Financial Decisions and the Treasury Functions - Assignment Example

Financial Decisions and the Treasury Functions Introduction: When a firm reduces its risk exposure with the use of derivatives, it is said to be hedging. Hedging offsets the firm’s risk, such as the risk in a project, by one or more transactions in the financial markets. The Primary objective of hedging is to reduce the price risk of current or potential cash Position, but still hedgers must be concerned with the cost of risk reduction. When a hedger’s sole objective is to reduce the variability of an underlying position, this Objective is consistent with the objective of minimizing risk. However, in reality, many Hedgers also consider the effect of the hedge on the return of the position. The difference in the objectives can be illustrated by considering two different views regarding the motivation to hedge. At one extreme, hedging objectives can be viewed as Varying from pure risk minimization (minimum-variance hedging) to pure profit Maximization (arbitrage or speculative hedging). Under the risk-minimization approach, a hedger’s objective is to minimize risk without any consideration to the return on the Underlying position. On the other hand, under speculative or "basis arbitrage" hedging, one tries to improve return from predicting relative movements in the spot and futures prices. Part A: Explanation of each tool: In hedging, Derivatives are tools for changing the firm’s risk exposure. A derivative is a financial instrument whose payoffs and values is derived from, or depends on, something else. For example, an option is a derivative. The value of a call option depends on the value of the underlying stock on which it is written. Actually call options are quite complicated examples of derivatives. The vast majority of derivatives are simpler than call options. Most derivatives are forward or futures agreements or what are called swaps. There are some tools, which may be used in hedging strategies. They are described below: Hedging with interest rate futures: Interest rate futures can be used to hedge against an existing or future interest rate risk. This is accomplished by maintaining a futures position that will generate profits to cover (or offset) the losses associated with an adverse move in interest rates. It is important to note that a properly constructed futures hedge can also generate losses that will off- set the effects of a beneficial interest rate move. In addition, because futures are quoted in terms of price rather than interest rate, futures exhibit an inverse relationship between rates and price. A borrower would sell futures to protect against an interest rate rise, i. e., to profit from a decrease in the futures price, and a lender would buy futures to hedge against an interest rate decline or capitalize on an increase in the futures price. January F July N Interest Rate Option: An Interest Rate Option (Cap or Floor) enables a user to retain the upside potential of rates moving in their favors, while achieving a known downside. Caps can be used as hedging tools by synthetically exchanging the uncertainty of floating rate based payments for fixed rate payments if rates rise while the user retains any gain if rates fall. The user's exposure is 'capped' Floors can be used as hedging tools by synthetically exchanging the uncertainty of floating rate based payments for fixed rate payments if rates fall, while the user retains any gain if rates rise. The user's exposure has a 'floor'. The buyer of an Interest Rate Option has the right, but not the obligation, to synthetically pay (in the case of a Cap) or receive (in the case of a Floor) a predetermined interest rate (the strike price) over an agreed period. Interest rate swaps: Like other derivatives, swaps are tools that firms can use to easily change their risk exposures and their balance sheets. It is in which one pattern of coupon payments, say, fixed payments, is exchanged for another, say, coupons that float with LIBOR. Numerical illustration of possible alternative strategies that are proposed: Hedging with interest rate futures: Suppose, in late September a corporate treasurer projects that cash flows will require a $1 million bank loan on December 16. The contractual loan rate will be 1% over the three- month Eurodollar (LIBOR) rate on that date. LIBOR is currently at 5.56%. The December Eurodollar futures, which can be used to lock in the forward borrowing rate, are trading at month funds at 5.75%, but have to roll over this funding in three successive quarters. If he does not lock in a funding rate and interest rates rise, the loan could prove to be unprofitable. The three quarterly re- funding dates fall shortly before the next three Eurodollar futures contract expirations in March, June, and September. At the time the loan is made, the price of each contract is 94.12, 93.95, and 93.80, corresponding to yields of 5.88%, 6.05%, and 6.20%, respectively. Coupled with the initial funding rate of 5.75%, the bank could lock in a cost of funds for the year equal to 6.11%.3 The banker knows that the money needed to fund the loan can be locked in for a year at approximately 6.11% in the futures market. This rate can be used as a basis for quoting the fixed rate to the customer. Generally speaking, the rate quoted will cover hedging expenses and allow a profit margin. However, the actual funding over the term of the loan was, on average, one and one- third basis points lower than the futures liquidation rates. Put another way, these basis adjustments positively affected the performance. The minimal difference between the target rate and the effective funding rate can be attributed to the fact that the refunding dates were quite close but not identical to the futures expiration dates. If the respective dates were further apart, the funding rates and the futures rates would not necessarily converge as closely as those used in the above example. This example of a one- year loan funded with three- month deposits illustrates a negative interest rate “gap”– that is, where shorter- term liabilities are funding a longer term Asset and rising interest rates will have an adverse impact. The same basic hedging approach can be followed to remedy an overall balance sheet maturity mismatch. Interest Rate Option: Example - Hedging a GBP floating rate loan Situation: Client A, a UK based engineering company has a Pound Sterling 20 Million (GPB 20M) 2 year floating rate loan, fixing semi-annually. They are using this loan to fund a project and have calculated that their break-even cost will be breached if their interest payments exceed 7.40%. View: Client A is concerned about a rise in GBP interest rates over the period of the project and wants to have a limit on the interest rate they pay if rates increase. Strategy: Client A buys a 6.75% Cap from SCB. If GBP interest rates go above the strike price (6.75%) then SCB pays the difference between the floating interest rate and the strike price to Client A for the interest period. Interest rate swaps: Consider a firm that has borrowed and carried on its books an obligation to repay a 10-year loan for $100 million of principal with a 9-percent coupon rate paid annually ignoring the possibility of calling the loan, the firm expects to have to pay coupons pf $9 million every year for 10 years and a balloon payment of $100 million at the end of the 10 years. Suppose, though, that the firm is uncomfortable with having this large fixed obligation on its books. Perhaps the firm is in a cyclical business where its revenues vary and could, conceivably, fall to a point where it would be difficult to make the debt payment. Suppose, that the firm earns a lot of its revenue from financing the purchase of its products. Typically, for example, a manufacturer might help its customers finance their purchase of its products through a leasing or credit subsidiary. Usually these loans are for relatively short time periods and are financed at some premium over the prevailing short-term rate of interest. This puts the firm in the position of having revenues that move up and down with interest rates while its costs are relatively fixed. This is a classic situation where a swap can be used to offset the risk. When interest rate rises, the firm would have to pay more on the loan, but it would be making more on its product financing. What the firm would really prefer is to have a floating-rate loan rather than a fixed-rate loan. It can use a swap to accomplish this. Of course, the firm could also just go into the capital markets borrow $100 million at a variable interest rate and then use the proceeds to retire its outstanding fixed-rate loan. While this is possible, it is generally quite expensive, requiring underwriting a new loan and the repurchase of the existing loan. The ease of entering into a swap is its inherent advantage. The particular swap would be one that exchanged its fixed obligation for an agreement to pay a floating rate. Every six months it would agree to pay a coupon based on whatever the prevailing interest rate was at the time in exchange for an agreement from a counter party to pay the firm’s fixed coupon. A common reference point for floating-rate commitments is called LIBOR.LIBOR is commonly used as the reference rate for a floating-rate commitment, and, depending on the creditworthiness of the borrower, the rate can vary from LIBOR to LIBOR plus one point or more over LIBOR. If we assume that our firm has a credit rating that requires it to pay LIBOR plus 50 basis points, then in a swap it would be exchanging its fixed 9-percent obligation for the obligation to pay whatever the prevailing LIBOR rate is plus 50 basis points. Figure 25.2 displays how the cash flows on this swap would work. In the figure we have assumed that LIBOR starts at 8% and rises for four years to 11% and then drops to 7%. As the figure illustrates, the firm would owe a coupon of 8.5% × $100 million=$8.5 million in year 1, $9.5 million in year 2, $10.5 million in year 3, and $11.5 million in year 4. The precipitous drop to 7% lowers the annual payments to $7.5 million thereafter. In return, the firm receives the fixed payment of $9 million each year.actually, rather than swapping the full payments, the cash flows would be netted. Since the firm is paying variable and receiving fixed – which it uses to pay its lender-in the first year, for example, the firm owes $8.5 million and is owed by its counterpart, who is paying fixed, $9 million. Hence, net, the firm would receive a payment from the swap of $.5 million, it really only pays out the difference, or $8.5 million .in each year. Then the firm would effectively pay only LIBOR plus 50 basis points. Figure 25.2 fixed-for-floating a swaps: cash flows ($ million) Coupons Year 1 2 3 4 5 6 7 8 9 10 A. Swap Fixed obligation 9 9 9 9 9 9 9 9 9 9 9 Libor floating -8.5 -9.5 -10.5 -11.5 -7.5 -7.5 -7.5 -7.5 -7.5 -7.5 -7.5 B.original loan Fixed obligation -9 -9 -9 -9 -9 -9 -9 -9 -9 -9 109 Net effect -8.5 -9.5 10.5 11.5 7.5 7.5 7.5 7.5 7.5 7.5 -107.5 Critically appraised of each tool: Hedging with interest rate futures: In early December the finance team of IT Technical Departments in the required problem projects that cash flows will require a £35 million bank loan on December 1. The contractual loan rate will be 5.26125% over the three- month Eurodollar (LIBOR) rate on that date. LIBOR is currently at 5.09375%. The December Eurodollar futures, which can be used to lock in the forward borrowing rate, are trading at month funds at 4.75%4, but have to roll over this funding in three successive quarters. If he does not lock in a funding rate and interest rates rise, the loan could prove to be unprofitable. The three quarterly re- funding dates fall shortly before the next three Eurodollar futures contract expirations in March, June, and September. At the time the loan is made, the price of each contract is 94.12, 93.95, and 93.805, corresponding to yields of 5.88%, 6.05%, and 6.20%, respectively6. Coupled with the initial funding rate of 4.75%, the bank could lock in a cost of funds for the year equal to 6.11%.7 The banker knows that the money needed to fund the loan can be locked in for a year at approximately 6.11% in the futures market. This rate can be used as a basis for quoting the fixed rate to the customer. Generally speaking, the rate quoted will cover hedging expenses and allow a profit margin. However, the actual funding over the term of the loan was, on average, one and one- third basis points lower than the futures liquidation rates. Put another way, these basis adjustments positively affected the performance. The minimal difference between the target rate and the effective funding rate can be attributed to the fact that the refunding dates were quite close but not identical to the futures expiration dates. If the respective dates were further apart, the funding rates and the futures rates would not necessarily converge as closely as those used in the above example. Here, a one- year loan funded with three- month deposits illustrates a negative interest rate “gap”– that is, where shorter- term liabilities are funding a longer-term asset and rising interest rates will have an adverse impact. The same basic hedging approach can be followed to remedy an overall balance sheet maturity mismatch. Interest Rate Option: Hedging a GBP floating rate loan Situation: Client IT Technical firm, a UK based engineering company has a Pound Sterling 35 million six months floating rate loan, fixing monthly. They are using this loan to fund a project and have calculated that their break-even cost will be breached if their interest payments exceed 5.60%. 8 View: Client IT Technical firm is concerned about a rise in GBP interest rates over the period of the project and wants to have a limit on the interest rate they pay if rates increase. Strategy: Client IT Technical firm buys a 4.75% 9 Cap from SCB. If GBP interest rates go above the strike price (4.75%) then SCB pays the difference between the floating interest rate and the strike price to Client IT Technical firm for the interest period. Interest rate swaps: The firm of our problem that has borrowed and carried on its books an obligation to repay within six month loan for £35 million of principal with a 5-percent coupon rate paid monthly. Ignoring the possibility of calling the loan, the firm expects to have to pay coupons pf £ 5 million every month for 5 months and a balloon payment of $10 million at the end of the 10 years. Suppose, though, that the firm is uncomfortable with having this large fixed obligation on its books. Perhaps the firm is in a cyclical business where its revenues vary and could, conceivably, fall to a point where it would be difficult to make the debt payment. Suppose, too, that the firm earns a lot of its revenue from selling products.typically, for example, a manufacturer might help its customers finance their purchase of its products through a leasing or credit subsidiary. Usually these loans are for relatively short time periods and are financed at some premium over the prevailing short-term rate of interest. This puts the firm in the position of having revenues that move up and down with interest rates while its costs are relatively fixed. This is a classic situation where a swap can be used to offset the risk. When interest rate rises, the firm would have to pay more on the loan, but it would be making more on its product financing. What the firm would really prefer is to have a floating-rate loan rather than a fixed-rate loan. It can use a swap to accomplish this. Of course, the firm could also just go into the capital markets borrow £35million at a variable interest rate and then use the proceeds to retire its outstanding fixed-rate loan. While this is possible, it is generally quite expensive, requiring underwriting a new loan and the repurchase of the existing loan. The ease of entering into a swap is its inherent advantage. The particular swap would be one that exchanged its fixed obligation for an agreement to pay a floating rate. Every month it would agree to pay a coupon based on whatever the prevailing interest rate was at the time in exchange for an agreement from a counter party to pay the firm’s fixed coupon. A common reference point for floating-rate commitments is called LIBOR.LIBOR is commonly used as the reference rate for a floating-rate commitment, and, depending on the creditworthiness of the borrower, the rate can vary from LIBOR to LIBOR plus one point or more over LIBOR. If we assume that our firm has a credit rating that requires it to pay LIBOR plus 50 basis points, then in a swap it would be exchanging its fixed 9-percent obligation for the obligation to pay whatever the prevailing LIBOR rate is plus 50 basis points. Figure 1 displays how the cash flows on this swap would work. In the figure we have assumed that LIBOR starts at 5.20500% and rises for six months to 5.3262%. Figure 1: fixed-for-floating a swaps: cash flows (£ million) Month 1 2 3 4 5 6 A. Swap Fixed obligation 5 5 5 5 5 5 10 Libor floating -5.20500 -5.22500 -5.26125 -5.28313 -5.30375 -5.3262 -5.3262 B.original loan Fixed obligation -5 -5 -5 -5 -5 -5 -10 Net effect 5.20500 5.22500 5.26125 5.28313 5.30375 5.3262 5.3262 Remark 10 Recommendation: In this problem, finance team of IT Technical departments should use short hedge. An individual or firm that sells a futures contract to reduce risk is instituting a short hedge. Under short hedge, the firm may use any of the above-mentioned tools. But I as a member of finance team recommend using interest option. Because, it helps the firm to avoid the interest rate fluctuating problem. Part B: Evaluation of the outcome of recommendation at 30th March 2007: Hedging a GBP floating rate loan Situation: Client IT Technical firm, a UK based engineering company has a Pound Sterling 35 million six months floating rate loan, fixing monthly. They are using this loan to fund a project and have calculated that their break-even cost will be breached if their interest payments exceed 5.60%. 11 View: Client IT Technical firm is concerned about a rise in GBP interest rates over the period of the project and wants to have a limit on the interest rate they pay if rates increase. Strategy: Client IT Technical firm buys a 4.75% 12 Cap from SCB. If GBP interest rates go above the strike price (4.75%) then SCB pays the difference between the floating interest rate and the strike price to Client IT Technical firm for the interest period. By taking this tool, in this problem the firm is beneficial in some sides. Such as: Gives the buyer known downside with unlimited upside potential Option buyer receives net interest payments from the seller when the option is In-The-Money Up-front premium paid by the buyer Flexible - can be tailored to meet a customer's specific requirements No exchange of principal Off-balance sheet Remark 13 Another tool which may be used: Hedging with interest rate futures may be used in this problem as short hedge strategy tool. If this tool is used, the firm is beneficial as by using it can avoid the problem of interest rate fluctuation risk. It can be used to hedge against an existing or future interest rate risk. This is related with maintaining a futures position that will generate profits to cover (or offset) the losses associated with an adverse move in interest rates. Hedging can ensure that a firm has sufficient internal funds available to take advantage of attractive investment opportunities by reducing unnecessary fluctuations in either investment spending or external financing Hedging can increase a firm’s value by reducing the deadweight costs (probability of default) and increasing the debt capacity. It can reduce the probability and the expected cost of financial distress by reducing the variance of a firm's cash flows or earnings. References: 1. Ross, Stephen A, Randolph W.Westerfield, Jeffrey F.Jaffe. (2003-2004), corporate finance, 6th Ed. McGraw-Hill, Irwin.p.695-725. 2. An Interest Rate Option, (Cap or Floor), Copyright ©2007 Standard Chartered Bank, available at: < http://www.standardchartered.com/global/gmkts/gmkts_iro.html > 3. To get Started CME Interest Rate Product available at: http://www.cme.com/files/I19_How_to_Interest.pdf > 4. Appendix 1 and 2, which are enclosed with the required problem. Read More