INDEXIntroductionTraditional Functions in Details The Age of UncertaintyChanging ResponsibilityPolicy FormulationNew Tools Case StudiesGuidelines for the Way Ahead

Introduction

The role of Treasury Manager has changed dramatically during the last decade. From a narrow facilitator of transactions, with few analytical tools, the task of treasury management has become a dynamic, quantitative function, providing service and often-additional profits to the entire corporation. The financial arm, today, is often the lifeblood of a corporation. Today the strength of treasury operations is often what distinguishes a lackluster performance from stellar growth in quantity in quality of earnings. We have explored the traditional function in detail, with particular reference points; we will be able to see how treasury management has changed. The forces behind these changes will be explained and assessed for importance. We will also review some of the important new tools used by Treasury Managers to achieve the broader, more difficult tasks required in the modern, global business climate. Some case studies will illustrate Treasury operation in practice. Lastly, we will conclude with some sensible guidelines for the task of Treasury Management.

Traditional Functions of Treasury Manager

To say that financial management is critical to all businesses is an obvious truism. But to observe that the task of financial management has changed dramatically in recent years is less obvious. In terms of product and technology many industries evolve slowly. Although Financial Management as a field has been studied separately since the turn of the century, early emphasis was upon the legal aspects of such matters as mergers, formation of new companies, and type of securities. With primitive capital markets, the main task facing the corporate treasurers was securing funds for expansion. Earnings and assets values as reported in the accounting statements were often unreliable. With insider trading and manipulation, stock prices fluctuated widely. The average person had neither the means nor acumen for playing bond and stock markets. As a result of these conditions, some of which played a role in the great crash of 1929, the purpose of the financial mangers was as largely a legal function. Even after the reform of 1930s, finance was still taught not until the 1950s, using rigorous mathematical methods that such issues as:

The purpose of financial markets and innovation; The optimal mix of securities; How securities are priced; and How investors make investment decisions

Were addressed. Both the assets and liability sides of the balancesheet became much more interesting, especially form the standpoint of how they are related.

New tools for analysis were created. Most importantly, the above intellectual achievements led to a general theory of finance, which finance managers utilize for both day-to-day as well as the long-term challenges facing the firm. We will review these achievements below. After which we will examine some of these traditional functions of financial managers, beginning with general responsibilities and thereafter turn to specific applications.

Intellectual AchievementsDuring the 1950s and 1960s, the science of finance, from humble beginnings, grew into widely accepted and used general theory addressing the issues mentioned above. Although research since then has enhanced and refined these achievements, it is arguable that the foundations achieved will rest secure for a long time to come. Without attempting an exhaustive literature review, from the standpoint of Treasury Management, it is useful to take note of this intellectual heritage and the key concept, which it created. Net Present ValueInvestments involve the exchange of know amounts of cash today for expected returns in the future. Given what we have in hand, the fundamental question is always how much is the future worth. When we calculate Net Present Value, we are determining whether the investment or project is worth more than it costs. All Treasuries utilize this basic but critical method of analysis. Using the relevant cost of capital, managers will discount future cash flow to determine their present worth. The methodology underlying NPV, permits millions of shareholders of vastly different backgrounds and expectations, to participate in the same enterprise through bonds and shares, with one view in mind: maximize the Net Present Value of my investment.

Capital Asset Pricing ModelThe CAPM is centerpiece of modern financial theory, because it gives Treasury Managers and other financial professionals a meaningful and manageable way of thinking about the required return on the risky investment. Or, how one trade off risk and return. The model is attractive because it specifies two kind of risk those, which one can diversify away and those which one cannot, - market risk. Market risk measure by beta, which is a measure of the extent to which a particular investment is affected by a change in the aggregate value of all assets in the economy. The most important risks are those, which are not diversifiable, which is why, the required return on an asset increase with its beta. The Model is a cornerstone of the practice of Financial Management.

Efficient Capital Markets The third fundamental idea upon which modern financial theory is based is that the prices of securities accurately reflect available information and respond rapidly to new information as soon as it becomes available. Although expressible in different strong and weak versions, the idea merely says that capital markets are very competitive. Of course, some people will use available information better than others. The point, however is that there are no easy ways to make money in such markets…prices generally reflect true values.

Value AdditivityThe fourth principal of modern finance is that the whole is equal to the sums of the parts. This rule applies to investments and the corporate structure of firms. For example, if a petroleum company decides to diversify into the prepared food business, an activity where there is no clear synergy such as transferable technology or decreasing average cost, the new company will not be worth any more than its constituent parts. The principal of Additivity also applies to capital structure, other things equal a firm’s capital structure does not affect the value of the firm: so long as the total cash flow generated by the firm has not changed, its value is unchanged. With the same cash flow, value is independent of capital structure.

PROFITS ARE THE REWARD FOR TAKING RISK

X Rate of ReturnY RiskHigher return comes with greater risk.

Option Theory

The final cornerstone of modern financial theory is theories on the pricing and behaviour of options. In finance, options refer to the right to buy and sell a security or commodity in the future on terms, which have been fixed today. For a time in the future, an option with specific pricing, timing, delivery, quality provides the right to sell or purchase a security, a commodity, or foreign exchange. Options have long been part of the product repertoire, although beyond looking at the forces of supply and demand, it was not known how to evaluate them. Today, the use of option forms a critical ingredient in the risk management functions of the modern Treasury Manager.

General Responsibility

Using the above theories, the financial manager’s primary task is to plan for the acquisition and uses of funds or capital so as to maximize the value of the firm, in this regard; general responsibilities include the four following areas:(A) Forecasting and Planning - The financial manager must interact with

other executives as they make short and long term, strategic and tactical plans for their firm’s future.

(B) Major Investment and Financing Decisions – On the basis of long-run plans, the financial manager must raise the capital needed to support the firm’s growth. The economic growth and technological change imply that competitors are always on the horizon; therefore growth in sales and revenues is an on-going objective. This requires increased investment in plant, equipment, and current assets necessary to produce goods and services. The financial manger must help determine the optimal rate of sales growth, and he or she must help decide on the specific investments o be made as well as on types of funds to be used to finance these investments. Decisions must be made on the mix of internally. Should such funds be in the form of debt or equity? Should debt be of a long-term or short-term nature?

(C) Interaction with Capital Control – The financial manager must interact with executives in other parts of the business if the firm is to operate as efficiently as possible. All business decisions have financial

implications, and therefore all managers both financial and otherwise must take this into account.

(D) Interaction with Capital Markets – The financial manager must deal with the money and capital markets. Seldom is it prudent or desirable to use only internally generated funds for growth, and to be always matched in assets and liabilities.

Form the above, we see that the general responsibilities of financial managers involve decisions such as which investments their firms should make, how these projects should be financed, and how the firm can most effectively manage its existing resources. Success in these areas, using the new tools of finance mentioned above, would lead to the maximization of the value of their firms in the interest of shareholders, as well as serve the broader interests of those who work for the firm along with those who deal with the firm.

Applications

In the remarks below we turn to some of the traditional activities in which corporate treasuries are involved. No firm is identical, and therefore the importance given to these various activities may vary, but they are all important. We note that while some of the methodologies have changed, the applications remain critical to any corporation. We will look at some of the following traditional function of treasury management.

(A) Banking Relationships – There are a myriad of ways in which the modern Treasury Manager uses and relies upon relationships with banking and other financial institutes. Without describing the purpose in detail, in developing and maintaining good relationships with various banks, the Treasury Manager is ensuring that the bank’s resources, technology, and expertise will be available to him whenever required. It might involve access to trade finance or to facilitate sales to a customer in another country. It might involve a line of shot term credit to finance receivables. It involves the investment bank, which structures and places the new rights issue to raise equity capital for expansion. It might involve a dealing room of the bank through which commodity options may be purchased to manage the value of a running inventory. Banks clear cheques, operate lockbox plans, supply credit information, etc. the possibilities are as varied as the nature of business. Developing and

maintaining relationships with financial institutions, especially one whose strength is critically related to a firm’s needs, is a goods business practice.

(B)Cash Management – How much of a firm’s assets should it hold in cash a “Non Performing Asset” is an ever present question facing the management of both the smallest partnership and the largest transnational corporation. Statistical surveys reveal wide difference in the percentage of assets held in cash or fullyliquid securities. Synchronization of disbursement and receipt reduce the need to maintain idle assets such as cash, although having a positive float – the difference between a firm’s checkbook balances and the balance shown on a bank’s books, may be used advantageously. The Treasury Manager in deciding how much of a firm’s assets to hold in cash must look at some of the following reasons for holding cash:

Transactions – Cash balances are necessary in day-to-day business operations. Routine payments and collections required that a portion of assets be kept in cash.

Precautionary Balances – The less predictable the form’s cash flows, the larger such cash balances should be, although the firm has good access to borrowed funds, its need to hold cash will be smaller. A purchase of replacement inventory after an industrial accident, or having funds on hand to make a legal settlement; are all examples.

Speculative Balances- some cash balances may be held to take advantages of any bargain purchases that might arise. For example, buying –up inventory from a distressed or bankrupt seller.

(C)Long -term financing - Although an important role a treasury manager is to develop banking relationships, the financing of specific projects is critical task. In general, it is desirable to connect a particular project for example, a new plant or new division or new product to a particular tranche of financing capital. Using a general “pool of funds” approach for various project doesn’t relate the cost of funds to the project, therefore renders it difficult to measure the return on borrowed capital. Traditional long-term debt interments as used by Treasury Managers, may be in the form of a Term Loan, which is contract in which a borrower agrees to make a series of interest and principal payment on specific date to the lender. Unlike raising equity capital for an expansion, term loan are quicker to obtain, and usually more flexible. Finance may also be raised by issuance of bound, which are promissory note backed by the credit worthiness of the firm. Deciding which type of financing is best and how to structure it is the role of Treasury Management. The Treasury Manager must look at interest rates both now and into the future, along with the affect of borrowing upon the firm’s capital structure and condition. Always, the question is the marginal impact upon the overall position of a discrete decision, such as how to finance a new product line or expansion.

(D) Credit Management – Although one hears much of corporations being “lean &mean” & cutting cost to the bone, ultimately the generation of revenues come first. Unless a firm products are in demand, unless sales are healthy profits will not be generated. To maintain & grow sales, although pricing quality, advertising are important, credit policy is offer a critical factor. In fact, at times it may be an excellent source of revenues in itself, & actually enhance sales. Our willingness, on average, to enter into hire purchase agreement rather than paying cash is an obvious example of how the provision of credit may actually enhance sales. In developing credit policies, Treasury Managers must evaluate and following consideration with respect to their client base:

Credit Period: Hoe long to buyer has until they must pay for their purchases?

Discounts:Are their discounts to encourage early payment? Will it attract new customers? Will it reduce the collection period /

Credit standards:What are the financial requirements of a customer in order to qualify for the credit? A national credit rating agency might be utilized: The five “C’s” must be utilize: Character, Capacity to pay, Capital showing debt to assets ratio, collateral, and Conditions of the general business climate.

Collection Policy:How does a firm follow-up on show paying account? Remember collection agencies and attorney is an expensive option.

(E) Dividend Policies – An ongoing study at Harvard Business School recently reported that the present capitalization of many major firms is purely result of their investment over the last decade or so. Assets from the early 1980’s would today have a negative economic value. On the capital, which was invested, on average the return was below the market index. In other words, the shareholders of many blue chip corporations, would have been better –off, if all earnings had been aid as dividends, rather than being question is what should have been done to maximize the value of shareholder investment?

Observations such as the above have led to a great volume of research on optimal dividend policy. According to the Value Additivity Principals observed above, A firm’s dividend policy should have no bearing upon its capitalization in the securities market, because an investor should not value a dollar of dividends more than a dollar of capital gain, apart from tax considerations. This argument is known as the Dividends Irrelevance Theory, According to which the value of the firm is determined only by its basic earnings power and its business risk. Income Produced by assets, not how the income is split in what matters.

An alternative view is that the cost of capital increases when a firm’s dividend payout is reduced. Known as the “Bird–In-hand” theory, this approach to dividends more highly than expected capital gains, because the latter is less likely. So, therefore, the mix between dividends and capital gain achieved through retained earning does matter. Which is right? Empirical research has not yet settled the issue, but Treasury Managers must take into

account both perspectives, especially if they see their shareholders as making similar types of investments with disbursed earning, i.e. dividends Are investors going to use dividends to buy–into capital gains from other firms?

Other considerations, which Treasury Management must take into account in deciding on dividend policies, are such factors as Signaling and Client Segmentation. Changes in dividend policies are often regarded by the stock market as indicative of a firm’s overall health. Increasing earnings might say that the firm is doing well, although it might also say that the firm’s management has nothing else on the agenda to do with the retained earnings. Client segmentation refers to perception by the investing public of the firm. Is the firm a high risk, small capitalization growth stock with good ideas for further investment with retained earnings? ; Or it is stable, blue chip concern of which investors expect a consistent modest return? The formal type of concern seldom pays larger dividends if at all; by the latter invariably pays reliable returns. Investors in the highrisk concern are therefore the potential of capital gain; while investors in the stable blue chip concern are looking for regular income. In deciding upon dividend policies, Treasury Management must take into account that their shareholders are and what they are expecting.

(F) Insurance – Few of us are not at one time insured something, be it a motorcar, a house, or the commercial assets of the business. Insurance may cover all manners of business risk, including the health of key executives, industrial accident, industrial unrest, physical losses, business interruption, to mention only a few. Although an exhaustive review of the insurance field is beyond the scope of this discussion; it is important to note that many Treasury Managers have recognized that the topic should not be considered in isolation. Insuring against the loss in revenue from fire at a factory may not be that different from the loss in revenue if there is severe decline in market share or even a dramatic falls in the prices. As the theory of insurance is that the transfer of risk to firms betters able to manage it represent a gain in general, perhaps there are times when such risk should be born internally, i.e. self-insure. Thus comparing historically, premium payments with refunds can be very useful guide the net benefit of insurance. A good Treasury Manager thinks comprehensively.

(G) Pension Management – A pension fund is a pool of funds established by an organization to pay the pension benefits of retried workers. Annually

pension invests in securities markets. Generally, the earning on pension funds are tax deferred, that is the retired worker only pays taxes upon the earnings when the benefits are received upon retirement, when presumably he or she faces a lower marginal tax rate. The management of such funds is one of the main traditional roles for the management of treasury department. Although, like insurance, the management of pension funds is the specialized field in which the advice of outside experts is often useful, it is generally the role of Treasury Management to set the objectives and coverage for the fund and monitor its performance.

The Age of Uncertainty

As mentioned earlier the new role of Treasury Manager has come about in response to the changing economic and financial environment. If there is one word to describe how business is today versus half-a-century ago, the word would be risky. Measured by the range of possible outcomes in any business scenario, measured by how rapidly various trend fluctuates, measured by variance in key operating parameters, measured by the pace of technological change; the world is clearly a riskier place than it was at the end of the Second World War.

Financial Innovation and RiskIn the early 1970s, the Chicago Mercantile Exchange introduced the first successful exchange-traded currency futures. It was widely argued that such products as futures and options were introduced and become popular as a mean to manage the new risk found in the business environment. Known as Derivatives, they are derived from underlying markets, such as commodities or foreign exchange, which had now become unstable and volatile. In 1975, interest rate future contracts followed, which allowed one to established the future cost of lending and borrowing. By 1982, half-a-dozen exchanges had introduced various interest rate futures contacts, covering very short to longer-term borrowings.

The next step in global derivative development for managing and controlling risk was the introduction by the Philadelphia Stock Exchange in 1983 of currency options. Currency options linked the futures and options which had risen in the capital markets of key hard-currency countries, currency options and futures would lead to the development of many further risk management techniques. Without the tool of managing exchange rate movements, global trade and investment can be very risky. The Treasury now had an array of tools to manage the risks faced by modern, global corporations. Without the use of derivative products by proactive treasury managers, many of the benefits, which we enjoy today from globalization, would not be possible.

By the mid-19870s, a revolution in financial, foreign exchange, and commodity risk management had taken place through the use of futures, options, swaps and Forward Rate Agreements (FRA’S), which are series of consecutive forward or futures agreements. Such product enabled treasurers to price and transfer risk in a global manner. On the Chicago exchange, for example, the trading volumes involved tens of million of contacts annually. Derivative exchanges were introduced in New York in 1980, in London in 1982; in Singapore Monetary Exchange in 1983 saw financial futures were introduced France’s Matif. To meet the needs of management of controlling risk, the development of new derivative markets continues, with new contracts appearing regularly. On over fifty exchanges around the world some from of derivative instrument is today traded.

From the above we see that these markets have not arisen in isolation but in response to the global integration of trade and finance. By being global in scope, such markets have created a mechanism for pricing and transferring risk around the world. These markets allow financial officers and treasurers to manage risk efficiently. Today treasurers of corporations, banks, and public entities have no excuse for not managing unexpected surges in interest expenses, swings in exchange rates, or increased commodity prices affecting raw material cost. Innovation and Risk - Recent trendsAn important features of the growth in the use of derivatives markets, like futures and options, has been the evolution and maturing of Over-the–Counter (OTC) market. While traded futures and option are suitable for the day-to-day risks by most Treasury Management, often there are situations where only a custom-made solution will satisfy specific commercial and financial objectives. A new investment or an innovative financial structure

may have an unusual risk/reward profile. The “financial engineers” are using off the shelf futures and options products available on the major exchanges can devise one-off product to satisfy such needs. Often hybrid derivatives have been devised to address the combined risks involving several markets. It might be the ratio of gold to silver prices or an equity-linked bond. To address these exposures, Treasurer working with the financial engineer might use derivatives in combination, mixing futures and options, currencies and commodities and different maturities; all to achieve a particular objective.

Post-Industrialism and the Service Economy A quarter century or so ago, the service sector played a much smaller role, and information technology did not exits. The energy, communications, and transportation sectors operated under a rigorous regulatory framework. Similarly, the role of unionized labour was much greater than today, and of that portion, public sector employees played a small role. Mass discount retailing and micro marketing did not exist. Inventory was managed on a quarterly basis, or less frequently. The percentage of debt in corporate balancesheet was proportionately lower. Globalization of product, tastes, and suppliers was not yet imagined. Capital, labour, and technology were tied to the domestic economy. Broadly defined goods and services, which are taken, for granted today did not exist or were only the province of the rich.

How times have changed. It I difficult to think of a place anywhere in the world not effected by the dramatic changes of the last quarter century. By all the measures mentioned above and countless others, the world economy has transformed itself beyond recognition, and by and large it was the result of endogenous, organic factors. How and why these changes have occurred is a subject of ongoing research, but certainly it was not the result of the state intervention, no matter how much various government have attempted to promote, facilitate or retard such processes.

Today, the buyer for a major retailing firm such as Benneton or the Gap, can take notice of a fashion trend, and in less than a month have it designed, manufactured, market and stocked in the outlets throughout the world. Today, software engineers situated in distant parts of the globe hold “virtual

meetings” to discuss the production of software code. Today, investor looking for an attractive bond can browse the Internet searching for the highest yield. Consumer loyalty to goods and services lasts as long as the next product launch. Watching the exchange rate trends, corporate manager allocates production to plants throughout the world. Gone are the days of blanket advertising: today, modern “data mining” and data surveying techniques allow a corporation to target its customer with pinpoint accuracy. With knowledge of regional demographic, national chain stores are able to adjust the goods they feature to satisfy local taste. From head office, the head of marketing for a major petroleum company can adjust prices to the time of day, in a thousand service stations, by merely sending through code computer instructions. Just-in-time deliveries of raw materials and parts to the factory gate ensure smooth production without money tied up in inventory. Out-sourcing of required goods and services, for which a firm has no comparative advantage in producing, allows management to focus upon core activities.

The ways in which the global economy has changed in the last quarter century are virtually limitless. The above anecdotal observations are only here to remind us that given these dramatic trends, to imagine that the job of Treasury Management should be unchanged would be foolish. Higher levels of technology imply higher rates of returns, however the “Cost” is that the world has become a riskier place. Proactively and dynamically, Treasury Management must define their responsibilities as broadly as possible, taking into consideration the new upsides as well as the new downsides, which have become possible. In the next section, we will describe different “models” for Treasury Management for dealing with the new world in which we operate.

Changing Responsibilities

The 1970s saw Treasury Management attention diverted to such pressing problems as:

Inflation and its affect upon accounting; Deregulation of financial institutions into broad service corporations; Dramatic innovations in the use of computers for analysis and

telecommunications for receipt and transmission of information; New and innovative methods for financing long term investment; and Unprecedented volatility in the economic environment.

It was not that the financial manger’s primary task of planning for the acquisition and uses of funds or capital so as to maximize the value of the firm and facilitating transactions had changed. Rather, the task of doing this in a world of floating exchange rates, globally competitive labour forces, rapid technological change, etc., had become significantly more difficult. In the remarks below, we will present new approaches or models of Treasury Management.

Traditional Treasury – as a cost centre

Treasury as a facilitator of transaction flow of business units Treasury with a process orientation towards risk. Treasury with a reactive strategy towards business development.

Modern treasury mangers ready to meet the challenges of the post-industrial information age, may be modeled as either service centre, or even as a profit centre. Defined functionally, the two approaches would include the following responsibilities:

The Service Centre Treasury

New trading orientation Development of innovative risks management techniques. The application of such techniques to business units. Minimization of overall financial risk.

The Profit Centre Treasury

It has its own Profit and Loss account It undertakes exposures with no specific match with the natural exposure

of the firm Gains and losses are used to offset underlying exposures at a

consolidated level.

Which one is better? Which approach is correct? Well, it all depends. Certainly the service centre model of modern Treasury management is the more prudent of the two approaches. It addresses the needs of the corporation from the standpoint of the challenging and dynamic world in which the modern, global corporation operates. The profit centre model does that as well, but the taking on new exposures which may or may not directly offset losses, or enhance gains of operational profit centres. The

profit model transforms the cost or service centre approach into a dynamic unit, which may contribute to the quality and quantity of earnings.

The risks of the profit centre model however are significant. Performed correctly, it can add greatly to bottom line, badly, however, the results may be disastrous. General Electric is arguably one of the world’s most successful corporations. With a product base not dissimilar to Germany’s Seimens Corporation, GE earns twice the rate of return on equity. How does it do it? According to some experts the secret is in the management of GE Capital Corporation, which not only facilitates and enhances the sale of everything from refrigerators to industrial turbines, but also operates as a profit centre, with dealing and trading operation, which rivals any major commercial bank. When Treasury Management without any specific match undertakes exposures to underlying activity, purely for profit, things may go wrong. The spectacular losses by certain American, British, and German Corporations in the use of derivative exposure are notable examples. Creating additional risks for the possibility of profit when core business activities in which the firm is supposed to have an advantage are ignored or not properly facilitated is hard to justify. In deciding which approach to the Management of Treasury is favoured, the firm should evaluate its strength, and if those are not equal to those of GE Capital, probably the service modelshould be favored.

Strategic and Tactical Planning

Although corporations and firms have always planned for the future, the treatment of the Planning function as a separate entity usually falling under the Management of Treasury is a relatively new business innovation. Like the development of the service centre approach to treasury or the use of derivatives, the planning function has grown in importance because of the dynamic environment in which we live. Problems and issues never imagined several decades ago, are today the stuff of management meetings. Today still, many corporations neglect planing because the process requires thinking about the future, and the future is always uncertain. Although a full discussion of the topic of planning and management is beyond the scope of this workbook, some thoughts and guidelines may be mentioned.

The planning function is part and parcel of Treasury and Financial management. A capital budget cannot be conceived, a source of funding

identified, a risk management strategy developed without having a view of the future. Planning for the future starts with an intimate and realistic understanding of existing products, divisions, markets, profits, returns on investment, cash flow, availability of capital, research and development abilities, and the skills and capacities of personnel. How is the organization performing today? From understanding the present, we construct predictions of the future. There are many different, equally valid methods of forecasting the future. The Management of Treasury must evaluate forecasts prepared by divisions for reasonableness. Are they consistent with one another? In taking the lead on this important task, Treasury Management should consider the following guidelines for planning.

GUIDELINES FOR TREASURY MANAGEMENT OF PLANNING

1. Create an awareness of the need at Division level of the need for planning.

2. Assess how well the divisions have integrated the plans into their programs. Are they consistent?

3. Create a means of implementing continued planning so that the divisions will complete any unfinished plan or revisions during the coming financial year.

4. Determine what standards for measurement, if any, the divisions have in setting goals.

5. Determine if the plans are consistent with capital budgets and technological resources.

6. Promote the idea that Divisions should consider a wide range of possible projects. The ranking can come later.

7. Assess the reasonableness of goals, so as to devise a long-terms corporate goal.

8. Determine whether the resources, capital, manpower, and technology are available or can be made available to implement the selected plan.

9. Establish a programme for monitoring the Plan’s implementation; it must not be filed away.

10. Look for synergies between divisions in constructing and implementing the plan.

FORMULATION OF CORPORATE TREASURY POLICY

What a corporate treasury policy can do for you...

It can: Define the strategy on foreign exchange and interest risk - and it

communicates this strategy to regulators, shareholders and employees. Set a framework for the control and management of exchange rate and

interest rate exposure. Set objectives and performance criteria for corporate treasury personnel.

Who should be involved in drafting such a policy?

Foreign exchange and interest rate risk may constitute a significant element of a company's total business risk. If this is the case, senior operational executives must frame corporate treasury policy. This is necessary to ensure: The mandate from shareholders is fully understood.

The thrust of the policy is consistent with the business culture and orientation of the organisation.

Senior management fully understands and appreciates the parameters of such a policy. The policy gets full credibility in the eyes of employees and other stakeholders. An ideal team for drafting corporate treasury policy should include:

The corporate treasurer

A tax specialist

The financial accountant

The sales and purchasing executives

The chief executive officer.

When the policy is complete

The policy should be presented to the Board of Directors as a framework for the management of the organisation' s financial risk. The financial risk of the firm is dynamic and ever- changing. The Treasury Risk Management Policy needs to be reviewed regularly to ensure that it reflects these changing circumstances. The policy should be formally reviewed every year. It should be subject to ongoing evaluation through the course of the year. The formulation of a policy is the first step in defining a financial risk management culture for the organisation. The next challenge is to communicate this policy clearly to all interested members of the organisation - and maybe even outside stakeholders. This can be a demanding but vital exercise. Without the full understanding and support of all the business units, the Risk Management Policy may be less than fully effective.

Policy formulation questions and answers

The formulation of a Risk Management Policy will raise many key issues for the firm. Remember that the Risk Management Policy will be unique to the organisation. There are no generic policies or limits.

In the sections that follow address many of the key questions, which one will need to consider. And put forwards some suggestions and recommendations, which one will find helpful. These are statements of risk management principles and guidelines which one will need to translate and interpret for his/her unique business circumstances.

SHOULD THE FIRM HAVE A CENTRALISED TREASURY FUNCTION?This is usually an issue only for large, diversified corporations. The decision on whether or not to have such a function can be influenced as much by the culture of the firm as by business rationale. The principle criticism of a centralised treasury function is that it devolves financial responsibility away from local managers. This dilutes their sense of responsibility and accountability and can lead to lesser motivation on their part.

The weight of argument in favour of centralisation is powerful. There are real benefits, which include:

* Administration cost savings from centralised information, dealing and control systems.

* Greater efficiency in netting intra group exposures and the minimisation of third party dealing.

* More focused relationship with bankers and the potential for more competitive pricing due to larger volumes.

* Greater ability to exploit central treasury expertise as it becomes easier to tailor training programmes, reward structures and performance reviews for a distinctive staff grouping.

* Greater consistency in hedging practice and techniques.

A single source of contact with the market is also a good way to preserve and enhance the company's financial status. Errant behavior by subsidiaries - which might damage the whole group - is avoided.

Others argue for a halfway house position. Some firms operate on the basis of central monitoring of positions. Others have structures, which allow the local manager the facility of hedging his or her risk with the central treasury.

In this way, the central treasury maintains control but the local manager is still fully responsible and accountable for financial performance. There is no single best solution. On balance, it would seem there is more to be gained by a focused centralised approach. If such a strategy can be modified to ensure greater accountability at local level, this could be the best of both worlds.

YOUR TREASURY OPERATION - A PROFIT CENTRE OR NOT?

A key question for many firms is whether the Treasury operation should be a profit centre or not? The term "profit" centre may need to be defined. Some interpret this to mean trading in the financial markets; others see it more in the context of adding value for the firm. Let us review the merits and demerits of the profit centre approach.

The argument for....Advocates of a profit-led approach are in no doubt - it's the only way to ensure that the Treasury division does the best possible job. After all, they argue, if other business divisions must be profitable and add value to survive, why should a treasury function be a special case? How else can the success of a Treasury function be measured, if not by its financial contribution? Such advocates suggest a profit objective is the only way to make operating managers respect the Treasury function and for Treasury personnel to be seen as adding value to the organisation. Supporters of the profit imperative also say service and support is difficult to assess - some would add that it defies rigorous measurement. They feel that if Treasury, or any other business division, was left without financial performance criteria, it would be ill advised.

The argument against...Supporters of a non-profit centre approach are convinced that a Treasury department's main function is the reduction and control of risk. Profit-driven trading in financial markets is not part of their brief, they say, and not part of the business of the firm. In fact, if financial performance is the only yardstick, it can affect Treasury's ability - and desire - to help and support other business divisions in the organisation. At the extreme, operating units may see the Treasury function

more as a competitor than a service provider. This could lead to less trust and personnel may spend more time on internal profit appropriations rather than seeking to add value to the enterprise. The anti-profit centre lobby also argues that objectively and quantitatively measuring the financial performance of a Corporate Treasury function is far from an exact science. They say if an organisation puts a strong emphasis on risk reduction and this is achieved in demanding circumstances, how can a quantitative financial value be put on this?

How can your firm take the right decision?Both arguments are clear. So how does one make the right decision for his company? Both the extreme pro and anti profit centre positions have their pitfalls. The view would be that the Treasury function should be profit oriented ............but;

- This should be one of a series of objectives for Treasury and one define profit as seeking to add financial value for the firm (not trading)

Striking the right balance between the financial value-added objective and other objectives is the next challenge.

Striking the balance - the three key factors

Recommendation is that a financial objective should be set, along with other objectives. The emphasis placed on this financial objective will vary from one firm to another. When deciding what is appropriate for the firm one might consider each of the following three questions: -

What is the weight of financial risk as a proportion of the firm's total risk?

What is the gap between the firm's "natural" financial risk profile and their returns?

What is the expertise in financial risk management?

The greater the weight of the company’s financial risks as a proportion of total risk, the greater the need to add value from that element of the business. If the culture of the firm is to retain a high proportion of "natural" financial risk, the greater the demand for a return in this area.

The more expertise a company has in making money out of the management of financial risk, the more likely the desire to exploit these skills - and reap the appropriate rewards. In summary, the greater the significance of financial risk for the firm and the greater is the need to transform a natural risk profile, the more appropriate it will be to place a heavy emphasis on adding financial value. Even then, this is advisable only if one has the necessary expertise.

RISK POLICY IMPLEMENTATION

WHO SHOULD BE RESPONSIBLE FOR THE IMPLEMENTATION OF POLICY? WHAT DISCRETION SHOULD THEY HAVE AND WHAT INSTRUMENTS / HEDGING TOOLS SHOULD BE USED?

Policy implementation tends to be delegated to the Corporate Treasurer in large firms and to the Finance Director / Controller in smaller organisations. We think this is appropriate for small and medium sized firms or businesses with small volumes of uncommitted exposures. For firms with substantial volumes of uncommitted exposures it may be appropriate for the Corporate Treasurer to be advised by a Hedging Committee. This group might include the sales and purchasing executives and the Finance Director. The rationale for this Committee is that strategic exposure management is less clear-cut than the management of transaction exposures. It may change as a consequence of changing economic circumstances and the involvement of a wider management group will help identify the appropriate response. The Corporate Treasurer has the following specific responsibilities: -

He / She ensures that the desired risk profile is maintained

He / She solicits best advice from suppliers

He / She determines the most appropriate hedging strategy

He / She chooses the most appropriate instruments

He / She achieves efficient pricing

Of these five, the most important is the maintenance of the prescribed risk profile. The choice of an appropriate hedging strategy needs careful consideration. It should follow discussion and consultation with the bankers and a review of the available instruments.

What instruments or hedging tools should be used?Common sense dictates that the firm should use any instruments or products, which promote effective hedging. The Corporate Treasurer, with an exclusive responsibility for the choice of products, should advise the Hedging Committee of new products and convince the Committee as to how they can deliver more effective hedging. The Corporate Treasurer should also ensure that the workings of these new products are fully understood by all and give consideration to tax and accountings aspects. Issues such as price liquidity and the reversibility of deals in these instruments and the credit risk, which might be associated with them, should also be considered. Last but not least, the corporate treasurer must ensure new products can be captured on the appropriate systems.

CONTROL AND SUPERVISION

Control and supervision is a hot issue in the world of risk management. Recent high profile losses have highlighted the need for a robust and reliable control framework. An effective system is an integral part of procedure and must be comprehensively addressed in a company's policy. Controls must be practiced at all levels and the challenge is to convince managers that it is part of business - and not, somehow, alien to it.

The key questions to ask Who is authorised on behalf of the company and within what parameters?

How frequently will risk measurement take place and what exposure reports will be prepared?

What audit trails will be required and how regularly will they be reviewed?

Who will monitor cash outflows relating to hedge settlements?

Who will reconcile confirmations and review documentation?

What role will the firm's auditors play in supervising limits and policy requirements?

Policy must also incorporate another critically important feature of control. This is the segregation of the implementation function from the process of risk measurement, risk control and supervision of policy requirements. It is completely unacceptable that one individual should have responsibility for both these areas. Segregation should ensure that abuse or disregard for policy stipulations will quickly be discovered. This is a fundamental requirement of an effective control system. If a segregated structure is put in place and the key elements are defined (in answer to the questions above) one will then have a useful framework for control and supervision.

PERFORMANCE EVALUATION FOR TREASURY

Performance evaluation is the Cinderella of risk management - a discipline that rarely gets the attention it deserves. Yet without it the organisation could leave itself open to inefficient practice in risk management through the blind maintenance of outdated hedging strategies. Performance evaluation must take place all the time. The feedback one receives should then be used to continuously question and challenge risk management strategy. An effective performance evaluation system will provide: Feedback on the effectiveness of the risk management strategyguidance on determining when the strategy should change.Evaluation of the efficiency with, which the strategy was implemented.Information on inappropriate risk taking behavior

PERFORMANCE CRITERIA

Treasury should have a financial value-added objective as one of a series of different objectives. There should be correct balance between such

objectives. Let us identify the performance criteria, which might be set down.

Cash flow and liquidity managementA Treasury function should be evaluated in terms of its management of cash flows, it’s planning and its securing of the firm's future cash flows.

Observation of procedures and controlsThe implementation of policy should be clearly and transparently segregated from the risk measurement and supervision functions. These supervision procedures should feature: 1. An audit trail of cash flows.2. An investigation of documentation standards to include confirmations, mandates and masters agreements where applicable.Treasury must also conform to policy in the area of bank limits and credit limits in general. These should be checked and supervised.

Success in Strategic Long Term Risk ReductionA Treasury unit is charged with transforming the natural financial risk profile of a company to one desired by its senior management and directors However reinventing such a risk management wheel year after year, is costly and demanding. The Treasury function should therefore be obliged to explore and initiate strategic changes, which reduce and eliminate unnecessary risks. How can one do this? Here are just a few ways. 1. Highlight opportunities for changing invoicing policy.2. Advise senior management of opportunities for change in purchasing, sales and manufacturing policy, which would reduce financial risk.3. Pursue netting agreements with banks and other institutions where there is a two-way flow of business.4. Create matching asset and liability streams.

Service and support to the business divisionsTreasury operation must assist and support the business divisions. This service can be measured using the following checklist. 1. Does it raise consciousness and awareness of risks and opportunities?2. Does it help to secure new business and contracts?3. Does it seek to understand the underlying transactions so as to better understand the issues?4. Is it efficient and responsive?5. Is it informative and proactive with advice?

In short, does the Treasury function add value for the other business units?

Ensure best value from external providers of treasury servicesIt is not enough to evaluate a Treasury function in isolation. There is also a real need to ensure best value from external providers of financial products, especially those in the Treasury sectors. Competitive pricing for Treasury services is not the only issue. Real value is more often achieved by ensuring long term relationships are developed with banks and other service providers. Such a partnership yields greater dividends in the form of best advice, innovative risk management solutions and superior hedging strategies.

REWARDING TREASURY STAFF

Performance-related pay for Treasury personnel is an emotive issue. Should Corporate Treasury staff have a financial incentive to succeed in adding value or is there an inherent danger in such motivation? The arguments for performance pay are simple.

In a market sector where such payments are normal, it's vital to link performance to pay to attract the best people.

Performance-related pay is a strong motivation and it helps people focus on objectives.

Critics of such systems say it encourages irresponsible "speculation", a lack of focus on the non-financial elements of the job - risk containment, advice and best service to the business divisions. Once again, argue that a balance needs to be achieved. A performance-related payment scheme that strikes the proper balance between the different elements of good performance is the ideal. The objectives of the wider enterprise should become the objectives of the individual. To do this, one must set up a transparent and credible evaluation system. A system that features a comprehensive series of objectives, which are subject to regular review and assessment. It is suggested that added financial value should only be one of these performance criteria.

It's all part of the process of performance evaluation. One must make sure the standards for the assessment of personal performance are matched with those of the unit as a whole.

New Tools for Treasury Management

In this section, we will review the many tools used by successful treasury managers to achieve the short-and-long-term financial and commercial objectives of their firms. We begin with derivatives, the products, which are used to price and transfer financial risk. While there are hundred of products on virtually every exchange, a top-down view of derivative products from the standpoint of managing risk is useful. Therefore we will look at advances in information technology, forecasting techniques, and lastly advances in the formation of capital.

DERIVATIVES: FUTURES AND OPTIONS

Once a facilitator of transactions, the financial officer or treasurer today faces many new daunting responsibilities. Among these responsibilities are the uses of an array of new financial products, which have appeared in response to the growth in uncertainty described earlier. Risk is the spark of innovation leading to the creation of the financial derivatives industry.

Modern derivatives markets provide a wide range of products linked to the key factors affecting financial and commercial performance. Whether one is the treasurer of a importing company or a Trans-national manufacturing giant, external risk is endemic to business. Risks include interest rates, foreign exchange, equity values and commodity prices. Derivative instruments allow a treasurer to manage and find opportunity in the exciting but uncertain world of modern business.

Begin with interest rate and foreign exchange linked derivatives markets, describing their general features, as well as offering perspective. Equity and commodity linked derivative markets will be treated in a similar manner. With regard to managing interest rate exposure, we will address both the generic products used by treasurer as well as the swap markets. The interest rate swap market began in the United State where it remains the largest, although since the mid-1980s the markets has taken-off in Europe and the Far East.

(A) INTEREST RATE OPTIONSBegin with traded options and futures on interest rates, which one find, may be divided into two distinct groups: First whether they are options on cash or options on futures; and second, whether they are options on short-term interest rates or options on long-term interest rates. Although a wide range of options on long term interest rates, such as long dated bonds, trade around the world, we will concentrate on the products and exchanges which are most popular. Today the greatest liquidity exists in Euro-dollar futures traded on the Euro dollar index. Options are traded on the London International Financial Futures Exchange (LIFE) and the Chicago Commodity Exchange (CME), which offer an options contract on a long dated national $100,000 Treasury Bond Future. Options on the LIFE Futures Contract confer the right to buy or sell a Euro-dollar Futures Contract at a specific price on or before a specific future date. The CME Contract calls for actual delivery of a Treasury bond against the contract, which is settled by reference to an Index on the Euro-dollar.

(B) INTEREST RATE SWAPS

Interest rate swaps have grown so popular as treasury products because they make use of one party’s comparative advantage in the capital markets.

Strong issues of notes, such as British Petroleum or Ford, are able to borrow through fixed cheap rate funds. Weaker borrowers only have access to floating rate loans. By exchanging their payment obligations through a swap, both parties are able to obtain a lower cost of funds. From this pattern of strong issuer/weak borrower and the source of capital markets for credit, the swap market has developed into the primary method of managing interest rate risk. This success has encouraged intermediaries to introduce a diverse array of further innovations, essentially derivatives upon derivatives, including interest rate caps, collars, floors and options on interest rate swaps – know as swaptions. By way of terminology, calls on interest rates are often known as caps, while Puts on interest rates are often known as Floors.

(C) FOREIGN EXCHANGE DERIVATIVES

The main foreign exchange linked derivatives are currency swaps, long dated forwards, currency options, and combinations of the above. For borrowers, access to currency derivatives ensures that they have access to the lowest cost capital markets around the world. The integration of international markets through foreign exchange derivative markets encourages a competitive cost of capital. In addition to this integration role, foreign exchange derivatives serve a very real purpose. Foreign exchange fluctuations affect the competitive positions of companies, the cost of borrowing abroad, and the returns on global investment portfolios. Precise commercial and financial objectives can be managed through such derivatives. Just as interest rate swaps involve interest rate futures and options, so are there currency swaps, linking futures and options in currency markets. Currency options and futures are among the oldest forms of options and futures products. Traded currency options are divided into two types: Options on cash, and options on futures. A Cash Currency Option is the right to buy or sell a fixed quantity of one currency in exchange for a specific quantity of another currency in a ratio determined by a specific exchange rate at or before a specific future date. A Futures Currency Option is the right to buy or sell a traded currency futures contract at a specific futures price at or before a specific date in the future. The London International Futures Exchange (LIFE), the Philadelphia Stock Exchange, and the Chicago Mercantile Exchange, all offer futures, options, and options on futures as a means of hedging and speculating on foreign exchange risk. Using these products, many banks make markets in more complicated

foreign exchange linked derivatives such as currency swaps and long dated forwards, and combinations of the above.

For borrowers, access to currency options and futures derivates ensures that they have access to the lowest cost capital markets around the world. In addition to this integration role, foreign exchange derivatives facilitate the treasurer's role in asset management. Foreign exchange fluctuations affect the competitive positions of companies, the cost of borrowing abroad, and the returns on global investment portfolios. Precise commercial and financial objectives can be managed through such derivatives.

(d) EQUITY LINKED DERIVATES

The late 1980s saw the growth in modern derivative products applied to equity markets. Just as the growth of interest rate derivates spurred the innovation of foreign exchange derivatives, thereby linking international capital markets; the emergence of equity derivatives was almost inevitable in order for the risk/reward profile of equity investments to remain competitive with the fixed income offered by debt instruments, such as bonds. Equity derivative instruments allow treasurers managing portfolios and pension a means to structure requirements in terms of market timing, and risk/reward profile. Importantly, the use of equity derivatives has changed the nature of equity portfolio management. Traditional techniques such as fundamental and technical analysis, diversification strategies, and asset allocation strategies now rank along side derivative risk management as means of achieving investment object ivies.

e. COMMODITY LINKED DERIVATIVES

Unlike the issuer/borrower and investor/lender pattern of participation seen in the derivative markets described above, the treasurers of producers, refiners, and consumers of the world’s materials use commodity derivatives. The original derivative market, commodity derivatives satisfy the needs of participants to manage price risk. Commodity price risk often forms the core business of users such derivatives. Liquidity, solvency, and possibly even survival demand the use of derivatives. Today, active users include the treasures of oil producers, airline companies, electricity generation companies, mining companies to mention only a few. Treasurers working with lenders and investors to ensure the returns and carrying capacity of new projects are also using commodity derivatives.

For Treasury Management, derivatives markets provide a wide range of products linked to the key factors affecting the financial and commercial performance of their organizations. Whether one is small domestic importer or a trans-national manufacturing giant, external risk is endemic to business. These factors include interest rates, foreign exchange equity values and commodity prices. The power of options, futures and other derivatives instruments to manage and find opportunity in risks, explain the growth of these markets, and are the reasons for their continued use.

FORECASTING TECHNIQUES

Among the many important new tools, which Treasury Management must learn to adopt and utilize, are those involving Forecasting. Forecasting relates to capital budgeting, planning; the use of derivatives for risk management, technology choices, and a host of other things. Although the science of forecasting is an enormous topic involving such fields as statistics econometrics, and computer simulation techniques, we will make note of some guidelines relevant to the task of Treasury Management.

In virtually every decision made by treasurers, there is some kind of forecast. The outlook for interests rates, demand trends for consumer items, the speed of technological change, the impacts of government policy. As it is surely better to forecast such items explicitly, rather than taking them for granted or using erroneous inputs; the methodology of forecasting deserves attention. The selection of methods depends on many factors, including but not limited to the following:

FORECAST SELECTION METHODS

1 The context of the forecast2 The relevance and availability of historical data3 The degree of accuracy desirable4 The time period of the forecast5 The cost/benefit or value of the forecast to the firm- what’s the cost of

being wrong?6 The time and resources available for constructing the forecast.

To elaborate upon these points from the standpoint of Treasury Management, one should begin by considering how the forecast is to be used, or even possibly misused? Unless the forecasts are of operational significance to the firm, it is doubtful whether they will have any use. The results of forecasts must feed into decision making in some way, forecasts themselves may fall into three different categories. They are the following:

FORECASTING TECHNIQUES

1 Qualitative Techniques involve the use of the opinions of experts and other sources to construct casual but interesting observations about the futures. The significance of discrete events are often interpreted.

2 Time series techniques use historical data to make statistical projections on their future outcome. It is somewhat like driving a car forward by looking in the rear view mirror. They often fail because of secular changes in the economy.

3 Casual models and techniques use highly refined and specific information about relationship between system elements. It is the most sophisticated forecasting tool, allowing the construction of “what if” scenarios.

Although forecasting is critical to the success of Treasury Management, and although it is better to forecast explicitly than sweeping one’s assumption under the rug; it must always be remembered that obviously forecasts may be wrong. Three common types of forecast error are often considered.

TYPES OF FORECASTS ERROR

Phase Error – One has the trend and direction correct but the timing is off. Perhaps a lag or lead structure should be introduced.

Specification error – One’s casual model suggests the inverse relationship to what is observed as the future unfolds. Remodel the theory behind the forecast.

Bias Error – The model is on the trend and neither leading nor lagging the real world, however, it regularly over or under predicts. Reconsider the constants in the equations.

In closing remember that the future is unknowable. All we can hope to do is plan in an intelligent manner. The resources devoted to forecasting and the type of errors in forecasting acceptable should be related to the tasks facing management. While it is recommended that forecasting become one of the key activities of Treasury, it should be remembered that some of the world/s most successful products, the most successful projects, the most successful technological innovations were not the result of planning, but rather intuitive, inductive leaps.

INNOVATIVE FINANCING TECHNIQUES

On the basis of long run plans the financial manager must raise the capital needed to support the firm’s growth. Traditionally, investors participated in a corporation by either purchasing its equity, ie buying shares, or making the corporation a loan, i.e. buying bonds from the corporation. While both such methods remain overwhelmingly the dominant method of capital formation; it is useful to make note of innovations in the area of hybrid securities. They are known as hybrid because they are often constructed synthetically in the financial engineering departments of investment and commercial banks using off the shelf products. For example, an ordinary share might be bundled with options, or a new security might be constructed based upon the relationship of traded securities. The purpose of all such hybrid securities is to allow the treasurer to access the funds of potential investors wishing to express complex view on the market. One purchases shares in the expectation of capital gains and dividends – a bullish view. But how might

an investor express the view that the share will rise, but the industry of which it is a component will decline? Or suppose the performance of a firm were closely tied to certain commodities, such as petroleum. Perhaps a hybrid security, which took into, accounts the affect of general price movements in the commodity upon the security itself. The point then is that by designing and using hybrid securities, financial managers may be able to access capital which otherwise would have found the investment uninteresting. The well-known junk bonds were really just a hybrid between bonds and shares, because their performance than interest rates and reinvestment risk. Innovative financing using hybrid securities is another tool for Treasury Management to accomplish the critical role of capital formation.

A TREASURER'S GUIDE TO COMPUTER SYSTEMS

(SYSTEMS, TECHNOLOGY AND THE CORPORATE TREASURER)

Control

It seems that as one control scandal dies down, another replaces it. It is required to impose of controls in the critical areas: separation of duties between front, middle and back offices; deal confirmation issuance and checking; the proper authorization of outgoing payments; and in the independent pricing and valuation of positions and exposures. The implementation of secure systems is an essential element of setting up a properly controlled treasury environment.

Processing Facilities

Many older computer systems lack the scope and flexibility to manage hedging instruments such as swaps, options and FRAs. Treasuries who are forced to rely on insecure spreadsheet ‘fixes’ are vulnerable to errors and failures. The replacement of inadequate systems frees treasury personnel

from mundane and ultimately unproductive tasks, to concentrate on their professional duties of treasury and risk management.

Integration

Treasuries supported by inadequate systems usually have to re-key the same transaction into a series of systems, which cannot communicate with each other. In extreme cases, these systems may separately address the functions of deal tracking and valuation, confirmation, accounting, payment processing, bank statement reconciliation and management reporting. Re-keying is of course a wasteful occupation, and it introduces inevitably high error rates. Contemporary systems allow treasury departments to enter transactions just once; subsequent processing, including interfacing with internal and external systems, is achieved automatically, with the imposition of prudent verification and control steps.

Reporting

Every treasury has unique reporting requirements. These reflect such diverse issues as the corporation’s structure and business, management’s approach to treasury control, the Treasurer’s interpretation of the needs of risk analysis, and the company’s cash forecasting environment. These requirements are met through a modern system’s use of powerful report writing engines, which give the Treasurer freedom of access to the entire treasury database and to industry standard and user-specific calculations.

Risk Management

Today’s focus on risk management means that treasury departments are expected to be able to quantify and analyze treasury exposure and risk quickly and easily. Treasurers require the tools to quantify a number of variables, such as positions, mark-to-market valuation, Value at Risk and the bottom line consequences of hypothetical ‘What-if?’ scenarios. A sophisticated and powerful system is an essential component in the fulfillment of this requirement.

THE FIRST STEPS

A common error, which has been repeated countless times over the history of computer systems, is the automation of flawed and outdated processes. This error simply institutionalizes inadequacy, and makes its subsequent rectification even more difficult. With this in mind, the following process sequence is recommended for treasuries who have decided to embark on systems replacement:

Review the existing systems and methods.

Develop a strategic plan, defining the ultimate goals in terms of results, processes, reports and interfaces.

Survey the marketplace.

Define the project objectives and budget.

Select the system.

System implementation.

The Review

This is perhaps the most mundane aspect of the process, but it is essential to develop a coherent, systematic understanding of the problem before an effective solution can be contemplated. It is useful to employ business analysts even at this stage, especially if such a resource is available in-house. The objective is to document the flows of all the processes in the treasury. This exercise alone will pinpoint the weak spots, by revealing the inefficiencies, labour-intensive redundancies and risk points. It may even indicate where interim measures may be applied as a temporary solution to pressing problems. But, most significantly, the Treasurer will have developed a documented basis from which the subsequent creative process can build.

Strategic Plan

The construction of an innovative strategic plan follows logically from a systematic definition of the problem. The failures and omissions of existing systems and methods will have been clearly identified, and therefore the required solutions may be defined and prioritized.

The details of the strategic systems plan will naturally vary from company to company, but a typical result is likely to encompass at least some of the following points.

Control elements: the processing of transactions.

Reporting requirements: functional definitions of the key reports to be generated.

Critical import interfaces: bank statements, forecasts, and subsidiaries trade requests; netting cycle inputs, market rate information.

Critical export interfaces: bank payments and pre-advices, electronic confirmations, General Ledger Accounting system entries (detail or summary), MIS information, netting results.

Communications requirements: communications within the treasury, communications with other departments, inter-linking of subsidiaries and regional centres with Headquarters.

Technology considerations: internal standards for operating systems, database management systems, networks, hardware, E-mail, spreadsheets.

Risk management: treasury and corporate requirements for monitoring and managing risk.

Time constraints: how time critical is the production of the various information sets, processes and reports?

Market Survey

Now that the Treasurer has a planned set of systems objectives, it is appropriate to survey the market to determine which systems generally meet the company’s strategic requirements.

There are many potential sources of information. Treasury conferences and well-attended conferences are a primary source of up-to-date information. The system suppliers will of course be there, showing their systems to best advantage, but perhaps the most valuable source here is presentations and conversations with other treasurers who have recently been through the systems selection process. Interestingly, there is a solidarity among

treasurers that seems to transcend corporate rivalries, and there is some evidence that peer group collaboration plays a significant role in gathering useful information.

Not surprisingly, specialist treasury publications frequently carry articles about systems and technology, by suppliers (such as this one), consultants and treasurers. Prudent treasurers will of course take advantage of others’ experiences, and the market seems to be well served by the coverage of relevant topics.

Many treasurers turn to the services of their in-house systems departments or to external consultants at this stage of the process. The role of in-house systems departments has evolved rapidly over the last few years. Where once their primary role was systems development, this has now, in many cases, changed to internal consultancy, especially in support of the selection and implementation of systems. External consultants naturally bridge this gap when in-house expertise is unavailable.

The end result of this phase of the process is a list of treasury system suppliers whose products meet the content and quality parameters of the project.

Project Definition

At this stage, the Treasurer is in a position to define the objectives of the system selection project, and to request funding for the chosen solution. It is best to delay budget finalizing until this point, since in practice the scope of the project may quite reasonably increase in the light of studying the marketplace (a decrease is unlikely!). The Treasurer will have discovered the broad scope of new developments in systems and technology, and will have a much better idea of its practical value in the treasury environment.

The process of defining project parameters should be relatively straightforward, since the general definition of the plan should be a pragmatic expansion of the strategic plan, in the light of expanded information set.

The project’s definition may need to be supplemented by a cost/benefit analysis, and a number of caveats apply to the preparation of this. A new system is an essential tool in advancing the treasury’s performance and goals, and its selection and implementation are the beginning of the process

of achieving those goals. The actual goals will of course vary from treasury to treasury, and they may range from the tangible benefits of reducing operational costs, optimizing bank account management, reducing funding costs and increasing investment returns, to intangibles such as the improvement of control and risk identification and mitigation. It is unlikely that all of these can be concentrated into a single project, so the Treasurer has the opportunity to prioritize objectives and refine the department’s mission.

1 – Treasury Management System Selection Process

2 – Client-server Technology applied to a Treasury

Systems Selection

A typical process is illustrated in Chart 1 – Treasury Management System Selection Process.

Prospective system purchasers often issue an RFI (request for information) to a long list of suppliers, in an attempt to identify a short list. This alone is a time consuming process, and there are a number of publications such as The Buyer’s Guide to Treasury Management Systems Worldwide (Authors: Ken Lillie and David Middleton, published by The Bank Relationship Consultancy), which may help to truncate or even, bypass it. The Treasurer’s contacts are again useful; a few telephone calls to contacts at companies who use the contemplated systems may well establish particular system suppliers’ suitability for the task in hand.

The selection process inevitably brings the issue of technology to the fore. Most treasurers now have direct experience of PC technology through both home and office computers. PC power and price continue to follow an inverse relationship, and the dominance of Windows has resulted in universal user friendly computing. Nonetheless, one key aspect of the

selection process is weighing the benefits of the different technologies that will be presented by competing systems. The decision will affect many aspects of the project, including cost effectiveness, performance, flexibility and future upgrade path.

The price/performance ratio of PC workstations has been dazzling, and industry specialists see no abatement in this trend until the ultimate constraints imposed by the Laws of Physics are confronted. Within the last decade, the ‘standard’ desk-top PC has evolved to the 200 MHz Pentium, and the implications of this advance are understated by the logarithmic nature of measuring processor speed using MHz. It is now cost effective to use large amounts of memory, which means that more data and program instruction is instantaneously available to the processor. Contemporary workstations are now able to offer top levels of performance to exploit the full power of Windows NT and other multi-tasking operating systems, so that several tasks may be executed virtually simultaneously on one workstation. The best advice for workstation purchasers is to buy top of the range equipment, to minimise performance issues in this area. Treasurers often ask how long should the write-off period for workstations be, and I have heard answers recently that range from two years, to zero! In any event, this is an area in which the value of virtually any economy seems to be false, since it is in the nature of the designers and developers of computer technology to exploit innovations to the full. The treasurer may reasonably select a new system to last for five or ten years, but he or she should be resigned to review hardware on a two-yearly cycle.

The relationship between hardware, network and database management system has much in common with the theory of convoys, which are as fast as their slowest ship. System selection in this area may be subjected to a number of in-house constraints, and expert technical advice should certainly be sought. Most contemporary treasury systems are built using client-server technology, which is illustrated in Chart 2 – Client-server Technology applied to a Treasury. The interactions of the various components of a client-server system are intricate, and need to be optimised in pursuit of the treasury’s performance objectives for their new system.

The selection of the database management system may be constrained by internal standards; for example, many European companies are now using the Microsoft SQL Server or ORACLE databases as corporate standards. The benefit for the Treasurer in selecting a system that supports an internal standard is that he or she should be able to call on in-house expertise for the

installation and management of the database in the course of system implementation and operation. This role is often formalised in the appointment of a Database Administrator or ‘DBA’ who may be a computer-literate treasury analyst.

LANs (Local Area Networks) are another area which has seen a recent quantum increase in speed; the standard treasury LAN performance is presently shifting from 10 Mbps (Mega bits per second) to 100 Mbps, and treasurers should be assured that potential new systems can take advantage of this increase. If treasuries are inter-connected using a WAN (Wide Area Network), it is often the performance of this link, which is the critical limiting factor. WAN performance is affected by many variables, including the configuration of the database management system and the network protocol, and projects involving WANs require a relatively high degree of technical input.

A final technical issue is the system’s development plans for use of the Internet. Today, the Internet is not a suitable vehicle for the secure, efficient transmission of large amounts of data, but it is virtually certain that this will change in the near future. It is likely that companies will be able to use the Internet for cost-effective treasury communication with a network of subsidiaries, and treasurers should ensure that this pathway would be open to them with their new system.

The selection of a system which meets a treasury’s functional needs is less daunting to the Treasurer, since this part of the process involves verifying the prospective systems’ relative handling of treasury business, against the established strategic plan. Many treasurers use the RFP (Request for Proposal) approach to evaluate systems and suppliers, and the completion of responses to good RFPs present suppliers with an onerous (and revealing!) task. Suppliers sometimes complain that some RFPs are poorly edited and repetitive, and certainly questions that can be answered using ‘copy & paste’ functions should be avoided. The art of RFP writing is to establish the differences between critical elements of different vendors’ solutions, and these are best revealed by ‘How do one...?’ as opposed to simple ‘Do one...?’ questions. A proper market survey will have revealed the answers to the latter form of question.

MCM advocates the use of structured work sessions as the key step in the system selection process. Essentially, these involve setting an agenda with several system suppliers for a detailed review of the system. This should

involve hands-on experience of the system, and a review of the system’s results when processing a representative selection of typical transactions. The Treasurer needs to ensure that the chosen system can produce the information required, through a review of system processes, portfolio analysis and report writing techniques. The end of this demanding process should accurately reveal the competing systems’ strengths and weaknesses in meeting the goals of the treasury’s strategic plan.

Aside from the issues of technology and functionality, system buyers need to be assured in areas such as the depth and quality of the prospective supplier’s support operation, of their stability, and their long-term commitment to the corporate treasury marketplace. These areas are best addressed through contact with several reference sites, and the vendor should be asked to introduce several companies, which have successfully achieved similar goals to the buyer’s own.

Ultimately, the decision is taken on a range of concrete and abstract issues, and the project enters the transitional phase of contract negotiation and finalisation. Purchasers are recommended to agree contracts, which include clear definitions of project deliverables and milestones.

System Implementation

MCM firmly believes that implementation must be a structured process, and the client treasury department must enter into a close partnership with the supplier to manage and execute a mutually agreed Implementation Project Plan. Clearly, successful systems suppliers are continually undertaking implementation projects, but the treasury will (hopefully!) have only occasional experience of this process. Both parties have a vested interest in the quick and clean execution of the plan, and the key to achieving this is detailed, realistic planning, and the dedication of key treasury resources to the project.

It is important for all treasury personnel to develop a sense of ownership in the new system. This may well make exacting demands on the staff, and good planning can minimise the pain and go far to assuring the required results. Effort expended in the early stages in the design and organisation of static data and the definition of outputs, reports and interfaces will be amply

rewarded. It is also important to arrange the participation of third parties such as systems specialists, banks and accountants.

We have previously indicated the importance of securing appropriate technical support, including the appointment of a part-time DBA. The practical technical support starts with the selection, ordering and installation of the hardware, network and database, and with working with the supplier’s technicians in the installation of the actual treasury system. Subsequent technical support may include database administration, and the establishment and monitoring of security arrangements such as back up and recovery. Overall, the technical requirements should not be over-demanding, but they are critical.

Strategic Plan

The construction of an innovative strategic plan follows logically from a systematic definition of the problem. The failures and omissions of existing systems and methods will have been clearly identified, and therefore the required solutions may be defined and prioritised.

The details of the strategic systems plan will naturally vary from company to company, but a typical result is likely to encompass at least some of the following points.

Control elements: the processing of transactions.

Reporting requirements: functional definitions of the key reports to be generated.

Critical import interfaces: bank statements, forecasts, and subsidiaries trade requests; netting cycle inputs, market rate information.

Critical export interfaces: bank payments and pre-advices, electronic confirmations, General Ledger Accounting system entries (detail or summary), MIS information, netting results.

Communications requirements: communications within the treasury, communications with other departments, inter-linking of subsidiaries and regional centres with Headquarters.

Technology considerations: internal standards for operating systems, database management systems, networks, hardware, E-mail, spreadsheets.

Risk management: treasury and corporate requirements for monitoring and managing risk.

Time constraints: how time critical is the production of the various information sets, processes and reports?

Market Survey

Now that the Treasurer has a planned set of systems objectives, it is appropriate to survey the market to determine which systems generally meet the company’s strategic requirements.

There are many potential sources of information. At the beginning of this article, we mentioned treasury conferences, and well-attended conferences are a primary source of up-to-date information. The system suppliers will of course be there, showing their systems to best advantage, but perhaps the most valuable source here is presentations and conversations with other treasurers who have recently been through the systems selection process. Interestingly, there is a solidarity among treasurers that seems to transcend corporate rivalries, and there is some evidence that peer group collaboration plays a significant role in gathering useful information.

Not surprisingly, specialist treasury publications frequently carry articles about systems and technology, by suppliers (such as this one), consultants and treasurers. Prudent treasurers will of course take advantage of others’ experiences, and the market seems to be well served by the coverage of relevant topics.

Many treasurers turn to the services of their in-house systems departments or to external consultants at this stage of the process. The role of in-house systems departments has evolved rapidly over the last few years. Where once their primary role was systems development, this has now, in many cases, changed to internal consultancy, especially in support of the selection and implementation of systems. External consultants naturally bridge this gap when in-house expertise is unavailable.

The end result of this phase of the process is a list of treasury system suppliers whose products meet the content and quality parameters of the project.

Project Definition

At this stage, the Treasurer is in a position to define the objectives of the system selection project, and to request funding for the chosen solution. It is best to delay budget finalising until this point, since in practice the scope of the project may quite reasonably increase in the light of studying the marketplace (a decrease is unlikely!). The Treasurer will have discovered the broad scope of new developments in systems and technology, and will have a much better idea of its practical value in the treasury environment.

The process of defining project parameters should be relatively straightforward, since the general definition of the plan should be a pragmatic expansion of the strategic plan, in the light of expanded information set.

The project’s definition may need to be supplemented by a cost/benefit analysis, and a number of caveats apply to the preparation of this. A new system is an essential tool in advancing the treasury’s performance and goals, and its selection and implementation are the beginning of the process of achieving those goals. The actual goals will of course vary from treasury to treasury, and they may range from the tangible benefits of reducing operational costs, optimising bank account management, reducing funding costs and increasing investment returns, to intangibles such as the improvement of control and risk identification and mitigation. It is unlikely that all of these can be concentrated into a single project, so the Treasurer has the opportunity to prioritise objectives and refine the department’s mission.

CASE STUDIES FOR TREASURY MANAGEMENT

CASE STUDY I

HEDGING INTEREST RATE RISK

SCENARIO:

A major aircraft manufacturer has decided to replace its mainframe computer. The cost after trade in is $10 million, payable on delivery.

DELIVERY

Mid December, 1995

FUNDING

A Projected cash flow short fall will increase a $10 million borrowing

BORROWING RATE:

Libor + 50 basis points

OUTLOOK

The treasurer is worried that the Central Bank’s future policy directions will lead to an increase in short term rates.

MARKET CONDITIONS

Current Libor 8.38%

EURO-DOLLAR OPTIONS ON FUTURES;

December 91,25 (implied rate of 8.75%)Put, Premium of .25December 91,00 (implied rate of 9.00%) Put, Premium of .15

STRATEGY

The treasurer buys the December Put option with a strike price of 91.25 (implied rate of 8.75%), which allows the manufacturer to enter into Euro-Dollar futures contract for a premium price of .25. The notional principal, that is the size of the contract is $1 million, so ten contracts are taken to cover the full short term borrowing cost. The Put will make money only if the underlying future falls below the strike price less the price paid for the option. Remember the Euro dollar future is quoted as an index on a base of 100, a lower price means a higher rate of interest.

RESULTS:

In mid-December depending upon how the Libor rate has changed, the treasurer will use or not use the put option on the future, which was purchased. If the cost of short-term borrowing has remained the same or declined, the Put Option will expire worthless. The money expended upon the Premium of 0.25% per $1 million dollar contract, will have been lost. If however, interest rates were to rise, the Put option Contract on the Euro dollar future will be exercised. If, for example, Euro-dollar rates rise to 10.76% (89.10 on the index) which would have given the treasurer a borrowing cost of 11.26% (Libor +50 basis points) the Put would be utilized, exercising the right to sell the Option on the Future at the strike price of 91.25 for an intrinsic value of 2.15 (or 2% in interest terms). The gain in value on the Put Options contract compensates for the increased cost of borrowing on the Libor rate. The risk of funding the new mainframe computer has been managed.

CASE STUDY II

HEDGING FOREIGN EXCHANGE RATE RISK

SCENARIO

A US manufacturer of clothing imports fabric from the United Kingdom. In six months time, in anticipation of the winter season, he will need to purchase 1 million Pounds Sterling, in order to pay for the desired imports. In order for these finished goods to be competitive and ensure adequate margins, the exchange rate must not fluctuate significantly. A weakening of the US dollar by more than 5% may create problems in terms of price competitiveness and profit margins.

DELIVERY

In mid-June 1996, the manufacturer is scheduled to receive and pay for the imports.

FUNDING

The manufacturer has no funding exposure, as the imports will be paid from working capital.

EXCHANGE RATE

The present rate is STG/USD= 1.50, which is satisfactory with respect to commercial objectives, but a weakening of more than 5% will result in diminished margins or a non-competitive position.

OUTLOOK

The manufacturer is worried that because of declining rates of interest and a current account deficit, t he US dollar may weaken against t he Pound Sterling, from its current rate of 1.50

MARKET CONDTION S

Current Spot Rate: STG/USD=1.50June Calls @Strike Price of STG/USD=$1.51, premium of 2.50% per contract, that is 4 US centsJuly Calls @Strike Price of STG/USD=$1.52, premium of 2.00%, per contract that is 3 US cents.

STRATEGY

The manufacturer buys one Call Option Contract with a strike or exercise price of 1.51. If US dollar weakens the call contract will be used to buy the pounds sterling at the set price. If, the US Dollar stays the same or strengthens, the contract will expire worthless and the premium paid for the option will have been lost.

RESULTS

In June1996, the US dollar does weaken and the new spot exchange rate is STG/USD 1.60. Hence the Call Option at 1.51 now has intrinsic value of 9 US cents. Instead of the 1 million Pound Sterling required by the manufacturer costing 1.6 million US dollars, the exercise of the Call Contract will net $90,000 US ($1.6million minus $1.51 million). After subtracting the price of the premium of 2.5%, t he net gain will be $50,000 US ($1.6million minus $1.55 million) which partially offsets the depreciation in the US dollar exchange rate and is within the manufacturer’s target range of 5% to remain competitive on pricing. Through hedging the commercial objectives will be ensured. If the US Dollar exchange rate had not weakened, the expenditure on the premium would still have kept his net cost of the imports within the self imposed limit.

CASE STUDY III

PURCHASING COPPER OPTIONS AS PRICE INSURANCE

SCENARIO

In January, a cable manufacturer receives an order from an electric utility that will require, 50,000 pounds of copper in April and another 50,000 in June. The manufacturer quotes the utility a price for the cable based on current prices for copper. He desires to secure his profit on the transaction by purchasing at today’s prevailing price levels. For example, he could purchase the copper and store it until needed in the manufacturing process.

Buying copper, however, may create storage problems and will tie up large amounts of working capital in inventory, which does not earn interest. Alternatively, the cable manufacturer could buy copper futures contracts for delivery in May and July. The manufacturer may decide, however, that he is not prepared to finance periodic margin calls should copper prices fall.

The third alternative is of the cable manufacturer is to purchase Call Options on COMEX copper futures. If the price of copper rises, the options will increase in valued right along with the futures price. But if the price of copper falls, there will be no margin calls, because the potential loss in options is equal to the premiums, which are paid.

INVENTORY

April and June, the manufacturer needs 50,000 pounds each

FUNDING

The manufacturer has no funding exposure as the premiums for the options represent the total outlay for the “insurance” against price increases.

PETROLEUM PRODUCT MARKET

The manufacturer based upon his analysis, is worried that prices may be increasing.

OUTLOOKThe company is worried that to maintain a physical inventory is expensive and that futures contracts would involve margin calls.

MARKET CONDITIONS

May and July copper futures are trading at 84.5 and 86 percents per pound.

STRATEGY

For may and July, the copper manufacturer will buy two 84 cent May calls at a 2.5cents per pound and two 86 cents July calls at 2.6 cents per pound.

ACTIONS

Having purchased the two calls, the manufacturer is surprised to learn that the spot copper has risen to 87.5 cents per pound, and the May call to 4 cents per pound. The manufacturer sells his two May 84-cent calls and purchases 50,000 pounds of cash copper. When the manufacturer is ready to close the balance of his position in June, copper is trading at 90 cents per pound and the July call is 4.4 cents now. Again the manufacturer liquidates his options and buys cash copper.

CASH PRICE FUTURES PRICE OPTION PREMIUM

In January May copper May option84.5 cents 2.5 cents

July copper July Option86 cents 2.6 cents

In April May option87.5 cents 4 cents

In June July option90 cents 4.4 cents

Result: Average Purchase Price for copper = 87.1 cents (Cash price less profit on options, or 88.75 cents – 1.65 cents)

Summary

In this example, the manufacturer pays only 87.1 cents a pound to acquire the physical copper, despite the fact that the market price for copper has risen considerably. Had the price of copper fallen, the manufacturer would have let the options expire worthless, and purchased cash copper at the lower

prices. As a user, the manufacturer has opened “insurance” against price increases. Similarly, copper producers can protect against price declines by purchasing put options.

CASE STUDY IV:

CASH FLOW MANAGEMENT BY A MAJOR OIL COMPANY

SCENARIO A major oil company maintains an inventory of heating oil throughout the year to meet regular customer demand. Management is concerned that fluctuating prices of heating oil in the cash (spot) market will adversely affect their financial planning and they wish to protect the value of their assets (inventory). Having purchased heating oil at one price, they are worried that a soft market may erode profit margins in the future.

INVENTORY

Throughout the year, in quantities and trading months roughly corresponding to the actual physical inventory position, futures contracts will be sold and bought.

FUNDINGS

The manufacturer has no funding exposure, as the imports will be paid from working capital

PETROLEUM PRODUCT MARKET

On 20.1.1996, Cash Heating oil is $0.42 cents, but the price trend based upon fundamental and technical analysis appears bearish for owners of inventory.

OUTLOOK

The company is worried that the value of their inventory may decline, realizing diminished profit when sold in the cash market.

MARKET CONDITIONS

Current spot price of heating oil is $0.42 cents per gallon. The April Futures is priced at $0.41 cents per gallon. May Futures is $0.40.

STRATEGY

The company sells heating oil futures on the New York Mercantile Exchange (NYMEX) in quantities and trading months roughly equivalent to the actual physical position of the company. As physical inventory is sold and priced (valued) the company buys the heating oil futures back on NYMEX at then current price levels. Selling the April futures at $0.41 cents per gallon yields $430,500 dollars in revenue on a shipment of 1,050,000 gallons. The May future sold yields $420,000 revenues.

ACTIONS

On 18/3/1996, as feared the cash market has fallen to $0.3650 cents per gallon. The April Futures has fallen to $0.36. The Company now sells in the spot market 1,050,000 gallons of physical heating oil to customer at the current spot price of $0.3650 cents per gallons, to yield $383,250 in revenue. Simultaneously, the company has buys 25April heating oil contracts on NYMEX at $0.36 cents per gallons, for a cost of $378,000, which nets $52,500 ($430,500 minus $378,000). This transaction closes the April contract entered into previously in January.On 7/4/1996, again the company sells 1,050,000 gallons of physical heating oil at the new prevailing price of $0.3925 cents per gallon, to yield $412,125. To close the May Futures contract, the company buys 25 May heating oil contracts on NYMEX at $0.3952 cents per gallons for a cost of $ 414,960.00, which nets $5,040.00($420,000 minus $414,960).

SUMMARY

By initiating the two short hedges (selling in the NYMEX Futures Market)The oil company is able to determine a projected financial condition in a fluctuating market and secure the value of their physical inventory. If the oil

company had any sold its physical inventory of heating oil without using the futures market, its revenues would have been $795,375. With the use of the selling and buying futures, it s new revenue is $852,915, that is an additional $57,540.00 has been earned. This revenue translates into an average priceper gallon of $0.4062 cents per gallon. Thus the company has protected itself from the downward trend in prices.

GUIDELINES FOR THE WAY AHEAD

The profound changes in Treasury Management over the last twenty years or so have arisen because of the challenges faced by the modern corporation.

From a mere facilitator of transactions, treasurers have become forecasters, risk managers, corporate finance specialists to mention only a few of the hats which today’s treasurer must wear. Treasury Managers must be appraised of political unrest in foreign countries, foreign exchange rate trends. Reserve Bank of India’s policy on interest rates, regulations and compliance requirements and countless other factors all of which must filter into decision making, as well as facilitating the decision making of others. Without reiterating all of the observations made above, it might be useful to draw emphasis to some of the critical points.

Although treasury operations have the potential for becoming stand-alone profit generating units, one must never lose sight of the core activities of the firm. Even with the success in other areas, the treasurer’s role must still be to facilitate transactions of the business units. This might mean managing foreign exchange exposure; redeploying international assets based upon comparative tax regimes, securing long-term competitive capital for major Research & Development effort. In whatever activity, it is critical for the successful treasurer to connect the task to its underlying purpose.

In arranging a source of finance for a new project, unless such funds are used for the purpose at hand, performance measures such as Net Present Value or Return on Investment cannot be calculated. Matching by use and time period of investment and capital allows the monitoring of performance and provides useful information to shareholders and investing public. By such matching, inadvertent exposures are avoided, such as funding a long-term expansion with short-term funds needing renegotiation regularly. In deciding credit terms to customers, the cost of financing must be taken into consideration along with the impact upon sales activities. Would increasing the number of days credit increase or decrease collection problems, and how would it relate to factoring operations and t he amount and cost of working capital. The treasurer must think comprehensively and multi-dimensionally. In the use of derivatives for managing the risks of a business unit, a void the creation of speculative positions. If a treasurer feels he or she has the expertise to outperform the market, then proceed. But hedging activities, themselves should be tied to the needs of the business unit. Unless the Company’s directors strongly believe that they are better at speculating and trading, for example in foreign exchange than the dealing rooms of the word’s money centre bank, the use, of currency options and futures should be able to manage the transaction and asset translation risks of their global

business. In order to hedge successfully, a company must clearly understand its risks and as importantly understand how those risks relate to the commercial and financial objectives of the corporation. After objectives have been defined, the risks associated with these objectives must be measured and analysed. A risk with a small impact in a relatively less important market may not be worth the time of management. Some treasurers rank risks in terms of earning exposure or bottom line impact. Like any expenditure to protect the value or profits of business, it must be weighted against its costs. Hedging like insurance should be for significant, non-diversifiable, risks. A treasury in such circumstances, should be regarded as a cost or service center to the revenue earning divisions. The role of new profit center by Treasury Management must be undertaken only with the utmost confidence in the organisation’s competence in this highly complex field.

If a treasurer is undertaking speculative activity with a view to offsetting the gains and losses of transactions of other business units, there are many guidelines to follow. For speculators the size of the position taken must be related logically to the amount of risk capital available. Therefore just like the capital, which was raised for an operating division, the treasurer must take into account the amount of capital used for speculative activities and how much capital is being put at risk. Derivatives confer great amounts of leaverage……a small amount of premium can control a significant amount of underlying position. A mildly risky speculative position, may explode overnight, threatening one’s trading capital or even solvency. The profits from speculating arise from understanding analyzing and measuring risk.