Financial Decisions and the Treasury Function - Case Study Example

Financial decisions and Treasury Function Part A 1. Introduction The hedging strategy of any firm will involve two positions; one is static and off setting position in a financial contract. In the case of static position, the firm has to call a stock or a portfolio that can give returns in a currency that can appreciate in future. In case of offsetting position in a financial contract, the counter balancing position can be adjusted when market conditions change. In order to hedge the call the firm may need to buy the derivatives of the underlying stock or portfolio. This decides the number of derivatives purchased at time t that depends on the price of the underlying stock and the amount of time remaining until the expiry of the call. To hedge the future receipt of the foreign currency or the increase in interest rate the firm can enter into a forward contract and can be considered as static hedge position. In another attempt the company can buy a derivative on Deutschmarks that can give the right to sell DM for a given price in its own currency and can be considered as still a static position. The next possibility is to simulate a put option dynamically. The position of the second foreign currency to replicate it to hold the amounts of the required currency can be considered as dynamic. These dynamic operations lead the trader to consider value at risk which makes possible to measure the possible future losses to avoid them. In the present context the firm can follow the stop loss strategy. They can purchase the shares as the calls will be in the money. Initially the firm can sell the calls for a certain amount as the share price is less than the call exercise price and the call should be chosen like that. After that the firm can invest the money in the bonds or shares for a certain period known as hedging period. At the end of the hedging period, if the current asset you buy is less than the expected price reinvest them in bonds and if it increases, buy more shares to cover the call. The money borrowed in this case can earn profits more than the interest rate rise as the profits in the contracts are more than the rise of interest. 2. Hedging 2.1 Portfolio appreciation: In this case the hedging is being done to protect from interest rate. This is possible in two ways; one from protecting the assets and other by appreciation of the portfolio. When the company is anticipating the interest rate hike, the loss can be compensated by portfolio appreciation. Considering the interest rate hike as a negative event, the portfolio manager can use the hedging technique to reduce the exposure to the various risks. In this context the hedging is done against the investment risk. This needs the usage of strategic instruments. These can offset the risk of any adverse price movements. In this course of hedging the company need to invest on two securities with negative correlations. As the company is hedging to reduce the impact of interest rate hike, the derivative should be chosen to reduce the risk in the returns. 2.2 Options and futures: In hedging the options and futures can be used. To protect from the interest rate hike the money can be invested in buying a put option, which is a derivative. This gives the right to sell the shares the company have at a specific price or a strike price. The put option is to do away with the probable losses incurred due to interest rate hikes. On the other hand the company can buy a futures contract that allows the company to meet the requirements of liquidity and the losses caused due to interest rate hike. This makes the company to go a head with the proposed introduction of the product that is an outcome of years of research. The cash crunch supposed to be experienced due to the introduction of the new product can be balanced by taking a loan and the risk of interest rate hike can be balance by entering into a futures contract. In case of interest rate hike, the CTC will save money by paying the lower price and in case of not happening that the company can pay the price in the contract which is better off than the absence of hedging. In this course of hedging the cost of hedging also should be considered while the company plans to reduce the interest rate hike. The profit incurred from hedging should be more than the sum of risk due to hike in interest rate and cost of hedging. The company should not ignore the short term fluctuations in the price of the assets involved in the derivative as it is hedging to reduce the risks due to short term interest rate hike. It is better to consider the asset that is not having short term fluctuations. This is not the precaution followed for every hedging, but in this context as the company is hedging to overcome short term interest rate hike, the short term fluctuations should be taken into consideration. As the company is a hardware company it can hedge against the price of the raw materials it require. The company can also use the foreign exchange fluctuations to reduce the risk of interest rate hike. 3. Alternative strategies of Hedging 3.1 Types of hedging: As the company is having interest rate risk and involves investment in derivatives, the risk hedging can be done in three ways. The risk to be hedged here is the interest rate risk. The interest rate risk mentioned by the company can affects the value of bonds more directly than stocks. As the company is taking a loan to meet the cash demands, the major risk is involved. As the interest rates rise the cost of debt will increase and the profitability will decrease. In this case the company cannot invest in bonds as the increase in interest rate will decrease the cost of holding of the bonds. This is because the investors try to get greater yield by switching to other investments. This reflects the risk in high interest rate in purchasing the bonds as a portfolio to reduce the risk regarding interest rate hike. 1The company wants to park the investment in a high return investment. If the company is expecting the rise in interest rates it can take a short position by purchasing treasury futures contract. The company can also use the interest rate swap as they can simply exchange one set of cash flows based on interest rate specifications for another. This is because they are contracts set up between the two or more parties. This makes them to be customised in number of ways. The swaps can be preferred by the firm as it desires a type of interest rate that another firm can provide less expensively. As the company is expecting a interest rate hike, it can use interest rate swaps. 2 3.2 Swaps: The swap makes the company to pay a fixed rate of interest while receiving floating rate payments. The received floating rate payments are used to pay the increased rate of cost of the debt. In this context the company will be left with floating rate debt. This will be therefore managed to convert a variable rate obligation into a fixed rate obligation. This will be made with the addition of derivative. The company is having product input hedge also. The introduction of the company is involving the shortage of short term cash and thus arises necessity loan. The increase of interest rates will affect the prices of raw material inputs also. 3 3.3 Interest rate Swap: The interest rate swap involves the exchange of cash flows. These are between the two parties based on payments of interest. This is based on particular principal amount. The principal amount is not exchanged. The exchange of cash flows will be according to the needs of the company depending on the change of interest rates. The main condition is that the principal amount should be same on both the sides. A fixed payment is frequently exchanged for a floating payment and this will be linked to the interest rate. Usually this will be LIBOR. 3.4. Currency rate swap: This involves the exchange of both the principal and the interest rate in one currency for the same in another currency. Unlike in the case of interest rate swap, the principal is exchanged at market rates and will be usually same for both the inception and maturity of the contract. In these cases the derivatives will help to limit or manage exposures to fluctuations in interest rates. 3.4.1 Forwards: By arranging simultaneous bid and offer money market transactions one can fix the rate of interest today on future borrowings or deposits. For example the company is having a $1m deficit within 3 months. The company can borrow amount today, so fixing borrowing cost. The management can invest sum received today for 3 months period in a forward derivative. The company can favour swaps as it can receive better rate than a foreign firm. The company is located in England. This should select a company located in US which wants to take a loan in pounds and our company should take the loan in dollars. The company can engage a swap in order to take advantage that they have better rates in their respective countries. The privileged accesses they have in their own markets make the companies to combine them to receive interest rate savings. 3.4.2 Futures: Using swaps the company can hedge against interest exposure to reduce the uncertainty of future cash flows. Using the swapping the company can revise the debt conditions to take advantage of current or expected future market conditions. This is for revising the debt conditions. For example today’s Spot Price for wheat is £100 per tonne. Company can buy wheat with the amount available and can enter into a futures contract to sell wheat in three months. The strategy the company should follow. Buy wheat today at spot price. Store for three months. Storage incurs additional cost i.e. Storage, financing, opportunity costs. Additional costs known as cost of carry Futures Price = Spot Price + Cost of Carry = 100 GBP + 10 GBP (per tonne). As maturity approaches so cost of carry will fall. At maturity cost of carry will be zero. As maturity approaches spot and futures price will converge in the following manner. This results in advantages the foreign currency can offer according to the future market conditions. Therefore the currency and interest rate swaps can be considered as the financial tools for hedging the consequences of interest rate uncertainties. In the afore mentioned case the company should use and take the advantage of the global markets. This is possible by efficiently bringing together two parties that have an advantage in different markets. The risk will increase when the other party fails to meet the obligations. This may overweigh the costs of the swaps undertaken by the company. This risk can be minimised by selecting companies of good financial performance. 3.5 Usage of derivatives: The company can use the duration as a gauge to reduce the interest rate risk. This is made possible by setting the duration gap as zero. This is because the interest rate changes will effect both assets and liabilities in the same amount. This decreases or eliminates the sensitivity of the value of the firm to changes in interest rates. When the duration is D and the liabilities is L the weighted average based on the market value is calculated. The change in interest rates will bring the change in net worth E of the company. This will be equal to change in assets from which the change in liabilities is subtracted. 4 Duration is the most commonly used measure to hedge interest rate risk. The important features f the duration will relate the important of it to the management of the company’s liabilities and assets. This is because the duration can measure the sensitivity of an asset. This is usually bond’s price but this may be shares or stocks also to the changes in the market interest rates. As the company mentioned in the case is trying to hedge the interest risk it can have a port folio of shares or stocks instead of bonds as the bonds will help in reducing the risk regarding the decrease in rates. 5 The relationship between the maturity of a fixed income instrument and its duration should be estimated. The instrument should be considered here should be high yielding instrument. In this case duration is till more important as this represents sensitivity and the derivatives need to be taken are short termed. The future contracts provide a means to quickly and easily alter the pay out structure in case of a fixed income instrument. 6 4. Appraisal of Derivatives 4.1 Foreign currency derivative and interest rate swaps: The derivatives existed in foreign currencies are observed to be under development in the form of interest rate products. The regulated derivatives are about anything of value would drop into vast categories. These include securities, other financial instruments and even intangibles. These intangibles stock indexes or inflation measures. While planning derivates to hedge interest rate hike or fall the inflation and foreign exchange rate also should be considered. The assessment of the reverse in logic order will give an estimate about the rise and fall of the returns from the derivatives. The expansion of derivatives into many sectors of economic life needs the tradable credits issued by the government to be controlled. This will be done by consumer price index, index of bankruptcy filings, claims filed by insureds aftera natural disaster, the standard and poor’s 500 stock index and index of crop yields in the considered country. This brings out regulations on the derivatives and investment of derivatives should take into consideration all the above factors. The commercial rental rates, airline fare prices, medical costs etc also should be taken into consideration based on the nature of the derivatives the company invested on. In case of interest rate the inflation rate, unemployment growth rate, consumer price index, index of bankruptcy filings, claims filed by insureds after natural disaster should be taken into consideration and should be invested. It is evident from the derivatives that the trading on the commodity gives value to it. This is due to the fact that the derivatives cannot be hobbled by the need to transfer property. The evidence of ownership and payment of price changes also will not matter in case of foreign exchange derivatives. When the above mentioned risks are over come, the derivatives can be readily created. The reason for the growth of the derivatives is the value rising for the credit risk. 7 Use can exchange a stream of floating rate based on interest payment for fixed rate payments. This will be useful for hedging the risk regarding the interest rate hike in the short term. This can be used as a hedging tool. This is done by exchanging the uncertainty of floating rate based payments and receipts. This is in return for the certainty of fixed payments. This can be done for better matching the amounts and timing of cash flows. As the company is planning the hedging of interest rate hike, it can hedge the interest rate hike by investing the part of the amount taken to meet the required cash flows in the short term period due to introduction of the new product. The derivates should be short term to meet the requirement of the company as it is hedging the short term risk. The interest rate swap will exchange a stream of fixed interest payment over multiple specified interest periods. In this case the payments and the receipts will be in same currency and the exchange rate difference will not show any effect on transactions. The principal is not exchanged and it will be risk free up to some extent. As the interest transactions between the parties are netted, the returns are after paying the costs for the transactions. As this is flexible, the company can select the products meeting its requirements. As this involves the conversion of a floating rate into a fixed rate loan, the company can be without loss in adverse consequences if the risk hedging is not possible. The important advantage in this is to convert a fixed rate asset into a floating rate asset and vice versa. The company is having 25 million GBP and it can invest 5 million GBP to hedge the interest rate risk. I t can take a loan of 20 million GBP and the remaining amount in the form of yen as the rate of interest is less in Japan. The company can invest the yen equal to 5 million GBP in the shares that can increase in the short term period. Care should be taken to guarantee the cost of funding. The loan taken in the form of Yen should guarantee the cost of the funding. The company can pay for the loan in Yen at fixed rate and the loan of 20 million GBP can be taken on the basis of floating rate. The company can invest the loan amount taken in the form of yen to receive the payments in GBP. This will be useful when the stocks or shares the company invested will give returns more than the cost of investing and the interest rate hike. 8 4.2 Currency Swap: The currency swap will enable the company to get the cash flows in different currencies. This is similar to the Yen carry trade mentioned in the above section. As the currency swap involves the exchange of principal along with the return, the returns are netted. Currency swaps are quoted both for fixed floating and floating- floating structures. In general the currency swaps involve the floating-floating structures as all the currencies are prone to observe the changes in exchange rate. These swaps can be used by company to exploit the inefficiencies in international debt markets. The company unlike the method mentioned in the above subsection can take a loan of GBP and can swap it for another currency that can increase against the GBP in the short term considerations. 9 Situation of Pound: As per the currency swap is considered in hedging the pound can take a loan in the form of On 2nd January 2007 the Lombard street research showed that the house prices in UK are over valued. This resulted in interest rates and affordability has fallen to 3 percent in the last nine months. This resulted in the rise of interest rates up to 6.25 percent in an effort to slow inflation. 5. Recommendations The company can enter into a currency swap derivative as there is every chance for JPY and Euro to appreciate against in 2007. To exploit this situation the company can prefer the currency swap instead of interest rate swap. This is suggested because interest rate swap will take into consideration only the interest rate rise and falls but the currency swap will involve the advantages of the appreciations of the other currencies against the GBP. According to the observations for JPY and Euro it is suggested to invest in derivatives to purchase Euro or for a currency swap between GBP and Euro instead of Yen. If the company want to hedge using Yen also, it can take loan in the form of Yen and it can invest it to get returns in GBP to benefit from the lower interest rates in Japan which are expected to be decrease in the near future. Part B Situation: The Recommendation is implemented The action: The company purchased the derivatives to get returns in Euro taking a loan in the from of Yen from bank of Japan. The company entered into a future contract for the purchase of Euro for the present day January 2nd price. 1. Evaluation After 1st January 2007 it was observed that due to accelerating inflation and economic growth, the Bank of England raised the borrowing costs and the expectation of the company came true about the hike in the interest rate in the near future. As the retail sales rose in the previous month of the month the company took loan this bolstered the demand for UK currency. As a result the pound gain and it may stoke the inflation and push up the wages. Actually this is a bad news for the company which decided to invest the GBP loan for the returns in JPY or Euro. The appreciation of UK currency will result in the decrease of returns from the derivatives regarding currency swap. This did not happen. This is because, the Euro strengthened more than the UK currency and this gave the company a profit on the derivatives invested on Euro. The European central bank also increased the interest rates higher than the Bank of England and this resulted in increase of Euro more than the UK currency. The Euro rose approximately 11 percent against the UK currency and this profit for the company successfully hedged the increase of interest rate lesser than 2 percent by Bank of England. In the second case the company implemented the decision of taking loan in the form of Yen from Japanese banks and investing in the shares to get returns in GBP. This also successfully hedged the interest rate risk for GBP as Bank of Japan decreased the interest rates. The Yen has weakened against dollar and GBP and this makes the company to pay the loan easily from the returns it got in the form of GBP from the investment in shares. In the first implementation, there is no risk of decrease of price of shares purchased by the company. In the second implementation there is a risk of decrease of the price of the shares, and neutralisation of profits attained by less interest rate of Yen. According to Axia Fx Euro has been most consistent currency over the last trading days till the first week of June. The LIBOR rate increased by 1 percent and reached 6.2 percent from 5.3 percent in January. Though Euro has appreciated against the UK Pound, the appreciation is not that much to hedge the risk of rise in interest rate. So to efficiently hedge the interest rate rise risk, the company invested in Carry trade of Yen. As the interest in Japan bank is far less than that of England, the company took a loan from Japan bank in the form of Yen and invested in the shares and currency purchase activities. If the shares increase their price, the company can effectively hedge the interest rate risk. It is clear that the GBP is appreciating against Yen and the returns in GBP for the investment in Yen can give enough cash flows after the cost of investment to meet the rise of cost of debt due to rise in interest rate. According to the market oracle, the value of GBP, euro and Yen are as follows. GBP = 1.48 EUR 1.00 GBP = 240.28 JPY The value of GBP in January is less than the value of it against in June. By buying the Euro at the price of January in June will give a profit to the company by converting them into GBP. This can hedge the risk caused to the rise of interest rate from 5.2 to 6.1. The company invested on Euro as the GBP Euro rate is 1.4854 on 2nd January and was set to increase in the short term period. In case of JPY the rate of exchange of GBP JPY is 233.74 and is set to increase. The company took a loan of 5 million GBP valued yen from Bank of Japan. It invested in shares giving the principal and returns in GBP as it is expected that the yen will depreciate and the interest rate in Japan may increase. The company bought a derivative for the exchange with the available GBP to get the returns in Euro on a future date expecting the Euro to appreciate against GBP. Both the Euro and Yen appreciated against GBP and by buying them at the rate of January the company will be in a position to hedge the rise of interest rate risk. The recommendations used to hedge the company’s risk were in 3 models. In the first tool the company got a loan in the form of Yen and invested in the shares to get returns in GBP. As the interest rate for Yen is lesser than GBP, the company has got an amount at lower interest rate and was able to reduce the cost of debt. The appreciation of the share value purchased and converting them into GBP after clearing the loan gave company enough amount to hedge the interest rate risk. In the second tool the company entered into a future contract to buy euro at the price of January. As the price of Euro has appreciated slightly, this deal also gave enough profit to hedge the interest rate rise. In the third tool used, the company entered into a future contract for Yen at the price of January. As the Yen appreciated from 233 for 1GBP to 244 the appreciation of the Yen resulted in the enough profit for the company to hedge the risk of interest rate hike. 2. Choosing another tool with Hind sight The Company choose to invest in a portfolio for the purpose of hedging. The need of choosing a investing tool other than that of implemented in the previous section is not necessary. The reasons can be broadly classified in to two; 1. the lack of investment, 2. the accuracy of the tool and forecasting. When the forecasting and the selecting of the portfolio is not accurate there is a need to invest in another tool. This investment is not for increasing the portfolio but to hedge the interest rate. This makes the company to have limited cash available to invest in different tools. This compels to invest accurately and safely. The situation like hedging the interest rate hike cannot support the additional investment in alternative tool to hedge the loss. References: 1. Investopedia Staff, 2003, A beginners guide to hedging, investopedia.com, ,electronic, 17-8-07, http://www.investopedia.com/articles/basics/03/080103.asp 2. http://finance.wharton.upenn.edu/~benninga/mma/MiER71.pdf 3. investopedia staff, 2007, interest rate risk, investopedia.com, ,electronic, 17-8-07, http://www.investopedia.com/terms/i/interestraterisk.asp 4. investopedia staff, 2007, interest rate risk, investopedia.com, ,electronic, 17-8-07, http://www.investopedia.com/terms/i/interestrateswap.asp 5. D,avid Harper 2005, Corporate Use Of Derivatives For Hedging, investopedia.com, ,electronic, 17-8-07, http://www.investopedia.com/articles/stocks/04/122204.asp6. 6. Bernrud, Erik. Derivatives and Risk Management. Chicago, IL, USA: Dearborn Trade, A Kaplan Professional Company, 2005. p 863. http://site.ebrary.com/lib/nulibraries/Doc?id=10155082&ppg=896 7. Standard Chartered, 2007, Interest rate swap, Standard Chartered, ,electronic, 18-8-07, http://www.standardchartered.com/global/gmkts/gmkts_irs.html 8. risk glossary, 2007, vanilla currency swap, riskglossary.com, ,electronic, 18-9-07, http://www.currencytoday.co.uk/euro-pounds-02012007.htm 9. currency today, 2007, currency advice with currency today, currencytoday, ,electronic, 18-8-07, http://www.currencytoday.co.uk/euro-pounds-02012007.htm 10. Axia Fx staff, 2007, market report, Axia Fx, ,electronic, 18-8-07, http://www.axiafx.com/marketinfo/market_information34.asp Read More