ACCA P4 Advanced Financial Management - 2010 - Study text

Подождите немного. Документ загружается.

Chapter 11: The money markets. The treasury function

There is an active market in Treasury bills. Buyers of Treasury bills can re-sell them

before they mature to other investors or banks. Treasury bills should be risk-free,

because they are promises to pay by the government. A company with a short-term

cash surplus might therefore decide to invest in Treasury bills, which can be re-sold

at any time or held until the bills eventually mature.

2.3 Bills of exchange

A bill of exchange is a form of promise to pay a stated amount of money at a date in

the future (usually in several month’s time). A bill has a drawer and a drawee.

 The bill is issued by the borrower, and is ‘drawn on’ the drawee. When the bill is

drawn, it is a form of ‘You Owe Me’. With the bill the drawer is stating that the

drawee owes a specified amount of money.

 The bill is then ‘accepted’ by the drawee, who signs the bill to indicate

acceptance. An accepted bill becomes an undertaking by the drawee to pay the

specified amount of money at the specified date.

A bill of exchange that is drawn on and accepted by a bank is called a bank bill.

There is an active market in bank bills, especially bills that have been accepted by

banks with high credit ratings. This means that the drawer of a bill is able to obtain

short-term finance by selling the accepted bill in the money markets.

Bank bills might be used as a source of short-term finance by companies in two

ways.

 As a method of financing foreign trade transactions. Trade finance is described

in a later section.

 As a method of raising short-term finance by means of bankers’ acceptances

(BAs), as an alternative to bank borrowing or issuing commercial paper.

Bankers’ acceptances (BAs)

A company that intends to borrow amounts of money for a short-term over a period

of time in the future might arrange a BA programme with a bank. Under the terms

of the agreement, the bank undertakes to accept bills of exchange that are drawn on

it by the company, up to a maximum amount. When the company needs short-term

funding, it draws a bill on the bank. The bank accepts it and then sells it in the

money market on behalf of the company at a discount.

The company therefore receives the money ‘now’. The company must also pay the

bank the face value of the bill when it reaches maturity, to enable the bank to settle

the bill. The bill is therefore a form of short-term finance, and the interest cost is the

difference between the discounted value of the bill when it is sold and the face value

of the bill that must be paid in settlement

An advantage of BAs for a company is that if the programme is arrange with a top-

quality bank, the discount rate (interest rate) on the accepted bills might be fairly

low – lower than on other forms of money market borrowing.

Paper P4: Advanced Financial Management

296 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

Example

A company has arranged a bankers’ acceptances programme with its bank. Under

the terms of the arrangement, which lasts for one year, the company is able to draw

bills on the bank up to a total value in issue at any time of $25 million.

The company might draw a bill on the bank for $1,000,000 with a settlement date in

three months’ time. The bank accepts the bill and sells it for the company in the bills

market. The company might receive, say, $985,222, so that the discount on the bill is

$14,778.

The discount means that the rate of interest for the three months is about:

($14,778/$985,222) × 12/3 = 6.0%

After three months when the bill reaches maturity, the bank pays the bill and the

company pays $1,000,000 to the bank.

2.4 Certificates of deposit (CDs)

A certificate of deposit is a certificate issued by a bank stating that the bank is

holding a specified quantity of money as a term deposit, on which interest is being

earned at a specified rate. The deposit cannot be removed from the bank until the

end of the stated term, but it can be sold in a money market for CDs.

For example, an investor might place a deposit of $20 million with a bank for a fixed

term of six months, and receive interest at 5.5% on the deposit. It might be agreed

that the bank should issue a certificate of deposit that the depositor holds. However,

if the depositor needs access to money before the end of the six months, it can sell

the CD on to another investor or a bank and receive immediate cash.

2.5 Commercial paper (CP)

Large creditworthy companies have several ways of raising short-term finance, and

might select the least-cost financing method. This might be borrowing a money

market rates from a bank, arranging a BA programme or issuing commercial paper.

The cheapest rate of financing might vary according to conditions in each of the

money markets.

Commercial paper (CP) is an unsecured promissory note. A promissory note is a

promise by the issuer of the note to pay a specific amount of money on a specified

date. When a company issues CP it promises to pay the face value of the paper at a

specified date in the future.

Non-financial companies issue CP through a bank, as part of a commercial paper

programme. The bank issues the CP on behalf of the company and sells it to

investors. All CP is negotiable, which means that it can be sold in the money market.

In practice, however, investors buying CP normally hold it to maturity when they

are paid the face value of the paper they have bought.

Chapter 11: The money markets. The treasury function

The company issuing the CP therefore receives immediate cash (at a discount to the

face value of the paper) and makes a payment when the paper reaches maturity.

Only companies with a good credit rating are able to issue CP, and commercial

paper is normally given a credit rating by one or more of the major credit rating

agencies (Moody’s, Standard & Poor’s and Fitch). The interest rate payable on CP

varies with the term to maturity of the paper when it is issued, the credit rating for

the paper and conditions in the market at the time of the issue.

Example

A large company has arranged a commercial paper programme with a bank. The

programme will last for two years. During that time the company may issue CP up

to a total value of $300 million in issue at any time.

Initially, the company might issue $50 million of CP with a maturity date in three

months time. The bank sells the paper to a number of investors, who buy the paper

at a discount and will receive payment o f the full face value after three months.

Investors buying the CP are able to re-sell it if they wish to do so at any time before

maturity, through a bank that deals in the CP market.

The company can issue more CP at any time, up to the specified limit.

Example

A company has arranged a commercial paper programme with a bank. It issues $40

million of paper with a maturity of three months. The interest rate is 6.2%

Required

Calculate the amount of money the company will receive from the CP issue.

Answer

The annual interest rate is 6.2%, so for three months the interest rate is

approximately 6.2% × 3/12 = 1.55%.

Amount received from the issue × 1.0155 = $40 million.

Amount received from the issue = $40 million/1.0155 = $39,389,463.

Interest payable will be $40 million - $39,389,463 = $610,537.

Paper P4: Advanced Financial Management

298 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

The treasury function

 Role of the treasury function

 Cash flow forecasting and cash management

 Financing long-term and short-term investments

 Financial risk management

3 The treasury function

3.1 Role of the treasury function

In many large organisations, there is a treasury function or treasury department.

The role of the treasury department consists mainly of:

 managing the liquidity and cash flows of the organisation

 managing the foreign exchange positions and cash flows

 helping to obtain finance for the organisation

 managing the exposures to financial risk, by hedging currency exposures,

interest rate exposures and other risk exposures.

3.2 Cash flow forecasting and cash management

Cash flow forecasting is an important aspect of treasury management. A company

must have enough cash (or access to borrowing, such as a bank overdraft facility) to

meet its payment obligations. Cash forecasts are therefore made and revised

regularly, to establish whether the organisation expects to have a cash surplus or to

be short of cash.

 If a cash deficit is forecast, measures should be taken to ensure that cash will be

available. It might be necessary to ask a bank for more finance. Some

expenditure might be deferred. Alternatively, measures might be taken to speed

up receipts from customers.

 If a cash surplus is forecast, the treasury department will consider how the

surplus funds should be used. For example, if the surplus is expected to be

temporary, how long will the surplus last and what is the most profitable

method of investing the money (without risk) for that period?

Short-term cash forecasts can be prepared using receipts and payments cash

budgets. Longer-term cash forecasts can be made by preparing an expected cash

flow statement for the forecast period.

Cash management

A centralised treasury department is able to manage the cash position of the group

as a whole. It can manage total cash receipts, total cash payments and total net cash

balances.

Chapter 11: The money markets. The treasury function

One technique for doing this is to pool bank accounts. All the bank accounts

throughout the group for a particular currency might be pooled. At the end of each

day, the balances in each account are transferred to a centralised cash account. (The

cash is ‘pooled’). The cash deficits in some accounts and cash surpluses in other

accounts are therefore netted. In this way, the company can avoid interest charges

on accounts that are in deficit, and transfer cash between accounts as required.

Pooling and netting of cash flows therefore improves cash management. However,

for pooling and netting to be effective, the cash has to be managed by a central

treasury department.

3.3 Financing long-term and short-term investments

A company must be able to finance its planned long-term and short-term

investments (including any proposed takeovers). Preference share capital is rare,

and the options available to companies are therefore as follows:

 For long-term investments, there should be long-term finance. Long-term

finance is either equity or debt. Bank loans might be classified as long-term debt,

provided that it is a fixed loan or a revolving credit facility for several years.

However, bank loans are typically for up to about seven years

 Short-term investments might be defined as working capital assets. Inventory

and receivables should normally be financed by a combination of long-term

finance and short-term liabilities (such as trade payables).

Sources of equity

For many companies, the main source of new equity finance is retained profits.

Profits are retained and reinvested to finance new investments and further growth.

Occasionally, a company might wish to raise extra capital by issuing new shares for

cash. However, it is difficult for a small company to raise new finance in this way if

its shares are not traded on a stock market and it has only a small number of

individual shareholders.

A company whose shares are traded on the stock market might wish to issue new

shares for cash. In some countries (such as the UK), it is a legal requirement for

companies issuing new shares for cash to offer the shares to the existing

shareholders in proportion to their existing shareholding. (The shareholders might

agree to waive this right in certain circumstances and within certain limits).

A company will only be able to issue new shares for cash in this way if it has the

confidence and support of its shareholders and other institutions in the stock

market.

In a takeover bid, the shareholders in the target company might be offered new

shares in the bidding company as the purchase consideration.

In some cases, a company whose shares are not traded on the stock market might be

able to raise new capital by issuing shares, when the new equity finance is provided

by specialist ‘venture capital’ organisations.

Paper P4: Advanced Financial Management

300 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

Sources of debt

For most companies, the main source of debt capital is their bank or banks. Large

companies, however, are able to raise debt capital by issuing bonds in the bond

markets.

Sources of short-term finance

Companies obtain short-term finance mainly from trade credit and bank lending.

Large companies might have access to other sources of short-term borrowing, such

as:

 commercial paper programmes (CP), or

 bankers’ acceptance facilities (BA acceptances).

Trade finance

When the company needs finance to support its foreign trade, the treasury function

might be responsible for arranging the financing.

3.4 Financial risk management

The treasury department is usually responsible for the management of financial

risk. The main financial risks facing companies are:

 foreign exchange risk or currency risk

 interest rate risk

 credit risk

 market risk, where companies hold large quantities of market securities (such as

shares and bonds) as assets. Market risk is the risk of an adverse movement in

the market price of these assets.

Foreign exchange risk and interest rate risk are described in later chapters (although

translation risk and transaction risk have been described in the context of overseas

capital investment, in an earlier chapter.)

Credit risk

Credit risk is the risk that a debt will not be paid and will become a bad debt, or that

a customer will make debt payments later than scheduled. Credit control and credit

risk management are aspects of day-to-day financial management, and you should

already be familiar with credit management and debt collection systems.

Companies that borrow from banks are a credit risk to the bank, and a function of

the treasury department in large companies might be to monitor the perceived

credit risk of the company. Large companies might have a formal credit rating from

one of the credit rating agencies (such as Moody’s and Standard & Poor’s). The cost

of borrowing for these companies depends on their credit rating.

 Banks will charge a higher ‘spread’ over the risk-free rate on loans to companies

with a lower credit rating.

Chapter 11: The money markets. The treasury function

 If a company wants to issue new bonds, the interest payable on the bonds will

depend on the credit rating attached to them.

The treasury management of a company that has debt with a credit rating might

therefore be required to monitor the rating and maintain a dialogue with the credit

rating agencies.

The link between credit ratings spreads over the risk-free rate and the cost of

borrowing has been explained in the earlier chapter on the cost of capital.

Paper P4: Advanced Financial Management

302 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

Risk management methods in banks

 Value at Risk (VaR)

 Scenario analysis

 Stress testing

4 Risk management methods in banks

For your examination, you are expected to have an awareness of the latest

derivative products and risk management techniques. Financial risk management is

at its most sophisticated in the banking industry, with extensive use of risk

management techniques such as Value at Risk (VaR) modelling, scenario analysis

and stress testing.

4.1 Value at Risk (VaR)

Value at Risk models (VaR models) have been developed as a method of monitoring

and managing exposures to risk. They are used mainly in banking and financial

services, and cover risks in their positions on financial derivatives trading as well as

risks on ordinary bank lending. Banks use VaR models for both their credit risk and

market risk.

Market risk is the risk of losses to the bank from adverse movements in market

prices, such as changes in share prices and changes in interest rates and currency

exchange rates. Changes in market prices can affect banks through their direct

holdings of shares, bonds and currencies, but can also result in losses on derivatives

positions.

Value at Risk is a technique for measuring risk as a single number. VaR models

produce a probability distribution for expected losses (or losses and gains), and this

probability distribution can be used to identify the maximum loss that will be

incurred within a given period of time at a given level of probability or confidence

level.

For example, the credit risk VaR model used by a bank might predict that the

maximum loss from bad debts in any one week will be, say, $10 million at the 95%

level of confidence. Similarly the market risk VaR model of a bank might predict

that at the 95% level of probability the maximum loss on the bank’s market

positions in any one day is $500 million.

Confidence levels of 95% or 99% are commonly used, so that Value at Risk can be

defined as a statistical estimate of the level of loss on a portfolio that is expected to

be equalled or exceeded will a specified, small probability.

Chapter 11: The money markets. The treasury function

Using VaR models

VaR models can be used only by organisations whose employees have the expertise

to construct and use reliable models. They were used initially by banks as a means

of obtaining readily-understandable information about their exposures to credit risk

and market risk.

They may also be used by banks under the Basel 2 rules for capital adequacy as a

method of establishing their minimum capital requirements for credit risk and

market risk.

VaR is also used to control risk. For example a bank might set VaR limits. A VaR

limit is the maximum amount of Value at Risk that the bank will accept for a given

period of time, at a given confidence level. For example, a bank might have a policy

that its monthly VaR for credit risk must not exceed $30 million at the 95% level of

probability.

When the VaR model indicates that this level might be exceeded, or has been

exceeded, management can take action to reduce the risk, for example by

purchasing credit protection with credit default swaps or reducing the size of its

loan portfolio.

Similarly, trading limits can be set with reference to market VaR for individual

market traders in banks or for dealing desks. If a dealer or dealing desk exceeds its

VaR limit, it will be required to change its ‘positions’ in the markets so that VaR falls

back within the acceptable limit.

4.2 Scenario analysis

Value at Risk measures risk under a given set of assumptions about what should

normally be expected to occur. They are based on an ‘official’ version of what is

likely to happen in the future, and so what might possibly go wrong.

An additional method of risk analysis is to challenge the ‘official’ view of the future

and measurement of risk by creating alternative circumstances and market

conditions that might happen, and looking at these realistic alternatives in detail.

The technique is therefore to create alternative ‘scenarios’ and assess the risk under

each different scenario. Scenario planning or testing therefore makes management

think in detail about the potential consequences of unexpected circumstances or

events. Contingency plans can then be developed as necessary, to deal with

problems that might arise if one of these scenarios does occur.

4.3 Stress testing

Stress testing is a form of risk analysis that tests what will happen in the event that

extreme conditions occur. For example, a bank might use stress testing to test the

robustness of its market positions or capital adequacy and liquidity in the event of

extreme conditions, such as a 10% or 20% fall in one day in the value of the US

dollar. Stress testing can help management to understand the strength of their risk

management systems, and their ability to function effectively in extreme conditions.

Paper P4: Advanced Financial Management

Finance of international trade

 Problems for companies

 Letters of credit (documentary credits)

 Export factoring

 Forfaiting

 Countertrade

5 Finance of international trade

5.1 Problems for companies

Companies involved in international trade face larger financial problems and risk

than companies that trade in only their domestic markets.

 Either the exporter or the importer, or both, are exposed to currency risk.

Currency risk is described in another chapter.

 An exporter might be required to send goods abroad without knowing whether

the customer will actually pay. If the customer refuses to pay, taking measures to

obtain payment in another country can be time-consuming and difficult. Credit

risk is therefore a major problem.

 Similarly, there can be credit risk for an importer, who is asked to pay for goods

before the shipment has actually arrived (especially when goods are sent by sea).

The risk is that the exporter will take the payment but fail to deliver the goods.

 Exporters often have to allow long periods of credit to their customers. This is

because importers might ask for time to pay after the goods have been delivered,

but delivery might take several weeks. Financing the receivables for export sales

can therefore be difficult, especially for small exporters.

5.2 Letters of credit (documentary credits)

Letters of credit, also called documentary credits, are a procedure for arranging the

shipment of exports and the payment by the importer, that:

 provides protection against credit risk for both the exporter and the importer,

and

 can be used by the exporter to obtain short-term finance.

When an exporter and importer agree to a transaction, the method of payment

might be by letter of credit. Essentially, this system requires the exporter to provide

specific documentation to the importer, giving evidence that the goods have been

shipped as specified (and where appropriate that the goods have been properly

insured and that the exporter has paid the freight charges).

On receipt of the documentary evidence, the importer arranges for payment by bill

of exchange. The bill of exchange is one of the documents provided by the exporter,

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

Подождите немного. Документ загружается.