If you read the job description of just about any treasurer or CFO it will centre on being a strategic designer of matters financial; hedging, funding and interest cost reduction. In the days prior to the broad-based application of derivatives, pursuit of any one of the above would bring about (typically) uncontrollable consequences in the other two.
For instance, if a company's main source of financing was floating rate bilateral loans from banks, it was exposed to the consequent effects of an upward move in short-term interest rates. If it did not want that risk, it would have to physically go about an alternative form of financing based on a fixed rate of interest.
Compromise
In such a case, the company would have been making a compromise - and if risk preferences drove a funding decision, it was unlikely that the company would be able to access the cheapest form of debt.
The power of derivatives for companies, therefore, is that it breaks the linkages between funding, risk and cost.
In fact, it is possible to pursue strategies for each, knowing that a derivative overlay strategy can transform the inherent risk profile of any funding strategy into terms that are more palatable and can be objectively compared from a risk (hedging) and return (cost reducing) trade-off perspective.
The question is, what does "palatable" mean? For many companies, there is no obvious or consensus answer, making it impossible to design a financing strategy that accommodates funding, risk and cost considerations.
Strong foundations
If I were to construct a sturdy building, it would be remiss of me not to pay attention to the design of the foundation upon which that building would one day stand. Likewise, designing a funding/hedging/cost strategy is overwhelmingly achieved through a clearly defined risk management and funding policy.
A company must have clearly defined targets and operational procedures that assist it in making financial decisions. There are many companies that have waited "for that last 10 basis points" lower in yield before committing to a fixed rate swap, only to see markets weaken and interest rates rise 100 basis points, at which time it has become "too expensive". Was the 10:1 risk / reward demonstrated in that decision part of the company's risk management policy - you can bet not!
The policy, if nothing else, invokes a discipline that is often difficult for a team to otherwise have if the "rules" have not been declared to all (or at least those that matter) within the organisation. For the same reasons that a fund manager compares return on an equity portfolio against a market index, so too a company treasurer should strive to measure both risk and return against some pre-agreed and transparent benchmarks.
Many companies in Asia-Pacific have favoured structured Libor strategies for managing down the cost of funds on their debt, attempting to achieve internally set benchmarks for interest rates. Not as many, however, seem to have measured the risk or VaR of such strategies.
How much risk
A treasury policy will include, among other features, detailed procedures as to what types and tenor of funding should be maintained, what form of risk profile is desirable (i.e. limiting cover in the form of swaps and non-limiting cover in the form of options), and what cost benchmarks are applicable (often driven by the individual business lines' need for funding and level of cost they can absorb to meet individual return on investment targets).
Benchmarks may also be driven off company-wide measures, such as weighted average cost of capital (WACC) and return on equity (ROE), against industry competitor standards or against economic forecasts provided by banks. In all cases, it is imperative that the Board of Directors understands and endorses the chosen policy framework and is aware of the level of expertise, systems and operational requirements to maintain that policy.
It's great to have a policy in place, but unless performance against benchmarks can be monitored, measured, audited and reported, it will be of limited use. Nowadays, this also means being able to account for funding costs and hedging impact under several accounting standards, including that of the home country of incorporation and often US GAAP and soon FAS133. Issues of mark-to-market versus accrual accounting and matched versus unmatched portfolio hedges can dramatically affect a company's reported results. These are all considerations in designing the policy and therefore financial strategy of the company.
Overall risk tolerance
The Board should also drive the overall risk tolerance of the company in its funding and risk strategy. During the Asian crisis, many good companies with both strong domestic market share position and strong local currency revenues became insolvent or required massive debt restructuring. Why? Not because they had a poorly performing underlying business, but because they had an inadequate financial risk management policy, which placed too much emphasis on cheapness of debt (i.e. via foreign currency borrowing) and not enough on the attendant currency risk that was involved.
In setting policy, treasurers should commence with an internal risk audit. A risk audit will identify and measure to what degree financial and economic variables will impact the cashflow and net income of the company. Yes, cashflow effects are just as important as the bottom line, as the lessons of Metallgesellschaft demonstrate.
Cash margining and collateralisation, a key strategy toward generating deeper credit lines with financial services providers, needs to be backed up, again, by a policy ensuring its most efficient deployment and to ensure a cashflow restriction does not hamper underlying business activity.
Pleasant surprises
A risk audit can sometimes throw up pleasant surprises - for example, a company's exposure to commodity price swings may be considered less serious than first thought, depending on the price elasticity of the finished good in which it is used. Or, perhaps, a perceived correlation between commodity prices and the general economy could mean naturally increased turnover and revenue offsetting the increased price of commodity.
The bottom line is that sometime risks within a business can offset, but other times they do not. A clear understanding of these inter-relationships is required before an effective financing and risk management policy can be implemented.
Other risk issues that might arise during the risk audit would be the identification of specific legal, regulatory and/or country risk issues that might affect the way a business line is funded or risk is managed. Beware also of hidden options, particularly in loan agreements or trade contracts. One can often uncover a hidden option in trade contracts, where a contract price is fixed, but only within some pre-agreed range of movement of an underlying FX rate. What happens outside of that range? A contract price adjustment occurs. More interestingly, what happens within that range? No price adjustment, a potentially more "risky" outcome for the seller!
Separating impacts
Take a second example of a company contemplating the decision between raising debt through a public FRN or a through a traditional syndicated loan. To refinance a public debt issue, any buy-back (which may be difficult to achieve anyway) will be at market prices. Banks, however, often allow a floating rate borrower to refinance floating rate loans without penalty. If the company's credit spreads have narrowed significantly since issue (and you can therefore refinance cheaper), that latter form of debt includes a free credit option!
Further complicating the issue, some markets (consider India, for example) will only allow a small percentage of foreign currency loans to be refinanced in any year, unless it is with another foreign currency loan. By accessing the foreign currency debt market, the company is accepting a potential limitation to future re-financing and therefore assuming a liquidity risk.
Consider what happened to several corporates in Asia that had previously availed themselves of Japanese yen funding on a fixed rate basis, when interest rates in Japan were considerably higher than they are now. After interest rates fell, companies wished to refinance to take advantage of the lower interest rate environment (again a free option in many cases meant that the fixed rate loans weren't marked-to-market).
However, in the midst of the Japanese banking crisis, liquidity from Japanese banks was difficult to source and, in fact, only being offered at a substantial premium (i.e. margin over yen Libor). For those borrowers in a regulatory environment where refinancing onshore was not permitted, a derivative-led solution emerged - raise a foreign currency loan from the deeper and more liquid US dollar market, then use cross-currency swaps to re-create a synthetic yen liability, at much lower rates of interest than those of existing liabilities. Again here, the derivative market was used to drive a cheaper funding solution with the desired risk profile.
Needless to say, by taking low cost foreign currency funding, certain assumptions are being made about cost-of-carry savings vis-a-vis the assumed depreciation rate of the local currency unit. If such an assumption is being made, it should be documented by a policy benchmark and a strategy to safeguard, in the event that such assumptions turns out to be false.
Policies abound that describe the procedure for hedging foreign currency liabilities when cost-of-carry comes within a certain pre-determined range. What to do, though, in the event that the carry blows out beyond an economical comfort zone? An effective stop-loss strategy is something that all risk and funding strategies should include, again enforcing a discipline and ensuring that at the end of the year, the Board does not have to explain that the company's record operating profits were eroded because of unforeseen currency fluctuation!
Much of a company's ongoing work in designing a strategy for funding, hedging and debt cost reduction is driven by the development of clear and internally supported financing policy. The issues above point to most areas that are important to address. By recognising the role derivatives play in separating the impact of one financing objective from the others, maximum financing flexibility and freedom is achieved by the company.
Greg Major is regional head of derivative marketing, Asia Pacific for ABN Amro.
