TREASURY AND  CASH MANAGEMENT ESSENTIALS

Treasury and financing risks

Treasury and financing transactions are subject to a number of risks and consequences that are important for management and Boards to understand.

Many markets have become more difficult and expensive to operate in since the 2008 global financial crisis. Greater risk awareness within organizations means that businesses take long-term views in planning business development. Treasury must therefore ensure that management understands the risks or consequences of treasury transactions.

Getting ahead – The management accountant’s perspective

Banks and financial intermediaries profit from selling specialist derivative products to organizations that are seeking to mitigate a range of different financial risks. An awareness of treasury issues will help management accountants to buy appropriate products, reducing the risk of being mis-sold (or mis-purchasing) overly complicated or inappropriate derivatives for their organizations.

Management accountants who carry out treasury activities should seek some treasury training to gain an appreciation of the possible complexities, risks and issues associated with treasury activities. Such an appreciation should increase a management accountant’s awareness of when to secure specialist treasury advice.


Key treasury and financing risks include interest rate risks, foreign-exchange risks related to transactions, and risks associated with the translation of assets and liabilities denominated in foreign currency that are consolidated into group financial statements.

Interest rate risk

If interest rates rise, borrowers will pay more interest. If they fall, depositors will earn less. However, there are more facets than this to interest rate risk, as described below.

Table 4: The aspects of interest rate risk

The aspects of interest rate risk

Normally, market interest rates that are fixed for longer periods are higher than those fixed for shorter periods (the yield curve).

Figure 8: The yield curve

The yield curve

If an economy slows, the government or central bank may reduce the interest rate to stimulate activity. This means a business may be somewhat protected against economic downturn.

Organizations with a naturally high leverage structure, such as property companies and those financed by private equity, will usually have a high proportion of fixed-rate debt. Generally their revenue streams, such as rental income, are also reasonably fixed. This matching between debt and income reduces their exposure to interest rates.

Borrowers with steady amounts of debt will generally find it cheaper in the long run to adopt a fully floating interest rate approach.

This is mainly because longer-term (fixed) rates include inflation, a liquidity premium and, arguably, a maturity premium. Because many organizations can generally raise prices with moderate inflation, paying a premium by fixing seems wasted expense.

For some organizations, the objective may be to minimize the chance of a financial covenant being breached, making interest cost a secondary issue. This is achieved by managing the fixed/floating ratio of debt. Since bond finance is usually at fixed rates and bank finance is usually at floating rates, it is possible to enter into interest rate swaps to reach the chosen ratio.

Tool: Interest Rate Swaps
Economic foreign-exchange risk, or strategic foreign-exchange risk

Economic foreign-exchange risk is the risk of a change taking place in the value of an organization due to varying exchange rates. It is the aggregate of the present values of all types of foreign-exchange risks. The largest component is sometimes called ‘strategic foreign-exchange’ risk, which arises from any consequential changes in the organization’s competitive position. Factors affecting economic foreign-exchange risk include:

  • The organization’s market position and its ability to control sales and cost prices
  • Markets, such as aerospace, which are effectively denominated in a particular currency (in this ccase USD)
  • Businesses concentrated in particular geographies, as opposed to truly global businesses. (The specifics of an individual organization mean that economic foreign-exchange risk usually differs materially between organizations.)

Economic risk goes to the heart of a business strategy and an organization’s underlying competitiveness. The response to economic risk is therefore based around the business strategy itself, and the risk can rarely if ever be avoided. The risk to the organization needs to be properly measured, considered and responded to with a view to containing or reducing that risk, using means such as facilitating contingency plans for business operations. In principle, the nature of the risk might properly be responded to with instruments designed for the purpose, such as financial options. However, given the very long terms and the large sums involved, costs are usually prohibitive.

Tool: Foreign-exchange options to hedge exchange rate risk
Currency/commodity transaction risk

Pre-transaction risk

Pre-transaction risk arises when an organization has to commit to a price before actually entering into transactions or commercial agreements. It can also occur where volumes to be shipped are uncertain, under call-off contracts or contracts with cancellation or partial cancellation clauses, for example, or when tendering for a construction contract.

This contingent risk is ultimately best managed with a contingent risk-transfer product, such as an option. Alternatively, companies may hedge proportions of the forecast cost or revenue using foreign exchange (FX) forwards (agreements conveying the right to buy or sell FX at a set price at a predetermined time). For example, when the German auto industry cancelled call-off orders early in the recent European financial crisis, it left central European suppliers with outstanding outright currency contracts that were cripplingly expensive to cancel. If options had been in place, they could have been exercised if in the money, or allowed to expire if out of the money. That is why companies commonly use a proportion of options, partially to hedge or transfer such risks.

Options have certain important characteristics:

  • They provide the option buyer (the holder) with the right (but not the obligation) to exercise the option if the price of the underlying asset meets or exceeds a certain price – the ‘strike price’.
  • Once purchased, they provide protection against adverse price movements while allowing the holder to benefit from favorable movements.
  • Purchased options can never be a liability for the holder.
  • There is an up-front cost to buying options (the premium) which can seem expensive.
  • They can be seen as speculative if used for cash flows that are in fact certain.
  • For most organizations, selling options is speculation, as they place a potentially unlimited liability on the seller.

Options can be combined, usually offsetting the cost of a purchased option with the proceeds from selling an option. This reduces the up-front cost in return for a reduced benefit. There is no standardized name convention for such combinations, so such instruments should only be entered into after a thorough evaluation of the possible outcomes for the corporate customer. The potentially unlimited pay out under the sold option may negate the effectiveness of such a hedge.

Foreign-exchange transaction risk

Transaction risk is the risk that changes in FX rates may make committed cash flows in a foreign currency worth less or cost more than expected. Examples of its causes can include sales or purchases made or contracts entered into in a foreign currency.

Like other risks, transaction risk can either be avoided altogether (by buying or selling goods and services only in local currency), or accepted, reduced or transferred. Some exposures can be reduced or avoided by netting against opposite exposures within the organization or another group subsidiary. Others can be transferred to a third party. The relevant external hedge is often a forward contract, usually used in foreign exchange. Another option is a future, usually used for commodity risk, which transfers the risk to the hedge counterparty.

External hedging with forward contracts and futures provides a degree of certainty for periods, depending on the organizational policy, that can extend to several years. While hedging can smooth out some of the market volatility in rates/prices, if there is a permanent and significant change to market rates it only buys time before the impact is felt. In the long run, the organization may still have to adjust its business model by changing its geographic sales patterns or the currency of its input costs. This might even mean relocating its manufacturing location.

Leaving a non-trivial FX exposure un-hedged can itself be seen as speculation. This applies to foreign exchange (FX), as much as commodity risk.

Figure 9: FX risk lifetime

FX risk lifetime

Getting ahead – The management accountant’s perspective

Management accountants should ensure that any hedging product or forward contract considered is fully thought through, particularly in terms of the impact they could have on the organization’s reported profit and loss or balance sheet under relevant reporting regulations (e.g. IFRS [International Financial Reporting Standards] or GAAP [generally accepted accounting principles]). It may be beneficial to bring together treasury expertise and the organization’s auditor to consider the options and the range of possible impacts.


Foreign-exchange transaction risk

Foreign-exchange translation risk results from exchange differences that arise when consolidating foreign currency assets and liabilities into the group financial statements. This is not a cash exposure but an accounting issue, and it is therefore often not hedged by the organization. This is the approach that shareholders generally expect when investing in an international group.

Accounting standards, however, tend to point managers towards ‘net investment hedges’. These are where an organization borrows or enters into a derivative to hedge against movements in the value of the accounting net assets of an overseas entity. However, this hedge of accounting net worth may bear little relation to the economic risks/value in such investments. In fact, the hedge may actually increase risk by introducing a cash flow from the hedge that is not balanced by an offsetting cash flow from the foreign investment.Translation exposure can nevertheless affect credit ratios and cash flow measurements that may be relevant to debt covenants.

  • The measures and ratios that can be affected by movements in exchange rates include:
  • Net worth or enterprise value
  • Gearing
  • NNet debt/EBITDA
  • Interest cover
  • Cash flow (and measures involving cash flow).

The risk of covenant default is often the measure adopted in the management of foreign exchange translation risk. It can be assessed by modelling various ‘what if’ scenarios applied to the business plan.

The response to such a risk is usually to adjust the amount of debt by currency, so that the debt is more evenly balanced against earnings or net worth by currency.

Table 5: The impact of weakening local currency (CCY)

The impact of weakening local currency (CCY)

This example shows the impact of a weakening local currency (‘CCY’) on the ratios listed above for a local holding company which has a subsidiary in the United States. While debt has increased from CCY135 to CCY180, EBITDA and net worth have also both increased.

For simplicity, the example uses a single exchange rate to translate the balance sheet, income statement and equity in each scenario; the exact treatment will depend on the reporting jurisdiction. The point remains however, that changes to ratios are unlikely to be linear or necessarily intuitive.

TOOL
INTEREST RATE SWAPS
 
TOOL
Foreign-exchange options to hedge exchange rate risk
 

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