Chapter 7- TREASURY MANAGEMENT

Foreign exchange risk and commodity/security

derivatives
Exchange rates
It is the price of one currency relative to another currency.
Quotes
The exchange rate may be expressed as a direct quote or an indirect quote.
Direct quote is the number of domestic currency units needed to buy one
unit of foreign currency. E.g. Rs 95/$1.
The indirect quote the number of foreign currency units needed to buy
one unit of domestic currency. $0.01/Rs.1.
Spot rate
Spot rate is the exchange rate on currency for immediate delivery.
The Rs to $ spot rate may be quoted as follows Rs 95- 95.3 (direct) or
$ 0.1050-0.1049 (indirect).
In direct quote, the first rate is the bid price (buying rate) and the second
is the offer price (selling rate) and indirect quote vice versa.

Calculation of future exchange rates Purchasing power parity:

Forward rate= spot rate x (1+inflation % Pakistan)/ (1+inflation
%abroad)
Interest rate parity:
Forward rate= spot rate x (1+interest % Pakistan)/ (1+interest %abroad)
Foreign exchange risk
Companies may be exposed to three types of foreign exchange risks.
I.Transaction risk
The risk of an exchange rate changing between the transaction date and
the subsequent settlement date.

Associated with exports/imports.

II.Economic risk
Risk of long term effects of changes in exchange rates on the value of a
company (PV of future cash flows).

Looks at how changes in exchange rates effect competitiveness, directly

or indirectly.
Example 1- Is a UK company, which is not engaged in any form of foreign
trade and therefore not involved in any transactions denominated in a
foreign currency, exposed to currency risk?
Answer YES! One of the UK’s company’s competitor could be foreign
(e.g. Italian), or could import its product from another country. Hence
for example, the pound strengthened against EURO, the UK firm’s
competitors would gain an advantage, they could charge lower price for
their product and therefore potentially take market share from the UK
Company but still receive the same value in Lira.
III.Translation risk
Risk of change in exchange rates and its effect on the translated value of foreign
assets and liabilities (e.g. foreign subsidiaries).
Gains/losses usually unrealized so many firms do not hedge.

HEDGING EXPOSURE TO FOREIGN EXCHANGE RISK

The purpose of hedging an exposure to risk is to eliminate or reduce the
possibility that actual events will turn out worse than expected. The
purpose of hedging an exposure to currency risk is to remove (or reduce)
the possibility that a future transaction involving a foreign currency will
have to be made at a less favorable exchange rate than expected.
Exchange rates can move up or down, and spot rates could move
favorably as well as adversely. However, many companies prefer to hedge
their currency risks by fixing an exchange rate now for a future
transaction, even if this means that it will not be able to benefit from any
favorable movement in the exchange rate.
Hedging Strategies
Invoice in home currency
Insist all foreign customers to pay in your home currency and that your
company pay for all imports in your home currency.
The rate risk has not gone away; it has just passes onto the customers.
It is achievable if you are in a monopoly position, however in a
competitive environment this is an unrealistic approach.
Leading and lagging
If an importer (payments) expects that the currency it is due to pay will
depreciate, it may attempt to delay the payment. This may be achieved by
agreement or by exceeding credit terms.
If an exporter (receipt) expects that the currency it is due to receive will
depreciate over the next three months it may try to obtain payment
immediately. This may be achieved by offering a discount for immediate
payment.
Matching
When a company has receipts and payments in the same foreign currency
due at the same time, it can simply match them against each other.
It is then only necessary to deal on the forex market for the unmatched
portion of the total transactions.
Decide to do nothing
The company would “win some, lose some”.
Theory suggests that, in the long run, gains and losses net off to leave a
similar result to that if hedged.
In the short run, however, losses may be significant.
One additional advantage of this policy is the saving in transaction and
administrative costs.
Forward contracts
The forward market is where you can buy and sell a currency, at future
date for a predetermined rate.
The forward exchange rates are quoted at a premium or at a discount
from the spot.
For direct quote: Add premium; less discount

For indirect quote: less premium; add discount.

Advantages
It is over the counter (OTC) tailor made and so can be matched exactly to
the sums involved.
Simple and easy to understand.
Disadvantages
Binding contract for delivery, even if commercial circumstances change.
Eliminate exposure to upside as well as downside movements.
Example-2
An Australian company has just bought some machinery from a US
company for US$ 250,000 with payment due in three months’ time.
Exchange rates are quoted as follows:
A$ 1= US$ spot 0.7785-0.7891 three months forward 0.21-0.18 cents
premium.
Calculate the expected payment using forward rate.
Money market hedges
For payment
There is a liability in forex, set up an asset in forex by converting borrowed local
currency to forex and depositing in a bank account.
Required forex deposit= payment in forex / (1+interest on deposit in
forex).
Convert the forex deposit amount into local currency= forex amount x
selling rate
Liability/cost in local currency= local currency required x (1+interest on
borrowing in local currency).
For receipt
There is an asset in forex, set up a liability by borrowing in forex and
converting to rupee today.
Required forex borrowing= receipt in forex / (1+interest on borrowing
in forex)
Convert the forex borrowed into local currency = forex amount x buying
rate
Receipt in local currency= local currency x (1+interest on deposit in local
currency)
Example-3
Marcus is based in France has recently imported raw materials from the
USA invoiced for US$ 240,000, payable in three months’ time. In addition, it
has also exported finished goods to Japan and Australia. The Japanese
customer has been invoiced for US$ 69,000 payable in three months’ time and
the Australian customer has been invoiced for A$ 295,000, payable in four
months’ time. Current spot and forward rates are as follows:
US$/EURO EURO/A$
Spot: 0.9830-0.985 Spot: 1.8890-1.8920
3 months forward: 0.9520-0.9545 4 months forward: 1.9510-1.9540

Current money market rates (p.a) are as follows: US$: 10% - 12 %

A$: 14%-16%EURO: 11.5% - 13%
Show how the company can hedge its exposure to FX risk using:
(a)The forward markets
(b)The money markets.

Future contracts
For receipt
Choose the first contract to expiry after the conversion date.
Calculate the currency requirement in contract currency units (Use
current spot rate of future if required).
Divide by the contract size to determine the number of contracts.
Sell forex futures or buy local currency futures.
Close the position by taking inverse action once the exposure period is
over.

Calculate the difference in buying and selling rates. Difference= sale

price- buy price
Calculate profit/loss= difference x no. of contracts x value of each
contract.
Add/(less) the profit/ (loss) to the receipt.
For payment
Choose the first contract to expiry after the conversion date.
Calculate the currency requirement in contract currency units (Use
current spot rate of future if required).
Divide by the contract size to determine the number of contracts.
Buy forex futures or sell local currency futures.
Close the position by taking inverse action once the exposure period is
over.
Calculate the difference in buying and selling rates. Difference= sale
price- buy price
Calculate profit/loss= difference x no. of contracts x value of each
contract.
Less/(add) the profit/ (loss) to the payment.
Important to note that if future prices at close out date are not given in
question, it can be found using the basis provided spot rates and future
prices are given.
Example
On January 1
Spot rate = Rs/$ 145.25/1

31 March $ future price= Rs/$ 146.3

On February 28:

Spot rate is 146.27

31 March $ future price=??
Currency Options
Currency option is contract between parties where option writer gives an
option to option holder to exchange currency at the committed rate. This
contract is not binding for option holder. He only exercises the option if
favorable. Options are more expensive than forwards and futures.
Call option
Call option is the option to buy currency at exercise price on exercise
date.
Put option
Put option is the option to sell currency at exercise price on exercise
date.
Exercise price
At which option is exercised.

Terminology
Options are in-the-money, at-the-money or out-of-the-money.
An option is in-the-money when its exercise price (strike price) is more
favorable to the option holder than the current market price of the
underlying item. i.e market price > exercise price at exercise date.
An option is at-the-money when its exercise price (strike price) is
exactly equal to the current market price of the underlying item. i.e
market price = exercise price at exercise date.
An option is out-of-the-money when its exercise price (strike price) is
less favorable to the option holder than the current market price of the
underlying item. i.e market price < exercise price at exercise date.

An option agreement has an expiry date, after which the option lapses
and the agreement comes to an end.
An American-style option can be exercised by its holder at any time
on or before the expiry date.
A European-style option can be exercised only at the expiry date for
the option and not before.
A Bermudan option can be exercised on a restricted series of dates.

The terms do not refer to the countries where these types of option are
available. All three types of option agreement are made throughout the
world.
OTC and exchange-traded options
Some financial options are arranged directly between buyer and seller.
Directly negotiated options are called over-the-counter options or
OTC options. Examples of OTC options include borrowers’ and lenders’
options, caps, floors and collars. Currency options might also be arranged
in OTC agreements.

Some options are traded on an exchange. Traded share options and

some currency options are exchange-traded. In addition, there are
options on futures contracts, and all options on futures are traded on the
futures exchange where the underlying futures are traded.

Steps for hedging using traded option

Determine the contract type (call or put). It can be summarized as
follows:
Contract currency is FCY Contract currency is DCY
FCY payment Call option FCY payment Put option
FCY receipt Put option FCY receipt Call option

Choose the options contract having expiry date on transaction date or if

not available then expiry date immediately after transaction date.
Determine the number of contracts
-If contract currency is FCY
No of contracts= total FCY amount to be hedged/ contract size
-If contract currency is DCY
No of contracts= total FCY amount converted / contract size
Determine the option premium- Include the opportunity cost of funds i.e.
assume the company will have to borrow the cost of options between now
and conversion date.
Net outcome on transaction date
-Case-1 option is not exercised
Spot transaction (at transaction date spot rate) xxx
Option premium xxx
Xxx
- Case-2 option is exercised
Option exercise at exercise price xxx
Option premium xxx
Under/ (over) hedging at spot rate xxx
Xxx
Total option premium is calculated as follows:
Premium per unit x contract size x no of contracts
Another important thing to remember if in case of option different exercise
prices are given then you need to select most suitable exercise price.

For call option – select the option which gives lowest value for
“exercise price+option cost”.
For put option – select the option which gives highest value for
“exercise price-option cost”.

Multilateral netting and matching agreements

ICAP Winter 2013 Q. 3

Interest rate risk
Interest rates can move up or down, although economists are often able
to predict the direction of future movements. A movement in interest
rates can affect companies in either a positive or a negative way.
Short-term and long-term interest rates
A distinction is made between:
short-term interest rates, which are money market interest rates; and
long-term interest rates, which are bond yields.
Each major financial centre has a money market and a ‘benchmark’ rate
that the participants in the market use.
KIBOR
In Pakistan, the benchmark rate of interest is the Karachi Interbank
Offered Rate more commonly known as KIBOR.
Basis points: 1% = 100 basis points, and in the money market, interest
rates may be stated as a number of basis points above KIBOR. For
example, KIBOR plus 1.50% might be stated as 150 basis points above
KIBOR.)
Some organizations might wish to hedge their exposures to interest rate risk.
They might also want to take advantage, if possible, from any favorable
movements in interest rates. There are several ways in which risks can be
hedged and opportunities to benefit from interest rate changes can be
exploited. Different strategies to hedge interest rate risk are as follows:
Forward rate agreements (FRAs)

It is used when borrowing or lending is to be made on some future date.

It is an agreement when bank fixes the interest rate for a certain
agreement period such as two months, three months six months and so
on starting at a specified time in future.
In the terminology of markets, an FRA on a notional three month loan
starting in five months’ time is called a “5-8 FRA’ or “5v8 FRA”

The FRA is totally separate contractual agreement from the loan itself
and could be arranged with a different bank.

The amount of the payment is calculated from the difference between the
FRA rate and the benchmark rate (LIBOR rate), applied to the notional
principal amount for the FRA and calculated for the length of the interest
period in the agreement.
Example:
A company has forecast that due to an expected cash shortage, it will need
to borrow Rs 20 million for three months in two months’ time.
A bank quotes the following rates for FRAs:
2v3 3.59 – 3.61
2v5 3.63 – 3.67
3v5 3.65 – 3.68
Required
What would be the FRA agreement with the bank, and what rate would
apply to the agreement?
If the company can borrow at KIBOR + 50 basis points, what will be its
effective rate of borrowing for the three months if KIBOR is 4.50% at the
start of the notional interest period for the FRA?
Interest rate futures
These are standardized exchange traded forward contracts on a notional
deposit of a standard amount of principal, starting on the contract’s
settlement date.
Future prices are traded as “100-r” where “r” is the interest rate e.g. A 3
month future is quoted as ‘88.5’ which means rate is 11.5 % (100-
11.5=88.5).

Steps for hedging using interest rate futures.

1)Choose the contract (i.e. contract of suitable maturity date) Future
contract having maturity on or immediately after our transaction date
will be chosen.
2)Type of contract (i.e. buy contract or sell contract)
-If we have to lend at transaction date then: Buy future now and sell later
-If we have to borrow at transaction date then: Sell future now
and buy later
3)No. of contracts
Amount to be hedged (actual amount) x loan period____
Contract size contract period
(Round off the answer to whole number)
Transaction date

4)Actual transaction
Actual interest = loan amount x actual rate x actual period
5)Gain on future
Contract size x no of contracts x contract period x gain / (loss) %
6)Hedge effectiveness
Future gain/ (loss) / (loss)/gain on actual transaction
Gain or (loss) on actual transaction
=loan amount x loan period x change in actual interest rate
Gain or (loss) % on future
=Future price (sell) – Future price (buy)
Example
ABC has taken a 6 months Rs. 10 million loan with interest payable of 8%.
The loan is due for rollover for another 6 months on 31 March. At January
1, the company treasurer consider that interest rates are likely to rise in
the near future. The future prices of relevant 3 moths future is 91. For
simplicity it may be assumed that future contract period and loan period
is same. The standard contract size is Rs 1 million.
On March 31, loan is rollover at spot interest rate of 11% and future prices
falls to 88.5. Demonstrate how futures can be used to hedge against
interest rate risk?
Interest rate options (exchange traded options)
These are options on future contracts i.e. a contract that gives the right to
buy or sell a future contract at the exercise price. These are exercised by
the holder only if there is potential gain i.e. if exercise price is favorable.
Call option is an option to buy a future and put option is an option
to sell a future contract at strike price.
Steps for hedging using traded option
Determine the contract type (call or put). It can be summarized as
follows:
-If we have to lend at transaction date then buy Call option.
-If we have to borrow at transaction date then buy Put option.

Choose the options contract having expiry date on transaction date or if

not available then expiry date immediately after transaction date.
Determine the number of contracts
Amount to be hedged (actual amount) x loan period____
Contract size contract period
(Round off the answer to whole number)

Calculate premium= contract size x no of contracts x contract period/12

x premium %.
Net outcome on transaction date
- Case-1 option is not exercised
Interest (paid)/received in spot market xxx
(Loan amount x spot rate x loan period)
Premium xxx
Net interest (cost) / income xxx
- Case-2 option is exercised
Interest (paid)/received in spot market xxx
(Loan amount x spot rate x loan period)
Premium xxx
Option outcome xxx
Under/ (over) hedging at spot rate xxx
Xxx

Example
A company intends to borrow US$10 million in four months’ time for a
period of three months, but is concerned about the volatility of the US
dollar LIBOR rate.
The three-month US$ LIBOR rate is currently 3.75%, but might go up or
down in the next four months.
The company therefore takes out a borrower’s option with a strike rate of
4% for a notional three-month loan of US$10 million.
The expiry date is in four months’ time. The option premium is the
equivalent of 0.5% per annum of the notional principal. The company is
able to borrow at the US dollar LIBOR rate.
Determine whether the company should exercise the option and also
calculate effective interest rate if after four months;
a)LIBOR rate is 6%;
b)LIBOR rate is 3%.

Interest rate swaps

In a swap agreement, the parties agree to exchange ‘interest payments’ on
a notional amount of principal, at agreed dates throughout the term of
the agreement.
An interest rate swap is an agreement whereby the parties agree to swap
a floating stream of interest payments for a fixed stream of interest
payments and vice versa.
Plain-vanilla-swap/Generic swap
Two parties have same loan amount from different banks. If amounts are
different then they agree on a notional amount. One party has obtained
the loan on the fixed rate and other party on floating rate. But both parties
are not satisfied and want to change the interest rates. To avoid
transaction costs instead of arranging the loan or having it modified with
bank, they mutually SWAP the interest rates. One party pays fixed rate
and receives the floating rate from other. Primary responsibility towards
respective banks remains with the original borrower.
Example
A company has a bank loan of £10 million on which it pays variable rate
interest at KIBOR + 1%. The loan has five more years to maturity. The
company is worried about the risk that interest rates will soon rise, and it
wants to set a limit on its interest costs.
Another company B is paying fixed interest rate of 5.39% on a five-year loan
and it is expecting that future interest rate will decline therefore looking for
floating interest rate. Both the companies agreed to swap interest rate by
agreeing that A will pay fix rate of 5% to B and will receive KIBOR from
B. Calculate effective rate for both the parties.
Credit arbitrage/market inefficiency swap
Two parties have same loan amount from different banks. If amounts are
different then they agree on a notional amount. One party has good credit
rating and has a comparative advantage of lower interest rates over other
party.
Total arbitrage gain= difference in fixed rate – difference in floating rate
Steps to solve
Identify the potential saving.
Decide how the savings would be shared
Write the actual rates and target rate first.
Make fixed party pay KIBOR/LIBOR
Remaining would be balancing
Calculate the net cost and savings:
Interest payable on loan (%)
Swap receive %
Swap pay (%)
Net cost (%)

Example
Swaps through intermediaries
A swap is usually arranged by an intermediary who will charge a fee for
arranging the swap. This fee might be stated as a share of the savings
available under the swap. Thus, any fee will reduce the benefit of the swap
to each of the counterparties.
The swap can be analyzed and set up as previously.

Treasury - evolution, importance, theories, functions,

classification

The treasury department is responsible for a company’s liquidity. The

treasurer must monitor current and projected cash flows and special
funding needs, and use this information to correctly invest excess funds,
as well as be prepared for additional borrowings or capital raises. The
department must also safeguard existing assets, which calls for the
prudent investment of funds, while guarding against excessive losses on
interest rates and foreign exchange positions. The treasurer needs to
monitor the internal processes and decisions that cause changes in
working capital and profitability, while also maintaining key
relationships with investors and lenders.
Important Functions of Treasury Department
1. Liquidity Management in Treasury - Cash Forecasting.
The accounting staff generally handles the receipt and disbursement of
cash, but the treasury staff needs to compile this information from all
subsidiaries into short - range and long - range cash forecasts. These
forecasts are needed for investment purposes, so the treasury staff can
plan to use investment vehicles that are of the correct duration to match
scheduled cash outflows. The staff also uses the forecasts to determine
when more cash is needed, so that it can plan to acquire funds either
through the use of debt or equity. Cash forecasting is also needed at the
individual currency level, which the treasury staff uses to plan its hedging
operations.
A cash forecast is useless unless it can be relied upon to yield accurate
cash flow information for some distance into the future. There are a
number of ways to improve the forecast, all involving the continuing
comparison of past forecasts to actual results and correcting the system
to ensure that better information is provided for future forecasts.
2. BANK RELATIONS
A key part of the treasury’s responsibilities includes the management of a
company’s banking relationships. A large company may deal with dozens
of banks, so it makes sense for the treasurer to gradually reduce the total
number of banks with which the treasury department transacts business.
By doing so, the relationship task can be refined down to only a core group
of key banks. As part of bank relationship activities the treasurer will
perform the following tasks:
Bank Account Analysis
The treasurer should receive an account analysis statement from each of
the company’s banks shortly after the end of each month. The statement
contains a summarization of the bank’s fees for services rendered and the
company’s usage volume for each of those fees. Fee structure will vary by
bank.
Bank Account Management
One of the most inefficient activities in bank relations is maintaining up
to - date lists of bank account signatories — that is, authorized check
signers. The typical bank requires not only a signature card containing
the signatures of all signatories, but also a board resolution approving the
check signers. Further, each bank wants the same information, but in a
different format, so there is no way to standardize the reporting required
by each bank. This can be a real problem when a company has hundreds
of bank accounts that are spread among multiple banks, since ongoing
personnel turnover is bound to result in a continuing authorization
updating process. There are more efficient methods being discussed for
electronic bank account management (eBAM), but these discussions have
only just begun to translate into commercial products. In the meantime,
the treasury staff should have a quarterly procedure to review and update
authorized signatories.
Loan Covenants
The treasurer should have an excellent knowledge of the loan covenants
imposed on the company by its banks, and be in frequent communication
with them regarding any approaching covenant violations. A treasurer
who spends considerable time with his banking counterparts is much
more likely to be granted a waiver of a covenant violation than one who
suddenly springs a violation on bankers whom he barely knows.
However, a prolonged violation is likely to yield additional covenants,
higher fees, or an interest rate increase. Also, if a loan was originally
priced below the market rate, a lender will more likely impose fees in
response to a covenant breach, simply to improve its rate of return on the
loan.
3. CREDIT MANAGEMENT
There are no receivables unless a company elects to extend credit to its
customers through a credit policy. Thus, proper credit management is key
to the amount of funds that a company must invest in its accounts
receivable. A loose credit policy is common in companies having a certain
mix of characteristics. There are benefits due to credit but it also costs to
company to sell on credit.
The treasurer can set up a considerable number of credit controls to
reduce the probability of default by customers. Here are some
possibilities:
 Issue credit based on credit scoring
 Alter payment terms
 Offer financing by a third party
 Perfect a security interest in goods sold
 Obtain credit insurance
 Require a credit reexamination upon an initiating event

4. Risk Management
In this area the treasurer will be performing tasks to mitigate/reduce the
different types of risk relating to treasury functions. Such risks may
include foreign currency risk, interest rate risks. We have already learned
what these risks are and how to reduce such risks.
Internal audit of Treasury department
Treasury is also an excellent place to schedule internal audits, with the
intent of matching actual transactions against company policies and
procedures. Though these audits locate problems only after they have
occurred, an adverse audit report frequently leads to procedural changes
that keep similar problems from arising in the future.
Functions of internal audit in a treasury department with
respect to controls
Control over Documents:
 Verify that all money market deals are recorded timely and
accurately at the correct monetary value.
 Inspect and ensure that filed copies are pre-numbered and
continuous for ease of reference and continuity in document filing.
 Verify that all the documents and statements have been received
from concerned parties (brokers, bankers, lenders etc.) and
properly filed in a logical sequence.
Control over Accounting Procedures:
 Verify that adequate systems are in place to track all matured
investments.
 Check for accurate recording and accounting of positions.
 Verify that an independent person checks the recording of postings.
 Trace all deals to the General Ledger and re-compute interest
calculations.
 Check that account reconciliation is done and time frame is set for
clearing all outstanding items
 Inspect source documents for accuracy of information on source
documents and ascertain that they are initialed as evidence of
checking.
Controls over compliances with policies:
 Verify that adequate systems are in place to ensure that company’s
policies are being followed.
 Verify that company’s policies for investments etc. are in
compliance with relevant laws/regulations.
 Verify that required legal/regulatory reports are being submitted on
timely basis.

ICMAP

Sr. Q No. in Attempt Topic

No. paper
1. 7 August 2018 Risk Hedging
2. 7 August 2017 Interest risk hedging
3. 7 February 2017 Risk Hedging
4. 4 February 2016 Risk Hedging

ICAP

Sr. Q No. in Attempt Topic

No. paper
1 2 Winter 2018 Hedging
2 3 Summer 2018 Hedging
3 5 Winter 2017 Hedging
4 3 Summer 2017 Hedging
5 1 Winter 2016 Hedging
6 5 Summer 2012 Hedging
7 4 Winter 2011 Hedging
8 2 Winter 2010 Hedging
9 6 Winter 2009 Hedging
10 3 Winter 2008 Hedging
11 6 Summer 2008 Hedging