The Role of Treasury Functions

The functions of the treasury

Treasury management is the corporate handling of all financial matters, the generation of
external and internal funds for business, the management of currencies and cash flows, and the
complex strategies, policies and procedures of corporate finance.

Roles of the Treasury management

1. Cash management
2. Managing financial risks
3. Raising finance
4. Sourcing finance
5. Currency management
6. Effective taxation administration

The Association of Corporate Treasurers

cash the treasury section will monitor the company's cash balance and decide if it is
management advantageous to give/take settlement discounts to/from
customers/suppliers even if that means the bank account will be overdrawn.
financing the treasury section will monitor the company's investment/borrowings to
ensure they gain as much interest income as possible and incur as
little interest expense as possible.
foreign the treasury section will monitor foreign exchange rates and try to manage the
currency company's affairs so that it reduces losses due to changes in foreign exchange
rates.
tax the treasury section will try to manage the company's affairs to legally avoid as
much tax as possible.

The role of the finance function in determining business tax liabilities

One of the roles of the finance function is to calculate the business tax liability and to mitigate
that liability as far as possible within the law.
1. Tax avoidance
is the legal use of the rules of the tax regime to one’s own advantage, in order to reduce the
amount of tax payable by means that are within the law.
2. Tax evasion
 is the use of illegal means to reduce one’s tax liability, for example by deliberately
misrepresenting the true state of your affairs to the tax authorities.
 The directors of a company have a duty to their shareholders to maximise the post tax
profits that are available for distribution as dividends to the shareholders, thus they have a
duty to arrange the company’s affairs to avoid taxes as far as possible.
 However, dishonest reporting to the tax authorities (e.g. declaring less income than
actually earned) would be tax evasion and a criminal offense.
 While the traditional distinction between tax avoidance and tax evasion is fairly clear,
recent authorities have introduced the idea of tax mitigation to mean conduct

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 that reduces tax liabilities without frustrating the intentions of Parliament, while tax
avoidance is used to describe schemes which, while they are legal, are designed to
defeat (nullify) the intentions of Parliament.
 Thus, once a tax avoidance scheme becomes public knowledge, Parliament will nearly
always step in to change the law in order to stop the scheme from working.

Responsibilities of the finance function

The finance function of any company is responsible by law for:
1. maintaining proper accounting records that contain an accurate account of the income and
expenses incurred, and the assets and liabilities pertaining to the company.
2. calculating the tax liability arising from the profits earned each year, and paying amounts due
to the tax authorities on a timely basis.
In practice, most companies (particularly small companies) will seek the advice of external tax
specialists to help them calculate their annual tax liability.

Investment appraisal and financing viable investments

 Investment appraisal is concerned with long term investment decisions, such as whether to
build a new factory, buy a new machine for the factory, buy a rival company, etc.
 Typically money is paid out now, with an expectation of receiving cash inflows over a
number of years in the future.

There are two questions to be addressed:

1. Is the possible investment opportunity worthwhile?
2. If so, then how is it to be financed?

 For example, if a company is offered an investment opportunity that requires paying out €1m
now, and will lead to cash inflows of €2m in one year’s time and €2m in two years’ time,
during a period when interest rates are 5%, you can see that this investment is worthwhile in
real terms.
 If the €1m was invested to earn interest, it would be worth €1.05m in one year’s time.
 However the investment will give you €2m in one year’s time and another €2m in two years’
time.
 So the investment is worthwhile.
 The second question is how this €1m required now should be financed.
 Perhaps there is a surplus €1m sitting unused in a bank account.
 It is more likely that fresh funds will be required, possibly by issuing new shares, or
possibly by raising a loan (e.g. from the bank).

There are advantages and disadvantages of each possibility.

Advantages of issuing new ordinary shares:
 Dividends can be suspended if profits are low, whereas interest payments have to be paid
each year.
 The bank will typically require security on the company’s assets before it will advance a
loan.
 Perhaps there are no suitable assets available.

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Advantages of raising loan finance:
 Interest payments are allowable against tax, whereas dividend payments are not an allowable
deduction against tax
 No change is required in the ownership of the company, which is governed by who owns the
shares of the company.

Generally the finance function and the treasury function will work together in appraising
possible investment opportunities and deciding on how they should be financed.

Management of working capital

A company must also decide on the appropriate level of investment in short term net assets, i.e.
the levels of:
 inventory
 trade receivables (amounts due from debtors for sales on credit)
 cash balances
 trade payables (amounts due to creditors for purchases on credit).

There are advantages in holding large balances of each component of working capital, and
advantages in holding small balances, as below.
advantage of large balance advantage of small balance
inventory customers are happy since low holding costs. less risk of
they can be immediately obsolescence costs.
provided with goods
trade receivables customers are happy since less risk of bad debts, good for cash
they like credit. flow.
cash creditors are happy since more can be invested elsewhere to
bills earn profits.
can be paid promptly
trade payables preserves your own cash suppliers are happy and may offer
discounts

Factors to consider before deciding to protect transaction exposure

The factors may include the following:
 Future exchange rate movement.
The future movements in exchange rate may depend on a number of factors including interest
rate, inflation, central bank actions and economic growth.
 The cost involved in the hedging, eg commission.
 The ability of the company to absorb foreign exchange losses.
 Expertise within the company.
 The company’s attitude towards foreign currency transactions and the importance of overseas
trading.

Exchange and over the counter (OTC) markets

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Secondary markets can be organised as exchanges or (OTC) markets
Exchanges - where buyers and sellers of securities buy and sell securities in one location
Examples of exchanges include:
1. the london Stock Exchange and the New York Stock Exchange for the trading of shares
2. the Chicago Board of Trade for the trading of commodities
3. the London International Financial Futures and Options Exchange (LIFFE) for the trading of
derivatives.

Over the counter (OTC) markets

- where buyers and sellers transact with each other not through an exchange but by individual
negotiation.
The prices at which securities are bought over the counter may be the same as the corresponding
transactions in an exchange, because the buyers and sellers agree the most competitive price
based on constant contact through computers with other market participants.

Securities that are issued in an over the counter market can be negotiable or non-negotiable.
 Negotiable securities can be resold.
 Non-negotiable securities cannot be resold.

Futures
Ticks
 A tick is the minimum price movement permitted by the exchange on which the future
contract is traded.
 Ticks are used to determine the profit or loss on the futures contract.
 The significance of the tick is that every one tick movement in price has the same money
value.
 Example 1
 If the price of a sterling futures contract changes from $1.3523 to $1.3555, then price has
risen by $0.0032 or 32 ticks.
 If you entered/bought into 50 contracts the profit on the futures contract will be calculated
as:
 Number of contracts x ticks x tick value
 50 x 32 x $6.25 = $10,000
 Ticks are used to calculate the value of a change in price to someone with a long or a short
position in futures.
 If someone has a long position, a rise in the price of the future represents a profit, and a fall
in price represents a loss.
 If someone has a short position, a rise in the price of the future represents a loss, and a fall
represents a profit.

Margins
When a deal has been made both buyer and seller are required to pay margin to the clearing
house.
This sum of money must be deposited and maintained in order to provide protection to both
parties.
 Initial margin

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  Initial margin is the sum deposited when the contract is first made.
 This is to protect against any possible losses on the first day of trading.
 The value of the initial margin depends on the future market, risk of default and volatility
of interest rates and exchange rates.
 Variation margin
 Variation margin is payable or receivable to reflect the day-to-day profits or losses made
on the futures contract.
 If the future price moves adversely a payment must be made to the clearing house, whilst
if the future price moves favourably variation margin will be received from the clearing
house.
 This process of realising profits or loss on a daily basis is known as “marking to market”.
 This implies that margin account is maintained at the initial margin as any daily profit or
loss will be received or paid the following morning.
 Default in variation margins will result in the closure of the futures contract in order to
protect the clearing house from the possibility of the party providing cash to cover
accumulating losses.
Example 2
Contract size £62,500
3 months future price $1. 3545
Number of contract entered 50 contracts
Tick value $6.25
Tick size 0.0001
Required:
Calculate the cash flow if the future price moves to in day one $1.3700 and 1.3450 day two
(variation margin). Assume a short position.
Solution 2
1. Day One
Selling price 1.3545
Buying price 1.3700
Loss 0.0155 = 155 ticks
Variation margin = payment of the loss
= 155 x 50 x $6.25 = $48,437

2. Day 2
Selling price 1.3700
Buying price 1.3450
Profit 0.025 = 250 ticks
Variation margin = receipt of the profit
= 250 x 50 x $6.25 = $78,125

Basis and basis risk

 Basis is the difference between the futures price and the current cash market price of the
underlying security.
 In the case of exchange rates, basis is the difference between the current market price of a
future and the current spot rate of the currency.

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 At final settlement date itself, the futures price and the market price of the underlying item
ought to be the same otherwise speculators would be able to make an instant profit by
trading between the futures market and spot cash market.
 Most futures positions are closed out before the contract reaches final settlement, hence a
difference between the close out future price and the current market price of the underlying
item.
 Basis risk may arise from the fact that the price of the futures contract may not move as
expected in relation to the value of the underlying item which is being hedged.
 Futures hedge
 Hedging with a future contract means that any profit or loss on the underlying item will be
offset by any loss or profit made on the future contract.

A perfect hedge is unlikely because of:

Basis risk.
 The “round sum” nature of futures contracts, which can only be bought or sold in whole
number.

Risks
 In order to manage a portfolio of options, the dealer must know how the value of the options
will vary with changes in the various factors affecting their price.
 Such assessments of sensitivity are measured by: Delta
Delta = Change in option price / Change in price of underlying security

 Delta is a measure of how much an option premium changes in response to a change in the
security price.
 For instance, if a change in share price of 5p results in a change in the option premium of
1p, then the delta has a value of (1p/5p) 0.2.
 Therefore, the writer of options needs to hold five times the number of options than shares
to achieve a delta hedge.
 A delta value ranges between 0 and +1 for call options, and between 0 and -1 for put
options.
 The actual delta value depends on how far it is in-the-money or out- of-the-money.
 The absolute value of the delta moves towards 1 (or -1) as the option goes further in-the-
money (where the price of the option moves in line as the price of the underlying asset) and
shifts towards 0 as the option goes out-of-the-money (where the price of the option is
insensitive to changes in the price of an underlying asset)
 At-the- money calls have a delta value of 0.5, and at-the-money puts have a delta value of -
0.5.

Gamma
Gamma = Change in the delta value / Change in the price of the underlying security
 Gamma measures the amount by which the delta value changes as underlying security
prices change.

Theta
 Theta measures how much the option premium changes with the passage of time.

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  The passage of time affects the price of any derivative instrument because derivatives
eventually expire. An option will have a lower value as it approaches maturity.
 Thus:
Theta = Change in the option price (due to changes in value) / Change in time to expiry

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