Treasury Function

• The Treasury Function includes functions such as managing cash, investing excess cash, and managing risk.
• Currency risk is the potential for losses due to adverse movements in foreign exchange rates.
• In a direct quotation, the Rand is quoted relative to foreign currency, meaning $1 is equal to R15.2.
• In an indirect quotation, the foreign currency is quoted relative to the Rand, meaning R1 is equal to $0.06.
• Purchasing power parity states that the difference between the spot and forward rates is attributable to the difference in expected inflation rates.
• Interest rate parity states that the difference between the spot and forward rates is attributable to the difference in expected interest rates.
• Hedging techniques include internal hedging techniques such as matching payments and receipts from different transactions in the same currency, diversification of foreign customers and suppliers, invoicing in local currency, and leads and lags.
• External hedging techniques include money-market hedge, forward exchange contract, foreign exchange futures contract, foreign exchange option contract, and currency swap.
• The bid (buying) rate is the rate at which the bank will buy currency at, meaning if you wish to sell foreign currency to the bank.
• The ask (selling) rate is the rate at which the bank will sell currency at, meaning if you wish to buy foreign currency from the bank.
• The bid-ask spread is the difference between the buying and selling rates quoted by the bank, representing the bank's profit.
• The mid-rate is the average rate between the buying and selling rates, calculated as the sum of the buying rate and selling rate divided by 2.
• The cross-rate is the rate between any two currencies, calculated using the cross-rate mechanism.
• The spot rate is the rate which only applies at that specific given point in time.
• The forward rate is the rate determined and quoted today for settlement on a future date, and is quoted at a discount or premium to the spot rate.
• The overall gain of 1% is shared between the parties as follows: Grayston has obtained a variable rate and has managed to better the variable rate offered by the bank by 0.5% (from 10.5% to 10%), while Woodmead has obtained a fixed rate and has managed to reduce their interest rate by 0.5% (from 14% offered by the bank to 13.5%).
• Both parties managed to reduce their interest rate and both parties are borrowing according to their preferred agreement with regard to fixed/variable interest rates.
• Grayston receives from the counterparty 13.5% fixed and 11.5% variable, while Woodmead receives from the bank 11.5% variable and 13.5% fixed.
• The net effect of the swap agreement is that Grayston pays to the bank 10% variable and receives 13.5% fixed, while Woodmead pays to the bank 10.5% variable and receives 14% fixed.
• The effect of the swap agreement is that Grayston pays to the bank 12% fixed and 11.5% variable, while Woodmead pays to the counterparty 11.5% variable and 13.5% fixed.
• Both parties must benefit from the swap agreement and therefore the overall gain of 1% must be shared between Grayston and Woodmead.
• Consideration should be given to the fact that this gain will be reduced by the percentage charged by the bank as a fee for arranging the swap.
• External hedging techniques include forward rate agreement (FRA), interest rate futures contract, interest rate option contract, and interest rate swap agreement.
• Total saving over the 6 month period = R10 million x (9.5% - 9%) x 6/12 = R250,000.
• Forward rate agreement (FRA) is a contract where the rate of interest which will apply on the future date is fixed in terms of the agreement.
• Forward rate agreements are traded over the counter and the agreement is binding, meaning both parties must deliver even if the underlying transaction falls through.
• The forward rate fixed in terms of the contract is 9% per annum.
• On cash settlement date (1 October 20X6), Quicksand Ltd will receive a cash settlement of R23,866 from the bank.
• Upon entering into the loan agreement on 1 October 20X6, Quicksand Ltd will then fix the interest rate at 9.5% for the duration of the loan.
• Quicksand Ltd has effectively hedged the interest rate risk it was exposed to before entering into the loan agreement.
• The loan amount on 1 October 20X6 will consequently decrease to R9,976,134 (R10 million - R23,866).
• Quicksand Ltd decides to hedge themselves against increasing interest rates by entering into a 6 month forward rate agreement today (1 July 20X6) for a period of 6 months starting on 1 October 20X6 and ending on 31 March 20X7.
• Quicksand Ltd would have to pay an interest rate of 9.5% if no FRA.
• Quicksand Ltd needs to borrow R10 million in 3 months’ time from a local bank.
• Internal hedging techniques include matching the term and duration of floating rate debt and floating rate investments as far as possible, maintaining a mix of floating rate and fixed rate debt, and pooling cash surpluses within a group to offset cash shortages.
• Quicksand Ltd is concerned that interest rates will increase and this would have a negative impact on borrowing costs in the future.
• They will, therefore, swap cash flows (but not legal obligations with the bank) in terms of the underlying borrowings.
• The option is only worthwhile if the cash settlement from the option writer exceeds the premium paid.
• Grayston Ltd currently has a long-term borrowing with a fixed interest rate of 12%.
• Grayston can borrow directly from their bank at a variable rate of 10.5%.