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AFM - International investment and

financing decisions

Contents

Forecasting Foreign Exchange Rates ...................................................................................... 2

INTRODUCTION .................................................................................................................. 2

TYPES OF CURRENCY RISKS ................................................................................................. 2

Appraisal of Foreign Investments .......................................................................................... 6

APPRAISAL OF FOREIGN INVESTMENTS ............................................................................. 6

EXAMPLE ............................................................................................................................. 6

SOLUTION 2 ........................................................................................................................ 8

Fiscal and other issues in international investment projects .............................................. 10

INTRODUCTION ................................................................................................................ 10

DOUBLE TAXATION ........................................................................................................... 10

EXCHANGE CONTROLS AND RESTRICTIONS ..................................................................... 12

INFLATION IMPACT ........................................................................................................... 12

Sources of financing in international investment projects .................................................. 14

INTRODUCTION ................................................................................................................ 14

FINANCING OPTIONS ........................................................................................................ 14

TYPES OF FINANCIAL INSTRUMENTS ................................................................................ 16

The Role of Treasury Function in a Multinational Organisation ...................................... 18

THE ROLE OF TREASURY FUNCTION ................................................................................. 18

TREATING TREASURIES AS COST CENTRES AND PROFIT CENTRES ................................... 20

Treasury and Advanced Risk Management Techniques ...................................................... 21

Exchange Traded and OTC Derivatives ............................................................................. 21

FEATURES AND TYPES OF DERIVATIVES ........................................................................... 21

Role of Treasury Function in Multinationals ........................................................................ 24

Basis Risk in Hedging ........................................................................................................ 24

Economic Environment for Multinational Organisations .................................................... 26

VALUE AT RISK (VAR) ........................................................................................................ 26

Revision ................................................................................... Error! Bookmark not defined.

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Keshi (Interest Rate Risk Management) .............................. Error! Bookmark not defined.

Forecasting Foreign Exchange Rates

INTRODUCTION

In previous modules, we learned how to evaluate investment projects using discounted cash

flow techniques, such as net present value and adjusted present value. In all of the

examples analysed, we assumed that the financing and proceeds generated by the

investment were actually denominated in the domestic currency of the company.

However, this is not the case with international investment projects, where the proceeds

may be denominated in a foreign currency, resulting in exposure to currency risk.

TYPES OF CURRENCY RISKS

When a company enters a foreign market, it may be affected by currency risk in three ways:

1) Transaction risk. This risk refers to the variability of the domestic currency

equivalent of FX-denominated cash flows resulting from a given transaction,

such as a sale or purchase. Typically, exposures to transaction risk can easily be

identified, quantified and hedged using FX derivatives;

2) Economic risk. It generally results from investments undertaken in foreign

markets. Companies typically use forecasted exchange rates when evaluating

foreign investment opportunities. However, future changes in foreign exchange

rates cannot be estimated with any degree of certainty, so the actual

profitability of a foreign investment, as measured in the domestic currency of

the company, will vary with fluctuations in FX rates;

3) Translation risk. It occurs when the financial statements of a foreign subsidiary,

prepared in a foreign currency, are translated into the domestic currency of the

holding company for consolidation purposes. When the exchange rate changes

from period to period, the value of the subsidiary as measured in the domestic

currency also changes, thus impacting ratios and metrics computed on the basis

of the group’s consolidated financial statements.

We are going to discuss the forecasting of exchange rates for the purposes of

evaluating investment projects whose cash flows are denominated in a foreign

currency.

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Generally, when pursuing an international investment opportunity, the company may

either:

a) Invest capital raised in its domestic currency. Under this option there will be a currency

mismatch between the source of financing used and the proceeds from the investment,

giving rise to currency risk;

b) Set up a foreign subsidiary, which will obtain financing in the foreign market. A currency

mismatch described above will not exist under this scenario.

Note: Independently of the actual financing option elected, when assessing the profitability

of an international opportunity, the investor is interested in the present value of the

investment as expressed in their domestic currency. Accordingly, cash flow estimates

denominated in a foreign currency need to be translated into the investor’s domestic

currency using FX rate forecasts.

FORECASTING APPROACHES

The most sophisticated approaches to the forecasting of foreign exchange rates are based

on an analysis of international economic relations or rely on a purely econometric approach,

involving an analysis of the statistical properties of time series. These models are

mathematically complex and therefore difficult to apply in practice by non-experts.

Consequently, multinational companies typically adopt simpler approaches to forecasting:

1) An interest rate parity theory assumes that the interest rate differential between two

countries should be reflected in the difference between the spot exchange rate and the

forward exchange rate of the currencies used in those countries. This method is applied

in financial markets to construct forward exchange rates;

2) Purchasing power parity states that the currencies of two countries are in equilibrium

when identical goods and services are also priced identically in both countries. Taking

into account that prices are affected by inflation, the future exchange rate between any

two currencies should differ from the spot rate by the inflation differential projected for

the two countries;

3) In accordance with the International Fisher Effect, changes in the spot exchange rate

between two currencies should reflect the difference in the level of nominal interest

rates in those currencies.

All three theories may easily be reconciled, which leads to the conclusion that forward

exchange rates provide an estimate of the future spot FX rate.

Naturally, all three theories listed above, suffer from some rather restrictive underlying

assumptions, related to:

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The free flow of capital across borders;

Lack of transaction costs;

Perfectly efficient financial markets.

The quality of estimates made when these assumptions do not hold is not perfect.

A key advantage of these theories comes from the simplicity of calculation and easy

interpretation of their results.

Example:

Suppose that a Eurozone-based company is considering an investment in the United States.

It is assumed that the project will generate cash flows denominated in US dollars after year

1 and after year 2. The euro-dollar spot bid rate equals 0.98 dollars per one euro, and the

asking rate is 1.02 dollars to the euro. The rate of inflation expected in the Eurozone is 1%

for the first year and 2% for the second year, whereas inflation in the United States is

expected to reach 5% and 6% in years 1 and 2 respectively. We are required to compute the

eurodollar rate forecasts that the company could use so as to convert its dollar-

denominated cash flow estimates into euros.

Solution:

First, we have to decide if the company should use bid or ask rates. We know that in the

euro-dollar quote, the euro is the base currency and the dollar is the quote currency,

meaning that the asking rate represents the amount of dollars, which have to paid to

purchase one euro, whereas the bid rate reflects the amount of dollars which will be

received when selling one euro.

In our example, the project will generate dollar inflows, which will have to be converted into

euros. Such conversion implies buying euros for dollars, meaning that the euro-dollar ask

rate is the relevant rate to apply.

However, the example does not specify whether the mentioned dollar inflows are the only

dollar cash flows to be generated by the project. In reality, an investment may produce both

inflows and outflows, which means that both the bid and ask rates should be used when

appraising a foreign-currency investment. A practical approach involves the use of mid

rates, that is rates which lie mid-way between the bid and the ask, for the purposes of

converting both inflows and outflows.

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So, in order to derive the forecast in the example, we will make use of the mid-rate and

apply purchasing power parity theory:

CROSS RATES CONCEPT

There are cases when an exchange rate quote in respect of a given currency pair is not

available. Typically, in such cases, the currency, whose rate is missing, is quoted against

other currencies, which may be used to construct a synthetic cross rate.

Example:

A European company is doing business in Israel, and is evaluating a transaction

denominated in Israeli shekel, but cannot obtain a quote for the euro-shekel rate. It knows,

however, that the euro-dollar rate amounts to 1 dollar and 5 cents per euro, and that the

dollar-shekel rate equals 3.7 shekel to the dollar.

Solution:

The company may use given rates to compute the euro-shekel cross rate. To do that, we

have to solve a simple mathematical problem:

1 EUR = 1.05 USD

1 USD = 3.7 ILS

1 EUR = 1.05 USD x 3.7 ILS = 3.89 ILS

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Appraisal of Foreign Investments

APPRAISAL OF FOREIGN INVESTMENTS

The net present value of a foreign project may be calculated using two methods:

1. All cash flows denominated in a foreign currency are first converted into the investor’s

domestic currency using forecasted exchange rates, and are subsequently discounted,

together with the cash flows denominated in the home currency, using the company’s

cost of capital;

2. The cash flows denominated in the foreign currency are separated from those which are

expressed in the domestic currency. The NPV of foreign cash flows is calculated by

discounting them using the company’s foreign currency cost of capital, by applying

interest rate parity theory, and the NPV of cash flows expressed in the domestic

currency is computed at the domestic currency cost of capital of the company. Next, the

NPV of the foreign currency cash flows is converted into the home currency at the spot

rate, and the overall value of the project is calculated as the sum of both net present

values.

Note: If all calculations are performed correctly, both methods should yield the same result,

but, as you can see, the second method is far more time-consuming.

EXAMPLE

Assume that a French company, whose domestic currency is the euro, is considering

investing in Poland, where the applicable currency is the zloty. The estimated cash flows of

the project are as follows:

The initial investment amounts to 500 million zloty;

The net proceeds from the investment equal 250 million zlotys in years 1, 2 and 3.

The euro-zloty spot rate equals 3.98 - the bid rate and the ask rate is 4.02.

In the euro-zloty currency pair, the euro is the base currency and the zloty is the quote

currency, which means that an investor needs to pay 4.02 zloty to buy one euro, and

receives 3.98 zloty, when he or she is selling euro for zloty. The interest rate in Poland

amounts to 4% per annum, and the interest rate in France to 2% per annum.

We are required to calculate the net present value of the project, assuming that the

investor’s cost of capital is 8% annually.

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SOLUTION

We will solve this task using the first of the two methods mentioned, i.e., we will convert

the zloty-denominated cash flows into euro, and use the original cost of capital as the

discount rate.

Step 1. We have to derive the forecasted exchange rates using interest rate parity theory. In

accordance with that theory, the forecasted future spot rate is equal to the forward

exchange rate, and is calculated as follows:

Year 1 = (1+4%) / (1+2%) = 1.0196

Year 2 = (1+4%)2 / (1+2%)2 = 1.0396

Year 3 = (1+4%)3 / (1+2%)3 = 1.06

Forecasted future spot rates = Current spot rate x Interest rate differentials

Please note that in our example, both the cash inflows and outflows are denominated in the

foreign currency.

We may therefore either use the bid rate to convert the value of the foreign-currency initial

investment and the ask rate to convert the foreign-currency cash inflows or use the mid rate

to convert both inflows and outflows.

Mid rate = (3.98 + 4.02) / 2 = 4.00

Forecasted spot mid rate Year 1 = 4.00 x 1.0196 = 4.0784

Forecasted spot mid rate Year 2 = 4.00 x 1.0396 = 4.1584

Forecasted spot mid rate Year 3 = 4.00 x 1.06 = 4.24

Note: As you may have noticed, the analysed example assumes that the interest rate curve is

flat for both the zloty and the euro, which means that the level of interest rates is the same

in year 1, year 2 and year 3 in both currencies. In reality, however, interest rates follow a

term structure, meaning that rates for different periods are typically different, forming a

non-flat yield curve. In such cases, the term structure should naturally be taken into account

in the computation of interest rates differentials.

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Step 2. We may now convert the foreign exchange denominated cash flows into euros and

calculate the NPV:

NPV Calculation – First Method

Description Year 0

(Million)

Year 1

(Million)

Year 2

(Million)

Year 3

(Million)

Initial investment (500)

Cash inflows 250 250 250

Exchange rate 4.0000 4.0784 4.1584 4.2400

Conversion into € (125) 61.3 60.12 58.96

Discount rate @ 8% 1 0.926 0.857 0.794

Present values (125) 56.76 51.52 46.82

NPV 30.1

Notes:

The computed NPV is positive implying that the project ought to be accepted;

However, this NPV was obtained under the assumption that interest rate parity

would hold for the next 3 years, whereas the actual future spot rates may differ

significantly from those projected;

When deciding to invest in a foreign project, a company may choose to hedge itself

against the variability of cash flows caused by changes in FX rates, by applying

currency derivatives.

Let’s now apply the second approach to evaluate the investment project once again, to see

if we obtain similar results.

SOLUTION 2

The adjustment to the cost of capital is performed on the basis of interest rate parity

between the domestic currency of the company and the foreign currency, in which project

cash flows are denominated.

If parity holds, then the relationship between the 1-year forecasted exchange rate, or the 1-

year forward exchange rate and the current spot rate between the two currencies should

reflect the differential in interest rates of the two currencies:

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This relationship should hold not only in respect of risk-free interest rates but also in respect

of the cost of capital, which may be computed as the sum of the risk-free rate and the

relevant market risk premium, scaled by the company’s beta coefficient in accordance with

the capital asset pricing model.

Consequently, under the assumption of interest rate parity, the relationship between the

forecasted spot rate in one year’s time and the current spot rate should be the same as the

differential between the cost of capital in terms of the quote currency and the cost of

capital in terms of the base currency:

We may now proceed to discount the cash flows expressed in the original currency, that is

the Polish zloty, using the adjusted discount rate:

NPV Calculation – Alternate Method

Description Year 0

(Million)

Year 1

(Million)

Year 2

(Million)

Year 3

(Million)

Initial investment (500)

Cash inflows 250 250 250

Discount rate @ 10% 1 0.909 0.826 0.751

Present values (500) 227.25 206.50 187.75

NPV 121.50

Conversion rate 4.00

NPV in € 30.38

Note: The difference between this figure and the result obtained under the first approach is

due to the rounding down of the foreign cost of capital to 10%.

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Fiscal and other issues in international investment projects

INTRODUCTION

There are a number of additional issues associated with appraising a foreign investment.

These issues relate, in particular, to double taxation and exchange controls, as well as their

impact on the remittance of funds and intercompany cash flows.

DOUBLE TAXATION

Double taxation means that a taxable profit generated in a foreign jurisdiction is taxed twice

- first in the foreign country, and again in the country of residence.

Double taxation is particularly disadvantageous for multinational companies, which often

operate through a network of foreign subsidiaries, whose profits get expatriated to head

office. For such companies, double taxation would result in a significant drop in the

profitability of their international activities, since all profits would be subject to taxation first

in the host country, and then, in the country where the group’s head office is located.

In order to address this limitation, many countries have signed double taxation treaties.

Typically, under such a treaty, profits are first taxed at source, that is in the country where

they were generated, in accordance with the income tax rate of that country. The taxes paid

at source are subsequently treated as already paid by the fiscal authorities of the country of

residence, and so the taxpayer will only be required to pay an additional tax in their home

country if the local tax rate is higher than the one applied at source.

The are three possible scenarios of corporate income tax rates in the home country and the

foreign country:

1) The tax rates are the same in both jurisdictions. In such case, investors will only pay

income tax at source;

2) The tax rate at source is higher than in the home country. In such case, an investor will

not be required to pay any additional income tax on foreign profits as well;

3) The tax rate in the home country is higher than at source. In such case, the investor

will first pay income tax in the foreign country, and then the difference between the

tax already paid at source and the tax that would be paid in the home country is paid

to the fiscal authorities of the home country.

Conclusion: Under a double taxation treaty, the most disadvantageous situation for a

foreign investor is when the foreign tax rate is higher than the one in the home country

(scenario 2). In such circumstances, international companies have an incentive to transfer

profits from countries with higher tax rates to those where tax rates are lower.

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Businesses may apply a number of measures for this purpose, such as:

Transfer pricing, or

Using various inter-company payments such as royalties, management charges, and

loans.

Note: Tax authorities in many countries require foreign companies to prove that the prices

used as part of transfer pricing systems and other cash flows reflect market prices which

would be available to the company at arm’s length. This limits the possibilities to effectively

transfer profits to countries with lower tax rates.

Please be aware that inter-company cash flows, such as royalty payments and management

fees, increase the profitability of their recipient and are therefore subject to income tax in

its jurisdiction. This effect should be taken into account in the evaluation of a foreign

investment project.

Example:

Assume that a company based in the Czech Republic is considering opening a subsidiary in

Germany. The annual projected cash flows of the planned subsidiary comprise 25 million

euro in revenue and 10 million euro of costs. The exchange rate between the euro and the

koruna, that is the currency of the Czech Republic, is 30 koruna to 1 euro. The company is

concerned about the 40% corporate income tax rate in Germany, which is high when

compared to the local Czech rate of 20%.

Solution:

Let’s calculate the tax liability and the after-tax cash flow of the investment. The annual pre-

tax profit of the German project is calculated as follows:

Pre-tax profit = 25m - 10m = 15m

After-tax profit (@ German rate of 40%) = 15m - 6m = 9m

Profit after translating into Korunas = 9m * 30 = 270m

In order to lower the tax liability, the company plans to charge the German subsidiary an

annual management fee of 5 million euro. Let’s see how this move would impact the tax

liability and profitability of the foreign investment. From the point of view of the subsidiary,

the charge is an additional cost, and will thus lower its pretax profit.

Taxable income after deducting the charge = 15m - 5m = 10m

Tax liability = 10m x 40% = 4m (2m less than without the charge)

The after-tax income reported by the subsidiary would thus be 6 million euro or 180 million

koruna, which could subsequently be remitted to the parent.

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We have to remember that the management fee represents the parent’s income, which is

subject to taxation in the home country. The koruna equivalent of the management fee is

150 million, so the tax payable on this income at the Czech rate of 20% would equal to:

Tax payable = 15m x 20% = 30m

Final after-tax cash flow = 180m + 120m = 300m

As you can see, this amount is 30 million higher than without the management fee. The tax

saving on the intercompany charge may also be computed as the amount of annual charge,

multiplied by the difference in tax rates between the two countries.

EXCHANGE CONTROLS AND RESTRICTIONS

Certain countries impose restrictions on the remittance of funds between the subsidiaries of

multinational companies located in those countries and foreign head offices. The existence

of such remittance restrictions should obviously be taken into account in the appraisal of

investment projects.

In particular, remittance restrictions may impact the timing of cash flows from an

investment project, which will be repatriated to the parent company. For example, the host

country may impose a ban on the remittance of some or all annual profits, and in such

cases, the accumulated earnings may only be repatriated after the investment has been

wound up.

INFLATION IMPACT

Typically the budget of an investment includes the minimum working capital required in

each year, which is taken into account in the calculation of the project’s free cash flows.

In the case of international investment projects, the working capital requirement is assumed

to increase at the expected level of inflation of the host country, and this effect should be

taken into account when evaluating the investment.

Example:

Assume that an investment project will require 1,000 dollars of working capital at the

beginning of each year of the project, which is expected to last for 3 years. The working

capital investment is subsequently expected to be released in year 4. The inflation rate in

the host country is expected to equal 6% per annum throughout the project’s lifetime.

Solution:

We know that a working capital investment of 1,000 dollars will be required at time zero.

After the end of each year, in order to offset the decrease in value of the working capital, an

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additional working capital will need to be injected and so the working capital balance will

amount:

Year 1: $1,000 + (6% x $1,000) = $1,060

Year 2: $1,060 + (6% x $1,060) = $1,123.6

Year 3: $1,123.6 + (6% x $1,123.6) = $1,191.02

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Sources of financing in international investment projects

INTRODUCTION

The decision regarding the source of financing is one of the critical decisions in the financial

strategy of a company. In essence, it may be boiled down to the choice between:

Internal financing, where the investment is funded from the free cash flows

generated by the firm, and

External financing provided by investors, either through the issue of debt or equity.

FINANCING OPTIONS

In the case of foreign investment projects, the financing decision has to take into account

the choice of currency, in which the project is to be financed. Typically, companies prefer to

fund their foreign subsidiaries with financing denominated in the currency of the host

country. The two main advantages of this approach are:

When the source of financing is denominated in the same currency as the assets of

the subsidiary, a natural hedge exists in the balance sheet of the foreign investment,

against foreign exchange rate variability;

Financing denominated in the currency of the host country may be serviced directly

with cash flows generated by the subsidiary.

Due to these advantages, financing in the foreign currency is the preferred option but only

when the host country is a developed country. In the case of under-developed economies,

which often have an unstable currency and volatile or illiquid financial markets,

multinational companies prefer to raise financing denominated in international currencies,

such as the US dollar.

The financing options typically applied by multinational companies are to:

1) Use the foreign subsidiary’s own free cash flows. Under this option, the foreign project is

assumed to be financed by a subsidiary already operating in that country, using its free cash

flows.

Advantages:

This approach allows companies to avoid the costs of issuing additional debt.

Disadvantages:

This way of financing is possible only when a multinational already has a well-

established and highly profitable subsidiary located in the country, where the

investment will be pursued;

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It is not suitable to the financing of new ventures, which are not expected to

generate free cash flows in the short run;

Foreign subsidiaries typically expatriate their profits to the parent company and thus

seldom accumulate free cash flows which would be sufficient to fund a new

investment.

2) Use financing supplied by the parent company. This is a much more frequent

practice. This financing pattern assumes that the parent company acts as a central

treasury to the entire multinational organisation, meaning that the parent first collects

free cash flows from the various group members, and then allocates them to

subsidiaries which are in need of funding.

Advantages:

It allows an organisation to finance itself internally to a significant extent;

Raising external financing is also centralised, which means that the group can build a

dedicated team of professionals, specialised in the effective raising of funds across

global financial markets.

Disadvantages:

The existence of exchange controls and blocks on the remittance of funds;

The central management of capital implies that financing is generally denominated

in the domestic currency of the parent company, creating an exposure to currency

risk in the financed project;

There is a political risk, which may potentially result in a loss of the subsidiary.

3) Use financing raised externally but in the subsidiary’s country.

Advantages:

Issuing debt locally typically helps reduce a subsidiary’s exposure to foreign

exchange risk, because both the financing and the assets which it is intended to

finance are denominated in the same currency;

The level of political risk from the perspective of the entire organisation is lower

because the potential loss of a subsidiary would result in the elimination of its

financing liabilities;

There is a positive perception that this creates on the part of the host country’s

government and markets.

Disadvantages:

In certain developing countries, financial markets are not sufficiently mature to

provide the foreign company with a stable long-term source of funding;

The credibility of a subsidiary is typically lower than the credibility of its parent or the

entire organisation, and the conditions of financing raised locally may negatively

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deviate from those which would be available to the parent, mainly in terms of prices

and covenants.

4) Raise finance in a third country, which is neither the home country of the parent nor

the country of the subsidiary. The availability of such funding depends on the free

flows of capital between the country, in which the borrower is situated, and the

country, in which the debt financing is to be raised.

Advantages:

Low-interest rates in a particular currency, which may help reduce the overall cost of

capital for the investment project.

Disadvantages:

The currency risk resulting from the mismatch between the currency of the assets

and the currency in which the resulting liability is denominated.

TYPES OF FINANCIAL INSTRUMENTS

1) Eurocurrency loans. These are bank loans taken out in the currency of a different

country (e.g., a loan granted by a UK bank, but denominated in US dollars).

Eurocurrency loans may be used to finance investments denominated in the currency

of the loan, or investments in a different currency, but taking advantage of lower

interest rates in the currency of the loan. Like any other loan, a eurocurrency

borrowing may take on various forms:

Investment loan;

Credit line;

Revolving facility.

2) Syndicated loan. In the case of particularly high values, if one credit institution is not

in a position to grant the loan individually, eurocurrency loans are syndicated, which

means that they are granted by a consortium, where each of the banks participates in

a specific portion of the loan disbursement and subsequent repayments.

a) A multi-option facility is a type of syndicated loan, which has only recently been

developed. This is a credit line allowing the borrower to take out advances in multiple

currencies.

3) Debt securities issued in a third currency is another type of eurocurrency instrument:

a) Euro notes are short- and medium-term versions of such securities. Euronotes

is the legal form of a promissory note, typically issued for periods of up to 3

years. They are transferable, meaning that they may be traded in the secondary

market.

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b) Euro bonds are long-term versions of such securities. Their maturities may

extend up to 20 years. They are typically interest-bearing bonds, with fixed or

floating coupons, issued and traded in international financial markets, thanks to

which the issuer is not subject to the constraints of domestic regulation.

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The Role of Treasury Function in a Multinational Organisation

THE ROLE OF TREASURY FUNCTION

The treasury function is typically responsible for those financial management activities of a

company which can be performed by means of operations. Those activities are aimed at:

1) The short-term management of financial resources. Here, the responsibility of

the treasury function encompasses short-term liquidity management as well as

the management of working capital, and includes such operations as taking out

short-term loans or depositing cash surpluses;

2) The maximisation of long-term value. In the long run, the treasury function is to

be responsible for ensuring the appropriate level of long-term funding to the

organisation. It is also involved in the process of issuing debt and the evaluation

of investment opportunities; and

3) The management of risk exposures. Here, the treasury function is to be in

charge of the quantification and hedging of financial risks, which are generated

by the organisation’s operating units. Risk management in treasury is typically

achieved by concluding derivative transactions used to hedge against foreign

exchange risk, interest rate risk, and other exposures, for example, those

resulting from commodity risk.

Note: The treasury function may also be involved in other areas of financial management,

such as providing the board with information on risk and performance, or managing

relations with banks and rating agencies.

The above list of roles and responsibilities of the treasury function is not comprehensive.

The roles assigned to the treasury function may differ across companies, depending

primarily on the type of business, scale of operations, as well as the company’s appetite for

risk.

In most large organisations, the treasury function is separated from the financial control

function, which allows for a greater degree of specialisation and development of

appropriate skills related to financial markets. Those skills have become crucial to effective

financial management given the increasing complexity of the financial environment in which

companies operate, resulting, among others, from the:

Globalisation of businesses;

Growing volatility in interest rates;

Foreign exchange rates; and

Developments in information technology.

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Financial control function is responsible: Treasury function is responsible for:

a) For the allocation of resources in an organisation; and

a) Providing financing to the organisation; and

b) For making investment decisions. b) Managing relations with lenders and shareholders.

c) In managing risk exposures, it is typically responsible for identifying the sources of exposures to risk.

c) In managing risk exposures, it is charged with the selection and application of appropriate instruments to hedge risk exposures.

CENTRALISED AND DECENTRALISED TREASURY FUNCTION

The treasury function in a multinational organisation is typically centralised at the

company’s head office. This means that a multinational company maintains only one trained

team of specialists with no need to duplicate know-how in this area.

Centralisation also offers other advantages, resulting mostly from economies of scale,

including the following:

1) Centralised treasury management allows for the aggregation of the company’s cash

balances, thanks to which cash surpluses may be invested in bulk by the centralised

treasury, potentially at more favourable rates. Such aggregation of cash balances is

commonly referred to as cash pooling.

2) The funding needs of operating companies are aggregated, and the required amounts

are borrowed in bulk, in the most favourable market. This allows for the optimisation

of borrowing costs for the organisation as a whole.

Note: The aggregation of both cash surpluses and financing needs of the operating

companies in a group, may help lower the company’s overall level of indebtedness, as it

eliminates situations where one operating company has a cash surplus, while another

requires financing.

3) The hedging of aggregated risk exposures using a centralised treasury is typically more

efficient than it would be at the decentralised level. That is because aggregating the

risk exposures generated by various operating units allows for the netting of opposite

exposures to certain risks among operating companies, thus lowering the number and

volume of hedging transactions that need to be conducted. This naturally has the

effect of lowering the overall cost associated with hedging.

4) An organisation can more effectively manage its transfer pricing strategy and thus

optimise the overall level of taxes paid.

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However, a decentralised approach to the treasury function also has certain advantages:

1) Some local financial markets have unique features, which are more adequately

addressed by a local treasury team as opposed to a central unit located at the head

office. Also, in some local markets, a degree of treasury decentralisation may be

forced by local regulations, which may, for example, impose limitations on cash

remittances from a subsidiary to the head office.

2) Operating companies tend to manage their financial resources more efficiently if they

are in charge of obtaining financing and investing surpluses, rather than if their role is

reduced to simply transferring those balances over to the head office. This is an

important motivational aspect.

TREATING TREASURIES AS COST CENTRES AND PROFIT CENTRES

Some companies not only treat their treasury functions as cost centres, providing services to

operating companies, but assign them the role of profit centre as well.

Treasury treated as cost centre Treasury treated as profit centre The costs associated with treasury operations are either allocated to the units to which treasury services are provided, or not allocated and remain with the head office.

The role of treasuries includes generating additional profits earned on market operations.

A centralised treasury in a multinational company may play the role of an intra-group bank, i.e., it purchases cash balances from over-liquid companies and provides financing to those units which are short of funding.

In addition to the above, in some cases, the centralised treasury may:

Open its own exposures in expectation of earning additional profits on

favourable changes in market prices; or

Take a decision to leave some risk exposures unhedged.

Such opening of additional exposures or leaving of risks unhedged means taking on

additional risk, which may potentially result in a loss if the decision proves incorrect. It is,

therefore, crucial for a company to set up a risk policy ensuring that all investment decisions

made by the treasury are consistent with the company’s risk appetite, and that a sound and

resilient limits and controls framework is in place.

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Treasury and Advanced Risk Management Techniques

Exchange Traded and OTC Derivatives

FEATURES AND TYPES OF DERIVATIVES

As you know, one of the main roles of a treasury department in a company is the

management of exposures to financial risks, which result from business activities conducted

by that company.

A typical approach used to manage exposures to financial risks is to hedge them with

derivatives, which economically offset the hedged exposures. The types of risks which are

most often hedged with derivatives are market risks, such as:

Currency risk, which results predominantly from the international operations

of a company; and

Interest rate risk, which is typically associated with the terms on which a

company sources its financing.

A derivative is an agreement, whose value changes in response to changes in the value of

another instrument or variable, called the underlying asset. Derivatives are usually grouped

into categories, depending on the nature of the underlying asset (e.g., equity derivatives,

commodity derivatives, credit derivatives, interest rate derivatives, currency derivatives).

Derivatives may also be classified with respect to the rights and obligations connected with

entering into such transactions:

1) Symmetrical derivatives: Here, both parties to the contract have an obligation to buy or

sell the underlying asset, or to exchange financial instruments, at a price fixed at the

inception of the contract. Examples of such derivatives are:

a) Forward and futures contracts, in which the parties agree to a purchase or

sale of a specific underlying asset at a future date, at a fixed price called a

forward price; and

b) Swap, representing an agreement under which the parties to the contract

exchange streams of payments on conditions determined at the beginning

of the contract.

2) Asymmetrical derivatives (options): In an option contract, one party, called the option

holder, has a contractual right to buy, sell or exchange underlying assets at a future date

and on pre-determined conditions, while the other party, called the option seller, has an

obligation to fulfil the holder’s right. Please note that the option holder must pay for the

right contained in the option. This option price is called the option premium. The existence

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of a premium marks one of the major differences between options and symmetrical

derivatives.

EXCHANGE TRADED DERIVATIVES AND OTC DERIVATIVES

Some derivatives are traded on stock exchanges, whereas others are concluded on a

bilateral basis.

Exchange traded derivatives are mostly futures contracts and options, whose prices and

values are publicly quoted.

They are typically settled net, which means that at maturity, the underlying

asset is not physically delivered, but a cash equivalent is transferred instead.

A position in exchange traded derivatives may be closed out before maturity.

Such derivatives are standardised instruments, meaning that they are

available in units reflecting a certain amount of the underlying asset subject

to the contract. The consequence of such standardisation is that it is not

always possible to obtain a perfect fit between the size of the exposure and

the size of the hedging derivative. Similar mismatches may occur between

the timing of the cash flows being hedged and the maturity date of the

futures or option contract used.

Their settlement is guaranteed by the stock exchange, which assumes the

role of a counterparty in relation to both the buyers and sellers of all

contracts.

All exchange traded derivatives are subject to margin requirements. There

are two types of margin: initial margin, which has to be paid to the stock

exchange when a contract is entered into; and a variation margin, which is

paid only when the value of an exposure falls below a specified amount.

Such instruments have a defined minimum incremental price movement

called a tick. Tick sizes may differ among instruments and exchanges.

Bilateral derivatives, usually referred to as “over-the-counter” or simply OTC contracts, are

generally free from the restrictions relating to exchange traded futures and options listed

above:

All terms of OTC instruments are subject to negotiations between the

counterparties. This pertains to maturity, size, as well as the remaining

parameters which define such contracts. As a consequence, their application

allows for a better fit between the exposure being hedged and the derivative.

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The method of contract settlement, which may either opt for physical

delivery of the underlying asset, or for cash settlement, is yet another

parameter that is subject to contractual agreement between the parties.

The fact that OTC deals are not standardised also means that there are many

more instrument types which are traded in the OTC market than on stock

exchanges. These include sophisticated types of contracts, such as barrier

and exotic options, or structured swaps.

Another difference consists in the approach to the management of

counterparty credit risk, which in the case of exchange traded derivatives is

addressed by means of the margining system. The OTC market is much more

liberal in this respect, typically allowing for the counterparties to the

transaction to utilise various forms of securing the risk of non-settlement,

which range from full cash collateralisation of a derivative’s market value, to

leaving the full exposure unsecured.

OTC derivatives are relatively easier to apply, principally because they can be

exactly matched with the exposure being hedged. Moreover, certain types of

derivatives (e.g., interest rate swaps) are typically traded only in the OTC

market.

OTC derivatives may be unavailable for certain underlying assets, which may

significantly reduce their applicability for hedging purposes. This relates in

particular to currency derivatives on those currencies which are considered

exotic.

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Role of Treasury Function in Multinationals

Basis Risk in Hedging

BASIS RISK

So, what is basis risk? It is the risk associated with imperfect hedging, arising when there is a

lack of perfect correlation between changes in the value of the hedged item, being the

company’s exposure to the hedged risk, and the hedging derivative. Let us now consider the

reasons which may lead to the occurrence of basis risk in the practice of hedging exposures

to currency and interest rate risk.

Typically, basis risk occurs when the hedged exposure and the underlying asset of the

hedging derivative are similar, but not the same. Imagine that an exposure to changes in

prices of jet fuel is hedged with a derivative whose underlying is heating oil or crude oil.

Obviously, the price of jet fuel is correlated with the price of oil in general or oil-related

products. However one cannot expect perfect correlation between them to exist.

Another example, this time coming from the interest rate market could be a hedge of the 3-

month forward dollar Libor rate with a futures contract on 3-month United States Treasury

Bills. The Libor rate will clearly be correlated with the rate of return on a treasury bill,

however, the hedge will, once again, not be perfect.

Please note, that in the risk management practice of treasury departments, basis risk is

typically avoided, especially when it comes to hedging currency and interest rate risk. This is

because companies typically prefer to utilise derivatives, whose underlying matches the

underlying of the hedged exposure. For example, in the case of a future euro/dollar

exchange rate exposure, the preferred derivative will naturally have the euro/dollar

exchange rate as its underlying.

This does not mean, however, that matching the underlying assets of the hedged exposure

and the hedging derivative ensures that basis risk is completely eliminated. In practice, basis

risk in hedging currency risk and interest rate risk may still occur, when the exposures are

managed with standardised exchange traded instruments, such as futures. The

standardisation of futures contracts means, among other things, that such contracts mature

on selected dates only, and these dates are set by the exchange on which the futures trade.

Companies naturally prefer choosing those contracts whose maturities exceed the timing of

hedged cash flows. Otherwise, if a contract maturing before the timing of the exposure was

used, the exposure would be left unhedged after maturity and settlement of the futures

position.

As a result, using futures with maturities exceeding the timing of the hedged exposure

means that the derivative position will have to be closed once the hedged exposure has

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materialised. Please note that the exact price at which this will be done is unknown at the

moment of entering into the futures contract, which leaves a degree of uncertainty

regarding the exact outcome of the hedge.

Economic meaning of basis

So, how can such risk be quantified? In order to do this, the so-called basis has to be

calculated. Basis is defined as the difference between the spot rate and the futures price at

inception of the hedge. Let’s consider the economic meaning of basis.

As you may know, in forward markets, the difference between the spot price and the

futures or forward price, which is also referred to as the cost of carry or, in forex markets as

swap points, may be thought of as the cost of maintaining the position in the underlying

asset until maturity of the derivative. In the case of interest rate derivatives, it is the cost of

financing the position in interest rates, and in the case of currency derivatives – the

difference between the cost of financing a position in one currency and the gain from

investing in the other currency of the underlying currency pair. Please note that in the case

of FX derivatives, the basis can either be positive or negative, depending on the difference in

interest rates observed between the two currencies.

It is important to appreciate that the cost of carry, and so the basis, should decline in time

as the derivative moves towards its maturity, reaching a value of zero, when the contract

expires. This may be explained using the following logic – at the maturity date of a forward

or futures contract, the pre-agreed sale, purchase or exchange effectively becomes a spot

transaction, and the result of its settlement is known. Accordingly, there is no outstanding

position in the underlying asset to be financed anymore.

Basis will also move to zero in the case of futures contracts with a maturity that spans

beyond the date of the hedged exposure. However, please appreciate that at the moment

when the hedged cash flow occurs and the futures contract needs to be closed out early, its

price will still contain a portion of the unamortised basis.

The exact assessment of the impact of the remaining basis on a given future date is difficult,

and so the final rate at which the exposure will be hedged, is unknown at inception of the

hedge. Intuitively we may expect that the scale of potential uncertainty increases with the

length of time between the occurrence of the hedged exposure and maturity of the futures

contract. There is a method to approximate the basis effect which is based on the

assumption that the decrease of basis over time occurs in a linear fashion. This

approximation is thought to produce relatively accurate results when applied to short

periods of time. We will present the application of basis risk approximation in the course

module devoted to hedging currency risk.

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Economic Environment for Multinational Organisations

VALUE AT RISK (VAR)

Value at risk shows how much the value of an investment, being an asset or portfolio of

assets, may change over a certain period of time, called the holding period, assuming

normal market conditions.

Value at Risk is a statistical method, which means that it is based on a probability

distribution of the measured variable. This variable is the value of the investment. According

to the theory which underpins value at risk, under normal market conditions, the value of an

investment is normally distributed, implying that possible changes in value cluster around

the mean value of the investment, tapering off symmetrically at both ends. The dispersion

of possible value changes is given by another parameter of the normal distribution, namely

the standard deviation. The lower the standard deviation the more the outcomes are

centered on the mean value.

Normal Distribution:

In a normal distribution, the cumulative probability of a given outcome is represented by

the area under the distribution curve. The entire probability, as represented by the entire

area under the curve, is equal to 1, and half of the area, measured from the far left end to

the mean value, reflects a probability equal to 50%.

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Value at risk is defined as the possible change in the value of an investment, assuming a

given confidence level. For example, a confidence level of 95% represents a 5% statistical

probability of a loss in value of the investment. So, knowing the parameters of the normal

distribution, that is its mean and variance, we are able to calculate the loss which should be

expected with a probability equal to 5%.

Example:

Imagine that a bank would like to quantify the price risk of its portfolio of securities. It is

interested in estimating the loss that the portfolio could potentially generate in a holding

period of 10 days. The probability distribution of possible value outcomes for this portfolio

over a 10 day period has an expected value of €100 million, with a standard deviation of €12

million.

The approach to calculating value at risk will depend on the desired accuracy of

measurement, as represented by the confidence level. At a confidence level of 99%, value at

risk will show the amount, below which the value of the investment should not fall with a

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probability of 99%. The higher the confidence level, the more accurate the result, but also

the higher the value at risk, or the statistically possible loss.

Use of Normal Distribution Tables:

In order to actually compute the Value at Risk, knowing the mean and standard deviation of

the investment’s value distribution, we may use normal distribution tables. In the case of

Value at Risk calculations, the cumulative probability is already known and given by the

confidence level. First, we will have to find the value inside the table representing the

probability reflected by the required confidence level, and subsequently, identify the input

value which corresponds to that probability. The distribution is symmetrical, so in order to

obtain the cumulative probability for an input value which is higher than the mean, we have

to add 0.5 to the probability found in the table, and if the probability is lower than the

mean, we need to subtract the relevant probability from 1.

If the confidence level of the Value at Risk calculation is 99%, we will need an input which

corresponds to a probability of 1%. From the fact that the normal distribution is

symmetrical, we know that the input value for which the cumulative probability is equal to

1% is the negative value of the variable, for which a probability equal to 1 minus 1%, that is,

99% is obtained. So, we have to find a cumulative probability inside the table, which is

closest to 0.99 minus 0.5, that is to 0.49. As you can see, the closest value to the one we are

looking for is 0.4901, corresponding to an input value of 2.33. We may, therefore, conclude

that the input value which corresponds to a cumulative probability of 1% is minus 2.33:

Normal Distribution Table

z 0 0.01 0.02 0.03

2.0 0.4772 0.4778 0.4783 0.4788

2.1 0.4821 0.4826 0.4830 0.4834

2.2 0.4861 0.4864 0.4868 0.4871

2.3 0.4893 0.4896 0.4898 0.4901

The asset portfolio from our example has a mean value of €100 million and a standard

deviation of €12 million. So, in order to interpret the result, we first need to transform it to

conform to the properties of the portfolio value distribution. We can do this by applying the

following simple formula:

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Where:

Mean = €100 million

Standard deviation = €12 million

Cumulative probability = –2.33

Therefore:

Interpretation:

This result may be interpreted as: ‘Assuming that the 10-day value of the investment follows

a normal distribution with a mean of €100 million and a standard deviation of €12 million,

then with a 99% probability the value of the investment should not fall below €72.04 million

over the next 10 days, assuming normal market conditions prevail. The value which is at risk

is thus €27.96 million.’

Let’s see how the value at risk in the example analysed would be affected if we changed the

confidence level from 99% to 95%. To do this we would have to find the variable

corresponding to a cumulative probability of 0.95 minus 0.5, and take its negative value.

Accordingly, the input for which a probability of 0.45 may be observed equals 1.65, so the

value which corresponds to a cumulative probability of 5% is minus 1.65:

Normal Distribution Table

z 0.04 0.05 0.06

1.5 0.4382 0.4394 0.4406

1.6 0.4495 0.4505 0.4515

1.7 0.4591 0.4599 0.4608

Applying the variable normalisation formula:

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Interpretation:

The value which, assuming normal market conditions, would be regarded as being at risk is

€19.8 million, compared to almost €28 million at a confidence level of 99%.

VALUE AT RISK – ADVANTAGES AND DISADVANTAGES

Value at risk has a number of advantages, the most important of which is the simplicity with

which it may be calculated and interpreted.

Disadvantages of using VaR technique include:

It makes the assumption that changes in the values of assets follow a given statistical

distribution, which is either assumed to be normal or constructed based on historical

observations. In reality, the actual future distribution may be unknown and far from

that which is being hypothesised.

Value at Risk assumes the existence of normal market conditions, which means that

it does not anticipate any shocks or other crisis situations. As a result, application of

VaR may give an institution a false sense of security, because the worst case

outcomes are not taken into account.

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