Financial Risk Management - Strategy and Performance of the Manager - Assignment Example

Strategy Report

Strategy and Performance of the previous manager

During the first quarter, the orange team portfolio was at 3.32% at the beginning of the period but dropped to 3.10% at the end of the quarter, compared to the benchmark portfolio of 3.85% and 3.64% respectively. During this quarter, the yield curve dropped slightly but picked up and steepened towards the end. The cost of funds at the start of the quarter was below the benchmark but at the end of the quarter, it was much higher. During this quarter, the portfolio consisted of swap movements (14%) and transaction cost (8%) on average. The initial position of each facility consisted of 0.76% cash/future margins, 18.24% commercial paper, Investments (0%), 62.71% domestic bonds, 18.18% Eurobonds and 0.10% swaps. The market value of the portfolio at the end of the quarter outperformed the market value of the quarter by 2,011,978.72 (Orange Team,Quarter 1 performance report). The short term instruments had higher cost of funds than long term instruments, as illustrated by the movement in the rates.

During the first quarter, the orange team portfolio was at 2.81% at the beginning of the period but dropped to 2.62% at the end of the quarter, compared to the benchmark portfolio of 3.85% and 3.57% respectively. During this quarter, the yield curve also dropped slightly but picked up and steepened towards the end. The cost of funds at the start of the quarter was above the benchmark but at the end of the quarter, it dropped to negative. The initial position of each facility consisted of -1.54% cash/future margins, 20.36% commercial paper, Investments (0%), 62.90% domestic bonds, 18.23% Eurobonds and 0.05% swaps. The market value of the portfolio at the end of the quarter underperformed the market value of the quarter by 902,134.40 (Orange Team,Quarter 2 performance report). During the second quarter, the long term instruments had higher cost of funds than the short term instruments, as illustrated by the movement in the rates. Despite the weak business investment reports, the cash rate 50 basis was reduced to 2.5%, but the Fed and ECB kept their rates on hold. The yield curves for the two quarters are as below:

Table 1: Movement in yields of portfolio

Movement in Yields QI

Movement in Yields Q2

Start Of

End Of

Start Of

End Of

Quarter

Quarter

Average

Quarter

Quarter

Average

Cost of funds

Overnight Rate

3.00%

2.50%

2.75%

2.50%

2.50%

2.50%

7%

3 Months

3.00%

2.60%

2.80%

2.60%

3.10%

2.85%

7%

6 Months

2.55%

2.30%

2.43%

2.30%

2.90%

2.60%

7%

9 months

2.75%

2.10%

2.43%

2.10%

2.80%

2.45%

7%

12 months

2.87%

2.37%

2.62%

2.37%

2.97%

2.67%

7%

DB10 (Domestic Bond - 1 yrs)

2.85%

2.10%

2.48%

2.10%

2.90%

2.50%

10%

DB12 (Domestic Bond - 3 yrs)

3.00%

2.50%

2.75%

2.50%

3.00%

2.75%

17%

DB14 (Domestic Bond - 5 yrs)

3.25%

2.75%

3.00%

2.75%

3.25%

3.00%

17%

DB19 (Domestic Bond - 10 yrs)

4.00%

3.75%

3.88%

3.75%

4.00%

3.88%

25%

Figure 1: Graph showing the movement in yields in the most recent two quarters

The graph indicates that the cost of funds throughout the quarter were above the yields, an indication of underperformance of the portfolio. The cost of funds rose up steadily and the difference between the yield and the cost of funds continued to rise. The yield curve for the portfolio was steady but very low compared to the market cost of fund. The movements of the yield curves during the first and second quarters were almost similar.

State of the economy at December 2009

The international economy during the December Quarter is characterised by low consumer spending, low capital expenditure and low bank lending activities. There were significant write downs during the quarter ending September 2009, leaving the banking sector to be in disarray. There are expectations of more write-downs during the December quarter due to slow economic growth. In order to increase lending by banks, the government has set to buy toxic assets of the bank and to nationalise banks for a short period. This strategy by the government will be a recovery condition that will set a pace for the economic growth.

The local economy was characterized by dropping levels in the sectors of mining and construction, increased unemployment levels. However, retail sales fared on well, and the more building permits and approvals were received through the government grant whose main objective was the building of new homes. The low RBA cash rate of 2.5% may also promote employment and more homes will be built in the near future (Economic Overview: December Quater 2009).

Forecast for the QTC yield Curve

Despite the fact that the economy experienced wean investment returns, the RBA maintained the low cash rate of 2.5%. The QTC yield curve is expected to grow in the near future due ro the increased building permits being offered, better financial markets and the less strct montary and governmenr fiscal policies. They have increased participation in the markets in terms of speculations, inspite of the high unemployment rate. The yield curve flattened during the december quarter as a result of the recession, coupled with the bankin crisis that was experienced in the previous quarters.

Desired Positioning of the portfolio and Proposed Portfolio Transactions

The desired portfolio was an increased swaps spread to go with the flat yield curve during the December quarter. Confident businesses opted to increase sales activities and speculate for higher rates of interest during the next quarter. As a result, more businesses paid fixed rates on the inter-estrate swap agreements, thus cutting down on the cost of borrowing before they could experience them (Economic Overview Q1 to Q3,2009).

Forecast for the copper price and the Australian dollar

The drop in copper price during the September quarter indicated a poor worlwide demand, thus low speculationlevels of the copper prices, inspite of the growth in the housing Sector within the US and the growing construction industry within China. This differences ame as a result of the wek demand especially in Europe and Japan. The drop in copper prices during the June quarter was due to the hanged expectations of short-term worldwide recovery and and an insignificant inrease in demand for copper in China.

In the June quarter, it was expected that the copper prices would continue to rise, following the tremendous increase in the prices in 2008, driven by the high demand levels in China and other Asian countries. However, the prices dropped sharply in 2009 as a result of the revision of the prospects for growth in many growing economies. However, the growing wealth in middle class markets was expected to promote demand among the East Asian countries, and keep the demand high upto say, early 2000s. Prior to the financial market crisis and the global recession, the major investments were made and those that were not feasible were eliminated from the markets. This iindicates a future lag on the suply of copper (Economic Overview Q1 to Q3,2009).

FX and Commodity Hedge Transactions

The transaction under consideration is the purchase of earth movement equipment to be delivered on 15th March 2010, at a cost of US3,000,000 in Quarter 2(CMT Course, Quarter 2,2009). The delivery date was however was changed during the third quarter to the 15th of Deember 2009. The central treasury was not required to fund the purchase of the equipment. With the change of the delivery date the central treasury was required to change and revisit the hedging strategy. The following hedge transactions can be used in reducing the exposure to foreign exchange risk(CMT Course, Quarter 3,2009).

• Future Contracts

A future contract is is an exchange transaction with limited contract size, a maturity date and security. They are traded on on an exchange which requires the parties of the contract to post their margins according to their position’s value, as a result, the credit risk is eliminated. In this case, the purchaser is expected to pay the seller an amount of US on the 15th of March 2010 (t). This is a forward contract because both the buyers and sellers have agreed to exchange set amount of money for the equipment, in the future. When the delivery date is changed to 15th December 2009 (t-3 months), the seller will have to change the contract terms to reflect the prevailing rates (t0). The following transactions will be carried out bey the seller:

Time

Transaction

Exchange

Cashflow

8/12/2009 (t0)

Forward sale of earth moving equpment of US3million to t

1US = 1/1.4208 EUR = 0.7038

0

15/03/2010 (t)

Roll over:

Purchase of US3 million

IUS = 1/1.1166 EUR = 0.8956

= (0.7038-0.8956)*3,000,000 = 575,400 US

15/12/2009 (t-3)

forward sale of $3 million to t-3

IUS = 1/1.4365 EUR = 0.6961

= (0.7038-0.6961)*3,000,000 = 23,100

Table 2: Calculation of futures contract

The best option for the seller is execute the forward contract by selling the US3,000,000 to Euros at the spot rate. The projected foreign exchange rate in 2010 is higher and this ias more likely to cause a loss of US575,400 compared to the forward contract where a profit of US23,1000 could be achieved.

• Interest rate swap

The other option is for the seller to borrow US Long term in order to hedge for the cashflows from the purchaser. The coupon rate for the US Eurobond is 2.5% while that of EUR Eurobond is 3%. Because there is a comparative advantage, the seller could benefit from a currency swap, where the seller exchanges US3 Million for EUR3 million during the initiation stage. The seller will ther receive monthly payments of US90,000(3,000,000*3%) for say ten years. During this time the bank will keep the difference as compensation and at the end of the contract, the two parties will return theirprincipal amounts.

Appendix One:Portfolio and Client Cashflow

The cashflows of the client include repayments, Debt service payments and repayments (CTM Course,2009). In this case, the additional contributions made by the client also constitute the standard contribution. The table below indicated the movement of the cash flow balances between quarter one and quarter three.

Quarter

Advances

Term

Additional Repayments

Term

1

100,000,000

8

0

8

2

50,000,000

9

10,000,000

9

3

30,000,000

8

20,000,000

9

Table3: Client Cashflows

The benchmark portfolio of the client changed during the second quarter in order to reflect the change in the proporton of the standard contribution. During the third quarter, the an extra 10,000,000 additional repayments was made towards the standard contribution, thus reducing the payment term. The benchmark portfolio also changed in order to reflect the changed payment duration.

Quarter 1 Cash Flows

Gross

Borrowing rate

Total Cash Flow

Advances

100,000,000

4.19%

100,000,000

Repayments

0

0

Net Cash flow

100,000,000

523,750.00

99,476,250.00

Quarter 2 Cashflow

Advances

50,000,000

4.04%

50,000,000

Additional Repayments

10,000,000

Net Cashflow

40,000,000

224,444.44

39,775,555.56

Quarter 3 Cash Flow

Advances

30,000,000

4.19%

Additional Repayments

20,000,000

Net Cash Flow

10,000,000

1,257,000.00

8,743,000.00

Total advances due

147,994,805.56

Table 4: Client cashflows including the interest rate

The applicable interest rate during the first and the third quarter was 4.19%(Ccentral Treasury management Course,2009). the borrowing rate during the second quarter dropped to 4.04% ( (Central Treasury Management Course,2009)but the repayment perid was high at 9 years.

Appendix Two: Deal slips

Orange

15/12/2009

INITIAL POSITION - QUARTER 3

Benchmark

Actual

Portfolio Market Value

875,090,020

Modified Duration

3.85

3.37

Cash at Bank

0.00%

-1.97%

Facility Class

Proportion

Cash at Bank

17,237,630.86

CP3M/Floating

20.00%

9.71%

Bills (CP3M Only)

0.00%

Portfolio Generated

0.00

DB10

0.00%

17.14%

Domestic Bonds

78.85%

Cashflows

DB12 *

25.00%

34.23%

Eurobonds

21.55%

DB14 *

30.00%

20.75%

DB19 *

25.00%

20.13%

Security

Coupon

Mod Duration

Face Value

Market Value

Face Value

Market Value

FUT3YR

6.00%

2.77

0.00

0.00

0.00

0.00

FUT10YR

6.00%

7.78

0.00

0.00

0.00

0.00

CP3M

0.00%

0.25

0.00

0.00

0.00

0.00

INVCP3M

0.00%

0.25

0.00

0.00

0.00

0.00

CP TOTAL

0.00

0.00

0.00

0.00

DB10

2.85%

0.49

150,000,000.00

149,968,908.50

150,000,000.00

149,968,908.50

DB12

3.00%

2.39

250,000,000.00

250,000,000.00

300,000,000.00

299,583,653.09

DB14

3.25%

4.16

180,000,000.00

180,000,000.00

180,000,000.00

180,000,000.00

DB19

4.00%

7.84

110,000,000.00

110,000,000.00

175,000,000.00

172,170,482.30

DB TOTAL

690,000,000.00

689,968,908.50

805,000,000.00

801,723,043.89

US12

1.25%

2.44

US0.00

0.00

US0.00

0.00

US19

2.50%

8.32

US65,000,000.00

85,407,187.95

US0.00

4,008,999.69

EUR14

2.50%

4.22

EUR55,000,000.00

103,209,748.56

EUR0.00

1,595,606.87

EB TOTAL (AUD)

198,626,373.63

188,616,936.51

0.00

5,604,606.56

CCSUS12 (Fixed)

1.25%

2.43

US0.00

0.00

CCSUS19 (Fixed)

2.50%

8.26

-US65,000,000.00

-81,398,188.26

CCSEUR14 (Fixed)

2.50%

4.21

-EUR55,000,000.00

-101,614,141.69

CCS TOTAL (AUD)

-198,626,373.63

-183,012,329.95

Floating side of all Cross Currency Swaps

0.25

200,000,000.00

200,000,000.00

200,000,000.00

200,000,000.00

IRSDB12 (Fixed)

3.00%

2.39

50,000,000.00

49,583,653.09

IRSDB14 (Fixed)

3.25%

4.15

0.00

0.00

IRSDB19 (Fixed)

4.00%

7.78

65,000,000.00

62,170,482.30

IRS TOTAL

115,000,000.00

111,754,135.39

Floating side of all Interest Rate Swaps

0.25

-115,000,000.00

-115,000,000.00

-115,000,000.00

-115,000,000.00

PORTFOLIO TOTAL

892,327,650.45

892,327,650.45

Table 3: Source (CTM Course,2009)

The table shows a lower portfolio cost of funds compared to the benchmark cost of funds, meaning that the portfolio underperformed. Cash at bank reduced significantly to -1.97% of the total portfolio. The domestic bond constituted the highest percentage at 78.45% while the eurobonds constituted of 21.55% of the total portfolio. Of all the bonds in the portfolio, DB19 had the highest yield of 4% and a market value of 172,170,482.30. total portfolio market value ws 892,327,650.45.

Reference List

Anon., 2009. Economic Overview Q1 to Q3. In: Economic News for Participants in QTC’s CTM Course. s.l.:s.n., pp. 1-3.

Anon., 2009. Economic Overview: December Quater 2009. In: Economic News for Participants in QTC’s CTM Course. s.l.:s.n., pp. 1-3.

Central Treasury management Course, 2009. Borrowing Rates for New Advances: Quater 2. In: Borrowing Rates for New Advances. s.l.:s.n., p. 2.

Central Treasury Management Course, 2009. Borrowing rates for new advances: Quater 1. In: Borrowing rates for new advances. s.l.:s.n., p. 1.

CMT Course, 2009. Change in Notification of Roadwork Equipment Purchase:Quarter 3 - 15/12/2009. In: Central Treasury Management Course. s.l.:s.n., p. 2.

CMT Course, 2009. Notification of Roadwork Equipment Purchase: Quarter 2 - 15/09/2009. In: Central Treasury Management Course. s.l.:s.n., p. 1.

CTM Course, 2009. Ctm portfolio management game. In: Gamebook. s.l.:s.n., pp. 19-21.

CTM Course, n.d. Playing the game. In: ctm portfolio management game. s.l.:s.n., p. 13.

Orange Team, 2009. Orange Performance report Quater 1. In: Portfolio Performance Report for the period ending 14/09/2009. s.l.:s.n., pp. 1-2.

Orange Team, 2009. Orange performance report Quater 2. In: Portfolio Performance Report for the period ending 14/12/2009. s.l.:s.n., pp. 1-2.