Topic: The role of the treasury function in multinationals

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  • 10 Marks

AFM – May 2019 – L3 – Q5a – The role of the treasury function in multinationals

Calculate intragroup currency transfers through netting and discuss the pros and cons of using currency options versus futures for hedging net exposures.

Edi Ltd, based in Accra, Ghana, is a multinational company with two wholly-owned subsidiaries: Gil Plc based in Nigeria and Zep Ltd based in South Africa. Until recently, the Edi group has been doing well, returning a stable level of dividends to its shareholders. The financial performance of the Edi group has dipped in the past two years. In the last quarter of last year, the directors approved the establishment of a central treasury department based at the group’s headquarters in Accra. It is believed that the central treasury function will help boost effectiveness and efficiency in the group’s liquidity management, currency risk management, dividend remittances, and borrowing.

Intragroup Currency Transfers:
There are a lot of intragroup credit transactions that are often settled independently between the parties involved. This year, the treasury department has been tasked to manage the settlement of intragroup indebtedness through netting to reduce the volume of currency transactions. It has been agreed that all settlements will be made in the Ghanaian cedi at the prevailing spot mid-market exchange rate.

Below is a list of intragroup indebtedness at the end of the first quarter to be settled today:

Required:

i) Suppose the currency netting is implemented. Calculate the intragroup company currency transfers that will be required for settlement by each member of the Edi group.
(6 marks)

ii) Suppose the treasury department is recommending the use of currency futures to hedge net currency exposures. Discuss the advantages and disadvantages of the Edi group using currency options instead of currency futures in hedging net currency exposures.

i) Intragroup Currency Netting Calculation

Step 1: Convert All Amounts to Ghanaian Cedis (GH¢)

ii) Advantages and Disadvantages of Using Currency Options vs Futures for Hedging

Advantages of Currency Options

  1. Flexibility: Options provide the flexibility to choose whether to exercise the contract. If exchange rates move favorably, the company can benefit from the upside while limiting its downside risk.
  2. Limited Risk: With options, the maximum loss is limited to the premium paid, which is not the case with futures where losses can be unlimited.

Disadvantages of Currency Options

  1. Premium Costs: Options require the payment of an upfront premium, which can be costly and reduce profitability.
  2. Complexity: Currency options may involve complex pricing and strategies that can be difficult to manage, especially if volatility affects the premiums.

 

  • 10 Marks

AFM – Nov 2018 – L3 – Q5b – The role of the treasury function in multinationals

Explain key money market instruments, including securitization, reverse repurchase agreements, banker’s acceptance, and commercial paper.

The money market deals primarily with short-term instruments with short-term maturities and the repayment of funds borrowed is required within a short period of time.

Required:
Explain the following in the money markets:
i) Securitization.
ii) A “Reverse Repurchase Agreement”.
iii) Banker’s Acceptance.
iv) Commercial Paper.
(10 marks)

i) Securitization
Securitization is the financial practice of pooling various types of debt—such as mortgages, auto loans, or credit card debt—and selling the consolidated debt as securities to investors. The underlying assets are sold to a special purpose vehicle (SPV) or special purpose entity (SPE), which then issues securities backed by the pooled assets. The goal is to transform illiquid assets into liquid securities, thereby providing liquidity to the originators and potentially offering higher yields to investors.

ii) Reverse Repurchase Agreement (Reverse Repo)
A reverse repurchase agreement, or reverse repo, is a transaction where one party buys securities with the agreement to sell them back at a later date at a higher price. This is effectively a short-term loan where the seller agrees to repurchase the securities at a later date. For the buyer, it is a way to invest funds and earn interest. Reverse repos are commonly used by financial institutions to manage short-term liquidity needs.

iii) Banker’s Acceptance (BA)
A banker’s acceptance is a short-term credit investment created by a non-financial firm and guaranteed by a bank. It is a form of trade finance where the bank guarantees payment to the seller on a specified date, and the buyer agrees to pay the bank at a later date. BAs are used to facilitate international trade and are considered low-risk since they are backed by the bank’s creditworthiness.

iv) Commercial Paper
Commercial paper is an unsecured, short-term debt instrument issued by corporations to finance their short-term liabilities, such as accounts payable and inventories. It is typically issued at a discount to face value and matures within 270 days. Commercial paper is considered a low-risk investment and is generally issued by companies with high credit ratings. It provides a flexible and quick source of funding for companies.

  • 10 Marks

AFM – Nov 2018 – L3 – Q5a – The role of the treasury function in multinationals

Determine whether GCB should borrow locally or through a portfolio of foreign currencies based on borrowing rates and expected currency changes.

The Ghana Cocoa Board (GCB) is contemplating borrowing one-year funds in anticipation of the coming cocoa season, which starts in September/October 2017. GCB can borrow from the local financial market in Ghana or borrow a portfolio of funds made up of UK pounds and Euros. The information below is the borrowing rates and the probabilities of expected strengthening of the international currencies vis-à-vis the cedi.

Required:
Determine whether GCB should borrow from the local financial market or borrow a portfolio of funds made up of UK pounds and Euros.

To determine the best borrowing option, we need to compare the effective borrowing rates from both options. First, we calculate the expected strengthening rates for both the UK pounds and Euros.

Since the portfolio borrowing rate of 6.62% is significantly lower than the local borrowing rate of 18%, GCB should borrow the portfolio of funds made up of UK pounds and Euros.

Conclusion:
GCB should opt for borrowing the portfolio of UK pounds and Euros due to the lower effective borrowing rate compared to the local borrowing rate in Ghana Cedis.

  • 5 Marks

AFM – May 2016 – L3 – Q3c – The role of the treasury function in multinationals

Prepare a memo explaining the potential benefits of treasury centralization for multinational subsidiaries.

c) Drake Limited is a Ghanaian-registered multinational company with FIVE subsidiaries in Europe, Asia, and Africa. These subsidiaries have traditionally been allowed a large amount of autonomy, but Drake Limited is proposing to centralize most of the group’s treasury management operations.

Required:
Acting as Group Head of Finance for Drake Limited, prepare a memo suitable for distribution to Senior Management of each of the subsidiaries, explaining the potential benefits of treasury centralization. (5 marks)

Memo: Potential Benefits of Treasury Centralization

To: Senior Management of Subsidiaries
From: Group Head of Finance
Subject: Benefits of Centralizing Treasury Management

As part of Drake Limited’s strategic initiative, we are considering centralizing the treasury management functions across all subsidiaries. This proposal aims to enhance the efficiency and effectiveness of financial management within the group. Below are the key benefits of this centralization:

  1. Improved Decision Making
    • Centralizing treasury functions will allow decisions to be made with a holistic view of the entire group’s financial position. This ensures that decisions are aligned with the group’s overall strategy and objectives rather than the goals of individual subsidiaries.
      (1 mark)
  2. Enhanced Foreign Exchange Risk Management
    • A centralized treasury can manage foreign exchange risk more effectively by netting and matching the group’s overall exposure. This reduces the need for individual hedges and minimizes transaction costs, as only net exposures will be hedged.
      (1 mark)
  3. Better Cash and Debt Management
    • Centralization will provide better visibility of the group’s cash flows and debt levels, allowing for more efficient allocation of surplus cash within the group. Subsidiaries with cash surpluses can lend to those with deficits, improving liquidity management and reducing external borrowing costs.
      (1 mark)
  4. Increased Investment Returns
    • Aggregating cash resources from all subsidiaries allows for larger, more favorable investment opportunities, leading to potentially higher returns on surplus funds. Additionally, centralized borrowing can enable the group to access more favorable loan terms.
      (1 mark)
  5. Cost Reduction and Efficiency
    • Centralized treasury management reduces redundancy and inefficiencies, as fewer resources are needed to manage financial transactions and risk at the subsidiary level. Economies of scale can be achieved through reduced transaction and administration costs.
      (1 mark)

In conclusion, centralizing our treasury operations will allow Drake Limited to achieve significant cost savings, improve risk management, and increase financial efficiency, benefiting all subsidiaries within the group.

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