Treasury Management Policy Process and Performance copyright anbirts

Why Manage Risk? Objective of the Organisation Maximise Shareholder Wealth How? Cash Flow = Value Discount Rate - Reduce Volatility - Reduce Risk - Reduce Cost of Capital copyright anbirts

Should We Manage Risk? Efficient Markets Parity Portfolio Theory copyright anbirts

Should We Manage Risk? Efficient Markets Basically current prices reflect all known information and the next price will be a random walk What Does Random Walk Theory Mean? The theory that price changes have the same distribution and are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement. So we cannot beat the market over time and there are costs in hedging e.g. wider spreads on the forward, management time copyright anbirts

Should We Manage Risk? Parity Purchasing Power Parity Expected change in Movement in spot exchange rate expected inflation Expectations International Fisher effect Fisher Theory effect Difference between covered Interest rate parity Movement in spot and forward interest rates From Alpha Dhanani copyright anbirts

Should We Manage Risk? So maybe we should manage risk due to: Even if the parity theories work long term we might, with large movements, be bankrupt short term There is some value in certainty, e.g. planning liquidity even if hedging does not reduce volatility copyright anbirts

Should We Manage Risk? Portfolio Theory If hedging makes sense there is still the question as to whom should undertake the hedging, Managers or Shareholders? Portfolio theory Asymetric information Internal hedging Asymetric tax effect Access to markets copyright anbirts

Foreign Exchange Policy Issues Define Exposures to Be Managed Economic Translation Transaction Objective: Minimise FX losses and Maximise FX Gains Commensurate with a defined level of Risk copyright anbirts

Foreign Exchange Policy Issues Which exposures are important Time Period Start Date Price List, Forecast, Order Date End Date Year end or beyond, invoiced or expected date Policy Alternatives Cover Everything Leave Open Selective Cover Hybrid copyright anbirts

Foreign Exchange Policy Issues Instruments Define proportions in each Options – write covered or uncovered, buy Set Limits Overall limits Individual limits Treasury Procedures copyright anbirts

Value at Risk (VAR) VAR estimates the potential pre-tax loss resulting from an adverse movement in market prices over a defined holding period. Equities Commodities FX Interest Rates copyright anbirts

VAR Correlation Approach Example: Single Asset Historic Data Normal Distribution 68% of changes within one Standard Deviation (SD) 95% of changes within two SD’s 99% of changes within three SD’s 10 million (GBP equivalent) long position in USD SD .15% Want 95% confidence Max loss = 10,000,000 x .0015 x 2 = 30,000 copyright anbirts

VAR Two Assets [(VAR1)2 + (VAR2)2] Example: Two Unrelated Assets 10,000,000 (GBP equivalent) long in USD SD .15% 10,000,000,Long (GBP equivalent) in Euro SD.20% 95% Confidence VAR = [(10,000,000 x .0015 x 2)2 + (10,000,000 x .002 x 2)2] VAR = (30,000)2 + (40,000)2 VAR = 900,000,000 + 1,600,000,000 = 2,500,000,000 = 50,000 copyright anbirts

VAR Correlation (Related Movements) VAR = [(VAR1)2 + (VAR2)2 + 2 x VAR1 x VAR2 x R] Example Same as above but Correlation Coefficient .6 VAR = (30,000)2 + (40,000)2 + 2 x 30,000 x 40,000 x .6] VAR = 62,769 copyright anbirts

VAR Advantages Reasonably simple concept to communicate Used to aggregate risks Can correlate Profits to Risk (Performance Measurement) Disadvantages Based on major assumptions (normal distribution, history repeats itself) Complex mathematics Sudden shifts of volatility Appears scientific copyright anbirts

Setting Limits: An Approach Co Net Worth GBP 10,000,000 Prepared to Lose 2,000,000 Currency Exposure USD Annual Volatility 20% and Monthly Volatility 20 x Maximum Exposure Period: 6 months copyright anbirts Month 1 2 3 4 5 6 Volatility 5.77 8.16 10.00 11.55 12.90 14.14 Position 3,198,976 Possible Loss 184,581 261,036 319,898 369,482 412,668 452,335 Maximum Loss 2,000,000

Electronic Banking Why is Security important and in what areas should communications systems (telephone, email, proprietary, internet) seek to give confidence? Authorisation Non repudiation Authentication Confidentiality Integrity What do these mean? copyright anbirts

Electronic Banking Authorisation. Determines that the users or entities involved are authorised to perform the actions they have taken. Non repudiation. Evidence that the sender of the transaction intended to send the transaction (and that the receiver received it). Authentication. Guarantees that each party requesting access to the transaction are who they claim to be. copyright anbirts

Electronic Banking Confidentiality. Ensures that access to the transaction is restricted to certain individuals. Integrity. Prevents data from being either maliciously or accidentally changed or corrupted. Internally, protection is also needed against Fraud and Error copyright anbirts

The Dealing Process Deal done Conversation recorded Authorised deal by FD, treas etc Dealer Bank Deal done Dealer limits Confirmation Authorised/ Mandates Bank dealer logs details authorised Limits on Bank Limits on company Co dealer logs details on TMS + competitive quotes. Also logs in ERP system Both parties send confirmations and reconcile Segregation of duties Settlement to standard settlement instructions Company back office copyright anbirts Conversation recorded Security/ controls on settlement Internal audit, Physical access, Dual input, Pre formatted payment details, Passwords, Encryption, Authorisations, Answer back, Reconciliation

Electronic Banking Security So how do we attain security and have a system that works? Authorisation for payments/deals Segregation of duties (back office/dealer) Physical security Dedicated computers for payments Separate room Password protected copyright anbirts

Electronic Banking Security Different levels of authorisation/activity Input Second input Verification Authorisation and release Free format Pre-format/Templates in TMS copyright anbirts

Electronic Banking Security Encryption or cyphertext Private key or symmetric Public key or asymmetric (public key infrastructure, PKI) not only ensures confidentiality but also provides authentication of the sender thus preventing repudiation SSL, Secure Sockets Layer HTTPS, Hypertext Transfer Protocol, Secure copyright anbirts

Electronic Banking Security Digital Signature Uses the asymetric method to perform two functions Authentication Integrity copyright anbirts

Performance Measurement Why have performance measurement? To justify existence To show value added To motivate and reward To control What areas need benchmarks/objectives What benchmarks may be used copyright anbirts

Performance Measurement Measures used will depend on objectives/policy i.e. Cover everything then focus on expertise of dealing Selective cover then focus on performance against a benchmark versus risk taken copyright anbirts

Performance Measurement Some areas Cash management Liquidity management Risk management, FX and Interest Rate Efficiency of Treasury copyright anbirts

Performance Measurement Benchmarks should be Agreed Attainable Measurable Some might be Cost per £1,000 of revenue Time to process Forward rate Three month Libor Overnight copyright anbirts