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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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