1. In this class we will discuss:
 The nature of Treasury Management
 Spot and forward exchange rates
 The nature of exchange rate risk
 Internal and external hedging
 Derivatives used for hedging

2.  What does a treasurer do?
 Concerned with cash flow and risk
 Size and responsibility of treasury function
will vary
 Treasury aims,policies, authorisation levels,
risk levels and structure determined by Board
of Directors
 Eg Eon

3.  Liquidity and working capital management
 Financing
 Risk management

4. Centralisation Decentralisation
 Treasurer has  Local financing
overview – opportunities
maximises after-  Gives responsibility
tax profits (control) to
 Greater expertise divisional managers
 Benefits of scale

5.  To ensure that enough cash is available at the
right time
 Management of working capital
 Efficiency is key and can impact on financing
requirements

6.  How much should firm raise this year?
 What form of financing should be used?
 What should the balance be between short
and long-term funds?
 Currency of finance/Where should finance
be raised?

7. “Risk management is the process of identifying
and evaluating the trade-off between risk and
expected return, and choosing the
appropriate course of action” (Pike and Neale
2006)
 How does risk arise?

8.  The exchange (for an agreed price) of a risky
asset for a certain asset
 Hedges can be created for:
◦ Commodities
◦ Foreign currencies
◦ Interest rates
 Derivatives
◦ Financial instruments used for hedging

9.  Forward contracts
◦ An agreement to buy or sell
(commodity, currency or agreement on interest
rate on future borrowing) at a fixed price at some
time in the future
 Futures contracts
◦ Similar to a forward contract but standardised in
terms of period, size and quality
◦ Can be traded on an exchange

10.  Options
◦ Gives the right, but not the obligation to buy/sell at
an agreed price at or up to an agreed time
 Swaps
◦ An arrangement between two firms to exchange a
series of future payments

11.  Exposure to interest rate risk is determined by how
much profits and/or asset values are affected by
interest rate changes.
 Depends on whether company is a net borrower or
net investor

12.  Natural hedging
 Fixing the interest rate
 Hedging contracts
◦ Forward rate agreements
◦ Interest rate futures or options
◦ Interest rate swaps

13.  Two companies agree to exchange interest
payments with each other over an agreed
period
 Effectively they are swapping the different
characteristics of the two loans
 Called a plain vanilla

14. Two companies have access to the following interest rates:
Co. A Co. B
LIBOR Fixed 11%
Fixed 10% LIBOR +0.2%
(LIBOR – London Interbank Offered Rate)
 Co. A has an absolute advantage
 Co. B has a comparative advantage over A with its floating
rate

15. Company A Company B
(wants to borrow (wants to borrow
at floating rate) at fixed rate)
LIBOR Fixed 11%
Rates available:
Fixed 10% LIBOR + 0.2%
Borrowing action: Fixed 10% LIBOR + 0.2%
Swap Payments
Better or worse off? 0.2% Worse off
worse off 0.2%Better off
1% worse off
Balancing payment 0.6%
Post-swap borrowing LIBOR – 0.4%
0.2% worse off Fixed 10.6%
0.2% worse off
rates
Exhibit 12.5
An example of a plain vanilla interest rate swap between
two companies, A and B
Taken from Watson and Head (2007)

16.  Start and end dates of swap
 Notional principal
 Which party is paying floating interest and
receiving fixed interest in return and vv
 Level of fixed rate and basis of floating rate
 Profit sharing terms

17.  What is meant by the „exchange rate‟?
 Exchange rates (in free floating markets) are
determined by the interaction between the
relative supply and demand for a currency.
 Quotations
◦ Direct
How many units of FC per unit of HC eg $2.00 per £
◦ Indirect
How many units of HC per unit of FC eg £0.50 per $

19. Spot market rate
Quotation for immediate delivery
Eg Euro
◦ What is the „buy‟ rate?
◦ What is the „sell‟ rate?
◦ What is meant by the „spread‟?
◦ What determines the size of the spread?

20. Forward Market Rate
◦ The exchange rate for advance transactions
◦ Usually quoted as a premium or a discount on the
spot rate
Eg 3 month forward rate for
 euros
 Turkish lira

21.  Arises due to FC cash flows occurring at some
point in time in the future
 Tends to be short-term
 Eg A UK company contracts to buy IT
components from a German company with
payment (in euros) to be made in 6 months
time
 Unexpected changes in the euro/£ exchange
rate could result in losses

22.  Internal management
◦ Cheaper than external hedging
 External management
◦ Forward contracts
◦ Money market hedge
◦ Derivatives

23.  Matching
◦ Matching FC denominated assets with FC
denominated liabilities (or VV), or FC denominated
inflows with FC denominated outflows eg
 Netting
◦ Netting off FC transactions
◦ Often used by multinationals
◦ UK company with German subsidiary. UK parent
expects to receive $ inflows in 3 months and German
subsidiary expects to make $ payment in 3 months
time

24.  Leading and lagging
◦ Settlement of FC accounts either at beginning or after
the end of the allowed credit period
◦ Choice depends on expectations of future exchange
rate movements
◦ Eg company with a future $ payment may choose to
lag its payment if £ is expected to appreciate relative
to $
 Invoicing in domestic currency
◦ Transfers transaction risk to other company
◦ May place home company at a competitive
disadvantage

25.  Forward Contracts
◦ “Enable companies to fix in advance the future
exchange rate on agreed quantities of FC for delivery
or purchase at an agreed date” (Watson and Head,
2007)
◦ Tailor-made with respect to maturity and size
◦ Cannot be traded
◦ Cash flows occur at the end of the contract
◦ Locks out any potential benefit from favourable
exchange rate movements

26.  Involves setting up the opposite FC transaction
to the one being hedged
 Eg $ receipt expected in 3 month‟s time
◦ Set up $ debt by borrowing $s now
◦ Convert $ into £ at current spot rate
◦ Deposit £ on £ money market
◦ When $ loan matures it will be paid off by expected $
receipt

27. A company expects to receive $180,000 in 3
months time and wants to lock into current
exchange rate of $1.65/£. The annual dollar
borrowing rate is 7% (the 3-month borrowing
rate is 7% * 3/12 = 1.75%). The annual sterling
deposit rate is 6% and so the 3 month deposit
rate is …..

28.  Borrow an amount (Z) which when interest is
added in 3 months will be equal to $180,000
◦ Z * 1.0175 = $180,000
◦ Z = $180,000/1.075 = $176,904
 Convert $ into £ at current spot rate
◦ $176,904/1.65 = £107,215
 Invest £ in the sterling money markets for 3
months
◦ £107,215 * 1.015 = £108,822
 The £ value of the $ inflow using the money
market hedge is therefore £108,822 (compare
with using a forward exchange contract)

29.  What if it were a $180,000 payment to be made
instead?
 Steps
◦ Convert £ into $ at current spot rate
◦ Invest $ on US money market such that the deposit
plus interest will equate with the payment to be made
in 3 months
◦ Cost is the initial £ plus lost UK interest (or interest
on UK loan if initial amount borrowed)

30.  Nature of Treasury Function will vary
 Mainly concerned with
◦ Liquidity and WC management
◦ Financing
◦ Risk Management
 Exchange rate risk arises because of the
fluctuation in exchange rates
 Main hedging techniques
◦ Internal
◦ External
 Next week futures and options