from available free cashflow.
Such rules are designed to ensure that re-financing of existing debt in
any one year is kept to ‘manageable’ proportions and that loans do not fall
due for repayment when the company’s free cash flow is forecast to be
negative or when substantial incremental finance is already being raised to
finance new projects. To this end most treasurers try to maintain a relatively smooth maturity profile of their loan portfolio – that is, an even
proportion of the loans are due for re-finance on a year-by-year basis. This
spreads the burden of re-financing over a period of time. Should any of the
debt markets that the treasurer had identified as appropriate be unavailable,
another market can be selected without too great an impact on the
company’s cost of finance or loan structure.
Debt markets
Many companies are faced with a wide range of debt markets from which
they can finance themselves. However, the appetite for providing finance
from these individual markets can change from time to time. When they
TREASURY POLICIES: INTRODUCTION
27
do change, a treasurer may find that the availability of finance in any
particular market is severely restricted or the price of that finance
increases significantly.
The appetite to provide finance is often also linked to scarcity. Lenders
are often more enthusiastic to provide finance to a company if they have no
exposure to that company already and the company is a strong credit. In
managing their portfolios, debt investors will want to ensure they have a
broad exposure to a wide range of business sectors, and within each sector
to a wide range of individual companies. They want to avoid their portfolios showing excessive exposure to any one sector or company. This
spreading of risk prevents the consequent losses that can follow if there is
a downturn in one of the business sectors or one of the companies goes into
default. Consequently, treasurers need to ensure that they do not overutilize individual debt markets, otherwise when market liquidity becomes
tighter they may find themselves shut out of certain markets, or their cost
of funds may rise significantly.
Treasurers will finance their companies through the widest possible
range of markets so as to ensure, first, that when they need to undertake a
financing they get the best possible reception and terms, and second, that
whatever the state of individual debt markets they can always obtain
adequate finance.
‘Headroom’
A company’s need for finance is never static. Continual requirements for
finance can arise as a result of:
ᔢ
the need to effect small to medium acquisitions (often referred to as
bolt-on acquisitions)
ᔢ
an ongoing capital expenditure programme that cannot be financed
from existing free cashflow.
ᔢ
fluctuations in working capital.
The principal aspect of these financing requirements is that the amount of
finance required is comparatively small, in the sense that it is impractical
to finance them separately. Companies usually decide to keep financial
resources to meet these incremental changes in the requirements of finance.
These resources can be in the form of cash balances, but more frequently
are in the form of the unutilized portion of committed revolving facilities
provided by banks. (A committed bank facility is a facility where the bank
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CORPORATE TREASURY AND CASH MANAGEMENT
has an obligation to provide finance up to the level of their commitment
during the life of the facility. For instance, a syndicate of banks providing
a five-year revolving facility to a corporate for US$500 million is obligated
to provide funds up to the facility amount for the five-year period. Many
companies cope with the requirement for ‘headroom’ by establishing facilities for more than their forecast needs. Thus the company may forecast
needs of US$400 million, but establish a facility for US$500 million to
give US$100 million ‘headroom’. Committed revolving facilties and the
establishment of ‘headroom’are explained in more detail in Chapter 4.)
Equally companies can find that they have unplanned inflows of cash as
a result of sales of assets and of fluctuations in working capital. Committed
bank facilities that can be drawn upon when required and paid down when
cash inflow is positive add flexibility to a company’s financial structure.
Currency
Translation exposure has been discussed in Chapter 1 (and see pages 32–4).
Many companies handle their translation risk by maintaining a certain level
of loans in the currency of their overseas assets. The decision to handle
translation risk in this manner may have an implication for planning the
loan capital structure. The currency question is usually handled by either
the use of currency swaps or the ability to draw advances denominated in
foreign currencies under bank facilities.
Other matters
It may be that a treasurer considers it relevant to incorporate other issues
into the debt management policies. These items will usually be specific to
the company for which the treasurer works, or be an issue on which the
board has particularly strong opinions. Examples are described below.
Security
Generally, when a borrower provides security it results in a lower cost of
finance (although for companies with a very high credit rating this is not
always the case). This is because the provider of finance has a fixed charge
over specific assets, or a floating charge over a group of assets, and hence
has priority over unsecured creditors in the event of a liquidation. The
assets used for providing security are generally those regarded as being
easily realizable at or close to their current book value. The usual examples
of such assets are freehold land and buildings. The other aspect of such
TREASURY POLICIES: INTRODUCTION
29
finance is that assets are generally ‘overcollaterallized’; in other words, the
value of assets charged are more than the value of the loan.
Some companies have balance sheets rich in such asset types: typically
property, high street retailers, hotel and leisure companies. While it is natural for such companies to provide security for long-term loans they will
always want to put an upper limit to the proportion of assets so charged.
This ensures that their ability to sell and trade these assets is not hindered.
Covenants
Does the company have any specific attitude to covenants within its loan
documents? Companies might sometimes specify the financial covenants
they are prepared to provide or the maximum level at which these covenants
can be pitched. For example, a company may specify that the only financial
covenant that it will provide will be one related to interest cover, and that the
maximum such covenant that it will provide is that interest cover will exceed
three times (see Chapter 3). Other companies may specify that ‘carve outs’
are needed to enable them to issue secured debt, while others may wish to
specify the extent to which parent company support will be available to
support finance raised at subsidiary company level.
Guarantees
The provision of guarantees is a utilization of the company’s financial
resources in much the same way as a borrowing. Providers of finance will
take note of the amount of contingent liabilities outstanding and will adjust
the level or price of the loans they are providing if these levels are significant.
For some organizations the provision of guarantees is a related aspect of the
business sector they operate in; for example, construction companies have to
provide performance bonds for specific contracts. Treasurers of such companies will probably want to design specific policies relating to guarantees; for
instance the circumstances when guarantees are provided, who authorizes the
guarantees, clauses that are acceptable and those that are unacceptable.
F O R E I G N E XC H A N G E R I S K M A N AG E M E N T
Transaction exposure
Foreign exchange transaction risk was defined in Chapter 1 as covering
those situations where a clear obligation to make, or a right to receive, a
30
CORPORATE TREASURY AND CASH MANAGEMENT
payment in a foreign currency has arisen. The exposure spans the period
from the obligation or right arising to the final payment or receipt of the
foreign currency. The exposure exists because the amount payable or
receivable in domestic currency will fluctuate over the exposure period
with movements in foreign exchange rates. For example, a Hong Kong
company may purchase goods from an Australian supplier and pay that
supplier in AU$. From the point at which the obligation to make a payment
in respect of a specific purchase from the Australian company arises (say
on the placing of an order) to the point at which the supplier is paid for
those goods in AU$, the HK$ equivalent of the payment will fluctuate in
accordance with movements in the AU$/HK$ exchange rate.
Transaction exposure is usually:
ᔢ
Revenue in nature. The effects of foreign exchange movements flow
straight through to the profit and loss account.
ᔢ
Cash in nature. Foreign exchange movements are represented by
reductions or increases in cash payments or receipts in domestic
currency terms.
ᔢ
Often short term in nature. The time period from the point at which the
exposure arises to the point at which it is extinguished is comparatively
brief. (For many organizations, however, such as pharmaceutical, aerospace or construction companies, it is worth mentioning that transaction
exposures can extend over many months, or in some cases years.)
Transaction exposures often arise from the following:
ᔢ
Purchases or sales of goods or services in a foreign currency.
ᔢ
Royalties, management fees or licence fees, where these are payable or
receivable in a foreign currency.
ᔢ
Purchase of capital items (fixed assets) denominated in a foreign
currency.
ᔢ
Dividends on overseas investments, interest on loans payable or
receivable in foreign currencies.
Identification and measuring of transaction exposure
One of the challenges facing the treasurer is to identify and measure the
scale and timing of transaction exposures. Measuring transaction exposure
consists of identifying the following elements:
TREASURY POLICIES: INTRODUCTION
31
ᔢ
Whether the obligation is to make or receive a foreign currency
payment. (Where there is an obligation to make a payment this is a
short position; where there is a right to receive a payment it is a long
position.)
ᔢ
The currency in which payment is due to be made or received.
ᔢ
The foreign currency amount of the payment or receipt.
ᔢ
The timing of the payment or receipt.
There may often be differences of opinion as to when a transaction exposure arises. In the case of the sale of a product to an overseas customer that
is invoiced in a foreign currency, does the exposure arise when the order is
received from the overseas customer and the company acknowledges its
receipt; does it arise when the goods are actually shipped; or does it arise
when the invoice is raised and dispatched? Different companies will have
different opinions.
Some companies may go even further and consider that the publication
of a price list gives rise to transaction exposure. While there may be
currency adjustment clauses in a holiday brochure, actually activating
those clauses may be something a company is unwilling to do, particularly
if the market is very competitive and major competitors have not changed
their prices.
The larger the company and the more complex its international flows,
the more challenging it is to identify transaction risk as early as possible
and then quantify its size. The ability to identify transaction exposures at
a very early stage in the order cycle often depends on the systems used
by the company. Larger companies tend to have more sophisticated
systems and the development and implementation of enterprise resource
planning (ERP) systems – by linking order processing, stock control,
production and logistics with information that is recorded in finance –
has helped to improve control over the identification of many types of
transaction exposure. In many organizations these systems are also linked
to their customers through electronic data interchange (EDI) or some
other electronic link.
Pre-transaction exposure
Pre-transaction risk represents foreign exchange exposures that exist
before entering into the commercial contract that will turn them into transactional exposures. Take, for instance, the case of a dividend receivable
32
CORPORATE TREASURY AND CASH MANAGEMENT
from an overseas investment; until it has been finally declared, the amount
and timing of the dividend can only be anticipated. Up to that point, it
remains a pre-transaction exposure. The forecast sale of a product to overseas customers remains pre-transactional until an order has been received,
or the goods shipped or an invoice dispatched.
Identifying pre-transaction exposures can be even more difficult than
transaction exposure. Very often the sales or purchasing departments
cannot know in advance the exact timing of overseas sales or purchases.
These dates will continually change as the status of orders changes. In
addition, the departments will often be unable to identify the exact quantity
of the sales or purchases, which again may be subject to continual change
until the final orders are received or dispatched. The further out in time the
forecast goes, the more imprecise the data becomes. For instance, amounts
receivable in respect of royalties, licences and management fees can only
be estimated on the basis of information received on sales to date. Future
sales to overseas customers may be susceptible to broad forecasting, but
these forecasts may become very inaccurate when analyzed by currency.
The starting point for identifying pre-transaction foreign exchange risk
is very often the annual budget. Depending on the detail with which the
budget has been prepared, it contains the company’s forecast of receipts
and costs in foreign currencies for the year ahead. As the financial year
progresses the company will need to update the budget with ‘rolling forecasts’. These update the budget to reflect changes in the company’s business, and will also produce forecasts of foreign currency income and
costs for periods outside the current budget period. For example, many
companies employ a system of 12-month rolling forecasts. After say, six
months of the existing financial year have passed the budget will be
updated for the remaining six months of the financial year, and in addition forecasts will be produced for the first six months of the next financial year. Together they produce a new 12-month forecast of foreign
currency receipts and payments.
Translation risk
Translation exposure is the risk that the domestic book currency value of
assets and liabilities denominated in a foreign currency will alter due to
movements in exchange rates. Translation risk arises when these assets and
liabilities are converted to the domestic currency and consolidated in the
company’s group accounts. The assets and liabilities in domestic currency
terms will vary between two accounting dates, partly as a result of
exchange rate movements. Not only will asset and liability values be
TREASURY POLICIES: INTRODUCTION
33
affected but so will the profit or loss for the year. The impact of changing
exchange rates on the conversion of foreign currency assets and liabilities
and profit of overseas subsidiaries was explained in Chapter 1.
Most companies manage translation exposure by borrowing in the
currency in which overseas assets are denominated. Using the example in
Chapter 1, we find the situation outlined in Table 2.1 below.
In this example, the effect of matching US$ assets with borrowings in
US$ has been to offset the movement in foreign currency assets when they
are converted to domestic currency with the movement in the foreign
currency borrowings when these are converted to domestic currency. Any
movement in the domestic value of foreign currency assets will be offset
by movements in foreign currency borrowings when these are converted to
Table 2.1 Example of translation risk
US$
million
UK£ million
@ 1.60
UK£ million
@ 1.50
1 000
625
667
Liabilities
250
156
167
Net Assets
750
469
500
@1.55
@1.45
Gross assets
Net profit
after tax
150
97
103
If the company matched its US$ assets with US$ borrowings, the effect of
foreign exchange movements would be as follows:
US$
UK£
@ 1.60
UK£
@ 1.50
Net assets
750
469
500
Borrowings
in US$
750
469
500
@1.55
@1.45
Net profit
US$ interest
expense
150
19
97
12.3
103
13.1
34
CORPORATE TREASURY AND CASH MANAGEMENT
the domestic currency. To a much lesser extent, the impact on the net profit
of changing exchange rates is offset by the change in the US$ interest
expense when that is converted to UK£.
Many treasurers believe that translation risk is not an exposure that
requires hedging, since the economic worth of a company cannot be
affected by movements in the book value of assets. However, while these
movements are only ‘paper’ movements, they may at times have economic
consequences for the company:
ᔢ
Such movements may affect covenants in loan agreements that are
based on net worth or interest cover.
ᔢ
Reported earnings may be affected by foreign exchange movements.
The company believes that changes in reported earnings will have
some impact on its share price.
ᔢ
The overseas asset may some day be disposed of and any gain or loss
may be ‘crystallized’.
Economic exposure
Economic exposure is the risk that future foreign currency cashflows
generated by a company will vary in terms of its local currency equivalent.
It can be regarded as the impact that exchange rate movements may have
on a company’s future cashflows. There are a number of situations in which
economic exposure may arise.
ᔢ
Exposure of a pre-transactional nature can extend for a substantial
period into the future. One example might be an engineering
company based in the United States, selling its goods into Europe
and invoicing its customers in euros. Its local currency (US$) will be
affected by the €/US$ exchange rate for as long as that trade continues. (While companies often manage pre-transaction exposure
extending 12 to 18 months into the future, they often do not go
beyond that period.)
ᔢ
A price list may be issued in the company’s domestic economy where
goods or merchandise are imported, or may be denominated in a
foreign currency in an export market.
ᔢ
Bid to tender. Once a bid for a contract has been submitted, a company
may be exposed until that bid has been accepted or rejected if there is
a foreign currency component to the bid.
TREASURY POLICIES: INTRODUCTION
ᔢ
35
A company’s local currency cashflows may be affected by the foreign
exchange rates of other currencies. In Chapter 1 the example was given
of a hotel company whose business was affected by the movements in
its local currency and the US$. These currency movements may make
its room rates more expensive or cheaper than those of hotels in other
countries, depending on the US$ exchange rate with the currency of
these countries.
In many cases the distinction between transaction, pre-transaction and
economic exposure can be rather blurred. Many treasurers may consider
that bid to tender or the issue of a price list belong to the pre-transaction
element of foreign exchange risk. The important thing however is that the
company considers all risks to which it is exposed and whether they can
and should be managed.
Treasury policies for foreign exchange risk
In designing treasury policies to cover foreign exchange, a company will
have in mind a number of specific issues relating to its business. Some of
these issues are outlined below.
Accuracy of exposure identification
How accurately can the company identify its transaction and pre-transaction exposure? Some companies where there is a consistent trade may be
able to calculate pre-transaction exposure by examining sales or purchase
volumes from the past and extrapolating these into the future. Companies
whose overseas trade is more discrete may be unable to forecast future
exposures so accurately.
Natural hedges
Does the company have any natural hedges? For instance, a mining
company that sells most of its output on the world markets in US$ may
have identified that when the US$ is weak versus their domestic currency,
the demand for their commodity-type products is stronger.
A company importing French or German wine may find that, if the euro
strengthens versus their domestic currency, wines from other regions such
as the United States, Australia or New Zealand can be substituted. This is
because the company’s customers have a price target for the wine they
purchase as opposed to a regional preference.
36
CORPORATE TREASURY AND CASH MANAGEMENT
Ability to pass on price increases
Increasingly, in a competitive world with the emphasis on cost reduction,
the ability to even consider passing on price increases becomes less relevant. However, there may be circumstances where cost increases or income
reductions due to foreign exchange movements can be recouped through
the selling price.
Volatility of currencies
The more volatile the currencies in which it invoices overseas customers or
is invoiced by overseas suppliers, then the more likely a company is to take
a conservative and cautious approach to hedging overseas foreign currency
receipts and payments.
Significance of FX in costs and revenues
The more significant FX is in a company’s cost and revenue structure, the
more concerned the company will be to adequately manage all FX exposures.
I N T E R E S T R AT E R I S K M A N AG E M E N T
Introduction
Interest rate risk management, as explained in Chapter 1, is the extent to
which a company’s interest expense may increase due to increases in interest rates, or income from cash balances (if these are significant) will be
reduced by falling rates.
It is important to note that over the past few years interest rates have
consistently fallen around the world. Many companies that locked in their
interest expense at what they considered to be low levels have been left
with a much higher interest expense than if they had ignored interest rate
exposure. Companies now recognize that interest rate exposure is not just
the effect of increasing interest rates on their interest costs, but also the
opportunity cost of falling or stable interest rates when they lock in their
interest cost.
In the case of interest rates the risk management policy will be determined
by such things as:
ᔢ
The level of financial gearing within the financial structure. Generally,
the higher the level of financial gearing, then the more conservative the
TREASURY POLICIES: INTRODUCTION
37
company’s approach to interest rate risk management. When financial
gearing is high, movements in interest rates can have a significant
impact on earnings and cashflow.
ᔢ
The volatility of the organization’s cashflows. Again the more volatile
these cashflows, the more a company is likely to want to operate with
the interest rate fixed on a higher proportion of its borrowings.
ᔢ
The level of operational gearing (the level of fixed costs in its operations).
ᔢ
The importance of achieving the company’s determined strategy.
ᔢ
The nature of any natural hedges. Some companies, such as retailers,
find that when interest rates are high in the interest rate cycle, their
businesses do comparatively well. This is because these higher interest
rates are designed to restrain consumer expenditure and the inflationary impact that this may have, but this buoyant consumer expenditure
has benefits for the retailer.
The more volatile a company’s cashflows, and the higher the level of its
financial or operational gearing, then generally, the higher the level of fixed
interest rates the company will want to operate with.
Usually, a company’s treasury policies will establish a band within
which the organization will want to manage the ratio of its fixed/floating
interest costs. A policy may, for instance, state that between 30 and 50 per
cent of the next three years’ projected borrowings should be at fixed rates.
Companies normally establish a band to cater for the volatility in the level
of actual borrowings against those planned.
Identifying exposures
In most organizations the starting point for measuring interest rate risk is
the annual budget and a three (or five) year business plan. The financial
numbers that are put together to support the business plan and the budget
will establish the cashflows, levels of borrowing and resultant interest rate
cost for the relevant periods. This interest cost will normally be calculated
on a currency by currency basis.
In most organizations the annual budget is prepared after the business
plans have been agreed. If the company operates with three-year business
plans, then the budget when it is prepared normally reflects the first year
of the business plan and replaces that year. The three-year business plan
then becomes: year one the budget, years two and three the business
plan.
38
CORPORATE TREASURY AND CASH MANAGEMENT
C A S E S T U DY
Identifying selected financial risk at IDI
The following case study is intended to be illustrative of the steps involved
in identifying, measuring, setting policies for, managing and reporting on
financing, foreign exchange and interest rate risk.
Introduction
International Dynamic Industries (IDI) is based in the UK and manufactures
and supplies high-quality components to the aircraft and defence industries.
The company sells to customers in approximately 20 countries around the
world. Their principal competitors are local manufacturers based in the countries in which they sell, but they have one major international competitor
based in United States.
Sales
Manufacturing is undertaken primarily at plants in the United Kingdom,
United States and Taiwan. In addition to this the company operates a
number of warehousing units as well as sales offices. The plants supply
their own geographical region: the UK plants supply the UK and European
customers, US plants supply North America, and the plant in Taiwan
supplies the Far East. The company supplies customers either:
ᔢ
Directly from the manufacturing plants.
ᔢ
From warehousing operations.
ᔢ
Via sales operations. The deliveries are direct to customers, with the
manufacturing plants invoicing the sales unit who then invoice the
customer.
Deliveries to customers are made against contracts. These contracts are at
a fixed price and payment is usually received 50 per cent on receipt of the
contract and 50 per cent 90 days after the conclusion of the contract. Most
contracts are for periods up to six months; that is to say, deliveries are made
over a six-month period against contract specifications. All overseas sales
are invoiced in foreign currencies; thus sales from the plant in Taiwan to a
customer in Singapore will be invoiced in SG$. Approximately 35 per cent
of sales are to overseas customers.
TREASURY POLICIES: INTRODUCTION
39
Global sales are shown in Table 2.2.
Table 2.2 IDI global sales
Actual UK£ million Y/E 31/12/2002
UK
600
Europe
500
North America
700
Australia, Japan and Far East
500
2300
Supplies
Most raw material and semi-finished components are sourced within the
country where the manufacturing plant is situated. The exceptions are the
United Kingdom, where some supplies are sourced from Germany, and
Taiwan, where some supplies are sourced from Japan. All these supplies
are invoiced in foreign currency. Details are shown in Table 2.3.
Table 2.3 IDI supply costs
Estimated UK£ million Y/E 31/12/2002
Germany
50
Japan
25
75
In addition there is a certain amount of trade among the company’s operating subsidiaries.
Capital Employed and Profitability for year end 31/12/2002
Table 2.4 gives details of IDI’s assets and profits.
40
CORPORATE TREASURY AND CASH MANAGEMENT
Table 2.4 IDI assets and profits
Assets
UK£ million
Profits before interest and tax
UK£ million
UK
900
130
North America
800
115
Far East
600
75
2300
320
Loan capital
At 31 December 2002 the repayment details of the loans were as shown in
Table 2.5. The revolving credit facility is UK£1 billion.
Approximately 40 per cent of the loan capital – the Eurobond and the
leases – is at fixed rates. The weighted average rate of these fixed rate
borrowings is 7.0 per cent. The company has one financial covenant in its
loan documentation: Earnings before interest, tax and dividends and
amortization (EBITDA)/net interest must exceed 3.5 times.
Risk philosophy
The company has a conservative attitude to risk. It also operates in a business sector with a pronounced cyclicality, as a result of which earnings and
cashflow can be volatile.
Strategy
The company has recently undertaken a major acquisition by acquiring a
company based in the United States. The objectives of the acquisition are:
Table 2.5 IDI loan repayments
UK£ million
31/12/2002
Bank debt – revolving credit
Matures 30/9/2004
900
Eurobond
Matures 31/12/2005
400
Financial leases
Amortising to 31/8/2006
200
1500
TREASURY POLICIES: INTRODUCTION
41
ᔢ
To expand its product range. The company can now supply a complete
product range and is the world’s leading supplier.
ᔢ
Establish a manufacturing and major sales and marketing presence in
the United States, one of the most significant markets for its products.
The company considers that a key element in successfully implementing its
strategy is a tight control over its cost base. In addition, since the acquisition was greeted with some scepticism by the markets, the company
considers it imperative to meet and exceed the market expectations for its
financial results.
Question
Design the company’s treasury policies covering debt management, foreign
exchange and interest rate risk (the summary financial results are given
overleaf).
42
CORPORATE TREASURY AND CASH MANAGEMENT
INTERNATIONAL DYNAMIC INDUSTRIES
SUMMARY FINANCIAL RESULTS
YEAR ENDING 31 DECEMBER 2002
Profit and loss
UK£ million
Turnover
Cost of sales
2300
1340
960
Distribution and administrative expenses
Profit on ordinary activities before interest
640
320
Interest
Profit after interest
95
225
Taxation
40
185
Balance sheet
Fixed assets
Current assets less current liabilities
Net debt
Net Assets
Cash flow
Net cash flow from operating activities
1900
400
(1500)
800
420
Servicing of finance and taxation
(105)
Capital expenditure and acquisitions
(150)
Cash flow before financing and dividends
165
Note:
Depreciation
Maintenance capital expenditure
80
105
TREASURY POLICIES: INTRODUCTION
43
S O LU T I O N
Financing risk
ᔢ
The company operates with a relatively high level of financial gearing.
For the year ended 31 December 2002:
EBITDA/net debt = 0.27
EIBTDA/interest = 4.2 times
Free cashflow/net debt = 0.14
Note: EBITDA is calculated profit before interest plus depreciation.
Free cashflow is calculated as cashflow from operations less maintenance
capital less servicing of finance and taxation.
ᔢ
60 per cent of its loan structure is represented by a revolving credit
facility provided by banks. In addition, the financial leases may well be
with banks. The company is therefore exposed on the re-financing of
these facilities.
ᔢ
Currently there is only UK£100 million of available headroom under
its revolving facility.
Interest rate risk
Interest rate risk is one of the significant financial risks identified by the
company.
ᔢ
The interest cover ratio in their loan documents is a minimum
EBITDA/interest of 3.5 times. Prudentially however, the company’s
target is to get back to a minimum of five times cover.
EBITDA(320+80)/interest (95) was 4.2 for the year to 31 December
2002 and is forecast to be 4.5 times for the next financial year. Should
interest costs move adversely by more than UK£9 million, this cover
will reduce to below four times. Such a movement represents only a 1
per cent movement in interest rates.
ᔢ
Control over interest cost is critical to achieve the financial results
anticipated by the market. The company forecast pre-tax results next
year of UK£250 million.
Foreign exchange exposures
The process for analyzing the foreign exchange risks facing the company
is very similar to that used to analyze interest rate risk.
44
CORPORATE TREASURY AND CASH MANAGEMENT
Transaction risk
This would normally be considered to arise when the contracts are signed.
Since payment is made 50 per cent on signature of the contract, the major
exposure is for the remaining 50 per cent, which is payable 90 days after
completion of the contract or order. Since contracts normally extend over
six months, the exposure period is approximately nine months.
At any one time, the exposure to foreign exchange movements is
broadly:
Total sales
UK£2300 million
Of which, 35 per cent are sales
in foreign currencies
UK£805 million
The exposure on each contract
lasts nine months, so on average
the exposure on each contract
outstanding at any one point in
time is 4.5 months
UK£805x 4.5/12 =302million
Amount receivable in foreign
currency in respect of current
outstanding contracts
UK£302 x 50 per cent = 151 million
A further offset is the fact that
some sourcing is done overseas.
Since each contract lasts
approximately six months, at
any one time approximately
50 per cent of the annual projects
are being worked on. Annual
overseas sourcing is UK£75
million, and thus a broad offset
to the above.
UK£75 x 50 per cent = 37 million
(This is very much the
maximum offset however,
since the currency of receivables
may not be offset by the
currency of payables)
A 5 per cent movement in foreign exchange rates could therefore affect
cashflow and reported earnings by between UK£7.5 million and UK£5.8
TREASURY POLICIES: INTRODUCTION
45
million. This represents approximately 3 per cent of profits before taxation,
and over 3 per cent of free cashflow. Offsetting this is the fact that the
exposures would be in a range of different currencies. A strengthening in
one currency of exposure may be offset by a weakening in another.
Pre-transaction risk
This is a more difficult area for the company to assess. At any one time the
company may be in negotiation to conclude a number of different contracts
or orders. These negotiations may take many weeks to conclude. Much
depends on its ability to adjust the contract price to reflect any foreign
exchange movements before the contract is finally signed.
However, budgets and forecasts that the company is working to achieve
will be based upon some assumption of sales by country by currency, and of
exchange rate levels. To this extent the company may consider that it has pretransaction exposure that it wishes to manage. The ability to hedge pretransaction risk also depends on the extent to which the company can forecast
sales by currency with any accuracy.
Translation risk
The UK-based company has 60 per cent of its net assets and 60 per cent of its
profits before interest and tax being earned from overseas operations. A 5 per
cent movement in foreign exchange rates against the UK£ would therefore
have a significant impact on reported earnings and on capital employed.
Treasury policies covering the above exposures
The following could be an extract from IDI’s treasury policies:
Debt management
Objectives of debt management
The objectives of debt management policies are to ensure a continued
availability of funds to finance its strategic aims at the lowest cost.
Debt profile
The group’s objective is to maintain a smooth maturity profile to its
46
CORPORATE TREASURY AND CASH MANAGEMENT
outstanding long-term debt. To achieve this the company will observe
the following:
ᔢ
No more than 30 per cent of the group’s long-term debt shall be
re-financeable within the following 12-month period.
ᔢ
No more than 50 per cent of the group’s debt shall be re-financeable
within the following three years.
ᔢ
No more than 75 per cent of the group’s debt shall be due for
repayment within seven years.
Sources of debt
To prevent excessive exposure to one debt market the company
will try to finance itself in the widest number of markets practicable. In particular, bank finance shall not represent more than 50 per
cent of outstanding debt while outstanding debt is more than UK£1
billion. In meeting this target the company will use the following instruments: private placement, Eurobonds and medium-term
notes.
Headroom
To ensure there are always sufficient financial resources available to
meet the capital expenditure programme, small acquisitions and
fluctuations in working capital, the company will always maintain
sufficient unutilized committed finance to meet the monthly forecast or budgeted cash outflow before financing for the next 12
months, plus further headroom of UK£100 million. If these cashflows are positive, then available headroom will not be less than
UK£100 million.
Foreign exchange
Objectives of foreign exchange management
The objectives of hedging foreign exchange exposures are:
ᔢ
To protect the projected profit and cash generated from customers’
contracts and orders from foreign exchange movements.
TREASURY POLICIES: INTRODUCTION
47
ᔢ
To provide some measure of stability to budgeted and forecast
earnings where these have been based on sales contracts and
orders being awarded at specific exchange rates. This recognizes
that the company operates in a competitive environment and has
limited immediate ability to adjust pricing on overseas contracts
and orders in response to a change in foreign exchange rates.
ᔢ
To ensure that interest cover, one of the major measures of the
company’s borrowing capacity, remains broadly similar by
currency.
Transaction exposure
ᔢ
All contracts/orders invoiced in foreign currencies must be
hedged back into the domestic currency at the point at which
these contracts are awarded. Contracts and orders are awarded at
the point at which signed authorized orders and contracts are
received from a customer.
ᔢ
All purchases from foreign suppliers must be hedged into the
domestic currency as soon as the liability is established. Liabilities are established once authorized orders are dispatched, either
electronically or by mail, to the supplier.
ᔢ
Payments and receipts in the same currency must be netted in
establishing the currency exposures above, including currencydenominated interest costs.
Pre-transaction exposure
Estimates of foreign currency receipts (sales to foreign customers that
have not yet been converted to contracts) may be covered or hedged
as follows:
50 per cent for estimated sales over the next six months
25 per cent of estimated sales covering the period 6–12 months.
Cover can only be taken where there is a consistent underlying sales
trend in that particular currency. No cover may be taken for estimated
sales beyond 12 months without specific approval of the Finance
Director or Main Board.
48
CORPORATE TREASURY AND CASH MANAGEMENT
Translation exposure
The company will match overseas assets with relevant foreign
currency borrowings. In establishing the relevant level of foreign
currency borrowings to match an overseas asset, regard will be had to
the level of total borrowings, and the proportion that the overseas
asset bears to total assets. For example if euro-denominated assets are
25 per cent of total assets, then 25 per cent of total borrowings will be
in euros.
Interest rate risk
The objective of the interest rate risk policy is to enable the company
to achieve a high level of confidence that any increases in interest
rates will not adversely affect the achievement of its strategic and
financial objectives.
Short-term interest rate risk
The company may take out interest rate hedges for up to 100 per cent
of forecast net interest expense risk for the following rolling
12 months. Treasury is authorized to take out these hedges without
prior reference to the risk committee.
Long-term interest rate risk
Between 40 per cent and 70 per cent of forecast net interest rate risk
over the following four years may be hedged, and between 40 per
cent and 25 per cent of net interest rate risk for the following four
years.
Authorized instruments
In managing interest rate and foreign exchange exposure the treasury
team may use the following instruments:
ᔢ
forward rate agreements
ᔢ
interest rates swaps
ᔢ
interest rate caps
TREASURY POLICIES: INTRODUCTION
ᔢ
forward FX
ᔢ
foreign currency options.
49
Certain exotic derivatives such as barrier options or digital options
can only be used with the express agreement of the treasury committee. Exotic options should not consist of more than 20 per cent of
outstanding derivative hedges.
The company does not believe that combinations of derivatives
such as interest rates collars add significant value to the hedging
process and their use is forbidden unless authorized by the treasury
committee.
Reports
Reports are designed to show how treasury activities are aligned to
implementing treasury policies. Among the reports produced are:
ᔢ
debt management
ᔢ
headroom within banking facilities
ᔢ
maturity profile of the company’s debt
ᔢ
analysis of debt source.
Interest rate risk
Total net borrowings analyzed by fixed or floating borrowings:
Borrowings are further analyzed between fixed and floating rate
borrowings by month/period, by currency over a rolling 12-month
period and year-by-year for the next three years.
Hedges in place: Hedges are analyzed by derivative by
month/period over a rolling 12 months and year-by-year for the next
three years. Derivative hedges are further analyzed by notional
derivative amount and by average strike rate or fixed rate under the
derivatives:
Foreign exchange risk
ᔢ
transaction exposures analyzed by period by currency
50
CORPORATE TREASURY AND CASH MANAGEMENT
ᔢ
hedges in place against transaction exposure by period by
currency
ᔢ
reasons for the non-hedging of any transaction exposure
ᔢ
pre-transaction exposure by currency by period
ᔢ
hedges against pre-transaction exposure by currency by period
ᔢ
details of hedges in place (forwards, options)
ᔢ
foreign exchange rates or exercise prices of hedges in place
ᔢ
sensitivity analysis
ᔢ
analysis of translation exposure: overseas net assets and profits
ᔢ
hedges in place against translation exposure.
Transaction and pre-transaction exposure are usually reported
monthly, while translation exposure is usually reported quarterly or
semi-annually.
51
TREASURY POLICIES: INTRODUCTION
Sample Reports
Debt Maturity
UK£ mns
Debt maturity
1000
900
800
700
600
500
400
300
200
100
0
1
2
3
4
5
6
7
8
9
10
Years
Headroom
12 month rolling forecast cumulative cash outflow
Cash outflow
Available lines
120
Millions
100
80
60
40
20
0
1
2
3
4
5
6
7
Months
8
9
10
11
12
1
28
2
25
3
32
4
18
5
16
6
7
8
1.8282
1.8267
1.8249
1.8230
1.8302
1.85
Current market rates
1.85
1.85
1.85
1.83
Budgeted FX rate
1.8
1.8
1.81
10
Strike rate on options
1.81
15
1.8
1.81
15
Average forward FX rate
20
5
26
1.8212
1.85
1.8
1.78
5
5
1.85
1.78
5
1.8194 1.8175
1.85
1.8
1.78
5
3
26
20
15
15
15
10
8
5
_______________________________________________________________________
2
5
17
20
17
18
20
25
_______________________________________________________________________
17
16
28
28
30
_______________________________________________________________________
28
25
32
35
32
28
28
30
Periods
FOREIGN EXCHANGE EXPOSURE – BUDGETED
Vanilla options
Forward FX
Analysis of cover already taken
Net forecast exposure to SG$
Cover taken
Total forecast SG$ income
Forecast receivable but no
committed orders received
Committed orders SG$ receivable
Budgeted exposure – SG$m
Foreign exchange report
TREASURY POLICIES: INTRODUCTION
53
Excerpt from a typical foreign exchange exposure report showing
budgeted SG$ receivables for a US company. The receivables are split
between orders received and those forecast. Hedges are analyzed between
instruments and the rates at which the hedges have been taken out are
shown against budget. Further analysis could be provided by showing the
effects of a given movement in US$/SG$ exchange rate, and the effects
on the budget of hedging at the current exchange rates.
Strike rate under caps
Average rate under FRAs,
swaps and Eurobond
Proportion fixed
Total hedges
FRAs
Interest rate swaps
Caps
Other
2
100
400
750
1575
3
150
200
100
400
500
1585
4
250
200
100
400
250
1555
5
250
200
100
400
100
1540
6
200
200
100
400
1500
6.50%
83.33%
6.50%
6.60%
79.37%
6.50%
6.70%
85.17%
6.50%
6.60%
77.17%
6.50%
6.70%
68.18%
6.50%
6.90%
60.00%
________________________________________________________
1300
1250
1350
1200
1050
900
________________________________________________________
400
Fixed rate borrowings
Derivatives:
900
1560
Months
1
Drawings
Hedges in place:
Forecast borrowings
All currencies
SAMPLE REPORT FOR INTEREST RATE EXPOSURE
3
150
60
400
1250
5.50%
7.00%
45.00%
5.00%
7.00%
48.80%
________________
630
610
________________
150
80
400
1400
Years
2
CHAPTER 1
Risk Management:
Introduction
INTRODUCTION
Most treasurers would consider that their primary role in the organizations
they work for is the management of financial risk. This financial risk, as far
as it affects the corporate treasurer, can be defined as the extent to which
an organization may incur losses as a result of:
ᔢ
An adverse movement in prices or rates in certain financial market,
such as foreign exchange rates, interest rates or commodity prices.
ᔢ
An adverse change in financial markets. For example, the appetite of
lenders in certain debt markets may change so that the company is no
longer able to raise finance in its preferred market, or the cost of its
finance increases substantially.
W H Y M A N AG E F I N A N C I A L R I S K ?
Corporate finance theory
Broadly stated the Capital Asset Pricing Model (CAPM) indicates that shareholders require compensation for assuming risk. The riskier a share then the
greater the return the shareholder requires to compensate for that risk. The
risk of an individual security is measured by the volatility of its returns to the
holder over and above the volatility of return from the market overall. The
volatility of return for a security is affected by three main factors:
ᔢ
the business sector of the company
3
4
CORPORATE TREASURY AND CASH MANAGEMENT
ᔢ
the level of operational gearing (level of fixed costs in its business)
ᔢ
the level of financial risk.
The objective of managing financial risk is thus to reduce the volatility of
return from a security over and above that of the volatility of return from
the market. This should increase returns to existing shareholders, since the
price of the share should rise to reflect the lower return appropriate to a
now less risky share.
Avoiding financial distress
Financial distress is usually reflected in the inability of a company to raise
fresh finance, to re-finance existing financial liabilities, or to meet liabilities as they arise. In addition excessive strain may be placed on a
company’s financial structure as a result of breaches in any financial
covenants in its loan documents. Such breaches will have a knock-on effect
for the pursuit of the company’s strategy.
Preventing an adverse impact on a company’s chosen
strategy
Most boards of directors need to know that they can continue to pursue key
strategies unhindered by unexpected financial losses. Furthermore the
boards of most non-financial organizations believe that they have no
specific skills in financial markets, and therefore any risks arising from the
company’s exposure to, involvement in, or access to these markets should
be managed. Losses arising from adverse movements in financial markets
may, if they are significant, require all or part of an organization’s strategy
to be modified, put on hold or cancelled.
P R I N C I PA L T R E A S U RY - R E L AT E D F I N A N C I A L R I S K S
Companies face a number of different financial risks. The following are
probably the most common classifications of the principal financial risks
that relate to corporate treasury operations.
Financing risk
This is the risk that a company may either be unable to finance itself in its
RISK MANAGEMENT: INTRODUCTION
5
chosen debt markets, or may have to pay too high a price for its finance and
hence reduce returns available to shareholders.
Financing risk is probably one of the most significant risks that the majority of treasurers have to manage. It is a risk that, if it materializes, may result
in the company being unable to pursue its chosen strategy. This is particularly
the case when a company’s strategy involves expansion through acquisition or
organic growth, or if it assumes the successful re-financing of existing debt.
Financing risk may materialize from breaches in a company’s financial
covenants within its loan agreements as a result of an inappropriate financial structure. However, it can equally well result from an inappropriate
financing strategy. This may occur when a company fails to diversify its
funding sources, or has too high a proportion of its debt maturing at one
point in time. As a result of changes in debt markets it may find itself being
unable to re-finance existing debt successfully.
Closely related to financing risk are bank relationships and credit rating
risks (indeed many companies consider these exposures as part of their
financing risk).
Bank relationships
Banks have for some time tried to link the provision of medium and longterm finance to the provision of other ‘added value’ services. Some banks
maintain that the provision of financial support is wholly dependent on
their being able to supply these other products. Equally, many companies
are concerned to ensure that services and products provided by banks
conform to a given level of quality. This leads some organizations to
consider that their banking group represents an exposure or risk that needs
to be specifically managed to ensure that they can always obtain the right
banking products at a desired level of service, quality and price.
Credit ratings
There are few debt markets (other than the bank and private placement
markets) that can be accessed without either a short or long-term public debt
rating. The cost of finance raised in these markets is often closely related to
the credit rating assigned to a company by the rating agencies. A company’s
strategic or financial actions will have an impact on its public debt ratings
and hence on its cost of debt, its ability to access certain debt markets, or its
ability to undertake long-term derivative transactions. The relationships with
the agencies involved in rating a company’s various debt instruments are
therefore sometimes considered to require specific management.
6
CORPORATE TREASURY AND CASH MANAGEMENT
Liquidity risk
Closely connected to financing risk, liquidity risk results from insufficient
financial resources to meet day-to-day fluctuations in working capital and
cashflow (Figure 1.1). The results of inadequate liquidity management are:
ᔢ
A company making both cash deposits and short-term borrowings,
with the result that cash resources are not being used reduce short-term
financings. The cost is the difference between the deposit rate and the
cost of borrowing.
ᔢ
The company having insufficient resources to pay its liabilities as they
fall due, resulting in penalty costs or loss of reputation.
ᔢ
The organization incurring losses as a result of either deposits being made
with financial institutions that fail, or the purchase of financial instruments
that cannot be subsequently sold or realized to meet cash needs.
Foreign exchange risk
This risk is commonly analyzed as transaction risk, pre-transaction risk,
translation risk and economic risk.
Transaction risk
This is the risk that a company’s cashflows and realized profits may be
affected by movements in foreign exchange markets. Generally foreign
exchange transaction risk is:
Day to day financing
needs of liquidity
shortfalls or surpluses
UK£
Core debt representing financing risk
Figure 1.1 Liquidity risk
RISK MANAGEMENT: INTRODUCTION
7
ᔢ
short term (although some companies may have long-term transaction
exposure)
ᔢ
revenue in nature
ᔢ
created where there is a firm commitment to pay or receive in a foreign
currency.
Transaction risk represents definite foreign currency receipts or
payments where a clear obligation to make a payment or a right to
receive a payment has arisen. Examples of transaction risk are payments
to be made in a foreign currency for deliveries from an overseas supplier,
the receipt of foreign dividends or the payment of royalty and franchise
fees.
Pre-transaction risks
These are contingent foreign exchange exposures arising before entering
into a commercial contract, which would turn them into transactional exposures. Examples of pre-transaction risks are the publication of a price list,
overseas sales not yet made but forecast by the company, or the forecast
receipt of foreign dividends not yet declared.
Translation risk
Companies with overseas subsidiaries will find that the domestic value of
the assets and liabilities of these subsidiaries will fluctuate with exchange
rate movements. In addition the domestic equivalent of the foreign
currency earnings of these subsidiaries will also be affected by movements
in exchange rates.
Consider a UK company that has an investment in the United States. On
the consolidation of this investment the sterling value of these dollar assets
will vary depending on UK£/US$ exchange rate ruling at the date of
consolidation, and the domestic value of the related foreign currency earnings of the investment will vary depending on the average exchange rate
during the year (see Table 1.1).
These movements in the value of the consolidated net assets and earnings of overseas subsidiaries may have significant consequences,
depending on financial covenants within loan documents or internal
prudential cover ratios such as internal interest cover guidelines. In addition, they may substantially affect published financial results and market
expectations.
8
CORPORATE TREASURY AND CASH MANAGEMENT
Table 1.1 Foreign currency earnings and exchange rates
US$
million
UK£ million
@ 1.60
UK£ million
@ 1.50
1 000
625
667
Liabilities
250
156
167
Net Assets
750
469
500
@1.55
@1.45
Gross assets
Net profit
after tax
150
97
103
Economic risk
Companies may be exposed to foreign exchange movements not only
through transactional and pre-transactional exposure but also due to their
competitive position. Consider a UK-based engineering company exporting to the United States, with its major competitor there being a Japanese
manufacturer. Such a company has exposure not only to the UK£/US$
exchange rate on its transactional and pre-transactional exposures, but
may also have exposure to US$/JPY. If the JPY weakens against the US$
whilst at the same time sterling strengthens against the US$, that will
clearly weaken the company’s competitive position vis-à-vis its Japanese
competitor.
Again, a London hotel will have all its operating costs in sterling, but
nevertheless may find its room occupancy rate affected by UK£/US$
exchange rate. As sterling strengthens against the US$ it becomes more
expensive for American tourists to visit London, and they switch their
holidays to other venues.
Interest rate risk
Companies with substantial borrowings or deposits will find that their
borrowing costs or deposit returns will be affected by movements in interest
rates.
Companies with their borrowings at variable rates will be exposed to
increases in interest rates, whilst those companies whose borrowings costs
are totally or partly fixed will be exposed to a fall in interest rates. The
reverse is obviously true for companies with term cash deposits.
RISK MANAGEMENT: INTRODUCTION
9
Some companies may find that they have a form of natural hedge against
interest rate exposure. A common example is the retailing sector, which
tends to find that its business is buoyant during periods when interest rates
are at the peak of the interest rate cycle as rates are lifted to reduce the level
of consumer demand and the inflationary impact that that may have.
Equally, low interest rates, designed to boost consumer expenditure, will be
linked with lower levels of sales.
Commodity risk
This arises when a company’s cost structure is influenced by fluctuations
in the price of energy or certain raw materials. An example might be an
airline company that needs to purchase substantial amounts of aviation
fuel. Equally a mining company, the selling price of whose output depends
on the market price for the commodity mined, will have commodity risk
exposure.
Counterparty risk
This represents the credit strength of a counterparty in many treasury transactions.
If a company uses derivatives it will find that its exposure to its counterparties will change as the market price of the underlying derivative
changes. This exposure may represent:
ᔢ
The replacement cost of the derivative should the counterparty be
unable to fulfill its obligations under the contract. For example,
an interest rate swap taken out to swap a bond issue to floating
rates, where the corporate receives fixed under the swap, will represent an exposure to the swap counterparty if interest rates subsequently
fall.
ᔢ
The need in some cases for companies under the terms of their derivative contracts to lodge cash collateral if the mark-to-market value of
the derivatives contracts with a specific counterparty exceed a stated
level. The ability of a counterparty to lodge collateral with a corporate
if the market value of a derivative trade moves against it will depend
on its credit strength.
Counterparty risk also arises on making cash deposits, or buying negotiable
instruments. It represents the possibility of a financial institution that
10
CORPORATE TREASURY AND CASH MANAGEMENT
accepts deposits, or a company that issues financial instruments, failing
and being unable to meet its obligations.
Equity risk
Manifestations of this include share repurchases, when a company is
exposed to the increase in its own share price. It can also arise in mergers
and acquisitions, due both to increases in the share price of potential targets
and, if a company is contemplating using its own shares to make a
purchase, to falls in its own share price. Finally companies that make use
of share option schemes are exposed to increases in their share price. The
difference between the market price of their shares when an employee or
director exercises an option and the cost of the option to the employee or
director represents a cost to the company.
Other financial risks
As companies begin to manage and increase their knowledge of treasury financial risk, they may recognize other exposures that can be
managed by the treasurer. This may be as the result of the development
of new derivatives or because a more extensive analysis of risks identifies exposures that hitherto had lain undetected. A recent example
is the development of weather derivatives by some banks in response
to companies who identified a relationship between temperature and
financial results.
M A N AG E M E N T O F F I N A N C I A L R I S K S
There are a number of distinct steps in the management of financial risks:
ᔢ
Identify financial risks within the organization.
ᔢ
Measure these risks.
ᔢ
Define the company’s risk management policies, which will be
enshrined in the company’s treasury policies.
ᔢ
Implement the financial risk management programme.
ᔢ
Report on the progress of risk management.
ᔢ
Periodically re-evaluate the whole management process.
RISK MANAGEMENT: INTRODUCTION
11
Identification of financial risks
In most organizations the treasurer will generally know quite accurately
those treasury financial risks to which the company is subject. He or she
will either be involved in actively managing these risks, or equally there
may be a number of financial risks that the company is aware of but has
decided for one reason or another not to manage. In larger companies,
where flows are more complex, or where the treasurer or finance director
has just been appointed, a separate exercise may be required to identify and
map treasury financial risks.
One common approach is to analyze the income statement and balance
sheet on a line-by-line basis and identify those financial risks which apply
to each line.
This analysis might be conducted as shown below.
Turnover
ᔢ
To whom does the company sell and in what currency? Are customers
price or quality sensitive? Do customers have access to alternative
products? What are the standard terms of business?
ᔢ
Where does the company sell? What is the proportion of domestic and
international sales, and which currencies are sales made in? Are
exchange controls operating in certain countries? Is there concentration
of revenues in certain countries or industries, or is there a default risk
of a significant customer?
ᔢ
Where are the company’s competitors based? In what currencies do they
sell, and in what currencies do they buy? What is their hedging policy?
Cost of goods sold
ᔢ
Where does the firm manufacture the goods it sells?
ᔢ
What goes into what the firm makes or does? A production process
may use substantial amounts of raw material or semi-finished goods
that must be purchased overseas. Alternatively it may use commodities
that fluctuate in price according to market conditions and are priced in
a foreign currency such as US$.
ᔢ
Where are the company’s suppliers based? Do the suppliers invoice in
their own currency or in the company’s currency? If the latter, what
financial risk is the company carrying? Do the suppliers use currency
variation clauses?
12
CORPORATE TREASURY AND CASH MANAGEMENT
Other general costs
ᔢ
Does the company operate share option schemes? Do they represent an
exposure?
ᔢ
How significant is interest expense?
ᔢ
Are premises, equipment or vehicles leased? Are the lease rental
payments effectively fixed rate finance?
Balance sheet
ᔢ
Are receivables concentrated in one or two large customers?
ᔢ
Does the company provide significant amounts of financing to its
customers?
ᔢ
What currencies are its major assets and liabilities denominated in?
ᔢ
What is the company’s financial structure? What is the maturity profile
of its debts? Which markets does it raise its finance in? Has the
company issued convertible bonds or debt with warrants, and are they
still outstanding?
ᔢ
What is the fixed/floating structure of its debts?
ᔢ
Does the company have cash on deposit?
ᔢ
What is the currency denomination of receivables?
The above approach analyzes the profit and loss and balance sheet. Other
approaches may be to identify key business drivers or business processes
and analyze the financial risks inherent in those drivers or activities.
Mapping treasury-related financial risks
Once identified, the risks can be mapped as shown in Table 1.2.
Measurement of financial risk
One of the corporate treasurer’s concerns is how to actually measure the
exposures identified. A company may decide that interest rate risk and
foreign exchange transaction and pre-transaction risks are its major
treasury-related financial risks, but how do they quantify the size of these
risks? This must be done before one can answer the next question: ‘How
significant are these risks?’
US$
liabilities
Liabilities
£1bn debts
US$ assets
Assets
Purchases
from €
FX
translation
US$
revenues
Purchases
from €
Cost of sales
50%
overseas
sales
US$, €, ¥
FX pretransactions
Admin.,
selling and
interest
50%
overseas
sales
US$, €, ¥
FX
transactions
Turnover
Financing
10% energy
– electricity
Commodity
Short-term
liabilities
Cash
deposits
Liquidity
Derivatives
Derivatives
3 major
customers
Counter
party
Table 1.2 Mapping treasury risks against profit and loss and balance sheet items
30%
fixed
70%
floating
Interest
rates
14
CORPORATE TREASURY AND CASH MANAGEMENT
Business planning process
The starting point for most organizations is the annual business planning
process, which is usually followed by the budget process. A company with a
year ending 31 December may have the following planning and budgeting
timetable and process for managing the business.
Three year business plans completed and
approved by board
31 August
Annual budget, related to the first year of the business 31 November
plan, completed and approved by the board
Monthly reports comparing actual results against
budget
Monthly
Reforecast budget
Twice a year
(Period 5 and 9)
Rolling 12 month cash forecasts
Every three
months
Three-year business plan
In many organizations this is very much a ‘blue sky’ approach. It consists of
identifying the organization’s strengths and weaknesses, the economic and
business outlook it is likely to operate under, how it will respond to competitor actions, what its major risks and opportunities are. From an assessment
of these and many other strategic factors, the company develops its business
plan. This will summarize the markets it will operate in, which products or
businesses it will develop and which it will sell or reduce, and how it will
develop its business. Financial projections are prepared on the basis of the
determined strategy, to ensure that the business plan delivers the necessary
shareholder value and meets market expectations.
The financial projections normally consist of profit and loss accounts by
operating division or subsidiary, together with balance sheets and cashflows for each year of the business plan.
Annual budget
The annual budget often takes the financial projections for the first year of the
business plan and turns them into a detailed financial budget, together with
responsibilities for each line. Usually operating divisions/subsidiaries are
accountable for achieving financial targets within the budget, such as profit
RISK MANAGEMENT: INTRODUCTION
15
before interest, cashflow and return on asset targets. In addition there may be
qualitative targets that need to be achieved, such as like-for-like sales growth.
Some corporate departments may also have major budget responsibilities. The treasury department for example may have responsibility for
achieving the rates inherent within the interest budget.
Monthly reports
Monthly reports are submitted by operating divisions or subsidiaries,
comparing performance against budgets. These reports contain all the relevant variance analysis and action, together with remedial plans to correct
shortfalls or adverse variances.
Forecasts
As the year progresses the actual results will vary from budget. At some
point during the year the company will reforecast the remaining months of
its budget to reflect these changes.
Basis of exposure identification
It is these financial projections, budgets and forecasts that the treasurer
uses to identify the size of various financial risks. For instance, the threeyear plan and annual budget will identify cashflows and hence borrowing
requirements. The resulting borrowing requirements, when evaluated at
assumed interest rates for the plan and budget, will produce planned and
budgeted interest costs. The budget will identify overseas sales by
currency, and purchases in foreign currencies, which will be used as the
starting point for identifying pre-transaction exposure.
It is worth noting that actually measuring financial risks is often one of
the more difficult aspects of risk management. Business is increasingly
volatile; strategies decided today can quickly become obsolescent. Cashflows are often notoriously inaccurate due to swings in working capital
and the timing of the capital expenditure programme. Sales by currency
can in some cases be no more than an inspired guess on the part of sales
department, let alone the timing of cash receipts from these sales.
Ranking of treasury-related financial risks
The most usual way of ranking treasury risks is by attempting to measure
their scale and magnitude. Clearly only those risks that are significant or
16
CORPORATE TREASURY AND CASH MANAGEMENT
that might substantially impact on the achievement of an organization’s
strategy should be considered for active management. There are a number
of ways an organization may attempt this measurement.
Notional change in rates or prices
This assesses the impact of a notional change in the market rate or price on
the underlying risk. This assessment is often made by comparing the
magnitude of such notional changes against a benchmark such as the
underlying budget or forecast for the revenue, cost or balance sheet item.
For example, Company A has UK£500 million of borrowings, all at
floating rate. It measures the risk of borrowing at a floating rate by assessing the impact of a 1 per cent increase in sterling interest rates: UK£5
million. Budgeted interest expense for the year is UK£27 million, and
budgeted profit before tax is UK£100 million. Therefore a 1 per cent
increase in interest rates would increase interest expense for the year by
almost 20 per cent, and reduce profit before tax by 5 per cent.
The same approach can be applied to foreign exchange, commodity and
equity risks, and other financial risks that are denominated by financial
prices.
Mathematical techniques such as value at risk (VaR), cashflow
at risk or earnings at risk
Simply put, VaR or other related techniques measure the possible adverse
change in market value of a financial instrument, on the basis of what is
regarded as the largest likely adverse move in rates or prices over a given
timeframe. It also includes the correlation between different financial
instruments to measure the volatility of a financial portfolio of instruments.
These techniques have been adapted by some corporates to measure the
significance of market-price-related financial risks.
Qualitative measurement
Not all financial risks are influenced by changes in market rates and prices.
Examples of such risks are financing risk, bank relationships, counterparty
risk and liquidity risk An organization may assess the significance of these
risks by their impact on its strategic objectives should these exposures
mature. For instance the prospect of being unable to raise long-term
finance is likely to have significant implications for a company with an
expansionary strategy involving substantial amounts of new finance.
RISK MANAGEMENT: INTRODUCTION
17
Whatever the process or technique selected for measuring or assessing
financial risk, it should be related to a company’s overall risk management process (see page 20). There seems little point in spending large
amounts of time and resources in refining risk measurement techniques
in treasury, if more significant risks elsewhere in the organization can
only be qualitatively assessed.
Establishing risk management policies
What should a company’s policy be towards those financial risks that it has
identified and measured? A company first needs to consider what its risk
management objectives are. Is the organization risk averse or a risk taker?
Is its objective to eliminate, as far as possible, all financial risks or are there
certain risks it is accepting? If so, how large are they?
Influences on treasury policies
A company’s attitude to risk will be influenced among other things by:
ᔢ
Its corporate philosophy. Some organizations are naturally more
cautious, conservative and prudent than others; they may not only try
to manage a wider range of potential exposures, they may also manage
these risks down to a lower level of exposure.
ᔢ
Its financial structure and/or volatility of its cashflows. Arguably a
company with high financial and operational gearing will be more
conservative in its risk management and more risk averse than a
company with lower financial and operational gearing, since small
movements in financial market rates or prices can have a major negative
impact on the former company’s financial structure and viability.
ᔢ
What its competitors do.
ᔢ
The volatility of the business sector that it operates in. What does the
financial community expect it to do regarding risk management?
ᔢ
What its principal advisers tell it.
ᔢ
The achievement of its corporate strategy. For instance, companies
that have just embarked on a radical change in strategy that may
involve acquisitions, disposals or a major capital expenditure
programme will be reluctant to accept any risks that may adversely
affect this new strategy.
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CORPORATE TREASURY AND CASH MANAGEMENT
ᔢ
The size of its financial risks in relation to some benchmark such as the
current year’s budget or forecast, a 12-month rolling forecast or the
three-year strategic plan.
ᔢ
Natural hedges within its business.
Content of treasury policies
A company will need to determine which risks it wants to manage, the level
to which it wants to manage those risks and what its risk management strategy will be. The resulting approach to financial risk management will be
enshrined in its treasury risk policy. This will include statements defining:
ᔢ
what its principal financial risks are
ᔢ
what its objectives are in managing these risks
ᔢ
who has responsibility for managing the risks
ᔢ
what authority levels are and what instruments are authorized to be
used
ᔢ
what reports will be submitted and to whom.
The treasury risk policy will generally be approved by the main board.
Managing risks
Sometimes this is the easiest of all the steps in the risk management
process. It is the step that involves the implementation of the treasury
policy.
A company may, for instance, have examined and measured the various
financial risks to which it is exposed and concluded that the interest
expense on its borrowings is a major risk requiring management. Their
resulting treasury policy may have established that between 30 and 50 per
cent of their forecast borrowings over the next three years should be at
fixed rates, with the objective of minimizing the impact of any unforeseen
rise in interest rates. The management step involves:
ᔢ
examining forecast borrowings over the next three years
ᔢ
determining the level of those borrowings that are at fixed rate
ᔢ
implementing any necessary hedges, where the level of fixed rate
borrowings falls below the 30 per cent level
RISK MANAGEMENT: INTRODUCTION
ᔢ
19
making a further decision where the level of fixed rate borrowings is
between 30 per cent and 50 per cent.
It should be noted that treasury risks are not always managed through the
use of derivatives.
ᔢ
It may be inappropriate to rely solely on derivative instruments (e.g.
counterparty risk).
ᔢ
Some risks may be netted out (e.g. purchases and sales in the same
foreign currency).
ᔢ
There may be a natural hedge against some risks. For example, a
company with foreign currency receipts in two currencies may find
that when one currency weakens against its domestic currency the
other strengthens.
ᔢ
Some risks may be altered (e.g. currency adjustment clauses).
It is likely however that substantial reliance will be placed on the use of
derivatives, particularly those for managing movements in market prices or
rates. It is worth mentioning that most corporates will try to identify other
means of managing risks before using derivatives. Business and treasury
risks can be very volatile, and risks that exist today may disappear tomorrow as a result of changes in a company’s strategy. Derivative contracts
however, once entered into, represent contractual obligations that a
company may find expensive to cancel later on.
Reporting
A treasury department will need to report regularly on its the risk management process. Most treasury departments produce a monthly treasury
report that summarizes:
ᔢ
Financial exposures outstanding.
ᔢ
Hedges in place. This may be further analyzed between those brought
forward from the last report, those maturing this month/period and new
hedges implemented.
ᔢ
Sensitivity analysis.
ᔢ
Recommendations as to action.
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CORPORATE TREASURY AND CASH MANAGEMENT
Some organizations use a treasury committee to review outstanding financial risks periodically. Members of the committee may be the treasurer, the
finance director or chief financial officer, and perhaps the director of strategy. The objective of the committee is to bring a group perspective to bear
on treasury risk management. Decisions on treasury risks will be made in
the light of all risks currently being faced by the company, with the result
that treasury risk management is put into the context of the overall
company risk management.
Other organizations may just use periodic meetings between the treasurer and finance director to determine what further risk management action
needs to be taken.
E N T E R P R I S E R I S K M A N AG E M E N T
Outline
So far we have been considering risk management from the standpoint of
the corporate treasurer, and the concept of financial risk that was used
was that which the treasurer has responsibility for managing. In the
1990s the idea of managing risk throughout the organization was relatively new and most companies focused on specific, mainly financial and
insurable risks.
Companies have come to pay particular attention to the management of
risks throughout their organization due to a combination of: legal and
compliance requirements on companies; the increasing need to communicate a company’s risk management processes to various stakeholders; and
a recognition of the benefits that an active, and corporate-wide, risk
management programme can have on achieving the strategic aims of the
organization and building shareholder value.
An assessment of the system of internal control is as relevant for the
smaller listed company as it is for larger ones, since the risks facing such
companies are generally increasing. Risk management is essential for
reducing the probability that corporate objectives will be jeopardized by
unforeseen events. It involves proactively managing those risk exposures
that can affect everything the company is trying to achieve.
A poll of some 200 chief financial officers, treasurers and risk
managers conducted in the United States found that more than 75 per cent
of the respondents indicated that a major disruption would have a
dramatic impact on their companies’ earnings or even threaten their business continuity. According to the study, respondents were most worried
RISK MANAGEMENT: INTRODUCTION
21
about property-related hazards such as natural disasters, fires/explosions,
terrorism/sabotage/theft, mechanical/electrical breakdowns and service
disruptions. More than a third of the respondents believed that their
companies’ senior management team lacked a complete understanding of
what would happen to their companies’ earnings and shareholder value if
an interruption occurred.
Among the steps involved in implementing and maintaining an effective
risk management system are:
ᔢ
identifying risks
ᔢ
ranking those risks
ᔢ
agreeing control strategies and risk management policy
ᔢ
taking action
ᔢ
regular monitoring
ᔢ
regular reporting and review of risk and control.
As can be seen, the process for managing risks on an enterprise-wide basis
is essentially the same as that established by the treasurer for managing
treasury-related financial risks.
Identifying risks
Risks are often classified into: business, operational, financial and compliance risks.
Business risks
These arise from being in a particular industry and geographical area, and
from the strategy the company has chosen to undertake. The risks can range
from wrong business strategy, bad or failed acquisitions and inability to
obtain further capital, to competitive pressures on price and market share,
political risks or the decline of an industry sector.
Operational risks
These relate to the various administrative and operational procedures
that the business uses to implement its strategy. They may include skills
shortages, stock-out of raw materials, physical disasters, loss of
22
CORPORATE TREASURY AND CASH MANAGEMENT
physical assets, quality problems, loss of key contracts or poor brand
management.
Financial risks
In addition to those already discussed in relation to treasury risk management, financial risks can also comprise: going concern problems, overtrading, misuse of financial resources, occurrence of fraud, misstatement risk
relating to published financial information, unrecorded liabilities and penetration of IT systems by hackers.
Compliance risks
These derive from the necessity to ensure compliance with those laws
and regulations that, if infringed, can damage a company. They can
include breach of listing rules, breach of Companies Act requirements,
VAT problems, tax penalties, health and safety risks and environmental
problems.
In identifying risks, it is important to avoid selecting them from some form
of generic list. The risks need to be specific to the industry sector and
specific circumstances of the company. It is also useful to relate them to the
likely obstacles facing the critical success factors that underpin the
achievement of the company’s objectives.
Quantifying and ranking risks
As with the measurement of treasury-related financial risks, the company
is faced with the problem of quantifying or measuring the identified risks.
While many treasury financial risks relate to movement in market prices
and thus the possible impact of adverse price movements within certain
ranges can be calculated, many of the identified enterprise risks are incapable of such direct measurement. Most organizations therefore rank such
risks according to:
ᔢ
High likelihood of occurrence–high impact: Consider for immediate
action.
ᔢ
Low likelihood of occurrence–high impact: Consider for action and
have a contingency plan.
ᔢ
High likelihood of occurrence–low impact:
Consider action.
RISK MANAGEMENT: INTRODUCTION
ᔢ
Low likelihood of occurrence–low impact:
23
Keep under periodic
review.
The impacts should be considered not merely in financial terms, but more
importantly in terms of their potential effect on the achievement of the
company’s objectives.
Agreeing control strategies
Various methods can be used to deal with risks identified and ranked. The
directors need to ask the following:
ᔢ
Do we wish to accept the risk?
ᔢ
What is the control strategy for avoiding or mitigating the risk?
ᔢ
What is the residual risk remaining after the application of controls?
ᔢ
What is the early warning system?
Generally there are four main ways of dealing with risks:
ᔢ
Accept them. Some risks may be inherent to the business (e.g. economic
risks or volatility), and investors may actively have sought securities
reflecting them. In addition there may be some cases when the costs of
managing risks are greater than the benefits from risk reduction.
ᔢ
Transfer them. This is usually done through insurance or derivatives.
ᔢ
Reduce or manage them by improving controls within existing
processes; for example by improving production control techniques to
reduce the likelihood of stock-out of raw materials.
ᔢ
Eliminate them, generally through the pursuit of existing strategies.
For instance, the risk of market share pressures may be handled
through an existing strategy of repositioning products and expanding
the product range.
Taking action and reporting
Not only does the agreed action need to be taken but a regular reporting
procedure needs to be put in place. In a small organization, responsibility for
this may be delegated to the finance director or chief executive, but in larger
organizations this role is likely to be undertaken by a risk management
committee, led by senior executives or board directors.
24
CORPORATE TREASURY AND CASH MANAGEMENT
Implications for the treasurer
What implications does an organization-wide risk management system and
process have for the treasurer? It can be seen that the steps adopted in such
a process are essentially the same as those adopted by the treasurer in identifying and managing risks within the scope of the treasury department.
The treasurer’s risk management routines will in most organizations be part
of the organization-wide risk management routines. Treasury risks and
action to identify, measure, manage and report them need to be set within
the framework of corporate-wide risk management.
CHAPTER 10
Interest Rate Risk
Derivatives and Their
Use in Managing
Financial Risk
I N T E R E S T R AT E S WA P S
Definition
An interest rate swap is a legal arrangement between two parties to
exchange interest rate payments or receipts on a notional principal amount,
for a specific period of time. The interest obligations are in the same
currency. There is no exchange or payment of principal under an interest
rate swap.
Example
In the following example, a corporate has borrowed US$20 million under
a five-year bank term loan. The loan is at floating rate, whereby the corporate pays six-month US$ LIBOR plus a margin of 50 basis points. The
corporate wants to change the interest payment basis from floating to fixed.
To achieve this it enters into a fixed–floating five-year interest rate swap
with a bank whereby the corporate pays a fixed interest rate on US$20
million for five years, and receives floating rate at US$ LIBOR on US$20
million for five years.
209
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CORPORATE TREASURY AND CASH MANAGEMENT
Fixed
Bank
Borrower
Floating
LIBOR + 50bp
US$ 20m
term loan
Figure 10.1 Diagram of an interest rate swap with a borrower receiving floating
and paying fixed rates
The effect of the swap is as follows:
Term loan
SWAP
NET
Pay six-month US$ LIBOR + 50bp
Receive
six-month US$ LIBOR, pay fixed
__________________________________
Pay fixed + 50bp.
There is no exchange of principal, only interest is exchanged.
Effect of interest rate swaps
The corporate treasurer of the organization has now converted the floating
rate liability into a fixed rate liability. The two US$ LIBOR flows, one a
payment on the loan and the other a receipt under the interest rate swap,
cancel each other out. This leaves the fixed flow that is payable under the
swap, plus the 50 basis point margin on the loan.
Let us assume that the fixed rate payable under the swap is 5 per cent
every six months, and that US$ LIBOR for the first six months of the swap
is 4 per cent. At the end of the first six months the net cash paid under the
swap and term loan is:
Company pays 5 per cent on US$20 million for six months
(5 per cent × 20 m × 182/360) under swap
(505,555)
INTEREST RATE DERIVATIVES
211
Company receives six-month US$ LIBOR – 4 per cent on US$20 million
for six months
(4 per cent × 20 m × 182/360) under swap
404,444
Company pays US$ LIBOR + 50bp on US$ 20 million
for six months under term loan
(455,000)
________
(556,111)
________
A net payment under the swap of US$101,111 is payable by the company
to the bank. The final net borrowing cost equates to a fixed rate borrowing
of 5.5 per cent and is calculated:
Company pays 5 per cent on US$20 million
for six months under swap
Company receives US$ LIBOR on US$
20 million under swap
Company pays US$ LIBOR + 50bp on
US$20 million under term loan
(5 per cent)
LIBOR
(LIBOR + 50bp)
______________
(5.50 per cent)
LIBOR fixings or swap roll-overs
LIBOR (see Appendix) or its equivalent under an interest rate swap can be fixed
for different periods (three months, six months or a year being the most common).
If LIBOR is fixed every six months, then on a five-year interest rate swap there
will be ten fixings. At the beginning of each period, LIBOR for that period is
fixed, interest exchange taking place at the end of the period (Figure 10.2).
The five-year term loan is composed of ten LIBOR fixings. The matching five-year interest rate swap, which converts the floating rate borrowings to fixed, also consists of ten LIBOR fixings. There will be ten
exchanges of interest during the life of the swap. The dates of the roll-overs
under the swap must match those under the term loan to completely cover
the exposure to floating rate.
Variations in LIBOR during the life of the swap
During the life of the swap, six-month LIBOR may sometimes be above
the fixed rate in the swap. In this case the fixed rate payer will receive a net
payment at the end of the LIBOR period. On other occasions six-month
LIBOR may be below the fixed swap rate, in which case the fixed rate
payer will make a net payment at the end of the LIBOR period.
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CORPORATE TREASURY AND CASH MANAGEMENT
5-year term loan
6-month LIBOR payments
(10 in total)
5-year interest rate swap
6-month LIBOR receipts
(10 in total)
Figure 10.2 LIBOR fixings during a five-year interest rate swap
6-month LIBOR
Fixed rate
under swap
6-month LIBOR
Time
Figure 10.3 LIBOR during the swap in relation to the swap fixed rate
INTEREST RATE DERIVATIVES
213
Elements of interest rate swaps
There are a number of elements to an interest rate swap:
ᔢ
Interest rate swaps are always based on a notional principal amount.
In the case of the above example the notional amount is US$20
million.
ᔢ
Interest rate swaps always have a maturity period. In the above example,
the swap runs for five years.
ᔢ
The floating rate (LIBOR or equivalent) can be for any period up to
one year. However three months, six months or one year are the most
popular periods.
ᔢ
Usually both the interest payments are for the same period. If the floating
leg is based on six months, then the same will apply to the fixed rate leg.
ᔢ
Interest is always exchanged at regular intervals, usually at the end of
each interest period. The interest exchange is netted; in other words,
there is one net interest payment.
ᔢ
Interest rate swaps can be used to fix the interest receivable on a cash
deposit as well as the interest payable under a floating rate loan. (In this
case the corporate would pay floating rates under the swap and receive
fixed.)
ᔢ
Interest rate swaps can also be used to swap fixed rate borrowings to
floating. (In this case the corporate would receive fixed rates to offset
the fixed rate under the borrowing and pay floating.)
Determining the fixed rate under the swap
The fixed rate under an interest rate swap will be determined by the rates
ruling in the swap market when the swap is undertaken. It will be established in much the same way as the fixed rate under a corporate bond.
The yield on the relative government security (for a five-year swap this
is the yield on the five-year benchmark government security used by the
swap market) is determined, and the swap spread added.
The fixed rate under a swap will reflect three things:
ᔢ
The yield curve for the relevant benchmark government bonds used by
the stock market. This will change as a result of changes in both the
market perception of the outlook for interest rates and the supply of
and demand for government bonds.
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CORPORATE TREASURY AND CASH MANAGEMENT
Swap curve
Swap spread
Underlying government
bond yield curve
Figure 10.4 Swap yield curve versus the government bond yield curve
ᔢ
The perception of bank risk relative to the government risk. Banks,
who are the principal counterparties to interest swaps, lend to each
other at LIBOR. The size of the swap spread reflects the market
perception of bank risk relative to government risk.
ᔢ
The number of counterparties wishing to pay fixed under an interest
rate swap. Simplistically, a surfeit of counterparties willing to pay
the fixed rate will cause spreads to widen, since banks will increase
the price at which they receive fixed to a level where the counterparties no longer have the appetite to pay. Conversely a reduction in
counterparties willing to pay the fixed rate will cause spreads to
narrow.
For the corporate treasurer seeking the opportunity to undertake an interest
rate swap in a particular currency, the significance of the above is that not
only must the relevant government bond yield curve be kept under observation but the swap spread also needs to be monitored. This is because both
these factors establish the swap yield curve for a currency.
Different types of interest rate swaps
Interest rate swaps, being merely a package of cashflows, can come in as
many variations as there are variations in packaging the cashflows. The
following are some of the different types of interest rate swaps that a
corporate treasurer may use:
INTEREST RATE DERIVATIVES
215
Accreting swaps: The notional principal increases at each interest rate
setting. Accreting swaps can be used to hedge zero-coupon notes.
Amortizing swaps: The notional principal amortizes over a period of time.
Such swaps are used to hedge amortizing borrowings such as leases or term
loans that amortize over a period of time.
Basis swap: Enables the corporate treasurer to change the interest basis of
a loan, for example a basis swap where one party pays six-month LIBOR
and the other pays three-month LIBOR.
Forward starting swaps: Instead of the swap starting today (i.e. spot), the
swap starts at some time in the future. Treasurers taking out swaps often
have to ensure that the dates of the interest rate fixings in the swap coincide with the interest payment dates in the underlying loan that is being
hedged. Very often that next interest payment date on the loan when the
swap is transacted may be some months away.
I N T E R E S T R AT E O P T I O N S ( I R O )
Definition
An interest rate option gives its buyer the opportunity to protect the rate of
interest payable or receivable on a notional loan or deposit for a specified
period. The protection rate is the strike rate under the option. The option
will guarantee a maximum interest payable on a loan, or a minimum return
on a deposit. A premium is payable by the option buyer.
An interest rate cap protects the rate of interest payable on a notional loan
from an upward movement in interest rates, and thereby guarantees a maximum interest payable. An interest rate floor protects the rate of interest
receivable on a notional deposit from a downward movement in interest
rates, and thereby guarantees a minimum.
Example of an interest rate cap
The corporate treasurer in the previous example decides not to hedge the
floating rate borrowing with an interest rate swap. Instead he or she
decides to use an interest rate cap to hedge the exposure to rising interest
rates that a floating rate borrowing brings. The quotes obtained are shown
in Table 10.1.
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CORPORATE TREASURY AND CASH MANAGEMENT
Table 10.1 Elements of quotations for two alternative interest rate caps
(assuming a flat yield curve of 4.75 per cent)
Alternative one
Alternative two
Currency
US$
US$
Notional principal
US$ 20 million
US$ 20 million
Period
5 years
5 years
Roll-overs
6-monthly
linked to US$ LIBOR
6-monthly
linked to US$ LIBOR
Strike rate
5.00 %
5.50 %
Premium payable
1.81 %
1.21 %
Total premium payable
US$ 362,000
US$ 242,000
Clearly an interest rate cap with the strike at 5.5 per cent will cost less
than an interest rate cap with the strike rate set at 5.00 per cent. The treasurer decides to select the cap that provides the greatest protection, namely
that with a strike rate of 5.00 per cent.
Let us assume that at the beginning of the third six-month US$
LIBOR fixing that US$ LIBOR has now risen to 5.5 per cent, and that
the roll-over period is 182 days. The treasurer will receive under the
interest rate cap:
US$20,000,000 × 0.5 per cent × 182/360 = US$ 50,555.55
It may well be that, at the commencement of the fifth six-month US$
LIBOR fixing, US$ LIBOR has now fallen to 4.75 per cent. In that case
the interest rate cap is out of the money for that particular rollover period, and the cap buyer borrows at the lower US$ LIBOR rate
(Table 10.2).
Aspects of interest rate options
It is natural for the treasurer to look at the swap yield curve when deciding
where to set the strike price. However, it must be remembered that the yield
curve consists of a whole series of forward–forward rates. When the yield
curve is upward sloping, the curve for forward–forward rates rises more
steeply than the underlying par curve, and lies above the that curve. With a
INTEREST RATE DERIVATIVES
217
Table 10.2 The effect of an interest rate cap at different interest rates
LIBOR at 5.5 %
LIBOR at 4.75 %
Strike rate under cap
5.00 %
5.00 %
6-month LIBOR
5.5 %
4.75 %
Interest rate on underlying loan
5.50 %
4.75 %
Receivable under interest rate cap
0.50 %
NIL
Net borrowing cost
5.00 %
4.75 %
downward sloping yield curve, the forward–forward rates fall more steeply
than the underlying par curve, and lie below it (see Chapter 11).
The calculation of the premium payable under a particular interest rate
cap is established by splitting the option into a series of individual
‘caplets’. Each individual caplet relates to an individual roll-over period or
LIBOR setting. The strike rate under each caplet is compared with the
forward–forward rate for that roll-over period in determining the premium
payable for the caplet. The premium payable for the option is a summation
of the premiums for each caplet.
Table 10.3 shows hypothetical five-year swap rates for US$. The
forward–forward rates have been calculated using the formula explained in
in Chapter 11.
By setting the strike at 3.50 per cent for a five-year cap, the strike rate
for three of the four caplets will all be in the money when established.
Therefore the treasurer will need to consider a strike of say 3.25 per cent
for year two, 3.75 per cent for year three and so on.
Table 10.3 Swap rates and corresponding forward–forward rates
Swap rates
Forward–forward rates
1 year
2.50 %
2 years
2.75 %
12 vs 24
3.04 %
3 years
3.00 %
24 vs 36
3.55 %
4 years
3.25 %
36 vs 48
4.09 %
5 years
3.50 %
48 vs 60
4.65 %
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CORPORATE TREASURY AND CASH MANAGEMENT
Interest rate collars
It should be clear that one of the principal attractions of using options to
manage interest rate risk is the flexibility of the instrument. While the
downside of adverse interest rate movements (rising interest rates in the
case of a loan, or falling in the case of cash deposits) is protected against,
the option buyer benefits from any positive movement in interest rates. One
of the problems the treasurer faces with using interest rate options is that
boards of directors or finance directors often react negatively to the
absolute amount of the premium payable. In the example used above, the
absolute cost of the interest rate cap at 5.00 per cent was US$462,000. For
many this is psychologically too great a price to pay for protection.
Banks selling options to corporates have therefore developed structures
that, while trying to keep some of the flexibility of an option, reduce the
upfront premium. A common example of this type of structure is the interest
rate collar. If one of the problems with an interest rate cap is the premium
payable by the corporate buyer, this can be reduced if the corporate, in turn,
sells an option to the bank.
A corporate wishing to obtain protection against rising interest rates
could reduce the premium payable to obtain that protection by selling an
interest rate floor. In such a case, if interest rates fell below the strike rate
under the floor, the corporate gives up all further gain.
Sometimes collars are structured to reduce the premium payable to zero,
in which case the premium receivable from selling the floor exactly offsets
the premium payable on the cap. In other cases collars are structured to
reduce the premium payable, but not to zero.
In the scenario given in Table 10.4, assume that the corporate treasurer
selects example one. What happens under the two scenarios when sixmonth US$ LIBOR exceeds the cap rate and when six-month US$ LIBOR
falls below the floor rate interest rate? This is shown in Table 11.5.
Payout under different interest rate scenarios
It is probably clear from Table 10.5 that the collar operates something like
an interest rate swap operating within bands.
E XOT I C O P T I O N S
Exotic options in some cases not only reduce the size of the premium
payable, but can also provide a very flexible hedging instrument. The most
INTEREST RATE DERIVATIVES
219
Table 10.4 An example of two interest rate collars
(based on a yield curve of 5 per cent throughout)
Example one
Example two
Currency
US$
US$
Notional principal
US$20 million
US$20 million
Period
5 years
5 years
Roll-overs
6-monthly
linked to US$ LIBOR
6-monthly
linked to US$ LIBOR
Strike rate under cap
5.50 %
5.50 %
Strike rate under floor
4.50 %
4.00 %
Premium payable
0.20 %
0.68 %
Table 10.5 The net borrowing cost on a notional US$20 million loan under
different interest rate scenarios using an interest rate collar
LIBOR at 6.0 %
LIBOR at 4.75 % LIBOR at 4.0 %
Strike rate under cap/floor
5.50 %
5.50 %/4.50 %
4.50 %
6-month US$ LIBOR
6.0 %
4.75 %
4.00 %
Interest rate on
underlying loan
6.00 %
4.75 %
4.00 %
NIL
0.50 %
4.75 %
4.50 %
(Receivable) under
interest rate cap/
payable under floor
(0.50 %)
Net borrowing cost
5.50 %
usual exotic option that is marketed for interest rate management is the
‘digital cap’ (see Table 10.6). This gives a fixed payout if the strike rate is
breached on one of the interest setting periods.
Payouts under different hypothetical interest rate scenarios for the above
two instruments are shown in Table 10.7.
Digital options can be combined with standard options to produce different derivative structures. One example might be combining a digital cap
with a standard floor to produce a zero-cost collar. In this structure, the
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CORPORATE TREASURY AND CASH MANAGEMENT
digital cap buyer receives a fixed payout if the floating rate exceeds the cap
level, and pays the difference between the floating rate and the strike rate
under the floor if interest rates fall below the floor.
Interest rates
X
Receive under cap
Cap rate
X
X
Floor rate
X Pay under floor
Time
Figure 10.5 Operation of interest rate collar
Note: X = actual six-month LIBOR
Table 10.6 Comparison of a digital cap with an interest rate cap
Standard cap
Digital cap
Currency
US$
US$
Notional principal
US$20 million
US$20 million
Period
5 years
5 years
Roll-overs
6-monthly
linked to US$ LIBOR
6-monthly
linked to US$ LIBOR
Strike rate under cap
5.00 %
5.00 %
Payout
6-month US$ LIBOR
minus cap strike rate
50 basis points
Premium payable
1.81 %
1.20 %
INTEREST RATE DERIVATIVES
221
Table 10.7 Payout under the digital in table
under different interest rate scenarios
6-month US$ LIBOR
Standard cap payout
Digital cap payout
4.75 %
NIL
NIL
5.00 %
NIL
50 bps
5.25 %
25 bps
50 bps
5.50 %
50 bps
50 bps
5.7 %
75 bps
50 bps
6.00 %
100 bps
50 bps
6.25 %
125 bps
50 bps
S WA P T I O N
Definition
A swaption is a contract that confers on the buyer the right (but not the obligation) to enter into an interest rate swap on pre-determined terms at the
end of a specified period (option period) in the future. The buyer pays the
seller a premium for this right.
Elements to calculate the premium payable/receivable
A swaption is, as its name implies, an option on a swap. The premium
payable is based on:
ᔢ
the period of the option
ᔢ
the period of the swap
ᔢ
the fixed rate of the swap
ᔢ
whether the option purchaser will be a fixed rate receiver or a payer
ᔢ
the volatility of swap rates
ᔢ
whether it is an American or European option.
Given the US$ yield curve shown in Table 10.8, a quotation for a six-month
swaption on a three-year swap could be as shown in Table 10.9.
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CORPORATE TREASURY AND CASH MANAGEMENT
Table 10.8 Assumed US$ yield curve
Period
Rate
6-month LIBOR
1.40 %
1 year
1.55 % (s.a.)
2 years
2.25 % (s.a.)
3 years
2.75 % (s.a.)
4 years
3.25 % (s.a.)
5 years
3.40 % (s.a.)
Table 10.9 Quotation for a European swaption
Swaption details
Expiry date of swaption
Today + 182 days
Currency
US$
Nominal amount
US$20 million
Swaption buyer
Fixed rate payer/floating rate receiver
Swap maturity
Today + 3 years and 182 days
Swap rate
3.30 %
Premium
49 bps (US$98,000)
If, in six months, the three-year swap rate has fallen below 3.30
per cent, then the treasurer would let the option lapse and take a
swap out in the market. If the rate is above 3.30 per cent, the treasurer
would exercise the option and take out the three-year swap at 3.30
per cent.
It must also be remembered that the yield curve is upward sloping,
so the effective rate for a six-month forward starting swap is going
to be higher than the current three-year spot rate. Hence the rate under
the swaption (which would be equivalent to the rate for a three-year
swap forwarding starting six months), is higher than the spot four-year
rate.
INTEREST RATE DERIVATIVES
223
Use of swaptions
Swaptions can often be used in a hedging programme where the treasurer
is looking to ‘buy some time’ or add some flexibility into the programme.
A typical situation maybe where the treasurer has to undertake a major
hedging programme, but is hesitant about whether the current rates ruling
may not be bettered in the market over the next six months or so. A swaption enables the treasurer to take out protection, but retain the opportunity
to benefit from a substantial fall in long-term interest rates during the
option period.
Swaptions also have their uses in managing the issuance of bonds.
T H E E F F E C T I V E U S E O F D E R I VAT I V E S
There are two ways in which the corporate treasurer can approach the use
of derivatives to manage risk. The first is to wait for suggestions and
proposals from banks. The treasurer lets the banks know what his or her
hedging objectives are, sits back and waits for suggestions and proposals.
The second approach is for the treasurer to become very familiar with
the various derivative instruments and to identify and work out which
instruments and structures best suit the company and the particular exposures it faces. This puts the treasurer in control of exposure management.
To take this proactive approach the treasurer will have need to have access
to a derivatives valuation model. These can be purchased on a stand-alone
basis, but can also be purchased as a separate module as part of a treasury
management system.
There are two attitudes about the treasurer taking views on the direction
of market rates. One is that it is the responsibility of the treasurer to take
views on the direction of market rates, and to back those views with the
timing of hedging programmes. For instance, a treasurer who has a strong
view that interest rates will fall much more substantially than the market
anticipates may either decide not to hedge, to postpone any hedging, or to
purchase an out-of-the-money interest rate cap. Such a philosophy is
consistent with the quasi-profit-centre treasury.
The alternative philosophy is that over a long period of time there is no
evidence that the treasurer who takes views on the direction of market rates
adds value (indeed this often subtracts value). If so, the role of the treasurer
is to build a hedging programme that is flexible enough to respond to future
changes in interest rates. Such a philosophy is consistent with a valueadded treasury.
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CORPORATE TREASURY AND CASH MANAGEMENT
For those treasurers who like to consider the potential direction of interest rates on their hedging decision, which is applicable to both profit and
value-added treasuries, Table 10.10, applicable to a treasurer trying to
hedge floating rate borrowings, may help to clarify thoughts.
The table can be re-arranged or expanded to suit the treasurer’s own
preferences. For instance, instead of having headings for ‘interest rates rising,
remaining stable or falling’, the table could be headed: ‘interest rates rise
rapidly and quickly, interest rates rise slowly and gently, interest rates
remain stable’.
LO N G - T E R M C R O S S - C U R R E N C Y S WA P S
A long-term cross-currency swap can be defined as an agreement between
two parties to exchange interest obligations or receipts in different currencies. With a typical cross-currency swap there is an initial exchange of
principal and a re-exchange at maturity. The underlying interest payments
can be fixed or floating. The need for cross-currency swaps arises from a
number of different situations:
ᔢ
to convert a loan raised in a foreign currency into the company’s
domestic currency
ᔢ
to hedge a foreign-denominated asset into a domestic currency
ᔢ
to convert foreign currency cash balances to a domestic currency for a
period of time.
Table 10.10 Schedule for determining the appropriate interest rate
derivative to use based upon specific views on interest rates
Interest rates
will rise
Interest rates
will remain stable
Interest rates
will fall
Strongly agree
Take out swap
Use collar or other
combination of
derivatives
Leave or
purchase out of
money cap
No view
Buy swaption
Use collar or other
combination of
derivatives
Buy swaption
or interest
rate cap
Strongly disagree
Buy cap
Take out swap
or buy cap
Take out swap
or collar
INTEREST RATE DERIVATIVES
225
Example of use of long-term cross-currency swap
A Hong Kong-based company, with no US$ income, has access to the US
private placement market. It raises US$50 million by means of a five-year
private placement. Summary details are shown in Table 10.11.
However, the company’s requirement is for HK$ at floating rate. If it
sells the US$50 million it has raised for HK$ spot, then it is exposed to
movements in the US$/HK$ exchange rate. This exposure occurs for two
reasons. First, it has to finance the US$ interest payments out of HK$
income, and second, it has to repay the US$ loan on maturity from HK$
resources. To hedge these exposures the company enters into a five-year
cross-currency swap. In this transaction the corporate pays floating HK$
and receives US$ interest at the current five-year swap rate. The swap can
be seen diagrammatically in Figures 10.6, 10.7 and 10.8.
It can be seen that the Hong Kong company has effectively converted
the US$ loan into a HK$ loan. All the liabilities in respect of the borrowing – the liability to pay interest and the obligation to repay principal on
maturity of the loan – are now in HK$.
Table 10.11 Summary details for US$/HK$ long-term currency swap
Bond details
US$ principal
50 million
Term
5 years
Fixed interest rate
4%
US$ 5-year interest rate swap
3.25 %
US$/HK$ spot rate
7.7985
Initial exchange of principal
US$ 50 million
Company
Bank
HK$ 389.925 million
Figure 10.6 Step one in a cross-currency swap: exchange of principal
226
CORPORATE TREASURY AND CASH MANAGEMENT
Every year
Floating interest on HK$389.925m
Company
Bank
3.25 % on US$50 million
Figure 10.7 Step two in a cross-currency swap: exchange of interest throughout
the life of the swap
Of course during the course of the cross-currency swap, the company
will have to pay interest at 4 per cent on the US$ loan. This is partly
financed by the receipt of US$ interest at 3.25 per cent under the interest
leg of the swap. The remaining interest will need to be purchased forward
at the time the swap is entered into.
Forms of cross-currency swaps
A cross-currency swap may be fixed–fixed, fixed–floating or floating–floating. A floating–floating swap is often called a basis swap. For this type of
swap, a margin is typically put on one side of the deal in order to reflect
market forces of supply and demand. For example, a bank may offer to
receive euro LIBOR plus 0.03 per cent versus paying US$ LIBOR flat.
As a result of the margins embedded in basis swaps, the fixed rates used
on a cross-currency swap may differ slightly from those used for a single-
At the end of 5 years
HK$ 389.925 million
Company
Bank
US$ 50 million
Figure 10.8 Step three in a cross-currency swap: re-exchange of principal at end
of the swap
INTEREST RATE DERIVATIVES
227
currency interest rate swap. To price a standard cross-currency fixed–floating or fixed–fixed swap, the fixed rates quoted in the market are adjusted
by the basis swap margin. In the above case, if the euro five-year fixed rate
was 3.75 per cent and a company wanted a cross-currency paying fixed
euro versus receiving US$ LIBOR, then the fixed rate of 3.75 per cent
together with the basis swap margin of 0.03 per cent is used. This gives a
fixed euro rate under the cross-currency swap of 3.78 per cent.
EXERCISES
Interest rate swaps
Using the following US$ semi-annual swap rates:
Period
Bank pays
Bank receives
2 years
3.34
3.37
3 years
4.01
4.04
4 years
4.47
4.50
5 years
4.79
4.82
6 years
5.02
5.05
consider the following questions:
1. The treasurer of MultiMedia Inc. is concerned that US$ interest
rates will start to rise. They have a US$250 million term loan on
which they pay six-month LIBOR + 50bp, and which has a further
four years to maturity.
What will the swap structure look like, given the fact that a bank
requires an additional 5bp credit risk return for this client?
What is the company’s cost of funds?
2. The treasurer of another company, a utility company, forecasts it will
have core deposits of US$150 million for the next three years. They are
concerned that interest rates will fall, and want to cover this risk for the
next three years.
What swap will the bank quote?
What would be the fixed deposit rate the company would receive?
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CORPORATE TREASURY AND CASH MANAGEMENT
3. Five years ago a company raised US$300 million by means of a tenyear fixed rate bond.
The semi-annual cost of this bond was 9 per cent and was swapped to
floating whereby the company receives 9 per cent and pays LIBOR.
What is the effective cost of funds for the remaining life of the bond if
the company decides to re-swap into fixed payments at the current
market rate?
If the re-swap is effected with the original bank, which of the
following statements is true:
ᔢ Every six months the bank will expect to receive US$6,000,000 in
advance.
ᔢ Every six months the bank will expect to receive US$6,270,000 in
arrears.
ᔢ Every six months the bank will pay US$6,270,000 in arrears.
ᔢ Every six months the bank will pay US$6,000,000 in advance.
Interest rate options
An alternative strategy for Multimedia might be to take out an interest rate
cap. This way it has protection should rates rise, but can pick up the benefit of falling rates.
The market rates for four-year interest rate cap are:
Strike rate
Premium
4.75 %
2.75 %
5.00 %
2.40 %
How would you evaluate such an option strategy? The company’s five-year
borrowing cost is 5.25 per cent.
Application of interest rate derivatives
1. You are treasurer of a company that has a US$500 million floating rate
loan. You want to protect your company against the effects of rising
interest rates and wish to take out a cap. However you are concerned
that inflation will stay consistently low over the next five years and
want to design a structure whereby the option premium will be
refunded if any of the option caplets are unexercised.
How would you design such a structure?
INTEREST RATE DERIVATIVES
229
2. Another thought you have is that you would like a structure whereby
you could take out a five-year interest rate swap, but if the floating
rate was below the swap rate on any roll-over date, you would be able
to take the lower of the floating rates. You recognize that such a swap
has option type characteristics, but you are not prepared to pay a full
premium. You are however prepared to consider paying a higher
fixed rate should LIBOR rates fall below a certain level. One of your
thoughts is that, in return for such a five-year swap, if LIBOR fell
below 3.90 per cent on any rollover date, you would be prepared to
pay the current five-year swap rate of 4.82 per cent.
How would you design such a structure?
Application of interest rate derivatives with bonds
Given the following information on interest rates and swaptions consider
the questions below.
Swaptions
Exercise date Period (years) Rate %
Receive fixed
premium %
1 year
9
5.5
1 year
9
5.0
2.2
1 year
9
4.5
0.93
1 year
8
4.0
0.29
Pay fixed
premium %
2.0
3.5
Swap rates (semi-annual)
1 year
2 year
3 year
4 year
5 year
7 year
10 year
4.15 %
4.30 %
4.40 %
4.51 %
4.61 %
4.71 %
5.06 %
4.10 %
4.25 %
4.35 %
4.45 %
4.55 %
4.65 %
5.0 %
Note that three and six-month euro LIBOR is currently 3.75 per cent.
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CORPORATE TREASURY AND CASH MANAGEMENT
1. You are considering the issue of a bond for €100 million. Your objective is to keep the bond in fixed rate. However you are very concerned
about forecasts for zero inflation, zero or negative real interest rates
and stagnant economic growth. You therefore want the opportunity to
be able to call the bond at the end of one year should long-term interest rates fall another 1 per cent.
The bond will be a ten-year issue at 5.60 per cent all in. The swap
curve for euros is attached. You determine that there is currently no
investor appetite for a callable bond with the call date on the first
anniversary of issue.
How could you synthetically create a bond callable after one year?
How expensive would your structure be?
2. You are considering the issue of a ten-year euro Eurobond. Your objective is to switch it into floating rates. On the evening before launch you
are advised by the lead manager that the underlying government security is currently trading at 4.50 per cent, indicating a spread of 100
basis points over for your bond. What would you have to consider in
calculating the floating rate cost of funds for the issue?
Long-term currency swap swaps
A French company issues a US$ five-year bond and decides to swap the
interest exposure into floating euros. The rate in the currency swap market is
3.77–3.70 (annual 30/360). Spot €/US$ is .9734/.9738. Given that the US$
bond was issued at par in a nominal size of US$100 million with a yield of 4.4
per cent (annual 30/360), what is the effective euro cost of funds?
Fixed leg
€ yield curve
US$ yield curve
Forward points
1 year
1.53
2.75
0.0117/0.0127
2 year
2.10
2.94
0.0161/0.0184
3 year
2.64
3.22
0.0166/0.0201
4 year
3.05
3.48
.0.0163/0.0217
5 year
3.38
3.70
0.0152/0.0224
Discount any euro cashflows by the five-year euro swap rate.
INTEREST RATE DERIVATIVES
S O LU T I O N S
Interest rate swaps
1. MultiMedia
6-month US$ LIBOR
Multimedia
Bank
4.55 %
Loan
MultiMedia’s net cost of funds for next four years:
IN
OUT
OUT
NET (cost of funds)
US$ LIBOR
(US$ LIBOR+50bp)
(4.55
per cent ) (4.50 per cent + 5bp)
______________________________
5.05 per cent
231
232
CORPORATE TREASURY AND CASH MANAGEMENT
Interest rate swaps (contd.)
2. Utility Co.
4.01 %
Utility
company
Bank
6-month US$ LIBOR
Deposit
Utility company’s deposit rate
IN
IN
OUT
NET
LIBID
4.01 per cent
(US$
LIBOR)
______________
3.88 per cent s.a. (LIBID is generally 1/8 per cent
lower than LIBOR)
INTEREST RATE DERIVATIVES
233
Interest rate swaps (contd.)
3. A company
4.82 %
Swap
market
9%
Swap
market
Company
6-month LIBOR
6-month LIBOR
9%
Bond
IN
OUT
OUT
9 per cent
Initial swap
(six-months US$ LIBOR)
9 per cent
Bond
IN
OUT
NET
six-months US$ LIBORNew swap
4.82 per cent
__________________
4.82 per cent s.a. for 5 years
Every six months the company will receive six-monthly in arrears:
300,000,000 * (9 per cent- 4.82 per cent)
_________________________________
2
= US$6,270,000
Interest rate options
MultiMedia
For MultiMedia’s option strategy to work interest rates have to fall to a
level such that the lower borrowing costs enjoyed by the company on its
debt offset the premium payable.
Taking the interest cap with a 4.75 per cent strike:
The upfront premium is US$6,875,000
234
CORPORATE TREASURY AND CASH MANAGEMENT
The annual amount payable over the next four years, which at 5.25 per
cent has a net present value of US$6,875,000, is US$1,950,103.
Therefore interest costs on the loan have to fall to US$11,250,000 –
1,950,103 = US$9,229,897 for the premium to be recouped.
This corresponds to an interest rate of 3.69 per cent. US$ LIBOR has to
fall to and remain at 3.69 per cent for the option strategy to be better than
taking out an interest rate swap.
Application of interest rate derivatives
1. In this particular case the basic building blocks are:
Buy a standard cap with a strike rate at or near the money.
Buy a digital floor with a strike rate at or near the strike rate under the
cap.
The payouts from the digital floor should be set to equal the premium
under each individual caplet. If interest rates fall, the digital floor will
be exercised and the payout from this offset the cost of premium for the
unexercised caplets.
However two premia are paid under this structure. Would the company
be better off with, say, an out-of-the-money cap?
2. The building blocks here are:
Purchase a standard cap with a strike rate close to the money.
Sell a digital floor with a strike rate of 3.90 per and paying out 92 basis
poiints when LIBOR falls below the strike rate.
Application of interest rate derivatives with bonds
1. If the company had issued a callable bond and had actually called the
bond, then it would have had to re-finance it. This would have been
done at floating rates. Therefore the company needs to purchase a
derivative that would put it in the same position. This can be
achieved by buying a swaption, giving the swaption buyer the right
to receive fixed. Much depends on what the rate is under the swaption, but let us assume it is 5.0 per cent. Should the company decide
to exercise the swaption its position will be the one shown at the top
of the next page:
It will be left with the bond effectively at floating rates, where it
will be paying euro LIBOR + 60bp. However, the option premium of
2.2 per cent (€2.2 million) needs to be amortized over the life of the
transaction. This equates to 29bp per annum.
INTEREST RATE DERIVATIVES
235
€ LIBOR
Company
5%
5.60 %
2
Calculating all-in cost of funds with a bond issue.
There are a number of steps here:
ᔢ
Calculate the all-in cost of the issue. This primarily involves amortizing the lead managers’ upfront fees and including them with the
overall cost of funding. Lead managers’ fees are usually 40bps for
a Eurobond issue, which equates to 4 basis points a year (slightly
more when the time cost of money is taken into account).
ᔢ
The company will receive fixed under the swap, and the relevant
semi-annual rate is 5.00 per cent. However the Eurobond market is
an annual coupon. Therefore any swap will need an annual exchange
of interest to match the coupon payments, and the semi-annual
coupon will need to be adjusted for that. The calculation is:
 ___
.05 2
1+
– 1 + 5.06

2
ᔢ
Interest first starts to accrue on the bond two to three weeks after
launch. Therefore the interest rate swap that will be taken out on
the day of the launch will need to be forward starting to the first
interest accrual date. Given the interest rate curve outlined, a threeweek forward starting swap would give a fixed leg under the swap
of 5.13 per cent (annual 30E/360))
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CORPORATE TREASURY AND CASH MANAGEMENT
ᔢ
Putting these in a table:
Yield
Underlying government security
4.50
Spread
1.00
Lead manager’s fees
0.04
All-in fixed costs
5.54
Fixed rate under swap
5.13
Floating rate cost of funds
€ LIBOR + 41 bp
The above excludes rating agency fees, legal and printing costs.
ᔢ
It should be noted that under a bond, if interest is due to be paid on
a date that is a Saturday or Sunday, interest is delayed until the next
business day but the interest amount is generally not adjusted. This
is not the case in the swap market where the interest amounts are
adjusted for the additional days.
Currency swaps
The bond and swap can be portrayed diagrammatically as below:
€ LIBOR
Company
Swap
US$ 3.70% on US$100 million
US$ interest on loan
Bond
The issuer must pay an annuity of 70bp on US$100 million over the next
five years. This does not translate into euro LIBOR + 70bp funding due to
the FX risk on the US$ income stream. To calculate the true euro cost of
INTEREST RATE DERIVATIVES
237
funds, the US$ annuity must be translated into euros by buying the US$
forward, and the resulting euro cashflow must then be calculated as a euro
annuity in terms of basis points.
0.7 per cent × US$ 100,000,000 = US$700,000
Time
US$
Forward FX €
PV (€)
1
700,000
.9851
710,590
685,237
2
700,000
.9895
707,440
657,858
3
700,000
.9900
707,074
634,058
4
700,000
.9897
707,250
611,587
5
700,000
.9886
708,102
590,475
3,179,214
Solving for an annuity that yields a present value of €3,179,214 at a
discount rate of 4.4% over 5 years gives €722,182. On a principal of
1,026,905 million this translates to an annuity of 70.3 basis points.
The effective cost of funds to the issuer is therefore LIBOR + 70 bp.
5
Working Capital Management
When a company requires additional funding, the treasurer usually turns to
either debt or an equity issuance. However, if the cost of these traditional
funding sources is too high, the treasurer should take a hard look at unlocking cash that is trapped in working capital. While working capital management calls for a considerable amount of tactical work on an ongoing basis,
it can be a rewarding exercise if the result is a significant source of cash.
The following example shows how much cash can potentially be extracted
from a company’s working capital.
The following sections note how working capital tends to vary with
changes in corporate sales volume, and then describe the key management
aspects of each component of working capital that can impact the level of
funds invested in working capital.
WORKING CAPITAL VARIABILITY
Working capital is defined as a company’s current assets minus its current
liabilities. While there are a number of minor asset and liability categories
that can be included in this definition, the primary components of working
capital are cash, accounts receivable, inventory, and accounts payable. All
of these components tend to vary in proportion to the level of sales, but not
at the same time. For example, if a company experiences high seasonal sales
in its fourth quarter, then inventories and accounts payable will likely rise
in advance of the prime selling season, while accounts receivable will increase
during the fourth quarter and remain high through the early part of the
first quarter of the following year. Cash will decline before the key sales
season in order to pay for inventories, and will increase as receivables are
collected, so that cash levels are maximized after the prime selling season
is over. If a company is not profitable, the cash levels will not recover at the
end of the prime selling season, but will instead remain low.
83
84
Working Capital Management
Example
Carstensz Corporation is conducting due diligence on its possible purchase of
the Hamilton Furniture Company. The acquisitions manager, Mr. Harrer, is
interested in the possibility of reducing the amount of Hamilton’s working
capital, which can then be used to pay down the purchase price. Mr. Harrer
uncovers the following information about Hamilton:
Balances
Annual
revenues
Annual cost
of goods
Annual
purchases
Average
receivables
Average
payables
Average
inventory
Days
Outstanding*
Industry
Standard
Variance
Value of
Variance
$52,000,000
—
—
—
—
26,000,000
—
—
—
—
18,000,000
—
—
—
—
13,000,000
91
62
29
$4,143,000
2,250,000
45
45
0
0
10,000,000
140
100
40
2,857,000
Total
$7,000,000
The analysis shows that, if Carstensz were to buy Hamilton and reduce its
receivable and inventory balances down to their industry averages, this would
extract $7 million from working capital. Mr. Harrer is aware that the extended
receivables may be caused by longer-term payment agreements with key customers, while it may take a considerable amount of time to reduce Hamilton’s
inventory levels, especially if it is comprised of slow-moving items. Nonetheless,
it appears that careful management may unlock a considerable amount of
cash.
*The formulas used in the table to calculate days outstanding are provided later in the
Working Capital Metrics section of this chapter.
That example assumes that there is a sales peak during one part of a
year, so that there is a natural ebb and flow to the amount of working capital
needed. In that scenario, the treasurer can obtain a line of credit from a
local bank, which should be sufficient to handle seasonal cash needs, and
which can reliably be paid off once the peak period ends.
An alternative scenario is when a company’s sales continue to increase
over time, which occurs in an expanding market or as a company acquires
market share from other entities. In this case, both inventory and receivable
levels continually increase, while the corresponding increase in accounts
payable will not be sufficient to hold down the overall level of working capital
investment. All available cash will be used to pay for working capital, so that
Credit Management
85
the cash balance is essentially zero, and new funds are continually needed
as sales continue to increase. This is a demanding environment for the
treasurer, who must look for long-term loans or equity infusions to help pay
for the additional working capital.
A final scenario is when a company’s sales are declining. As inventories
are sold off and receivables are collected, cash may increase substantially,
since there is less ongoing working capital to fund. This is the easiest scenario for the treasurer to deal with, since it is the only case where working
capital becomes a net source of cash, which can then be applied to other
company requirements.
The treasurer should also be aware of unusually high proportions of
any one component of working capital, since this may be caused by improper
management practices. For example, if the investment in inventory is usually
high, this may correspond to an ongoing practice of purchasing in bulk in
order to save per-unit costs. Similarly, a very high receivables balance may
be caused by the use of special deals to boost sales over the short term or
because revenues are being accrued but have not yet been billed. In such
cases, the expanded working capital level is not related to sales, but rather
to company policy. If funding sources are in short supply, the treasurer may
be able to lobby for a policy change that eliminates the need for more cash.
The following five sections describe the various management practices
that cause changes in working capital, and note actions the treasurer may
take to control or at least monitor them.
CASH MANAGEMENT
Cash is a key component of working capital, and is thoroughly covered in
Chapter 4. That chapter reveals how to concentrate cash through various
pooling methods, so that the balances scattered in a multitude of bank
accounts can be centrally marshaled for use by the treasurer.
CREDIT MANAGEMENT
There are no receivables unless a company elects to extend credit to its
customers through a credit policy. Thus, proper credit management is key
to the amount of funds that a company must invest in its accounts
receivable.
A loose credit policy is common in companies having a certain mix of
characteristics. For example, they may have high product margins, such as
in the software industry, and so have little to lose if a customer defaults on
payment. Also, they may be intent on gaining market share, and so will
“buy” sales with a loose credit policy, which essentially means they give
liberal credit to everyone. Another variation is that a company may be
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Working Capital Management
eliminating a product line or exiting an industry, and so is willing to take
some losses on credit defaults in exchange for selling off its inventory as
expeditiously as possible. In all of these cases, a company has a specific
reason for extending an inordinate amount of credit, even though it knows
there will be above-average credit defaults.
A tight credit policy is common in the reverse circumstances; product
margins are small, or the industry is an old one with little room to gain
market share. Also, a recessionary environment may require a firm to restrict
its credit policy, on the assumption that customers will have less money
available to make timely payments.
Any change in a company’s credit policy can have a profound effect
on the funding requirements that a treasurer must deal with. For example,
if a $48 million (revenues) company has receivables with an average age of
30 days, and its wants to enact a looser credit policy that will increase the
average receivable days to 45 days, then the company’s investment in receivables is going to increase by 50 percent, from $4 million to $6 million.
Consequently, the treasurer must be prepared to find $2 million to fund
this increase in working capital.
In many companies, the treasurer has direct control over the credit
policy and, indeed, over the entire credit granting function. This is a wise
placement of responsibility, since the treasurer can now see both sides of
the credit policy—both the resulting change in sales and the offsetting
change in required working capital funds.
The treasurer can set up a considerable number of credit controls
to reduce the probability of default by customers. Here are some
possibilities:
• Issue credit based on credit scoring. There are several credit-monitoring
services, such as Experian and Dun & Bradstreet, which provide
online credit scores on most larger businesses. The treasury staff can
create a credit-granting model that is based on a mix of the credit
scores of these services, the company’s history with each customer,
and the amount of credit requested.
• Alter payment terms. If a customer requests an inordinate amount of
credit, it may be possible to alter the payment terms to accommodate the customer while still reducing the level of credit risk. For
example, one-half of a sale can be made with 15-day payment terms,
with the remainder of the order to be shipped upon receipt of
payment for the first half of the order. This results in payment of
the total order in 30 days, but with half the risk.
• Offer financing by a third party. If the treasury department is unwilling
to extend credit, then perhaps a third party is willing to do so. This
can be a leasing company or perhaps even a distributor with a loose
credit policy.
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87
• Require guarantees. There is a variety of possible payment guarantees
that can be extracted from a customer, such as a personal guarantee
by an owner, a guarantee by a corporate parent, or a letter of credit
from a bank.
• Perfect a security interest in goods sold. It may be possible to create a
security agreement with a customer in which the goods being sold
are listed, which the company then files in the jurisdiction where
the goods reside. This gives the company a senior position ahead
of general creditors in the event of default by the customer.
• Obtain credit insurance. Credit insurance is a guarantee by a third
party against nonpayment by a customer. It can be used for both
domestic and international receivables. The cost of credit insurance
can exceed one-half percent of the invoiced amount, with higher
costs for riskier customers and substantially lower rates for customers who are considered to be in excellent financial condition.
• Require a credit reexamination upon an initiating event. The treasury
staff should review customer credit at regular intervals to see if
they still deserve existing credit limits. These reviews can be triggered when the current credit limit is exceeded, if a customer places
an order after a long interval of inactivity, if there is an unjustified
late payment, or if a customer stops taking early payment
discounts.
An active treasury staff that manages the credit function can use the
preceding list of credit practices to retain the appropriate level of control
over accounts receivable and the corresponding amount of working capital
funding.
RECEIVABLES MANAGEMENT
Once credit has been granted to a customer, responsibility for billing and
collecting from the customer usually passes to the accounting department.
The ability of the accounting staff to reliably invoice and collect in a timely
manner has a major impact on the amount of working capital invested in
accounts receivable. The treasurer does not have direct control over these
functions but should be aware of the following factors, which can seriously
extend customer payment intervals unless carefully managed:
• Invoicing delay. Invoices should be issued immediately after the
related goods or services have been provided. If the accounting staff
is billing only at stated intervals, then receivables are being extended
just because of an internal accounting work policy.
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Working Capital Management
• Invoicing errors. If invoices are being continually reissued due to
errors, then additional controls are needed to increase the accuracy
of initial invoices. This can be a serious issue, since invoicing errors
are usually found by the customer, which may be several weeks after
they were originally issued.
• Invoice transmission. There is a multiday mailing delay when invoices
are delivered through the postal service. Instead, the accounting
system should be configured to issue invoices by email or electronic
data interchange, or the accounting staff should manually email
invoices.
• Lockbox receipt. If checks are received at the company location and
then sent to the bank, this creates a delay of potentially several days
before the checks are processed internally, deposited, and then clear
the bank. Instead, customers should send all checks to a lockbox, so
that checks are deposited in the minimum amount of time, thereby
increasing the availability of funds.
• Collection management. There should be a well-trained collection staff
that assigns responsibility for specific accounts, focuses on the largest
overdue account balances first, begins talking to customers immediately after payment due dates are reached, and is supported by
collection software systems. The group should use a broad array of
collection techniques, including dunning letters, on-site visits, attorney letters, payment commitment letters, credit holds, and collection agencies.
• Internal error follow-up. If payments are being delayed due to service
problems by the company or product flaws, the collection staff
should have a tracking system in place that stores the details of these
problems, and the accounting manager should follow up with managers elsewhere in the company to have them resolved.
The treasurer can periodically inquire of the controller if these collection issues are being managed properly. Another approach is to obtain an
accounts receivable aging report and determine the reasons why overdue
receivables have not yet been paid. At a minimum, the treasurer should track
the days receivables outstanding on a timeline, and follow up with the controller or chief financial officer if the metric increases over time.
INVENTORY MANAGEMENT
Of all the components of working capital, inventory management is the most
critical because it is the least liquid and therefore tends to be a cash trap.
Once funds have been spent on inventory, the time period required to
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89
convert it back into cash can be quite long, so it is extremely important to
invest in the smallest possible amount of inventory.
Responsibility for inventory resides with the materials management
department, which controls purchasing, manufacturing planning, and warehousing. None of these areas are ones over which the treasurer traditionally
exercises control. Nonetheless, the treasurer should be aware of activities
related to inventory management, because they can have a profound impact
on the level of funding needed for working capital. The following topics
address a number of areas in which inventory decisions impact funding.
Inventory Purchasing
When the purchasing department orders inventory from suppliers, it asks
them for the lead time they need to deliver orders and then creates a safety
stock level to at least match the lead time. For example, if a supplier says
that it needs two weeks to deliver goods, and the company uses $100,000
of its inventory per week, then the purchasing department creates a safety
stock level of at least $200,000 to keep the company running while it waits
for the next delivery. This lead time therefore requires $200,000 of funding.
The treasurer should be aware that extremely distant foreign sourcing, such
as to Asia, will drastically lengthen lead times and therefore the amount of
safety stock. Conversely, if a company can source its inventory needs from
suppliers located very close to the company and work with them to reduce
their lead times and increase the frequency of their deliveries, this results
in lowered safety stock and therefore a reduced need for funding.
Another contributor to long lead times is the manual processing of
purchase orders to suppliers. If inventory needs are calculated by hand, then
transferred to a purchase order, manually approved, and delivered by mail,
then a company must retain more safety stock to cover for this additional
delay. Conversely, if a company can install a material requirements planning
system that automatically calculates inventory needs, creates purchase orders,
and transmits them to suppliers electronically, then the ordering cycle is
significantly reduced and corresponding lead times can be shortened.
The purchasing department orders inventory based on its estimates of
what customers are going to buy. No matter how sophisticated, these estimates are bound to be incorrect to some extent, resulting in the purchase
of excess inventory. To reduce this forecasting error, a company should
attempt to gain direct access to the inventory planning systems of key customers.
This gives the purchasing staff perfect information about what it, in turn,
needs to order from its suppliers, and thereby reduces excess inventory
levels.
It may also be possible to shift raw material ownership to suppliers so that
they own the inventory located on the company’s premises. Suppliers may
agree to this scenario if the company sole-sources purchases from them.
Under this arrangement, the company pays suppliers when it removes
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Working Capital Management
inventory from its warehouse, to either sell it or incorporate it into the
manufacture of other goods. The resulting payment delay reduces the need
for funding.
All of the preceding changes in purchasing practices can reduce a
company’s investment in inventory. Conversely, a purchasing practice that
contributes to startling increases in funding requirements is the bulk purchase
of inventory. If the purchasing staff is offered quantity discounts in exchange
for large orders, they will be tempted to proclaim large per-unit cost reductions, not realizing that this calls for much more up-front cash and a considerable storage cost and risk of obsolescence.
Inventory Receiving
The receiving staff ’s procedures can have an impact on inventory-related
funding. For example, a supplier may ship goods without an authorizing
purchase order from the company. If the receiving staff accepts the delivery,
then the company is obligated to pay for it. A better practice is to reject all
inbound deliveries that do not have a purchase order authorization.
Another procedural issue is to require the immediate entry of all receiving
information into the company’s warehouse management system. If this is not
done, the risk increases that the receipt will never be recorded due to lost
or misplaced paperwork. The purchasing staff will see that the inventory
never arrived and may order additional goods to compensate—which
requires more funding. Similarly, a procedure should call for the immediate
put-away of inventory items following their receipt, on the grounds that they
can become lost in the staging area.
Inventory Storage
In a traditional system, inventory arrives from suppliers, is stored in the
company warehouse, and is shipped when ordered by customers. The
company is funding the inventory for as long as it sits in the warehouse
waiting for a customer order. A better method is to avoid the warehouse
entirely by using drop shipping. Under this system, a company receives an
order from a customer and contacts its supplier with the shipping information, who in turn ships the product directly to the customer. This is a somewhat cumbersome process and may result in longer delivery times, but it
completely eliminates the company’s investment in inventory and therefore
all associated funding needs. This option is available only to inventory
resellers.
Another option that severely reduces the amount of inventory retention time is cross-docking. Under cross-docking, when an item arrives at the
receiving dock, it is immediately moved to a shipping dock for delivery to
the customer in a different truck. There is no put-away or picking transaction, and no long-term storage, which also reduces the risk of damage to
the inventory. Cross-docking only works when there is excellent control over
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91
the timing of in-bound deliveries, so the warehouse management system
knows when items will arrive. It also requires multiple extra loading docks,
since trailers may have to be kept on-site longer than normal while loads
are accumulated from several inbound deliveries.
Production Issues Impacting Inventory
The production process is driven by several procedural, policy, and setup
issues that strongly impact the amount of inventory and therefore the level
of funding.
The traditional manufacturing system is geared toward very long production runs, on the justification that this results in the spreading of fixed
costs over a large number of units, which yields the lowest possible cost per
unit. The logic is flawed, because such large production runs also yield too
much inventory, which then sits in stock and runs the significant risk of
obsolescence. To reduce the funding requirement of this excess inventory,
a company should produce to demand, which is exemplified by the just-intime (JIT) manufacturing system. A JIT system triggers an authorization to
produce only if an order is received from a customer, so there is never any
excess inventory on hand. Though a JIT system initially appears to generate
higher per-unit costs, the eliminated carrying cost of inventory makes it
considerably less expensive. And, from the treasurer’s perspective, a JIT
system can release a great deal of cash from inventory.
Another production issue is to avoid volume-based incentive pay systems.
Some companies pay their employees more if they produce more. Not only
does this result in extremely high levels of inventory, but these pay systems
tend to yield lower-quality goods, since employees favor higher volume over
higher quality. A reasonable alternative is an incentive to exactly meet the
production plan. If the plan is derived from a JIT system, then employees
are producing only to match existing customer orders, which keep funding
requirements low.
A related issue is the use of complex, high-capacity machinery.
Industrial engineers enjoy these machines because they feature impressively
high throughput rates. However, they also require immense production
volumes in order to justify their initial and ongoing maintenance costs,
which once again results in the accumulation of too much inventory. Instead,
the treasurer should favor the acquisition of smaller, simpler machines having
lower maintenance costs. Such machines can be operated profitably with very
small production runs, thereby making it easier to drive down inventory
levels.
A simple method for reducing work-in-process inventory is to use
smaller container sizes. Typically, an employee at a workstation fills a container
and then moves it to the next downstream workstation. If the container is
a large one, and if there are many workstations using the same size container, then a great deal of work-in-process inventory is being unnecessarily
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Working Capital Management
accumulated. By shifting to a smaller container size, the inventory investment is reduced, as is the amount of scrap—because the downstream workstation operator is more likely to spot faults originating in an upstream
location more quickly if containers are delivered more frequently.
When a machine requires a substantial amount of time to be switched
over to a new configuration for the production of a different part, there is
a natural tendency to have very long production runs of the same part in
order to spread the cost of the changeover across as many parts as possible.
This practice results in too much inventory, so the solution is to reduce
machine setup times to such an extent that it becomes practicable to have
production runs of as little as one unit. Setup reduction can be accomplished
by using changeover consultants, process videotaping, quick-release fasteners, color-coded parts, standardized tools, and so forth.
A common arrangement of machines on the shop floor is by functional
group, where machines of one type are clustered in one place. By doing so,
jobs requiring a specific type of processing can all be routed to the same
cluster of machines and loaded into whichever one becomes available for
processing next. However, by doing so, there tend to be large batches of
work-in-process inventory piling up behind each machine because this
approach calls for the completion of a job at one workstation before the
entire job is moved to the next workstation. A better layout is provided by
cellular manufacturing, where a small cluster of machines are set up in close
proximity to one another, each one performing a sequential task in completing a specific type or common set of products. Usually, only a few employees
work in each cell and walk a single part all the way through the cell before
moving on to the next part. By doing so, there is obviously only the most
minimal work-in-process inventory in the cell.
The Bill of Materials
A bill of materials is the record of the materials used to construct a product.
It is exceedingly worthwhile to examine the bills of material with the objective of reducing inventory. For example, a bill may contain an excess quantity of a part. If so, and the underlying purchase order system automatically
places orders for parts, the bill will be used to order too many parts, thereby
increasing inventory levels. A periodic audit of all bills, where the reviewer
compares each bill to a disassembled product, will reveal such errors. For
the same reason, the estimated scrap listed in all bills of material should be
compared to actual scrap levels; if the estimated scrap level is too high, then
the bill will call for too much inventory to be ordered for the next production run.
A significant bill of materials issue from the perspective of inventory
reduction is the substitution of parts. This may occur when the engineering
staff issues an engineering change order, specifying a reconfiguration of the
parts that form a product. Ideally, the materials management staff should
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93
draw down all remaining inventory stocks under the old bill of materials
before implementing the new change order. If this is not done, then the
company will have a remainder stock of raw materials inventory for which
there are no disposition plans.
Product Design
There are a number of design decisions that have a considerable impact on
the size of a company’s investment in inventory. A key factor is the number
of product options offered. If there are a multitude of options, then a company
may find it necessary to stock every variation on the product, which calls for
a substantial inventory investment. If, however, it is possible to limit the
number of options, then inventory volumes can be substantially reduced. A
similar issue is the number of products offered. If there is an enormous range
of product offerings, it is quite likely that only a small proportion of the
total generate a profit; the remainder requires large inventory holdings in
return for minimal sales volume.
Customer Service
A company may feel that its primary method of competition is to provide
excellent customer service, which requires it to never have a stockout condition for any inventory item. This may require an inordinate amount of
finished goods inventory. This policy should be reviewed regularly, with an
analysis of the inventory cost required to maintain such a high level of order
fulfillment.
Inventory Disposition
Even if a company has built up a large proportion of obsolete inventory,
continuing attention to an inventory disposition program can result in the
recovery of a substantial amount of cash. The first step in this program
is to create a materials review board, which is comprised of members of
the materials management, engineering, and accounting departments. This
group is responsible for determining which inventory items can be used
in-house and the most cost-effective type of disposition for those items
that cannot be used. This may involve sending inventory back to suppliers
for a restocking charge, sales to salvage contractors, sales as repair parts
through the service department, or even donating them to a nonprofit in
exchange for a tax credit. Throwing out inventory is frequently better than
keeping it, since retention requires the ongoing use of valuable warehouse
space.
Payables Management
The processing and payment policies of the accounts payable function can
have a resounding impact on the amount of funds invested in working
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capital. Payables processing is managed by the accounting department, and
payment terms by the purchasing department. The treasurer does not have
control over either function but should be aware of the following issues that
can impact funding requirements.
Payment Terms
As part of its negotiations with suppliers, the purchasing staff may try to
extend payment terms. This is certainly an advantage for the treasurer, since
extended terms equate to free funding by suppliers. However, extended
terms may be at the cost of higher per-unit prices, which the controller may
not favor at all.
The reverse situation also arises, where suppliers negotiate for more
rapid payment terms. This is particularly common for large and powerful
suppliers that have near-monopoly control over their industries. It is also
common when a company’s financial condition is poor enough that suppliers insist on short payment terms or even cash in advance. While the treasurer may not be able to mitigate such onerous terms, he or she should
certainly be made aware of them, so that the resulting decline in cash flows
from working capital can be properly planned for.
Payment Processing
The accounting department may pay suppliers only at stated intervals, such
as once a week. If so, an internal policy likely governs whether payments
that are not quite due will be covered in the current payment period or the
next one. This is of some importance, since paying anything prior to its due
date will shrink the funding normally made available through accounts
payable.
The accounting staff may also have a policy of taking all early payment
discounts. Such discounts normally equate to a significant rate of interest,
and so are highly favorable to the company and should be taken. Nonetheless,
paying a very large supplier invoice early in order to take advantage of a
discount may significantly impact the borrowing activities of the treasurer.
Consequently, there should be a system in place to notify the treasury staff
in advance of the amount and timing of unusually large discounts.
Intercompany Netting
If a company has multiple subsidiaries, it is possible that they do a significant
amount of business with each other. If so, there could be a substantial
volume of billings between them. The best way to deal with these intercompany payments is to net them out through the accounting system so that
actual cash transfers are minimized. If each subsidiary uses a separate
accounting system, then intercompany netting can be quite a chore. However,
if they all operate under a single accounting system, then the software can
automatically handle this task.
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95
Supply Chain Financing
Under supply chain financing, a company sends its approved payables list to
its bank, specifying the dates on which invoice payments are to be made. The
bank makes these payments on behalf of the company. However, in addition
to this basic payables function, the bank contacts the company’s suppliers
with an offer of early payment, in exchange for a financing charge for the
period until maturity. If a supplier agrees with this arrangement and signs a
receivables sale contract, then the bank delivers payment from its own funds
to the supplier, less its fee. Once the company’s payment dates are reached,
the bank removes the funds from the company’s account, transferring some
of the cash to those customers electing to be paid on the prearrangement
settlement date and transferring the remaining funds to its own account to
pay for those invoices that it paid early to suppliers at a discount.
This arrangement works very well for suppliers, since they may be in
need of early settlement. In addition, they receive a much higher percentage
of invoice face value than would be the case if they opted for a factoring
arrangement with a third party, where 80 percent of the invoice is typically
the maximum amount that will be advanced. The amount of the discount
offered by the bank may be quite small if the company is a large and wellfunded entity having excellent credit. Finally, the arrangement is usually
nonrecourse for the supplier, since the arrangement with the bank is structured as a receivables assignment.
The arrangement also works well for the bank, which has excellent
visibility into the company’s bank balances and cash flow history, and so
knows when it can offer such financing. Also, it obtains fees from the
company in exchange for disbursing funds on behalf of the company.
This is also a good deal for the company, whose suppliers now have
ready access to funds. Further, since the bank is contacting suppliers with
payment dates, they will no longer make inquiries of the company regarding
when they will be paid.
Supply chain financing is less useful when payment terms are relatively
short, since there is not much benefit for suppliers in being paid just a few
days early. However, it is an excellent tool when standard payment terms
are quite long.
Since supply chain financing is arranged with the company’s primary
bank, and the treasurer is in charge of banking relations, this is one payables
area in which the treasurer can provide a considerable amount of value to
the company and its suppliers.
WORKING CAPITAL METRICS
This section contains four metrics for working capital, which the treasurer
can use to form an opinion regarding the amount of receivables, inventory,
and payables that a company is maintaining. There is no right or wrong
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Working Capital Management
result of these metrics, since they are tied to a company’s policies for granting credit, order fulfillment, and so on. Nonetheless, the treasurer should
track these metrics on a trend line to see if working capital levels are changing. The same trend line will reveal the results of the working capital
improvement tactics noted earlier in this chapter.
Average Receivable Collection Period
This measurement expresses the average number of days that accounts
receivable are outstanding. This format is particularly useful when it is compared to the standard number of days of credit granted to customers. For
example, if the average collection period is 60 days and the standard days
of credit is 30, then customers are taking much too long to pay their
invoices. A sign of good performance is when the average receivable collection period is only a few days longer than the standard days of credit.
To calculate the average receivable collection period, divide annual
credit sales by 365 days, and divide the result into average accounts receivable. The formula is as follows:
Average Accounts Receivable
Annual Sales 365
Example
The new controller of the Flexo Paneling Company, makers of modularized
office equipment, wants to determine the company’s accounts receivable collection period. In the June accounting period, the beginning accounts receivable balance was $318,000, and the ending balance was $383,000. Sales for
May and June totaled $625,000. Based on this information, the controller
calculates the average receivable collection period as follows:
Average Accounts Receivable
Annual Sales 365
=
($318, 000 Beginning Receivables + $383, 000 Ending Receivables) 2
($625, 000 × 6) 36
65
=
$350, 500 Average Accounts Receivable
$10, 273 Sales per Dayy
= 34.1 Days
Note that the controller derived the annual sales figure used in the
denominator by multiplying the two-month sales period in May and June by
six. Since the company has a stated due date of 30 days after the billing date,
the 34.1 day collection period appears reasonable.
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97
The main issue with this calculation is what figure to use for annual sales.
If the total sales for the year are used, this may result in a skewed measurement, since the sales associated with the current outstanding accounts receivable may be significantly higher or lower than the average level of sales
represented by the annual sales figure. This problem is especially common
when sales are highly seasonal. A better approach is to annualize the sales
figure for the period covered by the bulk of the existing accounts
receivable.
Inventory Turnover
Inventory is frequently the largest component of a company’s working
capital; in such situations, if inventory is not being used up by operations
at a reasonable pace, then a company has invested a large part of its cash
in an asset that may be difficult to liquidate in short order. Accordingly,
keeping close track of the rate of inventory turnover is a significant function
of management. There are several variations on the inventory turnover
measurement, which may be combined to yield the most complete turnover
reporting for management to peruse. In all cases, these measurements
should be tracked on a trend line in order to see if there are gradual reductions in the rate of turnover, which can indicate to management that corrective action is required in order to eliminate excess inventory stocks.
The simplest turnover calculation is to divide the period-end inventory
into the annualized cost of sales. One can also use an average inventory figure
in the denominator, which avoids sudden changes in the inventory level
that are likely to occur on any specific period-end date. The formula is
as follows:
Cost of Goods Sold
Inventory
A variation on the preceding formula is to divide it into 365 days,
which yields the number of days of inventory on hand. This may be more
understandable to the layman; for example, 43 days of inventory is more
clear than 8.5 inventory turns, even though they represent the same situation. The formula is as follows:
365 ÷
Cost of Goods Sold
Inventory
The preceding two formulas use the entire cost of goods sold in the
numerator, which includes direct labor, direct materials, and overhead.
However, only direct materials costs directly relate to the level of raw materials inventory. Consequently, a cleaner relationship is to compare the value
of direct materials expense to raw materials inventory, yielding a raw materials turnover figure. This measurement can also be divided into 365 days in
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Working Capital Management
order to yield the number of days of raw materials on hand. The formula
is as follows:
Direct Materials Expense
Raw Materials Inventory
The preceding formula does not yield as clean a relationship between
direct materials expense and work-in-process or finished goods, since these
two categories of inventory also include cost allocations for direct labor and
overhead. However, if these added costs can be stripped out of the work-inprocess and finished goods valuations, then there are reasonable grounds
for comparing them to the direct materials expense as a valid ratio.
Example
The Rotary Mower Company, maker of the only lawnmower driven by a
Wankel rotary engine, is going through its annual management review of
inventory. Its treasurer has the following information:
Balance Sheet Line Item
Amount
Cost of goods sold
Direct materials expense
Raw materials inventory
Total inventory
$4,075,000
1,550,000
388,000
815,000
To calculate total inventory turnover, the treasurer creates the following
calculation:
Cost of Goods Sold
Inventory
=
$4, 075, 000 Cost of Goods Sold
= 5 Turns per Year
$81
15, 000 Inventory
To determine the number of days of inventory on hand, the treasurer
divides the number of turns per year into 365 days, as follows:
365 ÷
= 365 ÷
Cost of Goods Sold
Inventory
$4, 075, 000 Cost of Goods
= 73 Days of Inventory
$815, 000 Inventory
The treasurer is also interested in the turnover level of raw materials when
compared to just direct materials expenses. He determines this amount with
the following calculation:
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99
Direct Materials Expense
Raw Materials Inventory
=
$1, 550, 000 Direct Materials Expense
= 4 Turns Per Year
$388 Raw Materials Inventory
The next logical step for the treasurer is to compare these results to those
for previous years, as well as to the results achieved by other companies in the
industry. One result that is probably not good in any industry is the comparison of direct materials to raw materials inventory, which yielded only four
turns per year. This means that the average component sits in the warehouse
for 90 days prior to being used, which is far too long if any reliable materials
planning system is used.
The turnover ratio can be skewed by changes in the underlying costing
methods used to allocate direct labor, and especially overhead cost pools,
to the inventory. For example, if additional categories of costs are added to
the overhead cost pool, then the allocation to inventory will increase, which
will reduce the reported level of inventory turnover—even though the turnover level under the original calculation method has not changed at all. The
problem can also arise if the method of allocating costs is changed; for
example, it may be shifted from an allocation based on labor hours worked
to one based on machine hours worked, which can alter the total amount
of overhead costs assigned to inventory. The problem can also arise if the
inventory valuation is based on standard costs and the underlying standards
are altered. In all three cases, the amount of inventory on hand has not
changed, but the costing systems used have altered the reported level of
inventory costs, which impacts the reported level of turnover.
A separate issue is that the basic inventory turnover figure may not be
sufficient evidence of exactly where an inventory overage problem may
lie. Accordingly, one can subdivide the measurement so that there are
separate calculations for raw materials, work-in-process, and finished
goods (and perhaps be subdivided further by location). This approach
allows for more precise management of inventory-related problems.
Accounts Payable Days
A calculation of the days of accounts payable gives a fair indication of a
company’s ability to pay its bills on time. If the accounts payable days are
inordinately long, this is probably a sign that the company does not have
sufficient cash flow to pay its bills. Alternatively, a small amount of accounts
payable days indicates that a company is either taking advantage of early
payment discounts or is simply paying its bills earlier than it has to.
100
Working Capital Management
The calculation is to divide total annualized purchases by 360 days,
and then divide the result into the ending accounts payable balance. An
alternative approach is to use the average accounts payable for the reporting
period, since the ending figure may be disproportionately high or low. The
amount of purchases should be derived from all nonpayroll expenses
incurred during the year; payroll is not included because it is not a part of
the accounts payable listed in the numerator. Depreciation and amortization
should be excluded from the purchases figure, since they do not involve
cash payments. The formula follows:
Accounts Payable
Purchases 360
Example
The Drain-Away Toilet Company has beginning accounts payable of $145,000
and ending accounts payable of $157,000. On an annualized basis, its total
expenses are $2,400,000, of which $600,000 is payroll and $50,000 is depreciation. To determine its accounts payable days, we plug this information into
the following formula:
(Beginning Accounts Payable + Ending Accounts Payable) 2
( Total Expenses − Payroll − Depreciation ) 360
=
($145, 000 Beginning Payables + $157, 000 Ending Payables) 2
($2, 400, 000 Total Expenses − $600, 000 Payroll
− $50, 000 Depreciation ) 360
=
$151, 000 Average Accounts Payable
= 31 Days
$1, 750, 000 Purchases 360
The most difficult part of this formulation is determining the amount
of annualized purchases. If a company has an irregular flow of business over
the course of a year, then estimating the amount of purchases can be quite
difficult. In such cases, annualizing the amount of purchases for just the past
month or two will yield the most accurate comparison to the current level
of accounts payable, since these purchases are directly reflected within the
accounts payable in the numerator.
Days of Working Capital
A company can use a very large amount of working capital to generate a
small volume of sales, which represents a poor use of assets. The inefficient
101
Working Capital Metrics
asset use can lie in any part of working capital—excessive quantities of
accounts receivable or inventory in relation to sales, or very small amounts
of accounts payable. The days of working capital measure, when tracked on
a trend line, is a good indicator of changes in the efficient use of working
capital. A low number of days of working capital indicates a highly efficient
use of working capital.
To calculate days of working capital, add together the current balance
of accounts receivable and inventory, and subtract accounts payable. Then
divide the result by sales per day (annual sales divided by 365). The formula
follows:
( Accounts Receivable + Inventory − Accounts Payable)
Net Sales 36
65
Example
The Electro-Therm Company, maker of electronic thermometers, has altered
its customer service policy to guarantee a 99 percent fulfillment rate within
one day of a customer’s order. To do that, it has increased inventory levels
for many stock-keeping units. Electro-Therm’s treasurer is concerned about
the company’s use of capital to sustain this new policy; she has collected the
information in the following table to prove her point to the company
president:
Time
Period
Year before
policy
change
Year after
policy
change
Accounts
Receivable
602,000
723,000
Inventory
Accounts
Payable
Working
Capital
Net
Sales
Sales
per
Day
Days of
Working
Capital
1,825,000
493,000
2,920,000
5,475,000
15,000
195
2,760,000
591,000
4,074,000
6,570,000
18,000
226
The table reveals that Electro-Therm’s management has acquired
an additional $1,095,000 of revenue (assuming that incremental sales are
solely driven by the customer service policy change) at the cost of a nearly
equivalent amount of investment in inventory. Depending on the firm’s cost
of capital, inventory obsolescence rate, and changes in customer retention
rates, the new customer service policy may or may not be considered a reasonable decision.
102
Working Capital Management
SUMMARY
One of the largest uses of cash within a company is its working capital.
Though the treasurer does not have direct control over many aspects of
working capital, he should be aware of the multitude of internal policies,
controls, and systems that, in large part, are responsible for changes in the
size of working capital, and which he may be able to influence. Of particular
importance is a company’s credit policy; a suddenly loosened credit policy
can spark a rapid increase in the amount of working capital. Conversely, if
a company is in need of cash in the short term, a well-managed tightening
of the credit policy can provide the needed funds. Inventory is the most
dangerous component of working capital because it can build rapidly unless
properly controlled and can be quite difficult to convert back into cash.
The treasurer should monitor all components of working capital on a
trend line, in comparison to revenue levels, and against industry benchmarks. If a company’s investment in working capital appears to be disproportionately high, the treasurer should bring this to the attention of senior
management and recommend ways to reduce the investment.
Chapter 3
3
Money and Capital Markets
Learning objectives
After studying this chapter, you should be able to:
1
Describe the structure, players, and instruments used in the Hong Kong
dollar market.
2
Describe the functions of the international money market and the
money market desk within organisations, including compliance with
regulatory requirements.
3
Explain the properties of money market instruments such as
government bills, certificates of deposit, commercial papers, and
repurchase agreements.
64 / Treasury Management
Introduction
Money markets exist in every market economy, which is practically every country in the
world. In every case, they comprise securities with maturities of up to 12 months. That’s
because the money market is designed for short‐term borrowing and lending. Its main
function is to transfer funds from lenders to borrowers through various financial instruments that have a tenor of a year or less.
The funding position of financial institutions varies day by day. To handle the short‐
term and long‐term requirement for funds, the treasury manager must properly monitor
the daily funding requirement and market situation so that he can: a) hold a minimum
cash balance required for day‐to‐day transactions, and b) put surplus funds in money
market instruments that are easily convertible to cash, that is, that are highly marketable.
Moreover, the treasury manager participates actively in the interbank money market in
order to maintain access to the money funds if required.
As with the foreign exchange market, which was discussed in Chapter 2, money
market transactions are traded over the counter. The market participants are commercial banks, governments, corporations, government‐sponsored agents, investment funds,
brokers, and dealers.
Hong Kong Dollar Market
The Hong Kong dollar (HKD) is actively traded. In 2010, daily turnover of the
global foreign exchange market was USD4 trillion. By 2013, the currency accounted
for about 1.4% of all foreign exchange trades on a daily basis and ranked 13th around
the world, according to a triennial survey of central banks by the BIS. The USD, the
most heavily traded currency, accounted for 87% of daily trades through 2013. The
euro, at number two, took 33.4%. The RMB was in ninth place with 2.2% of daily
turnover.1
The HKMA regulates the Hong Kong dollar market. The HKMA is a regulatory
body that is also responsible for achieving the monetary policy objectives set by the government of Hong Kong. The main policy objective of the Hong Kong government is currency stability and the monetary system is characterized by a Currency Board arrangement,
which requires Hong Kong’s monetary base to be backed by reserves of either foreign currency or a commodity equivalent to at least 100% of the monetary base.
1
Bank for International Settlements. “Triennial Central Bank Survey.” September 2013. P 6.
Chapter 3: Money and Capital Markets / 65
Peg System
Hong Kong uses the USD as the backing for the HKD through the Linked Exchang Rate
System (LERS). Changes in the monetary base have to be matched by corresponding
changes in the USD reserves. Since the main objective of Hong Kong’s monetary policy
is currency stability, Hong Kong maintains a link or peg to the USD, which is set within
a band of HKD7.75 to 7.85 to USD1. The Currency Board system ensures the stability of
the peg and the HKD.
In practical terms, the monetary base of the Hong Kong dollar is 100% backed by
corresponding reserves in USD. It is up to the Exchange Fund to ensure that the reserves
are adjusted daily to keep this 100% level.
Hong Kong’s LERS was established in 1983. The HKMA explains that operations
are essentially those of a Currency Board system, under which the stock and flow of the
HKD monetary based is fully matched by changes in foreign reserves.
Hong Kong’s monetary base includes:
•
•
•
•
Certificates of Indebtedness that provide full backing to banknotes issued by the
three note‐issuing banks and in 2013 amounted to HKD329 billion. Three commercial banks in Hong Kong are licenced by the HKMA to issue notes—HSBC, Standard
Chartered Bank, and Bank of China. Banks are required to submit to the Exchange
Fund enough USD to cover the bills they issue.
Government‐issued currency notes and coins amounting to HKD11 billion in 2013.
Balances in the banking system of HKD164 billion as of December 31, 2013.
Exchange Fund Bills and Notes (EFBN) issued in the amount of HKD673 billion
also as of December 31, 2013.
The HKMA operates using Currency Board system rules. The aggregate balance
varies depending on the flows into and out of Hong Kong dollars. To maintain stability, the
HKMA undertakes to buy USD from banks at a rate of HKD7.75 to USD1 and sell them at
a rate of HKD7.85 to USD1. Any surplus or proceeds are switched into USD‐denominated
assets and new Exchange Fund paper is only issued when there is an inflow of capital, which
ensures all new paper is backed by reserves of foreign currency.2
Operations of the Exchange Fund
The HKMA manages the Exchange Fund. The main objective of the HKMA’s monetary
policy is stability in the exchange rate. As discussed earlier, the main goal of Hong Kong’s
2
Hong Kong Monetary Authority. “Linked Exchange Rate System”. 26 August 2011. Accessed online at http://
www.hkma.gov.hk/eng/key‐functions/monetary‐stability/linked‐exchange‐rate‐system.shtml.
66 / Treasury Management
monetary policy is stability of the currency. This is achieved through a peg to the USD
that is maintained through foreign exchange reserves that amount to at least 100% of
Hong Kong’s monetary base. The Exchange Fund manages these reserves.
The main objective of the Exchange Fund is set out in the Exchange Fund Ordinance,
which requires the Exchange Fund to maintain the value of the HKD either directly or
indirectly.3 The Exchange Fund holds the reserves submitted by the note issuing banks
to cover the notes issued. As for the bills and coins issued by the government, the banks
responsible for storing and distributing them are expected to settle their reserves in USD.
The Exchange Fund can also be used to maintain stability and integrity in Hong
Kong’s monetary and financial systems, “to help maintain Hong Kong as an international
financial centre.” The Exchange Fund Advisory Committee has set a series of investment
objectives for the Exchange Fund. These include4:
•
•
•
•
To preserve capital;
Ensure that the monetary base is always backed by “highly liquid” USD assets;
Ensure sufficient liquidity is available to maintain monetary and financial stability;
Achieve and investment return that helps preserve the long‐term purchasing power of
the fund as long as the first three objectives are met.
The Exchange Fund is divided into two portfolios: a Backing Portfolio and an
Investment Portfolio. The Backing Portfolio holds liquid USD assets to back the monetary
base. The Investment Portfolio is invested in bond and equity markets of countries that are
membes of the OECD. The Exchange Fund keeps a long-term target bond‐to‐equity ratio of
74:26 in the two portfolios and, as of 2013, 83% of the assets were allocated to the USD and
HKD and the other 19% to other currencies.5
Setting the HIBOR
Under the currency board system in Hong Kong it is interest rates and not exchange rates
that are affected by the movement of funds in and out of Hong Kong. The rate of interest
for HKD loans made by banks on the interbank market is determined by the Hong Kong
Interbank Offer Rate (HIBOR)—the more commonly used name for the HKD Interest
Settlement Rate. HIBOR is similar to its UK cousin, the London Interbank Offer Rate
(LIBOR), but they are not identical neither in their ultimate objectives nor in how information is gathered to set them.
3 Hong Kong Monetary Authority. “Exchange Fund”. 26 April 2013. Accessed online at http://www.hkma.gov
.hk/eng/key‐functions/exchange‐fund.shtml.
4
Hong Kong Monetary Authority. “Reserves Management”. 2011. Accessed online at http://www.hkma.gov
.hk/media/eng/publication‐and‐research/annual‐report/2011/12_Reserves_Management.pdf.
5
Hong Kong Monetary Authority. “Reserves Management”. 2011. Accessed online at http://www.hkma.gov
.hk/media/eng/publication‐and‐research/annual‐report/2011/12_Reserves_Management.pdf.
Chapter 3: Money and Capital Markets / 67
In Hong Kong, interbank rates are set on interest rates that the different banks in
Hong Kong set on a daily basis. Interbank lending rates are used as a benchmark to determine the interest rates used in a variety of products, from simple loans to mortgages and
complex derivative products.
HIBOR has been in place for more than two decades. The TMA estimates that in
September 2012, Hong Kong banks held more than HKD2 trillion in products that referenced HIBOR.
As of early 2013, HIBOR was published for 15 maturities. The rates are set every
business day, from Monday to Friday, using references to market rates offered for HKD‐
denominated deposits on the Hong Kong interbank market. There are 20 banks designated
as reference banks that provide estimated offer rates that are quoted as of 11 am every
day. The Hong Kong Association of Banks (HKAB) selects the reference banks on recommendation from the TMA. The HKAB publishs the rate daily on its website and at least
four information providers (Bloomberg, Thomson Reuters, Tullett Prebon, and Quick)
publish the rates provided from each of the contributing banks. The Hong Kong Interbank
Clearing Ltd, a company that the HKMA and HKAB own, calculates the actual rate based
on the rates from each of the contributing banks.
As way of example, some of the rates (in %) set as of 24 April 2013 were:
•
•
•
•
•
Overnight: 0.08143
1 Week: 0.09571
2 Weeks: 0.12571
1 Month: 0.20714
12 Months: 0.84857
The HKMA’s Discount Window provides a cushion of liquidity to limit volatility in
interest rates. Through the Discount Window, banks can access overnight liquidity from the
HKMA with repurchase agreements using Exchange Fund paper or other eligible collateral.
The Base Rate of the Discount Window is the interest rate that sets the foundations
for the discount rates for repurchase agreements (repo) transactions. The Base Rate is set
using a formula that takes into account fund targets from the U.S. Federal Reserve and
HIBOR.
Central Moneymarkets Unit
In 1990, the HKMA set up the Central Moneymarkets Unit (CMU). At first, the CMU
offered computerized clearing and settlement for Exchange Fund Bills and Notes. Three years
later the service was expanded to include other HKD debt securities. The CMU has been
linked with other regional and international systems since 1994 as part of an effort to promote
HKD debt securities to investors abroad. Over the years, the CMU has continued to expand
the range of services on offer. CMU is now linked in real time to USD, EUR, and RMB RTGS
systems, which allows for real time delivery-vs-payment (DvP) services to members.
68 / Treasury Management
Among the services available to CMU members are6:
•
•
•
•
•
•
•
•
•
•
A Collateral Management System with an Automatic Repo Facility that covers both
intraday and overnight repos in HKD, USD, and EUR.
A Securities Lending Service for debt securities.
A market making arrangement for EF bills and notes.
An issuance programme for EF bills and notes.
Arranger, custodian, agent, and operator services for notes issued by public corporations.
Real time and end‐of‐day DvP for CMU securities set in HKD, USD, EUR, and RMB.
Cross border DvP settlement through central securities depositories and international
central securities depositories.
Other custodial services like paying agent, securities lodgement, and allotment by
tendering.
Income distribution services.
Bank‐to‐bank repo services.
CMU members (a complete list is included in Appendix A at the back of this book)
may also take advantage of repo facilities in USD. This is done through the USD Clearing
House Automated Transfer System (USD CHATS), a system that started operating on
21 August 2000 but has, since 2004, been operating under the Clearing and Settlement
Systems Ordinance of Hong Kong (CSSO).
The effective operation of a USD payment system in Hong Kong makes it easier to
settle USD transactions in Hong Kong in real time, thus eliminating settlement risk that
emerges when there is a time lag in settlements in a currency pair in different time zones,
an issue that arises when working across multiple time zones.
The Hongkong and Shanghai Banking Corporation (HSBC) is the designated settlement institution for USD CHATS. The Hong Kong Interbank Clearing Ltd operates the
system, which operates from 8:30 am to 18:30 pm every day except Saturdays, Sundays,
and January 1.7 Key functions of USD CHATS are:
•
•
•
6
Settlement and clearing of interbank payments in USD.
Settlement and clearing of DvP transactions for USD against the HKD, EUR, RMB,
Malaysian Ringgit, and Indonesian Rupiah.
Settlement and clearing of DvP transactions of USD debt securities through the CMU
in Hong Kong and RENTAS in Malaysia, as well as USD securities through the Central
Clearing and Settlement System (CCASS), a book‐entry clearing and settlement system for securities listed on the Hong Kong Stock Exchange.
Hong Kong Monetary Authority. “Central Money Markets Unit”. 12 March 2014. Accessed online at http://
www.hkma.gov.hk/eng/key‐functions/international‐financial‐centre/infrastructure/cmu.shtml.
7 Hong Kong Monetary Authority. “Assessment of the USD Payment System in Hong Kong Against the Ten
Core Principles for Systematically Important Payment Systems.” 2011. Accessed online at http://www.hkma
.gov.hk/media/eng/doc/key‐functions/banking‐stability/oversight/USD_CHATS_assessment_2011.pdf.
Chapter 3: Money and Capital Markets / 69
Banks can be Direct Participants, Indirect Participants, or Indirect CHATS Users
depending on their needs. In 2013, to put the size of the system in perspective, there were
18,220 transactions per day on average worth USD18.1 billion.
Since 2007, CMU members can access an Electronic Trading Platform, which provides the infrastructure for electronic trading of EF bills and notes and can be used for
other financial instruments. The use of the common platform, which was one of the recommendations put forth by a Review of Debt Market Development done by the HKMA in 2006,
increases transparency and makes the trading process easier. Although it is not the only
way to trade bonds and funds, local and foreign market players are encouraged to use it.
Registered CMU members can also take advantage of intraday repo facilities provided by the HKMA. These facilities are based on EF bills and notes. The repo facilities can
be discretionary or automatic but, in order to take care of automatic arrangements, banks
need to have a Master Sale and Repurchase Agreement with the MA. This allows intraday
repos to be triggered automatically if the bank’s settlement account with the MA has insufficient funds to meet the next outgoing payment, but the banks have to have enough EF
papers in the repo account with the CMU. An intraday repo that is not reversed by the
close of business is converted into an overnight liquidity adjustment facility (LAF) repo.
Certificates of Deposit and Bonds
Among the more common instruments used by the treasury to manage funds in Hong
Kong are certificates of deposit and bonds, denominated in HKD or RMB.
Certificates of Deposit (CDs) are fixed income investments with guaranteed interest paid either regularly or at redemption. Only banks or other authorized institutions
(AIs) can issue them. They are available in most currencies, including RMB, and interest can be paid at different intervals, such as semi‐annually, annually, or at redemption.
Although banks issue CDs, they are negotiable instruments that are held outside of the
banking sector. CDs can be denominated in multiple currencies in Hong Kong, with the
most popular being HKD and USD.
Other popular instruments are corporate bonds, which are debt issued by corporations that pay a certain interest or coupon over a prescribed amount of time. Bonds can and
often be traded.
Bonds are discussed in greater details later in this chapter and elsewhere in the
book, but it is worth highlight the growth in the issuance of RMB‐denominated corporate
bonds, known as “dim-sum” bonds.
Dim-sum bonds have grown in popularity in recent years as a result of economic
growth in Mainland China. Authorities in Mainland China have, since 2009, allowed corporations to use RMB to trade internationally. Hong Kong is at the center of the push to internationalize the RMB and has become one of the largest markets for RMB‐denominated
bonds, known as “dim-sum” bonds. From 2009 to 2013, the issuance of dim-sum bonds in
Hong Kong grew from RMB16 billion to RMB109 billion.
70 / Treasury Management
International Market
Money market debt facilitates the smooth running of the banking industry, as well as provides working capital for industrial and commercial corporate institutions. The money
market is characterised by a diverse range of products that can be traded within it.
Money market instruments allow issuers, including financial organizations and corporates, to raise funds for short‐term periods at relatively low interest rates. These issuers
include sovereign governments, which issue treasury bills or Exchange Fund bills (EF‐bills)
as they are known Hong Kong, companies that issue commercial paper, and banks that
issue certificates of deposit. At the same time, investors are attracted to the market because
the instruments are highly liquid and carry relatively low credit risk.
Government bills are the debt security of a country that carry the least credit risk, as
compared with other corporate issues that are denominated in the currency of that country, and consequently carry the lowest yield. Indeed, the first market that develops in any
country is usually the government bills market. Investors in the money market include
banks, local authorities, corporations, money market investment funds and mutual funds,
and individuals.
In addition to cash instruments, the money markets also consist of a wide range
of exchange‐traded and over‐the‐counter off‐balance sheet derivative instruments.
These instruments are used mainly to establish future borrowing and lending rates, and
to hedge or change existing interest‐rate exposure. Banks, central banks, and corporates
undertake this activity.
Interest Rate Risk Management
Buying securities, as much as lending or taking deposits, exposes banks and financial institutions to interest rate risk. Most banks accept some kind of interest rate risk but are aware
that this type of risk poses a danger to both earnings and capital adequacy. The HKMA
suggests that the institutions it controls have some kind of process in place to identify,
measure, monitor and manage interest rate risk.8
Interest rate risk can be divided into four categories:
•
Repricing or maturity mismatches: The most obvious source of interest rate risk
emerges from timing differences in rate changes and cash flows in the repricing and
maturity of fixed and floating rate assets, liabilities, and other instruments. Banks can
take this risk as part of their balance sheet, but it can affect both income and the value
of a bank if rates flucturate.
8 Hong Kong Monetary Authority. “Supervisory Policy Manual: Interest Rate Risk Management.” 13 December
2002. Web.
Chapter 3: Money and Capital Markets / 71
•
•
•
Yield curve risk: Mistmatches in repricing can expose a bank to risk associated with
changes in the relative level of rates across the yield curve of an instrument. This yield
curve risk emerges when unanticipated changes in the yield curve of instruments have
a negative effect on the income of a bank.
Basis risk: Arises from an imperfect correlation between changes in rates earned and
paid on different instruments but with similar repricing characteristics. An example
might be found in a bank’s mortgage business, if the bank has priced loans at a rate
that is different than the rate in its funding such as, in Hong Kong, the HIBOR rate. If
HIBOR changes but the prime rate does not, basis risk may emerge.
Option risk: This is interest rate risk associated with the options that are included in
a bank’s assets, liabilities, and OBS portfolios. Options my be standalone instruments
and include bonds and notes with call or put provisions or some types of loans with
prepayment rights.
There are different ways to manage interest rate risk, the HKMA says that the “policies, procedures and limits . . . should be properly documented, drawn up after careful consideration of interest rate risk associated with different types of lending, and reviewed and
approved by management at the appropriate level.”9 An information system that is accurate
and timely is key to managing this type of risk and the policies should be included in internal risk control manual.
Eurodollar and Euroyen
Money market instruments are denominated in the local currency of the country where the
market operates, but some loans and deposits can be in U.S. dollars. These are referred to as
Eurodollars, referring to loans and deposits denominated in U.S. dollars that are conducted
with banks outside the United States. These offshore activities are not under the jurisdiction
of the U.S. Federal Reserve. Consequently, such deposits are subject to much less regulation
than similar deposits within the U.S., allowing banks in theory to reap higher margins.
It is believed that a bank owned by the Soviet Union that sometimes used the telex
address “Eurbank” initiated the first transaction of this kind. Initially dubbed “Eurbank
dollars,” these loans and deposits eventually became known as “Eurodollars.” The latter
name became widespread because banks and financial institutions in Europe generally
held these money market instruments.
These loans and deposits are now available in many countries worldwide, but they
continue to be referred to as Eurodollars regardless of the location where they are transacted. Eurodollar money market instruments are particularly important to smaller banks
that have no branches in the U.S. or limited access to that market.
9 Hong Kong Monetary Authority. “Supervisory Policy Manual: Interest Rate Risk Management.” 13 December
2012. Web. Pg 15.
72 / Treasury Management
A similar situation applies to the Japanese yen. “Euroyen” deposits are yen deposits which are held outside Japan (not in a domestic bank account in Japan). There are
Euroyen markets in Hong Kong, New York, and Singapore, but it is London that has the
biggest share of Euroyen instruments. Euroyen instruments are facilitated by the Japan
Offshore Market ( JOM), which is patterned after the International Banking Facility in
the U.S.
Bond Market
The bond market, also known as the debt, credit, or fixed income market, is a financial
market where participants buy and sell debt securities usually in the form of bonds.
The size of the international bond market is estimated at more than USD45 trillion
and the size of outstanding U.S. bond market debt exceeds USD25 trillion. A bond is
a debt security, in which the authorised issuer owes the holders a debt and is obliged
to repay the principal and interest at a later date, known as the maturity. Other stipulations may also be attached to the bond issue, such as the obligation of the issuer to
provide certain information to the bond holder and limitations on the behaviour of
the issuer.
A bond is simply a loan, but in the form of a security. However, the terminology
used for bonds is different from that of a loan. The issuer of the bond is equivalent to the
borrower of the loan, the bond holder to the lender, and the coupon to the interest. Bonds
are generally issued for a fixed term (the maturity) of longer than ten years. For example,
the U.S Treasury issues bonds with a life of ten years or more. New debt between one year
and ten years is referred to as a note, and new debt with a tenor of less than a year is a bill.
Bonds are a large and intricate part of the money and capital markets and are discussed in
much greater detail in Chapter 4.
Participants
The debt capital markets exist because of the financing requirements of governments and
corporates. The source of capital is varied, but the total supply of funds in a market is made
up of personal or household savings, business savings, and increases in the overall money
supply. Individuals save out of their current income for future consumption, while business savings represent retained earnings. The entire savings stock represents the capital
available in a market.
Investment banks are the primary vehicle through which a corporate will borrow
funds in the bond markets. It will also act as wholesaler in the bond markets, a function
known as market‐making. The bond‐issuing function of an investment bank, by which the
Chapter 3: Money and Capital Markets / 73
bank will issue bonds on behalf of a customer and pass the funds raised to this customer,
is known as origination.
There is a large variety of players in the bond markets, each trading some or all of the
different instruments available to suit their own purposes. We can group the main types of
investors according to the time horizon of their investment activity.
•
•
•
•
•
Short‐term institutional investors. These include banks and building societies,
money market fund managers, central banks, and the Treasury desks of some types
of corporates. Such bodies are driven by short‐term investment views, often subject to
close guidelines, and will be driven by the total return available on their investments.
Banks will have an additional requirement to maintain liquidity, often in fulfilment of
regulatory authority rules, by holding a proportion of their assets in the form of easily
tradeable short‐term instruments.
Long‐term institutional investors. Typically, these types of investors include pension
funds and life assurance companies. Their investment horizon is long‐term, reflecting
the nature of their liabilities; often they will seek to match these liabilities by holding
long‐dated bonds.
Mixed horizon institutional investors. This is possibly the largest category of investors and will include general insurance companies and most corporate bodies.
Market professionals. They include the proprietary trading desks of investment banks,
as well as bond market makers in securities houses and banks who are providing a service
to their customers. Proprietary traders will actively position themselves in the market in
order to gain trading profit. These participants will trade directly with other market professionals and investors, or via brokers. Market‐makers or traders (also called dealers)
are wholesalers in the bond markets; they make two‐way prices in selected bonds.
Private investors. These are individuals and corporates that purchase bonds through
the primary market or secondary market. They can place a competitive bid or non‐
competitive bid in the primary market and/or buy bonds from bond market dealers.
Once the bond is purchased, the transaction is settled through a local or global clearing
house and the bond is lodged with a custodian.
Markets
A new issue of bonds made by an investment bank on behalf of its client is made in the
primary market. Such an issue can be a public offer, in which anyone can apply to buy the
bonds, or a private offer, where the customers of the investment bank are offered the debt
security. The secondary market is the market in which existing bonds and shares are subsequently traded.
Bonds may be traded over the telephone or electronically over computer links;
these markets are known as over‐the‐counter (OTC) markets, as we learned in the previous
74 / Treasury Management
chapters. There is a bond market in almost any country; they primarily deal in domestic
bonds, issued by borrowers domiciled in the country of issue and in the currency of that
country.
Bond markets can also trade international bonds (also known as Eurobonds) that
are issued across national boundaries and can be in any currency. Some may deal as well
in foreign bonds, which are domestic bonds issued by foreign borrowers. An example of a
foreign bond is a Bulldog, which is a sterling bond issued for trading in the UK market by
a foreign borrower. The equivalent foreign bonds in other countries include Yankee bonds
(United States), Samurai bonds ( Japan), Alpine bonds (Switzerland), and Matador bonds
(Spain).
RMB Market
Renminbi markets are increasingly important to banks and financial institutions in
Hong Kong. A push by the government of Mainland China to internationalize the RMB
has opened up this market, particularly in Hong Kong, London, and Singapore. For the
time being, Hong Kong remains the premier offshore RMB market in the world.
Although the onshore RMB market (known as the CNY market) has been active
for several decades, trading in offshore RMB (or CNH) is relatively new. Investors
include domestic and international funds that seek exposure through bonds and equities
listed on the A‐share market. A‐shares are listed in Mainland China markets and denominated in RMB as opposed to the much smaller universe of foreign‐currency denominated
B‐shares.
Foreign investors first got access to onshore RMB through the Registered
Qualified Foreign Institutional Investor (RQFII) program in December 2011, but faced
stringent rules that required them to invest as much as 80% of their funds in bonds.
Those rules were relaxed somewhat in March 2013. Investment quotas are allocated
by the China Securities Regulatory Commission (CSRC) and approved by the State
Administration of Foreign Exchange (SAFE). For the time being, allocations are around
RMB270 billion per year. Opportunities to invest in CNY are expanding as regulators
expand access in steps. By mid‐2013, all asset managers licensed by the Securities and
Futures Commission (SFC) of Hong Kong that are incorporated and mainly operated
there had some form of access.
The CNY market was further boosted by a push to encourage trade settlement in
RMB. This push started in five cities as a pilot project in 2009, but expanded to 20 provincies and cities in 2010 and to the entire country by 2011. By mid‐2013 there were 21
unlisted funds with RQFII quota.
The offshore RMB market, known as the CNH market, has also been evolving rapidly. Before 2009, the RMB could only be used inside China, with cross‐border flows effectively prohibited. Since then, China has been working to expand the use and convertibility
Chapter 3: Money and Capital Markets / 75
of its currency and has created a new and active market that is rapidly growing. The RMB is
now used in foreign currency trading, trade settlement, and as the currency of dim-sum
bonds.
The CNH Market
The development and evolution of the CNH market started in 2005, when China allowed
the RMB to appreciate. Over the next three years, the RMB appreciated 21% against the
USD but its rise was temporarily halted during the Global Financial Crisis. Since 2010, the
RMB has been allowed to fluctuate in a narrow band that is determined based on the prior
day’s price and is linked to a weighted basket of currencies.
In 2009, the government launched a pilot program that allowed 359 Mainland
Designated Enterprises (MDE) from five cities, Hong Kong, and Macau to trade in RMB.
This cross‐border settlement program was extended to 20 provinces and all foreign countries and expanded to also cover the trade in services. By December 2010, the list of MDEs
had expanded to some 67,000 enterprises. In early 2012, the government announced it
would soon eliminate the MDE list.
The first dim-bum bond was issued by China Development Bank in July 2007, but it
was not until July 2010 that the first such bond was issued by a non‐financial Chinese institution. The next month, fast food chain McDonald’s became the first foreign non‐financial
enterprise to issue one. In April 2011, the first CHN‐denominated IPO was issued in
Hong Kong. In November 2012, China Construction Bank issued dim-sum bonds in
London. Non‐Chinese banks like ANZ, HSBC and Banco de Brasil also issued dim-sum
bonds. In 2010, as much as RMB35.7 billion in dim-sum bonds was issued. The next year,
issuances topped RMB131 billion.
As of the end of 2013, the total outstanding dim-sum bonds amounted to
RMB310 billion, up 31% year-on-year. By December 2013, the total RMB‐denominated
deposits in Hong Kong amounted to RMB860 billion, according to the HKMA.
Remittances for cross‐border trade settlement amounted to RMB3841 billion.
Most banks and financial institutions in Hong Kong now offer a whole suite of services in RMB, from credit cards to deposits. While there are limits—individuals are limited from buying RMB20,000 per day, for example—there is little that cannot be done in
Hong Kong, which has emerged as the premier CNH center in the world. Bank accounts
denominated in CNH are common, and so are time deposits. Many ATMs allow for RMB
withdrawals.
In general, dim-sum bonds are sought after and their volume and issuance are growing rapidly. In the last half‐decade, RMB‐denominated products have become important
parts of treasury operations in Hong Kong. Along with new opportunities, these products
bring risks. Aside from the risks associated with all foreign exchange and bond transactions, there are a series of regulatory, interest rate, and legal risks associated with the trade
in CNH that treasury operations have to consider.
76 / Treasury Management
The Money Market Desk
The bank’s money market desk, which is typically part of the treasury function, deals in
money market operations primarily for liquidity ratio and cash flow management. It may
also use the money market to achieve a reasonable return from the bank’s surplus funds or
even to serve as a key profit centre, but its first and foremost goal is to use the money market
to make sure the bank’s liquidity ratio and cash flow management meet (or even exceed)
statutory requirements. The money market’s liquidity, short‐term nature, and diverse range
of products are useful in achieving this primary objective.
Liquidity Ratio
As required by Section 102(1) of the Banking Ordinance, authorised institutions (AIs) in
Hong Kong must maintain a liquidity ratio of not less than 25% in each calendar month as
calculated in accordance with the provisions set out in the Fourth Schedule and Part XVIII
(4.1.1‐2s) of the Ordinance. The ratio will apply only to the institution’s principal place of
business in Hong Kong and its local branches, in a manner that treats the principal place of
business and the local branches as collectively a separate authorised institution, excluding
subsidiaries and overseas branches.
The HKMA encourages AIs to set a target ratio higher than the regulatory requirement in order for management to get an early warning before the ratio dips below 25%. It
tracks each AI’s liquidity ratio closely, requiring them to report what their lowest monthly
liquidity ratio is as well as the average ratio for the month. The HKMA will hold discussions with AIs that have lowest daily liquidity ratios significantly or consistently below 25%
to make sure they have adopted prudent liquidity policies on a day‐to‐day basis.
The HKMA does not only look at the actual liquidity ratio levels. It also examines
the systems and processes that result in the authorised institution achieving that ratio. AIs
must set up a sound and proper cash management system so that the bank’s cash flow position in the next seven days and the near month can be monitored and remedial measures
taken whenever necessary.
Cash Flow Management
The HKMA’s requirements are comprehensive. The way authorised institutions execute
them in the light of their particular circumstances determine the volume of their money
market operations and the particular products and tenors they will engage in. Among these
requirements are the following:
•
Construction of a maturity profile of future cash flows. AIs should measure and
monitor their net funding requirements going forward by constructing a maturity
Chapter 3: Money and Capital Markets / 77
•
•
•
profile that projects future cash flows arising from assets, liabilities, and off‐balance
sheet transactions. All cash flows should be allocated into a series of time bands according to their expected maturity dates.
A net mismatch figure should be obtained by subtracting outflows from inflows
in each time band. A cumulative net mismatch figure should be derived by accumulating the net mismatch figures in each successive time band.
The maturity profile should encompass adequate time bands so that AIs can
monitor their short‐term as well as medium‐ to longer‐term liquidity needs. Short‐
term means five to seven days.
Maturity mismatch limits. AIs should set internal limits to control the size of their
cumulative net mismatch positions (i.e., where cumulative cash inflows are exceeded
by cumulative cash outflows) for the short‐term time bands up to one month (i.e., next
day, seven days, and one month). Such limits should be realistic and commensurate
with their normal capacity to fund the interbank market. Maturity mismatch limits
should also be imposed for individual foreign currencies in which they have significant
positions.
AIs should aim to keep their negative cumulative net mismatches within the
established limits. Any exceptions should be approved by senior management /ALCO
and must be fully justified.
Assumptions and techniques. As far as possible, AIs should incorporate in the maturity profile realistic assumptions underlying the behaviour of their assets, liabilities,
and off‐balance sheet activities, rather than relying simply on contractual maturities.
AIs may use a number of techniques ranging from historical experience and
static simulations based on current holdings to sophisticated modelling. There is no
standard methodology for making the assumptions. What is important is the use
of consistent and reasonable assumptions that are supported by sufficient historical
evidence.
Stress‐testing and scenario analysis. AIs should conduct regular stress tests by
applying various “what if ” scenarios on their liquidity positions, for all currencies in aggregate, to ensure that they have adequate liquidity to withstand stressed
conditions.
At minimum, AIs should include the following scenarios in their stress‐testing
exercise:
i. an institution‐specific crisis scenario; and
ii. a general market crisis scenario (based on assumptions prescribed by the HKMA
from time to time).
Money Market Instruments
The most common instrument is a loan/deposit transaction. A bank either accepts or
borrows funds from a counterparty. Lenders in the market are very cautious about the
78 / Treasury Management
creditworthiness of the borrower, as money market transactions are on a clean line basis10
—the lender is exposed to the credit risk of the loan in the full amount. This is why the cash
market usually concentrates on short tenors such as overnight, tom next (tomorrow next),
or within three months.
The following are some of the most popular on‐balance sheet products in the money
market.
•
•
•
•
10
Government (Treasury) bill: A short term financial instrument that matures in a year
or less, this is issued by the government or quasi‐sovereign bodies, as its name indicates. For example, U.S. Treasury bills are issued by the U.S. Government. The HKMA
issues Exchange Fund bills and notes. These instruments do not bear any coupon and
are always sold at a discount on the par value to create a positive yield to maturity at
inception. Many regard treasury bills to be default‐free investments, particularly those
issued by the U.S.
Certificate of deposit: A CD is a promissory note issued by a bank. It is a time deposit
that restricts holders from withdrawing funds on demand. It bears a maturity date and
a specified fixed interest rate and can be issued in any denomination. The term of a CD
generally ranges from one month to five years.
Banker’s acceptance: A BA is a time draft drawn on and accepted by a bank. Before
acceptance, the draft is not an obligation of the bank; it is merely an order by the drawer
to the bank to pay a specified sum of money on a specified date to a named person or
to the bearer of the draft. Upon acceptance, which occurs when an authorized bank
accepts and signs it, the draft becomes a primary and unconditional liability of the
bank. If the bank is well known and enjoys a good reputation, the accepted draft will be
readily sold in an active market.
A banker’s acceptance is also a money market instrument—a short‐term discount instrument that usually arises in the course of international trade. Maturities on
accepted drafts generally range from 30 to 180 days; payment is due at maturity, which
usually coincides with the delivery of goods to the buyer.
Commercial paper: A CP is an unsecured, short‐term debt instrument issued by a
corporation, typically for the financing of accounts receivable, inventories, and meeting short‐term liabilities. Maturities on commercial paper rarely range longer than
270 days. The debt is usually issued at a discount, although some papers are interest
bearing, reflecting prevailing market interest rates.
The interest rates on commercial papers are often lower than bank loan rates,
which makes the commercial paper market attractive to companies. Issuers market
their papers through dealers, or alternatively, through direct placement with an investor. A commercial paper is rated by debt rating agencies and is generally backed by a
bank line of credit. Secondary market sales are limited, as issuers are able to closely
match the maturity needs of investors.
Clean line means the borrower does not place any collateral against the loan.
Chapter 3: Money and Capital Markets / 79
•
Repurchase agreement: A repo is a financial instrument created when a party enters
into a Sale and Repurchase Agreement of an underlying asset in exchange for cash flow
from another party. The cash receiver (borrower/seller) sells securities to the cash provider (lender/buyer) and agrees to repurchase those securities back at a later date for
a greater sum of cash; the difference constitutes the interest paid. The repo rate is the
difference expressed as a percentage of the borrowing.
A repo is similar to a secured loan, with the buyer receiving securities as collateral to protect against default. There is little that prevents any security from being
used in a repo; Treasury or Government bills, corporate and Treasury or Government
bonds, and even stocks/shares may all be used as securities.
However, the legal title to the securities passes from the seller to the buyer, or
“investor.” Coupons (instalment payments that are payable to the owner of the securities), which are paid while the repo buyer owns the securities, usually passes directly
to the repo seller, despite the fact that ownership of the collateral technically rests with
the buyer.
Most repos are overnight transactions. Long‐term repos, or term repos, can
extend for a month or more, usually for a fixed time period. For the party selling the
security (and agreeing to repurchase it in the future) it is a repo; for the party on the
other end of the transaction, (buying the security and agreeing to sell in the future), it
is a reverse repurchase agreement.
Bond Repurchase Programs
One increasingly important variable at play in markets around the world is the extent
and depth of bond repurchase programs by central banks. Increasingly in the news, asset
purchase programs are also known as “quantitative easing” or “bond buyback” programs.
Through these programs government buy bonds from banks in exchange for cash when
they implement these programs. The end result is that banks have more money to lend. For
customers, this translates into easier borrowing conditions as the size of the money supply
increases while the supply of government bonds is reduced.
At times of weak economic performance, banks tend to step up their asset purchases. The rationale for this is that as central banks buy more bonds, bond prices go up.
This means that bond yields and interest rates go down. When interest rates go down,
customers have an incentive to borrow more and, hopefully, invest more. Following the
2008 crisis, central banks implemented record asset buyback programmes, which helped
increase the money supply while keeping interest rates at record lows for extended periods
of time.
Quantitative easing is not a conventional approach to monetary policy; rather, it is
a tool central banks use to supplement the impact of monetary policy on the economy at
times of unusual stress. During the financial crisis of 2007 to 2012, banks in the U.S., U.K.,
and the Eurozone all undertook quantitative easing because interest rates were close to zero
80 / Treasury Management
and there was little the banks could do, from a monetary policy standpoint, to encourage
more bank lending.
The size of these buyback programs swelled the balance sheets of central banks.
Take the U.S. Federal Reserve as an example. As of April 2013, the U.S. Fed was buying
assets at a rate of USD85 billion per month and its balance sheet had grown to USD3.2
trillion and rising. Prior to the crisis, the balance sheet ranged from USD800–900 billion.
Quantitative easing has also been a favorite policy tool of the Bank of Japan, which
adopted a zero interest rate policy in 1999 and brought it back several times over the next
decade and a half, always keeping a pledge to keep rates as low as possible. With an economy that stalled in the early 1990s, the BOJ first adopted a policy of quantitiative easing in
2001. In October 2010, it set up a JPY35 trillion (around USD430 billion at the time) asset
buying and lending program and steadily increased it to JPY55 trillion by 2001. In April
2013, the BOJ announced a massive asset purchase program, worth USD1.4 trillion, that
would double the country’s money supply and seek to power the economy.
Money Market Operations
There are a number of things to take into account when dealing in the money market. They
include the parameters that must be set in order to complete a transaction, among them
tenor, two‐way quotation, market convention, basis conversion, and pricing the forward rate.
Tenor
Tenor refers to a money market instrument’s maturity date. As discussed earlier, the tenor
of money market instruments can range from overnight to one year. The tenors are categorised into two groups: short‐date and term money.
Short-Date
The following are the short‐date tenors in the money market: overnight, tomorrow‐next,
spot‐next, spot‐one‐week, and tenors within one month.
•
O/N (overnight). An overnight loan commences today and terminates on the next
business day. The duration of an o/n tenor is normally one day during the weekday and
three days over the weekend, depending on the business day convention.
For example, if today is Tuesday, 1 May, the value day will be 1 May and the
maturity date will be Wednesday, 2 May. If today is Friday, 4 May, the maturity date of
the o/n loan will be Monday, 7 May—the first business day after non‐business days on
Saturday and Sunday. The calendar shown on Figure 3.1 can help you visualise these
examples, which are summarised in Figure 3.2.
Chapter 3: Money and Capital Markets / 81
Figure 3.1
Calendar months for tenor examples
S
29
6
13
20
27
May 2007
M T W T
30 1 2 3
7 8 9 10
14 15 16 17
21 22 23 24
28 29 30 31
S
1
8
15
22
29
M
2
9
16
23
30
July 2007
T W T
3 4 5
10 11 12
17 18 19
24 25 26
31
F
4
11
18
25
June 2007
S M T W T F
1
3 4 5 6 7 8
10 11 12 13 14 15
17 18 19 20 21 22
24 25 26 27 28 29
S
2
9
16
23
30
August 2007
S M T W T
1 2
5 6 7 8 9
12 13 14 15 16
19 20 21 22 23
26 27 28 29 30
2 3 4 5 6
S
4
11
18
25
1
8
S
5
12
19
26
F S
6 7
13 14
20 21
27 28
F
3
10
17
24
31
7
Source: HKIB
•
•
•
T/N (tom‐next, meaning tomorrow next). A T/N loan commences on the next business day and terminates on the day after, depending on the business date convention.
Refer once again to Figure 3.1. If today is 1 May, the value date of the T/N loan is
2 May and the maturity date is 3 May. If today is 3 May, the value day of the T/N loan
is 4 May and maturity day is 7 May (because 5 May and 6 May are non‐business days).
S/N (spot‐next). An S/N loan commences on the spot date, meaning two business
days from the transaction day, and terminates on the day after the spot date, depending
on the business date convention. Refer to Figure 3.1. If today is 1 May, the value date of
the S/N loan is 3 May and maturity date is 4 May.
S/W (spot‐one‐week). An S/W loan commences in two business days (spot) and terminates one week later, depending on the business date convention. The normal practice is “week day of this week to the same week day of the following week.”
Figure 3.2
Summary of short-date tenor examples
Today is 1 May
Tenor
Period
Number of days
O/N
T/N
S/N
S/1W
1 May to 2 May*
2 May to 3 May*
3 May to 4 May*
3 May to 10 May*
1
1
1
7
*Provided all the maturity dates are business days. Source: HKIB
82 / Treasury Management
Referring to Figure 3.1, if today is 1 May, the value day of the S/W loan is 3 May,
which is Thursday of the same week. The maturity date is the next Thursday, 10 May. If
10 May is a public holiday, the maturity date is the following business day, 11 May, which
is a Friday.
Term Money
Term money tenors are measured in months, not in days. Thus, an S/1M (spot‐one‐
month) loan terminates one month later. An S/2M loan matures two months later
while an S/3M loan ends in three months. The longest tenor in this series is S/12M
(spot‐twelve‐months).
For example (refer to Figure 3.1), today is 1 May. The value day for an S/1M loan is
3 May and the maturity date is 4 June because 3 June is not a business day. See Figure 3.3
for a summary of examples of term money tenors.
Day Count Convention
The preceding discussion used the phrase “depending on the business date convention.”
We explain this qualifier below in terms of the business day convention, following business
day convention, and preceding business day convention.
•
•
•
Business day convention. All loans must be due on a good business day of the
currency.
Following business day convention. If the original maturity day of the term money
loan falls on a non‐business day, it will be set on the following business day, except when
that day falls in a different month.
Preceding business day convention. Further to the previous statement, if the following business day of a term money loan falls in the next month, the settlement day will
be one day before the original day (the immediate preceding business day).
Figure 3.3
Summary of term money tenor examples
Today is 1 May
Tenor
S/1m
S/2m
S/3m
Source: HKIB
Period
3 May to 4 June
3 May to 3 July
3 May to 3 August
Number of days
32
61
92
Chapter 3: Money and Capital Markets / 83
For example, for a one‐month term loan starting on 29 April, the end day should be
29 May (next month). If 29 May is a bank holiday, the maturity day of the term loan will be
on 30 May instead. If both 29 May and 30 May are bank holidays, the maturity day of the
term loan will be on 31 May. If 31 May is a Saturday and since it is the last day of the month,
the maturity day of the term loan is set back to 28 May.
The value day of HKD term loans in the morning session is usually today. But if
the transaction is done in the afternoon session, it is typically valued tomorrow or spot.
However, the value date of a term loan is adjustable, so other arrangements may apply
depending on the counterparties involved.
Two-Way Quotation
Quotation of a loan in the inter‐dealer market is in terms of annualised interest rates and
is given in the form of “offer‐bid.” The terminology in the money market is different from
foreign exchange (see Chapter 2). The smaller number on the right hand side (the bid
side) is the acceptance rate. The bigger number on the left hand side (the offer side) is the
placement rate.
For example, an overnight HKD loan (O/N HKD) is followed by the notation
4 3/16 / 1/8. This means that the overnight loan is quoted at 4.1875/4.125. A user of the
quote (e.g., a customer) may either place overnight funds to the market maker (e.g. a bank)
at 4.125% per annum or accept overnight funds from the market maker at 4.1875% per
annum.
The above is the traditional UK style of quotation. Some transactions are denoted in
the decimal point format. For example, you may see a bid‐offer of “EUR spot one‐month
5.45/5.55 for EUR 100mio.”
Money Market Convention
The money market convention for calculating interest payment or accrual interest of a loan
is either ACT/360 or ACT/365, and is in simple interest rate. “ACT” means the actual
number of calendar days from the value day to the maturity day or a particular day. The
base value for major currencies is usually 360 days.
Note, however, that the convention for domestic loans may differ from offshore
loans. For example, the convention for the Australian dollar is ACT/360 for the offshore
market, but ACT/365 for the onshore market.
The formula to compute interest payment is as follows:
Interest payment =
Principal × Annual Rate × Actual Days
100 × (365 or 360)
The interest payment for a 63‐day term loan of USD10m at 5 ½% is therefore:
Interest payment = US$10,000,000 × 0.055 × 63/360 = US$97,777.78
84 / Treasury Management
Pricing an Odd Day Loan
Market practitioners quote only standard term loans in the inter‐dealer market. A loan
with a maturity day different from the standard term loan of the day is called an “odd day
loan.”
The market quote of broken day loans can be measured by different models. The
most popular one is the linear (straight line) interpolation model.
For example, you want to price a 39-day loan. The market data for one‐month and
two‐month standard term loans are given below:
•
•
•
1‐month LIBOR is 8.0% (30 days)
2‐month LIBOR is 8.5% (61 days)
So 39‐day loan = 8.0% + (8.5%–8.0%) × 9/31 = 8.15%
You may employ any model to price the broken day loan. If the quote is different
from what you derive from the market rates, in theory you may construct a market portfolio to take the arbitrage opportunity. Your model, of course, gives you only a theoretical
value. The actual market value may have already incorporated the credit risk of the counterparty, the liquidity premium, as well as the profit margin of the transaction at the time
when it is offered to the user.
Leap Year
You should pay attention to the effect of a leap year in your calculation of interest payment.
Suppose the market convention is ACT/360, but the actual number of days for a one‐year
loan in a leap year is 366. So, the calculation of the interest payment should be:
Interest payment for 1‐year loan (leap year) = principal × interest rate × 366/360
Basis Conversion
The return of a financial instrument is affected by the market convention of the product.
You must take into consideration the convention factor before making any comparison.
For example, you cannot compare the yield of a one‐year Treasury bill to a one‐year U.S.
interbank deposit.
If you pay AUD$9,900 today and receive AUD$10,000 30 days later, what is the
annualised return? From Figure 3.4, you can see that the AUD loan in ACT/365 offers a
higher return than the one in ACT/360. However, you get AUD10,000 in both cases.
The general equation for base conversion is as follows:
R 360x * D 360 = R 365 * D 365
R 360 = R 365 * 360 365
Chapter 3: Money and Capital Markets / 85
Figure 3.4
Two cases of different returns
Case 1: ACT/360
Case 2: ACT/365
10,000 = (1+ R * 36 360) * 9,900
R = 12.12%
10,000 = (1+ R *
R = 12.29%
36
365 )
* 9,900
Source: HKIB
Most money markets assume a conventional year of 360 days. However, there are a
few exceptions:
•
•
•
•
•
•
•
•
Sterling;
Greek drachma;
Hong Kong dollar;
Singapore dollar;
Malaysian ringgit;
New Taiwan Dollar;
Thai baht;
South African rand.
Pricing Forward Rate
Forward rate is the interest rate for a period of time that commences on a particular future
time. For example, a one‐month‐against‐four‐months loan is a loan where the borrower will
receive a three‐month loan in one month’s time, with the cost of that loan determined now.
Suppose a client asks 5% for a three‐month deposit, despite the fact that the market
rate for one‐month, three‐month, and four‐month deposits are 4%, 4.5%, and 5%, respectively. What will you do?
You may accept the deposit at 5%, but with the condition that the funds should be
transferred only one month later. Why? It’s because you can actually structure a portfolio
to lock in the profit immediately.
•
•
•
You invest funds for four months at 5%.
You borrow one‐month funds to finance the investment at 4%.
The expected return of your funds after one month is 5.32%, which is higher than your
offer of 5%, as computed below.
(1 + 4 % * 1 12)(1 + R 1×4 * 3 12) = (1 + 5% * 4 12)
R 1×4 = 5.32%
86 / Treasury Management
Relationship of Forward and Spot Rates
Figure 3.5 shows a forward rate curve and a spot rate curve. The Y‐axis is the level of interest rate and the X‐axis is the tenor of the instrument.
On the left‐hand side of the chart, the forward rate curve (red line) is always higher
than the spot rate curve. It is because the yield curve of this portion is positive (Rt2 > Rt1,
t2 > t1). On the right‐hand side, the forward rate curve is always lower than the spot rate
curve. It is because the yield curve is negative (Rt1 > Rt2, t2 > t1). The forward rate equals
the spot rate when the yield curve is flat.
The general equation of forward rates is as follows:
(1 + R 0,1 * D0,1 /year)(1 + F1,2 * D1,2 /year) = (1 + R 0,2 * D0,2 /year)
D0,1 = number of days between 0,1
D1,2 = number of days between 1,2
D0,2 = number of days between 0,2
For example, a one‐month loan is priced at 3% while a two‐month loan is at 4%.
What is the theoretical rate of a one‐month against two‐month loan?
(1 + 3% * 1/12)(1 + R 1,2 * 1/12) = (1 + 4% * 2/12)
R 1 ,2 = 4 .9875%
Figure 3.5
Forward rate and spot rate
Forward Rate
Spot Rate
Positive Yield
Curve
Source: HKIB
Negative Yield
Curve
Chapter 3: Money and Capital Markets / 87
Treasury Bills
A treasury bill is a short‐term debt obligation backed by a sovereign government such as
that of the U.S. It has a maturity of less than one year (usually13, 26, or 52 weeks). Treasury
bills are the securities most frequently purchased or sold by the U.S. Federal Reserve when
it carries out open market operations. Government/sovereign issues such as T‐bill instruments carry the lowest default risk among the similar debt securities of the same country,
and consequently carry the lowest yield among those debt instruments.
Government (T‐) bills are issued through a competitive bidding process at a discount from par, which means that rather than paying fixed interest payments like conventional bonds, the appreciation of the bond provides the return to the holder.
The opposite of competitive bidding is non‐competitive bidding, which is a process for the general public to participate in the bidding of government issues. For example,
about 10% of the government issue will be assigned to the public. The return of the paper
in the non‐competitive bidding is determined by the average rate of the competitive bidding. Investors of this sector do not need to propose a bid in the bidding process.
In Hong Kong, the analogous instrument is the Exchange Fund bill, but this is
slightly different from T‐bills because the HKMA is not a central bank. Because its currency is pegged to the U.S. dollar, Hong Kong does not have an official monetary policy—
it has to follow the monetary policy set by the United States.
Quotation of Discount Instrument
In the U.S. and UK, discount instruments are quoted in terms of the “discount rate” instead
of the yield of the instrument. The formula for converting the discount rate into the actual
settlement payment is giving below:
Discount in dollars = Days to maturity/360 × Discount basis
Quoted price = Face value × (1‐Discount basis × Days to maturity/year)
Settlement amount = Amount transaction × Quote price
For example, if a 180‐day T‐bill is selling at a discount rate of 7%, then:
Discount in dollars = (180 360)* 7% × 10,000 = $350
Quoted price = 10,000(1 − 7% * 180 360) = $9,650 or simply 96.50
True Yield
The bond equivalent yield of a 180‐day Treasury bill is as follows:
10,000 = 9,650 × (1+ R * 180 360)
R = 7.26%
88 / Treasury Management
You may compare the return (true yield) of the paper with another interest‐bearing
instrument using the formula below. Note that the calculation of true yield depends on the
convention (365 or 360) of the instrument that you want to compare with.
Discount/Purchase Price ×
360
180
= 7.25%
(350 9,650 ) * 360 180 = 7.25%
For example, if you buy a discount sterling bill (convention is 365) at a discount rate
of 9.84% for 58 days, the actual amount you need to pay will be:
Quoted price = 100 × (1 − 0.0984 * 58 365) = 98.436%
Quoted price = Face value / (1+ true yield × days/year ) , or
True yield = Discount / (1 − Discount × days/year )
Buy High, Sell Low
A trader in government bills should know when to buy high and when to sell low so as to
generate a profit from the trading. In T‐bills or any other discount instrument, the quotation is in terms of a discount rate. It means you will pay or receive less now if the discount
rate is high.
For example:
Discount in dollars = Discount Rate × Notional Amount × Days/Years
Assume that the face value is USD10,000 and the tenor is 180 days
Discount Rate
Discount in dollars
7%
10,000 * 7% *
10%
10,000 * 10% *
180
360
180
= 350
360
= 500
Cash settlement
9,650
9,500
The cash settlement value of the 10% discount paper is cheaper than the 7%. If you
buy the paper at 10% and sell the paper at 7%, you will gain a profit $150.
Another example is that of a 365‐day T‐bill that is quoted at 5.35% (the bid) and
5.25% (the ask). At first glance, the bid side seems to be higher than the ask side. But if you
convert the bid and ask side (discount rate) into the dollar amounts of the prices, you will
get $94.65 and $94.75 for a two‐way quotation.
Chapter 3: Money and Capital Markets / 89
Exchange Fund Papers
Exchange Fund Bills and Exchange Fund Notes are Hong Kong dollar debt securities
issued by the HKMA. They constitute direct, unsecured, unconditional, and general obligations of the Hong Kong SAR Government for the account of the Exchange Fund and
have the same status as all other unsecured debt of the government. The bills and notes
are for the account of, and payable from, the Exchange Fund, which holds the bulk of the
government’s financial assets.
Under the Exchange Fund Bills Programme, bills of 91‐, 182‐, and 364‐day maturity
are regularly auctioned by public tender. To facilitate the management of liquidity by banks
participating in the Real Time Gross Settlement System (the interbank Hong Kong dollar
payment system), 28‐day Exchange Fund Bills have been issued since November 1996.
But demand has tapered off as banks became more proficient in managing their intra‐day
liquidity. The HKMA is reducing the size of the tap issues of 28‐day Exchange Fund Bills
and replacing them with longer‐term Exchange Fund Notes.
Bills are issued on a discount basis in denominations of HK$500,000 each, and
higher integral multiples thereof. Settlement is effected on the first business day immediately following the relevant tender day. Appointed recognised dealers have undertaken
to quote bid and offer yields for Bills during normal money market hours (9:00 a.m. to
12:00 noon and 2:00 p.m. to 4:00 p.m. Monday to Friday). The bills are exempt from
profits tax and stamp duty in Hong Kong.
Application of Exchange Fund Instruments
Exchange Fund instruments are high quality debt paper that can be used for trading,
investment, and hedging. Authorised institutions that maintain Hong Kong dollar clearing accounts with the HKMA may use their holdings of Exchange Fund papers to borrow
Hong Kong dollars overnight from a discount window.
There are active primary and secondary markets for Exchange Fund bills and notes.
The establishment of a reliable benchmark yield curve for up to ten years has facilitated the
development of a sophisticated Hong Kong dollar debt market. The Hong Kong Futures
Exchange also accepts Exchange Fund papers as margin collateral for trading in stock
options and futures. Exchange Fund papers can be used as collateral in Hong Kong dollar
repurchase transactions as well.
Capital Markets: Risk and Valuations
Credit risk can be defined as the potential that a bank borrower or counterparty will fail
to meet its obligations in accordance with agreed terms. Generally, credit risk is greater
for securities with a long maturity, as there is a longer period for the issuer potentially to
90 / Treasury Management
default. For example, if a company issues ten‐year bonds, investors cannot be certain that
the company will still exist in ten years’ time. It may failed and go into liquidation before
the bonds’ maturity date. There is also credit risk attached to short‐dated debt securities.
There have been instances of default by issuers of commercial papers, which as we learned
in Chapter 3, is a very short‐term instrument.
Banks need to manage the credit risk inherent in the entire portfolio as well as the
risk in individual credits or transactions. Banks should also consider the relationships
between credit risk and other risks. The effective management of credit risk is a critical
component of a comprehensive approach to risk management and essential to the long‐
term success of any banking organisation.
There are two main types of credit risk that a portfolio of assets, or a position in a
single asset, is exposed to. These are credit default risk and credit spread risk.
Credit Default Risk
This is the risk that an issuer of debt (obligor) is unable to meet its financial obligations,
known as default. There is also the case of technical default, which is used to describe a
company that has not honoured its interest payments on a loan for (typically) three months
or more, but has not reached a stage of bankruptcy or administration. All portfolios with
credit exposure exhibit credit default risk.
Credit Spread Risk
Credit spread is the excess premium, over and above government or risk‐free risk, required
by the market for taking on a certain assumed credit exposure. The benchmark is the on‐
the‐run or active U.S. Treasury issue for the given maturity.
Credit spread risk is the risk of financial loss resulting from changes in the level of
credit spreads, used in the marking‐to‐market of a product. It is exhibited by a portfolio
for which the credit spread is traded and marked‐to‐market. Changes in observed credit
spreads affect the value of the portfolio and can lead to losses for investors.
Measurement of Credit Risk Exposures
There are two ways to measure the credit risk exposure of banks to derivatives: the current
exposure method and the original exposure method.
Current Exposure Method
International supervisory authorities believe that the best way to assess the credit risk exposure of banks is to ask them to calculate current replacement cost by marking contracts to
Chapter 3: Money and Capital Markets / 91
Table 3.1
Calculating potential future credit exposure
Residual maturity
One year or less
Over one year to five years
Over five years
Interest
rate
Exchange
rate and
gold
0.0%
0.5%
1.5%
1.0%
5.0%
7.5%
Equity
Precious
metals,
except gold
Other
commodities
6.0%
8.0%
10.0%
7.0%
7.0%
8.0%
10.0%
12.0%
15.0%
1. For contracts with multiple exchanges of principal, the factors are to be multiplied by the number of remaining
payments in the contract.
2. For contracts that are structured to settle outstanding exposure following specified payment dates and where
the terms are reset such that the market value of the contract is zero on these specified dates, the residual maturity
would be set equal to the time until the next reset date. In the case of interest rate contracts with remaining
maturities of more than one year that meet the above criteria, the add-on factor is subject to a floor of 0.5%.
3. Forwards, swaps, purchased options and similar derivative contracts not covered by any of the columns of
this matrix are to be treated as “other commodities.”
4. No potential future credit exposure would be calculated for single currency floating/floating interest rate swaps;
the credit exposure on these contracts would be evaluated solely on the basis of their mark-to-market value.
market. This is thought to capture the current exposure without the need for estimation. A
factor (the “add‐on”) is then added to reflect the potential future exposure over the remaining life of the contract.
In order to calculate the credit equivalent amount of these instruments under this
current exposure method, a bank would add together:
•
•
The total replacement cost (obtained by mark‐to‐market valuation) of all its contracts
with positive value; and
An amount for potential future credit exposure calculated on the basis of the total
notional principal amount of its book, split by residual maturity. Table 3.1 shows the
allocation of future credit exposure weights according to asset type and residual maturity. Note that credit derivatives are classified under “other commodities.”
Regulators will take care to ensure that the add‐ons are based on effective, rather
than apparent, notional amounts. In the event that the stated notional amount is leveraged or enhanced by the structure of the transaction, banks must use the effective notional
amount when determining potential future exposure.
Original Exposure Method
At the discretion of national regulators, banks may be allowed to use a simpler alternative method to determine credit exposure for interest rate and foreign exchange related
contracts. The potential credit exposure is estimated against each type of contract and a
notional capital weight assigned, regardless of what the market value of the contract might
be at a particular reporting date. The original exposure method may be used until market
risk‐related capital requirements are implemented, at which time this exposure method
will no longer be available.
92 / Treasury Management
Table 3.2
Calculating potential future credit exposure
Maturity
One year or less
Over one year to two years
For each additional year
Interest rate
contracts
Exchange rate
contracts and gold
0.5%
1.0%
1.0%
2.0%
5.0% (i.e. 2% + 3%)
3.0%
Source: HKIB
However, banks that engage in forwards, swaps, purchased options, or similar derivative contracts based on equities, precious metals except gold, or other commodities are
required to apply the current exposure method.
In order to arrive at the credit equivalent amount using this original exposure
method, a bank would apply one of two sets of conversion factors to the notional principal
amounts of each instrument according to the nature of the instrument and its maturity, as
shown in Table 3.2.
Potential Exposure of Credit Risks
When an asset is marked‐to‐market, the bank gets to know the current exposure. However,
there is no way for it to know what the credit risk on that asset will be tomorrow. It therefore needs to have a cushion against the credit risk that may appear in the future. To do so,
the bank needs to be aware of the potential exposure of its credit risks.
There are various models for measuring credit exposure, among them Monte
Carlo or historical simulation studies and option valuation models. The analysis generally involves modelling the volatility of the underlying variables (such as interest rates and
bond yield) and the effect of the changes on the value of the derivatives contract. These
techniques typically generate two measures of potential exposure: expected exposure; and
maximum or “worst case” exposure (see Figure 3.6).
The expected exposure of the contract at any point during its life is the mean of all
possible replacement costs as probability‐weighted, where the replacement cost is equal
to the mark‐to‐market present value (if the contract has a positive value) and to zero (if
negative). In general, expected exposure is the best estimate of the likely present value of
the positive exposure and is therefore an important input in making capital‐allocation and
pricing decisions.
On the other hand, the maximum exposure is an estimate of the “worst case” exposure. The calculations are based on the most extreme adverse movements in the underlying
variables. For example, if the maximum potential exposure is calculated as two standard
deviations in a one‐tail test, there is only a 2.5% statistical chance that the actual exposure
will be greater than this worst case. The worst case exposure is important to estimate the
maximum amount that could be at risk.
Chapter 3: Money and Capital Markets / 93
Percent of Notional Amount at Risk
Figure 3.6
Measures of potential credit risk exposure
8
Maximum
Exposure
6
4
Expected
Exposure
2
0
0
1
2
3
4
5
Years Elapsed
Source: HKIB
Figure 3.6 shows the profile of an interest rate swap’s expected and maximum potential exposure. The “hump‐back” shape is due to the offsetting effects of time on the magnitude of the potential movement in the underlying variables, and the number of cash flows
to be replaced if there is a default.
One impact of the passage of time on potential exposure is an increase in the probability that the underlying variable will move significantly from the initial value. This “diffusion effect” is determined by the volatility and other stochastic characteristics of the
underlying variable. The second effect, known as the “amortisation effect,” is the reduction
in the number of years of cash flows that must be replaced. The offsetting influences of the
diffusion effect and the amortisation effect create the concave shape in Figure 3.6.
We can make several observations about the interest rate swap contract in Figure 3.6
by looking at the present value of the replacement cost if a default occurs immediately after
the swap is executed. In this case, five years of cash flows will need to be replaced but it
is unlikely that the swap rate will have moved very far from its initial level in such a brief
period. Consequently, the expected and maximum potential exposures are low because the
diffusion effect is low.
At the other end, if a default occurs just before the swap’s last payment date, the market swap rate could be significantly different from its initial level. However, because only
one semi‐annual cash flow will need to be replaced, the expected and maximum potential
exposures are also low.
The peak exposure (top of the hump) occurs at an intermediate point during the
swap’s life, when enough time has passed for the per‐annum replacement cost to be high
and sufficient time still remains to make the remaining accumulated per annum replacement cost significant in size.
94 / Treasury Management
Figure 3.7
Expected and maximum exposures, cross currency swap
Percent of Notional Amount at Risk
35
Maximum
Exposure
28
21
14
Expected
Exposure
7
0
0
1
2
3
4
5
Years Elapsed
Source: HKIB
Unlike the interest rate swap, a cross currency swap shows a higher risk profile. The
final exchange of principal increases the importance of the diffusion effect and reduces
the amount by which the currency swap amortises, thus creating the upward slope of the
exposure profile (see Figure 3.7).
Compared with the exposure profile for comparable swaps, the exposure profile of
purchased options tends to be greater. In general, options do not have periodic payments,
but are characterised by an upfront payment of the option premium and a final option payoff. As such, the amortisation effect is limited to the time decay of the option price and is
outweighed by the diffusion effect. In other words, the longer the time period, the greater
is the scope for movements in the underlying variable, which can generate a large exposure
on the option payoff.
In contrast to a swap, purchased options with the premium paid upfront initially
create an immediate mark‐to‐market exposure equal to the option premium. If the option
seller defaults immediately, the option buyer must pay another option premium to replace
the option even if there has been no movement in the underlying variables.
Managing Credit Risk in Derivatives
Earlier, we examined the controls and measures that must be put in place in Treasury operations. These apply as well to managing credit risk in derivatives. As discussed, credit risk
can be controlled and mitigated by having a well‐designed and implemented oversight and
Chapter 3: Money and Capital Markets / 95
management systems within and outside the treasury function, including internal controls,
position and dealer limits, monitoring and control of the dealing operation, audit and compliance issues, management of conflicts of interest, and internalisation of the best‐practice
recommendations of The Model.
Treasury desks dealing in derivatives should make sure to carry out credit assessments of the counterparty, the underlying assets of the derivative, and the terms and conditions of the instrument. The prospectus or offer document for an issue provides investors
with some information about the issuer, so that some credit analysis can be performed on
the issuer before the instruments are placed on the market.
Banks typically employ specialists to carry out credit analysis. However, it is often
too costly and time‐consuming to assess every issuer in every market. Two other methods
are commonly employed in managing credit risk of derivatives: name recognition and formal credit ratings.
Name recognition is when the investor relies on the good name and reputation of
the issuer and accepts that the issuer is of such good financial standing, or sufficient financial standing, that a default on interest and principal payments is unlikely. However, the
collapse of Barings Bank in 1995 and the bankruptcy of Lehman Brothers in 2008 suggest
that it may not be wise to rely on name recognition alone in today’s marketplace.
Name recognition needs to be augmented by other methods to reduce the risk of
loss due to unforeseen events. One such method is credit ratings. The three largest credit
rating agencies are Moody’s, Standard & Poor’s, and Fitch Ratings. These institutions
undertake qualitative and quantitative analysis of borrowers and formally rate the borrower after their analysis. The issues considered in the analysis include:
•
•
•
•
The financial position of the firm itself, for example, its balance sheet position and
anticipated cash flows and revenues.
Other firm‐specific issues such as the quality of management and succession planning.
An assessment of the firm’s ability to meet scheduled interest and principal payments,
both in its domestic and in foreign currencies.
The outlook for the industry as a whole, and competition within it, together with general assessments of the domestic economy.
Figure 3.8 shows the credit ratings awarded by the three major agencies to long‐
term bonds, which are often the underlying assets of credit derivatives.
Note, however, that the reputation and credibility of the credit ratings agency have
been somewhat tarnished in the wake of the Global Financial Crisis of 2007–08. They have
been accused of assigning investment grades to collateralized debt obligations (CDOs)
that had some U.S. sub‐prime mortgages as underlying assets, along with triple‐A credits.
This situation underlines the need for banks to make sure their management of credit risk
of derivatives is exhaustive and thorough, and not just dependent on one method such as
credit ratings.
96 / Treasury Management
Figure 3.8
Fitch
Credit ratings by major agencies, long-term bonds11
Moody’s
S&P
Summary description
Investmaent grade—High creditworthiness
AAA
AA+
AA
AA−
A+
A
A−
BBB+
BBB
BBB−
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
AAA
AA+
AA
AA−
A+
A
A−
BBB+
BBB
BBB−
Gilt-edged, prime, maximum safety, lowest risk
High-grade, high credit quality
Upper medium grade
Lower medium grade
Speculative—Lower creditworthiness
BB+
BB
BB−
B+
B
B−
Ba1
Ba2
Ba3
B+
B
B−
BB+
BB
BB−
Lower grade; speculative
B
Highly speculative
Predominantly speculative, substantial, risk or in default
CCC
Caa
CC
C
Ca
C
DDD
DD
D
CCC+
CCC
CCC−
CC
C
CI
D
Considerable risk, in poor standing
May be in default, very speculative
Extremely speculative
Income bonds − no interest being paid
Default
Summary
•
•
•
Money markets exist in every market economy and comprise cash instruments and
some derivative products such as forward rate agreements. The money market’s main
function is to transfer funds from lenders to borrowers through various financial instruments that have a tenor of a year or less.
The Hong Kong dollar is one of the most traded currencies in the world. The HKMA is
the regulator and its main priority is stability, which is kept through a link to the USD.
The link is managed by the Exchange Fund.
The money market is important to banks because of its ability to achieve a reasonable
return on surplus funds and make trading profits. However, the first and foremost goal
11 Choudhry,
Moorad. “Bank Asset and Liability Management: Strategy, Trading, Analysis”. Singapore: John
Wiley & Sons (Asia) Pte Ltd, 2007. Pg. 752.
Chapter 3: Money and Capital Markets / 97
•
•
•
•
•
•
of the money market desk in using the money market is to make sure the bank’s liquidity ratio and cash flow management meet, or even exceed, statutory requirements. In
Hong Kong, the liquidity ratio requirement is 25% in each calendar month, although
authorised institutions are encouraged to maintain a higher target ratio.
The most common instrument in the money market is a loan/deposit transaction. The
other popular on‐balance sheet products include government (treasury) bills, certificates of deposit, banker’s acceptance, commercial paper, and repurchase agreements.
The tenor of money market instruments can range from overnight (O/N) to tomorrow
next (T/N), to within one year, and up to 52 weeks for a treasury bill. Contracts follow
business day convention. In certain markets and products, the year convention can be
365 days (ACT/365) instead of the usual 360 days (ACT/360). Traders should be
cognisant of which conventions are in use to avoid losses.
Quotation of a loan in the inter‐dealer market is in terms of annualised interest rates
and is given in the form of “offer‐bid.” The smaller number on the right hand side (the
bid side) is the acceptance rate. The bigger number on the left hand side (the offer side)
is the placement rate.
Forward rate is the interest rate for a period of time that commences on a particular
future time. For example, a one‐month‐against‐four‐months loan is a loan where the
borrower will receive a three‐month loan in one month’s time, with the cost of that loan
determined now.
A treasury bill is a short‐term debt obligation backed by a sovereign government such
as that of the U.S. It has a maturity of less than one year (usually 13, 26, or 52 weeks).
In Hong Kong, the analogous instrument is the Exchange Fund bill. In T‐bills or any
other discount instrument, the quotation is in terms of a discount rate.
A forward rate agreement (FRA) is an over‐the‐counter short term interest rate derivative contract between two parties that agree on the interest rate to be paid at a future
settlement date. The contract period is quoted as, for example, six against nine months
(6 × 9), which means that the interest rate for a three‐month period will commence
in six months’ time. The principal amounts are agreed, but never exchanged, and the
contracts are settled in cash.
Key Terms
Banker’s acceptance (BA)
Basis conversion
Business day convention
Buy/sell (B/S)
Cash flow management
Central Moneymarkets Unit
Certificate of deposit (CD)
Commercial paper (CP)
Discount instrument
Discount rate
Eurodollar
Euroyen
Following business day convention
Forward rate agreement (FRA)
98 / Treasury Management
Government (treasury) bill
Hong Kong Monetary Authority (HKMA)
Implied yield
Leap year
Liquidity ratio
Loan/deposit transaction
Market convention
Maturity date
Money market
Money/FX swap
Notional sum
Odd day loan
Over the counter (OTC)
Overnight (O/N)
Parallel movement
Preceding business day convention
Repurchase agreement (repo)
Rotation of the yield curve
Sell/buy (S/B)
Short‐date
Spot rate
Spot‐next (S/N)
Spot‐one‐month (S/1M)
Spot‐one‐week (S/W)
Stack hedge
Strip hedge
T‐bill
Tenor
Term money
Tomorrow next (T/N or tom‐next)
Trade date
True yield
Study Guide
1. Is it possible for the goals of liquidity ratio and cash flow management to achieve
reasonable returns on surplus funds and serve as a key profit centre conflict with each
other? Describe one situation when such a conflict may arise. What should the money
market desk do in this case?
2. “The return of a financial instrument is affected by the market convention of the
product.” What are these market conventions? Enumerate and briefly describe each
one. How may an ACT/360 convention affect the return on a deal compared with an
ACT/365 convention?
3. A wealthy client wants to place USD1 million on three‐month deposit with your
bank, but he wants to get 6.5% on it. The market rate for a one‐month deposit is currently 5.5%; 6% for a two‐month deposit; and 6.5% for four months. You do not want
to lose this client. What can you do to keep his goodwill without losing money for the
bank?
4. The client plans to use the USD1 million in deposit to complete a purchase of a property in London in three months’ time. How can he guard against a precipitous decline
in the value of the USD against pound sterling when it comes time for him to pay for
the property?
5. In stock trading, the mantra is “buy low, sell high.” The opposite is true with treasury
bills and other discount instruments, where the slogan is “buy high, sell low.” Explain
why this is the case.
Chapter 3: Money and Capital Markets / 99
Further Reading
Choudhry, Moorad. Bank Asset and Liability Management: Strategy, Trading, Analysis.
Singapore: John Wiley & Sons (Asia) Pte Ltd, 2007. Print.
Flavell, Richard. Swaps and Other Derivatives. West Sussex: John Wiley & Sons, 2002. Print.
Hong Kong Government. “Liquidity Management.” Banking Ordinance. Section 102.
Web. 26 April 2010. <http://www.hklii.org/hk/legis/en/ord/155/s102.html>.
______. “Liquidity Ratio.” Banking Ordinance. Schedule 4. Web. 26 April 2010. < http://
www.hklii.org/hk/legis/en/ord/155/sch4.html>.
Hong Kong Monetary Authority. “Liquidity Risk Management.” Supervisory Policy Manual.
Web. 26 April 2010. http://www.info.gov.hk/hkma/eng/bank/spma/attach/LM‐1.pdf.
______. “CMU Bond Price Bulletin.” Web. 07 May 2010. https://www.cmu.org.hk/
cmupbb_ws/eng/page/wmp0100/wmp010001.aspx.
Steiner, Robert. Mastering Financial Calculations: A Step‐By‐Step Guide to the Mathematics
of Financial Market Instruments. FT Press, 2007. Print.