TREASURY MANAGEMENT



TREASURY MANAGEMENT 2

SECTION A

MODEL SOLUTIONS

1. 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/$ = 285 X 1+ (0.21 X 181/360)

1+ (0.05 X 181/360)

FK/$ = K307.3807

iii. Forward rate as at 30 November 2012

▪ FK/$ = SK/$ X 1+(rK X t/360)

1+(r$ X t/360

FK/$ = 285 X 1+ (0.21 X 242/360)

1+ (0.05 X 242/360

FK/$ = K314.6691

iv. For 30 September client will pay

= $75,250 X K307.3807

= K23,130,397.68

v. For 30 November client will pay

= $75,250 X K314.6691

= K23,678,849.78

2. Purchasing Power Parity - essay

i. Meaning of PPP (pg 52)

The purchasing power parity (PPP) theory suggests that exchange rates tend to adjust so that a person will have the same purchasing power to buy goods and services in another country after the exchange that he/she had with his/her own money in the home market before the exchange. The theory is based on what is known as the law of one price that states that a good, such as a basket of groceries, will be the same price anywhere in the world if markets operate efficiently. Thus, if the basket of groceries costs £100 in the UK and $200 in the US, then the exchange rate will move toward £1.00 = $2 (and 1 US dollar will equal £0.50 or 50 pence). The theory predicts that countries experiencing relatively high inflation will cause their currency to depreciate in the long run.

ii. Two versions of PPP (pg 52)

Absolute PPP simply refers to the equalization of price levels across countries. Put formally, the exchange rate between Euro countries and the US is equal to the price level in the Euro area (PEUR) divided by the price level in the US (PUSA). Assume that the price level ratio PEUR/PUSD implies a PPP exchange rate of 0.83 Euro per 1 USD. If the exchange rate today is 0.85 Euro per 1 USD then PPP theory implies that the Euro will appreciate against the USD, and the USD will in turn depreciate against the Euro

Relative PPP relates to relative inflation rates between countries. Relative PPP states that the rate of currency appreciation will be equal to the difference in inflation rates between two countries. For instance, if the UK has an inflation rate of 2% and the US has an inflation rate of 4%, the Pound will appreciate against the Dollar by 2% per year. Relative PPP is found to hold for long-term exchange rate determination when inflation differences between countries are large.

iii. Two factors that have to hold for PPP to work (pg 53)

• Transportation costs, barriers to trade, and other transaction costs, that inhibit trade in goods and services must be insignificant;

• There must be competitive markets for the goods and services in both countries;

• PPP and the law of one price only apply to goods and services that are traded. Items such as houses, local services and other items that are not traded between countries will not be subject to price equalization as there are no competitive markets that can bring pricing into equilibrium across borders.

iv. Summary (pg 58)

Main use - The PPP theory seems to predict reasonably well long-term exchange rates suggesting relative over and undervaluation of currencies and especially if one confines the analysis to internationally traded commodities

Shortfall - It is of limited use if the market basket of goods and services used to measure the price level includes many that are not traded internationally.

3. (a) Meaning of interest rate risk (pg 182)

Interest rate risk essentially means exposure to a change in market interest rates. It can take a variety of interconnected forms. Thus, fluctuations in interest rates have become part of the economic landscape - and a challenge to bankers, corporate treasurers and investors alike

b) Interest rate swap in a Life Assurance company (pg 195)

A Life assurance company will use interest rate swap to hedge its interest rate exposure. The company has many, long-term, fixed rate liabilities through pension plans converted into annuities. These liabilities are partly serviced by investment income, which may fall when interest rates drop. Thus, the life assurance company will pay floating rate in exchange for fixed rate. If interest rates do fall, then less is paid out on the swap than is received, and income is enhanced to service the fixed-rate annuity.

c) Impact of interest movement to a treasurer (pg 182)

When a Treasurer is investing excess short-term cash flow in commercial paper or Treasury Bills, a fall in interest rates means that, when the investment is rolled over, a lower return will be achieved than if the treasurer had invested longer term.

This has also an impact on the funding side, if the treasurer is running a short position; the cost of borrowing is greatly affected with the movements in interest rates. For example, after devaluation in May 2012 in Malawi, the short position and high interest rates on the Kwacha side has made the cost of borrowing to increase

d) 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.

4. FIMDA 2012 CONFERENCE PAPER

TITLE : SWAPS

PRESENTED BY : XXXXXXXX

DATE : 25 November 2012

Content

i. Introduction - Defining a swap (pg 310)

A swap is an agreement between two parties for an exchange of streams of payments either directly or through an intermediary. The agreement specifies the dates when the cash flows are to be paid and how they will be calculated.

ii. Three basic reasons why companies use swaps (pg 310)

• Market constraints. A company may have taken a five year variable rate loan and may now not wish to face possible unfavorable movements in interest rates over the period. The company can swap the variable rate payments for a fixed rate payment.

• Cost advantages. Swap transactions can occur to exploit cost differentials between markets for the two counterparties, based on the principle of comparative advantage.

• 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. Three basic types of swaps (pg 312)

• Interest rate swap. The commonest is the exchange of fixed rate payments on a notional principal amount for floating rate interest payments on the same principal amount for a given number of years. For example one party (say Y) agrees to pay the counterparty (say X) a fixed rate on the notional sum and Y in exchange receives a floating rate. The principal is not exchanged and serves only to calculate the interest payments. A swap is thus conceptually equivalent to a series of FRAs.

• Currency swap. A currency swap typically involves an initial exchange of a given amount of principal in two different currencies by the counterparties with an exchange in the opposite direction at the end of the swap. In addition, each party assumes responsibility for interest payments in the currency it has received.

• Commodity swap. In commodity swaps, cash flows are between counterparties depend on the price of a commodity. One party agrees to pay the other a fixed price for a notional quantity of a commodity at certain specified dates in the future while the other party agrees to pay the first party a variable price - e.g. the ruling spot or futures price on the same day for the same quantity of the commodity

iv. Summary – overview of the market in Malawi

The swap market in Malawi is not very much developed as in most developed countries. Malawi economy is small and interest rates and forex rates have been relatively stable until after the devaluation in May 2012.

SECTION B

5. Floating exchange rates

Format: memo

TO : The Head of State

FROM : The Advisor on Economic Affairs

SUBJECT : Exchange rates

DATE : 30 May 2012

i) Factors that influence exchange rates (pg 44 -45)

Changes in Relative Inflation Rates. The sudden jump in MW inflation should cause an increase in the MW demand for American goods and therefore also cause an increase in the MW demand for American Dollars. This results in an outward shift of the demand curve. In addition, the jump in MW inflation should reduce the American desire for MW goods and therefore reduce the supply of dollars for sale, which causes an inward shift of the supply curve.

Changes in Relative Interest Rates. Changes in relative interest rates affect investment in foreign securities, which influence the demand and supply of currencies, and therefore influence exchange rates. If, in our example, MW interest rates rise while American interest rates remain constant, MW companies will likely reduce their demand for dollars, since the MW rates are now more attractive relative to the American rates, and there is less desire for American bank deposits. Since MW rates will now look more attractive to American companies with excess cash, the supply of dollars for sale by American companies should increase as they establish more bank deposits in the MW. Due to an inward shift in demand for dollars and outward shift in supply dollars for sale, the equilibrium exchange rate should decrease.

Changes in Relative Income Levels. Relative income levels of countries also affect exchange rates. If the MW income level substantially rises while the American income level remains constant, the demand schedule for dollars will shift outward, reflecting an increase in MW income and therefore increased demand for American goods. The supply schedule of the dollars for sale is, however, not expected to change. Therefore, the equilibrium exchange rate of the dollar is expected to rise.

Government Control Policies. The governments have direct and indirect tools of influencing the equilibrium exchange rate. By imposing foreign exchange and foreign trade barriers, by intervening (buying and selling foreign currencies) a government agency can directly influence the demand and supply of its currency value and therefore equilibrium exchange rate. Furthermore, a government agency can indirectly influence exchange rate equilibrium by affecting the above mentioned factors: inflation, interest rates, and income levels.

Expectations of Future Exchange Rates. Whereas trade related foreign exchange transactions are generally less responsive to news, the financial flow transactions are very responsive to news, since the decisions to hold securities denominated in a particular currency are often dependent on anticipated changes in currency values. Like other financial markets, foreign exchange markets react to any news that may have a future effect. For example, news of potential surge in MW inflation may cause currency traders to sell Kwacha, anticipating a future decline in the Kwacha’s value. While there is an obvious risk here that their expectations may be wrong, the point here is that expectations can influence exchange rates because they commonly motivate institutional investors to take foreign currency positions. This response places immediate downward pressure on the dollar.

ii) Clean Floating exchange rate (pg 69 – 70)

Pros.

• 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

Cons

• With no official intervention to stabilise 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

6. Notes on netting

i. Netting system (pg 242)

A netting system means that, by netting out receipts and payments between different units in an MNC, the volume of payments is reduced, as is the need for foreign currencies and the number of separate payments since only net amounts are settled. After netting out, the units participating in the system will either be net paying participants or net receiving participants. Payment is effected periodically (mostly on a monthly basis) by the net paying participant making a payment to a netting centre from which the net receiving participant receives its net proceeds. Generally, paying participants effect payment in their own currency. Currency conversions are carried out by the Netting Centre on the settlement day. The Netting Centre can also arrange for payments to be made to third parties, i.e. non-Group suppliers. Netting is often controlled by host governments and a firm may have to request permission to net

ii. Two ways in which netting can be done (pg 243)

Bilateral Netting. Two subsidiaries of an MNC, which have reciprocal trade flows, practice bilateral netting

Multilateral Netting. When more than two subsidiaries participate in the netting

iii. Explaining term and their benefits

• Re-invoicing centre (pg 245)

Multinational companies with complex inter-company and third party cross border flows usually establish a specialized financial vehicle which is a separate legal entity acting as a re-invoicing centre for the group. A re-invoicing centre is used to facilitate both cash and foreign exchange exposure management on a centralized or regionalized basis. The re-invoicing centre acts as an intermediary by taking title to, but not possession of, the goods manufactured.

Benefits:

➢ By centralizing cross-border transactions, expenses related to bank fees and commissions on foreign exchange transactions and money transfers will be reduced.

➢ Due to economies of scale available from converting foreign exchange centrally, the reinvoicing centre is able to obtain more competitive rates on larger transactions.

➢ By eliminating third-currency items from the books of the subsidiaries, the reinvoicing centre centralizes the foreign exchange transaction exposure of the whole group

• Finance company (pg 246)

A finance company is a specialized offshore vehicle used by MNCs to improve international cash management by centralizing liquidity management. For example, the finance company will borrow both short- and long-term money from financial institutions and lend it to the subsidiaries that are in need of cash. It also invests excess cash of subsidiaries. An offshore finance company should be located in a country which has tax treaties with the parent country to eliminate the withholding tax on foreign borrowings, has minimal taxes on income or capital, and has an extensive reciprocal tax treaty network with the countries to be involved.

Benefits:

➢ The finance company can borrow at rates that are below those available to subsidiaries in their local markets.

➢ It can gain access to the Euro capital markets for longer-term funds.

➢ Subsidiaries can lend excess funds to the finance company and often obtain rates of return that are higher than they would otherwise earn locally. The finance company can pool the small amounts, thereby investing larger amounts and obtaining higher rates in either the local or Euro money market.

➢ The finance company can fund subsidiary working capital needs or balance subsidiary foreign exchange exposures through intercompany loans or factoring (i.e., purchasing the receivables from a subsidiary)

7. Potential investor

Format: Business letter, two addresses (or under a headed paper) with the first paragraph referring to the meeting of 8th August 2012. And a proper closing remark, and duly signed.

i. 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

ii. Certificate of Deposit (pg 136)

Certificates of Deposit or CDs are large bank deposits that cannot be withdrawn on demand. Ownership of deposit is indicated on certificates issued by the bank. As negotiable bearer instruments, CDs can be bought and sold in the secondary discount market at varying yields. Depositors benefit from holding CDs in that, while they place their money in either a fixed-term or long-maturity deposit (thereby earning a higher interest than that which would be available in current accounts), they also have the assurance that they can always get their money back by discounting it, should the need arise.

iii. Commercial paper (pg 134)

Commercial Paper (CP) is a money-market instrument that offers an alternative to bank borrowing, to reputable entities. Basically a short-term promissory note, it can be issued by industrial, financial and insurance companies. Borrowers, that are issuers of commercial paper, also include utilities and sovereign borrowers. The minimum maturity is seven days and maximum maturity is 364 days. Papers are issued in minimum amounts of £100,000. There is no legal maximum.

iv. Other investment options

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

• Invest with a discount house

• Deposit in a time deposit with a local bank at a higher interest rate than the normal current account.

• Engage in a business of buying and selling a commodity

v. Recommendation.

Make a recommendation, with an intention of investing the funds on behalf of the client.

8. Translation exposure & Transaction exposure

i. Differentiate the two terms & give examples (pg 287 & 256)

Translation exposure

Foreign exchange translation exposure arises whenever a company transacts business in currencies other than its own or has a net asset or liability position outside the home country

Examples:

• Assets and liabilities of overseas branches.

• Balance sheets of foreign subsidiaries.

• Individual assets and liabilities in foreign currency.

• An equity investment in an overseas business, with no current intention of sale

Transaction exposure

If a company has a contract to receive or to pay an amount in a currency other than its local currency, it has a risk that the value of that foreign currency may fluctuate against its local currency

Examples :

• Purchases or sales of goods or services in a foreign currency

• The payment or receipt of management fees, royalties, franchise or other licence fees denominated in a foreign currency.

• The purchase or sale of capital investments denominated in a foreign currency.

ii. Four methods of translating financial statements (pg 288)

Closing Rate (Current Rate) Method. The closing rate method translates all the assets and liabilities in the financial statements at the rate of change which is valid at the balance sheet date.

Current/Non-Current Method. This is the oldest method. All current assets and liabilities are translated into the parent's home currency at the current exchange rate, while non-current assets and liabilities are translated at historical rates.

Monetary/Non-Monetary Method. All monetary items (cash, marketable securities, accounts receivable, and long-term receivables) are translated at the current exchange rate. All non-monetary items, essentially inventory and fixed assets, are translated at the historical rates of exchange. Income statement items are translated at the average exchange rate of the period, except for those items that are directly associated with non-monetary assets and liabilities (depreciations and cost of goods sold).

Temporal Method. The temporal method is a modified version of the monetary/non-monetary method. According to this method non-monetary items stated at the current price in the foreign market are translated using the current exchange rate just like monetary items. So an inventory can be translated using the current rate if the inventory is shown on the balance sheet at the market value.

iii. Four basic elements of any transaction exposure (pg 258)

• Position

• Currency of exposure.

• Amount of exposure (denominated in the foreign currency).

• Timing of future payment or receipt

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