Wardegul Co, a company based in the Eurozone, has expanded very rapidly over recent years by a combination of acquiring subsidiaries in foreign countries and setting up its own operations abroad. Wardegul Co’s board has found it increasingly difficult to monitor its activities and Wardegul Co’s support functions, including its treasury function, have struggled to cope with a greatly increased workload. Wardegul Co’s board has decided to restructure the company on a regional basis, with regional boards and appropriate support functions. Managers in some of the larger countries in which Wardegul Co operates are unhappy with reorganisation on a regional basis, and believe that operations in their countries should be given a large amount of autonomy and be supported by internal functions organised on a national basis.
Assume it is now 1 October 2017. The central treasury function has just received information about a future transaction by a newly-acquired subsidiary in Euria, where the local currency is the dinar (D). The subsidiary expects to receive D27,000,000 on 31 January 2018. It wants this money to be invested locally in Euria, most probably for five months until 30 June 2018.
Wardegul Co’s treasury team is aware that economic conditions in Euria are currently uncertain. The central bank base rate in Euria is currently 4·2% and the treasury team believes that it can invest funds in Euria at the central bank base rate less 30 basis points. However, treasury staff have seen predictions that the central bank base rate could increase by up to 1·1% or fall by up to 0·6% between now and 31 January 2018.
Wardegul Co’s treasury staff normally hedge interest rate exposure by using whichever of the following products is most appropriate:
– Forward rate agreements (FRAs)
– Interest rate futures
– Options on interest rate futures
Treasury function guidelines emphasise the importance of mitigating the impact of adverse movements in interest rates. However, they also allow staff to take into consideration upside risks associated with interest rate exposure when deciding which instrument to use.
A local bank in Euria, with which Wardegul Co has not dealt before, has offered the following FRA rates:
4–9: 5·02%
5–10: 5·10%
The treasury team has also obtained the following information about exchange traded Dinar futures and options:
Three-month D futures, D500,000 contract size
Prices are quoted in basis points at 100 – annual % yield:
Options on three-month D futures, D500,000 contract size, option premiums are in annual %
Recommend a hedging strategy for the D27,000,000 investment, based on the hedging choices which treasury staff are considering, if interest rates increase by 1·1% or decrease by 0·6%. Support your answer with appropriate calculations and discussion.
Forward rate agreement
FRA 5·02% (4–9) since the investment will take place in four months’ time for a period of five months.
If interest rates increase by 1·1% to 5·3%
Futures
Go long in the futures market, as the hedge is against a fall in interest rates. Use March contracts, as investment will be made on 31 January.
Number of contracts = D27,000,000/D500,000 x 5 months/3 months = 90 contracts
Basis
Current price (1 October) – futures price = basis
(100 – 4·20) – 94·78 = 1·02
Unexpired basis on 31 January = 2/6 x 1·02 = 0·34
If interest rates increase by 1·1% to 5·3%
Options on futures
Buy call options as need to hedge against a fall in interest rates. As above, 90 contracts required.
If interest rates increase by 1·1% to 5·3%
Discuss the advantages of operating treasury activities through regional treasury functions compared with:
– Each country having a separate treasury function.
– Operating activities through a single global treasury function.
Regional functions compared with national functions
Organising treasury activities on a regional basis would be consistent with what is happening in the group overall. Other functions will be organised regionally. A regional treasury function may be able to achieve synergies with them and also benefit from information flows being organised based on the regional structure.
If, as part of a reorganisation, some treasury activities were to be devolved outside to a bank or other third party, it would be simpler to arrange for a single provider on a regional basis than arrange for separate providers in each country.
A regional function will avoid duplication of responsibilities over all the countries within a region. A regional function will have more work to do, with maybe a greater range of activities, whereas staff based nationally may be more likely to be under-employed. There may be enough complex work on a regional basis to justify employing specialists in particular treasury areas which will enhance the performance of the function. It may be easier to recruit these specialists if recruitment is done regionally rather than in each country.
Regional centres can carry out some activities on a regional basis which will simplify how funds are managed and mean less cost than managing funds on a national basis. These include pooling cash, borrowing and investing in bulk, and netting of foreign currency income and expenditure.
Regional centres could in theory be located anywhere in the region, rather than having one treasury function based in each country. This means that they could be located in the most important financial centres in each region or in countries which offered significant tax advantages.
From the point of view of Wardegul Co’s directors and senior managers, it will be easier to enforce common standards and risk management policies on a few regional functions than on many national functions with differing cultures in individual countries.
Regional functions compared with global function
Wardegul Co is being reorganised on a regional basis because of the demands of its global expansion. As discussed above, reorganising treasury functions regionally will be consistent with the way other functions are organised. Reorganising the treasury function regionally will be one way of dealing with the problem of having a single, overstretched, global function.
A regional function could employ experts with knowledge of the regulations, practices and culture of the major countries within the region. It may be more difficult for a global function to recruit staff with local expertise.
There may be practical issues why individual countries prefer to deal with regional functions rather than a global function, for example, a regional function will be based in the same, or similar, time zone as the countries in its region.
A regional function may have better ideas of local finance and investment opportunities. There may, for example, be better alternatives for investment of the surplus funds than the centralised function has been able to identify.