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Chapter 21 Managing currency risk 605
This inequality signifies the scope for risk-free profit via covered interest arbitrage.
Uncovered arbitrage is where the arbitrageur does not sell forward, but takes a gamble
on how the spot rate changes over the year. In the example, he or she would earn bigger
profits if the spot rate in one year turned out to be lower than This distinction
highlights the difference between hedging and speculation. However, although differ-
ences in agios can persist for a while, transactions costs may preclude profitable arbitrage.
$1.55:£1.
Self-assessment activity 21.5
If interest rates are higher in London than New York by 2.5 per cent p.a. and today’s spot
rate is $1.4455 vs. what would you expect the three-month forward quotation to be if
IRP applied?
(Answer in Appendix A at the back of the book)
£1,
■ The Open Fisher Theory
The ‘Open Fisher’ Theory, sometimes called the ‘International Fisher’ Theory, claims
that the difference between the interest rates offered on identical bonds in different cur-
rencies represents the market’s estimate of the future changes in the exchange rates
over the period of the bond. The theory is particularly important in the case of fixed-
rate bonds having a long life to maturity, say, five to fifteen years’ duration.
Suppose that a firm wishes to raise for a one-year period. It approaches
a bond broker and is offered the following loan alternatives:
1 A loan in GBP at 12 per cent p.a.
2 A USD loan at 5 per cent p.a.
The Open Fisher Theory asserts that the interest rate difference represents the mar-
ket’s ‘best estimate’ of the likely future change in the exchange rates between the cur-
rencies over the next year. In other words, the market expects GBP to depreciate by
around 7 per cent against USD over the next year.
To understand this, recall the relationship between ‘real’ and ‘money’ interest rates
encountered in Chapter 6. The Fisher Effect concerns the relationship between expec-
tations regarding future rates of inflation and domestic interest rates – investors’
expectations about future price level changes will be translated directly into nominal
market interest rates. In other words, rational lenders will expect compensation not
only for waiting for their money, but also for the likely erosion in real purchasing
power. For example, if in the UK, the real rate of interest that balances the demand and
supply for capital is 5 per cent, and people in general expect inflation of 10 per cent
p.a., then the nominal rate of interest will be about 15 per cent (actually 15.5 per cent).
Recall that real and nominal interest rates are connected by the Fisher formula:
where P is the real interest rate, I is the expected general inflation rate and M is the mar-
ket interest rate.
The Open Fisher Theory asserts that all countries will have the same real interest
rate, i.e. in real terms, all securities of a given risk will offer the same yield, although
nominal or market interest rates may differ due to differences in expected inflation
rates. It can be more precisely expressed by amalgamating the PPP and IRP theories:
11 US inflation rate2
11 UK inflation rate2
Spot rate
11 US interest rate2
11 UK interest rate2
Spot rate Forward rate
11 P2
11 I2 11 M2
£50 million
uncovered arbitrage
Interest arbitrage without the
use of the forward market to
lock in future values of
proceeds
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606 Part VI International finance
For example, suppose the London and New York interest rates are 12 per cent and 5
per cent, respectively, as quoted by our bond brokers, and the respective expected rates
of inflation are 10 per cent and 3 per cent. If the spot rate is then the Open Fisher
Theory predicts a depreciation in the pound as expressed by the forward rate thus:
In other words, when the spot rate is this combination of inflation rates and
interest rates is consistent with a forward rate of as calculated earlier.
These economic theories are interlocking or mutually reinforcing, as shown by the
‘equilibrium grid’ in Figure 21.2. Several other factors, such as the timing of the
change, tax and exchange controls can also affect the relative movement of curren-
cies, but the major factor influencing the movements in exchange rates is claimed to
be the expected future movement in inflation rates, which is signalled by current dif-
ferentials in interest rates.
■ The international (Efficient Markets Hypothesis EMH)
The EMH claims that, in an efficient market, all publicly-available information is very
quickly incorporated into the value of any financial instrument. In other words, past
information is of no use in valuation. Any change in value is due to future events,
which are, by definition, unknowable at the present time. Past trends in exchange rates
cannot provide any useful information to assist in predicting future rates.
This theory applies only to information-efficient markets. Currencies operating
within a system of fixed average rates (or maximum permitted bands of fluctuation),
such as the former European exchange rate mechanism (ERM), are operating within
a controlled market, so the EMH will not apply fully. Where markets are information-
efficient, the EMH casts doubt on the ability of treasurers to make profits out of using
exchange rate forecasts.
This section of the chapter has provided a brief sketch of some economic theories rel-
evant to devising a foreign exchange management strategy. We will shortly try to
design such a strategy by applying these theories to the various types of foreign
exchange exposure outlined earlier. But because these theories may not always apply
(and some people think they rarely, if ever, apply), it is helpful to examine approach-
es to forecasting FX rates.
$1.5:£1,
$1.6:£1,
1.05
1.12
1.6 1.5
1.03
1.10
1.6
$1.6:£1,
Inflation
rate
differentials
Open
Fisher
Theory
Expected
change in
exchange
rate
Forward
premium or
discount
Interest
rate
differentials
Purchasing
Power
Parity
Theory
Interest
Rate
Parity
Theory
Expectations
Theory
Fisher
Effect
Figure 21.2
Interlocking theories
in international
economics
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Chapter 21 Managing currency risk 607
21.6 EXCHANGE RATE FORECASTING
First of all, consider why firms may want to forecast future exchange rates. There are
both short-term and long-term reasons for this:
■ To help decide whether to protect outstanding current assets and liabilities from
potential foreign exchange losses.
■ To assist in quoting prices in foreign currency when constructing an international
price list.
■ To aid working capital management, e.g. accurate exchange rate forecasts may assist
the decision regarding the most efficient timing of transmitting currency in situations
where the firm is able to lead and lag payments.
■ To evaluate foreign investment projects requiring exchange rate forecasts over sev-
eral years.
Because FX forecasts are required for both short- and long-term purposes, they may
require continuous revision. In addition, long-term forecasts for investment appraisal
purposes often require more intensive analysis of a range of different scenarios. In gen-
eral, the firm’s FX forecasting needs hinge on:
■ The pattern of its trading and investment activities, i.e. its degree of globalisation.
■ The required frequency of forecast revision.
■ The internal resources and expertise available for forecasting analysis.
■ Approaches to FX forecasting
There are two broad approaches to FX prediction: (a) Fundamental Analysis, which
bases forecasts on the financial and economic theories outlined earlier and (b) Technical
Analysis, which is based on analysis and projection of time series trends.
(a) Fundamental analysis
This approach is sub-divided into two analytical perspectives:
(i) The balance of payments (BOP) perspective
This regards a country’s BOP (more accurately, its balance of payments on current
account) as an indicator of likely pressure on its exchange rate. When a country, say, the
UK, spends more on foreign-produced goods and services than its export earnings, the
resulting deficit on current account increases the probability of depreciation of its cur-
rency. Overseas residents accumulate monetary claims on sterling – when they convert
into their own currencies, this will exert downward pressure on the GBP (and vice
versa for a surplus of exports over imports).
Analysts who focus on the BOP try to evaluate not only the country’s ongoing BOP
performance but also the determinants of international competitiveness, such as
prospects for inflation, e.g. a government budget deficit and how it is financed, and
underlying productivity movements.
(ii) The asset market approach
This examines the willingness of foreign residents to hold claims on the domestic cur-
rency in monetary form. Their willingness depends on relative real interest rates and
on a country’s prospects for economic growth and the profitability of its industry and
commerce. The asset market perspective could explain the continuing strength of the
USD during the ‘Greenspan Boom’ of the 1990s, during which the USA received a mas-
sive inflow of overseas funds seeking a home in the stock markets, helping to offset the
continuing gaping US current account deficit.
Technical Analysis
The intensive scrutiny of
charts of foreign exchange rate
movements attempting to
identify persistent patterns
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608 Part VI International finance
Any factor expected to increase real returns on investment, e.g. technological progress
such as the rise of e-commerce, promising higher corporate profitability is thus likely to
lead to relative exchange rate appreciation (and vice versa).
In practice, it is difficult to disentangle the various fundamental pressures on exchange
rates to identify the true reasons for their movements. Some argue that short-term move-
ments are largely determined by the relative attractiveness of international asset markets,
interest rates and the expectations of market players plus a dose of speculation, while in
the long-term, equilibrium exchange rates depend on PPP.
(b) Technical analysis
Technical analysts conduct intensive scrutiny of charts to identify trends in foreign
exchange rate movements. These chartists focus on both price and volume data to
ascertain whether past trends are likely to persist into the future. The underlying prem-
ise behind Chartism is that future FX rates are based on past rates. Chartists assert that
FX movements can be split into three temporal categories:
(i) day-to-day movements, mainly random ‘noise’
(ii) short-term movements, which extend from a few days to periods lasting several
months
(iii) long-term movements, characterised by persistent upward and/or downward
trends.
The longer the forecasting time horizon, the less accurate the prediction is likely to be.
However, for most firms, a major part of their forecasting needs are short-to-medium term,
so ‘expert’ forecasting may have some role to play. Forecasting for the long-term howev-
er, depends on the economic fundamentals of exchange rate determination, although
some people believe in the existence of long-term waves in currency movements (at least,
when they float!). A major flaw of technical analysis is that it is purely mechanical with
no attempt to provide supporting theory regarding explanation of causation.
Research by Chang and Osler (1999) suggests that technical analysis is largely a waste
of time and money for trades in most currency pairs. They studied the performance of a
particular dealing rule, the so-called ‘head and shoulders’ pattern. This pattern is
formed when a market price forms three peaks, a high one (the head) flanked by two
lower ones (the shoulders). When the price rises through the second neckline, many
technical analysts treat this as a buy signal. During 1973–94, this rule would not have
worked except for JPY–USD and DEM–USD trades, where profits at annualised rates of
19 per cent and 13 per cent would have been made. Possibly, this is because with the
widespread use of these techniques, such patterns often become self-fulfilling prophe-
cies. However, even for these trading pairs, much simpler trading rules, such as buying
when a price was above its recent trading levels, would have generated superior returns.
■ Forecasting in practice
Most leading banks offer FX forecasting services and many MNCs employ in-house
forecasting staff. The value of these activities is open to question, but this really depends
on the motivation for forecasting. A long-term forecast may be needed to underpin an
investment decision in a foreign country. A forecast based on long-term fundamentals
may not need to be perfectly accurate but may help in analysing more fully the risks sur-
rounding the decision and its implementation.
Conversely, short-term forecasts may be needed to hedge debtors or creditors for
settlement in a month or so. In such cases, long-term fundamentals may be less impor-
tant than market-related technical factors, e.g. closing of positions, political factors or
‘sentiment’ in the market. The required degree of accuracy increases as the prospect of
loss is more immediate and less remedial action is possible. In general, long-term fore-
casts are based on economic models reflecting fundamentals, while short-term forecasts
CFAI_C21.QXD 3/15/07 7:47 AM Page 608
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Chapter 21 Managing currency risk 609
A forecasting fiasco
During mid-to-late 1999, after an early flurry, the euro fell sharply from its opening
value of against the USD, reaching It was widely felt that the euro had
been oversold and would recover rapidly during 2000. Table 21.2 shows a selection of
forecasts made by 17 leading banks in November 1999 of the euro’s value twelve
months ahead, i.e. in November 2000.
The actual spot rate on 1 November 2000 was per USD. Similar shortfalls were
recorded against other major currencies. Subsequently, the euro did recover to 0.96 in
early 2000, but slipped back to 0.88 in April that year. The forward market was pre-
dicting in November 1999 a 3 cents appreciation in the euro. These figures remind us
that the ‘experts’ like the FX markets sometimes get things wrong, but warn us that, at
times, all the experts get things badly wrong – and so do the markets.
;0.86
;1.05.;1.17
tend to rely on technical analysis. Chartists often attempt to correlate exchange rate
changes with various other factors regardless of the economic rationale for the co-
movement.
■ FX forecasting and market efficiency
The likelihood of forecasts being consistently useful or profitable depends on whether
the FX markets are efficient. The more efficient the market, the more likely that FX rates
are random walks, with past behaviour having no bearing on future movements. The
less efficient the market, the more likely that forecasters will ‘get lucky’ and stumble on
a key relationship that happens to hold for a while. Yet, if such a relationship really
exists, others will soon discover and exploit it, and the market will regain its efficiency
regarding that item of information.
■ The role of central banks
A key requirement of market efficiency is that all market players are rational wealth
seekers. This is often not the case with a major market participant, the central bank
that tries to raise or lower its currency by buying or selling in the open market, often
in defiance of market trends and sentiment. Evidence exists that at times when central
banks intervene, markets become less efficient and it is possible to make money by bet-
ting against them. This happened most notably on ‘Black Wednesday’ in 1992 when
sterling was evicted from the ERM despite the Bank of England spending billions of
GBP worth of foreign exchange. However, these opportunities are likely to be only
very short-term phenomena.
Table 21.2
Twelve-month forecasts to 1 November 2000
Bank US$ vs. euro
American Express 1.15
Bank of Montreal 1.09
Barclays Bank 1.10
CCF 1.10
Citibank 1.15
Commerzbank 1.18
Dresdner Kleinwort Benson 1.18
Goldman Sachs 1.22
Hanseatic Bank 1.20
CFAI_C21.QXD 3/15/07 7:47 AM Page 609
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610 Part VI International finance
21.7 DEVISING A FOREIGN EXCHANGE MANAGEMENT (FEM) STRATEGY
■ Hedging translation exposure: Balance Sheet items
Total exchange exposure is made up of cash flowing across a national frontier plus the
assets and liabilities of the company that are denominated in a foreign currency.
An international treasurer who does not believe the theories outlined above, might
decide to hedge all foreign currency transactions plus the total net worth of all foreign
subsidiaries. This strategy is over-elaborate and very expensive, but is adopted by
many companies, particularly those dealing in currencies that fluctuate widely in value
over short periods.
Figure 21.3 illustrates a more systematic approach. The basic strategy is to remove
from consideration all items that are self-hedging so far as exchange rate risk is con-
cerned, and to concentrate attention on those cash flows, assets and liabilities that are
subject to exchange rate risk in the short term.
We start with a position where all cash flows, assets and liabilities denominated
in foreign currency values are assumed to be subject to exposure. Let us now try to
eliminate some of these items from the exposure equation. First, we eliminate all
non-monetary assets such as land, buildings and inventory. These should float in
value with internal inflation. The rate of adjustment in value will vary, internationally
traded goods will jump in local value faster than the value of land, but eventually the
Table 21.2 Continued
HSBC Midland 1.20
Lloyds TSB 1.18
NatWest Group 1.16
Royal Bank of Scotland 1.15
Societé Générale 1.08
Warburg Dillon Read 1.14
Mean 1.15
Range 1.22–1.08
Spot rate November 1 1999 1.05
Forward rate (one year) 1.08
Source: Corporate Finance, December 1999
The jury is still out on FX forecasting – it should not be possible to outguess the
market, but sometimes it works: the question is ‘when?’ Meanwhile, some busi-
nesspeople derive comfort from having ‘expert’ forecasts available, possibly as a
focus of blame! The implications for hedging are hazy – if one believes in PPP in the
short-term, then hedging is pointless, but PPP seems only to operate in the longer-
term and with unclear time lags. So, for peace of mind, most firms try to devise a
hedging strategy.
The Economist magazine publishes an annual survey (usually in April) on PPP. This
is based on the global price of a Big Mac (The Big Mac Index), and purports to identify –
in a tongue-in-cheek fashion – cases where PPP does not apply between currencies.
This has recently been extended to cover the worldwide price of Starbucks coffee, to
widen the range of goods examined. Results are broadly similar although, of course, a
more rigorous approach would scrutinise the prices of a standard ‘basket’ of goods, as
in national price indices.
CFAI_C21.QXD 3/15/07 7:47 AM Page 610
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Chapter 21 Managing currency risk 611
Consider hedging cash flows
and fixed interest loans if they
are short-term
DESIGN INFORMATION
SYSTEM TO CONTROL
SHORT TERM CASH FLOWS
Do you believe that
future exchange rates
can be forecast?
Select suitable INTERNAL
FEM hedging devices to
cover exposure
But what
about long-
term loans?
Decide on required
degree of exposure
in each currency
Decision:
minimize
exposure
Hedge net
worth
Hedge the
net monetary
position
No
No
No
Yes
Yes
Yes
What is exposed
to exchange
rate risk?
Do you believe in
the PPP theory?
For the balance
Select suitable EXTERNAL
FEM hedging devices to cover
balance of exposure
Do you believe
in the IRPT?
Figure 21.3
Flow chart demon-
strating a logical
approach towards
devising a foreign
exchange manage-
ment strategy
(based on McRae,
1996)
Self-assessment activity 21.6
Langer plc is worried about a fall in the Australian dollar by 5 per cent, compared to the
present A$2.75 per that might inflict translation losses regarding its A$100 million
assets located in Adelaide. Why should it not worry?
(UK inflation is 2 per cent. Australian inflation is 7 per cent.)
(Answer in Appendix A at the back of the book)
£1,
prices of all of these non-monetary assets will rise to compensate for the fall in value
of the local currency. PPP relates inflation differences to changes in exchange rates.
In time, the asset or liability denominated in the foreign currency will rise in value
sufficiently to compensate for the fall in the foreign currency value. In other words,
the owner of the asset could sell it for more foreign currency units, each command-
ing a lesser value than before. The total in terms of home currency will remain
unchanged.
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612 Part VI International finance
Non-monetary assets are thus self-hedging at least in the long term. If the asset has
to be sold in the short term and the foreign cash exchanged into local currency, the
amount then becomes a part of transaction exposure. A real loss might be involved.
Short-term loans can, for the most part, also be considered self-hedged. The higher
or lower interest rate on the foreign currency loan is a kind of insurance policy against
the future fall or rise of the ‘away’ currency in terms of the ‘home’ currency. A forward
contract could be taken out to cover the risk, but this would be a needless expense
(given that spreads are wider on forward transactions), since the forward rate is an
unbiased predictor of the future spot rate. On average, the forward contracts would
make neither a profit nor a loss.
Long-term loans are more problematic. A fervent believer in the Open Fisher
Theory would claim that the long-term loan, like the short, is also self-hedged. The
interest rate difference is the market’s best guess as to the future changes in the value
of the currency. A lower-rate loan suggests a higher capital sum to repay in the home
currency. A higher-rate loan suggests a smaller capital sum.
If in doubt about monetary assets or liabilities being self-hedging, one solution is to
calculate the ‘net monetary asset position’ in each currency and make sure it is either
in balance or in the ‘right’ direction. In other words, if it is predicted that a currency will
fall in value against GBP, the firm should owe money in that currency. If it is predicted that a
currency will rise in value against GBP, then it should be owed money in that currency. This
might require some juggling with the financing mix of the firm via ‘currency swaps’,
which we discuss later in the chapter.
The key problem in currency risk management is thus to identify the various types of expo-
sure facing the company and then to hedge any unwanted exposure risks. Non-monetary
assets and short-term loans in foreign currency are for the most part self-hedged. The
exchange risk involved in financing with foreign loans and bonds is less clear. With
regard to transaction exposure, a currency information system needs to be designed
and installed to identify estimated short-term cash flow exposure in each currency.
■ Transaction exposure: hedging the cash flows
The first step in identifying and hedging cash flow exposure in foreign currency is to
set up a currency information system. The control of currency is much simplified if this
information system is centralised, but this is not a necessary condition of efficient cur-
rency management.
Once this system is in place, the company must decide whether it (1) believes that
future exchange rates can be forecast, and (2) will permit speculation in currency. If
the answer to either question is ‘no’, then the company must seek to minimise the
exposure position in all currencies. If a profit-maximising strategy is adopted, the
company will use currency forecasts to decide on an optimal position in each foreign
currency. If the company believes that currency forecasting is impossible, or not
profitable, then it has to adopt a risk-minimising policy. The aim will be to reduce
exposure in all currencies to a minimum unless the cost of this policy is prohibitive.
Once the estimated cash flows in each currency have been identified, the next step is to
consolidate the data. The individual flows are netted to arrive at the estimated net balance
in each currency for each future period. Monthly estimates for six months ahead are the
most common requirement, but large companies holding, or trading in, many currencies
may require weekly or even daily reports (especially if speculative positions are opened).
If the company believes that currency forecasting is both possible and profitable, it
must decide, in the light of current currency forecasts, the degree of imbalance desirable
in each currency in which it trades. Even if forecasting is thought to be possible and prof-
itable, the company might decide to prohibit currency speculation as a matter of princi-
ple. Many UK multinationals take this position. In the past, US multinationals have been
currency information
system
An information system set up
to identify values that are
exposed to currency risk, e.g.
cash in- and outflows and
asset and liability values
risk-minimising policy
A foreign exchange policy
designed to eliminate as far as
possible, the firm’s exposure to
currency risk.
CFAI_C21.QXD 3/15/07 7:47 AM Page 612
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Chapter 21 Managing currency risk 613
more willing than similar UK companies to speculate in currency, but research by Belk
and Glaum (1990) suggests that attitudes among UK treasurers may have changed.
The next step is to convert the ‘natural’ exposure position arising from normal trad-
ing into the ‘desired’ exposure position. This is done by using various currency hedg-
ing devices, some of which are internal to the firm and others external. Prindl (1978),
who introduced the distinction between internal and external hedging, also pointed
out that internal hedging is almost invariably cheaper than external hedging. The
international treasurer should first adjust the ‘natural’ exposure position using inter-
nal techniques and use the more expensive external techniques only after the internal
hedging possibilities have been exhausted.
BMW bets on rebound for falling US dollar
FT
German carmaker stops
long-term hedging
BMW, the German luxury car-
maker, has stopped all long-term
hedging of the dollar, seeing an
end to the US currency’s two-
year decline.
The company is one of Europe’s
heaviest users of currency hedg-
ing to protect its revenues from
volatile foreign exchange markets.
But it now believes the US cur-
rency is ‘significantly’ underval-
ued and must bounce back.
The dollar has fallen by 29
per cent against the euro in the
past two years, pricing many
European exporters out of US
markets. As the US currency
approached the $1.30 mark
against the euro earlier this
year, European politicians
clamoured for a cut in interest
rates to make the eurozone
more competitive.
BMW said it believed the
‘correct’ value for the dollar was
$1.10 to the euro compared with
$1.22 – the level it reached in
late trading yesterday.
But the carmaker could be
premature in its belief in a dol-
lar rebound as few strategists
are confident of a dollar bounce
in the near-term, and currency
traders remain concerned about
the twin US deficits.
Bob Sinche, head of currency
strategy at Citigroup, said the
‘panic mentality’ that set in as
the dollar fell last year was
diminishing, but few companies
seemed ready to go completely
unhedged. ‘We have not seen a
lot of discussion [from compa-
nies] about whether the
process of dollar weakening
has come to an end,’ he said.
‘The general notion remains
one of concern about the dollar
on a medium-term basis, and
corporates are using periods of
dollar strength to put on some
hedging.’
Volkswagen, Europe’s
biggest carmaker, increased its
hedging at the end of last year
after the falling dollar knocked
from annual
profits.
Pension funds buying US
assets appear to be reducing
their level of hedging, however.
‘There are indications that
institutional [pension fund]
investors do not seem as keen
to hedge their dollar exposure
as they were in 2003 or even
2002,’ said Michael Metcalfe,
currencies strategist at State
Street Bank.
BMW said it was limiting its
use of derivatives to protect
against the weak dollar to short-
term ‘buying on the dips’.
‘We think that the euro will
go down again,’ said Stefan
Krause, finance director. ‘In such
a period of significant under-val-
uation of the US dollar it is
important to remain consistent
and to have the courage not to
hedge at unattractive currency
rates.’
Hedging the dollar has
become important to BMW
because the US last year passed
Germany as the company’s
largest market. But the strength
of the euro against the dollar is
also a wider issue for the
German economy.
Mr Krause said BMW
remained ‘widely’ hedged this
year, with between two-thirds
and all of the US turnover cov-
ered. He also said the company
had other hedging options, such
as cutting the allocation of vehi-
cles to sell.
The company still has short-
term hedges in place for next
year, but surprised analysts by
saying it had not increased these
beyond the one-third of turnover
already covered.
Source: James Mackintosh and Steve Johnson,
Financial Times, 18 March 2004.
;1.2 bn 1£810 m2
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614 Part VI International finance
21.8 INTERNAL HEDGING TECHNIQUES
Internal hedging techniques exploit characteristics of the company’s trading relation-
ships without recourse to the external currency or money markets. Most are simple in
concept and operation.
Netting applies where the head office and its foreign subsidiaries net off intra-
organisational currency flows at the end of each period, leaving only the balance
exposed to risk and hence in need of hedging. Netting is illustrated in the following
simple example.
A UK-based multinational has a German operating subsidiary. In a particular
month, it transfers components worth to Germany. In the same month,
the subsidiary transfers finished goods worth to the UK. With netting,
the company need only make a net currency transfer of rather than mak-
ing two separate transactions totalling As well as reducing exposure,
netting saves transfer and commission costs, but it requires a two-way flow in the
same currency.
Bilateral netting applies where pairs of companies in the same group net off their
own positions regarding payables and receivables, often without the involvement of
the central treasury. If the previous company also had a Swiss subsidiary, a bilateral
netting arrangement could operate between the German and the Swiss subsidiaries.
Multilateral netting is performed by the central treasury where several subsidiaries
interact with the head office. Subsidiaries are required to notify the treasury of the
intra-organisational flows of receivables and payments. Again, a common currency is
required. To illustrate this, Oilex is a UK-based oil company with an exploration divi-
sion based on Norway, major interests in the USA and chemical plants in the UK. The
group treasury ‘holds the ring’ at the centre of this nexus, as shown in Figure 21.4. All
intra-group transactions are conducted in USD, which is the operating currency of the
oil industry.
Table 21.3 shows transactions expected for one particular month. In total, currency
flows of $41 million would be required with no treasury intervention. By multilateral
netting, the treasury can reduce the exposed flows by $27 million. Such a system pro-
duces greatest benefits when the inter-subsidiary positions are most similar, and where
payments are made directly to the relevant subsidiaries, thus avoiding cash transfers
into and then out of the treasury. In this case, chemicals would transfer $3 million direct
;60 million.
;20 million,
;40 million
;20 million
US Division
Chemicals (UK)
Treasury
Exploration
(Norway)
11
3
410
5 12
2 8
Figure 21.4
Illustration of multilat-
eral netting
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