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MF0007 TREASURY MANAGEMENT

Q.1. Explain the features of a Forward Rate agreement

Answer: The forward, or future rate agreement, is a contract between two counterparties to fix a future interest rate. This contract defines the interest rate for a future period based on a principal. If on the agreed date (fixing date) the FRA-contract-rate differs from the agreed reference rate, a settlement payment depending on the difference must be paid by one of the contractors. The principal is not exchanged and there is no obligation by either party to borrow or lend capital.

The FRA can be used •

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By market participants who wish to hedge against ity futureminterest rate risks by setting

rs .co l i n 9> ma U g based on their expectations of the l 00profits â&#x20AC;˘ By market participants who want toamake p 5/2 84@ i future development of interest rates an /0 a M une alv J athadvantage of the different prices of FRAs and â&#x20AC;˘ By market participants whoim k try to< take r k ha by means of arbitrage. Si e.g. Futures, s other financial instruments, to il: a d e m itt Em FRAs are overb the counter (OTC) products and are available for a variety of periods: Su e the future interest rate today (at trading date) iv

starting from a few days to terms of several years. In practice, however, the FRA-market for 1-year FRAs offers the highest liquidity and is therefore also regarded as a money-market instrument. The FRA is not an obligation to borrow or lend any capital in the future. At settlement date, the principal just serves as the basis to calculate the difference between the two interest rates, or rather the settlement payment those results from this difference.

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FRAs work as follows: •

A customer enters into an agreement with his bank to either buy or sell an FRA. The FRA defines an interest rate for a principal of a deposit or a loan for a defined interest period that will start at a future date. The interest rate on which they agree - also known as FRA rate - is the price of the FRA as it is quoted by the market.

By doing so, the bank has not committed itself to lend or take money at this rate. Instead, the customer and the bank agree to compare the fixed FRA rate to a reference interest rate (e.g. LIBOR) two days (exception: GBP) before the defined interest period (fixing date). The reference rate is defined on fixing date; it is also called

a lv A • Who receives or pays the amount due depends on whether the customer or the bank ath r a is higher or lower than the bought or sold the FRA, and whether the FRA rate Sh reference rate at settlement date. by y t om rsi c e . l v ni 9> mai U l 00 g pa 5/2 84@ i an /0 a M une alv m J h ki < arat k Si sh : l to ai d e m t it E m b u S settlement rate.

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Q.2. Company A and B are offered the following interest rates on a loan of Rs5 million by their banks. You are required to construct an interest rate swap for these firms netting 0.5% to the bank acting as intermediary and be equally attractive to A and B Company

Fixed Rate

Floating Rate

A

15%

MIBOR + 2%

B

18%

MIBOR + 2.5%

Answer:

Calculation of: a) Interest payable by bank to Company A:

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y sit om r c e . l v ni 9> mai = Rs. 2044.52 U l 00 g paA:5/2 84@ b) Interest payable by bank to Company i an e/0 lva M –u0.5% n = (Rs.50,00,000 X 18% X 1/365) m <J atha i r = Rs.2453.42 kk ha Si s to Floating il: rate MIBOR: c) Interest receivable under a d e m itt 50,00,000 E- X 17% X 1/365) – 0.5% = 2317.13 Company A = (Rs. m b Company ASu= (Rs. 50,00,000 X 20.5% X 1/365) – 0.5% = 2794.18 = (Rs.50,00,000 X 15% X 1/365) – 0.5%

Thus, 1. Interest receivable by bank from Company A------- Rs.2,317.13 Interest payable by bank to Company A-------------- Rs.2,044.52 Net amount receivable -------------------------------- Rs.272.61 2. Interest receivable by bank from Company A------- Rs.2,794.18 Interest payable by bank to Company A-------------- Rs.2,453.42 Net amount receivable -------------------------------- Rs.340.76 ===== ===== ===== ===== ===== ===== ===== ===== ===== ===== ===== =====

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MF0007 TREASURY MANAGEMENT

Q.3. Do you think that “Central Bank’s Intervention’ in the foreign exchange markets to maintain the stability of domestic currency is good from economic growth point? If Yes / No substantiate your answer with reasons.

Answer: There are several reasons such interventions occur. The first reason central banks intervene is to stabilize fluctuations in the exchange rate. International trade and investment decisions are much more difficult to make if the exchange rate value is changing rapidly. Whether a trade deal, or international investment, is good or bad often depends on the value of the exchange rate that will prevail at some point in the future. If the aexchange rate changes

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consequence, international traders and investors tend to prefer by more stable exchange rates and

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iv l 20 @gm a The second reason central banks nintervene ip 5/ is4 to reverse the growth in the country’s a e/0 lva8 M account n trade deficit. Trade deficits (or current deficits) can rise rapidly if a country’s m <Ju atha i exchange rate appreciates significantly. A hhigher ar currency value will make foreign goods and kk Si s to il: imports, while domestic goods will seem relatively services relatively cheaper,d stimulating a e -m itt more expensive to foreigners, thusE reducing exports. This means a rising currency value can m b lead to a rising trade Su deficit. If that trade deficit is viewed as a problem for the economy, the > market whenever the exchange rate changes tooUnrapidly. 09

central bank may be pressured to intervene to reduce the value of the currency in the FOREX market and thereby reverse the rising trade deficit. Direct FOREX intervention The most obvious and direct way for central banks to intervene and affect the exchange rate is to enter the private FOREX market directly by buying or selling domestic currency. There are two possible transactions. First, the central bank can sell domestic currency (let’s use dollars) in exchange for a foreign currency (say pounds). This transaction will raise the supply of dollars on the FOREX (also raising the demand for £) causing a reduction in the value of the dollar and thus a dollar depreciation. Since the central bank is the ultimate source of all dollars (they can effectively print an unlimited amount), they can Page 4 of 13


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flood the FOREX market with as many dollars as they desire. Thus, the central bank’s power to reduce the dollar value by direct intervention in the FOREX is virtually unlimited. If instead, the central bank wishes to raise the value of the dollar, it will have to reverse the transaction described above. Instead of selling dollars, it will need to buy dollars in exchange for pounds. The increased demand for dollars on the FOREX by the central bank will raise the value of the dollar, thus causing a dollar appreciation. At the same time, the increased supply of pounds on the FOREX explains why the pound will depreciate with respect to the dollar. The ability of a central bank to raise the value of its currency through direct FOREX interventions is limited, however. In order for the RBI to buy Rupees ina exchange for dollars,

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r holdings of foreign assets by a central bank are called foreign ha exchange reserves. Foreign S

y held in case an intervention is exchange reserves are typically accumulated over time band ity

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iv g l 0 pa 5/2 84@ foreign exchange reserves. i an /0 a M une alv Indirect Effect of Direct FOREX intervention m <J ath ki effect r There is a secondary indirect k hathat occurs when a central bank intervenes in the Si s : toRBI sellsailRupees FOREX market. Suppose the in exchange for dollars in the private FOREX. d e m t it E This transaction involves of foreign assets (dollars) in exchange for Indian m a purchase b u currency. Since theS RBI is the ultimate source of Rupee currency, these Rupees used in the

> dollar through direct FOREX intervention willUndepend 09 onm the size of its dollar denominated

transaction will enter into circulation in the economy in precisely the same way as new rupees enter when the RBI buys a treasury bill on the open market. The only difference is that with an open market operation the RBI purchases a domestic asset, while in the FOREX intervention it buys a foreign asset. But, both are assets all the same, and both are paid for with newly created money. Thus, when the RBI buys dollars, and sells rupees, on the FOREX there will be an increase in the Indian money supply. The higher India’s money supply will lower India’s interest rates; reduce the rate of return on India’s assets as viewed by international investors, and result in a depreciation of the dollar. The direction of this indirect effect is the same as the direct effect.

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Q.4. ‘Liquidity management’ is a key to the success of earning more profits for a banking company. Support this view with valid reasons.

Answer: The key processes associated with liquidity management are as follows: 1) Liquidity requirements are addressed in the Bank’s risk management policy detailing guidelines for how risks to the institution’s liquidity are measured, monitored, and controlled. The risk management policy must address: statutory requirements with respect to deposit reserves; maintenance and management of operational and contingency liquidity; and the Bank’s ability to meet potential funding needs a arising from credit

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between the key/critical functions of the Bank,by such as capital markets, cash

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iv l 0 @g pa 5/2 are a. Specific capital markets personnel 4 authorized to execute investment i an e/0 lva8 M n transactions; m <Ju atha i r are responsible for forecasting financing and b. Cash management/treasury kk personnel ha Si s to obtaining il: funding on a daily basis to satisfy those needs. liquidity needs dand a e m itt haveE-been Target balances established to meet start-of-day and end-of-day m b u liquidityS needs. Excess funds are usually invested in money market transactions;

9> not committees. Specific examples may include, m limited to, the following: Unbut0are

c. Correspondent bank personnel are responsible for processing wire transactions; d. Accounting personnel are responsible for posting transactions to the general ledger and reconciling the accounts; e. Asset/liability management personnel provide reports to management that should reflect the institution’s degree of compliance with liquidity requirements; and f. Liquidity planning and funding is periodically reviewed with the applicable management committee(s). 3) The responsibility for monitoring the Bank’s position with the Federal Reserve Bank is usually assigned to the Bank’s cash management/treasury personnel. They should have inquiry access to the wire system allowing them to monitor large incoming/outgoing wire Page 6 of 13


MF0007 TREASURY MANAGEMENT

activity. In addition, the automated wire system should have software controls that establish internal dollar limits to reduce the potential for daylight overdrafts. 4) The Bank’s investment policies should authorize specific individuals to execute investments, restrict investments to only highly-rated counterparties, and require the diversification of money market transactions, reducing concentrations with specific counterparties. 5) The Bank’s credit personnel should monitor the credit quality and collateral of advance borrowers, and unsecured credit counterparties. 6) The Bank should establish agreements with other Banks to serve as a surrogate for

a lv A 7) The following information should be periodically reported to the asset liability committee ath r a and the board of directors: Sh a. Liquidity position and compliance; by y t si omand b. Regulatory liquidity and reserve positionercompliance; c . l v > ai ni gaps c. Projected asset and liability maturity U 09 togmassess whether liquidity targets in l 0 a 2 maintained. excess of policy requirements nshould 4@ ip 05/be 8 a e/ lva Liquidity management: acid tests to M spotunthehchallenges ahead: m <J at a i ar kk • A company having insufficient to pay liabilities when they fall due, hresources Si s : to or loss resulting in penaltydcosts ail of reputation; e m itt E- making both cash deposits and short-term borrowings. • A company simultaneously m ub This meansS that cash resources may not be effectively used to reduce short-term liquidity in times of need.

financings; • Idle cash balances; • Many banking providers in each territory; and •

Too many or an insufficient number of credit lines.

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Q.5. Comment on the objectives of Credit Risk Rating in the background of recent bank failures.

Answer: A credit rating is an assessment by a third party of the creditworthiness of an issuer of financial securities. It tells investors the likelihood of default, or non-payment, by the issuer of its financial obligations. Credit analysis is the financial analysis used to determine the creditworthiness of an issuer. It examines the capability of a borrower,a or issuer of financial

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ath r a Establishing the creditworthiness of borrowers is hone of the oldest established S financial activities known. Through history, the act of lending funds has been accompanied by y t m i by an examination of the ability of the borrower to rsrepay the ofunds. The direct lending and ve > ail.c i banking relied largely on character and directUnknowledge 09 gm of the financial situation of the l 0 a borrower. ip 05/2 84@ n a e/ lva n developed during the industrial revolution, As modern accounting and M finance m <Ju atha i banking and lending grew to a larger ar became more systematic. Just as governments kk scalehand Si s to itol: deal with the complexities of national governments, developed sophisticated bureaucracies a d e m itt housesE-grew large banking and financing to cope with the demands of international trade. m b u Modern credit S analysis developed in the late 1800s when the credit markets began to obligations, to repay the amounts owing on schedule or at all.

issue and trade bonds, largely to finance the development of the new world, particularly the United States. As lenders were purchasing bonds of countries and companies that they had little personal knowledge of, third party credit rating agencies such as CRISIL, ICRA, CARE and Standard and Poor's Corporation were founded to fulfill the need for an impartial assessment of the creditworthiness of bond issuers. These companies, most still active today, developed scoring systems that told investors of the creditworthiness of issuers. Each rating agency has its own nomenclature or "investment grade" that ranks the default risk of issuers. The scale begins at the highest quality ratings, such as AAA, with very low probability of default, and descends to risky or "speculative" ratings, such as BB, where the risk of default is high. Page 8 of 13


MF0007 TREASURY MANAGEMENT

An example of a rating system is the Ratings Definitions of Government Debt of the Canadian Bond Rating Service (CBRS), which is shown below: Ratings Definitions of Long-term Government Debt: Highest Quality ... AAA Very Good Quality ... AA Good Quality ... A Medium Quality ... BBB Lower Medium Quality ... BB Poor Quality ... B Speculative Quality ... C

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Among variations in business mix, the share of large-corporate loans in a bank’s portfolio has the largest implications for its internal rating system. Banks with a substantial large corporate market presence are likely to benefit from a rating system that achieves fine distinctions among relatively low-risk credits, while other banks may find significantly less value in such distinctions. In addition, an independent credit staff is often solely responsible for rating large loans. Such an arrangement can greatly reduce potential incentive conflicts, but may involve per-loan costs that are too large to be economic for smaller loans, which are often rated by relationship managers. Smaller loans also pose less risk to bank earnings and capital, and thus grading errors and biases may be more tolerable.

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MF0007 TREASURY MANAGEMENT

Q.6. Case study: Analyze the case and answer the questions following questions. 1. Why Treasurers resort to early payment discounts? 2. How EIPP program can help to achieve the objective? 3. ‘Managing Working Capital’ is a major challenge to ‘The Treasury Department’. Comment

Working Capital Management: Driving Additional Value within AP Regardless of the economic climate, companies are always seeking new and innovative ways to reduce costs and increase revenues. One approach attracting attention from leading financial executives lately involves maximizing working capital - or extracting more value from short term cash. a their organizations Accounts payable (AP) and procurement professionals oftenlvhelp A realize working capital opportunities by streamlining processesh for paying suppliers and t securing the best supplier discounts and terms. Treasury professionals typically manage ra a h working capital through days payable outstanding (DPO) and by optimizing the use of cash. S y Reaching these goals on a consistent basis, however, can be a daunting task as b y the mbest early payment discounts t companies are forced to strike a balance between capturing i s er .co can now leverage innovative and maximizing the "float" from short-term cash.ivOrganizations l i a n while methods to better utilize their working capital the needs of suppliers, 9> gmbalancing U 0 l 0 procurement, finance and AP and treasury. pa /2 @ 4 i Challenges in Managing Working Capitalan /05 a8 e v manage working capital often struggle Companies striving to improveMtheunwayalthey J m < rath that result in lengthy invoice cycle times, with paper-based, manual invoicing ki processes a k which in turn makes it difficultSito qualifyshfor and capture early payment discounts. Because : o tmuch these companies allocate so time ail and energy to simply processing invoices, they are d e m to strategically identify and work with suppliers. unable to devote the resources needed itt E- treasury, m Multiple groups, including finance, AP and procurement, impact an b u organization's ability S to manage working capital effectively but often work in silos. While each of these groups has its own goal, the entire organization must be aligned to receive maximum working capital efficiencies. Treasury, for example, wants to maximize working capital and optimize the use of cash by managing day’s payable outstanding and capturing negotiated discounts. AP professionals seek to streamline payments, gain processing efficiencies and increase controls and compliance. The procurement department is interested in maintaining good supplier relationships, rationalizing the supply base and negotiating better contract terms. While these goals may be similar, they are not perfectly aligned. A few - such as managing DPO and paying suppliers early to capture discounts- must be carefully balanced if an organization is to make optimal working capital decisions. Many companies are now turning to electronic invoice presentment and payment (EIPP) solutions as a starting point for increasing process efficiencies to drive working capital initiatives, while some are combining EIPP with early payment discounting strategies or new, innovative forms of settlement.

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MF0007 TREASURY MANAGEMENT

Answers:

1. Why Treasurers resort to early payment discounts? Answer: Within the EIPP framework, some companies are using dynamic discounting as an option for managing working capital. Most companies will have negotiated and clearly defined early payment discounts with their top strategic suppliers. However, dynamic discounting refers to the practice of buyers working with suppliers to capture discounts on a sliding scale when no early payment terms exist or when the payment falls out of pre-

a lv A For example, let's say a company has negotiated early hpayment discounts with a at ar supplier. With dynamic discounting, the supplier can offer hpayment discounts that are proS rated between the discount due date (day 10) and the netbydue date (day 30). This means that ity om a pro-rated discount of the buyer can elect to settle on day 20, andersbenefit .from c l v ni 9> mai approximately 1 percent. U l 00 @g pa 5/2 8program, Before implementing a dynamic discounting there are issues that companies 4 i an e/0 lva M n working capital benefits. First, pushing all or a must consider and address to receive optimal m <Ju atha i r early payment discount is not necessarily the large portion of suppliers to some kk form ofhaan Si s to il: best approach to managing dshort-term cash--most companies neither have nor want to employ a e m t it E that much liquidity formsupplier payments. b u Many would S rather negotiate discount terms with a specific number of strategic negotiated terms.

suppliers so they have a set amount of short-term capital working against their AP balance, while assisting their most important vendors with managing cash flow. Secondly, prompting all or a substantial portion of suppliers to offer some form of an early payment discount takes the control of DPO out of the hands of the treasury department because the supplier dictates the date of payment. This loss of control is not acceptable in most organizations.

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2. How EIPP program can help to achieve the objective? Answer: The purpose of this document is to provide an objective, educational tool on Internetbased Electronic Invoice Presentment and Payment (EIPP) in business-to-business transactions. It is intended to help businesses understand the different approaches available, or emerging, in the market today. The authors believe that broader understanding will drive adoption of EIPP. While some larger businesses have used Electronic Data Interchange (EDI) to automate business processes, the costs are prohibitive to many companies. The Internet is emerging as the venue for non-EDI businesses to automate inter-company transactions. a

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a standard tool for companies that regularly bill large numbers by of individual consumers.

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iv l 20 @g pa allows managing working capital. Because EIPP i 5/ 4 companies to process invoices from an e/0 lva8 M n payments on the back end, they no longer have suppliers electronically and handle electronic m <Ju atha i r processing. EIPP also captures full invoice to struggle with manual, paper-based kk payment ha Si s to controlsail:over both non-purchase order (PO) and PO-based details, providing additional d e m itt Espending. m b With the streamlined, accelerated invoice processing enabled by EIPP, companies are Su

n 9> mcompanies maximize options for invoices are processed quickly. When this Uhappens, 0

in a better position to capture the early payment supplier discounts that they have already negotiated with top strategic suppliers. In addition, they can negotiate early payment discounts with a larger population of the supply base--strategically determining which suppliers to target for negotiation. However, they must also balance the objectives of the treasury department for managing to a target DPO with allocating a specific amount of cash to pay suppliers.

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3. ‘Managing Working Capital’ is a major challenge to ‘The Treasury Department’. Comment Answer: Historically, while most treasurers and cash managers have focused on cash flow and liquidity, these are typically the larger financial transactions (high value, low volume) as opposed to commercial payments and collections (high volume, low value). However, treasurers are already well-placed to address working capital. “Treasury is already responsible for the corporation’s largest and most timely payments. The treasurer already has a view over the enterprise’s cash for cash positioning and forecasting, and has a detailed insight into planning and budgeting. a As treasury expands

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ath r a Moreover, the immediately quantifiable gains of working capital optimization are Sh likely to come from process and technology improvements, by but as we have seen already, the y t omforecasting more effectively benefits of achieving visibility over the organization’s rsi cash flow, c e . l v > ai ni 9are and making more strategic decisions – all of which m treasurer’s responsibility, should U 0 gthe l 0 2 pa descriptions. place working capital firmly on treasurers’nijob 5/ 84@ 0 a / a M une alv m J h ki < arat k Si sh : l to ai d e m t it E m b u S

its reach, working capital is a logical area on which to focus.”

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