Robert Cooper Corporate Treasury and Cash Management CORPORATE TREASURY AND CASH MANAGEMENT ROBERT COOPER Corporate Treasury and Cash Management © Robert Cooper 2004 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2004 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan ® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 1–4039–1623–3 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Cooper, Robert, 1945 May 11 – Corporate treasury and cash management / Robert Cooper. p. cm. – (Finance and capital markets series) Includes bibliographical references and index ISBN 1–4039–1623–3 (cloth) 1. Cash management. 2. Risk management. 3. Corporations–Finance. I. Title. II. Series. HG4028.C45C5785 2004 658.15’244–dc22 2003062317 Editing and origination by Curran Publishing Services, Norwich 10987654321 13 12 11 10 09 08 07 06 05 04 Printed and bound in Great Britain by Anthony Rowe Ltd, Chippenham and Eastbourne List of Figures x List of Tables xiii Acknowledgements xvi PART I RISK MANAGEMENT 1 1 Risk Management: Introduction 3 Introduction 3 Why Manage Financial Risk? 3 Principal Treasury-Related Financial Risks 4 Management of Financial Risks 10 Enterprise Risk Management 20 2 Treasury Policies for Debt, Foreign Exchange and Interest Rate Exposure Management 25 Introduction 25 Debt Management 25 Foreign Exchange Risk Management 29 Interest Rate Risk Management 36 Case Study 38 Solution 43 3 Debt Capacity 55 Introduction 55 Debt Versus Equity 55 The Impact of Debt on Financial Returns to Shareholders 57 Debt Equity Structure: Theory 60 v Contents Financial Ratios 65 Debt Capacity: Conclusion 69 Case Study 70 Solution 73 PART II FINANCING ALTERNATIVES 75 4 Bank Finance 77 Introduction 77 Forms of Bank Finance 77 Aspects of Syndicated Revolving Facilities 82 Advantages and Disadvantages of Bank Finance 89 Documentation 91 Specialist Financing 95 Case Study: Acquisition Finance 96 Solution 98 5 Bond Valuation and Credit Ratings 102 Introduction to Bond Valuation 102 Credit Ratings 111 6 The Bond Markets 120 Introduction 120 Advantages/Disadvantages of Bond Markets 120 The Pricing of Corporate Bonds 122 Bond Markets: General 124 Issuing a Public Bond: Eurobond 125 Medium-Term Note Programmes 132 Private Placements 135 Choice of Market 137 Case Study 141 7 Specialist Financings: Asset Securitization 145 Introduction 145 Principles of Asset Securitization 145 Why Securitize? 153 Should a Company Securitize Assets? 155 Developments in Securitization 157 Summary 160 Case Study: Lease Securitization 160 Solution 162 CONTENTS vi PART III THE USE OF DERIVATIVES TO MANAGE RISK 167 8 An Outline of Options 169 Introduction 169 A Basic Introduction to Options 169 Exotic Options 177 9 Foreign Exchange (FX) Markets and Derivatives 180 Spot Foreign Exchange 180 Forward Foreign Exchange 185 Foreign Exchange Swaps 189 Foreign Currency Options 194 Use of Options for Corporate Purposes 199 Exercises 200 Solutions 204 10 Interest Rate Risk Derivatives and Their Use in Managing Financial Risk 209 Interest Rate Swaps 209 Interest Rate Options (IRO) 215 Exotic Options 218 Swaption 221 The Effective Use of Derivatives 223 Long-Term Cross-Currency Swaps 224 Exercises 227 Solutions 231 11 Zero-Coupon Interest Rates , Forward–Forward Rates, Counterparty Exposure for Derivatives and Contracts for Derivatives 238 Zero-Coupon Rates and Forward–Forward Rates 238 Valuing Interest Rate Swaps 248 Counterparty Exposure 249 Contractual Terms for Derivative Contracts 252 Summary 256 12 Risk Management Summary and Use of Derivatives 257 Summary 257 Specific Considerations 258 Examples of Other Derivatives 260 Conclusion 262 vii CONTENTS PART IV CASH AND LIQUIDITY MANAGEMENT 263 13 Domestic Payment and Collection Instruments and Domestic Clearing 265 Cash Management 265 Domestic Collection and Payment Instruments 266 How Payments Clear 268 Clearing in the United States 275 Clearing in Other Countries 280 Some Techniques for Managing Payments and Receipts 281 Case Study 282 Solution 284 14 International Payments and Receipts 286 Correspondent Banking 286 SWIFT (the Society for Worldwide Inter-Bank Financial Telecommunications) 287 Foreign Currency Accounts 291 International Payment Methods: Non-Electronic 293 International Payments: Electronic 298 15 Pooling and Cash Concentration and Intercompany Netting 300 Pooling and Cash Concentration 300 Netting 312 Case Study 316 Solutions 317 16 Liquidity Management 321 Introduction 321 Cash Forecasting 323 Interest Rate Derivatives 328 The Management of Cash Surpluses 330 Instruments for Managing Liquidity Surpluses 333 Instruments for Managing Liquidity Shortages 337 Interest Calculations 341 Case Study 342 Solutions 344 CONTENTS viii PART V MANAGING THE TREASURY DEPARTMENT, TREASURY SYSTEMS, TAX AND ACCOUNTING 349 17 Managing the Treasury Function 351 Introduction 351 Internal Controls 355 Centralize or Decentralize Treasury? 359 Bank Relations 363 Performance Measurement 366 Outsourcing 369 Case Study 371 Solution 372 18 Treasury Systems 375 Treasury Management Systems 375 Electronic Banking (EB) Systems 378 19 Tax and Accounting 384 General 384 Appendix: LIBOR Fixings 388 Glossary 389 Index 410 Spreadsheets 416 ix CONTENTS [...]... pretransactions Admin., selling and interest 50% overseas sales US$, €, ¥ FX transactions Turnover Financing 10% energy – electricity Commodity Short-term liabilities Cash deposits Liquidity Derivatives Derivatives 3 major customers Counter party Table 1.2 Mapping treasury risks against profit and loss and balance sheet items 30% fixed 70% floating Interest rates 14 CORPORATE TREASURY AND CASH MANAGEMENT Business... results and market expectations 8 CORPORATE TREASURY AND CASH MANAGEMENT Table 1.1 Foreign currency earnings and exchange rates US$ million UK£ million @ 1.60 UK£ million @ 1.50 1 000 625 667 Liabilities 250 156 167 Net Assets 750 469 500 @1.55 @1.45 Gross assets Net profit after tax 150 97 103 Economic risk Companies may be exposed to foreign exchange movements not only through transactional and pre-transactional... collateral with a corporate if the market value of a derivative trade moves against it will depend on its credit strength Counterparty risk also arises on making cash deposits, or buying negotiable instruments It represents the possibility of a financial institution that 10 CORPORATE TREASURY AND CASH MANAGEMENT accepts deposits, or a company that issues financial instruments, failing and being unable... Typical treasury structure for a multinational company 362 18.1 Standard EB systems 380 List of Tables 1.1 1.2 Foreign currency earnings and exchange rates Mapping treasury risks against profit and loss and balance sheet items 13 2.1 2.2 2.3 2.4 2.5 Example of translation risk IDI global sales IDI supply costs IDI assets and profits IDI loan repayments 33 39 39 40 40 3.1 3.6 Aspects of equity and debt... of treasury- related financial risks The most usual way of ranking treasury risks is by attempting to measure their scale and magnitude Clearly only those risks that are significant or 16 CORPORATE TREASURY AND CASH MANAGEMENT that might substantially impact on the achievement of an organization’s strategy should be considered for active management There are a number of ways an organization may attempt... an impact on its public debt ratings and hence on its cost of debt, its ability to access certain debt markets, or its ability to undertake long-term derivative transactions The relationships with the agencies involved in rating a company’s various debt instruments are therefore sometimes considered to require specific management 6 CORPORATE TREASURY AND CASH MANAGEMENT Liquidity risk Closely connected... resources to meet day-to-day fluctuations in working capital and cashflow (Figure 1.1) The results of inadequate liquidity management are: ᔢ A company making both cash deposits and short-term borrowings, with the result that cash resources are not being used reduce short-term financings The cost is the difference between the deposit rate and the cost of borrowing ᔢ The company having insufficient resources... rating scales for Standard and Poor’s and Moody’s 110 110 113 114 6.1 Calculating the all-in cost of a fixed rate corporate bond 6.2 Relative merits of different bond markets 122 139 8.1 Premium variations consequent to different strike prices, contract periods, volatility and interest rates 177 9.1 Exercise decisions at different final market prices 9.2 Comparison of standard option and barrier option... spent time reviewing individual chapters and for their constructive comments and observations, in particular: Neil Barclay, Nicolas Cinosi, Verity Cooper, Geoff Henney, Keith Phair, Thomas Shippey and Roger Tristam xvi PART I Risk Management One of the basic building blocks for managing a successful treasury department is the establishment of a comprehensive set of treasury policies Such policies define... is affected by three main factors: ᔢ the business sector of the company 3 4 CORPORATE TREASURY AND CASH MANAGEMENT ᔢ the level of operational gearing (level of fixed costs in its business) ᔢ the level of financial risk The objective of managing financial risk is thus to reduce the volatility of return from a security over and above that of the volatility of return from the market This should increase . Robert Cooper Corporate Treasury and Cash Management CORPORATE TREASURY AND CASH MANAGEMENT ROBERT COOPER Corporate Treasury and Cash Management © Robert Cooper 2004 All. 11 – Corporate treasury and cash management / Robert Cooper. p. cm. – (Finance and capital markets series) Includes bibliographical references and index ISBN 1–4039–1623–3 (cloth) 1. Cash management. . 298 15 Pooling and Cash Concentration and Intercompany Netting 300 Pooling and Cash Concentration 300 Netting 312 Case Study 316 Solutions 317 16 Liquidity Management 321 Introduction 321 Cash Forecasting