Everyone can recognize many of the businesses that operate around them providing goods and services for their needs. But most people are not familiar with what goes on behind the scenes in order for those businesses to function.
When discussing the treasury operations of a company, we are really talking about the ability of a company to pay its bills and to have the funds to support its operations and make the investments in assets necessary to grow the business. The treasurer is the person that has the responsibility to make sure that there is cash available to do the things that the company has planned.
As companies sell products and services, they generate revenue. This revenue is turned into cash. One of the primary roles of the treasurer is to have ready sources available where they can invest this cash short term in order to generate some interest income.
Businesses are not paid interest for cash that just sits in their checking accounts. Say Mike is a treasurer. If he can take this money and generate interest income until that cash is needed to pay bills, he can often add several percentage points of profit to the bottom line of the business.
Concepts and application:
The best practices in treasury operation with respect to cash holdings:
Treasuries are the custodians of cash in a business, they control this through 1) the amount held and 2) its liquidity. The two levers of this are through the sheer size of the balance sheet and the relative stickiness (liquidity) of assets and liabilities held. Their management of this enables the basic fundamentals of an organization: allowing teams to operate and conduct activities by ensuring that there is cash on hand, be it in the petty cash box or an opportunistic M&A raid.
In addition to enabling business-as-usual (BAU) activities, treasuries partake in the macro-financial direction of a company and oversee the execution of company-wide strategies. For example, if the board decides to buy a business or expand into new territories, Treasury will help to determine the fit of the company from a balance sheet perspective and find the cash (or issue stock) to purchase it ultimately.
Funds Transfer Pricing (FTP):
Treasuries are mini-banks for their own companies (or banks) and must price up the liabilities on hand for use in everyday asset-generating activities. The FTP reflects the cost of liabilities and is charged to a business unit when it wishes to originate a new asset. Unlike the widely-known cost of debt figure, which can be represented as a standalone loan or benchmark bond yield, the FTP represents a fully-loaded cost. By that, I mean that it is the overall weighted average cost of all liabilities plus the internally shared costs of the business minus treasury profit.
Trading and hedging:
The responsibilities of hedging company-wide interest rate and FX risk sits with the treasury function, who will use derivatives to balance the books. Depending on the sophistication of the business, these risk management strategies can range up from FX spot trades to long-term interest rate swaps.
Treasury Management Best Practices
1. Structure and Compensation:
Starting right at the top, a business must place its treasury in the correct area of the organization. An effective team must be:
Impartial: Not allied or biased toward any commercial area of the business
Empowered: Both in terms of human and capital resources and flexibility to “roam”
Incentivized: In the absence of being a profit center, team members must have quantifiable goals.
Too many companies fail by having treasuries as operational offshoots of teams like accounting, working out of a back cupboard in the suburbs. Instead, they should report to the CFO directly and be relied upon as lieutenants in the business for their insight into the balance sheet. Similarly, all roles and functions should be contained within the same team. Trying to create a “cloud team” with roles scattered among the company will ultimately result in crossed wires and less effectiveness.
2. Get FTP Right:
Costing up a balance sheet is an arduous task and one that can become difficult if there is a high turnover of items and/or weak IT treasury management systems. Getting it right, though, will ensure that new business activities using the balance sheet are value-additive by ensuring that the mentality of fully-loaded margin is the minds of business units.
3. Communicate Effectively:
As the ears to the financial markets and the straddles of the balance sheet, the treasury management function is an important news source for the company. It should translate macroeconomic events into resultant risks, or conversely, opportunities.
Reporting the cash position of a business is a vital end-of-day reporting task, but it should not stop there. Reporting to the executive committee should be communicated in a concise manner, and not just a dump of mundane reports.
The conclusion:
Treasury Management also important from a performance mind-set to get compensation and incentives right. This comes optically from how the team is created and to literally where they are seated in the office. Treasuries interface externally, and thus must project confidence and the corporate image to external parties.
Because the team is not a profit centre (profits flow to the central company entity), there can be perverse incentives. For example, taking an ultra-high-risk policy of raising long-dated cash and lending it out short term is not a commercially sound practice, outside of severe market stress. But, if the treasury team is not incentivized, they may indeed take this option, because it’s safe and they will get paid regardless. Equally so, because the P&L is just swallowed by the company and performance is not related to it, this can lead to best execution policies going out the door.
Establishing suitable and compelling incentives for treasury staff reduces agency costs. I believe that variable compensation related to FTP movement is an interesting tool for measuring holistic team performance. Too many companies fail by having treasuries as operational offshoots of teams like accounting, working out of a back cupboard in the suburbs.
Question: 2
The introduction:
Foreign exchange:
Foreign Exchange (forex or FX) is the trading of one currency for another. For example, one can swap the U.S. dollar for the euro. Foreign exchange transactions can take place on the foreign exchange market, also known as the Forex Market.
The forex market is the largest, most liquid market in the world, with trillions of dollars changing hands every day. There is no centralized location, rather the forex market is an electronic network of banks, brokers, institutions, and individual traders (mostly trading through brokers or banks).
Key features:
Foreign Exchange (forex or FX) is a global market for exchanging national currencies with one another.
Foreign exchange venues comprise the largest securities market in the world by nominal value, with trillions of dollars changing hands each day.
Foreign exchange trading utilizes currency pairs, priced in terms of one versus the other.
Forwards and futures are another way to participate in the forex market.
The market is open 24 hours a day, five days a week across major financial centres across the globe. This means that you can buy or sell currencies at any time during the day.
The foreign exchange market isn't exactly a one-stop shop. There are a whole variety of different avenues that an investor can go through in order to execute forex trades. You can go through different dealers or through different financial centers which use a host of electronic networks.
A short report on various exposures Sneha would be facing while handling foreign exchange transactions:
Foreign exchange exposure is said to exist for a business or a firm when the value of its future cash flows is dependent on the value of foreign currency / currencies. If a British firm sells products to a US Firm, cash inflow of British firm is exposed to foreign exchange and in a case of the US based firm cash outflow is exposed to foreign exchange. Why we are so sceptical about this exposure? Simple! It is because the exchange rates tend to change or fluctuate.
A firm has transaction exposure/ short-term exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. A firm has economic exposure/ long-term exposure to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firm’s position with regards to its competitors, the firm’s future cash flows, and the firm’s value. A firm’s translation exposure is the extent to which its financial reporting is affected by exchange rate movements.
Foreign Exchange Work:
The market determines the value, also known as an exchange rate, of the majority of currencies. Foreign exchange can be as simple as changing one currency for another at a local bank. It can also involve trading currency on the foreign exchange market. For example, a trader is betting a central bank will ease or tighten monetary policy and that one currency will strengthen versus the other.
Transaction exposure:
The simplest kind of foreign currency exposure which anybody can easily think of is transaction exposure. As the name itself suggests, this exposure pertains to the exposure due to an actual transaction taking place in business involving foreign currency. In a business, all monetary transactions are meant for profits as its end result. There are all the chances of that final objective getting hampered if it is a foreign currency transaction and the currency market moves towards the unfavorable direction.
Translation exposure:
This exposure is also well known as accounting exposure. It is because the exposure is due to the translation of books of accounts into the home currency. Translation activity is carried out on account of reporting the books to the shareholders or legal bodies. It makes sense also as the translated financial statements show the position of the company as on a date in its home currency.
Economic exposure:
The impact and importance of this type of exposure are much higher compared to the other two. Economic exposure directly impacts the value of a firm. That means, the value of the firm is influenced by the foreign exchange.
The value of a firm is the function of operating cash flows and the assets it possesses. The economic exposure can have bearings on assets as well as operating cash flows. Identification and measuring of this exposure is a difficult task. Although, the asset exposure is still measurable and visible in books but the operating exposure has links to various factors such as competitiveness, entry barriers, etc which are quite subjective and interpretation of different experts may be different.
Foreign exchange (Forex or FX) is the conversion of one currency into another at a specific rate known as the foreign exchange rate. The conversion rates for almost all currencies are constantly floating as they are driven by the market forces of supply and demand.
There are some fundamental differences between foreign exchange and other markets. First of all, there are fewer rules, which means investors aren't held to as strict standards or regulations as those in the stock, futures or options markets. That means there are no clearing houses and no central bodies that oversee the forex market.
Many factors can potentially influence the market forces behind foreign exchange rates. The factors include various economic, political, and even psychological conditions. The economic factors include a government’s economic policies, trade balances, inflation, and economic growth outlook.
Political conditions also exert a significant impact on the forex rate, as events such as political instability and political conflicts may negatively affect the strength of a currency. The psychology of forex market participants can also influence exchange rates.
The most traded currencies in the world are the United States dollar, Euro, Japanese yen, British pound, and Australian dollar. The US dollar remains the key currency, accounting for more than 87% of total daily value traded.
Question: 3(a)
Asset liability management:
Asset Liability Management (ALM) can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. Liquidity is an institution’s ability to meet its liabilities either by borrowing or converting assets. Apart from liquidity, a bank may also have a mismatch due to changes in interest rates as banks typically tend to borrow short term (fixed or floating) and lend long term (fixed or floating).
A comprehensive ALM policy framework focuses on bank profitability and long-term viability by targeting the net interest margin (NIM) ratio and Net Economic Value (NEV), subject to balance sheet constraints. Significant among these constraints are maintaining credit quality, meeting liquidity needs and obtaining sufficient capital.
Importance of Asset liability management:
Implementing ALM frameworks can provide benefits for many organizations, as it is important for organizations to fully understand their assets and liabilities. One of the benefits of implementing ALM is that an institution can manage its liabilities strategically to better prepare itself for future uncertainties.
Using ALM frameworks allows an institution to recognize and quantify the risks present on its balance sheet and reduce risks resulting from a mismatch of assets and liabilities. By strategically matching assets and liabilities, financial institutions can achieve greater efficiency and profitability while reducing risk.
The downsides of ALM involve the challenges associated with implementing a proper framework. Due to the immense differences between different organizations, there is no general framework that can apply to all organizations. Therefore, companies would need to design a unique ALM framework to capture specific objectives, risk levels, and regulatory constraints.
Also, ALM is a long-term strategy that involves forward-looking projections and datasets. The information may not be readily accessible to all organizations, and even if available, it must be transformed into quantifiable mathematical measures.
Finally, ALM is a coordinated process that oversees an organization’s entire balance sheet. It involves coordination between many different departments, which can be challenging and time-consuming.
At its core, asset and liability management is a way for financial institutions to address risks resulting from a mismatch of assets and liabilities. Most often, the mismatches are a result of changes to the financial landscape, such as changing interest rates or liquidity requirements.
A full ALM framework focuses on long-term stability and profitability by maintaining liquidity requirements, managing credit quality, and ensuring enough operating capital.
An insightful view of ALM is that it simply combines portfolio management techniques (that is, asset, liability and spread management) into a coordinated process. Thus, the central theme of ALM is the coordinated – and not piecemeal – management of a bank’s entire balance sheet. Although ALM is not a relatively new planning tool, it has evolved from the simple idea of maturity-matching of assets and liabilities across various time horizons into a framework that includes sophisticated concepts such as duration matching, variable rate pricing, and the use of static and dynamic simulation.
Question: 3(b)
ALM Technique:
Asset liability management (ALM) can be defined as the comprehensive and dynamic framework for measuring, monitoring and managing the financial risks associated with changing interest rates, foreign exchange rates and other factors that can affect the organisation’s liquidity. ALM relates to management of structure of balance sheet (liabilities and assets) in such a way that the net earnings from interest is maximised within the overall risk-preference (present and future) of the institutions.
Thus the ALM functions includes the tools adopted to mitigating liquidly risk, management of interest rate risk / market risk and trading risk management. In short, ALM is the sum of the financial risk management of any financial institution.
ALM Technique used in banks:
ALM is Standard Practice:
Liability management is not new, and at one time was just a theory, but it is now standard practice. Banks began to practice strategies of asset liabilities management in the 1960s by offering negotiable certificates of deposit, or CDs. Banks were then able to sell the CDs into the secondary market in order to raise additional capital.
In this sense, liability management goes all the way back to the U.S.'s first secretary of the Treasury, Alexander Hamilton, who had the U.S. assume all the debt from the Revolutionary War and then to resell the debt mainly to U.S. speculators. Promising a good rate on return, Hamilton then used the proceeds from selling shares of the debt to finance the new U.S. government.
Balance Sheet Management:
Balance sheet management is very important in a business sense; that is, without proper management of assets and liabilities, a financial institution would cease to exist. Banks, and other financial institutions, have the added burden regarding the fact that their assets and liabilities are essentially moving targets. That is, if banks have to suddenly pay more to borrow money, which as noted generally involves short-term loans, then their liabilities would increase markedly in comparison to their assets, mainly the outstanding loans on which they are collecting interest from borrowers.
But balance sheet management also has an important regulatory definition. Balance sheet management covers 'regulatory policy for investment securities, Bank-Owned Life Insurance (BOLI), liquidity risk, and interest rate risk for national banks, as well as the assessment of interest rate risk and liquidity risk for the national banking system as a whole,' according to the U.S. Treasury Department, which sets standards and rules for balance sheet management.
ALM is a systematic approach that attempts to provide a degree of protection to the risk arising out of the asset/liability mismatch. ALM consists of a framework to define, measure, monitor, modify and manage liquidity and interest rate risk. It is not always possible for financial institutions to restructure the asset and liability mix directly to manage asset/liability GAPs. Hence, off-balance sheet strategies such as interest rate swaps, options, futures, caps, floors, forward rate agreements, stations, and so on, can be used to create synthetic hedges to manage asset/ liability GAPs. In order to enhance the loss in profitability due to such developments, financial institutions may be forced to deliberately mismatch asset/liability maturities in order to generate higher spreads.