TREASURY MANAGEMENT – NOTES FINALS

I. FOREIGN EXCHANGE RISK MANAGEMENT

When a company accepts foreign exchange currency in payment for its goods or services, it
accepts some level of foreign exchange risk, since the value of that currency in comparison
to the company’s home currency may fluctuate enough between the beginning of the
contract and receipt of funds to seriously erode the underlying profit on the sale. This is
becoming more of an issue over time because global competition is making it more likely
that a company MUST accept payments in a foreign currency.

When dealing in foreign currencies, a company must determine its level of exposure, create
a plan to mitigate the risk, engage in daily activities to implement the plan, and properly
account for each transaction.

Terminologies:

$1.00 = 0.7194 euros 1/0.7194 1 euro = $1.39

1. Base currency – is the unit of currency that does not fluctuate in amount. US dollar is
most commonly used as the base currency
2. Quoted currency or price currency – is the unit of currency that fluctuates
3. Indirect quote – presenting a quote for euros … $1.00 = 0.7194 euros … US dollar is
listed first and the currency it is being paired with is listed second.
4. Direct quote – when euro is used as the base currency … 1 euro = $1.39
5. Cross rate – the exchange rate between 2currencies if neither the base currency nor the
quoted currency is the US dollar.
 In any quote pairing, the currency referenced has always a unit value of 1.
6. Point – is a change of one digit at the fourth decimal place of a quote.
 Most exchange rates are quoted to 4 decimals since the sums involved in
currency transactions are so large that that the extra few decimals can have a
meaning impact on payments.
7. Bid price – the price at which the dealer will purchase a currency
8. Ask price/offer price – is the price at which the dealer will sell a currency
9. Delivery date or value date – date when 2 parties to a foreign exchange transaction
exchange funds.
10. Spot Rate – currency exchange rate between any 2 currencies.
11. Spot settlement – is engaged when a company requires foreign exchange immediately.
Though there is actually a one-to-two day delay in the final settlement of the
transaction.
FOREIGN EXCHANGE HEDGING STRATEGIES

1. To not hedge the exposure

2. To hedge the exposure through business practices
3. To hedge the exposure with a derivative

1. To not hedge the exposure – accept the risk

 Not hedging the exposure – simplest strategy of all
 A company can accept the foreign exchange risk and record any gains or losses
on changes on the spot rate as they occur.
 Size of a company’s currency exposure may dictate whether to hedge or not.
 For smaller currency position, the expense associated with setting up and
monitoring a hedge may be greater than any likely loss from the decline in the
spot rate.
 As a company’s currency positions increase in size, the risk also increases, and
makes this strategy less palatable.

2. Internal business practices that reduce currency exposure

a. Insist on home currency payment – it is possible to insist on being paid in the company’s
home currency – foreign exchange risk shifts entirely to the customer.
 Likely strategy for a company that is dominant in the industry – can impose
terms on its customers
 Smaller firms – modest competitive advantage if customers re required pay in
their own currency.
 Worst option – offer a customer a choice of currencies in which to make a
payment. Customer will use the one having the more favorable exchange rate.
Company bears the downside risk with no update potential.
b. Currency surcharges – if a customer will not pay in a company’s home currency, an option is
to bill the customer a currency surcharge if the company incurs a foreign exchange loss
between the time of billing and payment.
 Triggered by a significant decline in the exchange rate
 Customers are rarely happy – taking on the foreign exchange risk and they
cannot budget for the amount of the surcharge.
 Hardly a competitive advantage for a company to impose this practice on its
customers.
c. Get paid on time – if a payment period is unusually prolonged, the company is exposed to
changes in the spot rate to a much greater extent than would be the case if payment
interval were compressed.
 Prolonged payment period – 1. payments terms quite too long 2. Longer
delivery schedules 3. Border-crossing delays 4. Longer customary payment
intervals in the other country.
 Behooves company’s sales staff to constantly strive towards sales agreements
with shorter payment terms
  Collection staff – unusually aggressive in collecting
d. Foreign currency loans – offsetting a foreign currency risk exposure by creating a counter
liability – such as a loan.
 A company can borrow an amount of money in the foreign currency that
matches the amount of the receivable. When the customer pays off the
receivable, the company uses the proceeds to pay off the loan – all in the same
currency.
 Attractive option – if foreign interest rates on debt are low or if there are tax
advantages in which the company can take advantage of.
e. Sourcing changes – if there is a large amount of foreign currency cash flows coming from a
specific country, one way to hedge is to start using suppliers located in the same country.
 Company can find a ready use for incoming currency by turning it around and
sending it right back to the same country.
 A more permanent possibility - buy or build a facility in that country which will
require currency not only for the initial capital investment but also to fund
continuing operations. Favorable if there are local government subsidies that
can give the company additional cost savings.
 Local sourcing – not a good option if it will interrupt a smoothly operating
supply chain.
f. Foreign currency accounts – if a company regularly receives and pays out funds in a
particular foreign currency, it may make sense to open a foreign currency account in which
it maintains a sufficient currency balance to meet its operational needs.
 Cost effective – the company would otherwise have to buy the foreign currency
in order to pay those suppliers requiring payment in that currency and then
separately sell the same currency upon receipt of customer payments.
 Although company is still subject to risk of loss on fluctuation in the exchange
rate, it eliminates the cost of continually buying and selling the currency.
 Bank account need not be held in the country where the currency originated. It
is possible and more efficient to maintain a variety of currency accounts in a
single major currency center – New York, Amsterdam, London.
g. Unilateral, Bilateral and Multilateral Netting Arrangement
 A company that regularly conducts business in multiple countries must spend a
considerable amount of time settling foreign exchange transactions.
 It may buy and sell the same currencies many times over as it processes
individual payables and receivables.

3 ways to reduce the volume of transactions depending on the number of parties involved:

Unilateral netting – a company can aggregate the cash flows among its various subsidiaries
to determine if any foreign exchange payments between the subsidiaries can be netted,
with only the smaller residual balances being physically shifted. This reduces the volume of
foreign exchange cash flows, and therefore the associated foreign exchange risk.

Bilateral spreadsheet netting – if 2 companies located in different countries transact a

great deal of business with each other, they can track the payables owed to each other and
 net out the balances at the end of each month and one party pays the other the net
remaining balance.

Multilateral centralized netting –

 too complex to manage with a spreadsheet when there are multiple parties
wishing to net transactions.
 Common approach is to net transactions through a centralized exchange such as
the Arizona-based Euro Netting.

Under the centralized netting system, each participant enters its payables into a centralized
data base through an Internet browser or some other file upload system. The netting
service converts each participant’s net cash flows to an equivalent amount in each
participant’s base currency and uses actual traded exchange rates to determine the final
net position of each participant.

 Each type of netting arrangement can involve a broad array of payment types,
covering such arrays such as products, services, royalties, dividends, interest,
loans, and hedging contracts.
 Bilateral and multilateral netting – parties usually sign a master agreement that
itemizes the types of netting to be performed as well as which contracts or
purchase orders are to be included in the arrangement.
 Though netting is a highly effective way of reducing foreign exchange
transaction costs, some governments do not recognize the enforceability of
these arrangements because they can undermine the payment rights of third-
party creditors.
 Consult a qualified lawyer before entering into a netting arrangement.

3. Use of derivatives to hedge foreign exchange risks

a. Forward exchange contracts –
 The most commonly used foreign exchange hedge
 A company agrees to purchase a fixed amount of foreign currency on a specific
date and at a predetermined rate. This allows it to lock in the rate of exchange
up front for settlement at a specified date in the future.
 The counterparty is typically a bank which requires a deposit to secure the
contract, with a final payment due in time to be cleared by the settlement date.
If the company has a credit facility with the bank acting as its counterparty, then
the bank can allocate a portion of that line to any outstanding forward exchange
contracts and release the allocation once the contracts have been settled.
 Considered an over-the-counter transaction because there is no centralized
trading location and customized transactions are created directly between
parties.
Example: Toledo Toolmakers has a 100,000 euro receivable at a spot rate of 1.39079. Toledo can enter
into a forward foreign exchange (FX) contract with a bank for 100,000 euros at a forward rate of 1.3900,
so that Toledo receives a fixed amount of $139,000 on the maturity date of the receivable.

 When Toledo receives the 100,000 euro payment, it transfers the funds to the
bank acting as counterparty on the forward FX contract and receives $139,000
from the bank.
 Toledo has achieved its original receivable amount of $139,000 even if the spot
rate may have declined during the interval.

b. Currency Futures – is the same as a forward exchange contract, except that it trades on an
exchange.
 Each contract has a standardized size, expiry date and settlements rules.
 The primary currency futures center with substantial volume is the Chicago
Mercantile Exchange (CME). The CME offers futures trading between the major
currencies as well as some emerging market currencies. However, the volume
of contracts in the emerging market currencies is quite low.
 These contracts are handled normally through a broker who charges a
commission.
 Since currency futures have standard sizes and expiry dates, it is quite likely that
a futures hedging strategy will not exactly match the underlying currency
activity.

c. Currency Options – requires the payment of a premium in exchange for the right to use one
currency to buy another currency at a specified price on or before a specified date.
 A CALL OPTION permits the buyer to buy the underlying currency at the strike
price (the exchange rate at which the underlying currency can be bought or
sold).
 A PUT OPTION allows the buyer to sell the underlying currency at the strike
price.
 An option is easier to manage than a forward exchange contract because a
company can choose not to exercise its option to sell currency if a customer
does not pay it.
 Not exercising an option is also useful when it becomes apparent that a
company can realize a gain on changes in the exchange rate which would not
have been if it were tied into a forward exchange contract.
 Currency options are both available over the counter and are traded on
exchanges.
 Listed options – options traded on exchanges. The contract value, term, and
strike price of a listed option is standardized, whereas these terms are
customized for an over-the-counter option.
 Option Agreement Terms:
 Strike price -the exchange rate at which the underlying currency can be bought
or sold.
 Notional contract amount – the amount of currency that can be bought or sold
at the option of the buyer.
 Expiry date – the date when the contract will expire, if not previously exercised
 (option) In the money – buyer can exercise the option at a better price than the
current exchange rate
 (option) At the money – the buyer can exercise it at the current market price
 (option) out of the money – the buyer can exercise it only at an exchange rate
that is worse than the market rate.
 European-style option – is only exercisable on the expiry date
 American-style option – can be exercised at any time prior to and including the
expiry date.
 The problem with an option is that it requires the payment of an upfront
premium to purchase the option, so not exercising the option means that the
fee is lost. This may be fine if a gain from currency appreciation offsets the fee
but is an outright loss if the nonexercise was caused by the customer’s not
paying on time.

d. Currency Swaps – is a spot transaction on the over-the-counter market that is executed at

the same time as a forward transaction, with currencies being exchanged at both the spot
date and the forward date. One currency is bought at the spot rate and date while the
transaction is reversed at the forward date and rate. Once the swap expires, both parties
return to their original positions.
 The currency swap acts as an investment in one currency and a loan in another.
 The amount of a foreign exchange swap usually begins at $5 million, so this is
not an option for smaller foreign exchange cash positions.

e. Proxy Hedging – if a company elects to receive currency that is not actively traded, then it
may have a difficult time locating a hedge in the same currency. However, changes in the
value of the currencies of a large economic area, such as Southeast Asia, tend to be closely
correlated with each other. If the treasurer feels that the correlation will continue then it
may make sense to instead hedge through a highly correlated currency. However, it does
not necessarily mean that if they are correlated in the past, they will continue to be in the
future since a multitude of political and economic issues can break the correlation.

SUMMARY OF STRATEGIES

Forward exchange contracts and currency futures are easier and less expensive to engage in than
options, and so are favored by organizations with simpler treasury operations and conservative risk
profiles. Options are more expensive in the short-term and require closer monitoring but can be
financially rewarding to more aggressive treasury departments.
II. INTEREST RISK MANAGEMENT

Interest rate risk is the possibility of a change in interest rates that has a negative impact on
the company’s profit. A company incurs interest rate risk whenever it borrows or extends
credit. This is a serious issue for companies with large amounts of outstanding debts, since
a small hike in their interest expense could not only have a large negative impact on their
profits but possibly also violate several loan covenants such as interest coverage ratio (times
interest earned = EBITDA/interest expense). A less critical issue is when a company
forecasts a certain amount of available cash in the coming year that will be available for
investment purposes but cannot reliably forecast the return on investment beyond the first
few months of the year. In this situation, the company is forced to budget for some amount
of interest income, but it has no way of knowing if the forecasted interest rate will be
available throughout the year. In the first case, interest rate volatility can cause serious cash
flow problems and in the second case it can cause a company to miss its budgeted interest
income.

Interest Risk Management Objectives

Does a treasurer care if interest rates change over time?

 The objectives of interest risk management are 1) to safeguard company profits

and 2) to reduce the volatility of interest rates.

Interest Rate Management Strategies

1. Internal techniques
2. Interaction with outside parties – hedging with external entities

1. Internal Techniques
a. Cash netting – across the company in order to avoid excess investments in one part
of the company while a different subsidiary must borrow.
Combining cash flows from different parts of the company.
b. Intercompany netting center – that reduces the number of payment transactions
between related companies.

Before delving into specific techniques with external entities, the treasurer must
determine the overall level of risk the company is willing to accept.

 Full -cover hedging – most conservative level; a company enters into hedging
positions that completely eliminate all exposure.
 Selective hedging – leaves room for some hedging activity, usually by the
predetermined setting of minimum and maximum risk levels. The minimum
amount of risk is none at all – known as a NAKED POSITION. A naked position
may be intentional based on management’s assessment that hedging is not
necessary or through simple ignorance of how hedging can be used.
  Speculative positions – essentially reverses underlying exposure. Not
recommended, since the company can place itself at considerable risk by doing
so. This establishes the presumption that the company is earning profits from
its financing activities rather from its operations. Normally financial activities
are considered to be in support of operations and should never place those
operations at risk.

2. Hedging with External Entities

a. Forwards - Forward Rate Agreement (FRA) – an agreement between two parties to
lock in an interest rate for a predetermined period of time.
 A borrower wants to guard against the cost of rising interest rates, while the
counterparty wishes to protect against declining interest rates. The
counterparty is usually a bank.

When a buyer engages in an FRA, and if interest rates rise, then it will be paid by the
counterparty for the amount by which actual interest rates exceed the REFERENCE
RATE (typically based on an interbank rate such as the London Interbank Offered
Rate (LIBOR) or Euribor) specified in the FRA. Assuming that the buyer was using
the FRA to hedge the interest rate on its borrowings, it then pays its lender the
increased interest rate and offsets the added cost with the payment from the
counterparty.

Conversely, if the interest rates decline, then the buyer pays the counterparty the
difference between the reduced interest rate and the reference rate specified in the
FRA and adds this cost to the reduced interest rate that it pays its lender.

The FRA buyer has locked in a fixed interest rate, irrespective of the direction in
which actual interest rates subsequently move.

 A number of date conventions are used in an FRA.

1. Contract date – the start date of the agreement
2. Expiry date – date when the difference between the market rate and
reference rate is determined.
3. Settlement date – when the interest differential is paid. This is also the first
day of the underlying period.
4. Maturity date – the last of the underlying FRA period.

b. Futures – an interest rate future is an exchange-traded forward contract that allows

a company to lock in an interest rate for a future time period. Interest rates futures
are traded on the Chicago Mercantile Exchange (CME). The standard futures
contract is in eurodollars; which are bank deposits comprised of US dollars, and held
outside the United States.
 CME also offers futures contracts on a variety of other interest rate products
including 30-day federal funds, one-month LIBOR and even Euroyen TIBOR
(Tokyo Interbank Offered Rate).
  A company can buy a futures contract through a broker. The broker will charge
a fee on the transaction, and also imposes margin requirements on the
company that are used to ensure that the buyer or seller fulfills the futures
contract’s obligations.
 An interest rate future is a standard contract, with a standard value, term, and
underlying instruments; thus, its terms may vary somewhat from the amount of
the company’s borrowings. This means that there is likely to be an imperfect
hedge meaning that a company utilizing a futures contract must still carry some
amount of risk.

c. Interest Rate Swaps - is an agreement between two parties (where one party is
almost always a bank) to exchange interest payments in the same currency over a
defined time period which normally ranges from one to ten years. One of the
parties is paying a fixed rate of interest while the other party is paying a variable
rate. The variable interest rate is paid whenever a new coupon is set, which is
typically once a quarter. Fixed interest is usually paid at the end of each year.
 A company can shift from fixed to variable payments and vice versa.
 If a company uses a swap to shift from variable to fixed interest payments, it can
better forecast its financing costs and avoid increased payments but loses the
chance of reduced interest payments if rates were to decline.
 If it takes the opposite position and swaps fixed rates for variable rates, then it is
essentially betting that it will benefit from a future decline in interest rates.
 Useful for a company with a weak credit rating since such entities must pay a
premium to obtain a fixed-rate debt. They may find it less expensive to obtain
variable-rate debt, and then engage in an interest rate swap to secure what is
essentially a fixed-rate payment schedule.
 Parties deal directly with each other, rather than using a standard product that
is traded over an exchange.
 Customarily use a standard master agreement that is maintained by the
International Swaps and Derivatives Association (ISDA).
d. Debt Call Provisions – if a company is issuing its own debt, it can include a CALL
PROVISION in the debt instrument that allows the company to retire the debt at a
predetermined price.
 A treasurer would take advantage of this provision if market rates were to
decline subsequent to issuance of the debt and could then refinance at a lower
interest rate.
 The call provision typically incorporates higher prices for earlier calls, which
gradually decline closer to par pricing further in the future. The higher initial
price point compensates investors for the interest income they would otherwise
have earned if the company had not called the debt.

e. Options Contract – is a trade that gives the buyer the right to buy or sell an amount
of futures contracts at some date in the future.
  Options Premium – the cost of the right. It is paid to the counterparty at the
beginning of the contract. The cost will vary based on such factors as the
remaining term of an option, the strike price (interest rate at which the option
buyer can borrow or lend funds) and the volatility of the reference interest rate.
 If the option is entered into through an exchange, the exchange will ask for a
deposit which is refundable when the deal is completed.
 A CALL OPTION on interest rates protects the option buyer from rising interest
rates.
 A PUT OPTION protects the option buyer from declining rates.
 It is possible to modify the above features to meet a company’s specific needs
by dealing in the over-the-counter market.

f. Swaptions - is an option on an interest rate swap.

 The buyer of a swaption has the right but not the obligation to enter into an
interest rate swap with predefined terms at the expiration of the option.
 In exchange for a premium payment, the buyer of a swaption can lock in either
a fixed or variable interest rate. If the treasurer believes that interest rates will
rise, he can enter into a swaption agreement which he can later convert into an
interest rate swap if interest rates do indeed go up.

Counterparty limits – there is a limit to the amount of risk management strategies

outlined that a company can employ. The counterparty to FRA, swaps etc. are usually
banks, and they will reduce their risk by setting up counterparty limits for each
company doing business with them. Every time a company enters into one of the
agreements with a bank, the bank reduces the available amount of the limit assigned to
that company. Therefore, it is possible that some of the risk strategies outlined may
not be available beyond a certain level of activity.

SUMMARY

Of the strategies presented, forwards and futures are the most inflexible because they
do no more than lock a company into a set rate and present an opportunity loss if rates
turn on the opposite direction from the constructed hedge.

Options are more flexible since they can be tailored to provide payoffs that closely
match a company’s exposure while also yielding benefits from a favorable market
move.