Treasury Management

Nachiket Mor
December 22, 2001
In many Indian corporations, the Treasury is
largely viewed as a finance and accounting
function with little or no strategic role
Traditional Role of Corporate
Treasury
z Liquidity Management
z Working Capital and Capital Expenditure
z Cash Flow Management

z Monitor Borrowing Cost

z Borrow at finer rates at appropriate time
z Keep gearing within reasonable levels
z Ensure Solvency of the corporate
 CFO - Traditional Perspective

CFO Financial Policy Making

Corporate Planning
Treasurer Controller
•Banking Relationships •Accounting
•Cash Management •Preparing financial statements
•Obtaining financing •Internal auditing
•Credit management •Payroll
•Dividend disbursement •Preparing budgets
•Insurance •Taxes
Paradigm shift in focus
The past environment

z India had a highly regulated financial sector regime till 1991

which virtually eliminated financial price risk
z Borrowing and lending rates were prescribed, guaranteeing
spreads
z Regulated capital markets did not provide any incentive for
innovation in resource raising
z Controlled foreign exchange regime ensured rationing of
overseas resources as per Government policies
z License-permit raj ensured that the most sought after skill
was that of obtaining license and not business acumen
The changed environment
z Lending and borrowing rates are freed
z Access to capital markets made easier for corporates
z The government has liberalized the ECB policy and a large
number of corporates have accessed the international
capital markets, for equity and debt
z Indian market is less immune to external shocks compared
to a decade back
z Thin markets exaggerate the impact of shocks
z volatility higher than in developed markets
z considerable amount of jump risk
z Decreasing effectiveness of policy intervention in
smoothing out volatility
Changing role of a CFO
z CFOs role not limited to investing and financing
z CFOs role has expanded to include
z Risk management
z Foreign Exchange, Interest rate, Commodity and
Liquidity risk
z Financial Engineering - a new technical speciality
that can help CFOs achieve
z Their companies strategic objectives
z Funding at cheaper costs using innovative structures
z Outsource the traditional or non-core activities
z Develop an IT strategy for the finance function
Strategic decision making
Strategic decision making
z Financial engineering helps the CFO in many ways to
undertake and execute strategic moves having significant
payoffs such as
z Outsource or build capacity
z Tennessee Valley Authority
z Unlock value in the balance sheet using option
structures
z Amoco & Apache
z The innovative outlook helps to achieve the defined
objectives considering all the relevant aspects
Risk management
Risk management
z Proactive approach to identifying risks associated with
business and taking steps to mitigate them is the key to
success in the modern business environment
z Using financial structures and instruments to hedge out
unwarranted risks is a crucial decision for the decision
maker such as :
z Hedging exchange risk using forwards or options
z Tiffany & Co
z A commodity manufacturer adopts measures to hedge out
interest rate risk
z Use commodity swaps to reduce out the impact of price
fluctuations on the bottom-line
z Risk associated with ESOPs issued to employees
Managing commodity price risk
z A corporate (say a aluminum producer) raises funds by way
of debt
z Critical aspects to the transaction
z Corporate’s revenue streams are exposed to Aluminium prices
z Manage interest rate exposure in the balance sheet
z Solution proposed
z Raise a rupee loan with repayment linked to price of
Aluminium
z The corporate repays a fixed tonne of Aluminium on each
payment date
z The corporate is thereby hedged against fall in Aluminium
prices
 The proposed product structure

Aluminium Aluminium
Comm. Plus Lender LME
Trader
USD (fixed)

USD (fixed)
USD (floating) INR (fixed)
USD (floating)
USD/INR
Counter Party USD/INR
Counter Party
Features of the structure
z Aluminium producer delivers X tonnes Aluminium to
lender (instead of delivering physical it pays rupee
equivalent of LME price prevailing at the interest
payment date)
z From the lenders’ perspective the return on its rupee
investment is unknown
z Essentially the lender is taking the commodity
exposure
z Higher the forward price the risk taker is able to get
better the quote to the manufacturer
z Terms of OTC contract and margin needs to be
considered
z Higher the rupee interest rate received against the USD
LIBOR the better the quote to aluminium manufacturer
Commodity Swaps
A generic swap structure, which can be used by
various commodity players

Pay Floating Receive Floating

Market
Producer Consumer
Maker
Receive Fixed Pay Fixed

Advantages
z Only net commodity price will be exchanged
z Smoothing out income flows
z Producer wants to receive fixed commodity
price
z Consumer wants to pay fixed commodity price
Hedging Employee Stock Options
z A ESOP offered by a company
z Vests in the hands of the employee the right to ownership of
Equity in the company
z Results in a option written in favour of the employee by the
company
z The company has a short call position on the vesting date
z Hedge strategy
z Go long on the company’s stock by resorting to delta hedging
z Cover fully by going long call on its own stock (if such long
dated option contracts are available)
z Go long on index (sector specific if available) options by
proxying the beta of the company’s stock with the index (long
date options)
Asset Liability management
Asset Liability management

z Proactive approach to balance sheet

management is the primary responsibility of a
CFO
z A holistic approach rather than a individualistic
approach is required
z Understanding the dynamics and correlation of
every crucial item in the balance sheet is of
critical importance for every fund manager
z Union Carbide Corporation
Funds management
Funds management
z The essence of modern day fund manager is to:
z Raise funds at the optimum cost using innovative structures
z Using structures to enhance credit worthiness of the borrower
z Lower cost of debt by embedding options on final payoffs to
investors
z Use financial derivatives to raise optimum funds as opposed
to plain vanilla type products which entail higher costs
z Enron
z Product example : Equity Linked Bond
Structured transactions
Structured Finance
Client Objective Structured Product
Reduction in funding • Securitisation
costs • Asset backed
• Future flow
Balance sheet • Employee loan portfolio buyouts
management • Real Estate Investment Trusts
Unlocking hidden value in • Brand financing
the balance sheet • Investment monetization
Achieving strategic • Promoter funding
objectives • Acquisition financing
Improving linkages • Channel financing
• Dealer financing

Acquisition Financing Case Study

Brand Financing Case Study
Changing Role of Banks
z Information intensive and monitored credit
z Small firms
z Large, complex, projects
z Distressed firms
z Banks are becoming providers of contingent
liquidity and not primary providers of liquidity
z Back-up lines, commitments
z Bridge lending
z Leverage Information Technology to provide
cutting edge banking services
What the ICICI Group has to offer
Present Features

E-enabled Supply Chain Proposed Features

Management

Payroll Processing
Inter Bank Transfer

Online Trading & Settlement International CMS

Online quotes in Derivatives Commodity Trading

Statutory Payments
Risk Management Tools

Dynamic Risk Management

Structured Finance
Thank You
 Case Study :Tennessee Valley
Authority
z Produces electricity
z Decision Problem - “make or buy” decision for meeting
peak demand
z “Make” entails large-scale capital investments
z “Make” results in loss of flexibility in a deregulated
power industry
z “Buy” might lead to supply constraints and market price
uncertainties
z Solution - Purchase call options on power that gives the
right but not the obligation to buy power from other utilities
z Small upfront investment, equal to the option premia
z Ensures flexibility and a known price

back
Case Study : Amoco & Apache
z Amoco, an integrated petroleum and chemical
corporation wished to sell marginal oil and gas
fields as a separate company
z Apache, an independent oil and gas company
interested in the purchase
z Strategic win-win for both companies
z Deadlock reached in price because of different
views on future oil price
z Amoco expects oil prices to remain firm. Values
company higher
z Apache fears oil prices to decline. Values company
lower
 Case Study : Amoco & Apache
z Primary disagreement about commodity price,
not characteristics of business
z Amoco, which is more optimistic about oil and
gas prices writes Apache a capped price support
guarantee. Apache to be compensated if prices
fall below support level
z Apache enters into price sharing with Amoco to
share profits if prices rise beyond a level
z So, each party locks into price it forecasts.
z Structure equivalent to a collar on oil and gas
price

back
 Case Study : Tiffany & Co.
z Tiffany was an international firm engaged in the retailing,
designing, manufacturing and distribution of luxury items
z Mitsukoshi was distribution agent in Japan
z Tiffany sold products to Mitsukoshi in Dollars
z Mitsukoshi sold it to retailers in Yen
z Mitsukoshi bore the exchange rate risk
z In 1993 Tiffany took control of Japanese dealership due to
strategic reasons
z Resulted in Yen - Dollar exchange rate risk
z Objective was to stabilize Yen cash flows in Dollars
z Forward sold Yen and bought Dollars
z Bought Yen puts

back
Case Study: Union Carbide
Corporation
z The Bhopal disaster & a hostile take over defense
in mid-1980s resulted in
z A ballooning debt portfolio with a debt/capital ratio
of 88%
z Fixed rate component was 54% of the total debt
z Senior debt rating was lowered forcing the
corporation to pay junk-bond yields
z Service the huge debt
z Scale back additional spending in critical areas
such as research and development and capital
investment
Active Liability Management
z Develop a benchmark debt portfolio (normalized
portfolio) other than establishing a target for the
amount of debt which would serve as the objective for
the composition of the debt profile
z Not just be concerned with the lowering UCC’s
interest expense but play a more proactive role in
achieving interest rate risk management goals such
as:
z Committed long term funding with little rollover risk
z Ability to respond to favourably to interest rate risk
z Manage the duration of its liabilities with regard to its
asset duration
Application of Principles
z Understand and establish correlation with macro-economic
variables that will have a bearing on UCC’s optimal debt
portfolio
z Focus on duration rather than on a measure such as fixed
debt / floating rate debt for defining its ideal debt. This
would help the portfolio to be more responsive to interest
rate shifts
z Use IRS to transform some of its fixed rate debt into
floating rate payments
z Determine the roll-over profile and the fixed / floating mix
required for long term committed funding with little roll-
over risk
 Results
z Based on the steps suggested a normalized debt
portfolio was arrived at using interest rate
derivatives
z This portfolio arrived at was subjected to a
historical analysis for prior periods and
compared to the actual debt portfolio as it existed
at that point in time
z For the periods compared, the normalized
portfolio fared better than the actual portfolio on
6 out of 9 occasions

back
 Credit Sensitive Notes: Enron
Corporate expects a credit rating improvement
Option 1
z Short-term funding
z But if required to fund longer tenure fixed rate assets, then
subject to interest rate and liquidity risk
z Undergo a pay-fixed-receive-floating swap to counter interest
rate risk
z Take benefit of the reduced borrowing spread over T due to
better credit rating in future for subsequent borrowings
z However, still open to liquidity risk
Option 2
z Issue a credit sensitive note where the applicable rate reduces if
the credit rating improves
z Benefits if rating improves
z No liquidity risk
z Avoids paying the swap spread

back
Equity Linked Bond
z Investors would be interested in having the
upside from the equity markets
z However, not willing to bear the downside risk

z Possible structure
z Bond with an embedded call option
z Option can be on individual equity stocks or a basket
of stocks
Product Structure
z Investor to buy a bond by investing an amount P
z Payoff at time T = P + f * Max (0, (S - X) )
where,
S = Stock Price at the end of time T
X = Exercise Price in the option
f = Multiplier (representing the number of options per
bond)
z The product is principal protected
z Option Premium = P - Present Value of P
Product Features
z The option must be a call option
z Delta negative, hence hedging possible by going
long on the underlying
z Longer the maturity of the bond =>
z Higher the P - PV (P) value
z Hence, each bond can represent a larger
proportion of the option
z However, higher the delta hedging cost
z In the money options are preferable
z High Delta: hence base stock for easier hedging
Critical Factors
z Cost of the option
z European options are very expensive
z Reason: High volatility
z Cost of hedging
z Lack of accurate pricing model
z Volatility estimation
z Transaction costs
z Discontinuous delta hedging
z Jump risks
z To reduce cost of the option and the cost of
hedging, it is advisable to use an Asian option
 Advantages of Asian Options
z Useful for hedging when the cash flow is exposed
to price of the underlying at various points of
time
z Reduces extreme sensitivity of the option value
to the value of the underlying on a particular day
z Reduces risk of option expiring worthless
because of price manipulation
z Lower premium compared to European options
z For option writers delta hedging easier
z Delta and Gamma go down near maturity

back
Case study-acquisition financing
Clients objectives
z Raising off balance sheet financing for the acquisition
Limiting recourse to the Acquirer
z Leveraging cashflows of the Target company
z Low cash outflow in the period interim to potential
merger with Target
z Suitability of structure from accounting and tax
perspective
Structural features
z Financing an SPV owned by acquirer for takeover
of target
z Negotiated purchase of 40% and open offer of 20%
z Recourse to Acquirer through a put option on
loan receivables from SPV
z Low cash outflow through interest moratorium
z FRA with Acquirer starting at the end of 2 years
from date of disbursement of loan to SPV
 Deal diagram
Acquirer

Investment Shares of Target

SPV Co.

Call/Put Option on Loan

Receivables exercisable one
week before end of 2 years
ICICI

Acquirer

FRA starting at the end of 2

years from date of
disbursement of loan to SPV

back
Case study-off balance sheet brand
financing
Client objectives
z Unlocking the value of his brands, not reflected in
the balance sheet
z Wishes to raise money against security of the
Brands
z Wants to continue using the brands until an event of
default
Structural features
z Key undertakings from client
z To maintain and promote the brand
z Non compete clause in event of default
z No sub licensing allowed
z Creation of security on the brand
z Registering charge with the Registrar of Companies (for
companies)
z Registering lien with the Registrar of Trademarks and
Merchandise marks
z Taking a mortgage of all documents evidencing title to the
brand
z Power of attorney to dispose off brand in default
 Deal diagram
Purchase consideration

Transfer of Brand(s) and

Related Assets
Company Trust Brands
License of Brands and (SPV)
Related Assets
Subscr
Servicing
iption
of PTCS
to
PTCS
License fee
ICICI

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