In this class we will discuss: The nature of Treasury Management Spot and forward exchange rates The nature of exchange rate risk Internal and external hedging Derivatives used for hedging
What does a treasurer do? Concerned with cash flow and risk Size and responsibility of treasury function will vary Treasury aims,policies, authorisation levels, risk levels and structure determined by Board of Directors Eg Eon
Liquidity and working capital management Financing Risk management
Centralisation Decentralisation Treasurer has Local financing overview – opportunities maximises after- Gives responsibility tax profits (control) to Greater expertise divisional managers Benefits of scale
To ensure that enough cash is available at the right time Management of working capital Efficiency is key and can impact on financing requirements
How much should firm raise this year? What form of financing should be used? What should the balance be between short and long-term funds? Currency of finance/Where should finance be raised?
“Risk management is the process of identifying and evaluating the trade-off between risk and expected return, and choosing the appropriate course of action” (Pike and Neale 2006) How does risk arise?
The exchange (for an agreed price) of a risky asset for a certain asset Hedges can be created for: ◦ Commodities ◦ Foreign currencies ◦ Interest rates Derivatives ◦ Financial instruments used for hedging
Forward contracts ◦ An agreement to buy or sell (commodity, currency or agreement on interest rate on future borrowing) at a fixed price at some time in the future Futures contracts ◦ Similar to a forward contract but standardised in terms of period, size and quality ◦ Can be traded on an exchange
Options ◦ Gives the right, but not the obligation to buy/sell at an agreed price at or up to an agreed time Swaps ◦ An arrangement between two firms to exchange a series of future payments
Exposure to interest rate risk is determined by how much profits and/or asset values are affected by interest rate changes. Depends on whether company is a net borrower or net investor
Two companies agree to exchange interest payments with each other over an agreed period Effectively they are swapping the different characteristics of the two loans Called a plain vanilla
Two companies have access to the following interest rates:Co. A Co. BLIBOR Fixed 11%Fixed 10% LIBOR +0.2%(LIBOR – London Interbank Offered Rate) Co. A has an absolute advantage Co. B has a comparative advantage over A with its floating rate
Company A Company B (wants to borrow (wants to borrow at floating rate) at fixed rate) LIBOR Fixed 11%Rates available: Fixed 10% LIBOR + 0.2%Borrowing action: Fixed 10% LIBOR + 0.2% Swap PaymentsBetter or worse off? 0.2% Worse off worse off 0.2%Better off 1% worse offBalancing payment 0.6%Post-swap borrowing LIBOR – 0.4% 0.2% worse off Fixed 10.6% 0.2% worse offrates Exhibit 12.5 An example of a plain vanilla interest rate swap between two companies, A and B Taken from Watson and Head (2007)
Start and end dates of swap Notional principal Which party is paying floating interest and receiving fixed interest in return and vv Level of fixed rate and basis of floating rate Profit sharing terms
What is meant by the „exchange rate‟? Exchange rates (in free floating markets) are determined by the interaction between the relative supply and demand for a currency. Quotations ◦ Direct How many units of FC per unit of HC eg $2.00 per £ ◦ Indirect How many units of HC per unit of FC eg £0.50 per $
Spot market rate Quotation for immediate delivery Eg Euro ◦ What is the „buy‟ rate? ◦ What is the „sell‟ rate? ◦ What is meant by the „spread‟? ◦ What determines the size of the spread?
Forward Market Rate ◦ The exchange rate for advance transactions ◦ Usually quoted as a premium or a discount on the spot rate Eg 3 month forward rate for euros Turkish lira
Arises due to FC cash flows occurring at some point in time in the future Tends to be short-term Eg A UK company contracts to buy IT components from a German company with payment (in euros) to be made in 6 months time Unexpected changes in the euro/£ exchange rate could result in losses
Matching ◦ Matching FC denominated assets with FC denominated liabilities (or VV), or FC denominated inflows with FC denominated outflows eg Netting ◦ Netting off FC transactions ◦ Often used by multinationals ◦ UK company with German subsidiary. UK parent expects to receive $ inflows in 3 months and German subsidiary expects to make $ payment in 3 months time
Leading and lagging ◦ Settlement of FC accounts either at beginning or after the end of the allowed credit period ◦ Choice depends on expectations of future exchange rate movements ◦ Eg company with a future $ payment may choose to lag its payment if £ is expected to appreciate relative to $ Invoicing in domestic currency ◦ Transfers transaction risk to other company ◦ May place home company at a competitive disadvantage
Forward Contracts ◦ “Enable companies to fix in advance the future exchange rate on agreed quantities of FC for delivery or purchase at an agreed date” (Watson and Head, 2007) ◦ Tailor-made with respect to maturity and size ◦ Cannot be traded ◦ Cash flows occur at the end of the contract ◦ Locks out any potential benefit from favourable exchange rate movements
Involves setting up the opposite FC transaction to the one being hedged Eg $ receipt expected in 3 month‟s time ◦ Set up $ debt by borrowing $s now ◦ Convert $ into £ at current spot rate ◦ Deposit £ on £ money market ◦ When $ loan matures it will be paid off by expected $ receipt
A company expects to receive $180,000 in 3 months time and wants to lock into current exchange rate of $1.65/£. The annual dollar borrowing rate is 7% (the 3-month borrowing rate is 7% * 3/12 = 1.75%). The annual sterling deposit rate is 6% and so the 3 month deposit rate is …..
Borrow an amount (Z) which when interest is added in 3 months will be equal to $180,000 ◦ Z * 1.0175 = $180,000 ◦ Z = $180,000/1.075 = $176,904 Convert $ into £ at current spot rate ◦ $176,904/1.65 = £107,215 Invest £ in the sterling money markets for 3 months ◦ £107,215 * 1.015 = £108,822 The £ value of the $ inflow using the money market hedge is therefore £108,822 (compare with using a forward exchange contract)
What if it were a $180,000 payment to be made instead? Steps ◦ Convert £ into $ at current spot rate ◦ Invest $ on US money market such that the deposit plus interest will equate with the payment to be made in 3 months ◦ Cost is the initial £ plus lost UK interest (or interest on UK loan if initial amount borrowed)
Nature of Treasury Function will vary Mainly concerned with ◦ Liquidity and WC management ◦ Financing ◦ Risk Management Exchange rate risk arises because of the fluctuation in exchange rates Main hedging techniques ◦ Internal ◦ External Next week futures and options