Treasury Management

Nachiket Mor December 22, 2001

In many Indian corporations, the Treasury is largely viewed as a finance and accounting function with little or no strategic role

Traditional Role of Corporate Treasury

z

Liquidity Management
z

Working Capital and Capital Expenditure z Cash Flow Management

z

Monitor Borrowing Cost

z

Borrow at finer rates at appropriate time z Keep gearing within reasonable levels z Ensure Solvency of the corporate

CFO - Traditional Perspective

CFO
Financial Policy Making Corporate Planning Treasurer
Banking Relationships Cash Management Obtaining financing Credit management Dividend disbursement Insurance

Controller
Accounting Preparing financial statements Internal auditing Payroll Preparing budgets Taxes

Paradigm shift in focus

The past environment

z z z z z

India had a highly regulated financial sector regime till 1991 which virtually eliminated financial price risk Borrowing and lending rates were prescribed, guaranteeing spreads Regulated capital markets did not provide any incentive for innovation in resource raising Controlled foreign exchange regime ensured rationing of overseas resources as per Government policies License-permit raj ensured that the most sought after skill was that of obtaining license and not business acumen

The changed environment

z z z

z z

Lending and borrowing rates are freed Access to capital markets made easier for corporates The government has liberalized the ECB policy and a large number of corporates have accessed the international capital markets, for equity and debt Indian market is less immune to external shocks compared to a decade back Thin markets exaggerate the impact of shocks
z z

volatility higher than in developed markets considerable amount of jump risk

Decreasing effectiveness of policy intervention in smoothing out volatility

Changing role of a CFO

z z

CFOs role not limited to investing and financing CFOs role has expanded to include
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Risk management
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Foreign Exchange, Interest rate, Commodity and Liquidity risk

Financial Engineering - a new technical speciality that can help CFOs achieve
z z

Their companies strategic objectives Funding at cheaper costs using innovative structures

z z

Outsource the traditional or non-core activities Develop an IT strategy for the finance function

Strategic decision making

Strategic decision making

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Financial engineering helps the CFO in many ways to undertake and execute strategic moves having significant payoffs such as
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Outsource or build capacity

z

Tennessee Valley Authority

Unlock value in the balance sheet using option structures

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Amoco & Apache

The innovative outlook helps to achieve the defined objectives considering all the relevant aspects

Risk management

Risk management
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Proactive approach to identifying risks associated with business and taking steps to mitigate them is the key to success in the modern business environment z Using financial structures and instruments to hedge out unwarranted risks is a crucial decision for the decision maker such as :
z z z z

Hedging exchange risk using forwards or options

z

Tiffany & Co

A commodity manufacturer adopts measures to hedge out interest rate risk Use commodity swaps to reduce out the impact of price fluctuations on the bottom-line Risk associated with ESOPs issued to employees

Managing commodity price risk

z
z

A corporate (say a aluminum producer) raises funds by way of debt

Critical aspects to the transaction z Corporates revenue streams are exposed to Aluminium prices z Manage interest rate exposure in the balance sheet Solution proposed z Raise a rupee loan with repayment linked to price of Aluminium z The corporate repays a fixed tonne of Aluminium on each payment date z The corporate is thereby hedged against fall in Aluminium prices

The proposed product structure

Comm. Plus
Aluminium Aluminium

Lender
USD (fixed)

LME Trader

USD (fixed) USD (floating) INR (fixed) USD (floating)

USD/INR Counter Party

USD/INR Counter Party

Features of the structure

z

z z z z z

Aluminium producer delivers X tonnes Aluminium to lender (instead of delivering physical it pays rupee equivalent of LME price prevailing at the interest payment date) From the lenders perspective the return on its rupee investment is unknown Essentially the lender is taking the commodity exposure Higher the forward price the risk taker is able to get better the quote to the manufacturer Terms of OTC contract and margin needs to be considered Higher the rupee interest rate received against the USD LIBOR the better the quote to aluminium manufacturer

Commodity Swaps
A generic swap structure, which can be used by various commodity players Pay Floating Producer Market Maker Receive Floating Consumer Pay Fixed

Receive Fixed

Advantages z Only net commodity price will be exchanged z Smoothing out income flows z Producer wants to receive fixed commodity price z Consumer wants to pay fixed commodity price

Hedging Employee Stock Options

z

A ESOP offered by a company z Vests in the hands of the employee the right to ownership of Equity in the company z Results in a option written in favour of the employee by the company z The company has a short call position on the vesting date Hedge strategy z Go long on the companys stock by resorting to delta hedging z Cover fully by going long call on its own stock (if such long dated option contracts are available) z Go long on index (sector specific if available) options by proxying the beta of the companys stock with the index (long date options)

Asset Liability management

Asset Liability management

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Proactive approach to balance sheet management is the primary responsibility of a CFO A holistic approach rather than a individualistic approach is required Understanding the dynamics and correlation of every crucial item in the balance sheet is of critical importance for every fund manager
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Union Carbide Corporation

Funds management

Funds management
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The essence of modern day fund manager is to:

z z z

Raise funds at the optimum cost using innovative structures Using structures to enhance credit worthiness of the borrower Lower cost of debt by embedding options on final payoffs to investors Use financial derivatives to raise optimum funds as opposed to plain vanilla type products which entail higher costs
z z

Enron Product example : Equity Linked Bond

Structured transactions

Structured Finance
Client Objective Reduction in funding costs Structured Product Securitisation Asset backed Future flow Balance sheet Employee loan portfolio buyouts management Real Estate Investment Trusts Unlocking hidden value in Brand financing the balance sheet Investment monetization Achieving strategic Promoter funding objectives Acquisition financing Improving linkages Channel financing Dealer financing
Acquisition Financing Case Study Brand Financing Case Study

Changing Role of Banks

z

Information intensive and monitored credit

z

Small firms z Large, complex, projects z Distressed firms

z

Banks are becoming providers of contingent liquidity and not primary providers of liquidity
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Back-up lines, commitments z Bridge lending

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Leverage Information Technology to provide cutting edge banking services

What the ICICI Group has to offer

Present Features

E-enabled Supply Chain Management Payroll Processing Online Trading & Settlement Online quotes in Derivatives Risk Management Tools Structured Finance

Proposed Features

Inter Bank Transfer International CMS Commodity Trading Statutory Payments Dynamic Risk Management

Thank You

Case Study :Tennessee Valley Authority

z

Produces electricity z Decision Problem - make or buy decision for meeting peak demand z Make entails large-scale capital investments z Make results in loss of flexibility in a deregulated power industry z Buy might lead to supply constraints and market price uncertainties z Solution - Purchase call options on power that gives the right but not the obligation to buy power from other utilities z Small upfront investment, equal to the option premia z Ensures flexibility and a known price

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Case Study : Amoco & Apache

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z z z

Amoco, an integrated petroleum and chemical corporation wished to sell marginal oil and gas fields as a separate company Apache, an independent oil and gas company interested in the purchase Strategic win-win for both companies Deadlock reached in price because of different views on future oil price
z

Amoco expects oil prices to remain firm. Values company higher z Apache fears oil prices to decline. Values company lower

Case Study : Amoco & Apache

z z

z z z

Primary disagreement about commodity price, not characteristics of business Amoco, which is more optimistic about oil and gas prices writes Apache a capped price support guarantee. Apache to be compensated if prices fall below support level Apache enters into price sharing with Amoco to share profits if prices rise beyond a level So, each party locks into price it forecasts. Structure equivalent to a collar on oil and gas price

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Case Study : Tiffany & Co.

z

Tiffany was an international firm engaged in the retailing, designing, manufacturing and distribution of luxury items z Mitsukoshi was distribution agent in Japan
z z z

Tiffany sold products to Mitsukoshi in Dollars Mitsukoshi sold it to retailers in Yen Mitsukoshi bore the exchange rate risk

In 1993 Tiffany took control of Japanese dealership due to strategic reasons z Resulted in Yen - Dollar exchange rate risk z Objective was to stabilize Yen cash flows in Dollars
z z

Forward sold Yen and bought Dollars Bought Yen puts

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Case Study: Union Carbide Corporation

z

The Bhopal disaster & a hostile take over defense in mid-1980s resulted in
z z z z z

A ballooning debt portfolio with a debt/capital ratio of 88% Fixed rate component was 54% of the total debt Senior debt rating was lowered forcing the corporation to pay junk-bond yields Service the huge debt Scale back additional spending in critical areas such as research and development and capital investment

Active Liability Management

z

Develop a benchmark debt portfolio (normalized portfolio) other than establishing a target for the amount of debt which would serve as the objective for the composition of the debt profile z Not just be concerned with the lowering UCCs interest expense but play a more proactive role in achieving interest rate risk management goals such as:
z

Committed long term funding with little rollover risk z Ability to respond to favourably to interest rate risk
z

Manage the duration of its liabilities with regard to its asset duration

Application of Principles
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Understand and establish correlation with macro-economic variables that will have a bearing on UCCs optimal debt portfolio z Focus on duration rather than on a measure such as fixed debt / floating rate debt for defining its ideal debt. This would help the portfolio to be more responsive to interest rate shifts z Use IRS to transform some of its fixed rate debt into floating rate payments z Determine the roll-over profile and the fixed / floating mix required for long term committed funding with little rollover risk

Results
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Based on the steps suggested a normalized debt portfolio was arrived at using interest rate derivatives This portfolio arrived at was subjected to a historical analysis for prior periods and compared to the actual debt portfolio as it existed at that point in time For the periods compared, the normalized portfolio fared better than the actual portfolio on 6 out of 9 occasions

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Credit Sensitive Notes: Enron

Corporate expects a credit rating improvement Option 1 z Short-term funding z But if required to fund longer tenure fixed rate assets, then subject to interest rate and liquidity risk z Undergo a pay-fixed-receive-floating swap to counter interest rate risk z Take benefit of the reduced borrowing spread over T due to better credit rating in future for subsequent borrowings z However, still open to liquidity risk Option 2 z Issue a credit sensitive note where the applicable rate reduces if the credit rating improves z Benefits if rating improves z No liquidity risk z Avoids paying the swap spread
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Equity Linked Bond

z z

Investors would be interested in having the upside from the equity markets However, not willing to bear the downside risk Possible structure
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Bond with an embedded call option

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Option can be on individual equity stocks or a basket of stocks

Product Structure
z z

Investor to buy a bond by investing an amount P Payoff at time T = P + f * Max (0, (S - X) )

where, S = Stock Price at the end of time T X = Exercise Price in the option f = Multiplier (representing the number of options per bond)

z z

The product is principal protected Option Premium = P - Present Value of P

Product Features
z

The option must be a call option

z

Delta negative, hence hedging possible by going long on the underlying

Longer the maturity of the bond =>

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Higher the P - PV (P) value z Hence, each bond can represent a larger proportion of the option z However, higher the delta hedging cost
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In the money options are preferable

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High Delta: hence base stock for easier hedging

Critical Factors
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Cost of the option

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European options are very expensive

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Reason: High volatility

z z

Cost of hedging Lack of accurate pricing model

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Volatility estimation z Transaction costs z Discontinuous delta hedging z Jump risks

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To reduce cost of the option and the cost of hedging, it is advisable to use an Asian option

Advantages of Asian Options

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z z z z

Useful for hedging when the cash flow is exposed to price of the underlying at various points of time Reduces extreme sensitivity of the option value to the value of the underlying on a particular day Reduces risk of option expiring worthless because of price manipulation Lower premium compared to European options For option writers delta hedging easier
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Delta and Gamma go down near maturity

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Case study-acquisition financing

Clients objectives z Raising off balance sheet financing for the acquisition Limiting recourse to the Acquirer z Leveraging cashflows of the Target company z Low cash outflow in the period interim to potential merger with Target z Suitability of structure from accounting and tax perspective

Structural features
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Financing an SPV owned by acquirer for takeover of target

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Negotiated purchase of 40% and open offer of 20%

z z z

Recourse to Acquirer through a put option on loan receivables from SPV Low cash outflow through interest moratorium FRA with Acquirer starting at the end of 2 years from date of disbursement of loan to SPV

Deal diagram
Acquirer

SPV Co.

Investment

Shares of Target

Call/Put Option on Loan Receivables exercisable one week before end of 2 years ICICI

Acquirer FRA starting at the end of 2 years from date of disbursement of loan to SPV
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Case study-off balance sheet brand financing

Client objectives z Unlocking the value of his brands, not reflected in the balance sheet z Wishes to raise money against security of the Brands z Wants to continue using the brands until an event of default

Structural features
z

Key undertakings from client z To maintain and promote the brand z Non compete clause in event of default z No sub licensing allowed z Creation of security on the brand z Registering charge with the Registrar of Companies (for companies) z Registering lien with the Registrar of Trademarks and Merchandise marks z Taking a mortgage of all documents evidencing title to the brand z Power of attorney to dispose off brand in default

Deal diagram
Purchase consideration Transfer of Brand(s) and Related Assets

Company
License of Brands and Related Assets

Trust Brands (SPV)

Subscr iption to PTCS Servicing of PTCS

License fee

ICICI

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