The Adverane Group is a multinational group of companies with its headquarters in Switzerland. The Adverane Group consists of a number of fully-owned subsidiaries and Elted Co, an associate company based in the USA in which Adverane Group owns 30% of the ordinary equity share capital. Balances owing between the parent, Adverane Co, and its subsidiaries and between subsidiaries are settled by multilateral netting. Transactions between the parent and Elted Co are settled separately.
Transactions with Elted Co
Adverane Co wishes to hedge transactions with Elted Co which are due to be settled in four months’ time in US$. Adverane Co will owe Elted Co US$3·7 million for a major purchase of supplies and Elted Co will owe Adverane Co US$10·15 million for non-current assets. Adverane Group’s treasury department is considering whether to use money markets or exchange-traded currency futures for hedging.
Annual interest rates available to Adverane Co
Exchange traded currency futures
Contract size CHF125,000, price quotation US$ per CHF1
Three-month expiry: 1·1213
Six-month expiry: 1·1204
Netting
The balances owed to and owed by members of Adverane Group when netting is to take place are as follows:
Advise Adverane Co on, and recommend, an appropriate hedging strategy for the US$ cash flows it is due to receive from, or pay to, Elted Co.
Net receipt = $10,150,000 – $3,700,000 = $6,450,000
Adverane Co will have a net dollar receipt in four months’ time and needs to hedge against the Swiss Franc strengthening.
Money market
Borrow US$: US$6,450,000/(1 + [0·037/3]) = US$6,371,419
Convert into CHF at spot rate: US$6,371,419/1·1222 = CHF5,677,615
Invest in CHF: CHF5,677,615 x (1 + [0·027/3]) = CHF5,728,714
Futures
Buy Swiss Franc futures and use six-month futures contracts.
Basis
Assume that basis reduces to zero at contract maturity in a linear fashion
Using spot rate, predicted futures rate = 1·1222 – ([1·1222 – 1·1204] x 4/6) = 1·1210
Alternatively, predicted futures rate = 1·1213 – ([1·1213 – 1·1204] x 1/3) = 1·1210
Expected receipt = $6,450,000/1·1210 = CHF5,753,791
Number of contracts = CHF5,753,791/125,000 = 46·03 contracts, approximately 46 contracts
On the basis that futures give the higher expected receipt, they should be chosen, but Adverane Co should assess whether basis risk is likely to be significant. Adverane Co should also consider, as regards money market hedging, that CHF receipts could be used to pay off any existing CHF loans, or for other investment purposes, in which case the benefit to Adverane Co could be greater than hedging using futures.
(i) Calculate the inter-group transfers which are forecast to take place. (7 marks)
(ii) Discuss the advantages of multilateral netting by a central treasury function within the Adverane Group. (3 marks)
(i) Use mid-spot rates to translate amounts
Evaluate the extent to which changing to a market-price system of transfer pricing will resolve the concerns of the Adverane Group board.
Setting the transfer price at market price should enable a fair assessment of the performance of both the buying and selling divisions. Both internal and external sales will be accounted for at the same price. However, this may distort performance in that the costs of internal sales may be lower than external sales. For example, administration costs should be lower and there should be no costs of bad debts. These cost savings should be shared between the two divisions to give a fair picture. If the selling division has spare capacity, selling at incremental cost rather than market price may provide greater certainty that the buying division will use the selling division.
In theory, using market price should mean that the central treasury function has to intervene less. Simple market price provides an objective measure over which the divisions should agree. However, in reality, there may be complications that require central intervention. The market price may be difficult to determine or may fluctuate wildly, and central treasury may have to decide which price to use. If it is decided that an allowance should be made for costs of internal transfer being lower, central treasury may have to determine what this should be as it may vary significantly between products and divisions.
Specifying the transaction takes place at market price is designed to ensure that the buying division buys from the selling division, rather than an external supplier if the buying and selling division have failed to agree a price. The implicit assumption is that the buying division will use the selling division because of better service from, and greater dependability of, dealing within the group. This may not necessarily be the case. If the buying division previously purchased internally as a result of a low transfer price, forcing it to pay market price may mean it chooses an external supplier for non-price reasons.