Fall 2016

MBA Semester 4

MF0016: TREASURY MANAGEMENT

Q1. Give the meaning of treasury management. Explain the need for specialized
handling of treasury and benefits of treasury.

Treasury Management

Treasury management is the planning, organising and control of funds required by a

corporate entity. Funds come in several forms: cash, bonds, currencies, financial derivatives
like futures and options etc. Treasury management covers all these and the intricacies of
choosing the right mix.

According to Teigen Lee E, Treasury is the place of deposit reserved for storing treasures
and disbursement of collected funds. Treasury management is one of the key
responsibilities of the Chief Financial Officer (CFO) of a company.

Need for specialised handling of treasury

Treasury management should be practised as a distinct domain within the Finance function
of an organisation for the following reasons:

One of the most consistent demands on the CFO of a company is that money must
be available when needed, and this becomes a 24/7 task.
The cost of money raised for the business is probably the most crucial metric in a
company for many of its investment and operational decisions. Hence cost of funds
has to be tracked diligently.
Internal financial management in a multi-national corporate entity requires monitoring
of several global currencies.
Globalization of business has thrown up an unbelievable basket of opportunities for
the CFO to optimize the utilization of funds and minimize its costs. This requires
expert handling.
Globalization has also brought in unexpected risks that are not visible to the
untrained eye but can even destroy a business. Who would have thought that the
crash of Lehman Brothers could impact business houses in interior India? But that
was what happened in 2009.
With increasing financial risk shareholders have become jittery about their holdings
and need reassurance often. For a company the Treasurer is probably the best
spokesperson to allay the concerns of stockholders and other interested parties.
Benefits

Managing treasury as an expert subject has many benefits:

Valuable strategic inputs relating to investment and funding decisions

Close monitoring and quick effective action on likely cash surpluses and deficits
Systematic checks and balances that give early warning signals of likely liquidity
issues
Significant favourable impact on the bottom line for global corporations through
effective management of exchange fluctuation
Better compliance with the increasingly complicated accounting and reporting
standards on cash and cash equivalents

Q2. Explain foreign exchange market. Write about all the types of foreign exchange
markets. Explain the participants in foreign exchange markets.

Foreign Exchange Market

Foreign Exchange market (forex market) deals with purchase and sale of foreign currencies.
The bulk of the market is over the counter (OTC) i.e. not through an exchange which is well
regulated.

Types of foreign exchange market

Spot market Spot market is a market in which a currency is bought or sold for
immediate delivery or delivery in the very near future. Trading in the spot market is
for execution on the second working day. Both the delivery and payment take place
on the second day. The rate quoted is called as spot rate, the date of settlement
known as value date and the transactions called spot transactions.
The forward market involves contracts for delivery of foreign exchange at a specified
future date beyond the spot date and the transaction is called a forward transaction.
The rate that is quoted at the time of the agreement is called the forward rate and it is
normally quoted for value dates of one, two, three, six or twelve months.
Unified and dual markets Unified markets are found where there is only one market
for foreign exchange transactions in a country. They have greater liquidity, increased
price discovery, lower short-run exchange rate volatility and reliable access to foreign
exchange.
Offshore and onshore markets During the earlier stages of financial development,
forex market operated onshore i.e. within India. But after liberalisation of the
economy, offshore markets have developed and instruments based on foreign
currencies issued by Indian firms are traded in foreign markets.
Participants

The participants in forex market are the RBI at the apex, authorised dealers (ADs) licensed
by the central bank, corporates and individuals engaged in exports and imports.

Corporates Corporates operate in the forex market when they have import, export of goods
and services and borrowing or lending in foreign currency. They sell or buy foreign currency
to or from ADs and form the merchant segment of the market.
Commercial banks Banks trade in currencies for their clients, but much larger volume of
transactions come from banks dealing directly among themselves.
RBI RBI intervenes in forex market to ensure reasonable stability of exchange rates, as
forex rates impact, and in turn are impacted, by various macro-economic indicators like
inflation and growth.
Exchange brokers They facilitate trade between banks by linking the buyers and sellers.
Banks provide opportunities to brokers in order to increase or decrease their selling rate and
buying rate for foreign currencies..

Q3. Write an overview of risk mitigation. Explain the processes of risk containment.
Write about the tools available for managing risks.

Risk mitigation can be handed in four ways:

Risk avoidance: We can withdraw from an activity perceived to be risky, and elect not
to go through with it.
Risk transfer: We can insure ourselves against the risk and transfer it to another
party called the insurer.
Risk sharing: We can disperse the risk element in an activity and reduce its impact,
by the use of derivative instruments,
Risk acceptance: We can build our competence and capability to deal with the risk by
detailed study, research and methods developed specifically for the concerned
activity and its risk component.

Processes for risk containment

The basic steps in a typical risk containment process are:

Establishing the context i.e. analyzing the strategic and organizational context in
which risks occur
Identifying risks i.e. defining the risks associated with business, to have a
fundamental understanding of the activities causing risk of loss
 Quantifying risks i.e. measuring the probability, frequency and hence the value of the
risks, besides listing non-quantifiable effects of the risks
Formulating policy i.e. providing a framework to handle risks, which lays down
standard levels of exposure and policy guidelines for each level
Evaluating risk i.e. ranking the risks based on priority, and aligning action and cost
thereof with the rank
Treating risk i.e. development and implementation of a plan with specific methods to
handle the identified risks

Tools available for managing risks

Risk management tools do analysis and implementation of methods for mitigating risks. The
major tools available for risk are:

Failure Mode Effects Analysis (FMEA): This tool is used for identifying the cost of potential
failures in business. This method can be applied during analysis and design phases of new
business to identify the risk of failure.

Fault Tree Analysis (FTA): The tool is used as a deductive technique to analyse reliability
and safety of an organisation. It is usually implemented for dynamic systems. It provides the
foundation for analysis and justification for changes and additions of various actions to
reduce risks.
Process Decision Program Chart (PDPC): The tool identifies the different levels of risk
and the countermeasure tasks. The process of planning is essential before the tool is used
for measuring risks. It includes identifying the element causing risk. The next process
consists of identifying the context of problem and measures to reduce risks.

Q4. What is Interest Rate Risk Management (IRRM)? Write the components and
features of IRRM. Explain the macro and micro factors affecting interest rate.

Interest Rate Risk Management (IRRM)

Interest Rate Risk is the risk

to the earnings from an asset portfolio caused by interest rate changes

to the economic value of interest-bearing assets because of changes in interest rates
to costs of fixed-rate debt securities from falling bank rates
to impact of interest rates on cost of capital used by the firm as hurdle rate for capital
investment
Components of IRRM

IRRM can be broken into three parts: term structure risk, basis risk and options risk.

Term structure risk also called yield curve risk is the risk of loss on account of mismatch
between the tenures of interest-bearing monetary assets and liabilities. For example if
investments are held in 7-year assets yielding a fixed 7% return, funded by a 5-year bond
costing 6%, but renewed at the end of 5 years at 8%, there is a loss of 1% during the sixth
year. This can also happen if either of the tenures is on floating and not fixed rates and the
rate changes adversely.

This situation is called re-pricing and can be either asset-sensitive or liability-sensitive,

depending upon which gets re-priced first.

Basis risk is the risk of the spread between interest earned and interest paid getting
narrower.

Options risk is the term risk on fixed income options i.e. options based on fixed income
instruments.

Features of IRRM

Following are the features of corporate IRRM process:

Clarifying the policy with regard to interest rate risk

Constant watch on market rate fluctuations and studying its relevance to the firms
cost of capital
Fixing the band beyond which interest rate changes should trigger corrective action
Special attention to long-term fixed exposures in investments as well as funding
decisions
Effective, unambiguous and timely reporting on IRRM to the CEO and the Board

Macro factors

Cost of living index: Increases in price levels of goods and services over a period of
time reduce real value of the rupee and push interest rates up.
Condition of economy: Whether the economy is rapidly growing or its growth rate is
declining can make a difference.
Global liquidity: Global economic environment and availability of funds across the
world does have an impact.
Micro factors

Micro factors, meaning factors specific to the borrower, which play a role in the interest rate,
are:

Individual credit and payment track record, credit rating

Industry in which the business is operating
Extent of leveraging of the company viz. debt-equity ratio
Quality of prime security and collateral
Loan amount

Q5. Explain the contents of working capital. Write down the need for working capital.

Contents of working capital

A trading business for instance may have to purchase and store products to be sold,
paying for them before they can be sold and cashed. A factory that produces and
sells products has to store raw materials and finished goods, besides having some
unfinished materials under process.
A company may also need to allow the customers to pay later instead of insisting on
cash at the point of delivery.
Payments in advance may be required for certain expenses like annual insurance,
deposit for renting the office, foreign currency and tickets for foreign travel or
advance fees/deposits for statutory registrations.
And finally the business must have some idle cash and bank balances for making
spot payments.

Need for working capital

Can a business run without the need to invest in working assets like trade receivables and
inventories? Let us study the following case.

Pachai is a vendor of pani-puris in a makeshift stall of his own at the end of the street
in which he lives.
Every morning he goes to the market and buys the ingredients to make pani-puris for
the day, estimating the quantity based on anticipated sales. He buys more in the
weekends, naturally.
He does not pay for the material as he buys on credit.
 Through the day he does the processing of the pani-puris to the stage needed, and
at 4 pm sets up the stall and runs it till 8 30 p.m.
As he sells the pani-puris he collects cash, and at 8.30 or earlier, depending upon the
demand, he sells his days produce completely.
He goes across to the vendor from whom he bought the ingredients and pays for the
supply, and returns home with the balance money, which is his profit.
The cycle is repeated day after day.

Here is a businessman who, you might say, does not require working capital at all: no idle
cash, no deposits, no receivables and no inventories. But this is an extreme case under ideal
conditions.

If the produce is not sold fully it becomes inventory for the next day. Or the vendor might
want a security deposit. Or Pachai may think about expanding by selling a part of his
produce in bulk to another stall-owner, who will pay once a week. In all these cases he will
need to worry about working capital.

Q6. Explain the concepts and benefits of integrated treasury. Explain the advantages
and disadvantages of operating treasury.

Concept and Benefits of Integrated Treasury

The concept of integrated treasury works on the principle that Treasury can be a single
unifying force of a companys activities in the money market, capital market and forex
market; and can help the company derive synergy. Synergy is a powerful advantage in
business because it brings together two or more activity domains and achieves a total effect
that is greater than the sum of all the individual domains.

Thus a decision related to money market instruments, for example, is taken after reviewing
possible forex actions that could enhance the benefit of the decision.

The Indian rupee is freely convertible on current account and partially convertible on capital
account. This has made it possible to take a combined approach to a treasury issue.

The major functions of integrated treasury are as follows:

Ensuring liquidity reserve

Deploying surplus funds in securities with low risk and moderate profits
Managing multi-currency operations
Exploring opportunities for profitable placements in money market, securities market
and forex market
 Managing the sum total of treasury risks with some balancing actions as between the
three markets
The benefits of integrated treasury are:

Improved cash planning and better monitoring of the cash position

Constant watch on the impact of treasury activities on the balance sheet
Greater financial control by integrating budgetary control and financial information
The advantages of operating treasury as a profit centre than as a cost centre are:
Individual business units can be charged a market rate for the service provided,
thereby making their operating costs more realistic.
The treasurer is motivated to provide services as economically as possible to make
profits at the market rate.

The disadvantages are:

The profit concept is a temptation to speculate. For example, the treasurer might
swap funds from the currencies that are expected to depreciate and risk the company
cash values.
Management time could be wasted in arguments between Treasury and business
units over the charges for services, distracting the latter from their main operations.
The additional administrative costs may be excessive.