E1. The role of the treasury function in multinationals

Question 1

The functions of the treasury.

Answer 1

Treasury management is the corporate handling of all financial matters, the generation of external and internal funds for business, the management of currencies and cash flows, and the complex strategies, policies and procedures of corporate finance. A treasury department is likely to focus on four key areas:
• Risk management
• Liquidity management
• Funding
• Corporate finance

Question 2

The functions of the treasury.

Liquidity management.

Answer 2

The key function of treasury management is the management of short-term funds to ensure that a company has access to the cash that it needs in a cost-efficient manner (ie ensuring that company is not holding unnecessarily high levels of cash, or incurring high costs from needing to organise unforeseen short-term borrowing). The treasury section will monitor the company’s cash balance and decide if it is advantageous to give/take settlement discounts to/from customers/suppliers even if that means the bank account will be overdrawn.

Question 3

The functions of the treasury.

Risk management.

Answer 3

This involves understanding and quantifying the risks faced by a company and deciding whether or not to manage the risk. The treasury section will monitor foreign exchange rates and try to manage the company’s affairs so that it reduces losses due to changes in foreign exchange rates.

Question 4

The functions of the treasury.

Corporate finance.

Answer 4

This is the examination of a company’s investment strategies (such as how investments are appraised, and acquisitions valued). The treasury section will monitor the company’s investment/borrowings to ensure they gain as much interest income as possible and incur as little interest expense as possible.

Question 5

Factors to consider before deciding to protect transaction exposure

Answer 5

• Future exchange rate movement. The future movements in exchange rate may depend on a number of factors including interest rate, inflation, central bank actions and economic growth.
• The cost involved in the hedging, e.g. commission.
• The ability of the company to absorb foreign exchange losses.
• Expertise within the company.
• The company’s attitude towards foreign currency transactions and the importance of overseas trading.

Question 6

The functions of the treasury.

Funding.

Answer 6

This involves deciding on suitable forms of finance (and by implication the level of dividend paid).

Question 7

Treasury organization.

Centralized vs Decentralized.

Answer 7

It is the responsibility of the board of directors to ensure that a treasury department is organized appropriately to meet the organization’s needs. This will involve making decisions about the degree of centralization of the treasury department, and whether it should be organized as a profit or cost centre.

Centralized vs Decentralized.
• Centralised treasury is based at Head Office.
• Decentralised treasury decision making mainly takes place at subsidiary level.

Question 8

Advantages of centralization.

Answer 8

Within centralized treasury department, the treasury department effectively acts as an in-house bank serving the interests of the group.
• Economies of scale. Borrowing required for a number of subsidiaries can be arranged in bulk (meaning lower administration costs and possibly a better loan rate), also combined cash surpluses can be invested in bulk.
• Matching. Cash surpluses in one area can be used to match to the cash needs in another, resulting in an overall saving in finance costs. It is also possible to match receipts and payments in a given currency across all the subsidiaries. The time and cost of currency hedging is therefore minimised.
• Control. Better control through the use of standardised procedures.
• Expertise. Experts can be employed with knowledge of the latest developments in treasury management.
• Netting. Netting of inter-company balances can be applied to save on transaction costs.

Question 9

Cost centre vs profit centre.

Answer 9

• Cost centre. Treasury managers have an incentive only to keep the costs of the department within budget. The cost centre approach implies that the treasury is there to perform a service of a certain standard to other departments in the enterprise.
• Profit centre. Some companies expect to make significant profits from their treasury activities. Divisions are billed for services provided at market rates. Motivational for treasury staff. May expose the company to high levels of risk unless controlled.

Question 10

Exchange and over the counter (OTC) markets.

Answer 10

Secondary markets can be organised as exchanges or (OTC) markets
Exchanges - where buyers and sellers of securities buy and sell securities in one location. Examples of exchanges include:
• the London Stock Exchange and the New York Stock Exchange for the trading of shares
• the Chicago Board of Trade for the trading of commodities
• the London International Financial Futures and Options Exchange (LIFFE) for the trading of derivatives.

Question 11

Over the counter (OTC) markets

Answer 11

Over the counter (OTC) markets - where buyers and sellers transact with each other not through an exchange but by individual negotiation. The prices at which securities are bought over the counter may be the same as the corresponding transactions in an exchange, because the buyers and sellers agree the most competitive price based on constant contact through computers with other market participants.
Securities that are issued in an over the counter market can be negotiable or non-negotiable.
• Negotiable securities can be resold.
• Non-negotiable securities cannot be resold.

Question 12

Tick:

Answer 12

Tick: the smallest movement in exchange rate, which is normally quoted on the futures market to four decimal places. A tick is the minimum price movement permitted by the exchange on which the future contract is traded. Ticks are used to determine the profit or loss on the futures contract. The significance of the tick is that every one tick movement in price has the same money value.
Number of contracts x ticks x tick value
Ticks are used to calculate the value of a change in price to someone with a long or a short position in futures. If someone has a long position, a rise in the price of the future represents a profit, and a fall in price represents a loss. If someone has a short position, a rise in the price of the future represents a loss, and a fall represents a profit.

Question 13

To calculate futures contract price in the future:

Answer 13

• Calculate basis: current market price of a future - the current spot rate
• Calculate the basis for remaining time to expiry (2/6 2 months to expiry for 6-month contract)
• Subtract this amount from future spot rate

Question 14

Margins and marking to market.

Answer 14

When a deal has been made both buyer and seller are required to pay margin to the clearing house. This sum of money must be deposited and maintained in order to provide protection to both parties.

Initial margin. Initial margin is the sum deposited when the contract is first made. This is to protect against any possible losses on the first day of trading. The value of the initial margin depends on the future market, risk of default and volatility of interest rates and exchange rates.

Variation margin. Variation margin is payable or receivable to reflect the day-to-day profits or losses made on the futures contract. If the future price moves adversely a payment must be made to the clearing house, whilst if the future price moves favourably variation margin will be received from the clearing house.

This process of realising profits or loss on a daily basis is known as “marking to market”. This implies that margin account is maintained at the initial margin as any daily profit or loss will be received or paid the following morning. If losses are made that reduce the account below the maintenance margin (the minimum balance) the investor will be required to restore the margin account to its maintenance margin level.
Default in variation margins will result in the closure of the futures contract in order to protect the clearing house from the possibility of the party providing cash to cover accumulating losses.

Question 15

Basis and basis risk.

Answer 15

Basis is the difference between the futures price and the current cash market price of the underlying security. In the case of exchange rates, basis is the difference between the current market price of a future and the current spot rate of the currency. At final settlement date itself, the futures price and the market price of the underlying item ought to be the same otherwise speculators would be able to make an instant profit by trading between the futures market and spot cash market. Most futures positions are closed out before the contract reaches final settlement, hence a difference between the close out future price and the current market price of the underlying item. Basis risk may arise from the fact that the price of the futures contract may not move as expected in relation to the value of the underlying item which is being hedged.
To manage basis risk, it is important that the futures contract chosen is the one with the closest maturity date after the actual transaction.

Question 16

Treasury and portfolio management

Answer 16

A treasury department may be responsible for managing a company’s portfolio of investments. The company will be faced the risk that the value of these assets decreases. One technique for managing risk involves the use of options.

Use of put options.
Put options entitle the holder to sell the shares at a fixed price. Put options result in compensation being received if share prices fall which allows investors to protect themselves against a drop in the share price. When an investor buys an option, they are setting up a long position.

Question 17

Black-Scholes model and greeks

Answer 17

Black-Scholes model. The BSOP model is built around a number of variables, often referred to as the greeks, which each have implications for risk management.

Delta
Gamma 
Theta. 
Vega. 
Rho.

Question 18

Black-Scholes model and greeks

Delta

Answer 18

Delta is N(-d1) for put option and N(d1) for call option. Delta measures how much an option’s value changes as the underlying asset value changes.
Delta = Change in option price / Change in price of underlying security.
For instance, if the delta of put options on shares is -0.5, this means that a $1 fall in share price causes a rise in the value of a put option of $0.5.
A delta value ranges between 0 and +1 for call options, and between 0 and -1 for put options. The actual delta value depends on how far it is in-the-money or out- of-the-money. The absolute value of the delta moves towards 1 (or -1) as the option goes further in-the-money (where the price of the option moves in line as the price of the underlying asset) and shifts towards 0 as the option goes out-of-the-money (where the price of the option is insensitive to changes in the price of an underlying asset).
Delta also defines the hedge ratio, i.e. the number of option contracts required to manage the risks of underlying assets. For example, the number of share options required = number of shares/delta.

Question 19

Black-Scholes model and greeks

Gamma.

Answer 19

Gamma measures how much delta changes with the underlying asset value.
Gamma = Change in the delta value / Change in the price of the underlying security
This indicates by how much the delta hedge needs to be adjusted as the underlying asset value changes. For instance, if gamma is 0.01 this means that for 1% rise in the underlying asset value the delta should change by a factor of 0.01%.
• When the value of gamma is low (ie delta change is small as the asset value changes)
o Delta = 0, Options is deep out-of-the-money. Delta constant as asset price changes i.e. gamma = 0
o Delta = -1 (put) or +1 (call), Options is deep in-the-money. Delta constant as asset price changes i.e. gamma = 0
• When the value of gamma is high (ie delta change is high as the asset value changes). When a long-put option is at-the-money (which occurs when exercise price is the same as the market price the delta is -0.5(+0.5 for put) but also changes rapidly as the asset price changes. Therefore, the highest gamma values are when a call or put option is at-the-money.

Question 20

Black-Scholes model and greeks

Theta.

Answer 20

Theta. Theta measures the change in an option’s price (specifically its time premium) over time.
Theta = Change in the option price (due to changes in value) / Change in time to expiry
An option’s price has two components, its intrinsic value and its time premium. When it expires, an option has not time premium. Thus, the time premium of an option diminishes over time towards zero and theta measures how much value is lost over time, and therefore how much the option holder will lose through retaining their options.

Question 21

Black-Scholes model and greeks

Vega.

Answer 21

Vega. Vega measures the sensitivity of an option’s prices to a change in the implied volatility of the underlying asset.
Vega = Change in the option price/ Change in volatility
For instance, if option has a vega of 0.2, its price will increase by 20 cents for a 1% increase in the volatility of the asset. Long-term options have larger vegas than short-term options. The longer the time period until the option expires, the greater the potential variability of the underlying asset.

Question 22

Black-Scholes model and greeks

Rho.

Answer 22

Rho. Rho measures the sensitivity of option prices to interest rate changes. Am option’s rho is the amount of change in value for a 1% change in the risk-free interest rate.
Rho = Change in the option price / Change in the rate of interest
Generally, the interest rate is the least significant influence on change in price and, in addition, interest rates tend to change slowly and in small amounts. Long-term options have larger rhos than short-term options, because the more time there is until expiration, the greater the effect of a change in interest rates.