UNIT 3: Corporate Treasury Advisory Services

3.1 The Function of Corporate Treasury Management

3.1.1 Corporate versus Bank Treasuries

• Unlike corporate treasuries, bank treasuries are profit centres. In other words, bank treasuries aim to make profits. A bank’s treasury is a business unit and is trading oriented. For example, a bank treasury quotes foreign exchange transactions against current market prices and earns the spread between the bid (buy) and ask (sell) rate. Any open position on a financial instrument is the investment asset or liability of the bank.

• In corporations, treasury activities and exposure are complementary to the main business. All financial positions of a corporate treasury should be secondary to the main business, such as manufacturing, importing and exporting. For instance, an oil producer in the Middle East exporting to the US will naturally have financial exposure on oil prices and the US dollar. The creation of the financial exposure is not to gain trading profit from oil and US dollars but is merely complementary to the normal operating cycle of the oil production.

3.1.2 Treasury Advisory Services in Corporate Banking

• Banks provide many banking services to help corporations achieve their treasury functions. For instance, banks help corporations invest their short-term surplus funds, provide them with short-term credit facilities for liquidity purposes, provide them with long-term loans for business development, and underwrite their debts, equities and market financial derivatives for the purpose of hedging their risks.

• Currency exchange is one of the first services that banks offered to customers. A bank traded one form of currency, such as US dollars, for another such as Euro or Japanese yen — in return for a service fee. Today, only the largest banks carry out trading in foreign currency, because of the risks involved and the expertise required when carrying out such transactions.

• There is an increasing trend for corporate treasurers to call for cash management services from banks. In cash management, banks handle cash collections and disbursements for a business, and invest any temporary cash surpluses in short-term interest-bearing instruments until cash is needed to pay bills

3.2 Cash and Liquidity Management

3.2.1 Liquidity Management Services

• Unlike corporate treasuries, bank treasuries are profit centres. In other words, bank treasuries aim to make profits. A bank’s treasury is a business unit and is trading oriented. For example, a bank treasury quotes foreign exchange transactions against current market prices and earns the spread between the bid (buy) and ask (sell) rate. Any open position on a financial instrument is the investment asset or liability of the bank.

• Banks can help corporations improve liquidity in many ways. The liquidity management services provided by banks can be categorized into investing idle cash and procuring funds.

• Cash investment services• Fund procurement services

3.2.2 Cash Management Services

• Cash management products offered by banks have broadened from account balance reporting and electronic funds transfer to include lockbox, in-country collection services, bulk payments and cash concentration systems.

• There are probably four stages in cash management:

• 1 collection of cash, • 2 collation of balances, • 3 management of balances, and • 4 dissemination of funds.

3.2.3 Challenges in Offering Cash Management Services

• One of the major challenges for banks to provide cash management services is the commitment to invest in information technology. In order to reduce operational time and cost, corporations try to work with a bank that has the capability to interface with their own back office systems. This means that the bank’s cash management system must be technologically up-to-date so that it can seamlessly integrate into the corporation’s system.

• Another challenge is the capability for banks to provide local and regional knowledge on unwritten local market practices and the ambiguity of the regulatory environment. This is particularly important if the corporations are operating in emerging markets in which regulations are not well established. Only a bank with a good branch network covering specific regions can help corporations structure domestic and cross-border cash management solutions to save time and cost.

• Obviously, banks can play many roles relating to cash and liquidity management in corporations. Depending on the domestic environment, banks’ cash and liquidity management services could vary from country to country.

3.3 Capital Management

3.3.1 Cost of Capital When banks advise firms on how to finance their business, it is necessary to analyse the cost of new capital. In a broad sense, capital is all sources of fund such as loans, bonds and equities. In a narrow sense, it is long-term funds, including:•Equities •Retained earnings •Preference shares •Long-term bank loans •Long-term bonds •Convertible bonds •Convertible preference shares

3.3.2 Capital StructureFactors influencing capital structure:• Maturity matching • Nature of assets and earnings • Control • Risk • Cost • External constraints

3.4 Financial Risk Management Objectives

3.4.1 Risk Identification

The following are some examples of financial risk exposure that corporations can encounter: •Stock market risk •Commodity risk •Exchange rate risk •Interest rate risk •Credit rating risk •risk (or political risk)

3.4.2 Risk Measurement According to the Basel Committee’s work, the basic principles of risk management related to the risk measurement process include:•Risk measures must identify and address all major sources of risk.•Risk measurement processes must be reasonable and transparent, with the underlying assumptions used to quantify risk understood by those relying on the measures.•The risk measures must consider possible breakdown of key assumptions, particularly the liquidity of markets, on the measured results.

3.5 Financial Risk Hedging Techniques

3.5.1 Currency Risk

There are three major types of currency risk:

• Transaction exposure • Translation exposure • Economic exposure

3.5.1 Currency Risk Internal hedging techniques• Currency of billing • Matching • Leading and lagging External hedging techniques• Hedging with forward contracts • Hedging with currency futures • Hedging with currency swaps • Hedging with currency options

3.5.2 Interest Rate RiskInternal hedging techniques• Matching • Refinancing External hedging techniques• Hedging with interest rate futures • Hedging with interest rate swaps • Hedging with interest rate options