TREASURY MANAGEMENT

BSFM 201

TREASURY MANAGEMENT

BSFM 201

TREASURY MANAGEMENT (BSFM201) Treasury Management is sometimes referred to as Treasury Operations. No organisation does not have treasury functions whether it is a profit making organisation or a non-profit making organisation or a financial institution or a non financial institution. Treasury Management is a discipline that is concerned with borrowing, investing liquid investments and managing foreign exchanges and interest rates exposure. . Buckley (1996) Investment is a sacrifice or commitment of current money or resources for future benefits (in terms of expected returns).
Shareholders

Accounting Tax management Maintaining records

TREASURY The Oxford dictionary of finance and banking defines a treasurer as A person who is responsible for looking after the money and other assets of an organisation. This may include overseeing and the provision of the organisations finance as well as some stewardship over the way in which money is spent. Treasury refers to:

Board of Directors Managing Director

i.

The UK government department responsible for the countries financial policies and management of the economy. The First Lord of the Treasury is the Prime Minister but the Treasury is run by the Chancellor of the Exchequer. The Central Finance department of the US Government. The treasury management function performs several duties and responsibilities and is normally created and broken down into the following departments: - A Fixed income/ money market desk that is devoted to buying and selling interest bearing securities - A Foreign exchange desk that buys and sells foreign currency - A Capital markets/ equities desk that deals in shares listed on the stock market. - A proprietary trading desk that conducts trading activities for the banks own accounting capital. - An asset liability management desk that manages the risk of interest rates mismatch and liquidity. - A transfer pricing or pooling function that prices liquidity for business lines within the bank. This is done by the liability and asset sales teams.

IT Director

Marketing director

Finance Director

HR Director

Production Director

ii.

Treasurer

Comptroller

The duties and responsibilities of the treasurer and those of the controller complement each other meaning that their duties are interdependent Treasurer-ship Provision of capital Short term borrowing Control over borrowing costs Foreign exchange management Risk management Cash management Money market investment Credit management Retirement benefits Controllership Planning and budgeting Performance evaluation Inventory management

The role of the Treasurer The Association of Corporate Treasurers has listed the experience required of a corporate treasurer. The following list is a good summary of the role of the treasury department: i. Corporate financial objectives. ii. Liquidity management/ cash management iii. Funding management iv. Currency management v. Corporate Finance

TREASURY MANAGEMENT

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TREASURY MANAGEMENT

BSFM 201

i.

Corporate Financial Objectives Financial aims and strategies. Financial and treasury policies. Financial and treasury systems. v.

International monetary Current dealing can save or cost the company considerable and money for the success or shortcomings and the treasurer can have significant impact on the companys profit and loss which is involved in foreign currency exchange trade. Corporate finance Equity capital management Business acquisitions and sales Project finance and joint venture

ii. Liquidity Management/ Cash Management Liquidity is the firms ability to meet its short term obligations from a Finance point of view Making sure that the company has the liquid assets it needs and invests any surplus funds even for very short terms. Working capital management and money transmission management Banking relations and arrangements Money management Cash management and liquidity management are probably the most obvious responsibilities of a treasurer. In some organisations, the task is largely one of controlling stocks, debtors, creditors and bank overdrafts (short term assets and liabilities). In cash rich companies, the treasurer will invest surplus funds to earn a good yield until they are required again for another purpose. A good relationship with one or more banks is desirable so that the treasurer can negotiate overdraft facilities, money market loans or longer term loans at reasonable interest rates iii. Funding Management Funding policies and procedures Sources of funds Types of funds Funding management deals with forms of borrowing and alternative sources of funds such as leasing and The treasurers need to know the following: i. Where funds are obtainable ii. For how long iii. At what interest rate iv. Whether security is required v. Where interest rate will be fixed or variable Currency Management Exposure policies and procedures Exchange dealing including features and options.

Corporate finance in concerned with matters such as raising share capital, (it is for ordinary shares or preference shares), obtain a listing for new shares and admission of the shares to be traded on the stock exchange, dividends policy, financial information for management, mergers, acquisitions and business sales. Related subjects Corporate taxation (domestic and foreign taxation). Risk management and insurance. Pension funds investment management. Many of the responsibilities of a treasury function are associated with cash flow control and management of cash flow risk. Centralized or Decentralized Treasury Management A large company may have a number of subsidiary companies. In the case of a multinational corporation, these subsidiary companies will be located in different countries. In such cases, a decision is to be taken about whether all or part of the treasury function should be centralized. With centralized cash management, the central treasury department effectively acts as the bank to the group and has the job of ensuring that individual operating units have all the funds they need at the right time. When a subsidiary or division needs cash, it applies to the treasury department and does not make its own approach to an external bank.

iv.

Advantages of having a specially centralized treasury department i. Centralized liquidity management avoids having a mix of cash surpluses, overdrafts e.t.c. in different localized bank accounts and facilitates bulk cash flows so that lower bank charges can be negotiated.

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BSFM 201

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BSFM 201

ii.

iii.

iv.

Larger volumes of cash are available to invest, giving better short term investment opportunitiese.g. investing short term cash surpluses in money market instruments such as high interest account and certificates of deposit. Any borrowing can be arranged in bulk and lower interest rates than for smaller volumes and perhaps on the global market. A central treasury function is able to manage the interest rate risk exposures of the group as a whole. Foreign currency risk management is likely to be improved upon by central management e.g. central treasury department match foreign currency income earned by one subsidiary with expenditure in the same currency by another subsidiary.

Treating the treasury department as a profit centre recognizes the fact that treasury activities such as speculation may even earn revenues for the company and may as a result make treasury staff more motivated The profit centre approach is probably appropriate only if the company has a high level of foreign exchange transactions or a large volume of borrowing and lending transactions. If the treasury department is established as a profit center the following issues should be addressed: i. Competence of staff: The company should recruit competent staff and train them to the required levels of competence. Controls: Adequate controls must be put in place to prevent costly errors and overexposure to risks such as foreign exchange risks. Information A treasury team must have access to current market information. For example a treasury department trading in features and options or in foreign exchanges competes with other trades employed by major financial institutions who may have better knowledge of the market because of the large number of customers they deal with. Inorder to compete effectively, the team responsible for information needs to have detailed and up to date information. Much of this information is provided through online financial information systems supplied by information providers and examples of information provider from a global context is Reuters and Bloomberg. Attitudes to risk Treasury professionals might take an aggressive approach to risk taking in order to improve profits from treasury activities. This attitude might be difficult to reconcile with a more measured approach to risk that might be taken by the Board of Directors. The recognition of treasury operations as profit making activities might not fit in well with the main business operations of the company. v. Internal charges If the department is to be a true profit centre, then market prices should be charged for its services to other departments. It may be difficult to put realistic

In this way, the risk of losses on adverse exchange rate movements can be avoided without the expense of forward exchange contracts or other hedging methods. ii. v. A specialist treasury department will employ experts with knowledge in dealing with forward contracts, the Euro current markets and derivative instruments such as features, options and swaps. Localized departments could not have such experts. The centralized pool of cash required for precautionary purposes will be smaller than the sum of separate precautionary balances that would have to be held under centralized treasury management. If the central treasury department is established as a separate profit Centre, attention will be focused on the risk management strategy of the group and the contribution to group profit performance that can be achieved by good management of cash, funding, investment and foreign currency.

iii.

vi.

vii.

Advantages of Decentralized Cash Management i. Greater autonomy can be given to subsidiaries and divisions because of the closer relationships they will have with the decentralized cash management function. ii. A decentralized treasury function may be able to be more responsive to the needs of individual operating units. iii. Local treasury departments should have a better knowledge of the local financial markets (the closer the treasury department the more their knowledge about a particular market) The Treasury Department as a profit center A treasury department might be managed as a profit center, being accountable for its contributions to the profits of the group. Some companies have made significant profits from their treasury activities.

iv.

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BSFM 201

prices on some services such as arrangement of finance or general financial advice. Organisation of treasury Treasury is organized either as a department of the bank or as a specialized branch under the direct control of the banks head office. In either case the treasury functions with a degree of autonomy and normally has its own accounting system. The branch status is preferred as the books of accounts of treasury can be maintained independently (with its own profit and loss and general ledger account). On the other hand, the departmental form has the advantage of easier coordination with related departments at head office such as accounts and credit department in a line management. Treasury as a specialized branch enjoys an additional advantage, as the branch can act as authorized dealers for foreign exchange business and can participate in clearing and settlement systems directly, while head office departments can only act through a branch for its business operations. We may therefore conclude that in the context of interrelated treasury operations, a treasury brand should be the preferable form of organization. The treasury is headed by a senior management person such as a general manager or a deputy general manager or vice president or some other titles preferred. Treasury being a key activity of the bank, head of treasury should be a person who would report directly to the chief executive officer of the bank. However, the level of reporting and delegation of powers would depend on the size of the bank and the importance attached to treasury activities within the bank. Treasury may be divided into three main divisions i. The Dealing Room (or Front Office). ii. The Treasury Admission (or Back Office). iii. The Middle Office. The Dealing Room The Dealing Room is headed by the Chief Dealer who is in charge of the front office. The dealers working under him buy and sell various securities in the market. Each dealer specializes in one of the markets such as the foreign exchange markets and also money

markets, derivatives markets, although in an integrated treasury, the dealers are generally familiar with all the markets and all the securities. (Short term security: financial assets whose maturity date is within 12 months such as treasury bills, commercial paper, repos). Depending on the size of the operation, there may be dealers dedicated to major currencies or dealers specializing only in forward markets or derivatives markets. It is also common to have a separate corporate dealer exclusively to attend to major corporate customers or merchant businesses. Securities (financial assets/instruments/ financial investments) market (a market where you can buy or sell financial assets) is normally divided into two parts i. Primary markets where we are trading financial assets for the first time ii. Secondary markets where we are buying and selling securities already in existence (i.e. financial asset that have been traded before) it becomes logical to appoint dealers responsible for primary markets and others for secondary markets. As a matter of convenience, the dealer also participates in auction of government securities such as treasury bonds, treasury bills etc. conducted periodically by that governments central bank. The primary market comprises of new issues of non-government, debt paper commonly referred to as non-statutory liquidity ratio securities which are mostly issued by way of private placement. The primary market issues are subscribed by the investment department situated outside the dealing room but will be part of treasury. This is so because primary issues need appraisal of credit risk thorough examination of issue terms and where so stipulated, documentation for secured debt through a trustee. Often banks require inputs from market research for which either they may have an in house research department or may collect it from published material The Back Office This is responsible for verification and settlement of the deals completed by the dealers. The deals are verified on the basis of deal slips prepared by the dealers and also from the confirmation received from the counterparts. The back office staff also confirms the deals independently with the counterparts such as the banks and other institutions over telephone or through email or fax machines for the purpose of verifying the authenticity of the confirmation documents. The Back office takes care of all related book keeping and submission of periodical returns to the Central Bank.

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TREASURY MANAGEMENT

BSFM 201

The Back Office also maintains foreign currency accounts with correspondence banks, funding and securities accounts with the central bank, accounts with depository participants and ensures that adequate margin money is held with the clearing system of the money of the local currency and other settlements with the local currency. Settlement refers to receipt and payment of amounts following deals made by dealers (i.e. sale and purchase of foreign currency, lending and borrowing, sale and purchase of securities e.t.c. Settlement is a key function of the Back Office as all payments and receipts must take place on value debt. Any delay in settlement would result in financial loss to the bank due to purchasing power risk. Delays in payments are considered a default by the bank since they normally severely affect the banks reputation. Middle Office The Middle Office is created exclusively to provide information to management by establishing a management information system to implement a risk management system. Middle office monitors exposure limits and stop loss limits of treasury and reports to management on key parameters of performance. Transfer pricing mechanism may also be implemented through the middle office. (transfer pricing when the in-house services of the treasury are paid at market price for by the departments which need the services within the organisation) In smaller organisations such as banks, middle office may also function as Asset-Liability Management Support Group and be responsible for balance sheet risk management which is directly related to treasury risk management. (the assets and liabilities of a banks balance sheet are highly sensitive to changes in various market parameters conditions and have to be closely monitored by a team of people appointed who will be measuring exchange rates volumes of change, interest rates and they adopt measures which will sustain the bank . AL MSG) Investment Department Deals with primary issues (i.e. selling of new financial assets that have never been traded before. Whenever a suitable offer is received, the investment department would put up an investment proposal and obtain an approval at an appropriate level. Minimum marketable investments are stipulated; the investment proposals are scrutinized closely and are generally considered by an investment committee before the sanction is obtained at appropriate level.

The other departments in treasury, namely accounts and administration, systems administration, remittances (swift RTGS) would be mainly administrative in nature. Some banks may also prefer to have their inter-branch cash transfer department as part of treasury as the treasury maintains the bank accounts with the central bank. The Treasury Function (The success of any organization lies in the ability of the treasury to operate effectively (doing the right thing) and efficiently (doing the right thing right)) In a large bank, it is likely that the treasury function and the financial control function will be segregated whereas in a smaller bank, a combined unit is more common. The centralized treasury operation is concerned with the following function: - Risk exposure management embracing credit, country liquidity, interest rates and exchange rate risks together with those risks associated with dealing in foreign exchange, deposits, securities, commodities and various financial instruments including derivatives such as futures, forwards, options and swops. - Asset and liability management which incorporates domestic and foreign currency, wholesale and retail funds throughout the world, the funding of assets on the best possible terms, mobilization of deposits and the utilization of surplus resources. With this process, liquidity, interest rate structures and sensitivities together with future maturity profiles are major considerations in addition to the management of day to day funding requirements. - The coordination of local money book management in various centers throughout the world. - Control and development of dealing operations incorporating cash, forward, futures, options, interest rates and currency swaps and forward rate agreements e.t.c. - Responsibility for the judicious use of the banks name. - The funding of investments in subsidiaries and affiliates. - Capital debt raising and loan stock administration. - Control of investment portfolios and the utilization of a banks own liquid resources. - Fraud protection Financial control operations normally embrace the following functions; financial accounts, international taxation, management information, budgeting and forecasting, capital appraisal (i.e. investment appraisal/ capital budgeting)

However one wonders whether smaller firms do not need a treasury department. All firms to some degree are involved in one way or the other, although in smaller firms it may not be the separately defined job.

TREASURY MANAGEMENT

BSFM 201

TREASURY MANAGEMENT

BSFM 201

Although Treasury Management can be defined in many ways, the multi- popular can be adopted from the Association of Corporate Treasurers as the efficient management of liquidity and financial risk in the business. Treasury functions The size, structure and responsibilities of the treasury function will vary greatly among organizations. The key factors influencing the treasury function will be i. Corporate size (the larger the organization the more the functions and vice versa) ii. Listing status iii. Degree of international business. iv. Attitude towards risk
Risk aversion Expected return C B A Risk indifferent

iii. Corporate finance Deals with capital markets, banking relationships, trade finance, risk and liability management. iv. M and A equity management Deals with M and A, equity markets, investor relations, diversity trust (reducing the size of the company by selling off some branches especially if the organisation has become too large with many departments) *Treasurer February 1992 * For most companies, the treasury department is much simpler typically with a distinction between i. Funding (cash and liquidity management, short term financing and cash forecasting) ii. Treasury operations (financial risk management, portfolio management, investment management e.t.c.). Treasury departments have increasingly come under close scrutiny by the financial press. Barely a week passes without some large company announcing hefty losses resulting from some major blunder by its treasury department. In the highly complex, highly volatile world of finance there are bound to be mistakes. The secret to set up the treasury function in such a way that mistakes are easily discovered and that are never catastrophic. It is the responsibility of the board of directors to set up aims, policies, authorization levels, risk position and structure e.t.c. it should establish for example the following: i. The degree of treasury centralization. ii. Whether it should be a profit centre or a cost center. iii. The extent to which the company should be exposed to financial risk. iv. The level of liquidity which is desired. Degree of Centralization A primary consideration in establishing the appropriate structure to achieve treasury goals is the extent to which a function should be centralized. Even in the most highly decentralized companies, it is common to find a centralized treasury department because the advantages of centralization are self-evident and these include The treasurer sees the total picture of cash, borrowings and currency and is therefore able to influence and control financial movement on a global basis

Risk loving/seeking Risk

Every relational investor is risk aversive. It is therefore not surprising to see that international corporate organizations such as BP have highly developed group treasury functions. BP is a major Multinational companies (MNC) with a strong emphasis on value creation where currency and oil price movements can have a dramatic impact on corporate earnings. (there are 3 risks associates with investing in foreign countries which are transaction exposure, transaction exposure and economic exposure) Multinational corporations need to establish group treasury functions taking into account the following: i. Global dealings ii. Treasury services iii. Corporate finance iv. Mergers and Acquisitions (M and A) equity management i. Global dealings Foreign exchange, interest rate management, short term borrowing and short term deposits are the major activities associated with global dealings. ii. Treasury services Includes cash management, information system, transactional banking e.t.c.

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TREASURY MANAGEMENT

BSFM 201

to achieve maximum after tax benefits. The gains from centralized cash management can be considerable. Centralization helps the company develop greater expertise and more rapid knowledge transfer. Centralization permits the treasurer to capture any benefits of scale (i.e. economies of scale). Dealing with financial and current markets on a group basis not only serves unnecessary duplication of efforts but should also reduce the cost of funds.

i. ii. iii. iv.

Funding (responsible for raising the capital and funding activities) Banking relationships Risk management Liquidity and working capital (Liquidity can be the ability of the firm to meet its short term obligations i.e. current liabilities)

A survey by Ross(1991) found that 76% of responding firms had centralized group treasury functions. However, there are some benefits associated with decentralizing certain treasury activities; i. By delegating financial activities to the same degree as other business activities, the business unit becomes responsible for all operations. It is understandable when the regional managers with centralized treasury become annoyed at being assessed on profit after finance ii. Decentralization encourages management to take advantage of local financing opportunities which group treasury may not be aware of. HP is one major operation which has opted for a more decentralized structure whereby treasury management decisions can be made at different levels. However, centralization is also evident through linkages in such areas as policy , common objective and information system. Profit Centre or Cost Centre The treasury function like any other business activity should be measured in terms of its performance vis a vis the objectives. An example of a profit center is Marks and Spencer which states in its accounts; the groups treasury operates as a profit centre, but within strict risk limit and with a prohibition on speculative activities. The construction company, Mowlem, on the other hand states; the groups treasury department is responsible for currency exposures and finance. The policy is for the group to borrow centrally and to lend to group companies and divisions on commercial terms. The treasury department does not operate as a profit centre.(1994 Annual report) A survey by Euro money (August 1994) reviewed that of major companies operated their treasury as cost centers. But whichever way treasury functions are structured, they are expected to manage their operations in the most cost effective manner. There are basically four pillars of treasury management these are:

1. Funding Corporate finance managers must address the funding issues of; i. a) How much should the firm raise this year and in what form? b) There is need to examine long term, medium term and short term funding requirement of the corporation. ii. Why do firms prefer internally generated funds? Internally generated funds, defined as profits after tax + depreciation, represent easily the major part of corporate funds (i.e. reserves or retained earnings.). The question of how much a firm should retain in the business is the other side of the coin to the question of what the dividend policy should be. In many ways, internally generated funds is the most convenient source of finance. You could say it is equivalent to a compulsory share issue because the alternative is to pay it all back to shareholders and then raise equity capital from them as the need arises. Raising equity capital via the back door of profit retention saves issuing costs and other related costs. But at the same time it avoids the company having to be judged by the capital market as to whether it is willing to fund its future operations in the form of either equity or loans. iii. How much should companies borrow? This is a very big question which has kept academics amused for many years. But it is also a vital question for corporate treasurers. Borrow too much and the business could go bust or borrow too little and you could be losing out on cheap finance. The problem is made no easier by the observation that levels of borrowing differ enormously among companies and indeed among countries. Levels of borrowing in Italy, Japan German and Sweden are generally far higher than in the United Kingdom and in the U.S.A. One clue to the conundrum might be found in differences in the strength of relationships between lenders and borrowers. Bankers in German and Japan tend to take a longer term funding view than UK banks. Japanese banks may even form part of the same group of companies which is some kind of strategic alliance.

TREASURY MANAGEMENT

BSFM 201

TREASURY MANAGEMENT

BSFM 201

iv. What form of debt is appropriate If the strategic issue is to decide upon the level of borrowing, the tactical issue is to decide on the appropriate form of debt. The two elements comprise the capital structure decision. The debt mix question considers the following: i. Form: loans, leasing or other forms. ii. Maturity: long term, medium term or short term. iii. Interest rates: fixed or floating. v. How do you finance asset growth? Each firm must assess how much of its planned investment is to be financed by short term and how much by long term finance. This involves tradeoff between risk and return. Current assets can be classified into: i. Permanent current assets: these assets are held to meet the firms long term requirement. For example there is a minimum level of cash and stock required at any given time and a minimum level of debtors will always be outstanding. ii. Fluctuating current assets: these are current assets which change with seasonal or cyclical variations. For example, most retail stores build up considerable stock levels prior to the Christmas period and run down to minimum levels following January sales. There is also a need to determine how investment such as fixed assets, permanent and fluctuating current assets for a growing business should be funded. There are several approaches to the funding mix problem; i. There is the matching approach where the maturity structure of the companys financing exactly matches the type of asset. Long term finance is used to fund fixed assets and permanent current assets while fluctuating current assets are funded by short term borrowing. ii. A more aggressive and risky approach to financing working capital involves using a higher proportion of relatively cheaper short term financing. Such an approach is more risky because the loan is reviewed by lenders more regularly. For example, a bank overdraft is repayable at any time the bank manager so requires. iii. A relaxed approach will be a safer but more expensive strategy. Here most if not all the seasonal variations in current assets is financed by long term funding, any surplus cash being invested in short term marketable securities or placed in a bank deposit. 2. Banking Relationship

Every company needs at least one bank but a recent survey reviews that only 8% of companies use just one bank. Global business may deal with hundreds of banks. For example Eurotunnel has 225 banks to deal with. The number of banks dealt with will depend on the companys size, degree of complexity and geographical spread of its branches or subsidiaries. While it makes sense to have more than one banks, too many can prove difficult to foster strong relationships. The real value of a good banking relationship is discovered when things get tough (such as the prolonged recession in the early 1990s) and when continued banking support is required. A flourishing bank relationship requires the company to deal openly, honestly and regularly with the banker, keeping the banker informed of any progress and ensuring that there are no nasty surprises. 3. Risk Management Every business needs to expose itself to risks in order to seek out profit. But there are some risks that a company is in business to take and others that it is not. A major company such as Ford is in business to make profits on cars, but is also in business to make money from taking risks on currency movements associated with its worldwide distribution of cars. While the risks of business can never be completely eliminated, they can be managed. The first step in risk management is to recognize the companys exposure to risk. For example there is need to explore ways in which investment risk can be identified, measured and reduced. The treasurer has a vital role of identifying and managing corporate risk exposure and in such a way as to maximize the value of the firm and ensure its long term survival i. Hedging: Risk management is often termed hedging which is the process of offsetting risks using a variety of techniques. Hedging is a way of guaranteeing a price. Example if ABC ltd is a medium sized, bakery business, its main risk exposure is in the potential variation in the following: a) Raw material prices specifically flour and sugar. b) Currency movements on imports and exports. c) Interest rate movements on its variable rates of borrowing. d) Profit due to lost production from a bakery fire. The first three risks can be managed through hedging in the commodity currency and financial markets, whilst the last risk of lost profits can be covered through insurance ii. Derivatives

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BSFM 201

TREASURY MANAGEMENT

BSFM 201

A derivative can be defined as a financial instrument whose value depends on (or derives from) the value of other or more basic underlying variables (an underlying asset). Let

futures

options

forwards swaps

There is a mutual benefit for the two parties to agree on a price for sugar delivery next year thereby hedge the price management risk. The confectioner (manufacturer) hedges against prices escalating while the sugar cane producer hedges against prices dropping. They do this by entering into a futures contract enabling future transactions and their prices to be agreed today but not to be paid for until delivery at a specified future date. Futures contracts are traded on the commodity markets and forwards contracts are traded on the foreign exchange market. They agree on a foreign exchange price today for a delivery in the future. Whatever happens to the market price does not change the price agreed upon. Forwards markets exist on most of the major commodities such as cocoa, metals, sugar but even more important is the priced market in the foreign exchange dealings. A forward currency contract is an agreement which a company enters to buy or sell a specified amount of foreign currency at an agreed future date and at a rate which is agreed in advance. If one wants to pay $50000 in six months time, one can use a forward contract to hedge against adverse currency movements. You can agree on a price today (exchange rate)that you will pay for a dollar by arranging with your bank to buy the dollar forward. At the end of six months, you will pay the agreed sum and take delivery of the US$. Some other trade commodities in a forward market use exchange rates as the basis for pricing. Futures contract Much like a forward contract is a futures contract. People agree to buy or sell an asset at an agreed date and at an agreed price. The difference is that futures are standardized in terms of period, size and quality and are traded on an exchange that is overnight exchange. The risk associated is almost zero because of the existence of a clearing house, the risk of default is eliminated unlike a forward contract in an OTC market products are nonstandardized or customized or tailor made to suit the buyers needs. Examples of futures markets are LIFFE (London Intermediation Financial Futures Exchange in the UK). A company may prefer to enter into a future contract when a forward contract could be tailor made to meet its specific requirements. The main reason lies in the obvious benefits from trading through an exchange . Not the least of which is that an exchange carries the default risk from the future for the other party to abide by the contract terms thereby alleviating the counterparty risk. For this benefit, both the buyer and the seller must pay a deposit to the exchange termed the margin. A margin account is opened to record the entries of payments by both the buyer and the seller. Financial futures have become highly popular among both hedgers and traders who buy or sell futures in order to profit from the view that the market will go up or down. The main forms of financial futures contract cover short term interest futures, bond futures and equity linked futures using stock market indices.

There are basically four types of derivatives which are futures, forwards, options and swap contracts. Derivatives are financial instruments whose value derives or is based on an underlying asset which enables investors to reduce risk or speculate. A risk management program should reduce a companys exposure to the risks it is not n business to take whilst reshaping its exposure to those risks it does wish to take. Risk exposure comes mainly in unexpected movements in interest rates, commodity prices and foreign exchanges all of which should be engaged. A commodity market is a market where there is buying and selling of agricultural products, minerals and other related assets. A clearing house is an intermediary which records what may have happened in a futures contract. It is a negotiable instrument- trade. The futures contract on an organized market. Maize is an underlying asset. Forward contract It is common to find in business that buyers and sellers are subject to exactly opposite risks. The manufacturer of confectionery is concerned that the price of sugar may rise next year while the sugar-cane producer is concerned that the price may fall. Use of forward contracts to hedge a price In a world in which it is extremely difficult to predict with any real confident future commodity prices, both parties may want to exchange uncertain prices for sugar delivery next year for a fixed price.

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TREASURY MANAGEMENT

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After all, portfolio diversification by investors is one form of hedging and shareholders can employ derivatives in the same way as ??????????to follow their own risk management. Swaps These are arrangements between two firms to exchange a series of future payments. It is essentially a long dated forward contract between two parties through intermediation of the third party such as a bank. A company might agree to a currency swap where it makes a series of regular payments of US dollars. Heavy dependence upon short term borrowing not only increases the risk of insolvency but it also exposes the company to short term increases ???????/ Options An option gives the right and not obligation to buy or sell the asset at an agreed price. It is this right not to exercise the option that distinguishes it from futures and forwards conracts. Options are traded on both exchanges and in the OTC market. There are 2 basic types of options (call option and put options). A call option gives the holder the right to buy an underlying asset at a certain date and price. A put option gives the holder the right to sell the underlying asset by a certain date for a certain price. The price in the contract is known as the strike price or exercise price. The date in the contract is known as the maturity/ expiration date. American options can be exercised at any time upto the maturity date whereas European options can only be exercised on the maturity date. Most of the options traded on the exchanges are American options. In the exchange traded equity market, one contract is usually an agreement to buy or sell 100 shares. European options are generally easier to analyze than American options. Some of the properties of American options are frequently deduced from those of its European counterpart. It should be emphasized that an American option gives a holder the right to do something. The holder does not have to exercise this right. This is what distinguishes options options from forwards and futures contracts where the holder is obligated to buy or sell the underlying asset. NB whereas it costs nothing to enter into a future or forward contract, there is a costs on acquiring an option. The question is that should we hedge or not. The answer to this question is usually provided by the Capital Asset pricing model (CAPM). CAPM suggests that hedging is a costly process doing no favours for shareholders wealth. In an organized market, the holder pays a deposit in an OTC, pay ???????????/ There is therefore need to know why many large companies hedge. All shareholders in a business have a vested interest in its longer prosperity and hedging risk exposureis an important link of abiding financial distress. Asset- Liability Management Assets are vulnerable and are affected by financial asset parameters; interest rates, foreign exchanges and money and other macro-economic variables. The asset management committee in banks are responsible for evaluating the changes in cost parameters.

Very often, the variables underlying derivatives are the prices of traded assets. A stock option for example is a derivative whose value is dependent on the price of stock. However, derivatives can be dependent on almost any variable, from the price of hogs to the amount of snow falling at a certain ski resort. Proctor and Gamble, Barings Bank, Metallgesellschaft and Kodak are examples of major businesses whose corporate fingers have been burnt through derivative transactions. Assignment: Comment on whether derivatives should be traded on the Zimbabwe stock exchange clearly evaluating the merits and demerits of trading derivatives in stock exchange markets in general and the Zimbabwe stock exchange in particular. (6-8 pages, fs: 12, 1.5 sp, References (text books(minimum of 6)& journal articles). References (Example) 4. Bain, K. and Howells, P ; (2003), Monetary Economics: Policy and its theoretical basis (1st Edition), palgrave Macmillan. New York Cover page (Assgnmnt 1, Name & Surname, Reg No. , Program, Course Code, Lecturer) 1.0 Introduction (1 continous paragraph). 2.0 Definition of terms (identify and define the key words). 3.0 The content part (body) may have sub headings. 4.0 Conclusion (1 continuous paragraph ).

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e.g. Suppose that a call option with an exercise price of $90 currently exists on one share of stock, this share of stock is expected to be worth either $80 or $120 in 1 year bur its not known which one is the present type If the stock were to be worth $80 when the call expires, its owner should decline to exercise the call. It would simply not be practical to use the call to purchase stock for $90 when it can be purchased in the market for $ 80. The call would expire worthless. If instead, the stock were to be worth $120 when the call expires, its owner should exercise the call. The owner would then be able to pay $90 for a share which has a market value of $120 representing a $30 profit. In this case, the call would be worth $30 when it expires. Let t designate the options term to expire and be the stock value at option expiry and also be the value of the call option at expiry. The value of this call option at expiry is determined by = [ ,( 1)]when = 80, = max[ , (80 90] -10]

When OPTION MATHEMATICS INTRODUCTION TO STOCK OPTIONS A stock option that is a legal contract that grants its owner the right but not obligation to either buy or sell a given stock.A derivative is a financial instrument whose value depends on an underlying asset. There are two types of stock options which are 1. Put options 2. Call options A call option grants its owner to purchase stock for a specified exercise price also known as a striking price on or before the expiration date of the contract. A call option is similar to a coupon that one might find in a newspaper enabling its owner to purchase something for a certain price on or before a given date (the given date is known as the expiration or maturity date and the price at which it will be bought is known as the exercise price) If the coupon seems to be a bargain, it will be exercised and the holder of the call option will purchase the asset in question. If the coupon is not worth exercising, it will simply be allowed to expire worthless. Similarly, the value of a call option at exercise price equals the difference between the underlying market price of the stock and the exercise price of the call option.

= 120 max[ 0, (120 90)] = max[0,30] (accept)

A put option grants its owner the right to sell the underlying stock at a specified exercise price on or before its expiration date. A put contract is similar to an insurance contract. E.g. an owner of stock may purchase a put contract insuring that he can sell his stock for the exercise price given by the put the contract. The value of the put when exercised is equal to the amount by which the put exercise price exceeds the underlying stock price or zero if the put is never exercised. e.g.suppose that a put option with an exercise price of $90 currently exists on 1 share of stock. The put option expires in 1 year. Again this share of stock is expected to be worth either $80 or $120 in 1 year but its not known which one at the present time. If the stock were to be worth $80, the put expires, its owner should exercise the put. In this case its owner could use the put to sell stock for $90 when it can be purchased in the market for $80. The put will be worth $10 in this case. If instead the stock were to be worth $120 when the put expires, its owner should not exercise the put. Its owner should sell for $90 a share which has a market value of $120. In this case the call will be worth nothing when it expires

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Let = The value of the put when it expires is determined as follows: = max [0, ( ) When = max[0, (90 80)] = [0,10] = 10 When = 120, = max[0, (90 120)] = [0, 30] = 0 The owner of the option contract may exercise his right to buy or sell; however, he is not obliged to do so. Stock options can simply be contracts between two investors issued with the aid of a clearing corporation, exchange and broker which ensure that investors honor their obligations to each other. For each owner of an option contract, there is a seller or writer who creates the contract, sells it to a buyer and must satisfy an obligation to the owner of the option contract. The option writer sells (in the case of a call exercise) or buys (in the case of a put exercise) the stock when the option owner exercises. The owner of a call is likely to profit if the stock underlying the option increases in value over the current exercise price of the option (he can buy the stock for less than its market value). The owner of a put is likely to profit if this underlying stock declines in value below the exercise price (he can sell stock for more than its market value). Since the option owners right to exercise represents an obligation to the option writer, the s losses. Therefore, an option must be purchased from the option writer and the option writer receives a premium from the option purchaser for assuming the risk of loss associated with enabling the option owner to exercise, options may be classified into either European variety or American variety. European options can be exercised only at the time of their expiration while American options may be exercised any time before and including the maturity/expiration date. Most options contracts traded in the US and Europe as well are of the American variety. American options can never be worth less than their otherwise identical European counterparts. BINOMIAL OPTION PRICING: one time period

The binomial option pricing model is based on the assumption that the underlying stock follows a binomial return generating process. This means that for any period during the life of the option, the stocks value will change by one of two potential constant values. e.g. the stocks value will be either u (multiplicative upward movement) its current value or d(multiplicative downward movement its current value thus in an upcoming period, there are two potential outcomes which we might name u and

d egConsider a stock currently selling for 100 and assume for this stock that u=1.2 and d=0.8.the stocks value in the forthcoming period will be either 120 if outcome u is realized or 80 if outcome d is realized.
Suppose that there exists a European call trading on this particular stock during this one time period model with an exercise price of $90 The call expires at the end of this period when the stock value is either 120 or 80. Thus if the stock were to increase to 120, the call will be worth 30 ( = 30) since one would exercise the call by paying 90 for a stock which is worth120. If the stock value were to decrease to 80, the value of the call will be zero ( = 0)since no one will be willing to exercise by paying 90 for shares which are worth only 80. Furthermore suppose that the current riskless return rate is 0,10. Based on this information we should be able to determine the value of the call based on the methodology presented below: Notice that we have not specified the probabilities of a stock price increase or decrease during the period prior to option expiration. Nor have we specified a discount rate for the option or made inferences regarding investor risk preference. We will not determine ex-ante expected option values nor will we employ a risk adjusted discount rate to value the options. We will value this call based on the fact that during this single time period we can construct a riskless hedge portfolio consisting of a position in a single call and offsetting positions in (alpha) shares of stock. This means that by purchasing same regardless of whether the underlying stock price increases or decreases. Let us first define the following terms for our numerical example: ); = 100( = 1,2 ( ) = 0.8( )] = 30 (max[0, ( [0, ( 0 )] value of stock if price decreases = 0(

) )

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0.10 Our first step in determining the va hedge ratio defines the number of shares of stock that must be sold or shortsold)* inorder to maintain a riskless portfolio (* shorting stock is the same as selling stock. If we do not already own shares, we can short sell the stock. For practical purposes, this means that we can borrow the stock and sell the stock with the obligation of repurchasing the stock at a later date.)

1+ (1 +

+ )

(1 + 0.10)(0.75)(100) + 0 0.75(0.8)(100) = (1 + 0.10) = 20.4545454545 Binomial option pricing ; multiple time periods The above equation is quite appropriate for evaluating a European call in a one time period framework. This means that in the model represented this far, share prices can either increase or decrease once by a pre-specified percentage. Therefore there are only two potential prices that the stock can assume at the expiration of the stock. This binomial option pricing model can easily be extended to cover as many potential outcomes and time periods as necessary for a particular scenario. The next step in the development of a more realistic model is to extend the framework to two time periods. One complication is that the hedge ratio only holds for the beginning of the first time period. After this period, the hedge ratio must be updated to reflect price changes and movements through time. Therefore, our first step in extending the model is to substitute for the hedge ratio based on equation =
( )

shares of stock. In this case, the riskless hedge portfolio made up of one call option and shares of stock will have the same value when the stock price increases to or .

be given as follows = 30

shares to sell for every call option. This value is known as the hedge ratio and by multiplying this hedge ratio we maintain or hedged portfolio. = ( )

1+ for each call option that he purchases to maintain a riskless portfolio. Since this hedge portfolio is riskless, it must earn the riskless rate of return otherwise arbitrage opportunities will exist. Empirical investigation of arbitrage pricing theory by PetrosJecheche = )(1+ ) = ( )
(

+ (1 + )
) ) [

] (

1+
) ( )

+ )

( ( )

From here we can work equally well with either outcome U or d since it makes no difference, we will work with outcome d. note that the time 0 option value can be solved for by rearranging the following equation. If equation above does not hold or if the current price of the option is inconsistent, a riskless arbitrage opportunity will exist. Thus we will rewrite the same equation to solve for the zero NPV condition that eliminates positive profits arbitrage opportunities = It is now quite simple to solve for the call value by rewriting the following equation

(1 +

This expression is quite convenient because the arrangement of potential cash flows in its numerator. Assume for the moment that investors will discount cash flows derived from the call based on the riskless rate . This assumption is reasonable if investors investing in options behave as though they are risk neutral. In fact they will evaluate options as though they are risk neutral because they can eliminate risk by setting appropriate hedge ratios. Their extent of risk aversion will already be reflected in the prices that they associate with the underlying stock. Note that

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the above equation defines the current call value prices rate.

and

and this riskless return

Since it is reasonable to assume that investors behave towards options as though they are risk neutral, the numerator of the last equation above may be regarded as an expected cash flow. Hence the terms that are multiplied by, might be regarded as probabilities. Define to be the probability that the risk neutral investor associates with the stock price changing to (1 ) as the probability of stock price changes to .
( ( ) )

Solving the formula IN SOLVING THE Formula, we know 4 of the 5 variables; the current stock price, the time to expiration of the option, the exercise price and the short term interest rate. The key unknown then is the standard deviation of the stock price. Black and Scholes assume that the stocks continuously compounded rate of return is normally distributed with constant variance *although this assumption is open to question, solving this assumption without a stationarity assumption is exceedingly complex. The valuation formula is very sensitive to the standard deviation employed as an estimate of the volatility of the stock. The usual approach to the problem is to use the recent past volatility of the stock as a proxy of its volatility during the life of the option. We might use the weekly observation of stock prices over the last year and derive the annualized standard deviation of the natural logarithm of price relatives. *a price relative is simply the stock price this week divided by the stock price last week (if > 1 there was an increase in the price level t.o.i.t). if the stock price this week is $33 and the price last week was $31.50, the price relative is 1.047619048. The natural logarithm of this number (0.046520015) can also be found in a natural log table or on a calculator equipped with the log function. Given a listing of 52 price relatives and their natural logarithms, we can easily derive the standard deviation (52 wks to the year). To annualize this weekly standard deviation, it must be multiplied by the square root of 52. There are other ways to estimate volatility and there is need to explore some of these ways.

1-

( ( )

INTERPRETING THE FORMULA this formula mayseem hopelessly complicated but it has a rather stra

in the equation, n(

represents the delta of hedge ration of options of stock.

Necessary to. In keeping with what we have said above, the option holder can be viewed as a livered investor. He or she borrows an amount equal to the exercise price E at an interest rate of r.therefore ( )represents the loan, the present value of the exercise price times an ( )Thus the equation = ( ) E ( ) adjustment factor on

Represents the following Option Loan adjusted The important implication of the BS model is that the value of an option is the function of the short term interest rate of the time to expiration and of the variance rate of return on the stock but it is not a function of the expected return on the stock. The value of the option in the equation = ( ) ( ) increases with the

Illustration To illustrate the use of the BS model for option pricing, suppose that on the basis of an analysis of past volatility web found the standard deviation of the stocks continuously compounded return to be 0.40. by referring to a financial newspaper, we are able to look up the other four terms necessary to solve the options pricing formula.Suppose we find then following: Stock price = $30 continuously compounded r t Solving for and

increase of either or all of the terms : for duration to expiration of the option t for the variance rate ( ) and for the short term interest rate (r) The reasons for these relations were discussed above. Of the three factors affecting the value of the option however, the short term interest rate generally has the least impact. With increases in t, r and in the above equation, the value of the option approaches the value of a share of stock as a limit

for

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ln =

+ 0.10

0.5

0.4 0.5 = 0.562124687 ln 0.10 0.4 0.5

.

between the standard deviations of 0.25 and 0.30. interpreting here we obtain 0.4013(0.29/0.50)(0.4013Summarizing Given N(d1) and N(d2) together with the info on the stock price, the exercise price, the interest date and the length of time to expiration of the option, we are able to compute the equilibrium value of the option using the equation: E ( ) = ( ) = 30(0.713) 28
. ( . )

= = ln

0.5

0.610

The expression ln

can be solved either by using a calculator having such a function or

by looking it up in a natural log table and is equal to 0.068992871. Cumulative probabilities In the equation, = ( ) ( ), ( ) and ( )are the probabilities that are random variables with a standardized normal distribution will take on values less than ( ) ( ) . With the bell shaped normal distribution, slightly over 2/3 of the distribution falls within one standard deviation on either side of the mean, 95% within two standard deviations and 99.7 % within 3 standard deviations68%
95%

Thus the BS pricing model suggests that an option to buy one share of stock having the characteristics specified is worth $5.14* rather than solve for this value by hand, computer programs are available that will do it for you. Still it is useful to see how these programs both embedded and specialized go about the task of calculation. In the equation above, e for easy solving of the problem. Without this help we have to resort to tables for natural logs. The Hedge ratio to use The value of the hedge ratio to use tells us the value of ( ) The value of ( ) tells us the appropriate hedge ratio to employ. In our case, the hedge ratio is 0.713. this means that the movement on the stock price will be accompanied by 0.713 shares shares of stock for each option written. With the proportions, price movements of two financial assets will be offsetting. $5.14.it is over-valued or undervalued. However caution is necessary in interpreting the results because our estimates of the stock future volatility is based oon the past volatility. This may or may not be an accurate proxy for the future. As the formula is quite sensitive to the standard deviation employed, caution is necessary in judging whether an option is over valued or under valued In the table that follows, Black and Scholes options value are shown for other assumptions concerning the standard deviation, stock price, exercise price, interest rates and the time to expiration. Options Prices from the Black and Scholes equation for various parameter values (Price of Standard Deviation 0.20 0.20 Exercise Price 35 40 1 month 5.15 1.00 r=5% t=4 Month 5.77 2.18

A 0.562 lies between the standard deviation 0f 0.55 and 0.6 in the table corresponding to the right of the mean. Interpolating, we come up with 0.2912 (0.12/0.50) of (0.2912represents the area of a normal distribution i.e. .562 or more standard deviation greater than the mean. To determine the area of the distribution normal the is less than 0.562 SD we merely subtract 0.287 from 1. *if the value of d1 were negative we would be concerned with the area of the distribution that was to the left of the standard deviation. Asa result we would not subtract it from 1.00. it is only with positive values that we subtract the area of the normal distribution from 1.00 in the table that it lies

7 months 6.42 3.02

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0.20 0.30 0.30 0.30 0.40 0.40 0.40 Some refinements

45 35 40 45 35 40 45

0.02 5.22 1.46 0.16 5.39 1.92 0.42

0.51 6.66 3.08 1.26 6.90 3.99 2.11

1.11 7.19 4.20 2.24 8.11 5.38 3.44

3. 4. Vega (v): the first derivative with respect to volatility Exploration into these factors is very critical and needs to be seriously considered Implied volatility Black and Scholes is volatility or any other variable if you know four of the five variables in the equation. With the Black and Scholes formula, we can estimate the volatility of a stock if we know the other variable. Assuming equilibration between the stock and options market, the estimated variability of the stock can be backed out of the formula. In other words, if we know the market price of the stock, option, the expiration date and exercise price of the option and the short term interest rate, we can solve the formula for the standard deviation of the return of stock. In practice, much attention is paid to the variance assumption involved in the associated asset.in valuing an option or a contract with option features, often it will be prefaced by saying value is based on a 23% s.d assumption, or something of this effect. The black and Scholes formula, extensions of it and other formulae of the same general sort are widely used in the Wall Street. In recent years, the avenues for shifting risk have expanded enourmously; i. Options markets on stocks and fixed income securities ii. Futures markets on financial assets and commodities iii. Foreign exchange markets on different currencies With combinations of securities held outright, securities sold short, options contract, futures contract and currency contract, it is possible to derive a myriad synthetic security with precision, the investment or financial manager can lay off the desired degree of risk. American options In the above discussion, we assumed a European option on a stock paying no dividend and then proceeded to value it in a hypothetical example of the stocks volatility, its price, the exercise price of the option, length of time to expiration and the short term interest rates. We now need to determine the effect on the value of an option when we drop the assumption of a European option and no dividend. American options can be exercised at any time upto expiration date. They can be exercised by the holder before or on the expiration date because the American option provides all the ryts of a European option +

As mentioned above, the delta hedge ratio of stocks and options must be adjusted as prices and volatility changes. In theory, continuous adjustment is necessary to maintain a risk free hedge. Such continuous change does not occur in practical situations. There are delays in execution and there are transaction costs. These factors must be weighted against the benefits. Most people who use the Black and Scholes model or a similar one, adjust the hedge ratio every so often perhaps once a week. When prices are changing rapidly, more frequent adjustment is necessary than in a stable market period. In practice, one cannot obtain a perfect hedge and only approximations apply.

Standard Deviation

Exercise Price T 35 40 45 35 40 45 35 40 45

r=5% 1 month 5.15 1.00 0.20 5.22 146 10 539 192 42 4 months 5.77 2.18 0.02 6.26 308 126 690 399 211 7 months 6.42 3.02 0.51 7.19 420 224 811 538 344 1 month 5.30 1.09 1.11 5.36 155 18 552 200 45

r=10% 4 months 6.29 2.54 0.03 6.72 3.42 145 731 431 233 7 months 7.26 3.67 0.65 7.92 479 266 876 594 387 1 month 5.44 1.19 1.47 5.50 164 20 565 209 48

r=15% 4 months 6.81 2.94 0.03 7.18 378 167 773 465 257 7 months 8.11 4.38 0.82 8.66 542 312 942 652 434

0.20 0.20 0.20 0.30

0.40

Other parameters Our focus above has been on the effect of delta, the hedge ratio, on the equilibration process between the value of an option and the price of the associated stock. This is the 1 st derivative. Added precision to the Black and Scholes formula sometimes can be gained by knowing other parameters which include the following: 1. gamma( ): the second derivative of option value with respect to share price. 2.

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the ability to exercise it before the expiration date, its value must be at least that of an identical European option. In certain cases an American option is worth more than a Euro option however it has been demonstrated that an American option on a non-dividend paying stock should not be exercised before the expiration date. One gives up not only the option but also the time value of money in paying the exercise price early. With early exercise, the American and European options will be priced the same if they are alike in all respects. Only for options on dividend paying stocks is the distribution between the European and American option important and the issue is treated as follows: The effect of dividends Cash dividends work to the disadvantage of the option holder vis-a-vis the stock holder. A cash dividend on a common stock tends to lower the value of the option on that stock. The higher the dividend, the lower the options value ceteris paribus. In essence, a cash dividend represents the partial liquidation of a company liquidating dividend, the price of the stock will go to zero as will the price of the option. When a stock goes ex-dividend, the market price of stock will drop by an amount somewhat less than that of the dividend depending on the tax effecr. The greater the present value of the cash dividend likely to be paid prior to the expiration of the option the lower its value, ceteris paribus.