Chapter 12 - Financial Markets And The Treasury Function

Question 1

Secondary markets

Answer 1

1. Allow holders of financial claims (surplus units) to realise their investments before the maturity date by selling them to other investors.
2. Should also reduce the price volatility of securities as ‘second hand’ securities ensure smoother price changes which encourages investors to supply funds.
3. Secondary markets help investors achieve the following ends,

• Diversification
  Spreads the risk by giving the opportunity to invest in a wide range of enterprises.
• Risk shifting
  Deficit units issue various types of security on the financial markets to give investors a choice of the degree of risk they take. For e.g. Company loan stocks secured on the assets of the business offer low risk whereas equities carry much higher risk with corresponding higher returns.
• Hedging
  Financial markets give the opportunity to reduce risk through hedging e.g. A UK exporter is awaiting payment from a French customer, he is subject to risk that the Euro may decline in value over the credit period. He could hedge this by entering a counterbalancing contract and arrange to sell the Euros forward and use the foreign exchange market insures his future sterling receipt.
• Arbitrage
  The process of buying a security at a low price in one market and simultaneously selling in another market at a higher price to make a profit.

Well developed secondary markets are required to fulfil the above roles for lenders and borrowers. Without this, more surplus units would be tempted to keep their funds ‘under the bed’ rather than putting them at the disposal of deficit units.

Question 2

Eurobonds

Answer 2

Bonds denominated in a currency other than that of the national currency of the issuing company.

Question 3

The role of financial institutions

Answer 3

1. Lenders and borrowers contact each other directly.
   Rare due to high costs involved, the risks of default and the inherent inefficiencies of this approach.
2. Lenders and borrowers use an organised financial market.
   e. g. An individual may purchase corporate bonds from a recognised bond market. If this is a new issue of bonds by a company looking to raise funds, then the individual has effectively lent money to the company.

If the individual wishes to recover their funds before the redemption date, then they can sell the bond to another investor.

3. Lenders and borrowers use financial institutions as intermediaries.
   The lender obtains an asset which cannot usually be traded but only returned to the intermediary such as a bank deposit account, pension fund rights etc.

The borrower will have a loan provided by an intermediary.

Question 4

Intermediaries

Answer 4

Refers to the process where potential borrowers are bought together with potential lenders by a third party, the intermediary.

1. Risk reduction
   By lending to a wide variety of individuals and businesses, financial intermediaries reduce the risk of a single default resulting in total loss of assets.
2. Aggregation
   By pooling many small deposits, financial intermediaries are able to make much larger advances than would be possible for most individuals.
3. Maturity transformation
   Most borrowers wish to borrow in the long term whilst most savers are unwilling to lock up their money for the long term. Financial intermediaries are able to satisfy both the needs of lenders and borrowers.
4. Financial intermediation
   Financial intermediaries bring together lenders and borrowers through a process known as financial intermediation.

Question 5

Cash generators and cash consumers

Answer 5

Cash generators - Look to lay off cash on short term markets or return surplus funds to investors via a dividend.

Cash consumers - Look to borrow short term.

Question 6

The role of the treasury function

Answer 6

1. Short term management of resources.
   - Short term cash management (lending/ borrowing funds as required).
   - Currency management.
2. Long term maximisation of shareholder wealth.
   - Raising long term finance e.g. Equity strategy, management of debt capacity and debt and equity structure.
   - Investment decisions e.g. Investment appraisal, the review of acquisitions and divestments and defence from takeover.
   - Dividend policy.
3. Risk exposure.
   - Assessing risk exposure.
   - Interest rate risk management.
   - Hedging of foreign exchange risk.

Question 7

The centralisation of treasury activities

Answer 7

1. If centralised, each operating company holds only the minimum cash balance required for day to day operations, remitting the surplus to the centre for overall management.
2. If decentralised, each operating company must appoint an officer responsible for that company’s own treasury operations.

Question 8

Advantages of centralisation

Answer 8

1. No need for treasury skills to be duplicated throughout the group.
2. Necessary borrowings can be arranged in bulk, at keener interest rate than for smaller amounts. Similarly, bulk deposits of surplus funds will attract higher rates of interest than smaller amounts.
3. The group’s foreign currency risk can be managed more effectively. A total hedging policy is more efficiently carried out by head office rather than each company doing their own hedging.
4. One company does not borrow at high rates while another has idle cash.
5. Bank charges should be lower since balances and overdraft in the same currency should be eliminated.
6. A centralised treasury can be run as a profit centre.
7. Transfer prices can be established to minimise the overall group tax bill.
8. Funds can be quickly returned to companies requiring cash via direct transfer.

Question 9

Advantages of decentralisation

Answer 9

1. Greater autonomy leads to greater motivation. Individual companies will manage their cash balances more attentively if they are responsible for them rather than simply remitting them up to head office.
2. Local operating units should have a better feel for local conditions than head office and can respond more quickly to local developments.

Question 10

Primary markets

Answer 10

1. Primary markets provide a focal point for borrowers and lenders to meet.
2. The focus should ensure that funds find their way to their most productive usage.
3. Deal in new issues of loanable funds and raise finance for the deficit units.