Unit 3 Financing the organisation
Contents
• Session
• Session
• Session
• Session
• Session
• Session
• Session
• Session
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Viewing an organization from the value chain perspective
Raising finance: public equity finance
Pricing and product decisions
Optimisation of business processes
Market risk: interest rate risk
Market risk: foreign currency risk
Credit risk
Enterprise risk management
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Learning outcomes
• After you have completed Unit 3, you are expected to be able to:
• understand the role of working capital management in providing
shortterm finance
• understand equity, debt, lease and bank finance and how these
can be accessed by organisations
• interpret and calculate the determinants of the cost of each
form of finance and how to calculate an organisation’s
aggregate cost of finance – its weighted average cost of
capital (WACC)
• analyse the risks associated with different financing
structures – for example the split between debt finance and
equity finance
• understand the impact the 2007/08 global financial crisis has
had on organisations’ financing activities
• understand and be able to analyse the different financial and
nonfinancial risks faced by organisations and how they can be
managed, including:
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• liquidity and re-financing risk
• market risk (including interest rate risk and foreign currency (FX)
risk)
• credit risk
• operational risk
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• reputational risk
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Session 1
RAISING FINANCE: SMALL AND
MEDIUM-SIZED ORGANISATIONS
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Forms of finance typically
employed by SMEs
• These forms include:
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retained earnings
working capital management
debt factoring
bank overdrafts
bank facilities
leasing
equity finance – particularly venture capital and private equity
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Financing through retained earnings
and working capital management
• For small organisations, provision of finance to support operations can be
provided by the effective management of working capital and the use of retained
earnings from earlier business activities.
• For new organisations the early years of business may see limited or no
profitability due to the burden of start-up costs.
• Working capital comprises the resources organisations have at their disposal as
a result of the day-to-day running of their business. It comprises cash held at
the bank, the value of the holdings of stock (also known as inventory) plus the
cash due to be received from customers (trade receivables or, simply,
receivables) less the cash due to be paid to suppliers (trade payables or,
simply, payables).
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working capital management
• This is where the outstanding amounts due to creditors, or trade payables,
exceed those due to be received from customers, the trade receivables. In these
circumstances, the organisation’s creditors are, in effect, providing finance
for the business!
• If working capital management is employed to finance business operations,
account needs to be taken of how delayed payments to creditors may result in
price discounts on supplies being forfeited. Such a loss of discounts may
undermine the rationale for operating with negative working capital.
Additionally organisations may expose themselves to reputational damage that
could affect the terms on which suppliers are prepared to do business with
them.
• One overarching constraint on the ability of any organisation to use working
capital management for financing purposes is the legal constraints on the late
payment of bills
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Financing through debt
factoring
• Factoring is where an organisation sells its accounts receivables (i.e. its
invoices) to a third party (a factoring house) at a discount to the total value
of the receivable amounts.
• While there are many variations on the amount advanced and the terms, the
factoring house might initially pay up to 90% of the trade debt to the client
organisation after deducting its charges. The remaining balance is only paid if
and when the organisation’s debtor pays the factoring house.
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Activity 1.2 Deciding on
factoring
• Company ABC has average trade receivables of £200,000 and annual sales of £2.4
million. It is considering the use of factoring given that this would result in
a reduction in credit control costs of £50,000 per annum.
• The factoring house charges a fee of 1.5% of sales. It will provide an advance
to company ABC of 85% of its receivables and will charge interest on this
advance of 7% per annum.
• Assess whether it is financially beneficial for company ABC to enter into this
factoring arrangement.
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Bank overdrafts
• Overdrafts are particularly well suited to the financing of seasonal or other
temporary cash flow shortages.
• Access to this form of finance requires negotiation with the bank provider.
This will set the terms in respect of:
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the maximum size of the overdraft
the interest chargeable
whether fees are charged when the overdraft is utilised
the review period – typically this is at least once a year
the covenants on financial performance
the notice periods, if any, for drawing on the overdraft
the security provided – the owners of small organisations in particular may be required to
provide security against the overdraft usually in the form of property.
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Bank facility finance
• Bank finance can come in the form of a bilateral facility where the borrower
raises funds or establishes the right to draw on a banking facility from one
bank.
• Under the latter arrangement, one bank will be the arranger of the syndicate,
inviting other banks into the deal and often initially bearing a large
proportion of the facility until portions of it are sold down to partner banks.
The interest rate charged is usually linked to the prevailing three month money
market rate, known as three-month LIBOR with the bank(s) adding a margin (e.g.
250 basis points or 2.5%) to LIBOR when lending under the facility. This
overall rate charged to the borrower is known as the drawn fee.
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Lease finance
• Leasing is where an organisation arranges for a bank to acquire an asset that
it needs (e.g. IT equipment) and then leases it from the bank for a defined
term. In this arrangement the bank is the ‘lessor’ and the organisation the
‘lessee’. During the term of the lease the organisation makes payments to the
bank – in effect akin to repayments on a loan.
• At the end of the term of the lease the lessee may make a final payment to
secure ownership of the assets.
• Leasing is attractive to both lessors and lessees for various reasons. Given
that the lessor retains ownership of the leased assets they have security in
the event of the lessee defaulting on lease payments.
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Equity finance
• Both public and private incorporated companies can issue shares in order to
finance their operations.
• Shares may take the following forms:
• Ordinary shares. These give the shareholders ownership of the company and entitlement to a
share of the profits of the business only after the creditors, including bondholders and
the banks, have been paid.
• Preference shares. The rate of the dividend on preference shares is usually fixed and, as
noted above, is payable before an ordinary share dividend can be paid.
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Equity finance
• Dividend yield is the dividend paid divided by the prevailing share price.
• Dividends are the payments – typically annual or half-yearly – to investors in
shares. The size of dividend payments is usually linked to the financial
performance of the company that has issued the shares. It is at the discretion
of companies, subject to approval by its shareholders, whether dividends should
be paid.
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Venture capital and private
equity
• Venture capital companies are suppliers of private equity finance to new or
recently formed companies although increasingly, in recent years, they have
targeted more mature companies.
• Private equity relates to the non-public issuance of shares.
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Hedge funds
• some are targeted at wealthy individuals (those of high net worth) who may be
prepared to take greater risks with their investments than ordinary investors
• the managers of hedge funds charge high fees for their services, often linked
to the performance of their funds
• the funds tend to adopt riskier investment strategies than ordinary investment
funds, often building up their positions by borrowing money from the wholesale
market to finance their investments
• they have tended to be lightly regulated by comparison with conventional
investment funds.
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Session 2
RAISING FINANCE: PUBLIC EQUITY
FINANCE
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Equity finance
• In these circumstances companies may then seek equity finance through an
initial public offering of shares (IPO) through a stock exchange.
• Indeed, many private equity investors set a timescale for their investments and
seek to exit them at the end of a set number of years either through an IPO or
by selling out to other investors.
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Lead banks and co-leads
• The initial decision for the company would normally be to appoint a lead bank –
or possibly a small number of co-leads – to advise it through the listing
process and to manage the sale of shares to investors.
• These banks would usually be expected to underwrite the transaction – in effect
committing to buy those shares not subscribed to by investors on the launch
date.
• The regulatory and reporting requirements of a listed company vary between
exchanges and this could encourage some companies to seek a listing where such
requirements are less onerous, or to list on an exchange focusing on smaller
companies.
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Issuing a prospectus
• The next stage of the process involves the compilation of an issuing prospectus
that has to be reviewed by the relevant regulator.
• In the UK this would be the UK Listing Authority (UKLA) and in the USA this
would be the Securities and Exchange Commission (SEC).
• The information contained in the prospectus would include details of the
company’s financial performance in the recent past – normally up to five years
– and projections for future business performance.
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Due diligence
• Part of the process of producing the prospectus involves what
is known as due diligence where the company’s financial
performance, current financial standing and future plans are
subject to review by the banks who are underwriting the
transaction.
• Particular focus is placed on the viability of the company’s
business plan since the success (or otherwise) of this will
critically influence both the company’s share price and
dividends in the years after the IPO.
• Once this review has been completed satisfactorily the
prospectus can be issued to prospective investors who can
then form their view on whether they wish to invest in the
company and, after a review of the assessed risk, the price
they would be prepared to pay for the shares.
• Simultaneously, but separately, a report may be produced by
the lead bank which gives its own assessment of the company
and the worth of investing in it.
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Book building
• Ahead of the launch, the company and the lead bank would be likely to conduct a
roadshow by making presentations to groups of institutional investors such as
pension funds and hedge funds.
• After assessing market sentiment, the lead bank and others in the syndicate of
banks can advise on the appropriate price to offer the shares. This is often a
range rather than a specific price.
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Underpricing
• Much interest has been shown by analysts in the underpricing of shares offered
through IPOs. Underpricing is evidenced by the price of shares rising (often
sharply) in the immediate aftermath of the launch. Many traders, known as
stags, try to take advantage of this common phenomenon.
• The use of a when issued market in forthcoming share offers (also known as the
grey market) helps to limit underpricing.
• The when issued market is the trade in shares prior to the launch date. These
transactions are completed (settled) when the shares are launched on an
exchange.
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The cost of equity
• The cost at which equity finance can be raised must equate to the return
required by those investing in the company’s equity issues. As a consequence
the factors driving the cost of equity are those that determine the return that
investors expect to receive. Inevitably the return sought by those investing in
equities will be determined by the level of risk involved
• Government bonds are bonds issued by governments to raise finance. UK
government bonds are termed ‘gilts’ because the bond certificates used to be
edged in gold gilt – hence the phrase ‘gilt-edged’, meaning ‘secure’.
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CAPM
• The most widely adopted method to determine this is known as the capital asset
pricing model (CAPM) from which the securities market line can be determined
which estimates the expected (i.e. estimated) return on shares issued by
individual companies.
• The capital asset pricing model (CAPM) is a model for determining the expected
return on an individual share.
• The securities market line is the relationship between the risk of investing in
a particular share and the expected return from investing in the share.
• Equities and shares have the same meaning and the terms may be used
interchangeably.
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CAPM
• The formula that CAPM gives us for estimating the cost of
finance is:
E(Ri) =Rf + βi(E(Rm)−Rf)
• where:
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E(Ri) = the expected return on shares of company i
Rf = the risk-free rate of return
E(Rm) = the expected return on the market
E(Rm)− Rf = the expected equity risk premium
βi = the beta for the company
• A risk-free asset is a security or other investment where
there is deemed to be no risk of default by the issuer (or
borrower).
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Activity 2.1 Weir’s cost of
equity
• Weir Group, the engineering group, has a beta of 1.372. Estimate its expected
return (which equates to its cost of equity) using CAPM. Assume a risk-free
rate of 4.0% p.a. and an expected equity risk premium of 6.5% p.a. Is the
expected return higher or lower than the expected market return? How does this
compare with Pearson which has a beta of 0.824?
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• The return expected on Weir shares is 4.0% + (1.372 × 6.5%) = 12.92% p.a.
• The expected market return (i.e. the expected return on average from the equity
market as a whole) is the expected return assuming a market beta of 1, which is
4.0% + 1 × 6.5% = 10.5% p.a.
• Weir shares therefore have a higher expected return than the market as a whole
because they are more cyclical than the market – as their beta shows.
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Session 3
RAISING FINANCE: DEBT FINANCE
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Bonds and notes
• The financial markets provide the means for organisations to borrow money by
the issuance of securities in the form of notes or bonds. These typically have
maturities in the range of 1 to 30 years. Longer dated, occasionally undated or
perpetual bonds, with no defined maturity date, are also issued, although such
issues are infrequent. The bulk of funding activity in the bond (or capital)
markets is in maturities of up to 10 years.
• When we are referring to the fixed or determinable interest payments to be made
by the issuer of a bond the correct term is coupon.
• When we refer to the annual or other periodic rate of return that an investor
does or would earn by investing in a bond that has been purchased at a specific
price, the correct term is yield-to-maturity (YTM) or, more simply, yield. The
yield-to-maturity (YTM) is the internal rate of return (IRR) on a bond.
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Bonds and notes
• The world’s capital markets accommodate a variety of bond issues. These issues
may be categorised by their creditor ranking status. Bonds issued in senior
debt form rank as being at least equal (pari passu) to all the other unsecured
and unsubordinated obligations of the issuer and prior to the obligations to
holders of the company’s equity.
• ‘pari passu’ is the Latin term for ranking equally.
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The world’s bond markets
• The world’s bond markets can be subdivided into the following
categories.
• Domestic and foreign bond markets: Organisations can raise funds both
in the market of their home country (domestic bond) or in that of a
foreign country. In the latter case the issue is called a foreign
bond.
• International markets: These markets operate outside the jurisdiction
of a single country. The best example of an international market is
the Eurobond market. Here the term ‘euro’ simply means international
since they are outside the country of origin of the issuer.
• The global market: A global bond is the simultaneous issue of a bond
into a number of markets; for example, an issue of a US dollardenominated bond in the US market and the simultaneous launch of the
same bond (denominated similarly in US dollars) in the European and
Asian markets.
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Bond issuers
• Organisations that issue bonds include:
• governments (or sovereigns)
• supranationals: a supranational is an entity whose credit is underwritten, either
explicitly or implicitly, by two or more sovereign entities. Their shareholders are
typically the participating countries. Examples are institutions such as the Asian
Development Bank and the European Investment Bank
• municipals (local authorities)
• corporates (non-financial organisations)
• financials (including banks and insurance companies)
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Bond structures
• Fixed rate: Here the interest coupons are pre-determined and do not change.
• Floating rate: (or variable rate) is where the interest coupon is re-fixed typically
each quarter (or each month or half year) with reference to a fixed margin above or
below the prevailing money market rate.
• Zero coupon: These bonds pay no interest coupons during their term but they are
issued at a discount to par and redeemed at par on maturity.
• Hybrids: This category can apply to a variety of bonds including droplocks where the
borrower (and sometimes the investor) can opt at a defined point to convert a
floating rate bond to a fixed rate (or vice versa).
• A vanilla bond is a bond with a simple interest and term structure. Such bonds do not
incorporate any options like convertibility.
• Convertibles : A convertible bond, which is another type of hybrid bond, gives the
investor the right to exchange the debt for the equity of the issuer.
• Call and put options:
• Call options give the issuer the right, in defined circumstances, to repurchase the bonds prior
to their maturity.
• Put options give the investor the right to demand early repayment of the bonds, on specific
terms, from the issuer.
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Bond documentation
• Short-term debt is defined as debt that, at the time of issuance, has a
maturity of no more than one year.
• Bond issues need to be accompanied by the documentation specified by the
regulator and the listing authority for the relevant market, if the bond is to
be entered on to the official list of the local stock exchange. The prospectus
supporting debt issuance is called an offering memorandum or an offering
circular. This documentation normally needs to be updated annually or, if
issuance does not happen each year, on each occasion a bond programme is used.
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The rating agencies
• Prospectuses also have to be submitted to the credit rating agencies that
provide ratings for the bonds. A credit rating agency is a company that assigns
credit ratings for issuers of certain types of debt such as bonds.
• Ratings agencies provide credit ratings in respect of both the organisation and
the different debt issues of the organisation. An organisation with both senior
and subordinated debt will normally have different ratings for the different
types of debt.
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Bond issues, yields and credit
spreads
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The cost of debt finance
• Once issued this cost to the organisation (which equates to the return to the
investor at the point of the issue of the bond) is locked in for the life of
the bond.
• The aggregate return, or yield, to the investor on a debt issue comprises:
• the risk-free rate (typically the yield on government debt)
• plus the additional credit premium (or spread) required for the specific organisation,
based on an assessment of its credit quality. The organisation’s credit ratings will be
critical in determining the size of this premium. A cut in ratings will almost invariably
increase the cost of funds, since investors expose themselves to greater risk of default
by the issuer.
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Money markets
• The international money markets are the short-term partners of the bond
markets.
• As with the bond markets the world’s money markets can be subdivided in a
number of ways:
• by country or other geographic area
• by currency (e.g. the sterling money market or the euro-dollar market. The euro currency
market is the market for borrowing and lending in currencies other than those of the host
country. So US dollars traded in Europe are known as euro-dollars.)
• by the category of issuer (e.g. clearing bank)
• by the credit ratings of the borrowers – this particularly applies to the US market.
• As with the capital markets, the
and, given the short-term nature
higher than in the bond markets.
of debt that has been issued and
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volumes of outstandings are very substantial
of the funds, the turnover is considerably
Outstandings is the term for the total amount
which has yet to reach its maturity date (s).
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There are five major categories
of money market instruments
• commercial paper (CP): is the most widely used form of short-term debt issued
by companies internationally. CP is a short-term promissory note with a
maturity usually no longer than 365 days.
• certificates of deposit (CDs): are negotiable securities that can be issued by
financial institutions that have been authorised by the relevant regulator.
Maturities are normally up to one year and can also be issued at a discount or
be interest bearing.
• Bills: Treasury bills (T-bills) are short-term promissory notes issued by a
government. The non-government equivalents of these are what is known as
'eligible bills', typically with maturities of up to six months.
• cash deposits (called depo): The cash deposit (or depo) market is another
source of predominantly short term funds with maturities of up to three months.
• repo (sale and repurchase): The repo market (short for sale-and-repurchase) is
the means by which holders of debt securities (particularly government
securities) can raise short-term funds by exchanging the securities for cash.
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Table 3.4 Typical access to
debt markets
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The weighted average cost of
capital (WACC)
• The cost of debt (RD) is a weighted average for all the forms of debt finance
employed including both long-term and short-term debt issuance and the cost of
bank finance.
RDi = Rf + Rp
•
•
•
•
Where:
RDi = return on debt= cost of debt issued by company i
Rf = risk-free rate of return
Rp = credit risk premium (spread) for investing in debt issues for company i
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WACC
Where:
• E= the market value of equities issued by the organisation
• D= the market value of debt issued by the organisation
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Activity 3.3 Euro Holidays’
WACC
Euro Holidays has 1.8 million shares in issue. The current market price is €20
per share. The company’s debt is publicly traded on the Frankfurt Stock Exchange
and the most recent quote for its price was at 98% of face value. The debt has a
total face value of €10 million and Euro Holidays’ credit risk premium is
currently 3%. The risk-free rate is 4% and the equity market risk premium is 6%.
The company’s beta is estimated at 1.1 and its corporate tax rate is 30%.
Calculate Euro Holidays’
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WACC.
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The risks of different finance
structures and the financial crisis
• However this strategy makes the assumption that when debt issues mature they
can be refinanced at a similar cost. Gearing therefore increases exposure to
refinancing risk. So those organisations with high gearing saw their exposure
to refinancing risk crystallise, thus demonstrating the flaws in a capital
structure weighted to debt.
• Consequently the credit risk premium on debt issued by a company gearing up
could rise pushing up the cost of its debt finance. The consequence of these
reactions by investors could counter, in part at least, the reduction to the
company’s WACC achieved through gearing up.
• A further risk of gearing up is that since interest payments on debt have to be
paid – while dividends do not need to be paid – higher debt outstandings may
create cash flow problems for organisations.
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Session 4
RISK EXPOSURES AND LIQUIDITY RISK
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A risk management framework
• An effective risk management has five stages:
1.
2.
3.
4.
5.
risk identification
the measurement and estimation of risk exposures
the assessment of the potential effect of these exposures
risk mitigation strategies
the evaluation of risk management performance
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Financial risks
• Liquidity risk: this is the risk of running out of the money required to
support organisations’ activities. The materialisation of this risk is commonly
the precursor to the organisation going out of business.
• Interest rate risk: This is a form of market risk since it arises from the
adverse movements in interest rates in the financial markets. All organisations
have cash flows and once there are cash flows then inevitably there is exposure
to interest rate risk.
• Foreign currency risk: Foreign currency risk arises from exposure to
transactions and other business activities in more than one currency.
• Credit risk: the risk that arises from extending credit or making loans to
other people and organisations. In its simplest form it is the risk that those
who owe money do not pay it with the result that a financial loss is incurred
by the lender.
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Non-financial risks
• Operational risk is perhaps the most important and wide-ranging source of nonfinancial risk. It includes the risks arising from the failure of systems,
controls or people.
• legal issues and regulatory requirements where non-compliance may cause
financial losses.
• reputational risk: has been defined as how stakeholders view the organization.
A positive reputation can increase the loyalty of customers, employees and
suppliers and can therefore provide significant financial or operational
advantages. A negative reputation can have a severely detrimental impact.
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Managing sources of funds
• The last thing any organisation wants to do when it comes to liquidity
management is to go begging to its bankers when a cash flow crisis has already
arisen.
• First, projections need to be made of the organisation’scash flows.
• Organisations need to maintain a funding capacity that is ideally in excess of
this worst-case cash flow scenario.
• Maintaining a prudent maturity profile for funds is necessary.
• If the organisation is large enough, it should seek to fund itself from a
number of markets rather than just a single market.
• As far as allowed by those lending, organisations should seek optionality or
flexibility in the terms or conditions of loan agreements.
• Finally, while adhering to all the rules above, organisations should rank the
sources of funds available in terms of comparative cost.
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Managing investments and cash
resources
• If these are not needed for working capital, an organisation can invest this
cash in a number of assets, ranging from short-term money market investments or
in longer-term investments such as bonds and property.
• At least some investments should be made in liquid assets – those assets that
can be converted into cash at short notice for a predictable value.
• The appropriate way to manage the composition of a portfolio to avoid liquidity
issues really amount to common sense:
• maintain deep sources of funding in various markets with an average maturity that is not
too short
• hold liquid assets in low-risk investments that can be converted quickly into cash.
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Session 5
MARKET RISK: INTEREST RATE RISK
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The value of cash flows and
interest rates: some basics
• The key principle is that there is an inverse relationship between the two:
• when interest rates rise the present value of future cash flows falls
• when interest rates fall the present value of future cash flows rises.
• A discounted cash flow (DCF) measures the present value of future cash flows.
This is done by discounting these future flows by using the prevailing levels
of interest rates. The resulting value is known as the net present value (NPV)
of the future cash flows.
• A net present value (NPV) is the sum of a series of discounted cash flows
(DCFs).
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Gap analysis
• Thus, a tool is available for managers to understand the total amount of
interest rate risk being run. Those responsible for managing risk can then
assess whether this amount of interest rate exposure is within an acceptable
level.
• This is not an academic exercise or one applying only to participants in the
financial markets. All organisations have interest rate exposure arising from
their cash flows.
• Market risk comprises the total risk arising from fluctuations in the full
range of market prices to which an organisation is exposed. This includes
interest rates, foreign currency prices and commodity prices.
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The forward cash flows
• There are flows which arise from core business activities, including running
costs, cash receipts from sales, tax payments and other transfers and the
payment of bank charges. (inflows to, and outflows from)
• The net cash flow in each period, be it net inflow or net outflow, is the gap.
• If the organisation is operating in a multi-currency environment, it would have
to produce a cash flow analysis for each currency.
• The flows from the investments held as liquid assets by the organisation are
also shown.
• One important additional point relates to assets and liabilities where the
interest receivable or payable changes at defined points (known as repricing or
refixing) ahead of their final maturity.
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Interest rate risk stress
testing – shocking the gaps
• Clearly, a currency (GB pounds, euros, US dollars etc.) that has experienced
more interest rate volatility will be more likely, on the basis of its history,
to give the organisation a bigger maxi-shock than a currency whose interest
rate volatility has been low.
• Statistical techniques can be applied here. The organisation could assess the
mean (i.e. average) movement of interest rates over different time periods, say
over the past ten years, and compute their standard deviation. Other, simpler
techniques could be used.
• Historically, short-term rates have tended to be more volatile than long-term
rates, so the characteristics of the maxi-shock could be tapered from the short
to the long term.
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economic value of equity (EVE)
• An alternative methodology that is akin to gap analysis employs economic value
of equity (EVE), sometimes also termed as net economic value (NEV).
• EVE assesses the impact in net present value (NPV) terms on the expected cash
flows of assets and liabilities resulting from an interest rate shock.
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Risk exposure
• the measure of risk exposure (the NPV of the interest rate shock) is only
obtained by making assumptions about the potential scale of future interest
rate movements
• once that single number is generated the organisation must make a decision –
based in part on subjective criteria – as to whether the risk is tolerable
• the appetite for risk should reflect the nature of the organisation and its
risk capacity.
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Short-term interest rate risk
management
• Special instruments need to be employed for interest rate risk control. The
most commonly used of these instruments are:
• forward rate agreements (FRAs) and short-term interest rate futures – usually for interest
rate risk management for periods of up to one year ahead
• swaps – usually for long-term interest rate risk management for periods of one or more
years ahead.
• Both FRAs and interest rate futures are designed to help lock in interest rates
and they are close cousins. The key difference between them is that FRAs are
entered into over-the-counter (OTC), meaning through private contracts.
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Long term interest rate risk
management
• Interest rate swaps are another category of financial derivatives used to
manage interest rate risk.
• The vast majority of interest rate swaps are bilateral arrangements between an
organisation and a bank operating as a swaps market-maker. Provided the market
is liquid, the banks will normally be prepared to quote a two-way price for the
fixed-rate component of the swap against the floating rate. The two-way price
shows:
• the fixed rate of interest the bank will pay against receiving the floating rate of
interest
• the fixed rate of interest the bank wants to receive against paying the floating rate of
interest.
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From the viewpoint of the
market-making bank
• The differential between the two rates quoted by the bank (the bid-to-offer
spread) is one way the bank tries to make money out of the transaction. The
bank, however, will not always achieve its objective to make a profit (or turn)
between the two deals, because market rates are not stable. Swap rates can
often move quickly: for example, immediately after the publication of
surprising economic data.
• The other way banks may try to make money out of swap transactions is to use
them to establish trading positions where they bet on the future movement of
swap rates. In these circumstances the bank would not, immediately at least,
try to hedge the position resulting from the swap deal.
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From the viewpoint of the
organisation
• Organisations by contrast simply have to take the price that suits their needs
for managing interest rate risk.
• An organisation with fixed-rate borrowings that wishes to benefit from its
forecast of lower rates in the future will pay the floating rate and receive
the fixed rate.
• When looking at investments – as opposed to borrowings – the reverse applies.
Receive the fixed rate, and pay floating, to protect the earnings on your
investments if you think rates will fall in the future.
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Session 6
MARKET RISK: FOREIGN CURRENCY
RISK
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Foreign currency
• Foreign currency (also known as foreign exchange, forex or FX) risk arises from
exposure to transactions and other business activities in more than one
currency.
• the SWIFT codes for currencies (e.g. USD) will be used in addition to the
currency symbols (e.g. $). SWIFT stands for Society of Worldwide Interbank
Financial Telecommunication.
• Foreign currency, foreign exchange, FX and forex are terms used interchangeably
in the financial markets. Generally we use the term ‘foreign currency’ in this
unit.
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The mechanics of foreign
currency markets
• Spot rates: In the spot market, currencies are bought or sold for immediate
delivery, which in practice means settlement in one or two working days. The
rate for such a deal is called the spot exchange rate or spot rate.
• Forward exchange rates (forward rates): A forward exchange contract is an
agreement to purchase foreign currency at a specified date in the future at an
agreed exchange rate.
• A forward margin is the difference between a forward outright rate and a spot
rate of exchange.
• forward outright = spot + forward margin
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Premiums and discounts
• If a currency is trading at a discount this means that the currency is trading
at a lower price in the forward market than in the spot market.
• If a currency is trading at a premium this means that the currency is trading
at a higher price in the forward market.
• The base currency is normally the domestic currency in a foreign exchange rate
quotation. It is shown as one unit of the currency. For example, in GBP 1 = EUR
1.20, the base currency is GBP and EUR is the terms currency since the exchange
rate is showing the value of GBP in terms of EUR.
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The nature of foreign currency
exposures
• Foreign currency risk is the risk of financial loss caused by
movement (up or down) in the value of assets, liabilities and
future cash flows as a result of changes in exchange rates.
• Foreign currency risk:
• transaction exposure: Transaction exposure is the cash flow
consequence that changes in foreign currency rates have on existing
contractual obligations.
• translation exposure: Translation exposure (also called accounting
exposure) arises from the requirement under IFRS or national
accounting regulations to translate the foreign currency financial
statements of overseas subsidiaries into the home currency in order
to prepare a set of consolidated financial statements for the group
in the home currency.
• economic exposure: Economic exposure (sometimes called operating
exposure or strategic exposure) ‘measures the change in the present
value of the [organisation] resulting from any change in the future
operating cash flows of the firm caused by a change in exchange
rates.
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Measurement of foreign currency
exposure
• The key thing is to categorise foreign currency related cash flows by:
• future time periods –in the same way that interest rate risk exposure using gap analysis
• payables (imports) and receivables (exports)
• currencies.
• A grid of exposures can be drawn up to identify the time, size and currency
nature of each exposure.
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Measuring economic exposure would
involve the following
considerations:
• strategic consideration of expected future cash inflows and
outflows
• interrogation of the model by testing it with what if
scenarios:
• establishing the key currencies relevant to the organisation
• assessing what would happen if a relevant currency changed by, say,
±10% or ±20%. This could feed into different possible strategies: the
short term (six months), medium term (one to two years) and long term
(say, more than two years).
• evaluating the likelihood of the different scenarios occurring: for
example, how likely is it that the USD/EUR rate will be, say,
USD1.50/ EUR1 in one year from now?
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Techniques for foreign currency
exposure management
• If an organisation decides to hedge its foreign exchange exposure there are two
broad categories of actions it can take.
1.
2.
Operational hedging describes those activities within an organization which alter the
composition of its exposure to foreign currency risk. Some of these may involve
reorganisation of the organisation’s structure or the wholesale renegotiation of
contracts with suppliers and customers.
Financial hedging describes those techniques which involve the use of outside
institutional services and financial markets.
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Operational techniques
• Technique 1: matching
• Matching may involve rearranging the balance sheet to try to keep each scale individually
in balance as much as possible – meaning, for example, financing a rupee asset with a
rupee loan. This reduces foreign currency translation exposure before the event rather
than dealing with it after the event.
• Technique 2: pricing adjustments
• In the scenario, the exporter loses because receivables are in a currency that is devalued
(reduced in value) and payables are in a currency that is revalued (increased in value).
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Financial techniques
• Technique 3: long-term borrowing in foreign currencies
• Long-term borrowing in foreign currencies – mainly used for reducing economic exposure –
is simple, yet effective.
• Technique 4: financial instruments
• Forward contracts: The standard forward exchange contract is very easy to obtain in most
major currencies and has the merit of being a simple means of hedging currency exposure by
enabling the exchange rate applying to future foreign currency inflows and outflows to be
fixed in advance.
• Currency swaps: It is possible to use currency swaps – sometimes referred to as crosscurrency swaps – to separate the source of financing from the basis on which the
organisation pays interest.
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Session 7
CREDIT RISK
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Determining credit lines
• A credit line is set as the maximum financial exposure an organisation is
prepared to have to another organisation, be it a customer or a borrower.
• There are a variety of approaches that can be used to assess the credit
standing of counterparties and to determine the size of a credit line for them:
• using the ratings supplied by the credit rating agencies such as Standard & Poor’s
• employing basic methods of credit analysis, including an analysis of financial ratios
• undertaking detailed credit research on each potential debtor.
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Turning the analysis into
credit lines
• Impose a minimum credit quality
• Set an absolute maximum for the organisation
• Set a maximum for the sector
• Set a maximum for the country
• Demarcations for different types of exposures
• A base currency for measuring exposures
• Separate credit lines when lending is secured
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Credit risk management - four
techniques
• Debt factoring is used widely by small and medium-sized organisations to reduce
credit exposure to debtors and improve cash flow.
• Letters of credit (LC) and letters of guarantee (LG) are two methods of
containing credit risk for organisations involved in international trade.
• Securing credit exposures or supporting lending with specific assets held as
collateral. This includes use of the repurchase (or repo) market and
securitisation. The secured lending market is particularly helpful to
organisations with a weak credit status that may have difficulties borrowing on
an unsecured basis.
• Credit derivatives can be used to reduce the credit exposure or alter the
credit risk profile on investments.
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Session 8
ENTERPRISE RISK MANAGEMENT
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Enterprise risk management
(ERM)
• An ERM framework has been defined as the ‘set of components
that provide the foundations and organisational arrangements
for designing, implementing, monitoring, reviewing and
continually improving risk management throughout the
organisation. ERM is an iterative process that typically
includes the following key steps:
•
•
•
•
•
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clarifying corporate strategies and objectives
identifying both financial and non-financial risks
assessing risks
acting on those assessments with the tools already discussed
ongoing monitoring.
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ERM: Structure and
accountability
• Overall responsibility for ERM – including determining which risks to take and
to what extent – lies with the most senior management in an organisation. In a
company this means the board of directors.
• Once that overall risk level is decided, responsibility for specific aspects of
ERM may be delegated to committees of the board or to senior levels of
management.
• Powers to manage individual risks on a day-by-day or transaction-by transaction
basis are then delegated to managers below board level.
• The ERM framework should define who is responsible for every risk.
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Communications and training
• Communications, both internal and external, are an important part of a
successfully functioning ERM process. Information can be either qualitative or
quantitative in nature, depending on the type of risk being evaluated.
• External communications usually focus on legal, regulatory and governance
issues and reputational risk. Reporting must take place at regular intervals,
such as monthly or quarterly.
• Implementation of ERM needs to take human and cultural factors into account.
• Risk owners have the responsibility for communicating and training staff about
risk and how it is monitored, analysed, evaluated and treated.
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Commitment and mandate
• Establishment of the corporate mandate for ERM can be viewed as consisting of
three key steps, according to Shortreed (in Fraser and Simpkins, 2010, p. 111):
1.
2.
3.
The board makes the decision to proceed, assigns a champion, usually the Chief Risk
Officer (CRO) or Chief Financial Officer (CFO) and allocates sufficient resources to
support the project. Outside consultants are frequently also brought in to benefit
the organisation using their experience in project management and in ERM
implementation at various types of organisations where they have worked.
Various committees of key staff members, led by the champion, conduct an analysis of
the existing risk management framework, if there is one; look at the organisation’s
environment; design the ERM framework; and make recommendations for its
implementation.
The recommendations are approved and any needed changes to various organisational
processes, such as IT systems and management compensation plans to reflect risk
management proficiency, are agreed.
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Monitoring, review and
improvement
• Implementation of a truly integrated ERM process can be expected to take many
years.
• Risk owners are responsible for the continuous improvement of the monitoring
and controls for their risk but there should also be a system of third-party
reviews periodically. (such as the International Organisation for
Standardization - ISO)
• The most effective ERM processes take place in organisations that understand
that ERM is not a one-off project but a continuous process.
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