TREASURY MANAGEMENT



TREASURY MANAGEMENT 2 – NOV 2013 MODEL SOLUTIONS

1.(a) Explaining foreign exchange (pg 10)

Relates to money denominated in the currency of another nation or group of nations. Any firm or individual that exchanges money denominated in the home nation’s currency for money denominated in another nation’s currency can be said to be acquiring foreign exchange.

It can take many forms; cash, funds available on credit cards, bank deposits or other short-term claims.

b) The four categories of currencies with examples (pg 11)

i. Major global currencies – for which there is always a two-way market, usually 24 hours a day. Example the USD.

ii. Minor global currencies – of smaller countries which are actively traded but the markets are fairly thin. Example NZD.

Limited currencies – currencies in markets that are constrained, and become so thin at times that they are virtually non-existent. For example Mexican Peso and ZAR.

iii. Scarce currencies – virtually non-tradable and permission from the local bank is often necessary to exchange such currencies. For example the Naira.

c) Define money market.

The money market is a financial market whose instruments are generally characterized by high liquidity and have maturity of less than one year. The market provides a means for short term lending and borrowing and thus plays a key role in the management of liquidity by business and government economic units.

d) Two main participants in the money market

• Borrowers in the money markets – these are players who have a short position and are in need of funding influenced by; need for the funds in the short term only, a temporary measure in the process of securing long term funding, take advantage of lower interest rates and be willing to roll over the deal, and new, young and unknown company in the financial market thereby considered a credit risk for the long term.

• Investors in the money market – the money market is attractive to both issuer and investor as they meet both funding requirements of the issuer while allowing the investor to have acceptable collateral security and liquidity.

2. (a) Forward contract (pg 263 – 265)

i. A forward contract is an agreement between a bank and a firm to exchange one currency for another at some future date. The rate at which the exchange to be made, the delivery date, and the amounts involved are fixed at the time of the agreement. The delivery date of a forward contract can be anything from three days to over five years from the contract date. Forward contracts are the most popular hedging instrument.

ii. Forward rate as at 30 September 2012

▪ FK/$ = SK/$ X 1+(rK X t/360)

1+(r$ X t/360

FK/$ = 410 X 1+ (0.42 X 181/360)

1+ (0.02 X 181/360)

FK/$ = K491.6266

iii. For 30 September you will pay

= $100,000 X K491.6266

= K49,162,660 or (K49,162,657.16 to the nearest tambala)

iv. According to my projection, the rate will be:

= K410 X 1.25

= K512.5000/USD

iv. There will be a saving as follows:

= (K512.5000-K491.6266)/$ X $100,000

=K2,087,340.00

Q3 Swaps

i. Meaning of swap (pg 311)

A swap is an agreement between two parties to an exchange of streams of payments either directly or through an intermediary.

ii. Two uses of swaps (pg 311)

1. Market constraints – where a company wishes to hedge by exchanging a future stream of cash flows over several periods, say five years

2. Cost advantage – to exploit cost differentials between markets for the two counterparties, based on the principal of comparative advantage.

3. Hedging - A risk management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities. In effect, hedging is a transfer of risk without buying insurance policies.

iii. Net position

= (Future rate – spot rate)/$ X Foreign amount

= (K357.1897-K350.5566)/$ X $10,000,000

= K66,331,000

It will be in favor of my counterparty.

iv. Options that the dealer has

• Continue borrowing on the interbank for that period

• Sell off some of the dollars on the interbank or to willing takers

• Liquidity some assets (investments like Treasury bills) that you are holding.

• Mobilize deposits – promotions to attract depositors.

4 (a) How an FRA works (pg 182)

FRAs are used for hedging, although they can be used for speculating on interest rates when the user does not have an underlying cash position. It is an agreement to swap short-term interest payments over an agreed period at an agreed date in the future. The buyer of an FRA locks in a fixed interest rate while the seller locks in a floating rate. On the settlement date one counter party makes a payment to compensate for any difference between the agreed interest rate and the spot interest rate at the time the forward period starts.

b) If interest drops to 15% I will receive: (pg 183)

= (0.16-0.15) X 92/365 X K15mio

(1+(0.15 X 92/365))

= K36,431.12

c) If interest drops to 16.5% I will pay: (pg 183)

= (0.16-0.165) X 92/365 X K15mio

(1+(0.165 X 92/365)

= K18,149.00

d) Any other two instruments that are used to hedge interest rates movements. (pg 182)

• Short futures contracts

• Interest rate options

• Using bond futures

SECTION B

QUESTION 5

a) Explain a bond (pg 145)

A bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the maturity. Interest is usually payable at fixed intervals (semiannual, annual, and sometimes monthly). Very often the bond is negotiable, i.e. the ownership of the instrument can be transferred in the secondary market. Thus a bond is a form of loan or IOU: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.

b) Three main categories of bonds (pg 147)

• Domestic issues – those issued in the domestic bond market in a single country and typically include government bonds of that country.

• Foreign issues – those issued in a single domestic market by an issuer who is foreign to that market.

• Euro issue – one which is sold simultaneously at issue into many countries

c) Terms in bond trading

i) Issued with a put option (pg 145) – it is a bond that allows the investor to demand early repayment. This is useful if interest rates rise such that, by the put date, a similar bond with a higher coupon could be purchased by the investor.

ii) Issued with a sinking fund (pg 146) – the bond is in effect a simultaneous issue of securities with different maturities

iii) Issued in stripped form – bonds that are issued where by coupons and principal are separated as such can be traded separately as well.

QUESTION 6

(a) Briefly explaining the four exchange rate systems (pg 69)

• Clean floating – the exchange rates are left purely to market determination, with no direct or deliberate intervention from the monetary authorities. Solely determined by the supply of currencies and demand of currencies.

• Managed floating – the authorities intervene in buying and selling currencies in the foreign exchange markets, using official reserves or official borrowing from overseas.

• Crawling peg – this arrangement the official intervention takes place in order to achieve specific objectives in relation to controlled adjustment of the exchange rate. Intervention is on a continuous basis.

• Fixed exchange – one where the authorities attempt to hold the exchange rate at a fixed rate, or within a narrow margin of a predetermined value, against other currencies.

b) Malawi is currently using the clean floating exchange rate system.

c) Three advantages of the system Malawi is using (pg 69)

• In theory it provides an automatic mechanism for dealing with balance of payments problems.

• Official international currency reserves are not required as government exchange market intervention does not take place

• Market forces determine the exchange rate, thus relieving the government of making economically and politically difficult decisions

• The government's economic policy may therefore be directed towards domestic problems, e.g. unemployment, inflation and slow economic growth

Two disadvantages of the system Malawi is using (pg 70)

• With no official intervention to stabilize short-term exchange rate fluctuations, markets may become unstable, caused perhaps by pure currency speculation.

• If price elasticity of demand for internationally traded goods is low, then a balance of payments problem may result in persistent pressure on exchange rates as trade volumes fail to adjust sufficiently in response to exchange rate movements.

• A continuing depreciating exchange rate, leading to higher prices for imported raw materials and consumer goods, may generate inflationary pressures within the domestic economy. These pressures may well offset the competitive advantage to exporters given by the depreciating exchange rate

QUESTION 7.

Memo on investment options

FROM : Txxxx Pxxxx

TO : The Head of Treasury

Date : 12 May 2013

SUBJECT : INVESTMENT OPTIONS

We seek you consideration to invest the excess position we have. Some of the instruments we intend to employ are as follows:

i. Repurchase agreement (pg 137)

A repo enables someone to sell a security for cash and then buy that security back for a pre-arranged amount at a pre-arranged time in the future. For example, we can enter into repo contracts with businesses that are in short position by buying their investment assets and sell them back at a pre-determined price and date.

ii. Treasury bill (pg 132)

Treasury bills are issued by governments in order to raise short-term money. They are the most frequently used money market instrument by governments for purposes of fund raising. Similar to bank bills, they are sold at a discount, with the yield being an important indicator of the direction in which interest rates are moving. Governments also use the Treasury bill as a means to influence credit and money supply. They are negotiable bearer bills and have a considerable secondary market. There are two main methods of purchasing treasury bills. If prospective buyers are bidding against each other on a competitive basis, the highest bidders (on the basis of requiring the lowest yield) are the first to be presented with their bills. Those who participate on a non-competitive basis agree beforehand to purchase a specific amount at a price which is the average of the accepted bids

iii. Bankers Acceptance (pg 129)

This is an instrument where a bank makes finance available to its customers. It is a bill of exchange to be settled at a fixed date in the future and drawn and accepted by the bank. The bank agrees to pay the bearer the full amount of the bill on maturity, should the company which acknowledged the debt default.

iv. Three other investment options available

• Buy shares of a reputable public company, through a stockbroker.

• Invest with a discount house

• Actively lend out the excess on the interbank market on a daily basis.

• Mobilize lending to ordinary and corporate customers

• Deposit with the central bank at a negotiated rate.

v. Recommendation.

I thus propose the treasury bills as the risk of default is almost zero, and in times of short positions, the treasury bills can act as collateral for the loans, and we can also easily liquidate them in case the situation is dire.

QUESTION 8

Currency exposures

a) Meaning of ‘hedge for currency exposure’ (pg 260)

This is the creation of another exposure identical as to the currency, amount and timing to the first exposure, but with the opposite position. If the original exposure was long, the hedge would be a short position.

b) The three major types of foreign exchange exposure (pg 253)

• Transaction exposure – the possibility of incurring gains or losses, upon settlement at a future date, on transactions already entered into and denominated in a foreign currency.

• Translation exposure – arises when, for reporting and consolidation purposes, the results of foreign operations are converted from local currencies to the home currency of the parent company.

• Economic exposure – relates to the impact of foreign exchange rate movements on the net present value of the firm’s future after tax cash flows, which also link directly to the value of the firm.

c) Business configurations that are affected by currency exposure, with examples (pg 254)

Domestic Businesses - In open economies, many `domestic' businesses must, like international businesses, assess their foreign exchange risk exposure. Their revenue and cost transactions may be restricted entirely to the local currency. Still, their competitors may enjoy a base in a more favorable currency. When exposed, a domestic company may have few effective options available - short of moving away from its domestic orientation. Examples can be found amongst the domestic companies that conduct virtually all sales and value-added in domestic currency, but face strong import attacks from competitors based in other currencies. Companies in this category are subject to economic exposure. More precisely, they are exposed to competitive exposure version of economic exposure.

Export/Import Businesses - Businesses with costs in one currency and revenues in a different currency need to consider transaction and economic exposure - both portfolio and competitive dimensions. After all, transaction exposure exists where an agreed or expected amount of foreign currency will translate into an unknown quantity of domestic currency, and an export/import business will always have to deal with unbalanced currency flows. And competitive exposure comes from competitors based in local as well as different currencies. Reductions in competitive exposure will normally require substantial changes in the structure of the corporation.

Multi-Domestic Businesses - At an international level it is possible to distinguish businesses that are multi-domestic from those that are truly global. `Multi-Domestic' implies that a corporation's various locations are independent and either do not share significant resources or have limited flexibility to do so at will. Overseas manufacturing subsidiaries of MNCs which do not involve in international trade fall into this category. The term multi-domestic is appropriate here because exposure type and available actions are similar to those of domestic companies. What is different is that, from the corporate viewpoint, the competitive exposure of each unit adds up to an overall basket of risks. And more specifically, translation exposure exists for the parent company, i.e. exposure which arises when the accounts of overseas subsidiaries are consolidated into the home currency statements of the parent.

Global Businesses. These are companies that have significant cost elements in several countries and share some critical resources (such as product development, sourcing, or production) across countries to such an extent that the individual country units do not operate independently. All the currency exposure issues raised previously with the other business configurations are compounded in multinational companies with complex sourcing and sales. Global companies may be left exposed to shifts in competitiveness as an export/import business.

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