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Treasury and the Financial Environment

Section

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Part A Suggested References
When you are studying this topic we suggest the following references. Primary References (Texts) Ross, D.A., International Treasury Management 3 ed. Euromoney Books Treasury Management Association, The Treasurer’s Handbook of Financial Management, US: 1995, Chapters 1 to 9. Van Horne, James C., and Wachowicz, John, Financial Management and Policy, 12 (Prentice Hall, 2002), Chapter 1. Edn.
rd

Welch, Brian. (1999) Electronic banking and treasury security / edited by Brian Welch. (Boca Raton, FL : CRC Press ; Cambridge : Woodhead, 1999). Young, L.S.F. and Chiang, R.C.P., The Hong Kong Securities Industry, Hong Kong: The Hong Kong Stock Exchange Limited, 1997. Chapters 3 to 10. Primary References (Articles and Other) Moonen, M.H.P. and Voorrips, G.C., “The Euro: a European Currency to Reckon With”, The Australian Corporate Treasurer, February 1998. Treasury Management International has articles downloadable in PDF form on Banking, Corporate Finance, Equity Markets and many more. Many of these are free and provide a wealth of reading material to supplement these notes: At www.treasury-management.com. visit “TMI Magazine” and “Research” Kiff, John and Mills, Paul, “Lessons from Sub-Prime Turbulence” (August 2007) at http://www.imf.org/external/pubs/ft/survey/so/2007/RES0823A.htm

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Part B
Topic Treasury and the financial environment: Learning Outcomes i) ii) Report on the likely internal (financial) impact of actual or proposed business strategies. Report on the likely external (financial) impact of actual or proposed strategies and organisational decisions by:
• • •

• • • •

The banking and financial market environment The risk framework The financial environment and technology Sub-prime mortgage lending – lessons learned in 2007

financial markets, financial market participants, (existing and potential) debtors, creditors and suppliers, Government and regulatory bodies, etc.

iii) iv) v)

Comment on and interpret capital market trends. Classify risks within the financial, operational, political and legal framework facing any organisation. Identify and explain the potential impact of financial, operational, political, legal and business risks facing an organisation. Make recommendations about the economic impact of external and internal events/risks on an organisation relating to national and international factors. Identify and interpret the economic and financial implications of the potential impact of technological developments on an organisation.

vi)

vii)

You may choose to complete this topic in a step-by-step way or skip ahead, depending on your knowledge and assessment of your own competency in relation to the above Learning Outcomes.

Part C
Contents of this section 13.1 13.2 13.3 13.4 13.5 Introduction ........................................................................................................................2 The banking and financial market environment .................................................................5 The risk framework ..........................................................................................................17 The financial environment and technology.......................................................................24 Sub-prime mortgage lending – lessons learned in 2007..................................................26

13.1

Introduction

Finance is concerned with risk and return attributes of assets. It can be described as the art and science of managing money. It is broad and dynamic, dealing with the process, markets and institutions involved in the transfer of money among and between individuals, organisations, businesses and governments. Financial management encompasses the duties of the financial manager in organisations which can include budgeting, financial forecasting, cash management, credit administration, risk management, investment analysis and funds procurement. It requires a full understanding of the organisation’s business strategy, technology, financial markets, risks and cash flows.

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The increasing degree of globalisation of business activity and evolving communication technology (ICT) with implications for e-business have dramatically increased the challenges for companies’ financial management, sales and investments in other countries. The need to manage cash flows denominated in foreign currencies, to protect against political and foreign exchange risks and multiple legal jurisdictions naturally arises from international transactions. This makes financial management more demanding and complex. Without a holistic understanding of the company and the financial environment, no senior financial manager can perform the financial management function with confidence or competence. 13.1.1 Financial Markets Financial (capital) markets provide the means for economic entities to exchange obligations. They interact for the purpose of buying and selling financial assets (debt and equity instruments), allowing participants to achieve their desired portfolio mix of risk and return. Both buyers and sellers seek to increase their wealth through this interaction. Sellers of securities (“paper”) expect to invest the funds obtained in investment projects that increase wealth. Purchasers of debt and equity securities expect to increase wealth, essentially through the receipt of interest, dividends or capital growth. Funds transfers between two parties can be classified into two types: a) b) Direct - the lender and the borrower may be known to each other and the lender generally bears the credit risk. Indirect - the lender and the borrower are brought together through the use of a financial intermediary, with the intermediary generally bearing the credit risk.

Intermediation is the process by which the flow of funds between borrowers and investors (savers) are brought together as a result of the activities of a financial institution, such as a bank. This financial institution is able to bring borrowers and lenders together by absorbing the credit risk. Financial markets play both a primary and secondary role. A primary issue of a security results in a direct flow of funds and securities between the borrower and lender. Disintermediation is the process where companies raise funds directly from the public by issuing their own securities, without the use of an intermediary. A secondary market then enables the securities to be traded. The finance director and treasurer of a company are responsible for the flow of funds through their company. Accordingly, they must be aware of the major aspects of the financial markets in which the company operates. This awareness includes a basic understanding of how that market evolved, its current state of development, how prices are quoted, major influences on the market (including regulation), etc. It is difficult for any one person to know the intricacies of all financial markets so they must also know to whom to turn for detailed professional advice. The efficiency of the particular financial market is important, affecting the cost of raising funds or alternatively the return they will achieve on surplus funds (investments) of the company. The speed with which information is impounded in market prices and the extent of any bias in prices reflects the level of market efficiency. It is important that market participants can have confidence in the way prices are set. While it may not be a requirement for finance directors and treasurers to understand the impact of the emergence of city based or even national based funds into the financial markets, it would be an advantage to visualize how the financial markets react to national funds that involve in business transactions. An example of such is that in September 1998 the Hong Kong SAR government used her funds to purchase the shares of the Hong Kong Stock Exchange in the open market claiming for investment purpose, which aroused significant market reactions from the general investors.

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The existence of a secondary market improves the liquidity of investments. they will have a feel for what terms and conditions they should be able to command on pricing and documentation. These will include: • • • shares commercial paper. the balance between debt and equity. The treasurer needs to understand how lenders view the organisation and on what terms they have based their analysis. they will invest in debt paper such as debentures and loan securities.e. on the other hand. send positive signals to financial markets and facilitate cost efficient management structures. its management and strategy. or by investors wanting to hedge their exposure to their existing portfolio investments. the investor is demonstrably looking for something more than a fixed rate of return. This obviously strengthens the treasurer’s bargaining position. Recently because of international mobility concerns many international investors also purchase financial products for reasons that are not oriented from a finance perspective. The lower the proportion of a company’s income which is committed to fixed costs and interest. bonds etc. both domestically and internationally to choose from. In making an equity investment. Where they are seeking a yield (interest) return. Investors typically have a broad range of financial instruments. maturity and flexibility of securities. the better the lender’s prospects of recovering their money in a corporate failure situation. An investor will look at security.13. Management of both the financing mix and the reinvestment proportion of profit can add value to the organisation and in the case of companies increase share prices. The credit risk attendant with the issuer will be important.2 Investor Requirements Financial managers (the treasurer) must appreciate that whilst all investors are seeking a return on their investment. Derivatives are initially used either by more aggressive investors wanting to assume higher leverage. The costs of leverage stem largely from disruptions caused by financial distress. 13.1. then prior to any negotiations. and yet also aroused tremendous problems to the world in Hong Kong since early 2008 as will be discussed and elaborated in the next chapters. with the expansion of the derivative market and the development of more complex derivative products. An investor in shares is likely to be looking for growth in the underlying value of the investment. lowering risk to the holder. If the treasurer is cognisant of the organisation’s position relative to the lender. i. which has complicated the finance manager’s concern about investor objectives.1. This gives rise to investor types and the investment portfolio professional fund managers wish to develop. The emergence of these dual nature financial products has created more opportunities to the financial market participants.4 . This serves to emphasise the importance of close banking and investor relationships. there is an increasing trend of integration of debt and derivative products both in terms of appearance as well as underlining asset backup.3 The Role of Leverage Modern capital structure theory suggests that the treasurer can assist management improve shareholder wealth through the judicious use of corporate leverage. it will adversely affect its credit rating. The higher the proportion of equity finance. This may come from higher dividends or from greater capital growth. However. Capital market advances such as high yield bonds. the reason for purchase of the different types of “paper” will vary. If a lender misunderstands the organisation. Moderate amounts of leverage can generate significant tax shields. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . securitised assets and various risk hedging instruments have mitigated many of these costs. the better the chance that it will be able to meet its obligations to lenders. given their chosen risk level. derivatives Investors seek to maximise returns in the form of either yield or growth in their assets. They will choose government securities if they want maximum security and only are willing to lend to the corporate sector if they are prepared to accept some element of risk in order to receive a higher return (yield). interest rate volatility and restrictive debt covenants.

monetary policy operations and other means deemed necessary.gov. is bound by laws. Other intermediaries such as stockbrokers and life insurance companies will also be used in meeting funding requirements of the corporation.hk/hkma/eng/public/fs99/fs01.2. except (say) to the extent of committing commercial crimes.info. please note that some of the facts provided in the fact sheets were not updated on spot. They also have a responsibility to both owners e. However. The functions and objectives of the HKMA are: • to maintain currency stability. which reflect this requirement. integrity and development of the financial system. as an officer of the company. Thus.g. within the framework of the linked exchange rate system. 13. it is important to note that the treasurer is not regarded as a director or a substantive officer of the corporation. shareholders and to investors when issuing any information such as in a prospectus. and the supervision of authorised institutions. to promote the safety and stability of the banking system through the regulation of banking business and the business of taking deposits.2 The Banking and Financial Market Environment Corporations need to have relationships with banks for a number of activities ranging from providing debt finance. Bearing this in mind and making use of recent publications in updating the data. which means that they owe loyalty to it and a duty of care to act in its best interest. However.1 The Banking Structure in Hong Kong For a fuller understanding of the banking structure and financial markets in Hong Kong. The treasurer. 13. through sound management of the Exchange Fund. but rather were updated in other information sources contained in the web site of the Hong Kong Monetary Authority at www. refer to fact sheets 1 – 10 starting at http://www.4 The Treasurer’s Responsibilities Directors have a fiduciary duty to their organisation. • • Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 .pdf. financial advice and outsourcing of some treasury activities.1.13.info. particularly payment and settlement arrangements. retail transaction business. the treasurer's duty of care is not as onerous as a director.5 . and to enhance the efficiency. the following is a summary of the fact sheets with updates: Fact Sheets 1999 (with modifications and updates) Fact Sheet 1 The HKMA's Role and Policy Objectives The Hong Kong Monetary Authority (HKMA) was established on 1 April 1993 by merging the Office of the Exchange Fund with the Office of the Commissioner of Banking..gov.hk/hkma.

With the capital tsunami starting in the third quarter of 2008 and the general depression experienced by all parts of the world now. there are controversial opinions among economists and finance experts whether it is good or otherwise to Hong Kong at this moment to abandon or modify the said rate system. including the 1987 stock market crash. But the Financial Secretary of the Hong Kong SAR has repeatedly stated that the linked exchange rate system will not be abandoned or modified. Coupled with this has been the weakening of the US dollar in the first half of 2008 when most foreign currencies rose to the historic high against the US dollar. foreign government bonds.85 With the increasing trend of exchange rate inflation between the Renminbi (RMB) and the US dollar since 2005.80 to one US dollar.Fact Sheet 2 Exchange Fund and Reserves Management The Hong Kong SAR Government’s Exchange Fund (the Fund) was established by the Currency Ordinance of 1935 (later renamed the Exchange Fund Ordinance) to provide backing to the banknotes issued. Under the system.80 to 7. most economists and financial experts also expressed uncertainty on the movement of the Hong Kong dollar rate should its pegged exchange rate be abandoned. and the recent deterioration of the US economy due to the Sub-prime Mortgage Crisis and the “Capital Tsunami” in 2008. In the face of these shocks. or a change of the pegged exchange rate thereof. Disregarding the political consequence of any change in the linked exchange rate system. the role of the Fund was expanded to include the management of the official reserves when the assets of the Coinage Security Fund (which held the backing for coins issued by the Government) and the bulk of foreign currency assets held in the Government’s General Revenue Account were transferred to the Fund. In addition. It has withstood a number of tests since its inception. Fact Sheet 3 The Linked Exchange Rate System Hong Kong’s linked exchange rate system has been in effect since 17 October 1983. the Government began to transfer its fiscal reserves to the Fund. and announced the shifting of the existing weak-side Convertibility Undertaking from 7.75. the Mexican currency crisis in 1994/95 and the Asian financial turmoil in 1997/98. the Hong Kong dollar exchange rate has remained remarkably stable. which has affected the price of imported goods from China and the general inflation rate of Hong Kong. In 1976.6 . This is despite the fact the RMB has been inflating against the Hong Kong dollar. The HKMA introduced a strong-side Convertibility Undertaking to buy US dollars from licensed banks at 7. short-term deposits. the Gulf war in 1990. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . the ERM crisis in 1992. The Fund was originally held in gold. there is continuous guessing and speculation on the possible abandonment of the linked exchange rate system between the Hong Kong dollar and the US dollar. the collapse of the BCCI in 1991. from 1976 onwards. equities and gold. silver and British pounds. the Hong Kong dollar is linked to the US dollar at the rate of HK$7. the June 4 event in China in 1989. The Fund now holds the official reserves of Hong Kong predominantly in foreign currency assets including cash.

These measures have included: • • • the introduction of the Exchange Fund Bills and Notes Programme. The new system is one of the HKMA’s major initiatives to enhance the robustness of the financial infrastructure and the competitiveness of Hong Kong as an international financial centre. the implementation of the Real Time Gross Settlement (RTGS) System. the extending of the market making system for Exchange Fund paper to debt securities established by statutory corporations. • • • • • • Fact Sheet 5 Real Time Gross Settlement System Hong Kong’s interbank payment system entered a new era on 9 December 1996 with the launch of the Real Time Gross Settlement (RTGS) system by the Hong Kong Monetary Authority (HKMA) and the Hong Kong Association of Banks (HKAB). The first phase involves the purchase of mortgage loans for its own portfolio.Fact Sheet 4 Debt Market Development in Hong Kong In the course of the last decade. Fact Sheet 6 Hong Kong Mortgage Corporation The Hong Kong Mortgage Corporation Limited (HKMC) was incorporated in March 1997 with the mission of developing Hong Kong’s secondary mortgage market. The HKMC’s business is being developed in two phases. Cedel and other central securities depositories in the Asian Pacific region. the creation of a benchmark yield curve extending to 10 years. the listing and trading of Exchange Fund Notes on the Stock Exchange of Hong Kong. and incorporated under the Companies Ordinance. and the establishment of the Hong Kong Mortgage Corporation. wholly owned by the Government through the Exchange Fund. the HKMC will securitise the mortgages into mortgage-backed securities (MBS) and offer them for sale to investors.the CMU) and linking it to Euroclear. the establishment of an efficient central clearing and custodian system for debt securities (the Central Moneymarkets Unit . the Hong Kong Monetary Authority (HKMA) has taken a number of steps to develop the infrastructure and assist in the growth of the debt market in Hong Kong. It is one of the most advanced interbank payment systems in the Asia Pacific region. The HKMC is a public limited company. the use of Exchange Fund paper as margin collateral for trading in stock options and futures. the granting of profits tax exemption/concession for qualifying debt securities. funding the purchases largely through the issuance of unsecured debt securities. In the second phase.7 . Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 .

Fact Sheet 7 Banking Policy and Supervision Hong Kong maintains a three-tier system of deposit-taking institutions. The authorisation criteria for licensed banks. or redeemed. or otherwise associated with. and it is perceived that less than 30 licensed banks are generally recognized by the public.821) or above with an original term to maturity of at least three months. against payment to. through the Hong Kong Monetary Authority (HKMA). These companies may take deposits of HK$100. They engage in a range of specialised activities. 181 were beneficially owned by interests from 30 countries. introduces amendments to reflect the changing needs of the regulatory environment and to meet new international standards. to issue currency notes in Hong Kong (Chart 1). Only licensed banks may operate current and savings accounts. At the end of December 2006. restricted licence banks and deposit-taking companies seek to ensure that only fit and proper institutions are entrusted with public deposits. general investors and the public may not have comprehensive information about the banking industry in Hong Kong. there were 138 licensed banks. Fact Sheet 8 Banknotes and Coins The Government. at a specified rate of US$1 to HK$7. has given authorisation to three commercial banks. It should be noted that in October 2008 the Hong Kong SAR Government has announced a policy of 100% guarantee without to all bank deposits put to the licensed banks in Hong Kong. Despite this. Of these 202 authorized institutions. The guarantee will be in force until 2010 and then it will be subject to review depending on the progress or possible recovery of the world economy from the “capital tsunami”. Banknotes issued by the three commercial banks are printed in Hong Kong by Hong Kong Note Printing Limited (HKNPL). restricted licence banks and deposit-taking companies. Restricted licence banks are principally engaged in merchant banking and capital market activities. Authorisation is accompanied by a set of terms and conditions agreed between the Government and the three note-issuing banks. or from. The Hong Kong Monetary Authority (HKMA) conducts periodic reviews of the authorisation criteria and. A restricted licence bank may take time.000 (approximately US$12. licensed banks. namely.000 (approximately US$64. the Standard Chartered Bank and the Bank of China. the Government’s Exchange Fund in US dollars.80 under the linked exchange rate system. 31 restricted licence banks and 33 deposit-taking companies operating in Hong Kong. however.313 local branches. Deposit-taking companies are mostly owned by. This was to protect the Hong Kong banking system from collapse because of the “capital tsunami” and the bankruptcy of numerous banks in the US and other countries. Hong Kong has one of the highest concentrations of banking institutions in the world. which triggered the loss of confidence by general depositors to the banking system.103) and above without restriction on maturity.8 . the HSBC. Banknotes are issued by the three banks. banks. These 202 authorized institutions operate a comprehensive network of 1. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . including consumer finance and securities business. and accept deposits of any size and maturity. They are collectively known as authorised institutions (AIs) under the Banking Ordinance. when necessary. call or notice deposits from members of the public in amounts of HK$500.

and the Government of the Hong Kong Special Administrative Region (HKSAR) formulates its own monetary and financial policies. Hong Kong’s payment system entered a new era on 9 December 1996 with the launch of the Real Time Gross Settlements System (RTGS) by the Hong Kong Monetary Authority (HKMA) and the Hong Kong Association of Banks (HKAB). Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . In particular. The Hong Kong dollar. just behind the US. maximise returns on surplus funds. reduce transaction costs. The Hong Kong dollar continues to circulate as a freely convertible currency. Hong Kong enjoys a high degree of autonomy except in foreign affairs and defence matters. It is one of the most advanced interbank payment systems in the Asia Pacific region. and an efficient physical infrastructure. 13. held in the Exchange Fund. Tokyo and Shanghai Stock Exchanges. as the only legal tender in the HKSAR. As at end of October 2007. the Hong Kong Stock Exchange was ranked number 5 in terms of market capitalization. remains freely convertible. Banking is the linchpin of financial activities in Hong Kong. Hong Kong’s monetary system remains separate from that of the Mainland of China. a sound legal system. The free flow of capital within. Around 60% of banking business is denominated in foreign currencies (including Renminbi). Two Systems' Principle Under the principle of ‘one country. a low tax rate. are managed and controlled by the Government of the HKSAR primarily for regulating the exchange value of the Hong Kong dollar. The system is one of the HKMA’s major initiatives to enhance the robustness of the financial infrastructure and competitiveness of Hong Kong as an international financial centre. the free flow of capital and information.2 Cash Management in Hong Kong Corporate treasurers seek to: • • • • • • accelerate receivables. It has achieved this position through its strategic geographical location. Since the implementation of the RTGS system in 1996. a liberal economic policy. the Hong Kong Monetary Authority (HKMA) developed and implemented the Delivery versus Payment (DvP) facilities for share transactions in 1998. having built an interface between the RTGS system and the clearing and settlement system for shares operated by Hong Kong Clearing. The RTGS system has also provided the building block for Payment versus Payment (PvP) for US dollar exchange transactions in 2000. into and out of the HKSAR is guaranteed and no exchange control policies may be applied in Hong Kong. UK. reduce foreign exchange risks. and minimise borrowing costs. Hong Kong’s foreign exchange reserves.2.9 . two systems’ enshrined in the Sino-British Joint Declaration and the Basic Law (Annexes 1 & 2).Fact Sheet 9 Hong Kong's Monetary System and the 'One Country. and the authority to issue Hong Kong currency is vested in the HKSAR Government. reduce taxation risks. Fact Sheet 10 Hong Kong as an International Financial Centre Hong Kong is one of the world’s major financial centres. a diligent workforce.

2.htm 13. financial investment. the SFC has performed its monitoring duties satisfactorily as perceived by both the financial participants and the community in general. A PvP link will reduce the settlement risk in foreign exchange transactions arising from the difference in timing in the final settlement of the two currencies involved. please refer to the following web site: http://www. The RTGS may also be relevant to corporations that are “wired” to their banks.hk/hkma/eng/infra/index. Its detailed regulatory framework brings Hong Kong into line with international standards of market regulation and practice. Hong Kong will then act as an “offshore” exchange centre for overseas corporations to handle business transactions with Chinese business organizations. SFC. It exercises prudent supervision over: • • • the securities. with the break out of the capital tsunami.gov. Before the implementation of RTGS and DvP. Accountants and treasurers could make use of this potential benefit in the foreseeable future to execute global fund management related to China businesses. there was often a realization or delayed settlement risk for treasurers and financial controllers to hold short term funds in form of marketable securities and foreign currency. the market has experienced a reorientation from an equity focus to encompass a wide range of debt. especially when the funds could be suddenly called upon for immediate use at any time. Hong Kong’s unrestricted regulatory environment allows local. When the RTGS links with CNAPS while foreign exchange control is still exercised in the Mainland China. and (3) float is drastically reduced.3 Financial Markets in Hong Kong Hong Kong’s geographic position. equity linked and derivative instruments as financial market participants become more sophisticated and borrowers and investors demand more mature. (2) marginal costs of transactions will be lower. regional and global investors access to a broad range of currencies and instruments. including local and foreign currency current accounts. and excellent communications with the rest of the world have helped the territory to evolve into an important international financial centre. notably in the reduction of settlement risks between cash as well as share transactions. The existence of such realization risk imposed certain restrictions to the treasurers in managing cash and short terms finds. However. and commodities futures industries.The HKMA has also reached agreement in principle with the People’s Bank of China (PBOC) to establish a PvP link between the Hong Kong’s Hong Kong dollar payment system and China’s National Automated Payment System (CNAPS) when CNAPS goes live. The RTGS uplifted these worries and treasurers are now more comfortable in choosing various fund portfolios. customers and suppliers with the following 3 advantages: (1) records keeping and routine transactions are easy to automate. Surveillance of the financial market is exercised by the Securities and Futures Commission (SFC) established in 1989. The RTGS and its subsequently developed Delivery versus Payment (DvP) and Payment versus Payment (PvP) systems have enabled the finance people to manage their cash portfolios in a more efficient way. which provides a bridge in the time gap between North America and Europe. For further information and related links to RTGS. savings accounts and time deposit accounts. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . Until September 2008.10 . diverse and flexible products. In recent years. HKMA and other government agencies have been subject to severe criticism on the non-monitoring of the high risk derivative products in particular the Mini-Bonds issued by Lehman Brothers as well as other financial products related to this once globally praised bankrupted investment banker.info. strong links to China and other economies in South East Asia. An extensive range of fundamental cash management accounts and services are offered by Hong Kong’s principal banks.

When the Hong Kong stock market is considered as one of the possible factors for financial decisions. with sales of any financial products nearly coming to a total halt. this issue should be borne in mind. the financial market of Hong Kong has become stagnant in the fourth quarter of 2008. Starting early 2007. Thus the stock price movements of the shares listed on the Hong Kong Stock Exchange might be subject to many moderating factors and do not necessarily represent the economic performance and fundamental value of business corporations. It should be noted that with reference to the Efficient Market Hypothesis and based on researches done on other stock exchanges such as the NYSE. Investors in Hong Kong have temporarily lost trust in the financial market and the issuers of bonds and other financial products which might have once been regarded as low risk instruments. The Hong Kong government in the past operated an enviable surplus and as such was no need for debt markets as they exist in many Western economies. Fortunately the financial market in particular the stock market in Hong Kong had gradually recovered since the beginning of the second quarter in 2009. Its broadest measure is the Hang Seng Index (HSI) which is a market capitalisation weighted index. Hong Kong would best be regarded a semistrong market if not a weakly efficient market. Throughout the year 2009 the Task Force had held several meetings and proposed some recovery actions for the restoration of the financial market in Hong Kong. In order to lead Hong Kong recovery from the current economic depression due to the financial tsunami. Due to the HK$ being pegged to the US$. formed an Economic Task Force in October 2008 with 10 members from different disciplines.As a result of the Mini-Bond incidence in Hong Kong and the financial tsunami which happened around the world. counted the 42 largest stocks as its constituents. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . the price discrepancies between A and H shares have been getting closer since the second half of 2007. the general atmosphere of the financial market is not as bad as some pessimistic analysts might have predicted.11 . b) The Hong Kong Debt Market Hong Kong’s fixed income (debt) market is only a fraction of the global debt market. the Hong Kong stock market is highly sensitive to US interest rates. mainly due to the absence of government debt. However. Although the bond market is not yet recovered in domain.. there is also a notable sign that the Hong Kong stock market is also increasingly affected by the economic development of the Chinese Mainland and the stock market performance of Shanghai and Shenzhen. The aim of the Task Force is to seek solutions to the crisis or even grasp the opportunities available to Hong Kong in taking advantage of the situation. the Hong Kong Government has announced plans to launch debt in its 2004/5 budget and subsequently issued bonds in 2004 to finance her budget deficits. Thus the financial managers have to take note of the movements of both China and US markets now in judging the performance trend of the Hong Kong stock market. The market is gaining liquidity in hybrid debt and equity products as borrowers are increasingly looking to reduce their cost of capital using these products. which. With more state owned corporations who “returned” to China and issued A shares. It has been observed numerous times that the Hong Kong stock market follows the trend of the Mainland market despite the US stock market turns in the other way round. In the earlier period it had been observed that the price of A shares in the Chinese Mainland doubles that of the H shares in Hong Kong for some corporation that is listed both in Hong Kong (the H shares) and the Mainland (the A shares). in November 2008. The fluctuating stock price movements of Hong Kong listed shares throughout 2009 serve as a good indicator of this. the SAR Government at the initiative of the Chief Executive. a) The Hong Kong Stock Market The Hong Kong equity market is one of the most actively traded in Asia. Even utility companies are relatively debt free.

One of the major problems in the development of the debt market is the lack of secondary trading. the government in its own right does not issue any "Treasury Bills" or "Government Bonds" at present (although the government had once issued government bonds in the 1980s). Monthly Statistical Bulletin. Hong Kong also has a highly developed derivative warrants market. resulting in a lack of liquidity to attract substantial numbers of debt investors.12 .41 0.81 1. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . The HKMA is responsible for exercising effective influence over liquidity and interest rates in the HK$ market. In Hong Kong.14 2.25 billion 10-year institutional notes to institutional investors) However the HKMA has issued "Exchange Fund" bills and notes which are similar to Treasury Bills and Bonds. the average daily turnover of derivative warrants in Hong Kong was HK$6.59 1. The government issued bonds amounting to $20 billion.12 1.37 The Foreign Exchange Market The HK$ has pegged to the US$ at the rate of HK$7. Debt investors seek liquid markets in case they wish to liquidate their investment (with or without capital loss). with terms negotiated separately for each transaction.77 1.71 2.1 bn (US$780 mn). As a foreign exchange centre.32 2.93 2 Qtr / 2009 0. The average daily turnover rose by 6 times during 2002-2005.62 2. This eliminates the exchange rate factor as a variable in the territory’s economic development and stability."Yield of Exchange Fund Bills and Notes".69 2. leaving Singapore to concentrate on South East Asia. According to the HKMA Supervision of Markets Division.88 1. in 2004 and 2005 Hong Kong’s derivative warrants market was the most active market in the world.For Asian companies equity is still the most convenient and efficient option of financing business and there is little enthusiasm for corporations to switch to debt. The Exchange Fund Bills are issued with maturity ranges from 2 years to 15 years. d) Derivatives Markets Hong Kong has an active exchange traded and over-the-counter equity derivatives market and a developing debt derivatives market. Note that these tables reflect a fluctuating sloping yield curve in 2009. which was completed in July 2004. Contracts are made on a bilateral basis.71 1. Summary Interest Tables for Exchange Fund Notes issued by the HKMA Source: HKMA .49 0. As trading activities on the stock market as a whole also surged over the period. Hong Kong is increasingly geared towards serving the needs of Greater China. 75% higher than the 2005 level. Initiatives are being undertaken by the Hong Kong Monetary Authority (HKMA) to develop liquidity in Hong Kong debt markets.90 1. reflecting the unstable global financial situation after the outbreak of the capital tsunami.80 equals US$1 since 1983. The market has been growing rapidly in recent years. including the first time issue of US$1. Equity and debt derivative products such as forwards and swaps.19 2. The following tables summarise the offered interest rates in respect of Exchange Fund Notes from 2 year to 10 year maturities for the period encompassing first quarter 2009 to fourth quarter 2009. as well as exotic options are traded on the over-the-counter market. the share of derivative warrants in the total market turnover remained stable at about 19%.87 3 Qtr / 2009 0. During the first quarter of 2006. This initiative is helping to develop liquidity in the debt markets in Hong Kong.11 2.36 4 Qtr / 2009 0. 2 Year 3 Year 5 Year 7 Year 10 Year c) 1 Qtr / 2009 0. Interest rates rise and fall in line with movements in interest rates in the US except in the last quarter of 2004 to preserve the currency peg and the money demand and supply.

which is able to develop a wide range of derivative warrants to meet different risk appetites of different investors. and the Companies Registry. Transparency and disclosure is a focus of the Hong Kong Institute of Certified Public Accountants (HKICPA). Gaps can still be identified. For instance. with regard to the content of annual and interim reports. The regulatory framework is well established. Retrieved from www. operational analysis.treasury-management. surged by some 90% during the first quarter of 2006 from the second half of 2005 (the growth for the whole derivative warrants market was about 50%). and the government rarely intervenes in the market or protects individual sectors. the growth in trading activities was driven by the trading of derivative warrants issued on Mainland stocks.13 . Market Infrastructure Hong Kong has a well-developed market infrastructure. Moreover. One criticism. The political environment is relatively stable. encouraging good practices and providing a supportive environment. In 2006. namely China Life Insurance. As a Special Administrative Region (SAR) of the People’s Republic of China (PRC). however.com. Hong Kong’s banking system is sophisticated and well supervised. They provide a critical mass of expertise in the market. and its macro-economy demonstrated general resilience from the Asian financial crisis of the late 1990s. However. Local accounting standards are being harmonised with international standards. The Year of Corporate Governance p. access to public exchanges is relatively high.In particular. Hong Kong has also made improvements to the required informational infrastructure in recent years. the debt and derivative market in Hong Kong has been closed to a complete halt since the Lehman Brothers and the Mini-Bond incidence. the trading of derivative warrants issued on the top three Mainland stocks. Example 1: Required a) b) What key issues must a financial manager (treasurer) understand when considering the financing of a company? How are these financing decisions affected in the Hong Kong Market? Is the debt market growing? Comment on the depth of the market and pertinent institutional factors. the Stock Exchange of Hong Kong.3. though. Treasury Issues in Financing a Company Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . China Construction Bank and China Mobile. there were about 18 active derivative warrants issuers in Hong Kong and most were international investment banks. the Securities and Futures Commission (SFC). As mentioned above. Hong Kong is also linked closely with the increasing integration of the PRC in the global economy. frequently voiced by local market observers is that the regulatory powers of investigation and their ability to enforce regulations fall short of some more pro-active regimes. and executive remuneration. the global financial crisis has resulted in a reduction of derivatives trading activity in 2008 and 2009. The strong interest in Mainland securities was also reflected in the trading of H shares which soared 83% whilst the turnover of the total market turnover increased 58% over the same period. How long it would take before the derivative market could be re-operated as usual is the question to which no person could provide a concrete answer as at this moment. Treasury Networks 2003. Source: Ian Byrne.

14 . and financial advice or support if one party is in trouble is unlikely (in contrast to borrowing from a bank). • b) The Hong Kong market does not have the liquidity in the debt market as developed markets in Western countries. the higher the interest rate the issuing organisation must pay. the role of leverage. payroll). but are typically lower than banks' rates. e) Commercial Paper In the global money market. the operation of banking and financial markets. or may issue commercial paper when seeking additional cash. only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. Businesses may purchase commercial paper as an investment medium for excess cash.Suggested Solution Example 1: a) Treasury Issues in Financing a company A financial manager must understand. commercial paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. financial market efficiency. and the size of the debt market. One potential problem with commercial paper is that it is an impersonal relationship between two organisations. investor requirements. Accordingly there are differences in: • • • • • • the operation of banking and financial markets. financial market efficiency. professional advice. The use of commercial paper is therefore restricted to a comparatively small number of large companies. and to whom to turn for professional advice. Interest rates fluctuate with market conditions. Typically. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . as a minimum when financing the company: • • • • • • the company’s activities and cash flows. the longer the maturity on a note. and carries shorter repayment dates than bonds. Since it is not backed by collateral. investor requirements. Commercial paper is usually sold at a discount from face value. Commercial Paper is a money-market security issued (sold) by large banks and corporations to get money to meet short term debt obligations (for example. the financial manager’s (treasurer’s) responsibilities when operating in financial markets. and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. the role of leverage.

to simplify the issuance process.000 Total 13. In his review in the 2008 Annual Report. collateralized bonds etc.075 x $1. This had a number of implications for treasury management and the financial environment in Hong Kong.15 . redemption feature and convertibility feature.750 Interest = 0.500 $ 8. yield curves and the setting of short term interest rates. not just during the crisis itself but also over many years.000 x 1/12 Transaction fee = 0. different types of sinking funds and the effect of sinking funds on the equilibrium market interest rate on the bonds. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . to the actions that we have taken. Required Estimate the cost of the issue? Suggested Solution Example 2: Cost of Commercial Paper $ 6.0025 x $1.2. Features such as call feature. The Hong Kong Government also contributed funds to the Asian Bond Fund established by regional governments to stimulate local currency bond markets.” In spite of the financial crisis. including: • • • The determination of interest rates. to explore new channels for distribution of bonds. in 2004 the FSTB encouraged public corporations to issue bonds.Example 2: Cost of Commercial Paper Sound Products Ltd issues $1 million of 30-day commercial paper at an interest rate of 7. to provide necessary financial infrastructure.25% of the amount of the issue. “That Hong Kong has come through so far with its monetary system intact and its financial system still robust is due.4 Recent Developments in Hong Kong Financial Markets The development that has had the most impact on Hong Kong financial markets in 2008 and 2009 has been the global financial crisis.5% pa. including the cost of a backup credit line.000. The concept of default risk and how default risk affects interest rate and how it could change over time. their effect on the bond’s effective interest rate. there have been a number of positive developments over the last few years. the Hong Kong financial system remains solid. to offer tax incentives and to continue investor education. to prepare for unforseen events. The definition and issuance of bonds. in no small part. the sinking fund.250 2. the CEO of the HKMA stated. Market Development Bond Market To facilitate the development of a Hong Kong dollar bond market. The total transactions fee. Ordinary debenture bonds. on using commercial paper is 0.000. However.

Determination of capital structure – the equity/debt mix. The Legislative Council of Hong Kong SAR has passed the Banking (Amendment) Ordinance in July 2005. private and public (bond and stock) issues. Regulatory Framework With the Lehman Brothers incidence. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . Retirement of bonds and repurchase of stocks. current and capital gains yields. It is expected that the regulatory amendments will impose many stringent controls over the issue of derivative products and the responsibilities of issuers as well as selling agents and guarantors as it has been experienced under the Sarbanes Oxley Act in the US after the Enron incidence in 2001. It will also work with overseas regulators to allow international funds easier access to Hong Kong investors. Rating of corporate and country bonds by S&P and Moody’s. Accounting for bonds under US GAAP. the pecking order hypothesis. The aim is to facilitate RMB fund flows between the Mainland and Hong Kong through the banking system. the direct and signalling effects on the value of the firm.16 . The proposals involve giving certain listing requirements statutory backing and finding ways to improve the regulatory structure governing the performance of the listing functions. Market Infrastructure The FSTB is preparing new legislation to provide a formal regulatory regime in respect of clearing and settlement systems which will bring the Hong Kong dollar into the international Continuous Linked Settlement (CLS) System . the FSTB is now under pressure in determining how to amend and make tougher rules in respect to the securities and company legislation based on the comments of all stakeholders and the review carried out by SFC and other government agencies. yield to call. Fund Management The FSTB has issued a consultation paper regarding the proposal to exempt offshore funds from profits tax. yield to maturity. All these topics will become more relevant and more meaningful after the development of bond market in Hong Kong.a global system for clearing and settling cross-border foreign exchange transactions. and detailed discussion of them will be deferred until the market develops fully. Banking The implementation of the scheme for providing personal RMB business by banks in Hong Kong will be the main focus of FSTB in this area. floatation costs.• • • • • Valuation of bonds. which gives effect to amend the Banking Ordinance to provide for the introduction of the revised banking supervision standards modelled on “Basel II"). In addition to these policy initiatives the FSTB has issued a consultation paper on proposals to enhance the regulation of listing.

the foreign exchange transactions of the banking industry in the Chinese Mainland will be subject to both the general regulations of the CBRC and the specific regulations of the SAFE. there are still tight foreign exchange controls. Authorize the establishment. the foreign currency policies and exchange is under the authority of the State Administration of Foreign Exchange (SAFE) instead of CBRC.cn/english/home/jsp/docView.cbrc. Compile and publish statistics and reports of the overall banking industry in accordance with relevant regulations. the banking industry is going to fully opened in the Chinese Mainland to overseas financial institutions.000 or more in each year without the prior approval of the SAFE. This requires an understanding of: • • • Risk assessment: what can go wrong? Risk control: what can we do about it? Risk financing: how do we pay for it? Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 .jsp?docID=2871 As the Mainland banking system is still under transition from tight state controlled to market regulations. see the web site at: http://www. Otherwise it will cause much trouble to the business organizations involved. and other functions delegated by the State Council. For example. Unlike the Hong Kong situation. Corporate investors such as the Qualified Foreign Institutional Investors (QFII) are also subject to controls in remitting profits in securities investment back to their home based countries.3 The Risk Framework Financial management requires a full understanding of total risk to a business. 13. whenever the banking operations are required. Conduct fit and proper tests on the senior managerial personnel of the banking institutions. subject to the requirements that overseas financial institutions have to meet before allowing to performing banking operations in the Chinese Mainland. and take enforcement actions against rule breaking behaviours.5 The Banking Environment of the Chinese Mainland In the Chinese Mainland the banking industry is regulated by the China Banking Regulatory Commission (CBRC). The main functions of CBRC include the following: a) b) c) d) e) f) g) Formulate supervisory rules and regulations governing the banking institutions. an individual in the Chinese Mainland may not be able to remit an equivalent amount of US$2.2. In the Mainland.gov. Responsible for the administration of the supervisory boards of the major State-owned banking institutions. and both inward and outward remittance of foreign exchange is subject to severe regulations under different situations. Thus. With the honoring of the WTO commitment in December 2006. changes. Conduct on site examination and off site surveillance of the banking institutions. special attention and care should be taken to ensure that all the complicated regulations instituted by various departments have been compiled with.13. Provide proposals on the resolution of problem deposit-taking industry in accordance with relevant regulations. termination and business scope of the banking institutions.17 . The SAFE submits proposals to the central government for the settlement of foreign exchange rate of RMB as well as to regulate the foreign exchange policies and rules for RMB and other foreign country monetary units. For the details of the Regulations on the Administration of Foreign Banks issued by CBRC which became effective on 11 December 2006. A holistic approach to all risks faced by a business must be adopted.

Risk management requires imagination and innovation. These exposures need to be mitigated through control and failures to do this means the risk must be financed.Management must be aware that risk is a dynamic rather than static concept. The figure below provides an illustration of the ways in which risk exposures may arise. April 1991. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . The process of risk management must also be a mechanism for coping with the effects of a changing environment.18 . The diagram is divided into four quadrant showing different types of risks. the treasurer must understand the potential effects of risks on the cash flows and financing of the company. Historically it has tended to lag change. especially in risk financing. The effects of managing or mismanaging risk will have an effect on the finances of a company. It must be understood that there is no economic benefit to be derived from waiting until risk strikes! Accordingly. Trends and Techniques for Challenging Times. Financial/ market Operational Physical damage Commodities Credit Consequential Personnel Interest rate Controls Controls Criminal Currency Securities Date Financing Contracts Statutory liability Terrorism Controls Controls State action Tort liability Regulations Product liability Political Legal Business risks Hazard risks Source: Managing Risk.

and that future results will be worse than predicted or expected. Companies face two broad types of risk: business risk and financial risk. These are primarily the Operational level: risks derived from the processes. Provide data and analysis as a basis for decision making. For example. This is the primary responsibility of a “risk champion/manager”. is the possibility that an organisation’s operations will deteriorate. but risk management solutions must be shared with the rest of the organisation. or introduces a rival product. sales turnover might fall because a competitor undercuts the company’s prices. business risks and management process owners. Confirm control and compliance. It is well recognised that the function of management is to meet the challenges of business risk and bring successful products and services to the market in an efficient and effective way. Business risk arises when a company’s commercial activities and operations are less successful than in the past or as expected. A company must complete a risk audit on an ongoing basis.3. The critical contribution of the risk management function is to facilitate four-way communication between the Board of Directors. This requires an understanding of: a) b) c) Risk assessment: what can go wrong? Risk control: what can we do about it? Risk financing: how do we pay for it? 13. To make things happen there needs to be a conscious effort led from the top through the involvement of people who can command credibility throughout the organisation. Measure performance. Co-ordination: to bring strategic and operational risks together as a synchronised activity.1 Organisational Risk Strategy and Management The topic of risk management and the finance and treasury function is discussed in Section 15.13.3. These are primarily the responsibility of process owners. business units. iii) b) c) d) The shift in perspective required to move the business towards a proactive and preemptive approach to the management requires a fundamental change. The purpose of the following discussion is to highlight a few key points in relation to organisational risk strategy and management: a) Risk management must happen at three levels within the business: i) ii) Strategic level: risks derived from external sources.19 . Commitment of permanent resources to the risk management function will ensure that the process is continuous.2 The Role of Treasury and Financial Market Risks Risk. responsibility of the Board of Directors. Managing risk in the business must continue to be the prerogative and obligation of line management. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . in business. e) f) g) The risk management process must develop a process that identifies all risks and their potential impact on the finances of the company. Management reporting needs to: i) ii) iii) iv) Ensure activity is aligned with and fulfils the business strategy.

the availability of money to borrow and customer bad debts. To ensure that decision making activity is both efficient and prudent. Treasury must be established under strict guidance and written policy approved by the Board of Directors. The three major areas of treasury management can be summarised as: a) Liquidity (working capital management) A fundamental responsibility of treasury is the measuring. or could change.Financial risk is perhaps less understood.20 . such as the cost of borrowing. 13. where a good credit rating will enhance the prospects of borrowing in domestic or international capital markets. Working capital management is covered in Section 16 “Short Term Financing and Working Capital Management”. There are advantages if the use of funds can be matched in maturity and conditions with those of the sources of finance. treasury must have a combination of clear policy (including risk limits within which it can operate). All of these events may have an adverse effect on the cash flows of a company and affect the profitability and solvency objectives of the company. and resources to perform the functions. monitoring and managing of cash flow and liquidity to safeguard the solvency of the entity.3. b) Funding (long-term corporate finance) An optimal mix of equity supported by short-term and longer-term financing facilities can meet the funding of the entity’s operation and capital expenditures and investments.3 Financial Risk Categories Financial risk categories managed by the treasury operation can be broken down into a number of forms: a) b) c) d) e) f) g) liquidity risk funding risk interest rate risk commodity price risk operational risk (business risk) foreign exchange risk credit risk Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . together with operational flexibility to respond quickly to changes in the well-informed and fast-moving financial markets. to deteriorate. It is the risk that financial conditions could be either less favourable than expected. Financial conditions relate to money and debts. seasonal fluctuations in working capital could be financed by bank overdraft. Cash flow forecasting is a fundamental requirement of responsible financial management. International capital markets may give rise to foreign exchange exposure. c) Financial risk The extent to which treasury needs to be involved in risk management will vary according to the nature. the yield from investments. causing business positions in financial terms. An essential role of treasury is to establish and maintain good relations with banks providing finance and with credit agencies. size and complexity of the business and the availability of experienced staff. As an example.

depending on its movement in an upward or downward direction.ensures funds are available when needed. in an overall sense. This may include the risk that borrowed funds may not be available when the company requires them or they will not be available for the required term or at an acceptable cost. at an acceptable cost. at the right time. Funding sources may include equity issues (in all forms). Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . is the risk that the company will not have sufficient financial resources to meet its liabilities (creditors and debts) as they fall due. Liquidity. Short-term liquidity crisis management . capital expenditure. Interest rate volatility has substantially increased interest rate risk since the deregulation of financial systems around the world since the 1980s. seasonal fluctuations. is the ability to obtain: • • • • • • the right amount of funds at the right price in the right currency in the right time zone at the right cost at the right time Liquidity risk. Proper management of this risk by treasury can add to the profitability of the company. There is also the risk that borrowers may lose credit lines from banks if they fail to comply with loan covenants. potential acquisitions and contingencies. or take advantage of profitable opportunities when they arise. as a part of cash management.a) Liquidity Risk Liquidity risk can be defined as the risk of having insufficient cash resources to meet day-to-day obligations. Three forms of liquidity risk can be recognised: • • Day-to-day cash management . supplier finance and leasing. A company needs to be aware of the impact on its Income Statement and cash flow for a given change in interest rates. The company may have to maintain adequate unused funding sources (generally at a cost) in view of such factors as future debt repayments.management of liquid assets and stand-by facilities.ongoing processes of ensuring funding facilities are available to meet future long-term requirements. It is the ability to raise funds. b) Funding Risk Funding risk is a subset of liquidity risk.21 . • Liquidity risk will be broken down in Section 16 “Short Term Financing and Working Capital Management” under the headings “Working Capital Management” and “Cash Flow and Funds Management”. Long-term going concern liquidity management . c) Interest Rate Risk Interest rate risk is the risk that movements in interest rates will affect financial performance (profit) by increasing interest expense or reduce interest income. debt.

cash flows. The approach to managing commodity price risk is similar to the management of foreign exchange risk.resulting from normal operational business activities of converting foreign currency receipts or payments into the home currency. assets or liabilities to the home currency will move in a direction that causes profitability and/or net shareholder wealth to decline. negotiating and delivery of financial transactions. and the continuing negotiations between China and the US in exchange rate parity. f) Foreign Exchange Risk Foreign exchange risk is the risk that the rate of exchange used to convert foreign currency revenues. There are three types of foreign exchange risk: • transaction risk . breakdown of financial systems or failure of electronic systems. Even companies which have no international business are exposed to exchange rate risk because their domestic markets could switch to a foreign supplier if their product was cheaper. translation risk . security and the physical environment.22 . Such risks can place stress on the cash flows of a company and must be understood by the corporate treasurer. The risk arises from specific areas including staffing. as well as with other overseas countries given the exchange rate fluctuations between China and the US. Operational risk is generally associated with reliance on internal and external systems relevant to the monitoring. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . expenses.created by taking a different approach to managing foreign exchange exposures from that of the company’s competitors.resulting from the conversion of long-term foreign currency assets and liabilities into the home currency at regular intervals for statutory reporting reasons (annual balance sheet). foreign exchange risks faced by financial people are often magnified by the possible de-linking of the pegged exchange rate system between Hong Kong dollars and the US dollars. This risk is the inherent risk of operating a treasury function and would therefore be common to all organisations with treasury activities and a treasury function. e) Operational Risk Operational risk is the risk of financial loss arising from the operational activities of the treasury function. but it has become part of the total foreign exchange policy of the whole country of China. • • In Hong Kong. It is even suggested by some analysts that a decision on such is no longer totally controlled in the hands of the Hong Kong SAR government. human errors. Because the central government of China increasingly uses interest rate policy to monitor economic development pace of China. economic risk . The risks are wide ranging and can include natural disasters. Hong Kong at present faces foreign exchange risks both between Hong Kong dollars and RMB. information systems. Often commodity prices have a foreign currency component in their pricing and this amplifies the risk to the company.d) Commodity Price Risk Commodity price risk is the risk that a change in the price of a commodity that is a key input or output of a company will adversely affect its financial performance.

either reducing a bank overdraft or earning interest on deposit. for example. interest rates and foreign exchange rates. Delayed payments from customers also provide a cash flow deficiency and incur a cost. If a government were to decide. regulatory risk and economic risk. particularly for inflation.g) Credit Risk Credit risk is the risk that the other party to a financial transaction will not meet their financial obligations on time (or at all). but the financial consequences of a larger Public Sector Borrowing Requirement might be much higher interest rates for commercial and private borrowers. business opportunities would arise for suppliers and contractors to the government. There are three key categories of credit risk: • Counterparty risk is the risk that the other party to a financial transaction will not meet its obligations as to timing or amount of settlement. Economic risk is the risk that economic conditions within a country will have harmful financial consequences. Provide an example. Regulatory risk is the risk that regulations affecting financial conditions will be introduced. Country risk can be divided into political risk.23 . to increase public spending by borrowing heavily. or that existing regulations will be enforced more severely than in the past. control and retention. since money that is still owed ought to be cash in the bank. This substantially affects the profitability and solvency objective of a company. transfer. • - - • Settlement or delivery risk is the risk that there is default in a single settlement or delivery. Corporate Risk Management Example 3: Required a) b) c) d) What are the key headings for a corporate risk framework and what are the key questions that must be answered? What does an integrated organisation-wide system of risk management attempt to achieve? Risk can be managed through a process of avoidance. It is generally beyond the direct control of the counterparty. This could restrict the ability of debtors to pay. Political risk is associated with government directives and policies that may affect the (financial) contractual performance of either party to the transaction or create continuing uncertainty about what the government might do. Why focus on risk? Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . What is the role of the treasurer in risk management? Suggested Solution Example 3: a) Corporate Risk Management What are the key headings for a corporate risk framework and what are the key questions that must be answered? • • Focusing on risk.

This requires an understanding of Electronic Commerce (ECOM) and Electronic Data Interchange (EDI). Reduce volatility of performance. invoices. How might the risks be managed? Risk reporting and organisation.• • • • • • • • • • • • • A risk management framework. Transfer (performance bonds in financial markets or insurance for pure risk). remittance advices and payments. Provide a springboard for growth. What is the business case for developing a risk management framework? How should a framework be developed? The identification of risk. The two usually fall under the responsibility of the treasurer. What measures of risk are appropriate? Management solutions. 13. transfer. Control (sprinkler systems in buildings). What process might a company consider using for the identification of risk? The measurement of risk. born out of greater confidence about outcomes. should adverse events occur). which delivers greater reward for a given amount of risk. Create added value for shareholders. shipping documents.4 The Financial Environment and Technology Information exchanged between organisations in the operation of commerce includes requests for quotes. • • • • c) Risk can be managed through a process of avoidance.24 . order confirmations. Who is responsible for managing risk? b) What does an integrated organisation-wide system of risk management attempt to achieve? • • • Align management activity explicitly with corporate objectives. d) What is the role of the treasurer in risk management? • To enhance the quality of business cash flows by the better management of risk. control and retention. How could they be reported? The way forward. bids. Prompt investment in business. • • • • Avoidance (withdraw from the industry). the role of the treasurer. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . Provide an example. Retention (a situation where the company is capable of financing it. Increase the efficiency of the business. purchase orders. Demonstrate compliance with regulatory requirements.

disbursements and concentration change considerably bringing both benefits and disadvantages. The Finance and Treasury Association in Australia links the worldwide web of professional treasury bodies together (Internet address http://www. Technology covers wide range areas of finance and accounting. the financial manager plays a key role in the operation of the firm.2 The Internet The Internet is a source of a wide range of information about financial markets and treasury.25 . but also to be able to gain funds to fund expansion. the financial manager must have an understanding of how to solve financial problems. production. not only in ensuring that the company has sufficient funds to remain in business in an every day sense. you can see that this is already an issue. is more than just understanding financial fundamentals.4. Summary Because most business decisions are measured in financial terms.com.au). ECOM also changes cash flow time lines and therefore the level of current assets and working capital. As a result of these events and risks. Other Internet sites of interest are included in the list of primary references. Financial management. This requires an in-depth understanding of finance. especially where they are critical for banking relations and providing services. They provide real time (or near real time) financial information including movements in currency and interest rates. Integrated computer packages now allow the dealing room to interface with confirmations and settlement. purchasing. For a corporate treasurer. ECOM impacts all areas of a company: • • • • • marketing.4.asct. 13. even though China has recently fully open its banking system in honouring the WTO Agreements.From your reading about services provided in the financial markets in Hong Kong. and finance. the Internet links professional finance and treasury bodies together. 13. Technology has allowed the development of global views by bringing a vast array of functions together through the use of technology and communications. internally and external to the company. the typical cash management problem of collections. transportation.1 Technology and the Finance Function Technology has impacted greatly on the development of integrated packages that allow the finance function to interface internally within the company and externally with financial (and other) markets and others. accounting. however. cash management and treasury management areas. Internally. The issue is even more problematic in the situation of the Mainland because of both the information filtering process as well as the exchange control mechanism operated by the Central Government. Dealing with information exchanges with trading partners. When companies implement electronic payments. The treasury Internet link has been designed to assist members access information for treasury professionals on the Internet. as well as forums for discussion on important financial and treasury issues on a real time basis. The treasurer must be aware of these issues. financial managers require a full understanding of the company and events and risks that will impact on its cash flows. Banks also provide ECOM services. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 .

The speed with which delinquency and default rates have risen for loans originating in 2006 has been striking. and so have a lower expected probability of full repayment. despite favourable economic conditions. the mortgage loan-to-value (LTV) ratio. 13. As long as house prices were rising.5 Sub-Prime Mortgage Lending – Lessons Learned in 2007 Source: Kiff. The highest delinquency rates have been associated with hybrid and option ARMs. This assessment is usually made according to the borrower's credit record and score. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . The use of the Internet is increasing and the financial manager must be aware of its advantages. John and Mills. debt service-to-income (DTI) ratio and. distressed borrowers had the equity to renegotiate their loans or could sell their homes and repay their mortgages.which can result in negative amortization during the first few years. political issues and information. the rate reset shocks that occurred when the teaser rates expired could be averted by refinancing the mortgage into another hybrid or option ARM. delinquencies and defaults on sub-prime mortgages originated in 2006 soared. While house prices were rising. However. the financial manager must be prepared to use technology to gain information. “Lessons from Sub-Prime Turbulence” (August 2007) at http://www. As well as understanding the impact of these changes on financial markets. which resulted in the failure of a number of originators in 2006-07 as securitizers exercised “put-back” options . As house price appreciation decelerated in 2006. by 2005-06 higher DTI and LTV ratios were insufficient to close the housing affordability gap for many sub-prime borrowers. that such loans were not viable at the full interest rate.26 . Recent sub-prime lending growth in the USA was boosted by more highly leveraged lending against rapidly rising house prices. Paul.forcing lenders to take back delinquent mortgages. legal requirements.morganmarkets. slowing house price appreciation in 2006-2007 and rising interest rates left many stretched borrowers with no choice but to default. in some cases. which has been followed by rising delinquency rates. Fraud also appears to have played a key role in accelerating the deterioration.Finance is affected and influenced by financial markets. The pace of technological change appears to be increasing. But many lenders and borrowers knew.high LTV loans to high DTI borrowers with little income verification. or should have known. so lenders started to offer “affordability” products." (EPDs) in which the borrower misses one or two of the first three monthly payments.com) in October and November 2008 respectively Sub-prime mortgages are residential loans that do not conform to the criteria for “prime” mortgages.htm Please also refer to investment research reports issued by UBS and the Hong Kong Property Market Report by JP Morgan (www. The financial manager must have a broad understanding of all these issues with knowledge of to whom to turn to for specialist advice.imf. However. particularly those that involved risk “layering” .org/external/pubs/ft/survey/so/2007/RES0823A. The first sign of trouble was the high volume of "early payment defaults. These included “hybrid” and “option” adjustable-rate mortgages (ARMs) that require payments at low initial fixed “teaser” rates .

Investors have placed excessive trust in rating agencies' approaches to structured credit. this will now be significantly harder.S. To avoid future confusion.to medium term. imminent payment resets mean that defaults on riskier U. the combination of interest rate resets are likely to create significant payment shocks for borrowers in 2007-09. Hence. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 .S. However. with lending standards tightening and house equity falling.S. However. sub-prime borrowers were able to limit payment resets by refinancing. implying similar potential losses.27 . such pressures generally should be resisted due to the danger of reinforcing speculative or fraudulent behaviour . such initiatives also rely on consistent state-level enactment and enforcement. Losses should be dispersed to exposed investors rather than taken over by taxpayers if borrowers cannot be assisted through loan modifications Tighten oversight.Lessons learned Kiff and Mills have outlined lessons to be learned from the sub-prime incident in the United States. The five regulators can enforce compliance by their regulated institutions but. ratings for the different types of obligation should be clearly distinguished and investors should never just rely on ratings to determine investment policy. the fragmented nature of U. financial regulation means that observance and enforcement of such standards is not uniform. The U. mortgages are likely to continue rising in the short. Federal banking regulators have recently tightened guidance on non-traditional and hybrid ARM mortgage lending. Looking ahead. appear warranted. since non-bank lenders and loan brokers are regulated at the state level. In the recent past. The ratings methodology for corporate credit risk is fundamentally different from that used for structured credit and yet the ratings that result are placed on the same scale.losses should be dispersed to exposed investors rather than taken over by taxpayers if borrowers cannot be assisted through loan modifications. Resist pressure for bailouts. With lending standards tightening. However. So what can policymakers do to avoid a similar crisis in the future? Improve consumer protection. especially concerning the clarity of disclosures to borrowers and the availability of the riskiest loans. Federal Reserve is reviewing its powers to regulate mortgage transactions and tighter restrictions. These lessons should be applied to the housing mortgage market in Hong Kong. Kiff and Mills identify the following lessons. Securitisers have access to relevant information over loan quality and one option could be to assign (capped) liability to them if checks against fraud and predatory lending in the pools of loans securitized are inadequate. This is a challenging task within a regulatory and legal framework ill-suited to provide effective consumer protection against predatory lending in an originate-to-securitise financial model. the appropriate policy response needs to balance improving consumer protection with maintaining the viability of the securitisation model that has successfully dispersed credit risk away from systemically important financial institutions. Policymakers will face continuing pressure to bail-out or subsidise stretched sub-prime borrowers.

The company’s internal resources are likely to be inadequate to provide the finance necessary to take all of the potentially profitable opportunities available to the business. As part of this commitment the management of the company have recently implemented a total quality management programme. For more recent information on the likely implications of the sub-prime incident for Hong Kong and Mainland China. many corollary effects have begun to emerge in Hong Kong since October 2008 as many local organizations in the banking and finance. The board of directors believe that as the economy moves out of recession the opportunities for further growth in sales and profitability will continue to increase. The prime function of the treasurer in every corporation is to withhold and source as much cash resources as possible in these days to ensure that the corporation will not be distressed or even bankrupt because of insolvency. In consequence the first item on the agenda for the next board meeting is the formulation of a financing strategy for FFHK. The company’s managing director is very aware of his limited knowledge of the workings of the financial markets. In fact. John Ryan observes that the threat to China that worries accounting professionals is twofold. more likely threat. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . is that the US mortgage crisis will send the world’s largest economy into a recession and crimp sales of manufactured exports that many regard as the key factor sustaining China’s economic growth. Chinese banks and other financial institutions are already finding themselves among the many investors stuck holding billions of dollars of difficult-to-understand AAA-rated debt that has suddenly become toxically illiquid and accordingly difficult to price. To meet these new opportunities the company has recently been reorganised. refer to the February 2008 issue of “A Plus” the Hong Kong Institute of CPAs monthly journal. The business has adopted a more decentralised management structure and has committed itself to becoming a “world class manufacturer” of modern and traditional furniture. The second. In this issue. He wants to do some “homework” before the next board meeting and has asked you as his long-standing financial advisor to provide him with some background information to help him cope with the issues currently facing his business. Part D Practice Question 1 [20 Marks] Fine Furnishings (Hong Kong) Limited (FFHK) is a company that manufactures a wide range of high quality wooden furniture in its two factories in the New Territories.28 . manufacturing and notably the entertainment industries started to dismiss staff and cut down the organisation size in order to improve cash flow liquidity and achieve a strong position to survive the crisis. Despite the recent recession the company has continued to grow and has been able to maintain its profit margins at very attractive levels. He has been advised that if FFHK is to develop a coherent financing strategy he must understand the nature and role of the financial markets in Hong Kong and further that he must understand the characteristics of the relationships between lenders and borrowers as well as those between investors and the businesses they invest in. First. The board has accepted the need to raise a substantial amount of finance for new investments and believes that this is essential if the company is to achieve its stated objective of a Stock Exchange Listing within the next five years. until banks are willing to loosen their lending policies again.Recent information on sub-prime implications for Hong Kong and Mainland. The company’s managing director is conscious of the fact that the somewhat ad hoc approach to raising finance used by the business in the past is not going to be acceptable in the future. The directors of the company are aware that their objectives cannot be achieved without major investment in new machinery and equipment. Furthermore the market values of both properties owned by the company have increased slightly in spite of the recession. It was founded by the present managing director ten years ago and over the past ten years has enjoyed a period of unbroken growth in sales and profitability.

Required Provide a draft report for the managing director which: a) b) c) d) Explains the nature and role of the financial markets.29 . Considers the relationships between lenders and borrowers as well as that between investors and the businesses they invest in. [6 marks] [4 marks] [5 marks] [5 marks] [Total: 20 marks] The securities traded on Hong Kong’s equity and debt markets are as follows: Instrument Money market Commercial paper Promissory notes Exchange fund bills Bond markets Exchange Fund Notes Corporate bonds Certificates of deposit Non resident issues Equity Shares Foreign currency Instruments Dragon bonds Corporate bonds Yes No Primary market activity is dominant. Describes the main components of the financial markets in Hong Kong and the securities traded on those markets. Primary market Secondary market Comments Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . As part of requirement c) complete the boxes in the tables below.

the lender and the borrower are brought together through the use of a financial intermediary. Financial (capital) markets provide the means for economic entities to exchange obligations. Direct . Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 .Hong Kong derivative products are listed below: Products Interest rate Forward rate agreements (FRAs) Futures Swaps Options Caps/collars Equity Futures Options/warrants Suggested Solution Practice Question 1 Timing (minutes) Part a) b) c) & d) Total time spent on question: a) 9 6 15 30 minutes [20 Marks] Yes Reasonably active market. Disintermediation is the process where companies raise funds directly from the public by issuing their own securities. This financial institution is able to bring borrowers and lenders together by absorbing the credit risk. Intermediation is the process by which the flow of funds between borrowers and investors (savers) are brought together as a result of the activities of a financial institution. Indirect . There are two categories of the transfers of funds between parties: 1. without the use of an intermediary.the lender and the borrower may be known to each other and the lender generally bears the credit risk. with the intermediary generally bearing the credit risk.30 . still developing. Active Market? Comments The Nature and Role of the Financial Markets. such as a bank. They interact for the purpose of buying and selling financial assets (debt and equity instruments). 2.

but equity investment is normally listed shares.Additional Information about the Role of Financial Intermediaries There are a number of different types of financial intermediary and they all have different functions in the efficient working of the financial markets e. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . Advantage: as for unit trusts. as insurance companies.: Commercial banks • • • Cheque payment and clearing system Receive deposits from small investors Lend short term and medium term to companies (and individuals) Merchant banks • • • • Lend medium and long term to companies Provide financing and investment advice Organise share issues (including underwriting) Advice and representation on takeovers and mergers. Market value of investment trust’s shares is not necessarily easily related to value of underlying investments. (Not good practice to invest in the organisation for which the employees work) Unit trusts • • • • Trust funds which invest in a portfolio of listed equity shares Each investor holds ‘units’ which represent a proportion of the fund Market value of fund is directly related to market values of underlying investments Advantage: spreads small investor’s risk (portfolio effect) cheaply Investment trusts • • • Quoted limited companies which invest in the shares of other companies.g.31 . etc Finance companies • • • Finance houses: hire purchase and instalment credit Leasing companies Factoring companies Insurance companies • • • Collect insurance premiums Invest long term in debt and equity Debt lending can be to smaller firms. Pension funds • • Collect savings from employees Invest long term in debt and equity.

The maturity of the security i. diverse and flexible products. equity linked and derivative instruments as financial market participants become more sophisticated and borrowers and investors demand more mature. A secondary market then enables the securities to be traded. Generally the securities offered by a company are in three forms: • • • Shares Commercial paper. Aggregation (collect together small deposits . are looking for more than security and a fixed rate of return. If only long-term investments are available. On many stock exchanges the dividend yield on ordinary shares is very low so it is apparent that the primary objective of most equity investors is capital growth.Financial intermediaries serve three important purposes in the working of the financial markets 1. Financial markets play both a primary and secondary role. the reason for purchase of the different types of “paper” will vary. Foreign exchange turnover amongst the highest in the world. which comprises dividends and capital growth. bonds etc. Hong Kong has: • • • • The largest stock market in Asia. This results in different investor types and consequent differences in the investment portfolios professional fund managers wish to develop. Investors will look at the credit risk of the company in order to satisfy themselves that the funds will be repaid on the due date. An emerging debt market. Derivatives Companies and corporate financial managers must be aware that whilst all investors are seeking a return on their investment. A well functioning secondary market provides the flexibility investors require by enabling them to trade the securities they have bought in order to realise the funds invested. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . They seek a return on their investment. the investor will wish to be sure of the existence of a secondary market.e. maturity and flexibility. outside of Japan. c) Financial Markets in Hong Kong Hong Kong’s capital markets are among the most sophisticated in Asia.can lend long term) Risk reduction (can reduce risk cheaply for small investors by investing in a portfolio of equity shares which they could not afford to own individually). 3.can lend large amounts) Maturity transformation (collect short term deposits . Equity investors on the other hand. and A derivatives market. Investors in non-equity securities will be concerned with security. the market has experienced a reorientation from an equity focus to encompass a wide range of debt. b) Business: Investor Relationships Investors make their investment in a company by buying the company’s securities. In recent years.32 . the date for repayment will also affect the investors willingness to invest. A primary issue of a security results in a direct flow of funds and securities between the borrower and lender. 2.

but developing market. maturities usually exceed one year. Small. resulting in a lack of liquidity to attract substantial numbers of debt investors. The securities traded on Hong Kong’s equity and debt markets are as follows: Instrument Money market Commercial paper Promissory notes Exchange fund bills Bond markets Exchange Fund Notes Yes Yes Active and developing market: maturities largely out to three years. However. inaugural issues 1989. Debt investors seek liquid markets in case they wish to liquidate their investment (with or without capital loss). Stable primary market: limited secondary trading. One of the major problems in the development of the debt market is the lack of secondary trading.33 . the Hong Kong stock market is highly sensitive to US interest rates. for Asian companies equity is still the cheapest and most efficient option of financing business and there is little enthusiasm for companies to switch to debt. Small. Initiatives are being undertaken by the Hong Kong Monetary Authority to develop liquidity in Hong Kong debt markets. market growing (especially convertibles) Source: Hong Kong Stock Exchange Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . active secondary market Primary market Secondary market Comments Corporate bonds Certificates of deposit Non resident issues Equity Shares Yes Yes Yes No Yes No Yes Yes Foreign currency Instruments Dragon bonds Corporate bonds Yes Yes No Yes Emerging market Small. Its broadest measure is the Hang Seng Index (HSI). Yes Yes Yes No Yes Yes Primary market activity is dominant.The Hong Kong stock market The Hong Kong equity market is one of the most actively traded in Asia. The Hong Kong debt market Hong Kong’s fixed income (debt) market is growing. Strong. developing market. but with only a small market for listed foreign company shares. Low activity. Well-established active market. Due to the HK$ being pegged to the US$.

and warrants issued by listed companies traded. Hong Kong derivative products are listed below: Products Interest rate Forward rate agreements (FRAs) Futures Swaps Options Caps/collars Equity Futures Options/warrants Yes No Yes Yes Yes Yes Yes Reasonably active market. Contracts are made on a bilateral basis. This eliminates the exchange rate factor as a variable in the territory’s economic development and stability although from time to time speculations on the possible de-linking of the pegged exchange rate system distort the market to a greater or lesser extent. As a foreign exchange centre.80 equals US$1 since 1983. to preserve the currency peg and the money demand and supply. Reasonably active market Reasonably active market Active market. Hong Kong is increasingly geared towards serving the needs of Greater China. still developing. Active Market? Comments Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . as well as exotic options are traded on the over-the-counter market. Options on stock and warrants written by financial institutions.The Foreign Exchange Market The HK$ has pegged to the US$ at the rate of HK$7. HIBOR futures contract not active Small developing market.34 . The HKMA is responsible for exercising effective influence over liquidity and interest rates in the HK$ market. Derivatives Markets Hong Kong has an active exchange traded and over-the-counter equity derivatives market and a developing debt derivatives market. Interest rates rise and fall in line with movements in interest rates in the US. with terms negotiated separately for each transaction. Equity and debt derivative products such as forwards and swaps. maturity lengthening. leaving Singapore to concentrate on South East Asia.

Result ranges: 30-40 less risk averse than most people 20-29 mid range 10-19 risk averse Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . If I received a $500. 5. Below is a reduced form questionnaire which may provide a clue to attitude towards risk.000 I would take the salary increase. The timing of borrowing and the structuring of the borrowing terms will depend on forecasts and an assessment of how likely they are. There are many psychometric profiling tools available to assess risk. 1 respectively. 6. 4 respectively Questions 3. (You may wish to search on the web under personal risk assessment to find more commercial instruments) Yes that’s me 1 2 3 I generally prefer familiar situations I generally give in when my plans conflict with those of family and friends If offered a choice of a performance related end of year bonus each year of $40. 2. 4. I believe that opportunity only knocks once. It should not be used as a serious tool.000 inheritance I would invest in fixed interest securities. Not all financial analysts will have the same attitude toward risk.Practice Question 2 [20 Marks] Liquidity risk is an essential component of the risks that Treasury needs to manage and should be covered in a formal policy.000 or a salary increase of $20. 2. 3.35 . I often put off making financial decisions because I am concerned I may make a mistake I can handle big losses and disappointments without difficulty. It is important to appreciate that not all individuals will assess risk the same way. I have confidence in my ability to overcome mistakes If I had to choose a comfortable life or an exciting one I would choose the comfortable one. 3. 7. 10 score from left column to right column as 1. 8.000 inheritance I would invest in shares If I received a $500. A bit like me Not really me Not Me 4 5 6 7 8 9 10 Scoring Questions 1. 2. 9 score from the left to the right as 4.

76% during the fourth quarter of 2008? Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . 4. While the long-term interest rate is lower than the short-term interest rate. future financing needs. Required Answer briefly.36 .2. In the short-term the short-term loan is better but in the longer-term the answer depends on what you expect the future to hold. in attitude toward risk. There is no definite answer as to how differing risk assessments will influence attitudes toward financing but they do point to the need for clear policies to ensure that decisions are not made on purely personal whims. to complete the questionnaire. If you need continuing finance and borrow short. strength of balance sheet and earnings/cash flow streams likely in the future. Were you correct in your assessment of their being a difference? Suppose a company could borrow money for six months from the bank at 9% pa.Required a) Complete the risk profiling questionnaire and compute your score. It is not possible to be definitive but generally we would expect risk averse people to hedge.3 of this CLP. Ask a colleague whom you intuitively feel may be different to you. among others. likely interest rates. Tally up the score. these rates refer to quite different time horizons.3% pa. The same is true with insurance in that the risk taker is more likely to self insure than pay a premium to transfer the risk to someone else. Considerations include.e. “Summary Interest Tables for Exchange Fund Notes issued by the HKMA”. [15 marks] b) c) Practice Question 3 Refer to Section 13.5% for six months or it could borrow on a 5 year term loan at an interest rate of 8. i. Which is best? Do you think that a risk averse person and a non-risk averse person would make the same decision as to whether to hedge interest rate risks? b) c) Suggested Solution Practice Question 2 Timing (minutes) Part a) b) c) Total time spent on question: a) 10 10 10 30 minutes [20 Marks] There is often a wide range of attitudes towards risk among people which is part of the risk tapestry of life. any restrictions on credit availability. the following questions in relation to this table: a) b) c) d) e) What do you observe about the relationship between interest rates and maturity? What is the name given to this phenomenon? What determines the shape of this phenomenon? Why is knowledge of this important to company financial treasurers and investors? Why had the two year interest rate on Exchange Fund Notes fallen to 0. Find the table titled. you will know your interest rate for six months but then be faced with borrowing again at the then prevailing interest rate.

which in this case is seen to be upward sloping. This happened in the early 1980s. expectations about future inflation and interest rates and.37 . one. the yield to maturity increases also. and this results in the upward sloping yield curve observed here. It results in a “yield curve”. perceptions about the relative riskiness of securities with different maturities. This reflected the actions of central monetary authorities around the world. c) d) Knowledge of the term structure of interest rates is important to company financial treasurers. Historically. The phenomenon is known as the “term structure of interest rates”. that they focus only on short-term returns.Suggested Solution Practice Question 3 Timing (minutes) Part a) b) c) d) e) Total time spent on question: 2 4 6 4 4 20 minutes [15 marks] a) b) As the maturity period increases. financial experts often call an upward sloping yield curve a “normal yield curve”. and that they are less concerned with risk. This dramatic fall in interest rates was triggered by the actions of the Federal Reserve in the United States and was followed by many other jurisdictions around the world. But it is possible for an abnormal downward sloping yield curve to occur. Some experts argue that the second factor – relative maturities – is considerably less important than expectations about future rates. when short term interest rates were abnormally high. a majority of experts would argue that risks associated with interest rates do matter. However. including the Hong Kong Monetary Authority. This argument has been called the pure expectations theory of the term structure of interest rates. For this reason. in most years longterm rates have been above short-term rates. e) Hong Kong Institute of CPAs Financial Management Module (printed May 2010) 13 . It is also important to investors. This view is often called the liquidity preference theory. They contend that the market is dominated by large traders who buy and sell securities of different maturities each day. and that the market regards long-term securities as riskier than short-term ones. because they must decide whether to borrow by issuing short-term or longterm debt. By the end of the fourth quarter of 2008 short term interest rates had fallen to very low levels. two. The shape of the yield curve depends upon two factors. who must decide whether to buy short-term or long-term fixed-interest securities.

legal and business risks facing an organisation. Government and regulatory bodies. political. Make recommendations about the economic impact of external and internal events/risks on an organisation relating to national and international factors. Identify and interpret the economic and financial implications of the potential impact of technological developments on an organisation. Hong Kong Institute of CPAs Financial Management Module (printed May 2010) After talking to my Workshop Facilitator After my examination preparation After my Workshop . political and legal framework facing any organisation.Part E How do I know I have succeeded in this topic? Can I: Should I do more research 13 . Report on the likely external (financial) impact of actual or proposed strategies and organisational decisions by: • • • • financial markets. Comment on and interpret capital market trends. operational.38 After working through this Section Report on the likely internal (financial) impact of actual or proposed business strategies. Identify and explain the potential impact of financial. Classify risks within the financial. operational. financial market participants. (existing and potential) debtors. creditors and suppliers. etc.